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Ericsson Is Undervalued and a Potential Acquisition Target

After delivering a decent quarterly performance and finishing 2019 on a positive note, Telefonaktiebolaget L M Ericsson (NASDAQ:ERIC) has been the subject of merger and acquisition-related speculation. The company is leading the 5G rollouts in Europe and North America, with the political scrutiny faced by rival Huawei acting in its favor.

There appears to be a possibility of a potential merger with Scandinavian peer Nokia Oyj (NYSE:NOK) or even a chance of Ericsson being acquired by an American mega-cap like Cisco Systems Inc. (NASDAQ:CSCO), Dell Technologies Inc. (NYSE:DELL) or Microsoft Corp. (NASDAQ:MSFT) given that the U.S. government might consider countering Huawei's role in the global 5G rollout through European company acquisition. Despite promising results, Ericsson's stock trades at a discount given the coronavirus-affected macro and weakened industry perception.

Company overview

Ericsson is the well-known telecommunication equipment giant from Sweden, which was once a key player within the global mobile handset industry.

Today, the company sells hardware, software and services primarily to communication service providers while licensing patents to handset manufacturers. It has two main divisions - Ericsson Networks and Ericsson Technologies. While the former deals with mobile networks like 5G, IP networks, fixed networks and optical networks, the latter provides various cloud and software solutions related to customer experience management, network operations and management, communications and collaboration, policy and charging, security and analytics platforms that enable digital services providers and enterprises to accelerate and optimize their customer experience.

Strong 5G-oriented growth

Ericsson has recently been in the news for leading the 5G rollout in Europe. The company has approximately 79 contracts and 24 live 5G networks (including SmarTone in Hong Kong and Cosmote in Greece, which were signed over the past couple of days) and is winning new contracts based on its technological superiority. Apart from Europe, where there is some competitive pressure from Nokia, Ericsson's rollout of 5G continues in North America with good underlying growth.

Another potential upside for the company is that Huawei has come under intense political scrutiny in Europe, which has been resisting pressure from the U.S. to ban the company from its core networks over fears that China could use them for spying. The British government has already imposed a cap on Huawei's involvement. Ericsson has been second to Huawei in the 5G implementation, but ahead of Finnish peer Nokia, and has made some strong technological advancements. Along with Japanese communications service provider KDDI (TSE:9433), the company has successfully demonstrated a cloud-native continuous integration/continuous delivery pipeline for the Japanese company's standalone 5G Core network. This is definitely a big breakthrough in delivering software features rapidly and with maximum efficiency. This will help Ericsson cater to the genuine need for communication service providers who are constantly requiring faster and more efficient software delivery models to reduce time-to-market for new features.

The company's market-leading 5G core and unique CI/CD capabilities imply a faster time to market, better performance and cost efficiency while maintaining high quality and availability of 5G core networks.

A potential merger is cooking

There are strong concerns in the U.S. with respect to Huawei taking the lead in the 5G technology implementation. President Donald Trump's attorney general, William Barr, believes that since the U.S. does not have a homegrown competitor that can match Huawei, the country should invest in a European giant like Ericsson or Nokia. The suggestion is to carry out the potential investment by acquiring a controlling stake in Ericsson through either a tech giant like Cisco or Microsoft. With potential tax benefits for the bidder, it seems likely that American tech companies, as well as leveraged buyout-focused private equity funds, could start bidding for a stake in Ericsson, which is a much stronger candidate than Nokia since it is more financially stable.

Apart from having stronger financial fundamentals as compared to Nokia, Ericsson also has more stable management. Nokia has been facing its fair share of issues after replacing CEO Rajeev Suri and is also dealing with cost issues, growth and profitability. South Korean electronics giant Samsung Electronics (XKRX:005930) could also enter the acquisition race in the near future. There is also a possibility that Ericsson explores the option of a potential merger with Nokia to build a formidable Scandinavian giant to compete with Huawei in the 5G race and provide better economies of scale.

Financial strength is unquestionable

Ericsson's stock fell from above $9 to about $6 before rebounding, and its upward momentum is continuing. The company ended fiscal 2019 with strong fourth-quarter results, reporting revenue of 6.94 billion Swedish krona, which was marginally above the analyst consensus estimate of 6.93 billion krona ($699.7 million), driven by excellent growth in the Middle East and the Northeast Asian markets. The company's gross margin and operating income rose to around 37.1% and 9.7% of revenue respectively, excluding structuring charges.

The Digital Services business has finally reached breakeven and also reported a positive operating margin. It must be noted that Ericsson bore a significant Securities and Exchange Commission fine recently, which took a bite out of net profits, but this hasn't hampered the company's ability to pay a dividend to investors and it continues to be cash-rich and generates strong free cash flow. It is worth mentioning that while the company's annualized revenue growth for the past three years has been slow, its Ebitda has been growing at a double-digit rate. This margin expansion is a very big driver of investor optimism.

Key takeaways

Investors should consider Ericsson given the company's attractively low valuation of about 1.1 times sales, strong positive margins, cash flows, promising technological developments and, most importantly, the fact that it is the best possible acquisition target for American companies in case they decide to take on Huawei in the 5G race.

The share price could zoom up if the company starts receiving bids or even announces merger talks with Nokia. The high dividend and the consistently growing payouts is also a strong positive factor that could lead to greater demand for the stock. Another point that is worth noting is the coronavirus has so far had a minimal impact on its business as the company's Nanjing factory seems to be running well. Overall, Ericsson is ideally suited for investors that have a minimum horizon of 12 months up to as much as three years.

Disclosure: No positions.

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This article first appeared on GuruFocus.