Motorola, Inc. (MOT)
Q1 2006 Earnings Conference Call
April 18, 2006, 5:00 p.m. EST
Ed Gams - Corporate VP of IR
Ed Zander - Chairman and CEO
Dave Devonshire - CFO
Ron Garriques - President, Mobile Devices Business
Greg Brown - President, Networks and Enterprise Business
Mark Sue - RBC Capital Markets
Ittai Kidron - CIBC World Markets
Inderbir Singh – Prudential
Susan Kalla - Caris & Company
Tim Long - Banc of America
Edward Snyder - Charter Equity Research
Daryl Armstrong - Citigroup
Maynard Um - UBS
Michael Ounjian - Credit Suisse
Tal Liani - Merrill Lynch
Hasan Imam - Thomas Weisel Partners
John Bucher - Harris Nesbitt
Christin Armacost - Glazer Capital
Jeff Kvaal - Lehman Brothers
Richard Windsor - Nomura Securities
Scott Coleman - Morgan Stanley
Good afternoon and thank you for holding. Your lines have been placed on a listen-only mode until the question-and-answer segment. Today's call is being recorded. If you have any objections, please disconnect at this time. I would now like to introduce Mr. Ed Gams, Corporate Vice President of Investor Relations. Mr. Gams, you may begin.
Good afternoon, everyone. With me on this conference call are Ed Zander, Chairman and CEO of Motorola, and Dave Devonshire, Chief Financial Officer. Joining us for the Q&A portion of this call are Ron Garriques, President of the Mobile Devices Business; Greg Brown, President of the Networks and Enterprise Business; and Dan Moloney, President of the Connected Home Business.
An Internet slide presentation is accompanying this call and can be viewed by visiting www.motorola.com/investor. Slides will be advanced automatically as our presentation proceeds. We encourage you to view these slides while you listen.
A replay of this web cast, including questions and answers, will also be available on our website at approximately 8 PM Central Time today.
Forward-looking statements will be made during this conference call. Forward-looking statements are any statements that are not historical facts. Such statements are based on the current expectations of Motorola and there can be no assurance that these expectations will prove to be correct. Because forward-looking statements involve risks and uncertainties, Motorola's actual results could differ materially from these statements. Information about factors that could cause, and in some cases have caused such differences, can be found in today's earnings press release on pages 19 through 27 of Motorola's Form 10-K for the fiscal year ended December 31, 2005, and in Motorola's other SEC filings.
This conference call is occurring on April 18, 2006. The content of this call contains time-sensitive information that is current only as of the time of this live broadcast. If any portion of this call is retransmitted at a later date, Motorola will not be reviewing or updating the material contained herein.
This call is the exclusive property of Motorola Inc. Any redistribution, retransmission or rebroadcast of this call in any form without the express written content of Motorola Inc. is strictly prohibited. Now I'd like to introduce Ed Zander.
Thanks, Ed, and good afternoon, everyone, and once again, we are very pleased with our results this quarter. Record first-quarter revenues exceeded our forecast and guidance, with earnings that were in line with our target range. I will once again acknowledged the continued hard work and dedication of our talented employees. It is the unrelenting focus of each of the thousands of Motorolans around the world that makes our continued success possible. Our results clearly demonstrate the success of our ongoing efforts to profitably grow market share.
For example, our Mobile Device market share for Q1 was 21% globally, the first quarter above 20% in seven years. We are making tremendous progress increasing Motorola's presence in fast-growing market such as Brazil, Russia, India and China. Our iconic products like RAZR, SLVR and PEBL have established Motorola's design leadership and help us to achieve increasing levels of customer satisfaction. We are more and more identified as the cool, innovative company with quality to match.
Our connected home vision and products both with Wireline and cable are driving new levels of interest from our customers. And finally, our vision of seamless mobility, now over two years old, connecting people anywhere at any time by any device, is no longer [inaudible] but a compelling value proposition to communication, consumer and content companies worldwide. We intend to be the number one in making the mobile broadband Internet a reality.
