A 3G Windfall for Ericsson?


By Ari Bensinger While poor connections for wireline phone service are unacceptable, they have, unfortunately, become the norm for wireless. Indeed, it's safe to assume that just about every wireless customer has had a cell-phone call dropped at some time. The sad reality is that most wireless networks in the U.S. have been neglected over the past couple of years, as carriers focused on improving their cash flow, primarily through lower capital spending.

However, carriers are quickly realizing that trustworthy wireless network quality is essential to retaining customers in an intensely competitive environment. With wireless increasingly becoming the sole phone service for many people, especially the younger generation, we at Standard & Poor's Equity Research believe that network quality has become a key success factor in this market. The aggressive "can you hear me" ad campaign for Verizon Wireless, the largest mobile service in the U.S., shows how important the perception of network quality is becoming to the carriers.

CATCH-UP TIME. Equipment vendors, in particular, are well positioned to benefit from this shift in spending to improve network quality, in our opinion. Indeed, most wireless-equipment makers experienced strong sequential sales growth over the past two quarters. After several years of significant capital-spending cuts, it's apparent that wireless carriers are beginning to loosen the purse strings once again.

We at S&P acknowledge that a spending catch-up from a prolonged period of severe network underinvestment will naturally abate over time. However, we also believe that an accelerated transition toward advanced third-generation, or 3G, technology will more than offset any slowdown in second-generation network-improvement spending.

Benefiting from Internet-style packet-based technology, 3G networks should offer substantially enhanced voice capacity and data rates, thus allowing advanced consumer services. In the U.S., carriers with substantial wireless businesses, such as Verizon (VZ

; ranked buy; recent price: $40) and Sprint (FON

; avoid; $20), as well as pure wireless play AT&T Wireless (AWE

; hold; $15) are all beginning to deploy some form of 3G technology.

SALES INCREASE. Greater network bandwidth should lead to newer and more powerful wireless applications, such as full-motion video and interactive conferencing. As carriers move toward advanced services, traffic demand will likely increase dramatically, which should drive still more purchases of network equipment. In our view, the evolution of 3G networks will provide a tremendous opportunity for equipment makers that are able to adapt to the changing characteristics of communications traffic.

With a roughly 30% share of the wireless infrastructure market, we at S&P believe Ericsson (ERICY

; accumulate; $28) is best-positioned to benefit from the current network upgrades and increased deployments of 3G technology. We forecast sales advancing 10% in 2004, to about $17 billion, following a 20% decline in 2003. Aided by the higher sales volume and aggressive restructuring initiatives, we see gross margins widening by more than 9 percentage points from 2003's 37%, well above the industry average.

Ericsson's operating expenses as a percentage of sales should be dramatically lower in 2004 than in 2003, thanks to continued cost cutting. After translating from Swedish kroner to U.S. dollars, and excluding restructuring charges, we see earnings per share of $1.60 for 2004, vs. 12 cents for 2003.

ROOM TO IMPROVE. With respect to valuation, Ericsson shares are trading at 17 times our 2004 EPS estimate, resulting in a p-e-multiple to growth (PEG) ratio of 1.4, using our 12% projected long-term growth rate, which is below the peer average PEG. The shares traded recently at 2.3 times our 2004 sales estimate and at 3.2 times book value, slightly above the peer average.

Our discounted cash-flow analysis, assuming a weighted average cost of capital of 11.2%, indicates an intrinsic value of $38. Based on a blend of relative and intrinsic analyses, we have a 12-month target price of $36 for Ericsson.

Risks to our recommendation and target price include delays in the widespread deployment of 3G technologies, increased acceptance of competing technologies, lower demand for wireless communications, and increased carrier consolidation.

Still, we at S&P view Ericsson shares as attractive in light of the significant growth opportunities we see as the wireless network market makes a transition to 3G technologies. We would accumulate the shares.

Note: Ari Bensinger has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. (SPSI). Affiliates of SPSI received noninvestment-banking compensation from AT&T Wireless and Verizon during the past 12 months. Price charts and required disclosures for all S&P STARS-ranked companies can be found at www.spsecurities.com Analyst Bensinger follows communications equipment stocks for Standard & Poor's Equity Research


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