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Telefonaktiebolaget LM Ericsson (ERIC) Q2 2021 Earnings Call Transcript | The Motley Fool

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Telefonaktiebolaget LM Ericsson (NASDAQ:ERIC)
Q2 2021 Earnings Call
Jul 16, 2021, 3:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Peter Nyquist

Hello everyone and welcome to the second-quarter report 2021 standing here from the studio in Chintsa. Together with me here in the studio is our president and CEO, Borje Ekholm; and our CFO, Carl Mellander. As usual, after the presentation we will have a Q&A session. And this is important, in order to ask questions, you needed to sign up via telephone.

So details can be found in today’s press release and on our website ericsson.com. During today’s presentation, we will be making forward-looking statements. These statements are based on our current expectation and certain planning assumptions, which are subject to risks and uncertainties. The actual results may differ materially due to factors mentioned in today’s press release and discussed in this conference call.

We encourage you to read about these risks and uncertainties in our earnings report, as well as in our annual report. With that said, I would like to handover the word to you Borje. Please Borje.

Borje EkholmChief Executive Officer

Great. Thank you, Peter, and good morning everyone and thanks for joining us at this video conference for the second quarter. We continue to see good momentum in our business and it is based on the 5G rollout, but also on market share gains. So we saw organic growth of 8% during the quarter and we could also strengthen the gross margin for the whole Group to 43.4%.

But before I step into the Q2 performance, I really want to highlight the efforts by our people to deliver this result during the second quarter, despite the global pandemic that we’ve been operating within several of our markets. Today, it’s also clear that we’re a leader in the 5G area. We’ve a very competitive portfolio and today we power 93 live 5G networks out of a total number of 169 globally. A few years back, we also made a strategic decision to try to deconstrain our supply chain, again to be able to deliver to our customers.

That means that we’ve invested in making our supply chain more flexible. And during the quarter, we’ve had no disturbances on our deliveries and we’ve been able to keep up with the demand we’ve seen in the market. I would say the ability to deliver in combination with significant efforts or investments we’ve made in the R&D area, and combined, of course, with our strong efforts by our people have allowed us to perform well, despite a very challenging environment during the second quarter. So let me go through a couple of key highlights on our strategic execution during the second quarter here.

We have continued to show great progress in our product portfolio, and it’s highlighted by the addition of the 5G mid-band, and massive MIMO support to our Cloud RAN portfolio. Cloud RAN is a critical element in our product portfolio as this will enable our customers to evolve their networks toward a cloud-native architecture and open network architecture leveraging automation and fully autonomous networks. Ericsson has always been and always will be a strong believer in openness in the mobile networks. And we will work in close partnership with our customers to leverage the benefits of the open architecture.

We take the same approach to open RAN solutions, and we are actively participating in the standard bodies in open RAN. We also continue to see great momentum in the U.S driven by strong demand for our 5G solutions and we expect to continue as 5G is rolled out across the nation. And this was further highlighted, of course, by the signing we had this morning over SEK71 billion five-year contract with one of the largest operators in the world and it’s Verizon, of course. And this is the largest contract in the history of Ericsson.

On the IPR side, we continue to see good momentum in signing up new licensors. And during the quarter, we have signed an agreement with Samsung that we believe is a very attractive agreement for us. And it kind of confirms the value of our portfolio. What we have also seen is that that momentum continues with signing up additional contracts here during July.

But despite the signing of the Samsung contract that also included revenues that’s attributable to the first quarter, we saw a decline in total IPR revenues of about SEK0.5 billion. We have previously communicated that it is high risk that we will be allocated lower market share in China due to Sweden’s decision to not allow Chinese vendors in the Swedish 5G network. And this can lead to significantly lower market share going forward compared to what we have today, of course. And when we look at the second quarter, we have seen that our sales in Mainland China has fallen by about SEK2.5 billion, and that’s a 60% reduction compared to Q2 last year.

We don’t really know the definite outcome of the tenders that’s ongoing. But we want to say that it’s prudent for you to already now plan for a significant reduction in market share, both in networks as well as digital services. And regarding digital services, we can see that the material loss in market share in China, in Mainland China would lead to a delay in reaching the targets in digital services. We have in addition, during this quarter, we have taken a write off of SEK300 million related to pre-commercial product development for the Chinese market.

And this is basically pushing out the ability of us to reach breakeven that we predicted. And I would comment on that, we already before took a decision to increase our investments in R&D in order to capture the 5G opportunities that we see in front of us. So now we expect a limited loss in 2022. But it will also be a bit backend heavy, so you will see a stronger development in the second half as the new portfolio start to generate significant revenues.

However, we can also see that based on the strong portfolio we have in digital services, and the strong momentum we have in the marketplace that we are going to over time compensate the Chinese volumes without the markets, so we’re going to see a path to exceeding the previous targets of 4% to 7% EBIT margin that we said, but it will take a bit longer than we earlier forecasted. Finally, I want to just highlight the work we do on ethics and compliance. We are sparing no efforts in investing in our procedures, ways of working to make sure that we have processes that are fit for purpose. But most importantly, we’re investing in creating a culture in the company where we are making sure that this will not happen again, that happened in the past.

And this is an area we are strongly committed to as a management team in the company because we believe this is going to be a long-term competitive advantage for us. Let me now move into the market area performance. Starting with Middle Eastern Africa, where sales declined by 10%. And this is mainly due to lower 5G investments in the Middle East and to an uncertain macroeconomic situation in Africa.