Now let me turn to our Q1 highlights. First, sales of 10 billion were up 23% from Q1 2005, an all-time record for Motorola. Our sales growth is among the strongest, if not the strongest, of large cap tech companies. 2004, we grew 35% year over year; 2005, 18%; and the first quarter of 2006, now 23%. Believe it or not, at $40 billion, we are a growth company. Net earnings, excluding investment gains, reorganization expenses and stock option expense, grew 31%, 8 percentage points faster than sales.
We delivered record Q1 earnings per share of $0.28, once again excluding investment gains and reorganization expenses and stock options, up 27% year over year. In summary, sales up 23%, net earnings up 31%, EPS up 27% -- solid performance.
Our balance sheet remains very strong. We generated 700 million in operating cash flow. We increased the pace of our stock repurchase program and we have over $10 billion in net cash.
And in Mobile Devices, more records and outstanding results. We shipped more than 46 million units in Q1, an increase of 61% over Q1 last year and up 3% more than Q4 in 2005. We anticipate that none of our competitors are close to this kind of performance.
We now have shipped over 90 million units in six months. Market share is over 21% -- as I said, a seven-year high -- up almost 5% year over year and 2.5% over Q4 2005. Remember, we were just about 13% a little over 18 months ago. We further distanced ourselves from number three, four and five and closed the gap on number one. And we gained all this market share and still increased operating margin by 100 basis points and achieved an 11% OE. We are achieving our goals of year-to-year operating margin and quarter-over-quarter market share growth.
Mobile Devices wasn't alone. Connected Home had also a great quarter, a new record for set-top boxes unit shipments -- over 2 million. Operating earnings without the supply chain manufacturing reorganization charges grew at over 200%.
The quarter was not without challenges, however. We did not meet our internal forecast for revenues and earnings in our network business. We were disappointed mostly by our Asian operation, and specifically China. The shortfall in this area was largely due to delayed capital expenditures for some of our largest customers in China caused by a delay in 3G awards, shifts from CDMA to GSM and contracts with deferred revenue. We also had an FX impact in Japan. We did not meet – we did meet our financial targets in most of our other regions and networks and expect Asia to recover somewhat during the second quarter. I will talk more about networks later.
A few other important achievements during the quarter. First, we reached an agreement with Continental of Germany regarding the sale of our automotive electronic business. Under the agreement, Continental will acquire this business for approximately 1 billion in cash. We expect the transaction to be completed in the second quarter of 2006. Second, we completed the Kreatel acquisition during the quarter, which is an outstanding addition to our portfolio in the Connected Home business, and strengthens our position in video and the European market. We also began integrating the acquisition of Wireless Valley Software for designing and managing wireless networks. And today we announced an agreement to acquire Orthogon Systems, a privately held leading provider of OFDM-based high-performance fixed wireless solutions, which will become part of the networks and enterprise business. This deal adds to our already-strong MOTOwi4 wireless broadband offerings.
And finally, we took additional steps to improve the cost structure of the Company. We recently announced our plan to combine the government and enterprise and networks business to streamline our operations and reduce costs. This will impact some of our workforce -- Dave will provide details in a few seconds, a few minutes -- as well as improve speed and focus within the Company.
We also announced the closing of two of our international manufacturing facilities as part of our ongoing supply chain cost improvements. Stu Reed is driving supply chain real hard and we're seeing the benefits not only this quarter, but throughout 2006. All of these cost improvements will have a positive impact in the second half of this year.
So in summary, and I'll go into details on each of the businesses in a few minutes, but in summary, we are growing revenue, profits and market share; we are focusing on our core competencies, seamless mobility products and services. In the past two years, Auto, Semiconductor, Clinical Micro, our energy products business are all out, and Quantum, MeshNetworks, Ucentric, Orthogon, Wireless Valley and Kreatel are all in.
And we are attacking cost structure with supply chain and manufacturing and organizational simplicity. Our revenue per headcount has been up every quarter for the past two years. And we are innovating for the future.
