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Ericsson (NASDAQ:ERIC)
Q2 2018 Earnings Conference Call
July 18, 2018, 8:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Welcome to Ericsson's analyst and media conference call for their second-quarter report. To view visual aids to this call, please log on to www.ericsson.com/press or www.ericsson.com/investors. Ladies and gentlemen, when you would like to ask a question please press 01 on your push button phone. If you would like to decline from the polling process please press 02. As a reminder, replay will be available one hour after today's conference. Peter Nyquist will now open the call.

Peter Nyquist -- Vice President Investor Relations

Thank you, operator, and hello everyone and welcome to this second call for the day. With me here today I have our CEO, Borje Ekholm, and our CFO Carl Mellander. During this call today, we will be making forward-looking statements. These statements are based on current expectation and certain planning assumptions, which are subject to risks and uncertainties. The actual result may differ materially due to factors mentioned in today's press release and discussed in this conference call. We encourage you all to read about these risks and uncertainties in our earnings report as well as in our annual report. With that said, I would like to hand it over to you, Borje.

Borje Ekholm -- Chief Executive Officer

Thank you, Peter. Welcome to our presentation of the second quarter and thanks everyone for joining. Last year, we defined a new focus strategy in order to turn our company around. We relied on three strategic pillars. The first one is to increase investments in R&D to secure technology leadership and to provide leading solutions to our customers but also to leverage technology to improve the competitiveness of our product. So basically, investing in R&D to improve gross margin.

For the second, was to obtain a competitive cost position in G&A, but more importantly, service delivery by simplifying and taking costs out. And that would also drive gross margin but also structural costs. And the third is to improve our competitiveness and based on the improved competitiveness we could selectively strengthen our market position. Our ambition was to establish a satisfactory profitability level assuming flat revenues. So basically, we wanted to improve our business in a flat to falling market by controlling what we can --basically our costs. This would allow us to have a competitive cost structure that once we see growth returning in the industry, we would be in a very good position.

It's been tons of hard work in the company but it is rewarding to see that hard work now paying off and we see good progress in turning around the performance and it's visible in the second quarter following a good first quarter as well. We also see an increasing momentum in the business and now we see networks returning to growth for the first time in some time. So I would say a lot of work remains but we feel traction is very good.

So at the capital markets last year we put a target for 2020 of reaching an operating margin of 10%. We see that we're tracking well toward this objective with the execution we've done on our strategy the first half-year this year. We continue to invest in technology leadership. We have hired more than 2,500 engineers over the last year and that we do to improve our cost position in what I would call a 4G portfolio but also lead the way into 5G. We have achieved the cost out objective we set last year of 10 billion run rates. Of course, we may have reached this objective and we have finalized that program we've had in place, but the work on the cost side never ends. We will not have any more programs but we will work with continuous improvements in the business.

And we continue to invest in capture in selective market opportunities where we have a competitive advantage. We know that pursuing these type of opportunities can and will have some short-term costs but they are long-term attractive, so we will capture those but having a very strong discipline and a strong focus on the operating profit level -- although it may impact lines above operating profit. We see traffic demand in the networks continue to grow very strongly on the global basis, basically doubling every 18 to 24 months.

And we see now operators investing again in order to provide a user experience to their end user and at the same time manage costs. We see this can only be done really through the use of technology. We also see the 5G discussion is heating up, the standard has accelerated more than a year and operators are increasing their preparing to invest in the network and preparing for 5G. We see the first business case for 5G being in-house mobile broadband but the interest for fixed wireless access is heating up globally as well.

We see that operators are increasingly wanting to install 5G ready hardware and of course, they do that for the same reason of not having to [inaudible] out as you upgrade to 5G. And here we are; our ERS portfolio is really only a software upgrade away from carrying 5G traffic. So based on the progress and the visibility we have, we feel comfortable that we're on track to achieving our long-term objective of 12% operating margin beyond 2020.

Our top line has also started to flatten out with a decline of only about 1%. The reason for the decline is really the strategic priority to exit some parts of our business and contracts. In addition, we are now seeing networks actually returning to growth in the quarter on the back of a more competitive cost structure. Gross margin has continued to improve as a result of cost out and increase the ERS penetration. Operating income still not where we want it to be of 2020 but it's a clear improvement compared to last year as well as the first quarter. Our focus on free cash flow continues and it has also improved compared to last year. We're now only slightly negative and that's primarily a result of the acquisition in emerging business but also less sale or trade receivables in the quarter.

