Q3 2019 was impacted by cost provisions of SEK -11.5 b. related to the investigation by the United States Securities and Exchange Commission (SEC) and the United States Department of Justice (DOJ) as well as a refund of social security costs of SEK 0.9 b.
Comments from Börje Ekholm, President and CEO of Ericsson (NASDAQ:ERIC)
Amid the continuing global COVID-19 pandemic and with more than 80 percent of our people working from home, we keep on executing on our focused strategy. We continue to win footprint in several markets leveraging our competitive 5G portfolio. The gross margin improved in all segments in the third quarter and reached 43.2 percent (37.8 percent), the highest since 2006. With the acquisition of Cradlepoint, expected to close in Q4, we are making further progress in our strategy to build an enterprise business. COVID-19 has so far had limited impact on our business, but we are closely monitoring any signs of a change in the situation. The year to date results strengthen our confidence in delivering on the 2020 Group target.
Networks grew organically by 13 percent and reported a gross margin of 46.7 percent (41.6 percent). This reflects high activity levels in North East Asia and North America. Underlying business fundamentals remain strong in North America driven by consolidation in the US operator market, pending spectrum auctions, and increased demand for 5G. The 5G contracts in Mainland China have developed according to plan, contributing positively to profits in Q3 and are expected to improve further. Our business in Europe grew based on several footprint gains. While the pandemic has hurt revenues for several of our customers, and in some cases this has led to a reduction of capex, we have not seen any negative impact on our business, largely due to footprint gains. However, the pandemic negatively impacted our sales in Latin America and Africa.
Digital Services continued to make good progress on the execution of the turnaround plan, transforming the business and increasing software sales. The gross margin improved to 43.5 percent (38.3 percent), supported by increased software sales and improvements in the underlying business. Our cloud-native 5G core portfolio shows very positive momentum with a high win-ratio and a significant number of new customer contracts. We are selectively increasing research and development investments to accelerate our growth portfolio to capture market opportunities. However, sales in our legacy portfolio is declining faster than earlier predicted. In the short term, this shortfall will not be compensated by the growth in new offerings and therefore our sales volume is lower than expected. With weaker sales in combination with higher R&D investments, there is a risk of further delay in reaching the 2020 operating margin target for Digital Services.
Managed Services delivered a gross margin of 20.1 percent (17.9 percent). The 4Q rolling operating margin is 7.4 percent. Sales declined mainly due to the US operator consolidation. We expect our investments in automation and AI to create future business opportunities, which are anticipated to gradually improve the margin profile as this new portfolio grows.
Emerging Business and Other reported a gross margin of 30.5 percent (20.5 percent). Our IoT platform sales grew by more than 40 percent despite an impact on demand from COVID-19. In the quarter we announced our plans to acquire Cradlepoint, which will strengthen our ability to grow in the 5G enterprise market alongside our existing dedicated networks and IoT portfolio. Cradlepoint will drive revenues for our customers as wireless WAN gains further penetration. Cradlepoint will operate as a standalone subsidiary within Ericsson, and we look forward to welcoming the team at Cradlepoint to Ericsson.
Patent licensing continues to perform well based on our strong IPR portfolio, even though revenues decreased in the third quarter as one of our licensees experienced lower sales volumes. We are approaching several important contract renewals. We are confident in the value of our broad patent portfolio, including a strong position in 5G and will seek to maximise the net present value of our patent estate that has been built over time through our large research and development investments. Depending on timing of the agreement renewals, we may see gaps in IPR revenues in 2021 and 2022.
Free cash flow before M&A amounted to SEK 3.9 (4.5) b. in the third quarter, a year-on-year improvement of SEK 1.9 b., if adjusted for a capital injection into the Swedish Pension Trust and last year’s positive effect from a social security refund. On a 4Q rolling basis we have generated SEK 17.7 b. of free cash flow before M&A if excluding the payments to SEC and DOJ.
We are committed to continue improving our Ethics and Compliance program. Through driving stronger management ownership and accountability for compliance, we are also reinforcing our commitment to responsible business practices and a stronger corporate culture. Our people should always be able to speak up and we expect Ericsson leaders to operate with integrity at all times.
Open RAN is a hot topic in our industry today and Ericsson is a strong supporter of openness and actively engages in alliances, such as 3GPP, ONAP and the O-RAN alliance. In the years to come, networks will gradually evolve, as will the current open standards. At the same time 5G is ready and happening now so focus must be on providing early access to 5G networks to enable the broader ecosystem to innovate at scale.
We remain positive on the longer-term outlook for the industry and Ericsson. The year to date results strengthen our confidence in delivering on the 2020 Group target.
View the report here.