With that, I'd now like to turn the call over to our CFO, Dave Devonshire, who will provide some more details about our first quarter.
Thanks, Ed, and good afternoon. For the quarter, we had a very strong quarter in sales, which were up 23% versus the first quarter of 2005. Our quarterly earnings per share results were $0.27 per share, versus $0.28 per share a year ago. Excluding a gain from the sale of investments, net of derivative loss, reorganization expenses and stock compensation expense from our results in both periods, operating margin decreased three-tenths of a percentage point -- this is on an apples-to-apples basis -- and was slightly below our internal plan for the quarter due to the results in our network segment. Ed will discuss networks in greater detail in moments.
Excluding these adjustments, earnings per share would be $0.28, up 27% versus last year's earnings per share of $0.22, demonstrating good earnings leverage on our sales growth of 23%. And as Ed mentioned earlier, the apples-to-apples earnings were up over 30% -- net earnings up over 30% over prior year. As Ed reviews our segment results, keep in mind that our stock compensation expense is reflected on the other elimination line and not in the individual businesses.
In looking at our sales trends, our quarterly trend of sales over the past nine quarters, you can see that -- oh, excuse me, missed a slide there. Okay, now we’ve got to cover the reconciliation of our non-GAAP items. Earnings per share includes several significant items shown here and listed in our press release which aggregate to a combined impact of $0.01 per share of expense.
The reorganization charges relate to the closing of two international manufacturing facilities in our Connected Home segment as production is moved to an EMS company. The reorganization charges are also related to a workplace reduction being implemented in our networks and government and enterprise mobility solutions segments. The reorganization impacts approximately 2500 employees, of which about 70% are related to positions in our manufacturing facilities that are going to be outsourced. And we anticipate annual savings of approximately $110 million, which we will begin to fully realize in the fourth quarter of 2006.
Additionally, other reorganization actions are anticipated to be announced later in Q2 in our Networks and Enterprise segment as a result of synergies to be realized from the combination of the networks and government and enterprise mobility solutions segment into a single segment. Specifics about these additional actions will be communicated at the end of the second quarter.
And now moving on to our sales trend, looking at the quarterly trend of sales over the last nine quarters, you can see that our rate of growth has been excellent. The midpoint of our guidance for Q2 continues that trend.
On a revenue per employee basis, we continue to show great performance in this area with a gain of approximately 19% since the first quarter of 2005. We remain focused on making further productivity improvements in the future.
Our cash flow performance in the quarter was strong. We generated approximately $700 million in operating cash flow. This is our 21st consecutive quarter of positive operating cash flow. Capital expenditures were $126 million, giving us free cash flow of approximately $600 million. Our debt to total capital ratio has remained substantially flat at 20.4%, versus 20.3% at the end of 2005. We ended the first quarter with $10.4 billion net cash positive, essentially flat to $10.5 billion net cash positive at the end of 2005, even though we significantly accelerated our stock repurchase program during the quarter.
And now I'll give you an update on the stock repurchase program. As you recall, we instituted this program back on May 19, 2005, which we were authorized by the Board to purchase $4 billion in stock over the next three years. During the first quarter, as I mentioned, we significantly accelerated the program and we purchased approximately 37 million shares -- 37 million shares -- at an average price of $21.99. This is almost as much as we purchased throughout 2005 since the inception of the program in May. Inception to date, we have now purchased approximately 78.7 million shares for approximately $1.7 billion versus, again, our authorization of $4 billion.
And now I'd like to update you on our guidance. Our guidance for the second quarter for sales between $10.3 and $10.5 billion, up 17% to 19% versus the second quarter of '05. Our EPS guidance for Q2 is in the range of $0.30 to $0.32, excluding stock option expense, which we expect to be $0.02 a share. Our second-quarter tax rate for continuing operations is estimated at 36%, with the weighted average number of shares outstanding expected to be in the range of 2.55 billion.
As we told you last quarter, we are going to transition to a different form of providing guidance. Effective with our July conference call, we will no longer be providing guidance on earnings per share. Other technology companies have taken similar steps and many have never provided EPS guidance. We will continue to provide sales guidance.