Of course, this is to large extent dependent on the global or the pandemic, COVID-19 pandemic. Despite the lower volumes in Mainland China, we saw Northeast Asia growing by 1% adjusting for currencies. This was driven mainly by networks and the continued 5G momentum in other markets in the market area or other countries in the market area. The 5G momentum continued in North America where sales increased by 11%, and this was driven both in networks as well as digital services.

In Europe and Latin America, sales increased by 14%. And if we break this down a bit, we can see that Europe grow 12% on the back of market share gains primarily. And we saw Latin America growing 28% and that is a bit of a recovery compared to very difficult second quarter last year that was heavily affected by COVID-19 pandemic. And finally, Southeast Asia, Oceania and India, where sales grew by 14%.

That was primarily driven by significant investments in LTE and rollouts in India. However, I want to also say that we are seeing a bit of concerns relating to COVID-19 in Southeast Asia, where many countries are heavily affected now, and we’ve had a very difficult situation in India that’s now gradually improving, but we see other countries affected. So we do believe we can see a risk for a slowdown in the general economies in Southeast Asia. If we then move on to business segment.

Networks grew organically by 11%, despite the loss of volume in China and lower IPR revenues. And this reflect our strong product portfolio and it has allowed significant gains in market share outside of China. And we continue to see good momentum as 5G is increasingly rolled out across the world. Gross margin increased to 47.9%, and that’s compared to 40.5% last year.

Of course, that’s supported by strong operational leverage, but also as you may recall, we took a write down on pre-commercial product inventory and initial 5G deployment in China in the second quarter of last year. In digital services, we saw double-digit growth in North America and Europe. While we can see that sales declined in the other market areas. For the full segment, sales were stable and that’s despite the reduction in volume in Mainland China as well as lower IPR revenues.

Gross margin decreased to 37.9% compared to 43.6% last year. That is to a large extent explained by the right of that we do to pre-commercial inventory in China of SEK300 million. So that impacted gross margin by almost four percentage points. We see overall otherwise a good momentum in the business in digital services and we’re continuing to execute on the plan.

But of course, as I said before, the breakeven and reaching a 4% to 7% target gets pushed out because of lower volume in China. Our commitment to developing leading products here stands firm. And we’re continuing to increase the investments in our R&D despite knowing that it will take a year to two years before we start to see those product developments converted into revenues in the P&L. But that will also allow us to grow outside of Mainland China, that will over time compensate for the chinese volumes.

Sales in managed services decreased by 2% in the quarter, and that was due to lower sales as a result of the merger between two operators in North America, but also unplanned contract exits in Europe. At the same time, we were able to increase gross margin to 19% from 17.2%. Also in managed services, we continue to invest in AI solutions for our customers and that will further strengthen our competitiveness. In emerging business and other, sales grew by 13% and gross margin continued to strengthen.

The most important part here is that we’re continuing to deliver and Cradlepoint is continuing to deliver according to our plans. And we perform well, see that we have offerings now that can capture a good growth opportunity in Enterprise segment that we forecast to be 20% to 30% over the coming several years. And we’re very excited about the opportunities to further grow in that area. With that, I give the word over to Carl Mellander, our CFO.

Carl MellanderCFO, Senior VP & Head-Group Function Finance

Thank you, Borje, and good morning, everyone from Stockholm. So we can really say that the strategy execution that Borje talked about is visible in our financials. So if we look at the P&L here, you see, again, that reported sales up to SEK54.9 billion, which is an 8% growth organically than with growth in four out of five market areas, as we saw just now. This growth is mainly driven by the networks business that grew 11%.

So we reach this growth in spite of the decline in China then by SEK2.5 billion that we mentioned earlier here. IPR revenues ended up at SEK2.3 billion. That’s part of the top line here. It’s a decline of SEK0.5 billion.

But of course, the quarter as such is a bit boosted here by the revenue coming out of the recently concluded Samsung deal where we have revenues both from Q1 and into Q2. On the four quarter rolling basis, if you look at the graph there on the bottom left, we are around SEK232 billion in top line. We continue on this picture to look at the gross margin, 43.4%, which is actually a 520 basis points improvement with strong improvement as we saw right now from three out of four segments. That’s very encouraging.

In networks, it deserves to be singled out again. We saw continued operational leverage contributing to the higher margins with a very high gross margin at 47.9%, up from 40.5%. digital services reported a decrease in gross margin here as a result of the write-down related to Mainland China that Borje mentioned. And excluding that gross margin would have ended up at 41.7%, a more healthy level in the underlying business.

And the underlying gross margin, [Inaudible] be mentioned 42.4% if you look at the four quarter rolling basis, which is really more relevant as individual quarters can vary up and down. Opex, SEK17.4 billion in the quarter. And as you see in the table here, R&D and SG&A amounted to SEK17.5 billion and then we have a positive impact of SEK0.1 billion positive related to impairments of trade receivables. SG&A, rather stable, as you can see helped by currency, of course, but also impacted by the investments we make in compliance and security.

The R&D side grew by SEK0.5 billion. It’s really coming from the digital services investments we do now in our cloud native 5G portfolio as we have planned and communicated around earlier as well. And then we shouldn’t forget that Cradlepoint performing on plan, but of course, adding also to the R&D and SG&A expenses. So this results in an EBIT of SEK5.8 billion, excluding restructuring up from four and a half a year-ago.

