Value hunting – Ericsson

What stocks are “Value”?

In a number of posts (Last section here, and here) I have concluded a desire to tilt my portfolio more towards Value. Particular in Europe where Value stocks have been hammered. So a few months ago I started by asking myself, what stocks in Europe are actually considered Value? At the time I had access to an advanced Value ranking which blends simple metrics like Book to Price with more advanced ones. I ran the Stoxx 600 members through the scoring and the top 5 stocks in that ranking were:

1. Ericsson
2. Lufthansa
3. Marks & Spencer
4. Casino Guichard Perrachon
5. Sanofi

They say Value should feel hard to invest in.. ..well they were right, that is not a list of stocks I find particularly attractive. In the future I intend to build a model which rank stocks on a blend of my own Value-metrics, but that will take some time to get in place. So I will use the advanced Value model (which I trust) and start with the list above. I don’t think I will analyse them all, but Ericsson looks interesting to me, so at least I start there.

Ericsson introduction

Ericsson is a huge company with 110 000 employees spread out over the world. Ericsson was one of the companies that was hyped during the dot-com bubble and thereafter crashed terribly and was saved thanks to strong owners (Investor and Industrivärlden) through a huge rights issue in 2002. A lot has happened since then (business model changed from phones to networks) but the company has failed to create meaningful shareholder value over the past 15 years:

As I want to merge Value investing with Momentum, this price graph is not ideal, given the sharp negative trend Ericsson is in, but let’s look further anyway.

Business Model

It’s current business model is fairly simple to understand – they build mobile networks and everything that comes with it. The company divides its business into three parts: 1. Networks, 2. Global Services and 3. Support Solutions. Below follows more details on the units.

1. Networks

40% of the world’s mobile traffic passes through Ericsson’s radio base stations and mobile switching centers. The mobile communication products is mainly what Networks is about. In co-operation with Mobile operators Ericsson builds out the latest generation of 4G/LTE networks and in developing nations 2G/3G. Currently a lot of research effort is putting into the next generation product – 5G, expected to launch around 2020. 5G is possibly the first generation of mobile connectivity that will enable everything around us to become connected (Internet of things).

2. Global Services

Is the implementation part of building out a mobile network. For example the design, planning and operation of a mobile network. At a later stage maintaining and servicing the network as well as offering value adding services.

3. Support Solutions

Is focusing on software for operation and business support systems as well as TV and media solutions.

Investment case

So with some basics out of the way, what is the investment case here? Let’s start with concluding that this is a seriously well researched company, like most large caps are. So I will take some short-cuts by looking at sell side research. Looking at respected sell side research analysis, they do a sum-of-the-parts valuation in the following way:

SOTP	2017E EV (SEKm)	2017E EV/EBIT (x)	Per Share (SEK)
Networks excl Patents	48 350	8	15
Global Services	46 973	10	14
SS excl Patents	10 471	1	3
Patents	83 940	10	26

It seems Patents, or IPR (Intellectual Property Rights) as Ericsson calls them, is explaining almost half of the company’s current valuation. This I find as the first interesting fact that gives us clues to if this would be a good Value investment or not. Another interesting figure is the amount spent on R&D during the last five years – 169 bn SEK. Compared with Ericsson current MCAP of 198bn SEK.

My Valuation

Some of my assumptions for DCF:

1. Growth at steady state (0% growth)
2. Initial WACC 9.87% – Higher than normal because: Parts of business in Emerging Markets, turmoil in company leadership and skewed past returns (see below for details)
3. Terminal WACC (after 10 years) – 7.8%
4. Tax-rate 31%

This gives me a target price of 60 SEK per share. With Ericsson trading at 59 SEK per share we are very much inline. Things can in other words continue in a fairly gloomy future and Ericsson is still worth around it’s current 59 SEK per share. A more blue-sky scenario where Ericsson returns to moderate growth 5% per year and clears some of its increased equity risk premium the stock is worth around 75 SEK per share.

Dividends

Ericsson has been increasing the dividend payout ratio to very aggressive levels (around 90%) as can be seen in the graph below. With the current depressed stock price that gives a seriously nice trailing dividend yield above 6%. The company has launched a fairly big savings programme, so maybe the current dividend level can be maintained.

Next generation networks

I’m fairly bullish on how networks needs to be built out for the next generation of devices. If I have understood things correctly, 5G is not so much about increasing the peak speeds, which are already good in 4G/LTE. But it’s rather about increasing the number of devices connecting towards one mobile tower, this is the big change. And this is how Internet of Things (IoT) is going to be born, all our large (cars, fridge, washing machine) and small devices are going to start to talk with each other through internet. So we will go from a few billion connected devices, to perhaps 10 times that. As I see it, this is bound to happen, as soon as the technology is there. And if Ericsson together with a few competitors like Huawei and ZTE are at the forefront of delivering this to market, I feel fairly bullish about the long term future. It’s not like we are talking about a Value stock here, in a business line which is facing slow death. Ericsson writes about this themselves under their Patent/IPR income:

“A major portion of the (IPR) revenues currently stems from handset manufacturers, but through continued digitalization and the developing IoT (the Internet of Things), the number of new licensees in consumer electronics and industry verticals is expected to increase. An increasing number of things benefit from being connected, and the value of wireless connectivity differs greatly depending on the device, its capability and use. By 2021, the number of connected devices is expected to grow to 28 billion (excluding passive sensors and radio frequency ID tags).”

