Be Careful Bottom-Fishing in Motorola Shares

Motorola (NYSE: MOT) is in a bit of trouble. The company recently announced a large profit shortfall and poor revenue growth stemming from declining prices for its RAZR phone and weak sales of its new offerings. While its email device, the Q, had received early praise, it now faces competition from Research in Motion's (RIMM) Pearl.

And, amidst all of these concerns, Apple's (AAPL) iPhone may force MOT to alter its competitive strategy for profitability in the cell phone market. There's also a small Finnish firm named Nokia (NOK) that likes to stick its finger in MOT's eye domestically and create havoc for the firm overseas.

Although MOT has always encountered strong competition (and Apple will likely target much less than 10% of the global cell phone market of 1 billion devices), it now must handle the traditional players - NOK, LG, Samsung, SonyEricsson - while attempting to convince consumers that its non-iPhone/non-Pearl offerings should command higher prices.

Investors' expectations may have been too high for MOT, and several ongoing concerns signaled problems:

1) MOT's past reliance on one-time income gains to bolster earnings. In reviewing its 10-Q's over the last 18 months, I felt uneasy with the firm's reliance on one-time gains (sale of its automotive division, MOT's Nextel stake, and Freescale Semiconductor spinoff) to bolster its short-term profits, and was not convinced that RAZR sales would later offset mediocre performance by the firm's other products - cell network equipment, cable boxes, semiconductors, emergency communication devices. While the stock hovered in the low 20's, analysts lauded the company for shedding capital intensive businesses, strengthening its balance sheet, and initiating stock buybacks and a dividend increase.

But its stock price left little room for error in handset profit and revenue growth. To demonstrate MOT's dependency on cell phone sales, according to the latest 10-Q, MOT 's mobile phone division now provides nearly 66% of the firm's revenue and 67% of its operating income compared to 61% and 54%, respectively, in the year-ago quarter. Based on details included in the warning, RAZR's still sell in volume, but at much diminished profit margins and no signs of a price recovery.

The firm now faces deteriorating profit margins and slowing revenue growth in the core, retained businesses, and it will need to bolster its R&D spending to be competitive. MOT focused too heavily on financial engineering, and demonstrated mediocrity in executing its business strategy. These remain significant concerns that management will need to address to rebuild its reputation on Wall Street.

2) MOT also underestimated consumers' willingness to pay premiums for widely available cell phones without highly desirable proprietary features. Focusing on customer gains, cell phone carriers have systematically devalued mobile phones in the consumer's mind. By constantly promoting low-end cell phones bundled with a long-term contract and indulging the willingness of Asian carriers to sell quality phones at low price points to gain a foothold in the US market, these carriers have conditioned Americans to think that they should pay $50 or less for a cell phone. Great for carriers, terrible for handset makers.

In anticipation of the iPhone, I'm sure that some investors hoped that Apple would independently sell the device without carrier bundling. AAPL could then reestablish a price floor for high-end cell phones and a market for unlocked devices that can be used with multiple carriers. However, as we learned yesterday, it will only be offered at Cingular, and the iPhone's features may be so superior to any other device that it becomes its own product category. Not good for the profit margins of MOT, NOK, or possibly even RIMM. MOT's ability to price its devices at a premium will suffer.

3) MOT may have mismanaged its carrier relationships. Carriers have become reluctant to promote phones that they do not exclusively sell because they promote the device more than their service. Also, as Smith Barney noted in its November assessment of MOT, consumers will frequently (and only) pay a premium for devices that possess "carrier exclusivity" - phones available from only one provider. Thus, MOT can attempt to maximize profit through exclusivity deals that maintain high sales price points for its merchandise, but it caps overall sales volume through the inability to offer devices at every carrier. MOT has experienced a tough balancing act with these issues, especially as they fail to offer compelling devices to which consumers would spend more money to upgrade.

For example, over the last year, nearly all US carriers have offered the RAZR at rapidly declining prices, and MOT has been unable to sell its replacement, the similar KRZR, at a higher price point even at selective carriers such as Verizon (VZ). Investors have witnessed the mass advertising of the lower priced RAZR for at least 12 months. In retrospect, more concern should have arisen that MOT's profit margins would decline as the RAZR became a mass market item that would only gain full acceptance and sell in volume at prices that would severely damage MOT's profitability.

Foreign Sales Gain Importance
So, what happens in 2007 as MOT's other subsidiaries continue to lag? Sales in China, India, and emerging markets become acutely more important to the company, regions of the world in which MOT's supply chain and international carrier relationships can distribute millions of low-cost phones. The international category currently accounts for 60% of the firm's wireless device sales. Hopefully for MOT shareholders, once those nations establish a viable middle class that would welcome higher priced devices, the firm will have developed products to match other offerings.

It also purchased wireless email software provider Good Technology last quarter to bolster its messaging offering for future devices and compete with RIMM's Blackberry. However, MOT must demonstrate its capacity to integrate the software into useful products that can capture market share from RIMM and deserve higher profit margins.

Private Equity Buyout?
At 1-times sales (using enterprise value), could a private equity firm buy the company? The firm's book value remains nearly $7/share (inc. $14.5B in cash and short income securities), it retains a manageable $3.8B in debt, and MOT possesses one of the strongest global brands. However, what's the real free cash flow for the firm? Using EBITDA may be dangerous - MOT faces the need to significantly increase spending for R&D and potential acquisitions over the next two years. Also, the cost of debt may be cheap, but I'm unsure that the existing shareholder base has given up on the company yet.

While stocks of firms with strong balance sheets and a global brand that have a great deal of negativity surrounding them have typically been great investments, MOT has several fundamental business issues to solve. I'd take a good look at the stock a few dollars down from the $19 level, as its free cash flow yield rises above 7% and P/E ratio hovers around the mid-teens. All said, MOT shares may be be dead money for at least the next 6-12 months as it attempts to rebuild its profit margins, but you may be able to eventually catch some discounted shares.

Thanks for your time, and I welcome all feedback.

Disclosure: I'm long AAPL

MOT 1-yr chart:

Comments

[Alan Harris:]

Everyone seems bearish on MOT, the more so now that iPhone is coming. However RIMM is the one likely to suffer most from the iPhone since it will sell well with the very same affluent prosumer clients RIMM is depending on for their ambitious growth drive with the pearl, and one does not need 2 phones. It is far more likely that the lofty p/e of RIMM will trip up investors, as the expectations from analysts leave no room for disappointment. Furthermore, RIMM's recent reported increase in "revenues" is mainly Pearl channel fill, some of which is into unlikely carriers in exotic locations, and might significantly falter mid-year should the end consumer buy alternative products. MOT is well positioned to be a long term success in the mobile space but is priced for no upside.

2007 Jan 11 07:47 AM

[Sonia Mirza:]

Great article Bill. I think, despite what the analysts are saying and the doubts over MOT with respect to RIMM etc, MOT is a good long term investment. Given the recent downturns - likely a decent buying opportunity.

Alan - I'd like to know why you think MOT is priced for no upside?

Cheers,

Sonia

2007 Mar 13 10:40 PM