Ericsson's Surprise Nosedive

Sudden news of declining profits sent investors running for cover. Is it a sign of things to come for the telecom industry?

Ericsson president and CEO Carl-Henric Svanberg attends a meeting in New York, Sept. 28, 2007 Stephen Hilger/Bloomberg News

by Andy Reinhardt

Was it bad luck, bad management, or a warning sign of deeper problems lurking in the $250 billion telecommunications equipment business? Investors didn't know the answer, so on Oct. 16 when mobile networks giant Ericsson (ERIC) warned of lower-than-expected third-quarter revenue growth and a sharp decline in profits, they took the path of least resistance and pressed the sell button. And pressed it again. And again.

By midday, Ericsson stock had plummeted more than 29%—the biggest intraday drop ever recorded for the century-old Swedish company—taking shares down to levels last seen in 2004. In a blink, some $17.5 billion in market capitalization had vaporized, though by the end of the day, prices had recovered somewhat to a loss of 23.8%. Ericsson's swoon also dragged down the Stockholm exchange, which closed off 3.1%, and other stocks and exchanges across Europe.

An Abrupt About-Face

Overblown market reaction or not, Ericsson's warning struck a nerve among investors scanning for signs of economic slowdown in the wake of the U.S. subprime loan crisis and its late-summer spread to global capital markets. The sudden reversal of fortune for the strongest player in telecom gear suggested that operators might be paring back capital spending because of slowing demand or the rising costs of financing.

Even if a broader slowdown isn't under way, investors were rattled by the rapid change of tone from Ericsson's executives. Just six weeks ago, the company met analysts in London and delivered a bullish forecast. "Confidence in management has been shattered," says analyst Richard Windsor with Nomura Securities in London. "They stood up two weeks before the end of the quarter and said that everything was okay. They should have known by then."

Ericsson had been scheduled to announce third-quarter earnings on Oct. 25, and analysts were expecting roughly 10% year-on-year revenue growth with steady operating margins of around 20%. Instead, less than 24 hours after final quarterly figures were compiled, the company held an emergency board meeting and then disclosed that sales would be up just 6%, to 43.5 billion Swedish kroner ($6.77 billion), short of the $7.07 billion forecast by the Street.

Poor Outlook on Future Margins

That doesn't sound so bad, but the real problem lay deeper in the numbers: Quarterly profits were down 36% from last year, to 4 billion Swedish kroner ($623 million), about 37% below consensus expectations. Worst of all, operating margins plunged from 21.2% last year to just 12.9% in the quarter, and Ericsson's fourth-quarter guidance suggested future margins in the "mid-teens," far below what analysts were banking on. The company also projects slightly lower-than-expected fourth-quarter revenue growth.

Ericsson blamed the shortfall on an unexpected decline in sales for its high-margin software and network-upgrade businesses. The company relies on these more profitable sales to offset lower margins in new network construction, especially in the developing world, where it has been discounting heavily to nab business away from rivals Alcatel-Lucent (ALU), Nokia Siemens Networks (NOK) (SI), and Nortel Networks (NT).