This represents then a margin of 10.6, which is then an increase of 240 basis points year over year. Again, the gross margin in networks is the big driver for this improvement on bottom line as well. We have a graph there in the bottom also showing the EBIT margin. On a rolling four-quarter basis.

we are 13.4%, which is done well within the range of the 2022 targets, which is between 12% and 14%. And I can add also, which is not on the slide here that the EBITDA target of 15% to 18% that we have set up for the long-term can now be compared with the actual performance in four quarters, which is 14%. So let’s have a look at how these profits then translate into cash flow. And you can see here that cash flow from operating activities increased by SEK0.5 billion, of course supported by IPR payments coming into Q2 rather than Q1.

But also offset by certain tax payments were last quarter benefited from tax refunds to the tune of SEK0.7 billion. So here I think the important thing is to talk about this working capital where we really continue to focus on lead times in our company and keeping capital efficiency in our company and specifically the focus on project deliveries. And the whole credit to cash cycle now has really enabled us to become more and more capital efficient, while at the same time growing top line. And this is of course something we will continue to focus on going forward as well.

Important also to mention when we talk about working capital is the inventory piece where we continue to monitor obviously the component situation and make sure that we have proper resilience so we can deliver on time to our customers, which we have done so far. So free cash flow thereby before M&A came out at SEK4.1 billion. This also is an increase then by SEK0.8 billion year over year. And again looking at the rolling profile here and comparing with long-term targets, we are now delivering free cash flow before M&A at 9.6% of sales.

And as you know the long-term target that we have discussed is between 9% and 12%. So we are within that range as well. When it comes to our cash position then, net cash increased by 0.7 quarter over quarter coming out of course of this free cash flow generated in the business, but also impacted or netted out by the dividend part one that was paid now SEK3.3 billion for the first half of the dividend payout. So net cash ended up at 43.7%.

And gross cash there are a couple of movements there as well. We are now up to SEK77.1 billion. As you know, we issued 500 million euros bond an eight-year unsecured bond in the market during the quarter. We have also utilized loan commitment from the European Investment Bank during the quarter about $300 million as well which also is that to support our R&D in 5G.

So as a result of these events or actions regarding the debt portfolio, we have extended now the average maturity in the debt portfolio to four years from 2.2 years, a year ago. Lastly on this picture, I would like to comment on return on capital employed. Important metric for us also which amounted to 13.5% now compared with 9.9%. This is an increase, obviously, almost four percentage points year over year.

Again, a combination of improved profits and capital discipline. I wanted to say a few words about IPR. And this period that we have had has been active when it comes to renewal renegotiations. Of course, we’re very pleased with the renewal with Samsung.

It’s a global multiyear agreement, which confirms again the value over a patent portfolio. In addition to that, we signed up with one additional company for another renewal in July. So that falls out to the Q2 period, but still important to mention here because it will impact the Q3 numbers. So all in all, now our portfolio of licensed contracts amounted to SEK7 billion on an annual basis.

And this is the starting point that you can see here in this bridge. And then there are a couple of factors that explain the difference, which is a question we often get to the SEK10 billion, which we had in 2020. And I’ll go quickly through them. Of course, we’re exposed to FX movements here, that’s the first bar here.

We are impacted by the relative weakness of the U.S dollar toward the Swedish Kroner. The other factor, of course, is the upcoming renewals of expired contracts that we are working on, as mentioned. And then the third bucket has to do with the fact that not all of the revenue in IPR is recurring. Some is nonrecurring, and this can vary between quarters and from time-to-time.

And then finally, the fourth bucket is lower volumes from one of the licenses affecting the numbers as well. So to conclude on this, we do feel confident that the leading position we have in 5G on the patent side will create a foundation for growing the IPR revenue going forward. Now, I’m going to round off with a few words on the planning assumptions. First of all, it’s encouraging to see now the Dell’Oro forecast.

For the market growth has increased dramatically, I would say from 3% in the January report to 10% now for 2021. And you see here how that breaks down into different regions as well with North America 12%, Europe 9% and China 11%. Regarding our own top line, just want to remind you that the normal seasonality is plus 5% from Q2 to Q3. But again, I want to point out that this varies, of course, with big fluctuations between quarters depending on the deployment.

Then we talk about the risk of losing a significant market share in China, of course. And under the planning assumptions in the report, you can find the quarterly numbers of sales in China. Over to IPR here. I mentioned already that SEK7 billion is the annual volume of contracts that we have.

And then gross margin again, we’re not guiding specifically on that. But just to reiterate that the gross margin can vary quite a lot between the quarter, so look rather at the rolling four quarter. Last point, digital services then. Considering the risk in China, and also the fact that which we’ve already said earlier that 2021 is an investment year for Digital Services.

We expect now a similar earnings level in Q3 that we just delivered in Q2, while we expect Q4 to become breakeven on an isolated basis for digital services. With that, thank you and back to Borje.

Borje EkholmChief Executive Officer

Great. Thank you, Carl. So Ericsson continues to be well-positioned to take advantage of the market momentum we see now as 5G is increasingly deployed around the world. We see the North American market moving very fast with a strong demand for 5G and it will be a key opportunity now as the operators are building out mid-band spectrum that will be lit up at the end of the year.

