Motorola Solutions (NYSE:MSI) recently announced a weak set of Q1 2014 results as government revenues fell 11% and operating profits fell by 21% over the same period last year due to a higher-than-expected overhanging impact of narrowbanding in North America. A sustained decline in the federal business also had an impact on government revenues, and the company expects only a modest improvement this year from the government shutdown-related lows of last year. The company’s enterprise revenues, excluding iDEN, declined just 1% over the same period last year – recovering gradually from recent macroeconomic uncertainties and offsetting some of the impact of the under-performing government division. Motorola expects the demand environment, especially in the government business, to remain challenging in the near term, with government sales expected to decline by 8-11% in the second quarter.
In order to focus singularly on its government business, which accounts for almost 70% of its total revenues, Motorola has decided to sell off its enterprise division to Zebra Technologies for $3.45 billion in cash. The company expects the deal to close by the end of the year, following which the excess capital will be returned to shareholders “in a timely manner.” The enterprise sale provides Motorola with an opportunity to restructure and reduce costs in keeping with the current business environment. Motorola expects to cut around $200 million in operating costs over the next 18-24 months. We have a slightly revised $65 price estimate for Motorola, which is about in line with the current market price.
Narrowbanding And Federal Impact
One of the biggest reasons that Motorola mentioned for its top-line underperformance last quarter was its lower-aged government backlog in North America. The company acknowledged that it underestimated the impact of narrowbanding in previous years, which had led to record years in 2012 and 2011. Motorola’s government revenues in those years were boosted by the narrowbanding mandate issued by the Federal Communications Commission (FCC), which necessitated a switch to a more efficient spectrum band for public safety operations. With most of the narrowbanding-related equipment upgrades now complete and government agencies slowing their capital spending, Motorola’s government business faces near-term growth concerns.
The tough year-over-year comparison was accentuated by a challenging federal environment in the aftermath of the recent government shutdown in September. In the fourth quarter, Motorola had suffered a revenue hit of about $150 million in its federal business. Since most of this shortfall wasn’t deferred, Motorola was unable to recoup the losses in Q1. The federal slump should continue in the near term, with government sales expected to decline by about 9.5% at the mid-point of guidance. However, for the full year, the company expects a solid back-half recovery to help stem the slide to the low-to-mid single digits. The downside is limited by the fact that public safety is usually down the priority list of areas in which governments will look to cut their spending. As a result, we see any further impact to government revenues from sequestration, or the spending cuts that the federal government started implementing, being fairly muted.
LTE Transition And Margins Key To Long-Term Fundamentals
Going forward, we see the adoption of LTE for public-safety use, along with the broader trend of analog-to-digital shift in the U.S. and internationally, as the key drivers of Motorola’s value. U.S. public safety spending in the coming years will be bolstered by the job creation bill passed in 2012 that reallocated the D Block spectrum for public safety use and provided a funding of $7 billion to build out a nationwide network over eight years. We expect Motorola to benefit from the stickiness of its government customers as well as its strong market position and large installed base of security devices to grab a big chunk of that market going forward. The company’s recent launch of APX 7000L, its first two-way portable radio that works both on legacy LMR (Land Mobile Radio) and next-generation 4G LTE networks, bolsters our view that Motorola has positioned itself strongly to benefit from the LTE transition in the years to come (see Motorola Solutions Sharpens LTE Focus With First 4G-Capable Radio For Public Safety).
It is also a good sign for the future that the company has been successful in driving efficiency through its operations over the last couple of years, and expects to accelerate those efforts in the coming quarters. Despite the top-line concerns and significant operating leverage in the business, Motorola expects operating margins to improve by almost a percentage point to 18.5% in 2014, benefiting mostly from the cost controls in place as well as the $200 million in cost cuts expected over the next two years. Going forward, we expect the operational efficiencies to more than offset the gross-margin decline that could result from rising competition in the coming years as rivals increasingly address the ongoing transition of public safety networks from analog to digital.
Disclosure: No positions.