Saving Ericsson

The giant's fall was dizzying. Just as fast, Kurt Hellström must redesign the company or see it slam to earth

Ask investors what Ericsson's (ERICY ) business is, and you'll probably get the usual answer: It's the No. 1 seller of wireless telecom networks in the world. And oh--by the way, that business is in deep, deep trouble. Ericsson revenues this year will be 40% less than the record $24 billion booked two years ago. And losses? More than $5 billion total for last year and 2002. That's why Ericsson's widely traded B shares now sell for under a dollar. Sweden's most important company, in other words, is a penny stock.

But if CEO Kurt Hellström has his way, such ignominy won't be the final chapter. You can already get a glimpse of Ericsson's future in some farflung corners of the empire. Just stop by the operations center of O2 Netherlands, the Dutch wireless subsidiary of Britain's MMO2, for example, and you'll see workers in Ericsson T-shirts sliding new radio modules into racks of equipment and hunched over computer workstations monitoring the nationwide network. These 240 technicians aren't employees of O2. They're an all-Ericsson team, permanently based at O2 to run the wireless network lock, stock, and barrel--Ericsson, the company-for-hire. For this traditional maker of big network systems, it's a huge change.

There are more surprises. Ericsson once proudly made all its own products and hoarded the fruits of its research & development. But Hellström knows pride doesn't produce profits. So he has passed off a majority of Ericsson's manufacturing--and more than 5,000 of its employees--to contracting outfits like Flextronics International (FLEX ) and Solectron (SLR ). Even more startlingly, he's outsourcing some of Ericsson's R&D to more cost-effective contractors. Indian software powerhouse Wipro now runs Ericsson's software labs in New Delhi, Hyderabad, and Bangalore. At the same time, Hellström has opened new units to license the company's technology to rival companies worldwide. In other words, the Swedes are renting out the crown jewels. They've even handed off their mobile handset business to a joint venture with former rival Sony Corp. (SNE )

There's a fundamental shift going on at this hidebound place, and the result could be a transformation of Ericsson into a new kind of company: a wireless specialist that depends on services more than manufacturing, on knowhow more than metal. If the transformation requires the deconstruction of Ericsson, so be it. "I can imagine better situations to be in," Hellström says. "But on the other hand, the job has to be done."

The urgent question is whether Hellström has the time he needs to do that job. To get a sense of what this embattled CEO is up against, check out the ghastly numbers he reported on Oct. 18. Ericsson lost $460 million, as third-quarter shipments dropped almost a third from 2001 levels, to $3.62 billion. New systems orders plunged 49%, and there are some signs Ericsson may be losing share to rivals such as Nokia (NOK ) and Lucent Technologies (LU ). Ericsson's bet that operators would roll out new 3G wireless systems fast has proven disastrously wrong. True, shares have jumped 21% since the earnings announcement after Ericsson's executives said that costs were declining according to plan, edging the networks business closer to breakeven. But that rally just pushed the shares to all of 65 cents. At their peak in March, 2000, Ericsson shares traded at nearly $19.

Hellström is trying to build a future for the company while scrambling to survive a hellish present. Since being drafted back from a choice Hong Kong sales posting in 1999 to become Ericsson's president and later CEO, Hellström has had to lay off 40,000 of 110,000 workers, with an additional 10,000 to come. In August, he had to tour Europe and North America with a begging bowl, raising $3.1 billion in a fire-sale stock issue to keep Ericsson afloat. That offering largely succeeded because patriotic Swedes ponied up much of the dough. "I talked to a lot of small shareholders," says Chairman Michael Treschow, who joined Ericsson in April after turning around domestic appliances maker Electrolux. "There was a lot of emotion, a lot of national pride."

But don't mistake patriotism for affection. Hellström may be the most hated man in Sweden. He's regularly vilified by the tabloid press. Last year, one paper even made its front page into a mock "Wanted" poster, complete with mug shots of the job-slashing CEO. "People have done a really good job, and as thanks we get big layoffs," says Peder Bostrom, head of the metal workers union in Kumla, a town of 19,000. Ericsson's plant there has lost 2,350 of its 3,200 jobs in the last two years, in some cases leaving families without a breadwinner. Analysts say the cuts announced so far should be enough to return Ericsson to slight profitability in 2003 unless wireless- equipment spending falls even further than expected. But that's cold comfort in Kumla.