And as you all know, mid-band spectrum and build out in mid-band is critical to give the end user experience that you can get from a 5G network. So we are of course very excited about our position in the market and continue to work with the leading operators in North America to build out their networks. In digital services, we continue to see good momentum in 5G core, and we have here been gaining footprint over the last few quarters. But we also recognize to capture the opportunities that are in front of us we need to invest in R&D and cost will come before revenues.

So we are continuing here as Carl also highlighted to ramp up our investments in R&D to capture the market opportunities. And we will see revenue start to be generated from this portfolio, call it beginning of next year, but then ramping throughout next year. We also see that with 5G being built out as and as 5G is increasingly built out in mid-band, it will be a platform for innovation. And it will be for the consumer space, but it will especially be for enterprise basis.

And we are very excited and we are strong believers that with 5G wireless communication account for the first time with the primary choice of access technology for enterprises, and basically be the backbone of digitalizing enterprises for the future. We think this translates into a very exciting growth path for Ericsson. What we also see is that we are seeing a strong momentum in the business as we’ve already said. But also the investments we made in a flexible supply chain allows us to capture the growth opportunities in the market.

And it’s thanks to the investment in a global supply strategy we’ve had for a long time that actually have allowed us to respond to customer needs very quickly, and capture the extra demand that we see. So when we look ahead, we see that we’re well-positioned. With that we have a strong business momentum, competitive product portfolio. So we feel very comfortable about the targets on group level for 2022.

So with that, I think before moving over to Q&A, maybe you want to add something, Peter.

Peter Nyquist

No, I think we’re all happy with the presentation so far. So we’ll move into the next phase of this presentation here from the studio. So that would be the Q&A. So with that, I would like to connect with you, Richard, so you can open up the Q&A.

Questions & Answers:

Operator

Thank you. Ladies and gentlemen, at this time, we’ll begin the Q&A session. [Operator instructions]

Peter Nyquist

Thank you, Richard. We have the first question here. It’s from Ed Snyder from Charter Equity. So please Ed.

Ed SnyderCharter Equity — Analyst

Good morning.

Borje EkholmChief Executive Officer

Good morning.

Ed SnyderCharter Equity — Analyst

Thanks for the question. A couple of them, if I could please. First off, you mentioned O-RAN, but even if we ignore the interoperability and the system integration problems with a multi-vendor solution, you says never occurred before, it seems clear that a workable solution probably won’t be ready for a year or two. It kind of bags the question of what’s the point of O-RAN is if 5G is maturing in China in terms of the build out and the U.S is committing now to systems for their deployment.

It seems as if most of the big tenders will already be awarded and being built out before O-RAN even sees a practical solution. So would it be a 6G system? Or is there some sort of market dynamic that’s going to drive carriers to move from systems they choose now to something that has not been used before and will have to be shipped out halfway through 5G? And I have a follow-up please.

Borje EkholmChief Executive Officer

It’s a great question, Ed. The reality is clearly O-RAN is something that will happen and that’s what we are investing for as well. We see in reality, the first step to be the Cloud RAN portfolio as that will allow our customers to migrate toward an open architecture. And you know, it will take a few years before we have a fully operational O-RAN solution.

Then we can debate how long it is, but there is a question of here and now of building out 5G coverage and that’s what we also see our customers doing. But of course, we need to work with our customers here to make sure that they have the best solution. And it can be that O-RAN can have certain applications earlier where you have less performance demands. For example, it could be rural coverage, for example.

So there are pockets where we can see that come, but for sure, O-RAN will be a fundamental part of the 6G solutions. That’s no question in my mind. But exactly how it’s going to pan out in the meantime, I think remains to be seen. It depends on how the technology matures clearly.

Peter Nyquist

You said you had a follow-up, Ed.

Ed SnyderCharter Equity — Analyst

Thank you. And that does dovetail my next question. So U.S is obviously in ascendancy now in the 5G rollout, now that C-band auctions have been completed. But if you look at different segments, you get a lot of spectrum to clear.

So it’s going to be a multiyear process. And at the same time, I don’t think the business plan has been proven well enough in China that you’re going to see the same level of massive MIMO mix versus macro. So two pieces, if I could. One, do you see that the roll on the U.S will favor more of a macro cell approach initially with MIMO capacity and lower mix of the high density stuff.

And two, if this dynamic change, if you look at, say C-band 41 versus the C-band spectrum, which is higher, do we have a better chance of seeing either MIMO or maybe more macro in a 2.4 gigahertz environment than we do in say a C-band. Thanks.

Borje EkholmChief Executive Officer

Thanks, Ed. What we see, we see that, of course, we need to build out very big coverage and big density of mid-band because ultimately that is what’s going to give the end consumer the user experience of 5G. So today, in many countries, we’ve been focusing on, call it low band build out. In reality that gives a 5G coverage.

But in order to give the real performance benefits of 5G, you need mid-band and you need carrier aggregation across different frequencies. So we see right now that there will be a very big build out, of course of the C-band in North America that is going to drive the market. And we will see that build out happening for sure. It’s already starting to ramp, but it will continue throughout the year and into the next year.

After that we will start of course to see densification of the network. So that’s the next step. Exactly how this will be it depends on customer, depends on their specific situations. So I think that’s the question best posed to them rather than I tried to interpret their strategies and I shouldn’t really do that.

But we are very excited about the process we see in North America and the build out. And we by the way, we see similar activity in multiple countries being Australia, being Japan, being Middle East, for example. So a lot of things are moving in the 5G world.

