Here's the Sanford Bernstein report that has caused the sharp sell-off in Ericsson's stock today. I mostly post on the Nokia board and I invite anyone here to join me over there to discuss it because the argument there includes more people. Here it is:
* Based on interviews with numerous European contacts, we believe 3G infrastructure deployments will a) start later, b) be smaller, c) involve more vendors, and d) reduce vendor margins more than most investors currently assume. As a result, we believe Ericsson may deliver infrastructure results considerably below consensus expectations for 2001. Furthermore, we do not believe Ericsson will achieve hoped for improvements in its money losing handset division, adding to the drag on performance. We are reducing 2001 EPS from SEK 2.76 to 2.49 ($0.28 vs. $0.38 consensus). As a result, we are downgrading Ericsson from Market Perform to Underperform and setting a target price of $13, which is 45 times our 2001 EPS estimate.
* Based on comments from Ericsson, Nokia and several service providers, we do not expect vendors to begin recognizing revenues from 3G installations until at least 2H01. With the 6 month delay in GPRS as an example, there is asignificant risk that realization of these revenues may not begin until 4Q01 or even 2002. As most carriers will complete major voice capacity expansions by year-end 2000 - 2000 wireless spending grew 35%+ YoY - Ericsson may face relatively weak sales vs. tough compares in 1H01.
* 3G deployments may not be as extensive or as costly as originally assumed. Carriers are expected to implement 3G networks only in high-traffic areas, choosing to use much less costly 2.5G technologies for the majority of
geographic coverage. Given the limitations of a handheld platform, a hybrid solution will deliver equivalent user services at less than half the cost of a full 3G implementation. Overall, we believe that initial 3G equipment spending will be less than $60 billion through year-end 2002, considerably below industry estimates of better than $100 billion. To wit: BT CellNet this week
reported a capital budget of $2.1 to $2.8 billion per year through March 2003, considerably lower than previous annual spending projections of more than $4 billion.
* Given extraordinary license fees and tough competition, carriers are making timely deployment the most important consideration in awarding vendor contracts. While Ericsson is enjoying a strong winning streak early on, we believe carriers will turn to secondary vendors if a primary supplier cannot keep to schedule. Ericsson, which does not have a reputation for strong manufacturing or logistics, has a history of long delivery intervals in busy times. This could result in lost orders and is a strong obstacle to Ericsson meeting its goal of delivering 40% of industry 3G orders.
* We also expect a margin squeeze once 3G revenues begin to materialize. Pricing for new 3G contracts is significantly more competitive than the network expansion orders fueling strong 2000 sales. Furthermore, Ericsson must absorb
significant ramp up costs in introducing a new technology. We project operating margin declines of 300-500 bp on infrastructure sales by 2002.
* We have commented on Ericsson's poor performance in handsets many times. We do not believe that Ericsson's strategy of outsourcing design and manufacturing to Asian OEMs will stem the tide of losses and market share declines.
Investment Conclusion
We believe Ericsson will fail to meet consensus expectations for revenue and profitability in both wireless infrastructure and handsets. Our 2001 EPS projection of SEK 2.49, reduced from 2.76, is more than 25% below consensus.
As a result, we are downgrading Ericsson, which trades at a rich 74 times 2000 earnings, from Market Perform to Underperform. We have set a target of $13, which is 45 times our 2001 estimate.
Details
To date, wireless service providers have pledged nearly $100 billion worldwide in exchange for licenses to offer 3G (third generation) wireless services in recently cleared swaths of high quality spectrum. When the auctions and beauty contests are done, vendors selected, technologies tested, designs completed, and equipment deployed, we expect more than 80 new 3G networks begin service by
2003. Eyeing this apparent bonanza, investors have clung to wireless infrastructure leader Ericsson as the surest way to participate in the next gold rush. We are not so sure this is a good idea. We believe investors may have to wait until mid to late 2001 to begin to see 3G spending show up in equipment providers quarterly results. Meanwhile,
lucrative 2G capacity expansion projects will be complete by the end of 2000. We also fear that actual 3G deployments will be limited to densely traveled geographies, resulting in lower overall spending levels than many are assuming.