The company's woes--and those of the business ecosystem that sprang up around it--have shaved about 0.5% off Swedish gross domestic product and wiped out the source of one-fifth of the country's growth in the 1990s according to Klaus Eklund, chief economist of Stockholm bank SEB. Ericsson's near-death spiral has also hammered the portfolio of Investor, the publicly traded holding company of the powerful Wallenberg clan, which controls the biggest chunk of Ericsson stock. The Wallenbergs are standing firm. "Investor has actively supported management in very challenging market conditions," says Marcus Wallenberg, CEO of Investor as well as deputy chairman of Ericsson. But the loyalty exacts a price: Ericsson's crash has helped knock down Investor shares 54% this year, to the dismay of Wallenberg and his cousin Jacob, who jointly preside over the family's interests.

You would think Hellström would be a burnt-out wreck dealing with all this adversity. Yet on a recent fall afternoon in London, he seemed fresh and sharp and didn't hide his sardonic sense of humor. Commenting on what seems his quixotic quest to save Ericsson, Hellström replied with a grim laugh: "I enjoy being beaten up." What keeps him going, colleagues say, is his faith that mobile telecommunications--an industry he helped develop in the 1980s--will once more be a growth business. He's convinced Ericsson has a healthy future if he can just guide it through its crisis.

That future, however, will be starkly different from Ericsson's glorious past. Revenues grew fivefold from 1991 to 2001--a compound annual rate of 17.5%. Now, demand for traditional wireless equipment may not pick up for another half-decade, while the growing commoditization of communications hardware could permanently weaken margins. And turning a group of proud engineers into the leaders of a new service industry will require a huge cultural shakeup. Inside Ericsson, cynicism already runs high. Says one senior engineer: "They keep talking about reorganization and giving better service to customers, but we don't take it seriously."

Doubts about Hellström's plan even extend to the board of directors. "I don't think there is clear leadership," one board member says, "and there isn't agreement on the board about what should be done to try to turn the company around." In response, a company insider says the atmosphere on the board is better since Treschow's arrival and that the board realizes replacing the CEO now would spook the markets.

Such uncertainty isn't stopping Hellström from carrying on with his makeover. His strategy of selling services and basic technology bears a remarkable similarity to the model pursued by former IBM CEO Louis V. Gerstner Jr. during its turnaround in the 1990s. No wonder: The situation facing telecom today is eerily like that which confronted the info-tech business a decade ago. Proprietary products are being superseded by cheaper open systems built from off-the-shelf parts. Vertically integrated giants such as Ericsson, Lucent, and Nortel Networks (NT ) are being undercut by newcomers such as Cisco Systems (CSCO ) and even rising Chinese star Huawei Technologies, just as IBM (IBM ) and Digital Equipment were battered by low-cost PCs from Dell Computer (DELL ). And margins are in full retreat.

What's more, as in the computer industry, the "value" in telecom systems is shifting from hardware to software and services. Operators used to spend 80% of their capital budgets on hardware and just 20% on software, says Amrish Kacker, a senior consultant at researcher Analysys Consulting in Cambridge, England. Now, the software portion is on track to top 35% within five years.

Hellström also has to improve Ericsson's returns if it ever aspires to become a growth stock again. Revenues per employee in 2001 were just $240,000--well below the industry average of $320,000. Return on capital that year plunged to negative 14%, down from 25% in 2000 and far less than the 28% logged by Nokia Corp. That's why Hellström and crew now have to slaughter a lot of sacred cows. Ericsson is eliminating 70% of its operating units, consolidating back-office functions into regional centers. Local managers had opposed the move, but now, Hellström says, "people are more concerned about the common destiny."

He's also slicing R&D in half by closing three-quarters of Ericsson's labs and phasing out work on antiquated mobile technologies. Most shockingly, he's walking away from Ericsson's legacy, winding down investment in traditional circuit-type telephone switches. Analyst Sofia Ghachem of brokerage UBS Warburg figures such discontinuations will save $435 million per year, with the balance coming from more efficient R&D. Meanwhile, software and services now contribute one-eighth of Ericsson's sales, but Hellström aims to increase that ratio to one-third within four years.

