Whatever happens, there will always be winners….
Continuing our posts talking about which stocks are well placed to benefit from a post-Covid world, today I’d like to tell you about why large cap Swedish Telecom group Ericsson (which I hold in my personal portfolio) is particularly well placed in the year ahead:
Date: January 28, 2021
Telefonaktiebolaget LM Ericsson (Ericsson) provides infrastructure, services and software to the telecommunication industry and other sectors. The Company’s segments include Networks, IT & Cloud and Media. The Networks segment consists of two business units: Network Products and Network Services. The overall focus is on evolving and managing access networks, including the development of hardware and software for radio access and transport networks.
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Past performance is not a true indicator of future results.
Many telecom companies have been expanding their (5G) networks, which can transfer data up to 100 times faster than 4G networks, over the past year. The growth of 5G could pave the way for breakthroughs across the mobile, Internet of Things (IoT), automation, analytics, and artificial intelligence markets. Ericsson is in my opinion uniquely placed to benefit from the massive investment taking place in 5G infrastructure. Some 65% of the world’s population will have 5G coverage by end-2025, and these new networks will handle 45% of all mobile data traffic. By 2025, the number of 5G subscribers worldwide is expected to hit 2.6 billion, fuelled by a fast-developing ecosystem and strong growth momentum. It is also estimated that the number of Internet of Things (IoT) connections would climb from 1.3 billion by end-2019, to five billion by end-2025, clocking a compound annual growth rate of 25%.
Ericsson’s executive vice president and head of networks, Fredrik Jejdling, said: “In 2020, 5G-compatible devices will enter the volume market, which will scale up 5G adoption. The question is no longer if, but how quickly we can convert use cases into relevant applications for consumers and enterprises. With 4G remaining a strong connectivity enabler in many parts of the world, modernising networks is also key to this technological change we’re going through.”
Ericsson recently projected that there would be 190 million active 5G network subscriptions by the end of this year, with many more to follow in subsequent years. As a result, the global 5G services market could grow at a whopping compound annual growth rate of 43.9% between 2021 and 2027, according to Grand View Research. Investors who want a piece of that action have many stocks to choose from, but only a handful of those companies are at attractive valuations, pay dividends and have significant market share as Ericsson does.
Economic Moat Characteristics
In an earlier post, I described how businesses that prosper over the longer term often enjoy Economic Moat Characteristics and I believe Ericsson enjoys this rare type of durable competitive advantage. The company controlled 14% of the world’s telecom equipment market last year, according to Dell’Oro Group, putting it in third place behind Huawei’s 27% share and Nokia’s 16% share. Ericsson is arguably in the strongest position of the top three players according to many industry sources (e.g. from Vodafone, BT et al and illustrated by its continued strong sales into China). Huawei faces blacklists and sanctions. Nokia is dealing with sluggish network upgrades, tough competition in China, and a recent CEO change. Ericsson isn’t struggling with any management issues, is growing faster than Nokia in China, and it’s already signed 112 commercial 5G agreements or contracts with unique operators worldwide.
Looking at Ericsson versus their US competitors in terms of earnings forecasts and valuations, it’s clear that the company stands out. Furthermore, I believe the analysts’ forecasts below may prove too conservative, judging by their recent results, which clearly show an incredible win rate relative to other players. Nevertheless, all three companies are expected to generate solid revenue and earnings growth next year as the 5G market expands. All three stocks are also reasonably valued relative to those near-term forecasts, but Ericsson looks the cheapest even though it has the best growth prospects :
Source: Yahoo Finance
Why Infrastructure is the Better Way to Play the 5G Theme
Telecoms operators seem the obvious beneficiaries of investing in 5G. These companies supply mobile services to customers and therefore stand to benefit directly by adopting the technology so they can sell more. Telcos that win the race in providing 5G may gain subscribers over their competitors. Such stocks could rise if this competitive advantage translates into profit. But in my opinion, there is much uncertainty and we won’t know for years whether 5G actually delivers as it’s supposed to nor will we know which mobile operator actually outperforms.
Another way to profit from 5G is to invest in the infrastructure companies themselves which is where Ericsson sits. They are getting paid now to build what is needed regardless of whether it turns out to deliver all the benefits and regardless of which companies benefit the most from usage. Ericsson actually exemplifies the ‘picks and shovels’ investment approach that I explained in an earlier article
This investment case is further strengthened by the exclusion of market leader Huawei from bidding on contracts in the West, which clearly hugely boosts the next strongest player (i.e. Ericsson’s) prospects. Ericsson has been a massive loser in share price terms over the long term as it lost out in the mobile wars at the end of the last decade but its renowned hardware tech is now at the right place at the right time to drive growth, boosted by its largest competitor having been excluded.
Returns may increase or decrease as a result of currency fluctuations.
Past performance is not a true indicator of future results.
Ericsson’s recent results were absolutely stellar and far ahead of analyst forecasts. The third quarter 2020 results mean the company is back to its highest profitability rating since 2006. The gross margin — a broad measure of profitability — came in at 43.2 per cent, its highest level since 2006 and compared with analyst forecasts for 39.4 per cent.
The company has now won 112 5G contracts, up from 99 at the end of the second quarter, as more telecoms operators build next-generation networks and U.S.
diplomatic pressure pushes out market leader Huawei from more countries.
