Behind Ericsson's profit warning

Martin Garner and Steven Hartley
17 Oct 2007

Ericsson warned on Tuesday that its Q3 results would be lower than market expectations. Sales are now expected to be SEK 43.5bn (EUR4.8bn), operating income SEK 5.6bn (EUR615m) and a negative cash flow of SEK -1.6bn (-EUR176m). Ericsson's shares fell 29% in early afternoon trading in Stockholm.

There is no doubt that the announcement caught the financial markets by surprise and certainly no concerns were raised at Ericsson's Capital Markets Day last month, suggesting recent events are behind this.

The official reason given for the missed targets was that sales of higher margin mobile network expansions and upgrades were lower than expected, as were equally high margin software sales. The result is that the group's financials have been exposed to lower margin sales in developing markets. Networks sales are down 2% year-on-year and 15% quarter-on-quarter. On a regional level, sales in North America (up 4% year-on-year, down 1% quarter-on-quarter) and Western Europe (up 7% year-on-year, down 1% quarter-on-quarter) were lower than expected. Asia-Pacific also saw relatively flat growth due to lower mobile sales in China.

We spoke to Ericsson this morning and it is clear that they were genuinely caught out by the preliminary financials delivered to senior management yesterday morning. Q3 sales are heavily weighted towards September because of the summer holidays, so when network upgrade and software licence deals with AT&T and Hutchison were delayed Ericsson missed its profitability targets. Ericsson believes that these are not cancelled orders, merely delayed, but in the light of today's news they are being very cautious on when the deals will close and whether they are in for bumper results in Q4.

Furthermore, the results were skewed by higher than expected volumes of lower margin network sales in developing markets, meaning that revenues came in much closer to target than profit.

Ericsson has strongly suggested to us that they do not see the market slowing and that any parallels with Alcatel-Lucent's recent profit warning (see EuroView Daily, 14 September 2007) and reported grumblings about Nokia Siemens Networks' profitability are coincidence.

Ericsson is still in a very strong competitive position. Its major competitors are focusing their energy disproportionately on internal rather than market issues and do not yet benefit from their global scale or geographic scope. Ultimately, the infrastructure market is an extremely tough, cyclical, market that is reliant on difficult to forecast operator capex. For now we have to accept that Ericsson has been caught out.

However, judging by stock activity today investors clearly remain to be convinced, particularly in light of early Q4 guidance forecasting operating margins in the 'mid-teens' (compared to 22.7% in Q4 2006), albeit on flat to 10% sales growth. Ericsson must not get caught out again.

Martin Garner is mobile practice leader at Ovum.

Steven Hartley is a senior analyst focused on analysing the telecoms market for Ovum's EuroView service.

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