Hellström acknowledges that Ericsson looked to the IBM experience as a model. But the Swede faces a much nastier crisis than Gerstner ever did. Soft demand and pitched competition from desperate rivals such as Lucent, Nortel, and Alcatel (ALA ) have driven prices for wireless equipment down by as much as 30% in the last year. Even if Ericsson holds onto its one-third share of the shrinking business, it faces a revenue decline of more than $15 billion, or 56%, in the space of just 36 months.

The blunt-spoken Hellström, 59, made his name at the company as a sales whiz with a magic touch at preaching the wireless gospel to the world's big telecom operators. As CEO, his dark assessments of the state of the industry have given him a new dimension of notoriety. "I try to tell the truth as I see it," he says. "Even if it is harsh, I don't try to hide it." He's unhappy but not mawkish, for instance, about layoffs. "We don't have the option of doing nothing," he says coolly.

This summer's stock-rights issue put the company's balance sheet back in shape, with cash on hand rising above $7 billion and net debt effectively eliminated. It helped that Ericsson was relatively conservative about acquisitions in the go-go years. "They didn't buy market share in the wrong markets," says former CEO Sven-Christer Nilsson, whom Hellström replaced in 1999.

Problem is, Ericsson still depends too much on a recovery in equipment orders that may well not occur. "The critical thing is revenues," says telecom analyst Angela Dean of Morgan Stanley in London. Will services and software come to the rescue? "Ericsson can confidently say it has the skill to manage networks for other people," says analyst Bill Lesieur of Technology Business Research Inc. in Hampton, N.H., "and the downturn is really forcing the growth of outsourcing." Of course, battered rivals are also chasing services business and winning contracts, such as a $40 million job awarded last July to Alcatel to manage the wireless network at Austrian carrier Tele.ring Telekom Service. But on Oct. 21, for instance, Ericsson scored a hard-fought $150 million contract to upgrade China Unicom's (CHU ) mobile network--even though most of the equipment for the project will come from rivals Lucent, Motorola, and Nortel. The coup was also good news for Ericsson's China business, which analysts fret could be losing momentum.

In case services don't pay the bills, Hellström has another asset to exploit. Ericsson possesses a vast wealth of 10,000 technical patents, including key technology for hot properties such as Bluetooth short-range radio. One company unit now sells kits enabling other companies to churn out handsets based on Ericsson models. Another unit pursues licensing deals for communications technology. Designs have been licensed to six companies, including LG Electronics of South Korea, GVC of Taiwan, and TCL Group of China, as well as to Ericsson's 50/50 handset joint venture with Sony. Revenues are only a blip so far, analysts say, but with nearly 100% profit margins, licensing could become lucrative.

If all of Hellström's efforts aren't enough to stem Ericsson's cash burn, he might have to get out the begging bowl again. Investors next time would likely balk, especially since they are still uneasy about the company's unusual ownership structure. Quietly, Hellström, and especially Treschow, are now working to fix it. The issue: The company's two main shareholders, Investor and Industrivarden, a holding company affiliated with Stockholm bank Handelsbanken, control close to 78% of the votes at the company despite owning only about 11% of the equity. The two groups maintain their grip through special A shares that have 1,000 times the votes of ordinary B shares. The setup has proven a handicap of late. When Ericsson asked institutional investors for new capital this summer, they wondered why they should ante up for a company which they couldn't influence and whose main owners had allowed to drift close to the brink.

To allay such concerns, Investor and Industrivarden are considering a reduction in the voting ratio of A to B shares from 1,000-1 to 10-1, which would reduce their control of votes to around 30%. "The ownership question is not a problem," says Marcus Wallenberg, "but it can be a minor distraction in discussions with the financial markets." Treschow thinks that a change might make Ericsson shares more attractive and liquid. "There might be more participation by international investors who do not understand and live by our conditions," Treschow says. Those conditions are looking increasingly outmoded, and dangerously so. Swedes may find Hellström's medicine hard to take. But for Ericsson, there is no choice.

By Stanley Reed and Andy Reinhardt, with Ariane Sains in Stockholm

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