Ericsson Stock Is Too Lofty to Hold At These Prices

LM Ericsson (NASDAQ:ERIC) produces a good deal of free cash flow, including its most recent quarterly results. But ERIC stock already reflects this strength and there might be little room for upside.

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For example, Ericsson, a 5G telecom equipment manufacturer, has a market value of about $30.8 billion. In the last 12 months it generated about $1.07 billion in free cash flow. So it trades for 28.8 times its FCF.

Another way to look at this is that the ERIC stock has an FCF yield of 3.47% (i.e., the inverse of 28.8, or 1/28.8). This is not that high an FCF yield and reflects a fairly fully priced stock.

Another View on ERIC Stock

Maybe I am being too pessimistic. In today’s topsy-turvy stock market, any company like Ericson that produces a good profit, powerful cash flow and keeps its guidance steady is a good pick.

After all, the company is still paying its dividend. However, it only pays the dividend once a year and Ericsson just paid the dividend.

Moreover, the dividend yield is only 0.9%. This is because Ericsson only pays out just 23% of its FCF as dividends in the last 12 months. You can see this information in Seeking Alpha’s historical analysis of the company’s cash flow statements.

That is not a very high payout ratio compared to American tech companies that pay dividends. But on the other hand, Ericsson’s business fundamentals are very solid.

There’s Strong Demand for 5G Technology

Although Ericsson’s revenue for Q1 was up 2%, it was actually down 2% in constant currency and in terms of units sold when compared to a year ago. Compared to last quarter, ERIC revenue was down 25%.

But this is probably to be expected given the effect of the coronavirus on the worldwide economy. Ericsson CEO Borje Ekholm indicated that the underlying business fundamentals remain strong.

Here’s why: The data economy is growing stronger. This trend is stronger now that many are forced to work at home. Therefore, demand for Ericsson’s 5G and related switching equipment is robust. Ericsson seemed to imply that it was slow delivery and equipment supply impeded its revenue growth.

Moreover, its gross margins excluding restructuring charges improved to 40.4% versus 38.5% last year.

What Should Investors Do With Ericsson?

Ericsson is a growth stock in a sea of losers. But there is no great bargain element in ERIC stock. Frankly, there is no great compelling reason to buy the company.

One thing that investors might do is wait for a situation where there is a more compelling valuation. For example, right now ERIC trades at $8.24 per share, but its book value is much lower at $2.43 per share. That is 3.4 times its present equity value.

Moreover, in the past 10 years, this stock has gone nowhere. On May 4, the stock was $11.14 per share, with no splits during that period. This drop of nearly $3 per share has given an investor a negative 25.7% price return in the past decade.

Even if you include the once-a-year dividends, which have been all over the place, $3.14 in total, the total return was just 27 cents. So if you held ERIC stock for 10 years, your total return was 2.4% in total. That works to an annualized compounded return of just 0.24% per year.

My point is this: if Ericsson has such a terrible track record as a stock, why is the present market valuation so high? It certainly does not seem to be worth 28 times free cash flow, and a paltry 0.9% dividend yield.

Investors can find better places to put their money than Ericsson. Despite the company’s excellent business fundamentals and outlook, as well as its financial ratios, I would wait for a chance to buy it a bargain price.

As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide, which you can review here.

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