LM Ericsson (NASDAQ:ERIC), the Swedish telecom company, is poised for massive growth in the 5G market. But Ericsson stock still represents good value in the stock market, despite its huge growth prospects.
For example, it trades for just 16 times forward 2021 earnings. In addition, it has an attractive 1.35% dividend yield and a 4.87% free cash flow (FCF) yield.
Going forward, Ericsson stock has the possibility of rising at least 50% from here over the next year or two.
Reasons Why Ericsson Stock Will Rise
One reason for my optimism on the gain is because the average forward price-to-earnings (P/E) ratio for the stock has been 24x forward earnings, according to Morningstar. But the P/E ratio for 2021 is just 16.2x. Therefore its upside is 50% to get to 24x earnings.
Another reason is that analysts expect earnings to increase at least 24% next year, and likely the year after. This is based on the company’s expected uptake in 5G contracts it signs with clients over the next two years.
Much of this has been driven by gains in market share in Mainland China, as it noted in its latest quarterly report. In addition, it is picking up 5G contracts from telecom operators like BT that no longer want to deal with China’s Huawei for security reasons.
So even if its P/E ratio stays the same. the earnings growth will drive the stock up at least 50% over the next two years.
Moreover, its focus on boosting free cash flow (FCF) growth has been paying off. For example, FCF rose 51% year-over-year after adjusting for a pension obligation payment it had to make (i.e., a one-time charge). If this FCF growth continues Ericsson will likely rise as well.
For example, Q3 FCF increased to $481.8 million from $442.3 million in Q2. That is an 8.83% gain and represents an annualized compound growth rate of 40.7%. That kind of growth can only be good for the Ericsson stock price.
What Analysts Say About Ericsson
The Financial Times astutely pointed out that Ericsson remains vulnerable to retaliatory action by Beijing for Washington’s actions against its telecom manufacturers. That could put a huge dent in its growth prospects.
This risk also probably accounts for a good reason why Ericsson stock is so cheap.
However, in Ericsson’s Capital Markets Day presentation on Nov. 10, the company spelled out in more detail its focus on 5G growth. In addition, it showed how the company plans on maintaining its high 8 to 10% FCF margin.
TipRanks reports that three analysts have a Strong Buy rating on Ericsson stock, but it does not have enough information to delineate their average price target. Marketbeat reports that 15 analysts have an average price target of $12.50, or 4.4% above Wednesday’s close of $11.97.
However, Yahoo! Finance’s data reports that seven analysts have an average price target of $13.81, or 15.4% above today’s price. Moreover, the site’s data indicates that four reports out of 10 that have come out since the Q3 earnings report were for Buy or Strong Buy ratings. Another six were Hold, and two were Underperform.
What To Do With Ericsson Stock
Back in February, at the height of the U.S.-China telecom cold war, Ericsson’s largest shareholder, a European activist fund called Cevian, urged the board to allow a U.S. takeover. The problem was there was no proposal by any group or any official in Washington to do this.
Nevertheless, the incident shows that Ericsson is potentially a viable takeover candidate. However, a suitor would have to pony up at least $40 billion in cash and shares, plus a control premium.
Moreover, they would be taking on the risk that the Chinese government would stop it. They might not approve a takeover, given the company’s various contracts that require a change of control approval.
Therefore, I would not invest in Ericsson stock assuming that a takeover is likely going to happen. Short of that, this is more or less a “growth at a reasonable price” or GARP play.
The idea is that the company has embedded growth of 40% to 50% over the next several years as 5G contracts take hold. In addition, the price for Ericsson stock is reasonable at just 16x forward earnings.
On the date of publication, Mark R. Hake did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.
Mark Hake runs the Total Yield Value Guide which you can review here.