Overall, we have achieved savings in excess of our target of [inaudible] billion. The full effect toward the actions will not be fully be [inaudible] in the PNL until the second half of this year. We have achieved structure and run rate savings in GNA of 2.7 billion by the end of Q2. [Inaudible] in the PNL. In service delivery, we have reduced costs in excess of 8 billion on a run rate basis. We see this in an improving gross margin in all segments for basically a total uplift of 300 basis points in gross margin during the second quarter. So while we have achieved the 10 billion target, we see new opportunities to continue to improve our efficiency and we estimate the restructuring costs, therefore, to remain as five to seven billion for the full year even though we only used three billion in the first half of the year to complete the 10 billion target.

Our service delivery was clearly not cost competitive before but following the changes in ways of working as well as simplification and delayering, we have now a much more competitive cost position. With the changes we have done it's not only lowering our cost position -- or improving our cost position, it's making us much more flexible and more agile as well, which allows us to respond quickly to customer needs. So, unfortunately, we have had to reduce our workforce by a gross of 23,000 and net 20,500 after hiring 2,500 engineers in R&D. this has clearly put a lot of stress on the organization. The hard part may not be to take out this amount of cost; it's really to do that while protecting the top line. And I would say here we see that we've made good progress during the last year and the first and second quarter.

Of course, the focus on the total workforce -- and that's the only way to track the full costs -- so it's again, that's why we're tracking total workforce. We see a reduction in total workforce in the second quarter of this year as well. And that is net after having increased our headcount following some new contracts we have taken both in [inaudible] services as well as other parts of the business. In short, as a result of this reduction in cost, we clearly have a much more competitive cost position than we had a year ago. We see good growth in North America and that's really on the back of our customers getting ready for 5G and actually preparing the network. In China, [inaudible] investments have continued to fall, which has impacted the Northeast Asia market area.

Overall, in Europe, we see good growth but it's offset by some declines in certain markets as well as exited contracts, which is why you'll see a slight decline in sales in market area Europe or Latin America. In the Middle East and Africa, we had a slight decline due to some countries with monetary restrictions. In Southeast Asia, the decline was more related to timing or contract. So we continue to execute on our focus strategy, putting us comfortably on track toward the target for 2020. In networks, we see the penetration of ERS continue to increase and is now 84%. We've also taken out significant costs in service delivery. And we have increased our investments in R&D to strengthen our cost position but also to prepare for 5G.

Losses are reduced sequentially in digital services. But we clearly have more to do. We have seen cost efficiency gains in service delivery and we're also changing the ways of working in R&D, resulting in some improvement on R&D spent. In parallel with these cost activities, we're also increasing our investments in 5G ready and cloud-ready products. Many services achieve the second quarter of positive operating income. This is clearly on the back of cost out but also contract reviews. There were also some one-time positive effects in the second quarter but here we see a much more competitive offering in the market as well and we continue to increase our investments in automation and machine learning and we see some very important selective customer winds happening right now.

In our other business, operating income is still negative and is negatively affected by the media business to the tune of about 0.4 billion kronor. We continue to invest in selective new technologies in this area like IOT where we see very good growth. But it's also quite clear from the performance that the revenues are not yet covering costs but we would also say that we see good progress in our offering. So with that, I am going to give the word over to you, Carl.

Carl Mellander -- Chief Financial Officer

Thank you, Borje. Excellent. And a good morning, good afternoon everybody. So let's look maybe more a bit more in detail at the numbers per segment to start with. And then we look at networks and then [inaudible] back to growth, 2% in the quarter. Last time we had growth in this segment was in Q4 2015. So that growth has also come with improved margins and as you can see, gross margin over 40% here or 400 basis points improvement year-over-year. And this is really related to a structurally lower cost base around the service delivery piece as well as the hardware, Ericsson radio system.

So good momentum here in North America but also places as Borje was talking about and some very good market traction and growth in the portfolio with a strong margin improvement there in networks. Digital services have improved margins substantially, still reporting a loss of 1.5 billion but the direction is good and it's encouraging to see that we have been able to reduce the losses in this quarter. I want to mention that the proportion of large transformation contracts actually did increase in the quarter as we anticipated when we reported on the Q1 results and this weighs on the margin.

But there are effects in the other direction as well offsetting this. That has to do with further cost reductions mainly but also stronger software margins in this business. The topline decrease you see here of 12% is coming from the continued decline in the legacy portfolio. And the new portfolio also declines in the quarter but however, that's largely explained by a single contract delay in Northeast Asia where we have a tough comparison with Q2 2017. So encouraging improvements, still 1.5 billion of losses and our job is, of course, to take this number up toward the 2020 target of low single digits profit.