Moreover, we are concerned that the confluence of so many network deployments, albeit smaller than expected deployments, will create a significant premium for rapid delivery and installation - favoring a fragmentation of market share rather than further concentration. Finally, we
believe competition for orders, combined with the costs of testing and ramping production of a radically new product will compress vendor margins. As a result, we project industry revenues for wireless infrastructure will actually decelerate from 35% in 2000 to less than 30% growth in 2001 and 2002. At the same time, we believe industry leader Ericsson will experience difficulties achieving aggressive market share targets and could also suffer significant margin deterioration in its core business. On top of this, we believe Ericsson's handset division, which still accounts for 20% of sales, is unlikely to return to profitability or sustain double digit market share. Given this perspective, we are downgrading Ericsson from market perform to under perform and setting a price target of $13. 3G Infrastructure Revenues At Least a Year Away Although more than 25 3G spectrum licenses have already been awarded world-wide, actual revenues from 3G contracts outside of Japan will not begin before 3Q01 and could be delayed even further. The leading vendors have not yet finalized their equipment designs and will not complete testing for several months. Elements of the W-CDMA standard are still subject to change and a major patent dispute with Qualcomm has not yet been resolved. Handsets are unlikely to be available before 2002. Finally, installation personnel must be recruited and trained and manufacturing must ramp to full capacity. Equipment providers agree that all of these items will take time to resolve and could be subject to delays, potentially considerable delays if GPRS is any guide. GPRS technology, which is considerably less complicated to deploy than W-CDMA, has seen delays of 6 months or more. Indeed, late changes to the GPRS standard mean BTCellNet and T-Mobil must upgrade their early-bird implementations to comply with the standard. Most carriers will not begin commercial GPRS service until year-end. As a result, we believe that infrastructure vendors are unlikely to see 3G revenues until the second half of 2001, at the earliest. Moreover, incremental revenues from on-going GPRS deployments are unlikely to be sufficient to offset reduced spending on 2G capacity expansions in the first half of the year, creating the potential for poor year over year infrastructure growth in the first two quarters of 2001. Any delay in implementation would extend this pain by a quarter or more. No 3G in the Suburbs, Much Less the Countryside Even if the 3G build-out begins on time, we believe many observers may have over-estimated the scale and scope of deployment. While some countries which
have awarded 3G licenses based on a so-called "beauty contest" have required nationwide build-outs, most countries have included either a vague mandate to cover some percentage of the population or no particular coverage requirement at all. In both cases, we believe carriers will restrict 3G deployment to densely traveled business corridors, preferring to use GPRS and/or EDGE to
provide geographic coverage outside city centers.
This choice is pure economics. Because of its spectral efficiency, 3G can handle a great density of data and voice calls without requiring costly cell splitting and othe techniques to eke out capacity. Meanwhile, in the outlying
areas where there is no issue with capacity, the relatively modest cost of GPRS and EDGE upgrades will provide acceptable support for all expected data applications. Indeed, power requirements will make speeds faster than the EDGE maximum of 384kbps impractical in a handheld device for the next 5 years, rendering 3G claims of multi-megabit bandwidth moot for mobile applications. Software can manage a seamless integration, so that users will be able to roam
without any perceived loss of service. While the cost of a full 3G geographic deployment would easily run into
multiple billions of dollars for a country the size of the UK or Germany, a hybrid approach could keep the capital outlay to $1 billion or so, much less in a smaller market. This has two major implications: 1. Total spending growth
is likely to be more modest than many expect, and 2. Carriers will expect a tight integration with 2.5G technologies GPRS and EDGE. We are projecting 3G
infrastructure deployments to account for almost $60 billion in revenues for equipment makers spread before the end of 2002. This is far short of the $100 billion plus bonanza predicted in many quarters. For example, British
Telecom's wireless unit is now reporting that its capital spending will average $2.1 to $2.8 billion per year through March 2003, considerably short of previous estimates of more than $4 billion in annual spending.
Deceleration in Infrastructure Spending Growth
Instead of an industry bonanza, we project that 2001 wireless infrastructure spending will show a modest deceleration to 29% growth from 2000's 35% growth.
Global spending on voice capacity expansion will decline versus difficult compares. 3G spending will not kick in until the second half and even then may be disappointing to bulls that are expecting a major windfall. Spending on
2.5G technologies like GPRS will not make up the difference, particularly in the first half of the year, when we expect carriers to conserve as much capital
as possible. While we expect 2002 global wireless spending growth to sustain 2001 levels, it should decelerate sharply thereafter.
