($ERIC) Don’t Buy Into Ericsson Before You Read This

December 22nd, 2009

Tony Daltorio, Investment U Research
Tuesday, December 22, 2009

Once upon a time, the real mobile phone industry consisted of only two companies: Swedish-based Ericsson ADR (NASDAQ: ERIC) and the Finnish Nokia ADR (NYSE: NOK).

These days though, while Ericsson might still lead the sector as the world’s largest mobile network equipment maker, Silicon Valley dominates software innovation.

Just take the iPhone from Apple (NASDAQ: AAPL). Or Google (NASDAQ: GOOG), which continues setting new standards for the industry, most recently with its Android operating system.

Together, they’re leaving Ericsson in the dust at a crucial time, right when mobile network equipment manufacturers are facing difficult times as mobile phone operators cut back on capital spending.

For instance, during the third quarter of 2009, revenue fell 9.3% at Alcatel-Lucent, 21.2% at the number-two manufacturer Nokia Siemens Network and 6.0% at Ericsson.

Ericsson in particular faces an uphill battle, considering that it doesn’t just make equipment; it also has two loss-inducing ventures and a service unit that runs repair networks on behalf of mobile operators.

Neither Sony Ericsson – the mobile phone marker it owns with Sony ADR (NYSE: SNE) – nor ST Ericsson – the wireless semiconductor manufacturer it shares with STMicroelectronics ADR (NYSE: STM) – have done very well lately.

In addition, Ericsson’s mobile network equipment unit still suffers from the profit warning it had to issue two years ago, a necessary action that still sent shares plunging 25% in a single day.

Worse yet, the mobile network equipment unit’s operating profit margin was 17% in 2006, but dropped to 11% last year.

One Good Call

On the plus side, Ericsson paid $1.1 billion for Nortel’s bankrupt mobile network business back in February, a move that could eventually turn it into the leading equipment supplier in the U.S.

That deal gives it the opportunity to sell equipment to the four main US mobile operators: Verizon (NYSE: VZ), AT&T (NYSE: T), Sprint Nextel (NYSE: S) and Deutsche Telecom ADR (NYSE: DT)’s T-Mobile USA unit.

It also adds to Ericsson’s pact to supply Verizon Wireless with network equipment based on LTE, fourth-generation technology that enables speedy web browsing on mobile phones. Made in February, that agreement underlines the company’s position in the forefront of mobile network equipment, an area that it has to maintain in order to stay competitive.

Fortunately, its services unit, which manages that aspect of the business, continues to grow quickly.

It generated 40% of Ericsson’s revenue in the third quarter and could produce 50% in coming months, especially since mobile operators have chosen to cope with fierce competition by handing network management to third parties such as Ericsson in an attempt to cut costs.

In the long term, that brings in a tidy profit though over the shorter-term, it incurs significant implementation costs. For example, the company’s $5 billion, seven-year deal to manage Sprint’s network will depress Ericsson’s gross profit margin in the fourth quarter by two percentage points.

This International Call Could Cost A Lot

Just to make things even more difficult for the mobile maven, the Chinese, privately-owned Huawei Technologies, entered the mobile network equipment world and almost instantly jumped into third place in 2008, behind only Ericsson and Nokia.

Pushing heavily into the emerging markets especially, Huawei has doubled its share of the market to 17% over the past year. It also won a six-year deal with Norwegian mobile phone operator Telenor last month, to replace its entire wireless infrastructure in Norway and upgrade the network for 4G services.

And that just happened to be Ericsson’s stronghold.

Critics accuse Huawei of being subsidized by the Chinese government, which the company denies while still admitting to having a $35 billion credit line from the China Development Bank that customers can use to buy its equipment.

But in the end, whether it has connections or not doesn’t really matter.

As incoming Ericsson CEO Hans Vestberg says: “We just need to compete with them like anybody else… We just need to win.”

And for it and its investors’ sakes, Ericsson had better hope it does win… because as of right now, nothing is certain.

Good investing,

Tony Daltorio

View original at: Investment U

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