Following better-than-expected fourth-quarter earnings results, Ericsson's (ERIC -1.00%) board of directors plan to propose giving the company's dividend an impressive 33% boost at the annual general meeting in March. More interestingly, given the Swedish telecom specialist's solid balance sheet, low dividend payout, and attractive exposure to the promising 5G network market, that dividend should keep growing over the next several years.
Ericsson had strong Q4 execution
In 2017, Ericsson decided to boost its research and development (R&D) efforts to develop a competitive 5G portfolio and improve its margins. To that end, it increased its R&D spendings from 32 billion Swedish kronur ($3.8 billion) in 2017 to 40 billion kronur ($4.8 billion) in 2020.
That strategy is paying off. During the fourth quarter, revenue increased 5% year over year (or 13% adjusted for comparable units and currency) to $69.6 billion kronur ($8.3 billion), and the company's gross margin improved to 40.6%, up from 36.8% in the prior-year quarter. With strong execution, the operating margin increased to 12.5% in 2020 -- two years ahead of the 2022 target range of 12% to 14%.
Granted, Ericsson certainly benefited from geopolitical tensions that led to the exclusion of Chinese competitors Huawei and ZTE from the U.S. and some other important 5G markets. But during the fourth-quarter earnings call, CEO Borje Ekholm indicated "market share gain in China," where Huawei and ZTE operate, which suggests the company's competitive offerings contributed to those strong results.
In particular, Ericsson seems to outcompete its European peer Nokia. Because of operational challenges, the Finnish telecom vendor announced last year that it will reduce its scope and focus on areas where it can lead instead of proposing end-to-end solutions. That leaves more room for Ericsson to gain scale thanks to its broader portfolio.
Ericsson has a solid balance sheet
Besides the company's strong execution, the rating agency Standard & Poor's upgraded Ericsson's debt in November from speculative to investment grade, with a stable outlook.
Indeed, the company accumulated 41.9 billion kronur ($5.0 billion) in cash and cash equivalents in excess of total debt at the end of last year, compared to 34.5 billion kronur ($4.1 billion) one year before. That amount of cash also covers the company's significant post-employment (pension) liabilities of 37.4 billion kronur ($4.5 billion).
In addition, the proposed increased dividend won't put the company's solid balance sheet at risk. It represents an annual cash outflow of 6.7 billion kronur ($0.8 billion), way below the company's last-year free cash flow of 22.6 billion kronur ($2.7 billion).
Room to increase Ericsson's dividend
Looking forward, the company remains exposed to the secular and spectacular growth of the 5G market. According to the research outfit MarketsandMarkets, the infrastructure 5G market is poised to grow at a compound annual rate of 67.1% by 2027 to $47.8 billion. Taking into account the decline of legacy wireless technologies, management estimates the company's markets should grow in the low-single-digit percentage range over the next couple of years.
Beyond the medium term, it expects revenue growth above 1% and a free cash flow margin in the range of 9% to 12%. Given the company's recent strong performance and expanding 5G market, those ambitions seem conservative.
In any case, based on 2020 revenue of 232.4 billion kronur ($27.6 billion) and assuming the low end of the long-term prudent forecast free cash flow margin of 9%, free cash flow should exceed 21 billion kronur ($2.5 billion) and grow from there, way above the expected dividend cash outflow of 6.7 billion kronur in 2021 ($0.8 billion).
Thus, assuming Ericsson's results match the low end of management's prudent outlook, there's still plenty of room for the company to double its dividend over the long term while sustaining its investments and keeping its balance sheet safe.
For dividend-oriented investors
Following Ericsson's strong performance over the last several quarters, the stock price increased by 60% in one year. It is now trading at a forward price-to-earnings ratio of 15, which seems fair given management's forecast low-single-digit-percentage revenue growth over the long term.
Yet dividend-oriented investors looking for a safe and increasing payout should consider the 5G stock as a solid candidate. The proposed 33% dividend increase will improve the dividend yield from 1.4% to 1.9%, which is becoming attractive considering the potential for larger payouts going forward.