Importance of Rapid Deployment Opens Opportunity for Second and Third Suppliers
The key decision criteria for carriers choosing a 3G equipment provider is delivery. About 80 different operators will be deploying 3G networks in the same 18-month period, with 3 to 6 networks in each country. This will put enormous pressure on the leading infrastructure vendors Ericsson and Nokia to deliver and implement networks on schedule. Our research suggests that carriers will not hesitate to shift business to a secondary or even tertiary supplier if the primary vendor starts to fall behind schedule. We are particularly concerned about Ericsson, as its promise to capture 40% of world-wide 3G deployments appears unattainable, given a history of long
delivery intervals during busy times. We suspect Ericsson will take care of its biggest customers, but Orange and One-to-One will not sit and wait while Vodaphone takes regular monthly base-station deliveries. We do not have faith
that Ericsson can make sufficient improvement in their manufacturing and logistics to avoid losing business. As a result, we look for second tier suppliers like Lucent, Nortel and Motorola to pick up incremental business later in the deployment process. Moreover, we believe Nokia, which has won the most GPRS awards and is the dominant player with the newer GSM1800 operators, may be better positioned and better capable than Ericsson to deliver on 3G contracts. Nokia has demonstrated superior manufacturing and logistics skills, necessary to contemplate share gain in a market where delivery lead times are so critical.
New Network Builds Mean Lower Margins
Competition for new contract awards have insured that network build-outs have always carried lower margins than capacity expansion orders - somewhat following the razor and razor blade analogy. 3G network build-outs are likely
to follow the same pattern. While carriers may pay a premium for an accelerated deployment, this is likely to be offset by the costs of ramping production on a new technology. As such, there is a strong likelihood of
margin pressure as 3G infrastructure revenues become a significant part of industry revenues. We believe Ericsson's operating margins on wireless infrastructure will fall 300 to 500bp by 2002 as a result of this phenomenon.
Ericsson's Handset Business: Past the Event Horizon
Ericsson's handset business is losing 20% on every unit it sells. Its market share has dropped from 13.5% in 1998 to 10% in 2000. It is reducing its product line at a time when its competitors are making even finer distinctions in market segments and carriers are demanding increasingly customized products. It is outsourcing both the design and manufacture of its low-end and mid-range phones to a variety of Asian OEMs at a time when its brand is already
deteriorating and the need to engender customer loyalty vis a vis handset upgrades is increasing. It has expressed a willingness to accept pain from this business, which is still 20% of revenues, for the foreseeable future, in
order to support sales of its infrastructure. We do not expect Ericsson to achieve its goals of profitability by 2Q01 or to sustain its market share, and believe that this unit will be a significant drain on earnings in the future.
Risks
The key risks to our perspective are three-fold. First, our conclusion that 3G deployment will not spread outside of densely traveled geographies could be over-conservative if user demand for yet unforeseen high-speed applications
emerges more quickly and strongly than we have anticipated. We do not believe this is a likely scenario, as no killer application for such high speed is apparent and handset power limitations will remain a gating factor for several
years. Nonetheless, this would result in increased spending in 2002, adding as much as SEK 0.60 to Ericsson's projected 2002 EPS of SEK 3.37.
Second, our conclusion that market leader Ericsson will have difficulty meeting its goal of 40% share of global 3G deployments could be overly pessimistic. If Ericsson were to add 10 percentage points to its current 27% share of world wireless infrastructure sales over the next two years, it would increase its 2002 EPS by over 30% or SEK 1.10.
Third, our view that 3G contracts will result in reduced margins could be overstated if delivery and performance requirements prove difficult obstacles for second tier vendors. If Ericsson could sustain current operating margins
in its infrastructure business, it would increase its 2002 EPS by 23% or SEK 0.85.
Investment Conclusions
We believe Ericsson remains a considerable risk. Expectations are running very high, as evidenced by Ericsson's P/E of 74 times 2000 earnings. Curiously,
investors appear to have chosen to ignore Ericsson's hopeless handset business, still 20% of sales and losing 20% on operations, in favor of the industry leading infrastructure business. We believe Ericsson's handset business could yield a sufficient downside surprise to miss any quarter. As we believe industry infrastructure revenues may not be as strong as many suggest and that Ericsson may not meet its goals for market share advances, our 2001 EPS
estimate of SEK 2.49 or $0.28 is more than 25% lower than consensus. As a result, we are downgrading Ericsson from market perform to under perform and setting a target of $13 despite possible near-term upside from 3G contract
announcements. |