Many services executing on the strategy as Borje mentioned earlier, taking cost out, working through the 42 non-strategic contracts, 33 done to date. But also staying disciplined when it comes to taking new business, new contracts, which is extremely important here as well. And this is working well now with, as you can see, strong margin development in the quarter. I should mention that there are certainly one of here in the margin, about 100 million in one of the effects positive. We have [inaudible] the field service activity in Sweden and we are happy about a new owner taking over this business that can develop it further. So this is also another sign of [inaudible] execution. Emerging business and others collection of different parts, of course by connecting the North American market doing well with a number of portability contracts, which has started now.

When it comes to the future growth areas, we invest selectively in areas which we believe could be the future possible growth area and scalable, including IOT for example. And to mention one example, we have signed a contract with China Mobile, which we announced earlier around the device connectivity platform. And here is of course about being very disciplined when it comes to investment in this area. As you know, we committed to target to break even by 2020 in this total portfolio.

The media side we are accelerating at full speed ahead on the closing the MediaKind transaction. Gross margin area has improved. Borje mentioned that the loss in this quarter from [inaudible] from around 400 million, but we see a steady improvement there in margins. And in the Red Bee media piece, we see positive signs now as we are clear on the keeping this business in Ericsson, that customers actually take more comfort in that and entrust us with their business so we have promising signs there also; for example, the managed OTT platform.

Moving onto the gross margin. This is to say that we see improvements in gross margin across all the segments; all segments are contributing here, which is strong. Also, both hardware, software, and services in our business are all contributing to an improved gross margin. There is also market mix factor here. We should say that. It's a positive market mix this quarter. This can vary over time, of course. One comment here is that the sequential improvement really derived from managed services further improving them and that's [inaudible] the services were stable sequentially. If we move to the cost bridges, R&D continues as planned then, it follows the same path with increased investments in networks while we are reducing some in digital services.

When it comes to SGNA then, saving out of the cost program in the quarter was 0.7 billion Swedish krona and we had a couple of items offsetting this, namely evaluation of customer financing point to and certain other items here amounting in total to half a billion. And this includes also provision increases for valuable compensation compared with 2017 where of course Q2 was a very weak quarter where such provisions were installed. What's not shown on this picture is the third line in OpEx that you have noted now, which follows the IFRS 9, it has to do with impairment of trade receivables and there we have 0.4 billion in Q2 versus 0.2 in Q2 27.

Operating income then, you can see what the big contributors here are and a relevant question to ask here is of course, how are we going from this 4% to the 10% target in 2020 and just to mention some of the building blocks there starting with digital services. If we just for a minute assume that we would take that up to break even, this would be a contribution then on bottom line for Ericsson about three percentage points. This means continued cost out, service delivery, and SGNA, but also efficiency and R&D rates are working. And also factor of mix where software becomes larger in terms of proportion. So that's the digital service side, break-even would contribute three percentage points here.

Then networks, of course, we are continuing with the Ericsson radio system penetration. We are at 84 [inaudible] before and of course, we're going for 100%. But it doesn't stop there because this portfolio will continue to develop of course, and deliver a vector margin over time as well. More service delivery efficiency, better scale, remember that Q2 is of course seasonally low in top line. So there we have another, call it, two percentage points to be gained in our planning.

And then finally, we have emerging business and media there contributing a bit more than two percentage points as well from media improving toward break even. But also the emerging business where will control the portfolio to deliver a breakeven. And that has to do with of course the amount of investment we put into new areas. So all in all, with those improvements and the detailed plans behind, we would have a path toward the 10% operating margin by 2020.

Cash flow was clearly improved from previous year and we've had the number of [inaudible] now in a row where we surpass the year-over-year comparison and the main contributor here is working capital where we see further improvements now in the quarter. The free cash flow then, and you can see the isolated number here, but also important to see the year to date number, 0.3 billion negative, and that can be compared with same period lost here: -4.6 billion, so a clear improvement of more than four billion between the years. The financial position remains strong. Here we feel very confident, a solid cash position. We have also in the quarter find a 5G related loan with a European investment bank to further strengthen the debts find here and the debt maturity profile. It's a five-year maturity. And that is a loan that we haven't drawn down yet; therefore it's not visible here in the graph.

Next slide is around a couple of other financial items that we talk about in the report and in the interest of time, I will not work this through now but we include it here for your future assess but it has to do with a bit of explanation around impairment losses. The final net taxes, pensions, and respect between units that we have done in the quarter. It's all in the report as well. Final word from me around the planning assumptions then and here again I'd like to refer you to the report where this is all detailed. There are no major changes in Q1 here except for one thing. We mention the cost for separation of the media solutions, or now renamed MediaKind business, and that's 0.3 billion to impact in the Q3. With that, thank you for those part and back to you, Borje.

