Heard in Europe: Hard times ahead for Ericsson (WSJE)

WSJE column: By Jesse Eisinger, staff reporter of the Wall Street Journal

Ericsson's fourth-quarter results showed some strength but revealed deeper, fundamental weaknesses that will be hard to overcome anytime soon. Despite all the restructuring and turmoil at the Swedish telecom-equipment maker over the past couple of years, there is likely more to come.

The main debility is that gross profit margins are in decline, thanks to price erosion in the cellphone industry and overcapacity.

The gross margin fell to 27% in the fourth quarter from 32% a year earlier. For the full year, gross margins were 29%, compared with 37% a year earlier.

During a conference call with analysts, Ericsson officials said that they could attain operating profit margins of 5% this year after suffering operating losses in 2001. To reach 5% operating profit margins, the company said it needed a gross margin of 34%, up from last year's 29%. But the company also said sales will be down in the first quarter. With the year starting weakly, it doesn't seem realistic to expect an improvement of five percentage points in gross margins.

So how did Ericsson meet or slightly beat analysts' expectations for revenue and operating loss? One thing that helped was a cut in research and development spending to 9.5 billion Swedish kronor ($894.9 million or 1.02 billion euros) in the quarter from 13 billion kronor a year earlier. That's ominous. Ericsson officials have long talked about the importance of R&D. Perhaps some of Ericsson's R&D programs have fat that can be trimmed without putting the company's future in jeopardy. But Ericsson hasn't made that clear to investors. During the conference call, the R&D cuts didn't come up, according to investors who were listening.

Ericsson generated positive cash flow from operations in the quarter, managing to confront that stalking beast. This came primarily from improvements in working capital, the cash needed to run the business. A company improves working capital by reducing inventories, collecting bills faster and paying customers more slowly. Ericsson appears to have collected more efficiently from customers.

Some analysts pointed out that days sales outstanding, a measure of receivables compared with sales, fell sequentially to 88 days from 102 days in the third quarter. That looks great, but in fact, DSOs were 82 days last year in the fourth quarter. So there doesn't seem to be any real improvement. (For a discussion of why year-over-year comparisons are important, see below.)

What's the big deal about receivables anyway? Any unusual rise gives an indication that perhaps a company is giving better terms to customers, letting them pay more slowly. If receivables rise faster than sales, watch out.

But when gross margin are in decline, cash flow becomes far less important to watch. Cash flow may be improving merely because a company is getting rid of inventory at knockdown prices.

Nokia response

In a fairly glowing column Friday on Nokia, we argued that accounts receivable, the money customers owe Nokia, was showing improvement. To show this, we looked at trade accounts receivable, comparing the fourth quarter to the third quarter. That made it appear as if Nokia's sales grew faster than trade receivables, a sign that Nokia was healthy and collecting promptly from its customers. Wrong, a London-based hedge-fund manager e-mailed us on Friday.

A year-over-year comparison is better because Nokia is a seasonal business, he argues. He's right: Nokia's fourth quarters look much more like the other fourth quarters than they do the third quarter. "It's like saying that average temperatures fell sequentially. They usually do at this time of year, but this doesn't mean that December wasn't warmer than last December," he writes.

Before we look at what the numbers actually were, it is worth considering why analysts and investors often look at sequential numbers. For one thing, there is their chronic short-termism and myopia. But also, for fast-growing businesses, last year is an eternity and can be fairly irrelevant. Many technology analysts and investors, so used to the growth rates of the 1990s, got into the habit of looking at sequential numbers.

But as certain "tech" companies start facing slower growth and become more like industrial companies with pronounced seasonal patterns -- we've seen this for years in the PC industry -- year-over-year comparisons become more telling.

Heard in Europe neglected the year-over-year comparison and it contains, for Nokia, a potential red flag.

Trade accounts receivable rose 2.2% in the fourth quarter to 5.7 billion euros from 5.6 billion euros a year earlier. Days sales outstanding, a measure of trade receivables compared with sales, rose to 59 days in the fourth quarter from 55 days a year ago. Now, 59 days isn't bad. But sales fell year-over-year about 5% to 8.8 billion euros, from 9.3 billion euros. In other words, year-over-year, Nokia sold less and collected from customers more slowly. That's not a great combination.

"Other" receivables had a noteworthy rise: to 1.9 billion euros, up 29% from 1.5 billion euros a year earlier. What is this? It includes something Nokia calls "short-term loan receivables," which contains hedging and other financial transactions and some pre-paid expenses, Nokia officials said. The numbers aren't huge compared with the overall Nokia business.

But receivables are something to watch over the course of this year, even for a powerful and profitable company like Nokia.

This column appeared in The Wall Street Journal Europe on Monday January 28.