Should Investors Worry About Ericsson's Challenges in China's 5G Market?

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Following a Swedish court’s decision last month to uphold Swedish telecom regulator PTS’s decision to ban Chinese vendor Huawei from selling its 5G equipment in Sweden, the threat of Ericsson‘s (NASDAQ:ERIC) business in China suffering negative consequences intensified and then it materialized. 

During the second quarter, the Swedish telecom specialist saw a significant drop in its sales in China. And beyond the short term, Ericsson could lose significant market share there. So should investors worry about this development?

Underperformance in China

Overall, Ericsson had a good second quarter. Revenue declined 1% year over year to 54.9 billion Swedish krona ($6.32 billion). But adjusted for constant currency and other comparable items, revenue actually increased 8% year over year, thanks to the strong performance of 5G deployments in the U.S. and Europe.

Image source: Getty Images.

The poor performance in mainland China contrasted with those otherwise encouraging results. Last year, China represented 9% of Ericsson’s total revenue. But because of a 2.5 billion krona ($290 million) drop in revenue during the second quarter, sales from China shrank to only 3% of total revenue. As a result, revenue from the Northeast Asia region, which includes China, dropped 9% year over year to 7.1 billion krona ($820 million).

Management justified the underperformance with delayed 5G deployments in China. The root cause of such delays remains uncertain, but it’s fair to speculate it could be related to the Swedish telecom regulator’s ban of Huawei’s 5G equipment in Sweden.

More worryingly, Ericsson’s challenges in China may continue over the long term. Beyond the delayed deployments in the area, the outcomes of the various tenders for the deployment of 5G in China remain uncertain because of political tensions, which could result in a significant market loss in the region.

That could represent a significant headwind for the company’s top line, given the strength of that market. For instance, the research outfit Dell’Oro recently updated its 2021 growth forecast for the global RAN (radio antenna networks) equipment market in China from 3% to 11%.

Strength outside of China

Yet investors should not worry too much about this negative development.

The strong performance in other regions offset the challenges in China. During the second quarter, revenue (adjusted for currency fluctuations) increased by 14% year over year in Europe and Latin America, and by 11% in North America. And Ericsson should benefit from the ban of Huawei in the U.S. and in some other countries over the next several years.

Thus, despite short-term volatility, management maintained its 2022 outlook. That includes an improved operating margin now hovering in the range of 12% to 14%, up from 10.6% during the second quarter.

That stable guidance seems disappointing compared to Nokia‘s recent upbeat communication, though. But in contrast with Ericsson, Nokia doesn’t have to deal with potential new threats against Swedish interests in China. The Finnish competitor didn’t release its quarterly results yet, but management indicated in a press release that it will upgrade its full-year outlook at the end of this month thanks to continued strength in the business during the second quarter.

So Ericsson doesn’t seem to have an issue with the competitiveness of its 5G portfolio. CEO Börje Ekholm even highlighted during the earnings call that the company gained market share during the second quarter, playing a crucial role in 93 live 5G networks out of a total of 169 currently operating.

Also, thanks to its acquisition of Cradlepoint last year, Ericsson enhanced its portfolio for enterprise 5G connectivity, which represents an attractive long-term growth opportunity that didn’t exist with the less performant, previous wireless technologies.

Not too pricey

In any case, because of the concerns related to the deployment of 5G in China, the stock price dropped 10% following the publication of the second-quarter results. It’s now trading at enterprise value-to-sales and forward price-to-earnings ratios of 1.4 and 17.3, respectively.

That remains reasonable given the company’s improving profitability in its growing 5G markets outside of China. In addition, strong upside may materialize if challenges in China eventually become less significant than anticipated.

This all suggests that investors looking to buy a 5G stock should take a closer look at Ericsson.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.