Borje Ekholm -- Chief Executive Officer

So before we head over to Q&A, let's summarize where we are. So we set out on a journey of a focus strategy last year with the objective to turn the company around on a flat revenue base, i.e. not hoping for revenue growth to help us out. We will do this turnaround by investing in R&D to have a competitive portfolio and by taking out significant costs in service delivery and G&A. It's been a lot of hard work by my colleagues in the company, but it is, of course, satisfactory to see that we're executing on this strategy.

We see good improvements in our gross margin indicating a competitive offering and competitive cost situation. We're now adding a second quarter with improved performance to the first quarter including reaching the cost out objective. We will continue to execute on the strategy, investing in technology leadership and at the same time keeping a tight cost control. We know that when we have a more competitive business, we will see new opportunities materialize. We're seeing very strong business momentum in our business and we already now see networks returning to grow in the second quarter. In addition, we see the market increasingly gaining momentum. Operators are needing to invest in capacity to manage the sharply growing data traffic. And we see that this gives many new opportunities, especially with our 5G ready 4G portfolio. So we will use our cost competitive position and competitive product portfolio to selectively grab new opportunities. However, we will always remain disciplined in order to assure overall financial performance. With that, thank you.

Peter Nyquist -- Vice President Investor Relations

Thank you, Borje. Operator, we are ready to start the question and answer session, so, please.

Questions and Answers:

Peter Nyquist -- Vice President Investor Relations

Thank you, Borje. Operator, we are ready to start the question and answer session, so, please.

Operator

Ladies and Gentlemen: at this time, we will begin the question and answer session. If you would like to ask a question, please press 01 on your push button phone. If you would like to decline from the polling process, please press 02. As always, please limit yourself to one question at a time and please keep your question at a broad level. Detailed information is provided in the report and Ericsson's investor relations and media relations team will be happy to take additional questions and discuss further details with you after the call. And our first question comes from the line of Edward Schneider of Charter Equity Research. Please go ahead. Your line is now open.

Edward Schneider -- Charter Equity Research -- Analyst

Thank you very much. Borje, if I could, I'd like to dig into the Ericsson radio system, which seems to have a large positive impact on your operating income. How much more can we expect from this and what has changed that's giving it such an outside impact now? Does 5G lend itself to ERS sales? Is it a redesign that's improved the cost structure of that product? Or are you bundling it with system sales to a greater extent that you had done in the past? I'm just trying to get an idea of how large those factors could be over the next year term.

Borje Ekholm -- Chief Executive Officer

Thanks for the question. No, our ERS platform has a couple of key features. The first one being that it is a very cost competitive platform. It's designed for cost competitiveness. So that means that when we designed it, we actually looked to market demands and put the right features in place to be cost competitive. That's one thing. We continue to invest in DRS platform to bring costs down, launch new upgrades, new solutions that lowers the cost to manufacture the hardware. And lastly, which I think is equally important for the customer decision is that it's actually ready to carry 5G traffic with a software upgrade to the hardware. Of course, if you're in a different frequency boundary will differ.

But for one frequency boundary, you may not even need to go out to the side; you can actually do a complete remote upgrade with software and carry in our traffic. And we see that responding very well with customers, as they don't want to run the risk of having to make multiple site visits and tearing out the infrastructure they have installed. So I would say, we may not yet see 5G revenues from the commercial level, but we see this is a key driver for our business momentum around the DRS.

Edward Schneider -- Charter Equity Research -- Analyst

So why wasn't this a larger factor in 4G? Does it play better in 5G or is it part of your cost or efficiency programs lowered it?

Borje Ekholm -- Chief Executive Officer

It's actually very important in the improvement. So we talked about a 600 basis points improvement compared to Q2 last year. Half of that roughly comes from ERS.

Edward Schneider -- Charter Equity Research -- Analyst

What do you estimate the average impact of the contract renegotiations in managed services are on the gross and operating margin over the last year or so? And will the end of that effort, when you finally get to the end of renegotiation, be the biggest factor in getting you to the 4% to 6% operating margin target or is there something else you should be focusing on for that goal? Thanks.

Borje Ekholm -- Chief Executive Officer

As a matter of fact, if you look at managed services, the biggest contributor to the improvement is actually the changed ways of working within managed services. So the way we actually serve the customer, try to automate more, removing basically labor content. That's more important factor -- or getting efficiencies out is the more important factor in the improvement. Then, of course, the contract renegotiation has added to that. And the run rate of that improvement is about 800 million; I believe we say that in the report. But the key reason is actually ways of working, which I think is important to remember.