Turning to the comments on 2006, the full year -- our stock compensation expense is estimated annually to have an impact of between $275 and $300 million. Our estimated tax rate for the full year is 36%. We feel that an additional collection of $400 million related to the recovery of the Telsim receivable is expected in the second quarter.
We also expect to complete the sale of the auto business in the second quarter. We also expect further reorganization expenses related to the global supply chain consolidation and operating expense reduction initiatives in consolidating the two business segments, as we discussed earlier. Thank you very much, and now I'll turn the meeting back over to Ed.
Thanks, Dave, and what I’ll do now is run through, like I usually do, each of the businesses and then we can get to the Q&A. I have all of the division heads here today that can answer your questions. Let me start first with Mobile Devices. It’s hard to really -- last quarter, I thought it was a wow, and it's hard to do two wows in a row, but this quarter was just stunning in terms of what Ron and his team accomplished -- so many records -- and we entered Q2 with our strongest order book ever for units.
Again, Q1, we delivered all-time record for units, all-time record for Q1 sales and for Q1 operating earnings. For six consecutive quarters now, we have improved our OE percentage on a year-over-year basis, excluding reorganization charges. Additionally, we have delivered six consecutive quarters of sequential market growth. Our global market share, as I said earlier, is 21%, and we've accomplished this while sequentially expanding our gross margin percent.
In terms of some of the real highlights, RAZR continues -- it's the best-selling clamshell in the world. We will ship our 50 millionth RAZR this quarter and, but as I remind everybody in my staff, there's still a couple of billion people on the planet that could still use a RAZR. Certainly everybody I talk to wants one, and as we continue to expand more models, more units, more colors, more technology, we can give RAZRs to everybody.
During Q1, we shipped nearly 18 million handsets based on the ultra-thin platform. What began with RAZR and the clamshell is now redefining the candy bar category, too. The run rate for both SLVR L7 and L6 individually outpaced RAZR's first 180 days in market, and demand continues to grow. Thin is clearly in, and we are certainly leading the way.
Also, Motorola's suite of music-enabled handsets is increasingly hot. Since Q3 of 2005, we shipped more than 6 million music handsets from the MotoMusic suite as the E680i with RealPlayer, the ROKR E1, the E815 with VCAST and the SLVR L7 with iTunes.
Shipments of Motorola's 3G units are up nearly 400% versus Q1 2005 as demand continues to build for the DO and UMTS models. And for iDEN watchers, we're posting another record performance for Q1 units. iDEN is very strong, and it has great new products coming. I think -- I still believe it's the only push-to-talk capability in the handset that really works.
And finally, in the high-growth markets, a great story -- more in just a few minutes -- but it truly was an incredible quarter in terms of taking market share. And we continue to innovate across technologies and price tiers with new handsets for GSM/CDMA and iDEN units.
In terms of the numbers, comparing Q1 2006 to 2005, strong performance -- sales up 45%, operating 60%. While gross margins were up, we did increase investments in sales and market development to fuel that top-line growth. Operating margin, 11%, despite the increased investments in the market development area and a 4% decrease in ASP’s due to increased unit volumes in the high-growth markets. Our company-wide supply chain initiative helped offset the market development investments and helped to deliver our improved OE performance and year-to-year operating margin gains.
Unit shipments -- up 61%. Motorola shipped 59% more units than number three during Q1, and we expect that gap to widen in Q2 2006. As was the case for Q4 2005, at 46.1 million units for Q1, we expect Motorola unit shipments to again surpass those of both number three and number four combined for the quarter. And market share is up on a year-to-year and sequential basis. Again, the 21% is based on a TAM of 220 million units during Q1.
In North America, again the story is just great. We are now number one in all three, including Verizon, wireless operators. And Verizon is just a story in itself. Two years ago, we were nowhere in market share. The team in Mobile Devices worked really hard to build great products, and with RAZR there now and some of the other products, we are number one there, too.
