If you're looking for exposure to 5G, you should probably add LM Ericsson (ERIC 0.00%) to your watchlist. Despite the coronavirus-induced uncertainties, the Swedish telecom vendor maintained its 2020 and 2022 goals thanks to the strength of its 5G portfolio. The stock doesn't represent a bargain, though. But patient investors should wait for next-quarter earnings as the market may not welcome some short-term headwinds.
Improving margins thanks to 5G
First-quarter results confirmed the importance of 5G for Ericsson. Revenue increased by 2% -- but down 2% at constant currency -- to $4.93 billion (converted to U.S. dollars from Swedish Kronas using a $1 to 10.1 SEK exchange rate on April 23).
That weak result was driven by the 6% revenue drop to $720 million in the company's digital services segment (solutions and services for telecommunication providers). In addition to some delayed installations because of the coronavirus pandemic, reduced sales of services and legacy hardware had a negative impact on that segment.
In contrast, Ericsson's largest segment by far in terms of revenue, Networks, increased by 5% to $3.47 billion. That segment, which includes hardware, software, and services for telecommunication providers to build their mobile networks, grew thanks to the company's 5G portfolio.
Ericsson's flattish top line derives from management's decision to exit some low-margin contracts. And thanks to the boost from a favorable mix of software sales this quarter, the company's gross margin improved from 38.5% one year ago to 40.4%. In consequence, the adjusted operating margin jumped to 9.3%, up from 7.2% last year.
Since management expects the impact of the coronavirus outbreak to remain limited, it confirmed the 2020 and 2022 goals it had announced at the end of 2018.
Revenue should increase in the range of $22.80 billion to $23.79 billion this year, and adjusted operating margin should exceed 12% by 2022. The company didn't communicate its 2022 revenue forecast, but it seems reasonable to assume that revenue will match the estimated 2% to 3% annual compound growth of its market.
Taking into account the midpoint of that revenue growth and an adjusted operating margin of 12%, adjusted operating profits would reach $2.91 billion by 2022.
Ericsson's market capitalization corresponds to 9.6 times these estimated profits. Given the company's low, single-digit revenue growth, and keeping in mind adjusted operating profits exclude taxes and one-time expenses, that market valuation seems fair. Yet it doesn't represent a bargain.
Short-term headwinds may lead to an investment opportunity
However, next-quarter earnings may involve downwards pressure on Ericsson's stock price. Even if management maintained its medium-term goals, it expects a challenging second quarter that could have a negative impact on revenue and margins for a couple of reasons, in addition to the coronavirus-induced uncertainties.
First, during the earnings call, CEO Borje Ekholm said: "We see a number of strategic contracts falling in Q2 instead of being evenly spread out over the year." A strategic contract is a nicer way to say a contract is so important for the company to gain market share and scale that management sacrifices short-term profitability to win this contract against competitors such as Nokia.
In simple words, that means operating margin should drop during the second quarter as Ericsson will honor such contracts. For instance, the company will deploy 5G infrastructure for the giant Chinese telecom operator China Mobile.
Second, management indicated the approved merger between T-Mobile and Sprint will result in spending picking up in the second half of the year, which means it doesn't expect any meaningful revenue from the new giant U.S. telecom provider during the next quarter. In addition, since both telecommunication providers had different outsourcing approaches before the merger, Ericsson anticipates revenue headwinds from some of the managed services it delivers to them.
With its cash and cash equivalents in excess of total debt by $3.81 billion, Ericsson should survive these short-term headwinds -- and even a potentially prolonged recession -- without financial difficulties. Thus, Ericsson's next-quarter headwinds could give investors an opportunity to buy the company's shares and get prudent exposure to 5G at a cheaper price.