Ericsson Warning May Spell Trouble for Other Vendors
Published on: 16th October 2007
LONDON (Dow Jones) -- As with Alcatel-Lucent a short month ago, Ericsson on Tuesday blamed lower spending from operators in North America and Western Europe for a profit warning, suggesting other telecommunication-equipment vendors may be in trouble.
Ericsson Chief Executive Carl-Henric Svanberg said on a conference call that mobile operators in mature markets just weren't upgrading their networks as fast as expected.
"For instance Cingular is going to have to upgrade its network. We know that. But it hasn't happened yet," he said.
Jason Chapman of research group Gartner said network upgrades have come to a near standstill in the U.S. because none of the big operators, such as AT&T, Sprint-Nextel and Verizon Communications, want to jump first, particularly as an increase in data traffic has been too gradual to justify hefty outlays.
"Put yourself in their shoes. They can afford to wait and watch the data-services revenue trends. Why spend a dollar now if you don't absolutely have to? No one wants to be last, but no one wants to be first either," he said.
Lack of spending not limited to the USA
Svanberg said the situation is glum in the UK too, where most upgrade work has been put on hold as several operators discuss network-sharing agreements.
Chapman said there's little doubt the lack of spending witnessed by Ericsson and Alcatel-Lucent is an industry-wide problem.
"I don't think Ericsson's loss is anyone's gain," he said.
Emerging markets take a toll
The sharp decline in Ericsson's operating margin, which sank to 12.9% from 21.2% a year earlier, took investors by surprise. Shares in the Stockholm-based company slumped 27% in European trading as investors grappled to understand what had happened since an upbeat investor day little more than a month ago.
Steven Hartley, a senior analyst with telecoms research firm Ovum, said a conversation with Ericsson Tuesday morning indicated the company took a significant hit because two high-margin contracts failed to close in September.
Publicly though, Ericsson only said the shortfall in upgrade work had such a severe impact on the operating margin because it carries much higher margins than another type of contract known as a network rollout.
A network rollout consists of building mobile infrastructure from scratch for an operator. The majority of these contracts come from emerging markets such as India and China, where the adoption of mobile phones is exploding.
But there's a catch
Phil Kendall, of research firm Strategy Analytics, said margins on these rollout contracts can be extremely low because infrastructure vendors such as Ericsson face tougher competition in emerging markets than anywhere else, with the likes of China's ZTE aggressively competing.
"As a consequence, some of these contracts are won with very low and sometimes nonexistent margins," Kendall said.
The winning vendor, he added, hopes that the rollout will later generate expansion or upgrade work that carries much higher margins. But that can take years.
Still, Per Lindberg, an analyst at Dresdner Kleinwort who is consistently bullish on Ericsson, remained confident. In a note to clients published after the warning, he said Ericsson's strategy will bear fruit and is allowing the company to rapidly gain market share.
"Whilst these initiatives will temporarily restrain reported profitability, they also lay the foundation for lucrative capacity expansion assignments in subsequent phases," he said.
CEO Svanberg on Tuesday said the latest external report on market share suggests Ericsson now has 45% to 47% of the market, compared with 27% for its nearest rival.
Other vendors likely to see pressure
Gartner's Chapman said while Ericsson may be gaining market share, if it can't make money on these rollout contracts, then it's likely that nobody can.
"The rising proportion of these contracts in the business mix is likely to affect everybody's margins. Building these networks is unlikely to be a big-margin business for anyone," he said.
Chapman said the rising importance of emerging markets and increasing competition in the industry means vendors can't afford to ignore these contracts.
Ericsson competes for them with Alcatel-Lucent and also with Nokia Siemens Networks, Canada's Nortel Networks, Motorola's infrastructure division and China's ZTE.
Motorola shares were down 1.2% in early U.S. trading, while shares of Nortel lost 2.4%.
Even if competition abates, vendor margins are likely to remain squeezed. Emerging-market operators have less to spend on their networks because revenue per subscriber is much lower.
"They have to run everything as close to the bone as they possibly can. Looking at upgrades, they will only do it when it's absolutely necessary," Chapman said.
Nokia Siemens' results on Thursday should shed more light on the impact of these trends on other sector players.
But Ovum's Hartley said investors may have to wait until the fourth quarter to see if the Ericsson warning was just a blip, or evidence of a more worrying and pervasive trend.
(END) Dow Jones Newswires