Peter Nyquist

Thanks, Ed, for those questions.

Ed SnyderCharter Equity — Analyst

Great. Thank you.

Peter Nyquist

Thank you. We’ll move to Francois-Xavier Bouvignies at UBS. Hello, Francois.

Francois-Xavier BouvigniesUBS — Analyst

Hi, good morning, everyone.

Borje EkholmChief Executive Officer

Good morning.

Francois-Xavier BouvigniesUBS — Analyst

My first question is maybe a clarification on China. So when I look in your comments, you said that you had lower volumes from delayed 5G deployment in China, and that you had a negative impact of SEK2.5 billion in the quarter. So my question is this SEK2.5 billion of this delay is something that we’re going to see as you said, delay coming back in the second half of the year, or the significant impact this quarter is this an evidence of already some market share impact, I mean, negative share impact because of the [Inaudible]. Just wanted to clarify that, Borje.

Borje EkholmChief Executive Officer

Yes. No, it’s not coming back. It depends, of course, on how the ultimate tender will look like and the distribution intended. But we have said, and you see that we think it’s prudent to plan for a significant reduction in market share.

And if that is the case it’s not coming back. So what is the reality? We — it’s very hard to say. We know the geopolitical tension with Sweden, we know what goes on there. So what we see here is a reduction in the China volumes and we can speculate and we can have hypotheses, but the consequence is very clear on our sales volume.

And don’t be prudent enough don’t to assume it’s coming back.

Peter Nyquist

OK, Francois.

Francois-Xavier BouvigniesUBS — Analyst

OK. That’s very clear.

Peter Nyquist

Thank you.

Francois-Xavier BouvigniesUBS — Analyst

Can I have a follow-up?

Peter Nyquist

Yes, sure.

Francois-Xavier BouvigniesUBS — Analyst

The follow-up is on open RAN and specifically we are seeing a lot of projects in open RAN and the readiness is not there. I mean, Rakuten and DISH Network and also initiative like Vodafone with recently, which I think is one of the big customers of yours. From what we see in the release of public statements, you don’t seem to budge yet in this kind of project so far. So I was wondering, what would make you change your mind? Or what would be the trigger for you to participate more in the open RAN? And why don’t you participate today with a big project going on with your customers?

Borje EkholmChief Executive Officer

It’s a couple of things going on here. First of all, and that’s often not talked about, but we’re actually the largest contributor to the overall alliance on standards. So we’re already very active in that. But what we are doing now is that we recognize there is a need to build out the 5G networks around the world right now.

So it’s a here and now question where we do believe the purpose built networks actually can deliver the performance that’s required in 5G today. So we are simply saying, OK, by the time O-RAN is ready, we will also be there with solutions, but we don’t feel it’s the right time right now and divert focus from actually what goes on in the market.

Peter Nyquist

OK, Francois.

Francois-Xavier BouvigniesUBS — Analyst

It’s very clear. Thank you very much.

Peter Nyquist

Thank you. Let’s move to next question from Peter Kurt Nielsen at ABG. Hello, Peter Kurt.

Peter Kurt NielsenABG — Analyst

Hey, Peter. Thank you very much and good morning, gentlemen. A question related to digital services, please. It would appear that profitability here is highly dependent on volumes in China.

Could you elaborate a bit on that, please? Why we seem to be so dependent on China as you were sort of update your guidance for digital services. And also, it would appear that you invest, planning to increase your R&D spend more than previously anticipated within on the 5G core side? Why is that? Have you see an increased competition that are forcing you to this? Anything you can say on elaborating a bit on this, please. And just if I may give one follow-up. How has the lower volumes in China impacted the margins in networks? It seems clearly it’s been negative in digital services.

Has there been a positive impact on margins in networks because of the lower volumes in China? Thank you very much.

Borje EkholmChief Executive Officer

OK. If we start from the end, no, it’s not being positively contributing to the networks margins in the second quarter. But it is fair to say that the second quarter last year, we had a write-off of pre-commercial development, but we have a positive margin on what we ship in China. So we would have had better margins in networks with China volumes in to put it that way.

Digital services, no, it’s actually continuing according to the plan we’ve been operating with. And you know that we have been ramping R&D. And of course, that takes a bit of time before you see it on the cost line. So we have added resources throughout the years here.

And we are in a way to much less extent now adding resources in addition, but it’s all according to the plan to make sure that we can capture the 5G core opportunities that we actually see and that we are tendering for. So for us, this has been just part of the overall strategic plan for digital services. So if you tack on the China volumes, and you can understand that digital services is a business, it’s software like with a very high R&D intensity. So of course, any volume change is very important for our ability to deliver a margin and it is fair to say the Chinese volumes.

And if you look over all in telecom, they’re probably 50% plus, 60% plus in many parts of the total global volume. So of course, we have a dependency on losing footprint in China, that primarily hurts or is more exposed in digital services than it is in networks.

Peter Nyquist

OK, Peter Kurt.

Peter Kurt NielsenABG — Analyst

OK. Thank you very much.

Peter Nyquist

Thank you. We’ll move to the next question from Aleksander Peterc at Societe Generale. Hello, Alex.

Alex PetercSociete Generale — Analyst

Yes, good morning. Good morning. Can you hear me well?

Borje EkholmChief Executive Officer

Yes. Perfect.

Peter Nyquist

Go ahead.