Unlike Nordic rival Nokia, Ericsson has continued to win contracts from all three major operators even in China to supply radio equipment for 5G networks. But relations with China could become more fraught after Swedish authorities shut China’s Huawei and ZTE out of its 5G network, citing security concerns. “The 5G roll out in China was the big driver in this quarter,” Ericsson finance chief Carl Mellander said.
The impetus to build this new 5G network is so strong that the company has not been adversely impacted by Covid and there is every sign that this will continue to be the case whatever the shape of Post-Covid recovery. “While the pandemic has hurt revenues for several of our customers, and in some cases this has led to a reduction of capex (capital spending), we have not seen any negative impact on our business, largely due to footprint gains,” Chief Executive Borje Ekholm said in a statement.
Ekholm has driven a turnaround at Ericsson during his three years at the helm, improving margins amid growing demand for 5G equipment. Third-quarter gains came mainly from the Networks division, which reported an adjusted operating margin of 22.7%, well above the forecast of 17.8%, Liberum analyst Janardan Menon said. Adjusted operating earnings rose to 9.0 billion Swedish crowns ($1.0 billion) from 6.5 billion a year earlier, beating analysts’ mean forecast of 6.98 billion crowns, according to Refinitiv estimates.
Ericsson still trades at a paltry 16x earnings this year for a business with very attractive growth prospects and almost unrivalled competitive positioning. Multiple expansion seems very likely as the transformation of the business and new orders continue to come through. In fact the company has further raised its global forecast for 5G mobile subscriptions to 220 million by the end of this year, citing faster than expected uptake in China. The telecoms equipment maker, which had previously forecast 190 million subscriptions, said it expects China to account for almost 80% of the newly forecast total. “What has fuelled the growth is clearly China, and that is driven in itself by a strong strategic national focus on 5G in China,” Head of Networks Fredrik Jejdling told Reuters. Ericsson is currently winning contracts even in China and this could well continue.
All indications are that 5G is seen as essential to the growth of using data both for communication and for newer internet of things applications. The mobile network industry has faced waning demand for 4G and older network equipment, but 5G spending in North America and elsewhere has helped to fuel a return to growth. Ericsson sits at the forefront of providing the infrastructure to make all these new applications happen. Ericsson said in its biannual Mobility Report that 2020 had seen society take a “big leap towards digitalization”, as the pandemic acted as a catalyst for rapid change and highlighted the impact connectivity has on peoples’ daily lives. About 15% of the world’s population, or 1 billion people, are expected to be in an area that would be covered by 5G by the end of the year, said Jejdling. The company forecast 3.5 billion 5G subscriptions by the end of 2026, accounting for more than 50% of mobile data traffic, and with four out of every 10 mobile subscriptions being 5G.
To be one of the top three players building infrastructure to allow for these 3.5 billion 5G subscribers by 2026 will mean earnings could at least quadruple with obvious implications for the share price.
Risk are Mainly Focused on China Relations
China is still highly dependent on American technologies. In the past, many American companies signed joint venture agreements with Chinese companies to enter the market. The U.S. claims those deals forced some American companies to transfer their IP to their Chinese partners.
To curb their long-term dependence on American suppliers, many Chinese tech companies ramped up their development of homegrown components. Some of these companies, including Huawei, are led by people with close ties to the Chinese government. Chinese chip makers have already launched their own CPUs, mobile chipsets, memory chips, and other core components in recent years. These chips generally aren’t as powerful as their American counterparts yet, but the gap is narrowing in several key sectors. The risk remains that China becomes more self reliant in terms of technology and worsening trade relations could even mean that Western operators like Ericsson suffer supply chain disruptions trying to source components from China.
The exclusion of Huawei has been a major boost for Ericsson but there are political risks of retaliation and reversal here. It’s important to remember that Huawei led the sector last year with a 27% share, according to Dell’Oro Group. Not only is Huawei a leader in helping wireless carriers roll out 5G networks worldwide, it’s also one of the world’s top producers of 5G phones. The U.S. claims Huawei’s 5G ambitions and its alleged ties to the Chinese government represent national security threats, since China could gain access to protected networks and personal data. That’s why it’s trying to hamper Huawei’s progress with its inclusion in a trade blacklist, which prohibits American companies (or any company using American technologies) from selling products to the Chinese tech giant. Huawei has repeatedly declared that it’s a private company and that “no third parties,” including the Chinese government, hold any shares. Any softening of the political stance towards Huawei competing for business abroad could dent Ericsson’s growth prospects. Equally, the Chinese government could retaliate and lock Western operators like Ericsson out of the Chinese market, again removing one growth market for Ericsson.
This battle will affect investors in a number of ways. First, Huawei’s two biggest rivals in the telecommunications equipment market - Ericsson and Nokia - could pick up more 5G contracts if more countries follow America’s lead and replace Huawei’s equipment. We have already seen this happening for Ericsson in the UK and elsewhere. However, those gains could be offset by the loss of contracts in China, as seen in Nokia’s loss of China Mobile’s 5G contract earlier this year.
Disclaimer: This information does not constitute any form of advice or recommendation by Pynk One Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision.
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