And we recently are back in Sprint CDMA lineup with the Motorola C290. So now, consumers across the United States market can choose Motorola from each of the largest wireless operators. We are also doing extremely well with, of course, T-Mobile as the third operator, being number one. So T-Mobile, Cingular and Verizon, and now we are into Sprint.
We expanded market share as well as the gap, which is now nearly 10 points between Motorola and our nearest competitor, with unit shipments up 28% compared to Q1 2005. Innovation and re-innovation are key. The SLVR L7 is hot, and more to come this quarter.
Latin America -- again, we enjoy a solid lead in markets such as Venezuela, Argentina, Brazil. We're closing in on number one again in Mexico. Today, we are number one at the region's top two wireless operators and we are number one in sell-through to consumers. We've added new products across price tiers. At the higher end of the market, we've launched the PEBL U6, SLVR L7 and [C343] for the mass market. Toward the end of Q1, we added new and compelling color models with the C139 and C261. We are moving forward. We are focused on investments that strengthen Motorola brand in this marketplace, too.
In Europe, strong number two and growing. RAZR has become the standard for what consumers expect from a mobile handset in Europe. PEBL U6 is increasingly popular among consumers seeking a handset with style and fashion. Our market position continues to grow and strengthen with an increase of 4 points compared to Q1 2005 and nearly a point compared to Q4 2005. Unit shipments are up 44.5% compared to a year ago, and the UMTS during February, the RAZR V3x was named the best 3GSM handset during their GSM World Congress in Barcelona.
North Asia is a great story for Motorola. As with the rest of the world, RAZR continues its reign as the most popular handset in this area. That is well-known. What you probably don't realize is our success in the Linux-Java Smartphones. It's a great market for us, too. The Motorola A780 is China's top-selling Smartphone. And during the quarter, we expanded our lineup with a beautiful new must-have, the A1200, which we call MING. Early indications are that we have another hit four-letter product in hand.
Hits such as RAZR and MING, in addition to our complete lineup across price tiers, along with investments in distribution, marketing and retail presence, are paying off in the North Asia market. Our market share is up approximately 8 points compared to Q1 2005, and unit shipments are up more than 140% versus last year. Sequentially, market share is up 2 points compared to Q4 2005; a great story, and more to come.
In some ways, we saved the best regional story for last. A high-growth markets region is a hotbed of profitable growth and expansion. What a quarter! Market share in high-growth areas is up more than 12 points compared to Q1 last year and nearly 8 points compared to Q4 2005. Units are up more than 285% compared to a year ago, and we're very pleased to receive an extension for Phase 2 of the GSMA Award to connect the unconnected. Our partnership with the GSMA is helping people connect to people and information, enabling economic opportunity.
But the high-growth markets region isn't just about low-cost and low-tier handsets. We're growing across price tiers, from very low-end GSMA Award handsets such as the 113 and 115 to the SLVR L7, L6, PEBL and RAZR. In fact, in India, we shipped more RAZR’s during Q1 than we did during all of 2005. So clearly, demand and desire are not limited to the very low tier and the entry-level markets.
And looking ahead, we have the right leadership team in place to get results across the vast region. We are focused on keeping and driving profitable growth from Africa to the Middle East and India to Indonesia, the Philippines, Australia and New Zealand.
Let's shift to now some of the products that helped fuel the demand. Of course, RAZR was once the story again. If we keep going at this rate, and we think we will, 2006 may well be the year of the RAZR part 2. A lot of you are always asking what is after RAZR, and I say more RAZR’s. And on this slide, you can see what we're doing. From GSM of a year-and-a-half ago, we now have a great CDMA product, EV-DO products, UMTS products. We're introducing a dual-mode UMA product with British Telecom, more colors and more cool experiences. In fact, the RAZR V3m is our integrated music player that's just coming out on the market that offers just an incredible experience with music.