Alex PetercSociete Generale — Analyst

Good morning. Thank you very much and thanks for also the question. I would like to delve a little bit into your IPR, if I may. You provided a very helpful slide here on this.

So just to be clear, the SEK7 billion run rate that you now have, that’s for the current year, it’s up from SEK6.6 billion, if I remember, right. And so this presumably reflects the deal that you’ve signed in here in July. Now, my question is really on the expired contracts. Do you still expect some of that to come back on in IPR fully gets, potentially to somewhere around SEK8 billion going forward and then obviously FX here to stay let’s assume and lower volume [Inaudible] as well.

So we’re landing somewhere lower, but is there still some catch up that you would expect. And one on IPR. If you could give us a feeling on how you think about the upward negotiation which is to by the end of this year, especially you’ve anything to say on that? And then just a second quick follow-up would be on the time with Verizon contract. How many years will that be rolled over approximately so we can gauge how much it will contribute? Thanks a lot.

Carl MellanderCFO, Senior VP & Head-Group Function Finance

Thanks, Aleksander. I can take that. First of all, the Verizon contract is over five years. And as Borje said it’s the largest contract ever in Erickson’s history.

So that’s a nice thing to announce today. When it comes to IPR, yes, certainly we are working with the other not yet renewed licensees as well in order to get to agreements. And we signed one in early July, so that is going to help revenues going forward and that will be a catch up effect in Q3 from that as well. And we continue of course in the team to one by one settle the outstanding deals.

And when it comes to Apple, I would say it’s far too early to talk about that. It will expire as you say at the end of the year. And the parties will of course come together to resolve that in the best possible way. But that’s too early to comment on any specifics regarding that.

Alex PetercSociete Generale — Analyst

That was great. Thank you very much.

Carl MellanderCFO, Senior VP & Head-Group Function Finance

Thanks.

Peter Nyquist

Thanks, Alex. We’ll move to next question from Sandeep Deshpande at J.P. Morgan. Hello, Sandeep.

Sandeep DeshpandeJ.P. Morgan — Analyst

Yes. Hi, good morning. Thanks for letting me on. My first question is clearly, I mean, when you look at your networks business outside China, your market share gains.

I mean, your growth in market share gains are very significant. Are the share gains that you had made couple of years ago or in the past, or is this new market share gains that are happening starting in the last six months associated with the geopolitical tension, etc., which is causing the share shifts between China and the rest of the world. And I have a follow-up as well.

Borje EkholmChief Executive Officer

What you see now coming through in the numbers are mostly the wins we had some time back. So it takes some period of time depends a bit on the contract, depends on the situation for it to flow through. So, so far the most recent wins have only very limited impact on the numbers, you see. And I know this is a focus on the overall market share situation if its geopolitically driven.

I would say it’s, of course, very hard to separate the two. But we see that we win market share in markets where also all vendors are allowed, as well as we win in markets where only Western vendors are allowed. So our overall market share gain, sure port will be contributed to geopolitical situation. But I would also say here, it’s the strength of our product portfolio that allows us to be truly competitive against any competitor right now.

So for example, the recent win in Malaysia where we are able to build out the national 5G network. It’s a very important contract win for us as well, indicating that we can win market share in many markets.

Peter Nyquist

You had a second question, Sandeep?

Sandeep DeshpandeJ.P. Morgan — Analyst

Yes. Just a quick follow-up. Now talking about the same geopolitical issues and the digital services business, given that you might not be able to have that 4% or 5% share that you currently have in that business from China. Are there businesses within digital services, are there business units where you can now do reductions, etc.

because I mean, digital services have been promised to be profitable for a very long time, and it hasn’t delivered as such. And now that there is a potential structural change in one market, whether there needs to be a further thought process on the cost structure within the digital services business.

Borje EkholmChief Executive Officer

It’s a good question and it’s a good thinking. But I would say if you look at the product portfolio, it’s typically global products in there. So it’s just because you lose volume in one market doesn’t mean you can restructure in any way. So in reality, it’s just the loss of revenues.

The R&D remains the same to say pretty much. So for us that’s why we’re saying very clearly that due to the delay and or due to the risk of losing China volumes, it’s likely that we need to push out reaching the targets because we need to compensate that sales that we lose in Mainland China by growth in other markets around the world. So when you see that, that’s why you see the push out now. So I would say from a strategic execution in digital services, we’re continuing to deliver on the plan and on the objectives we set out a few quarters ago.

But due to the geopolitical situation between Sweden and China, we are saying that will get pushed out now. And that’s an unfortunate consequence. But we need to deal with it and develop the business in the other markets. But I will also say that the good thing is we’re seeing good growth in Europe and North America in digital services.

So we feel that we are going to grow into that loss of volume.

Peter Nyquist

OK. Thanks, Sandeep for those questions. The next question will come from Fredrik Lithell at Danske Bank. Good morning, Fredrik.

Fredrik LithellDanske Bank — Analyst

Good morning. Thank you for taking my question. Hope you’re all well. I just wanted to ask a little bit on Cradlepoint that you acquired some time back.

What is the sort of the status of that unit right now? And how do you expect and see that this should progress going forward? And when should we expect that this unit will be not heavily loss making more, but rather the opposite. And a little bit if you could talk about growth on that unit as well? Thank you.

Peter Nyquist

You want to take?

Borje EkholmChief Executive Officer

Thanks, Peter. Thanks for the question, Fredrik. Cradlepoint is developing well. I must say it’s on track on the plans.

