Ericsson becomes a software company, driven by NFV

By Caroline Gabriel, Research Director, Maravedis-Rethink

Virtualization and software-defined networking (SDN) have been a significant shock to the system for major wireless infrastructure vendors. They give carriers the opportunity to slash hardware spending by relying on off-the-shelf servers to run network functions, instead of highly priced, dedicated and proprietary boxes. However, the genie is out of the bottle, and the big OEMs are forced to make a virtue of necessity. Ericsson, the most threatened by the shift of spending from hardware to software, has also been the most proactive. It may still have its head in the sand about small cells, but it has placed itself in the vanguard of SDN, determined to shape that trend, not be consumed by it.

The Swedish giant is prominent in standards efforts like OpenDaylight and NFV (Network Functions Virtualization). The latter seeks to shape virtualization technologies, often created for the data center, for the specific needs of carriers. It has been criticized for putting the traditional vendors back in control, but it is being widely accepted by operators as a relatively 'safe' route to virtualizing their critical processes. In a recent study, Maravedis-Rethink's RAN Service team found that almost three-quarters of mobile carriers would deploy NFV in some areas of their commercial systems by the end of 2018, targeting TCO (total cost of ownership) reductions of up to 35% over five years.

Those operator plans, included in a recent research note entitled 'Pace of NFV uptake accelerates despite many risks', are the kind of trends which are driving Ericsson to become a software company, something it highlighted in its quarterly results announcement last week. On the surface, those Q1 figures revealed the usual preoccupations of recent years – balancing profits against revenues, capacity projects against modernizations, all while trying to boost services and Chinese sales. But the wireless giant is undergoing a deeper change, with a shift towards software that is likely to transform the make-up of its revenues, and its key quarterly concerns, over the coming years.

As the software content of mobile networks rises, and carriers toy with full SDN, Ericsson announced that it had reorganized its infrastructure division to create a dedicated unit for virtualization. This reflects a change in focus that has been building for some time – at the annual general meeting recently, CEO Hans Vestberg said hardware accounted for only one-third of Ericsson's revenues in 2013, down from 73% in 1999, while software contributed 23% and services 43%, up from a combined 27% at the earlier date.

One aspect of this change has been the development of networks which rely on software to support flexible design, agile reconfiguration and swift upgrades with limited hardware swapping required. The next step is the move to virtualize network functions entirely in software on standard servers, reducing the need for specialized hardware.

Now Ericsson's new drivers are made explicit in its organizational structure, with the splitting of the Networks division into two parts – Radio, and Cloud & IP. Cloud & IP will drive work on virtualization, SDN and other cloud-based network platforms, while Radio will take care of the traditional products. Both units will still report to Networks chief Johan Wibergh but will get their own separate heads too.

Vestberg said in a statement: "The business logic and Ericsson's relative position is different in the two areas. Radio is the foundation of Ericsson's technology leadership and we are the undisputed market leader, same size as number two and three together. We are committed to maintain our leadership as the market evolves with 5G. In the cloud and IP space, which are vital for the evolution to 5G, we have made significant progress but are still a challenger. In a transforming market we will now intensify our work to capture opportunities in virtualization and cloud, building on our leading position in core networks."

The restructuring will be completed by July, and so its impact on financial performance and reporting will not be felt for a while. But an ever-deeper focus on software should help the company in its quest to keep profit margins high, even if the hefty revenues of proprietary hardware are behind it. In its first quarter, Ericsson put its efforts into boosting profits, at the expense of sales growth, which went down badly with investors. The stock slumped by over 5% - the worst in six months - as the firm reported a 7% year-on-year revenue decline, to SEK 47.5bn ($7.2bn), though net profit was up 41% to SEK1.7bn ($257m).

The worst hit regions in terms of sales were North America – the bulwark of Ericsson's LTE growth in recent years, but with major roll-outs now slowing – and Japan. These declines were offset partially by improved performance in China, where Ericsson is participating in the major TD-LTE deployments of the three cellcos this year, as well as Middle East and Latin America.

The decline in sales was seen in the Networks and Global Services divisions but all segments enjoyed improved operating margins. An increase in gross margins across the board – up to 36.5% of sales, from 32% a year earlier and ahead of analyst forecasts - indicated the success of Ericsson's recent attempts to shift its balance of network deployments from low margin modernization projects, which have dominated the past couple of years and squeezed the company's profits, towards higher value capacity-driven roll-outs.

Gross margin was also improved by lower restructuring charges, increased IPR revenues. Like all the big vendors, Ericsson is pursuing revenues from its large stores of patents more aggressively than in the past, when the assets have often been used mainly for cross-licensing and standards influence.

Ericsson said that some key contracts have been awarded, but their impact will mainly be felt only in the second half of the year. It added that results had been hit by political unrest in some regions, notably parts of the Middle East and Africa plus Russia and the Ukraine. The firm reported SEK5.9bn of sales from Russia/Ukraine last year though the current crisis had not yet impacted sales in Q114.

Mikko Ervasti, an analyst at Evli Bank in Helsinki, told Bloomberg: "It needs to win new sizable projects in order to support the top line. Gross margin was very solid."

"Our focus on profitability is paying off," said CEO Hans Vestberg in a statement. "The business mix in the quarter was predominantly driven by mobile broadband capacity projects."

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