Operator

The next question comes from the line of Alex Duval of Goldman Sachs. Please go ahead, your line is now open.

Alex Duval -- Goldman Sachs -- Analyst

Hi everyone and congrats on a strong quarter. Just wanted to ask on a couple of points. Firstly, on the OpEx, which was a little bit higher than expected in the quarter. Seems some of that was due to one-time items but the majority was due to this R&D acceleration as you move toward 5G. The logical consequence of that seems to be that you'll have elevated R&D this year on a full year basis, albeit with those nice gross margins. But is it fair to assume R&D spend could go down next year as you'll already have ramped to lower the investment?

And secondly, when we think about 5G you cited enhanced mobile broadband as being ahead of fixed access as a 5G use case. Can you talk about what's really driving that? Seems you reference cost-effectiveness of delivering data so maybe you could put a bit more detail around that. And can you explain what is really underpinning your confidence in enhanced mobile broadband on 5G? Are you anticipating 5G handsets being released at scale over the next year or so? Many thanks.

Borje Ekholm -- Chief Executive Officer

The way we think about the business is, of course, the investments in R&D for us is, in a way, need to look at the payback over a longer period of time. So we basically see here that we need to have this R&D level for a period here and when we introduce 5G develop all the features for 5G, get ready for the product that ultimately will be launched in the different markets. And here, of course, we are participating in low-band, mid-band, as well as millimeter wave product. So we have in that sense a global opportunity for our products.

Of course, it drives a little bit near-term costs. But when that is going to fade away, I think is too early to tell. But we remain very focused on the operating income and reaching the operating income target for 2020 of 10% operating margins. We really think that if we are to have a higher level of R&D for a period, we need to sustain that with a higher gross margin or gross profit. We don't take that lightly in the sense of saying let's see what happens but we try to run it in a very disciplined way.

What drives enhanced mobile broadband? If you look at the traffic growth, it's basically increasing -- if you would label it in a different way -- eight times until 2023. So if the operators are to not have costs spiral out of control or having to degrade performance in the network, they will need to lower the cost per gigabyte. How is that done? Well, it's done first by adding carriers to a 4G. You get into my [inaudible] get into 5G. So what we have looked at is to look at the costs per gigabit transmitted, and if you look at that, we see 5G can actually lower the cost or can have ten times higher efficiency compared to a pure 4G site.

So we see this as a way to manage the costs and the quality to the end user. So that's why we think 5G is initially a capacity enhancer in metropolitan areas where the network is running short on capacity. Then over time it will evolve into broader coverage and leveraging the capabilities you get in 5G, i.e. higher speed, lower latency, longer battery life, more devices per site, et cetera. The initial use case we believe is actually just to manage the cost in the operator.

After that, we will see the other revenue opportunities. So one of the first will be, we believe, fixed wireless access. That's a clear interest in North America but we see that increasing, gaining momentum, in the rest of the world. And it's really a trade-off, building out fixed line fiber versus on-air broadband. And then here I would say, it has for many operators; it makes sense to build out fixed wireless access, as an access technology for broadband. And we think that actually will be an important area for revenue growth for our customers. So start with enhanced mobile broadband as a cost case, see revenue growth as fixed wireless access.

And after that, we believe, we are going to see the massive scale and critical scale IOT. That's when it will be used where connectivity's really critical first. So smart manufacturing for example. Connecting a factory with no latency and a very reliable and secure communication is going to be critical. We will see it in small shifts, we'll see it in agriculture, et cetera. But we think that's going to be phased into the market.

Handsets we believe will start to come online. You will see other user devices, without going into the details right now, during the year, and then as you go into next year you'll see other normal devices coming on.

Alex Duval -- Goldman Sachs -- Analyst

Just very briefly to understand this point about massive scale IOT. Can you just clarify why 5G would have the advantage versus other connectivity like Wi-Fi?

Borje Ekholm -- Chief Executive Officer

This is a little bit -- it becomes a technical discussion. We think Wi-Fi is one access technology that makes sense in certain applications, but when you need to ensure that you have reliable connectivity, 100% reliability in the connectivity, you have to consider other factors, right? So for example, when we look at our own factory where we have experimented with large-scale deployment of IoT, we see that in a factory of the future you're probably going to have one device per square meter, roughly. And when you have that amount of connectivity, you will run the risk of interference in a Wi-Fi network or [inaudible] in spectrum.