And following basically what we said from the start that there will be a one percentage point impact on the EBIT margin in ’21 and ’22. And we, as you saw, perhaps, in the report, it contributed now a bit positively from the final PPA calculation there. So now we are going forward, we are in good shape I think to deliver and grow that business also outside of the main markets where they have been successfully establishing footprint so far. So I think Cradlepoint is a well performing asset in our family now and it’s great to have them on board.

Fredrik LithellDanske Bank — Analyst

Is that going to be sort of a little bit of a hub for further acquisitions that fits into that, that type of portfolio of products and services, or what should we expect from this unit I mean in terms of growth and should it move out in the rest of the world in another way than what it did before and so on. So a little bit more if you could on the planning for that unit.

Peter Nyquist

You want to take it, Borje?

Borje EkholmChief Executive Officer

I can start. Yes, you’re absolutely right. What we are seeing is that we can leverage the [Inaudible] products has been predominantly sold in North America so far with very limited presence outside. We’re gradually now expanding globally.

And that is a quite exciting opportunity as well. So growth we foresee to be quite good for Cradlepoint. What we’re also seeing and you hit on that it becomes a bit of a hub for developing new solutions that we can actually let go through their network of distributors to the market. So we’re very excited about the opportunity we create with the acquisition of Cradlepoint to capture a larger, an increasing share of the enterprise market.

But we should also recognize that Cradlepoint is one piece that we need for enterprise. We’re also looking at other growth opportunities in enterprise being in dedicated network for corporations, campus networks being in our global connectivity platform IoTA. So there are a couple of additional opportunities, but we believe the market opportunity in enterprise is so large that we need to increase the investments in that area by also looking at the broader acquisitions outside of Cradlepoint.

Fredrik LithellDanske Bank — Analyst

OK. Thank you. Very clear. Thank you.

Peter Nyquist

Thanks, Fredrik. The next question is from Dominik Olszewski from Morgan Stanley. Hi, Dom.

Dom OlszewskiMorgan Stanley — Analyst

Yes. Good morning, everyone. Thanks for taking the questions. Two of them.

So from the Q2 revenue run rate that you’re indicating, it looks like there’s basically SEK5 billion downside for sales in the second half in China because of pro rata what we’ve seen in Q2. Could you please maybe talk about the regions and projects which could help mitigate that downside in the second half for other areas. Obviously, for example, you’ve a 95 Dell’Oro raising estimates for the rest of the world, North America globally. And then a second question is, in the past, you’ve talked a lot about labor shortages, particularly in North America for [Inaudible] and obviously today we’re in an inflationary backdrop, talk about labor shortages in certain regions.

So could you talk about whether that’s a constraint on deployment in the second half and in the next year?

Borje EkholmChief Executive Officer

Maybe I’ll take the first one first, actually not labor shortages that we talked about before, it was really about rollout crews and our feet on the ground, where that was actually limiting our volumes. We don’t see that to be a limiting factor now. I think it’s rather the site acquisitions from customers that determines the speed and as you see speed is very high at the moment. So we have sorted that problem out.

Carl MellanderCFO, Senior VP & Head-Group Function Finance

Yes, and if you look at our numbers, you see that we have grown. If you take networks, for example, or even the total company, we’ve had an organic growth of 8%, despite losing 60% in the China volumes. So we are growing in many markets for really two reasons. One is the build out of 5G drives demand and that drives increasing demand, but also that we’ve been able to gain market share.

And you know, we started to talk about that already in 2018, or end or 2017. So that is something that we have systematically invested in to make sure that we can gain scale outside of China as well. We believe that will contribute and help us to continue to grow even if the risk is very high that we will see significant loss of market share in China. So that’s probably the best we can look at it now.

So if you look at Q2, you’ll still see that even excluding China we have a very healthy development in the business.

Peter Nyquist

OK, Dom.

Dom OlszewskiMorgan Stanley — Analyst

Thank you.

Peter Nyquist

Thanks for those questions. We’ll move to Dominik Olszewski. Sorry, that was the previous one. Amit Harchandani from Citigroup.

So hello, Amit.

Amit HarchandaniCitigroup — Analyst

Good morning, Peter. Good morning, all. Amit Harchandani from Citi. Two questions, if I may.

My first question is on the topic of networks margin. You’ve delivered solid margins in this quarter, last quarter, indeed across 2020 versus your long-term rather 2022 guidance of 16% to 18%. Given what we’ve seen in China, in terms of volumes, and maybe potentially profitability profile of the Chinese business, is it fair for us to assume that the networks margin going forward is more sustainable on average at the levels that we have seen over the past four to six quarters? Are there any factors which could still take you down to that 16% to 18% range? So your thoughts on that would be appreciated. And then I have a follow-up.

Carl MellanderCFO, Senior VP & Head-Group Function Finance

Thanks, Amit. Should I start, Borje? Yes, on the networks margin I think what we see is the result of work in R&D mainly where we are able to define out costs of the product and make it both of course attractive from a feature functionality point of view for the customers, but also manage the cost situation and you see the fruit of that in the ever improving gross margin. We don’t see any particular reason why that logic would change over time. Then as we always point out, it’s, of course, individual quarters can change here and there because of how deployments are made and so on.

But basically, I think our aim is to establish a stronger and stronger logic with the cost side on the one hand, and the competitiveness leading to the price side then in networks to continue on good levels.