I think a lot of companies understand this, among them Cisco, which leads us to our next topic.

Cisco – and avoiding the Value trap

Something many Value investors talk about is the Value trap. Basically this means that there is no trigger in the future which will unlock the Value and the stock price continues to be depressed. I’m not sure if the Value of Ericsson is so much hidden, but a buyout is definitely unlocking value in some sense. Cisco buying Ericsson is something that has been talked about a lot in the press lately, some good articles written as well, for example this one (Cisco buys Ericsson case). Quite a lot has been written on this topic. It actually makes a lot of sense, Ericsson is “cheap”, Cisco has the cash, they already announced a partnership (Ericsson Cisco Partnership Announcement). But as I see it, the big problem is if the majority owners want to sell? That leads us to the next topic.

A and B shares

Ericsson has a company structure which is common in many of the old Swedish companies, A and B-shares. This construct is invented to make it possible to keep control of the company, although your actual share of the company is small. In this case the A-shares has 1 vote and the B-shares has one tenth (1/10) of a vote. By this construct Investor and Industrivärlden, two large Swedish investment companies can keep total control over Ericsson. So Cisco might be very willing to buy, but it will all come down to a negotiation with these two owners. Is it likely that these would sell? Unfortunately, no, in my view. They are both very long-term shareholders and would not be interested to sell Ericsson on the cheap at least, Cisco would need to give a very steep premium.

Interesting as well is that because of poor liquidity the A-share usually trades at a discount, but since around the Cisco partnership was announced, the spread has trended upwards and the A-share is now trading at a small premium, can we guess that this is the market pricing in a rising probability of a bid?

Ericsson A and B Share spread

Nasty stock price skewness

Being a Swede we follow most of the largest Swedish companies, like Ericsson. I kind of knew in the back of my mind that Ericsson has had a nasty habit of surprising the market on the downside. So I wanted to look into that in more detail. Inspired by the research piece I talked about recently (Section about the Small Cap factor) I wanted to look at the same thing for Ericsson. The idea is to get a profile of how the daily returns are skewed. I then did the same thing for Nokia, these were my findings:

All data based on the last 10 years of performance	Ericsson	Nokia
Total Share Price Performance (Including dividends)	-34.4%	-49.6%
Volatility (based on weekly returns)	32%	42%
Correlation (Eric vs Nokia, based on weekly returns)	0.32	0.32

Looking at this data, both have similar performance over the last 10 years, but the correlation tells us they took very different paths to reach the same destination. And looking at this data it would seem Nokia did it with higher weekly volatility.

Skew Analysis

I ranked the absolute value of daily returns for the last 10 years, from smallest to largest. I then removed the absolute value sign around the daily returns. I then accumulated all the daily returns, from smallest to largest. Which means I will end up with the same total returns of (-34.4% and -49.6%), just not time ordered, but magnitude ordered.

These graphs show a very different picture of which company is the riskiest. Here you can see what I just had a hunch about. The top graphs are the full history, and the bottom graphs is just zoomed in on the last 300 daily moves. Ericsson clearly has much more tail risk skewed to the downside compared to Nokia. Although Nokia has been the more volatile stock calculated in a more regular sense. Given the findings about how markets price skewness, everything else equal, Ericsson should trade to a discount towards Nokia based on skew. In my valuation model I increase the Equity Risk Premium with +1%.

CEO kicked out and now distrust for Chairman

It should probably also be mentioned that Ericsson’s CEO Hans Vestberg got fired about two months ago. Now Swedish media is speculating that the chairman has also lost the trust of Industrivärlden and that they want to replace him too. So there is definitely turmoil and uncertainty of what will happen. I’m not very worried though. If Investor and Industrivärlden is negative for the potential to be bought by Cisco, it is as much an assurance for that these things will be handled properly. In the company’s current state, I see it as a option for potential upside if they find a new CEO that the market has high hopes in.

Conclusion

The locked Value in Ericsson in my view seem to be in the research and huge Patent portfolio that the company holds. Those patents must be juicy to other companies with a big pile of cash, for example Cisco. It also gives Ericsson something of floor around 25 SEK per share.  If a bid does not materialize, the dividend yield of 6% is a cushion. A bit of a question-mark if this dividend payout will be possible to maintain though. If the savings programme is successful and markets do not deteriorate further, it should be possible. But medium-term I’m fairly bullish on the next generation 5G network and I think Ericsson might see some nice growth 3-4 years out. The negative stock price momentum is not attractive, I would feel more comfortable to wait for a bottom and not buy the “falling knife”.

I think Ericsson is attractive to buy in the 50-55 SEK range. So for the moment I will stay put and look to add Ericsson to my portfolio if it falls below 55 SEK. Given that 5G roll-out is so far away I don’t see any reason to hurry to get in, except for the risk of missing a Cisco bid.

Which of the other 4 “Value” candidates would you like me to look into next?

1. Lufthansa
2. Marks & Spencer
3. Casino Guichard Perrachon
4. Sanofi