So to reduce that risk, we see that there is a big use case or big application for license spectrum based on 5G and that will basically ensure a more secure connectivity. And when we talk to manufacturing partners, we have, we see that one of their biggest challenges in automating the factories for the future is actually the reliability of the connectivity and they are not trusting Wi-Fi for that.

Operator

Thank you. Our next question comes from the line of Tim Long of BMO Capital Markets. Please go ahead, your line is open.

Tim Long -- BMO Capital Markets -- Analyst

Hi, how are you doing? Thank you. Just wanted to ask about the European market. It's been pretty stable for you guys but obviously, North America's doing a little better here. Talk a little bit about what you're hearing. It seems for most that they're a little bit more measured in general on their approach to 5G. So when you look out the next year or two, is there a risk that that starts to look more like China is looking now? Or are there other dynamics that can keep that market afloat until we get to that 5G ramp phase like you're seeing in North America? Thank you.

Borje Ekholm -- Chief Executive Officer

No, I think the European market -- to put it maybe a little bit bluntly -- the uncertainty in the macro situation in Europe and then I'm talking about spectrum regulation, et cetera. It doesn't create the best investment environment so the discussion in Europe is very much centered on, how do we leverage the investments we have today in the best possible way? Focusing less on 5G, as more on, let's make sure we have the right capacity amount we need right now.

At the same time, that's where we feel that we have an advantage with our product portfolio as it is 5G ready, so the customer that buys our hardware can actually decide at some point in time in the future to switch on 5G with a software upgrade. So they are in a way hedging their bets a bit. But I think the discussion in Europe should focus more on how do we resolve the spectrum situation? How do we let the operators know more how much the spectrum will cost? How do we change regulations or actually create the investment-friendly environment in Europe that we're seeing today?

Operator

Thank you. Our next question comes from the line of Sandeep Deshpande of JP Morgan. Go ahead, your line's now open.

It seems we've lost Sandeep; we're actually going to Pierre Ferragu of New Street Research. Please go ahead, Pierre, your line is open.

Pierre Ferragu -- New Street Research -- Analyst

Thank you. Hi, can you hear me well? So yes, I just wanted to go back on the digital vision where you improved gross margin by like 15 points and very surprisingly you've actually rate or rated this [inaudible] so a second quarter in a row. So I had three quick questions on that gross margin. How much of the provision have you taken a bit more than a year ago [inaudible] margins in that division? So I assume you still have projects of which you do provision a bit more than a year ago that are still running -- do you have any sense of how much of that is left you remember that would be very helpful?

Then my second question is about the comments you make [inaudible] like being able to take down the cost of [inaudible]. I was very curious to hear more about what you've been doing in digital services to achieve that? You can take the cost of head come down, you can improve productivity, and any color you could give on that would be great?

And then my last question would be, if I think about the sustainability of this margin and margin improvements, I'm starting to wonder about your deal pipeline in services because you have a lot of contracts that went wrong where you lost a lot of money and this is being addressed and it's fantastic to see the results. My next thought is; do you have a pipeline of additional contract that are going to come in to replace these revenues? Or do you plan to shrink the size of the service business in digital? That's my third question.

Borje Ekholm -- Chief Executive Officer

So if we start with the last, the strategy is to be more software led, which means that we're prepackaging solutions more, which would ultimately, down the road, reduce the service need. At the same time, we continue to see even as we do that, quite a high service content in the product delivery. So I don't think it's realistic to assume that we will see a dramatically shrinking service content. It will happen, but it will happen very gradually.

If we look at the more recent winds we have, for example, in Packet Core. They are very similar in structure as it has been before, slightly hire software content but it's really, in broad terms, it's very similar. Then on your first question, we, of course, have some large transformation projects where we took provisions last year that are -- we're working through. And those deliveries of this end -- they will move into a profit-generating phase. We're not there yet, but we are working through some of them and we don't go into the details but it has only had a fairly limited impact.

Carl Mellander -- Chief Financial Officer

Maybe I can add just the mechanics of those provisions. So when a loss provision is made, it basically means that the margin of that contract will be feral going forward, so the lossless element eliminated once and for all.

Pierre Ferragu -- New Street Research -- Analyst

Okay, and maybe one last big word on the service [inaudible] platform and how you've mentioned, Borje, in your prepared remarks, that you're very happy with the way you've taken down the cost of [inaudible] services so I was wondering in digital services what you have done so far to get there?