Peter Nyquist

And you had a follow-up, Amit you said or a second question?

Amit HarchandaniCitigroup — Analyst

Yes. Yes, I did. My second question is, with regard to what you’ve seen in China, when the development is not ideal for you. I’m trying to understand what are you hearing on the ground in terms of your customers, your partners? If you’re going to lose share, do you get the impression that it’s going more to the domestic competition? Do you get the impression its foreign competition? Do you get a sense that they might be lobbying on your behalf and that is way back in into China? What is the feedback on the ground that you’re getting, and what’s the level of confidence that this might potentially even turn in your favor in the future?

Borje EkholmChief Executive Officer

There is an ongoing tender process right now in China. So it’s a bit hard to speculate where that is going to go. Normally the way they go, it’s hard to know where you end up. But you have also seen there have been indications that would result in significantly or getting a significantly lower share.

And that’s a bit what we point to, I think it’s easier to comment on these things. So more appropriate to comment on these things once we know how the tender process will fall out. But what we know when it’s the same thing across the world is that, if you look at the performance of our products, it infield performance, it’s very good. We have a competitive portfolio, we are gaining footprint in other market.

So in that sense feel that we have a strong proposition to customers. But let’s discuss more about the China situation once we’re through with the tender process.

Peter Nyquist

OK, Amit, thank you very much for those questions. We’ll move to today’s last question. It’s from Daniel Djurberg at Handelsbanken. Good morning, Daniel.

Daniel DjurbergHandelsbaken Capital Markets — Analyst

Good morning. Thank you for letting me in. Yes, two questions if I may, starting with the network gross margin. It was negatively impacted by a write-down of pre-commercial product inventory.

My question is, and this was related to Mainland China. And if you will see limited or lower volume in the [Inaudible], how significant the inventory write-down risk lies ahead? Or was your write-down in Q2 also related to possibly lower volumes ahead? And also a question if I may, would be on China again. And that would be out of the SEK1.5 billion in revenue you have in the quarter, how much would you say is sort of recurring to existing installment, software, etc.? And how much [Inaudible] to previous 5G deployments that will say disappear when done would be great to know.

Borje EkholmChief Executive Officer

I guess, you mean digital services, right, not on networks?

Daniel DjurbergHandelsbaken Capital Markets — Analyst

Yes.

Borje EkholmChief Executive Officer

Yes, OK.Carl MellanderExactly. So your second question that how much is recurring? I mean, there is of course, a portion of support revenue for installed base that we have to follow. What happens with that it’s hard to determine exactly and as Borje said, let’s await the conclusion of this and then we can comment on how it played out basically. On the other question, of course, we always scrutinize our balance sheet and make the impairments if we need to every quarter now in Digital Services.

We arrived at the conclusion that this SEK300 million write-down was the appropriate thing to do, given where we are on that pre-commercial inventory. But now, of course, our balance sheet is what it is for the situation we have now when we would have to consider that going forward. No material write-down risk that we see today in that context.

And it’s worth to say in the rest of the business we have is global products again, so that kind of helps. It’s really only when you have market specific products, and that’s what we have in this.

Carl MellanderCFO, Senior VP & Head-Group Function Finance

Exactly.

Daniel DjurbergHandelsbaken Capital Markets — Analyst

Perfect. And if I may, only the very, very last question would be on Japan. Obviously, very strong again in this quarter, making up for China weakness, it’s quite a lot, I would say. Is it any — we should be worried post the Olympics or something that has, or do you expect this strong strength in Japan to continue through second half or in 2022 or is it something that starts to fade off?

Borje EkholmChief Executive Officer

Yes, I don’t think the Olympics have actually had an impact on this. It’s more the need for the operators to get, first of all to build out 5G to start to develop applications on top of and for the capacity need they have in the network to cope with the increasing traffic volumes. So I mean, there are always going to be a little bit swings between quarters in the individual markets. But I would not say I would hang it up on the Olympic games.

Peter Nyquist

OK, great. Thanks, Daniel. So before we close today’s call, or video call, I would like to actually to hand over to Borje for any closing remarks.

Borje EkholmChief Executive Officer

Thanks, Peter, who is appropriately dressed in a tie today. So anyhow, we’re very excited about our market momentum and it has continued during the second quarter. But what we’re more excited about is actually that 5G is gaining momentum around the world with increasing build outs, and it’s a here and now question. And with the investments we made in the product portfolio, making that a competitive offering to our customers, as well as a competitive cost position that we’ve established over the last few years, we feel that we are in a strong position to capitalize on this increasing demand for 5G and we’re very excited about the future, the second part of this year but also into 2022.

Thank you.

Peter Nyquist

Thank you.

Duration: 64 minutes

Call participants:

Peter Nyquist

Borje EkholmChief Executive Officer

Carl MellanderCFO, Senior VP & Head-Group Function Finance

Ed SnyderCharter Equity — Analyst

Francois-Xavier BouvigniesUBS — Analyst

Peter Kurt NielsenABG — Analyst

Alex PetercSociete Generale — Analyst

Sandeep DeshpandeJ.P. Morgan — Analyst

Fredrik LithellDanske Bank — Analyst

Dom OlszewskiMorgan Stanley — Analyst

Amit HarchandaniCitigroup — Analyst

Daniel DjurbergHandelsbaken Capital Markets — Analyst

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