Borje Ekholm -- Chief Executive Officer

What we have done is -- if we want to be a little bit simple in the terms we have created pre-integration centers that we have several of them where we can more do the pre-integration and reuse pre-integration that has allowed us to be much more efficient in the total service delivery costs. So that's changing our cost position structure early and make us much more competitive and actually, that is the key driver behind the reduced loss.

Operator

Our next question comes from the line of Sandeep Deshpande of JP Morgan. Go ahead, your line is now open.

Sandeep Deshpande -- JP Morgan -- Analyst

Hi, my question is a more longer-term one. With regards to mobile broadband and capacity increases, Borje you've talked about that this will be a continuing driver in the future once new bands are added, et cetera. What I'm trying to understand is in 4G we did not see this as a big driver for Ericsson. I mean, this was a promised driver in 2010, 2011, but it never came through for Ericsson in terms of providing the upside.

Why is it, at this point, I mean, is this based on customer feedback and because of respect having use cases that you think is going to happen for 5G when it did not happen to a significant extent in 4G? And my second question is actually a clarification on the previous one. Carl, you mentioned that in terms of the provisions [inaudible] in those contracts where you've taken provisions, are you saying that the losses on those contracts now you report in your number, in the numbers you see are zero and that is part of the provision that once those contracts are restructured then you will start showing the earnings associated with those contracts? Is that how it is accounted for?

Borje Ekholm -- Chief Executive Officer

If we start with the first one, the reality is there is growth in 4G, call it profit margin that actually is a result of the growing traffic. But it's hidden with other technologies reducing at the same time, right? That's why you don't see the benefit. So I would just correct you on that. The second thing is, we see 5G, and what I tried to say is actually the first business case is to solve the cost position on just mobile data.

The next level is when you start to get other type of business cases, whether it is fixed wireless access or call it massive IOT for a moment -- or critical IOT. That will generate new features needed, new capabilities needed in the network, and that is something that will generate extra revenues for the operator then have the potential to generate extra revenues for us. So I think that's our whole business case here. So this is also why we invest in, they call it emerging business in IOT, basically to help our customers define new revenue sources based on connected vehicles, connected everything, basically. I take a little bit the notion that there isn't any growth in the connectivity market. On a global basis, there is growth in the connectivity market. We may not have captured it well enough in the past, but I think we are quite well positioned to in the future.

Carl Mellander -- Chief Financial Officer

Should I take your other question around lost provisions then? Yes, you're correct. When there is a loss estimated for the remainder of a contract we then make a loss provision in the PNL. I mean, it's really based on the full lifetime of that contract. And then, of course, it's our job to try to improve over that but basically deliver on the commitment under the contract. It will stay on [inaudible] margin as long as it follows that estimation. If that improves, for example, of course, the profit will start to generate.

Sandeep Deshpande -- JP Morgan -- Analyst

Sorry, Carl, so does that mean that in terms of your actual losses because you are reporting those losses that you are generating with those contracts today, who are taken in those provisions last year, and so essentially what you're today is zero on those contracts? That helps your margin?

Carl Mellander -- Chief Financial Officer

Exactly. So those contracts where we made a provision, that's correct, exactly.

Operator

Our next question comes from the line of Stefan Slowinski of Exane BNP Paribas. Please go ahead, your line is now open.

Stefan Slowinski -- Exane BNP Paribas -- Analyst

Thanks for taking my question. On digital services, you're still targeting low single-digit operating margin in 2020 and I'm just trying to understand maybe what the trajectory looks like from getting from here to there? You're still doing kind of -17% operating margins there so far this year. And you've talked about maybe addressing half of those 45 contracts by the end of this year. Should we expect a steady transition toward the low single-digit operating margins in 2020 or is this a business that could even break even potentially as early as 2019 with a smaller uplift into 2020?

Carl Mellander -- Chief Financial Officer

Let's put it this way: We put the guidance in place on 2020, we will not provide you any updates to that unless we feel there is a big change, up or down. We're very comfortable with the guidance we've given. Of course, the improvement will not be linear until 2020. So how that exactly is going to look like, we're not going to guide in detail now.

Stefan Slowinski -- Exane BNP Paribas -- Analyst

Okay, but you still expect -- is it half of those contracts to be terminated to addressed by the end of this year? Would those be some of the larger loss-making ones or how should we think about how those will be addressed this year versus next year?

Carl Mellander -- Chief Financial Officer

We have a number of loss-making contracts, primarily in the old industry and society that we're actually trying to work our way out of. So hopefully we'll have done those but we say half of the critical contract being addressed. We don't go into the detail there. But that's kind of the plan we're working. I would rather get those behind me this year, if possible.

Stefan Slowinski -- Exane BNP Paribas -- Analyst

Just a follow-up question on the networks business. It grew 2% in constant currency in Q2. I believe in constant currency it's the first growth you've seen in the networks business since Q3 2014 if I'm not mistaken. And I'm just wondering -- is that business now out of the woods? Should we expect that we've entered into a new growth phase for that business where we should see kind of year-over-year growth for the next X number of years as we go into this [inaudible] spending cycle?

Carl Mellander -- Chief Financial Officer

We are very happy that we have been able on the back of a strong [inaudible] portfolio as well as good cost position started to see that we can take new business opportunities within networks and that's what you see has happen. That's why we get a growth of 2% in the quarter. Clearly, our ambition is to stay ahead on technology. Never fall behind. And therefore we should be able to keep on developing the bi like we do today and that's clearly our ambition. Then I'm not going to give you any other guidance than what we've said on 2020. So the more specific I'm not going to be but we are very comfortable with the business momentum we see in networks and that's really in a way underpinned by good growth in Q2.

Operator

Our last question comes from the line of Tal Liani of Bank of America Merrill Lynch. Please go ahead, your line is now open.

Tal Liani -- Bank of American Merrill Lynch -- Analyst

I have two questions: First one is, could you discuss the impact of currency -- maybe you said it and I didn't hear it -- the impact of currency and foreign exchange on your both revenues and expenses and margins? And second, it's a broader question about the deployment of 5G. When you talk to carriers, where is their mindset right now? Is it mostly consumer broadband so just enhancement of 4G better speeds? Or do you see them taking active actions to develop most of the enterprise market and finding enterprise applications for 5G?

Borje Ekholm -- Chief Executive Officer

If we start with the latter question, the history of mobile broadband has primarily been a consumer market, you're absolutely right on that. We see carriers, though, increasingly focusing on the enterprise market and enterprise applications of 5G. So if you take, for example, in China the development is clearly driven by the enterprise market and the way they think about the enterprise market. But we're seeing that across the world in varying degrees but we see that operators are increasing, they're getting ready to address the enterprise market. We believe that it used to be revenue opportunity for the carriers and that's also when it sort of becomes really relevant with networks licensing for example. That can provide new ways to differentiate service and create new types of business. More needs to be done here. The network's not ready all the way for that. But we will see that happening over the next few years.

Carl Mellander -- Chief Financial Officer

Actually, the year-over-year impact was close to zero. If you look at the sequential impact, the impact on expenses -300 million but positive on the totality, on operating income with around 0.4 billion. That's a sequential impact.

Stefan Slowinski -- Exane BNP Paribas -- Analyst

When you say negative, you mean it's actually positive for margins, right? Is it negative meaning its deduced expenses?

Carl Mellander -- Chief Financial Officer

No, expenses increased due to the [inaudible] but bottom-line 400 million positive all in all, sequentially.

Borje Ekholm -- Chief Executive Officer

I think it's fair to update the rule of thumb: 10% on the US dollar is about 5% and 100 basis points of margin.

Peter Nyquist -- Vice President Investor Relations

Thank you for that question. So we will end this call by a closing remark from Borje.

Borje Ekholm -- Chief Executive Officer

In closing, we defined our focus strategy last year with the ambition to turn the company around on a flat revenue base, so not hoping for a revenue growth, and we will do this by investing in R&D to have a competitive portfolio and grow gross margin thanks to that as well as to take significant costs out of o service delivery and G&A. I would say that the second quarter shows that the strategy's working and that we're executing along those including having reached the cost out target that we set. Now we see good business momentum happening with our very competitive product portfolio but also a competitive cost structure. So we see the market in that sense, in increasingly positive terms and that's the reason why we also saw networks coming back to growth in the quarter. So we're going to continue to be disciplined on the cost side. We will selectively pursue new market opportunities to expand our business but we will do that with a very strong focus on the bottom line to assure overall financial performance and financial help of Ericsson. So with that, thank you.

Operator

This now concludes our conference call. Thank you all for attending. You may now disconnect your lines.

Duration: 60 minutes

Call participants:

Peter Nyquist -- Vice President Investor Relations

Borje Ekholm -- Chief Executive Officer

Carl Mellander -- Chief Financial Officer

Edward Schneider -- Charter Equity Research -- Analyst

Alex Duval -- Goldman Sachs -- Analyst

Tim Long -- BMO Capital Markets -- Analyst

Pierre Ferragu -- New Street Research -- Analyst

Sandeep Deshpande -- JP Morgan -- Analyst

Stefan Slowinski -- Exane BNP Paribas -- Analyst

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