So while Q1 was great, you'll see more cool additions this quarter. And in Q3, we're rolling out RAZR HSDPA in Japan, and in Q4, we will take RAZR HSDPA to the rest of the world. So RAZR is becoming the de facto brand for what we know as the cell phone today.
What else is going well? Well, SLVR, our reinvention of the candy bar form factor, is winning consumers in both the L7 and L6 models. In fact, in the U.S., SLVR L7 with iTunes is a big hit at Cingular Wireless. While it is early in the SLVR lifecycle, indications are that these products are hits. The individual run rates for both SLVR L7 and L6 outpaced RAZR's first 180 days in the market.
It's also important and helpful to remind people that we have a core suite of products in our mid-tier, and we've got clear leadership in Bluetooth-enabled handsets and accessories. These products are workhorses that don't often get the headlines or the PR hits of products like SLVR, but they are also driving results.
And of course, PEBL, another reinvention of the clamshell from Motorola. It’s moving solid results, having more than doubled its unit volume quarter on quarter, most notably outside the United States. Recently, we expanded choice for consumers that emphasize PEBL as a fashion statement by adding an array of colors for the spring market.
As I mentioned earlier, MING, the A1200, is our newest addition to our fleet of Linux Java Smartphones. It’s a beautiful feature-rich handset that enhances Motorola’s unmatched leadership in the China Smartphone market. Last week we celebrated the launch of MING in Beijing, and the week before that we welcomed celebrities and media to Shanghai. One thing is clear so far -- MING is the new must-have Motorola phone in China.
And of course, before you ask me about Q, we’re close. All I can tell you is we’re in testing. After using it for four months, several hundred people here at Motorola is as addicted to [inaudible] to bring it to market. I think it’s a great product. It’s a cool device. I think it’s going to define yet a new segment. It’s way more than a Smartphone, and stay tuned -- we’re close, and hopefully we’ll see that very shortly.
Another great series of products I want to bring some awareness to we call RDIO. It was unveiled at Barcelona during our press event. RDIO, pronounced radio, was the Motorola W220. It is a GSM device designed for the mass market. It's capturing the imagination of consumers and creating a lot of excitement. Inspired by RAZR and perfect for talking, texting and listening to your favorite FM radio station, RDIO is a compelling and aspirational design. Based on the reactions of tradeshows from Las Vegas to Barcelona, we're confident we've dialed another hit in Q3, so please stay tuned.
So there’s lots to come also in the second half of 2006. As Ron said I think back in Barcelona, we said throughout the first part of this year our new strategy is to announce products when we can ship them. But stay tuned, we've got a lot coming behind PEBLs and SLVRs and RAZRs and RDIOs and Qs. I think the second half is also going to be a great product launch.
In summary, our Mobile Device business once again grew profitably -- wicked compelling products, rich experiences with quality and efficiencies, and we're off to a great start this year. Our outlook for Q2, we started the quarter with our strongest order book ever for units, as I said earlier. Moving forward through Q2, we expect to improve market share sequentially, particularly in the world's rapidly growing markets. And on a year-to-year basis, we committed to delivering increased sales, increased operating profits, increased operating margins while continuing to drive investments in market development and while realizing further benefits from our company-wide supply chain initiative.
Let me move on to the Government and Enterprise Mobility Solutions. The sales were up here 2%. Government sales grew in the United States, state and local markets, and in EMEA, Latin America and Asia, but we had a decline in the U.S. federal market. We expect the federal market to be healthier in the second half of this year. Automotive market sales increased slightly. Excluding the reorganization charges of $8 million, operating margin was 11.6%, and of course would've been higher without auto. We initiated reorganization actions to achieve annualized net savings of approximately $10 million, which we will begin fully realizing in Q4 of 2006.
I think by now this is news that we all have known and read about. On April 3, we announced the decision to sell our automotive business to Continental, a leading automotive supplier, for $1 billion. The transaction includes our sensors, interior and telematics businesses and will hopefully be completed in the second quarter of 2006, subject to customary closing and regulatory conditions.
We believe that this electronics business in automotive will be better positioned to grow successfully and serve its customers in a company focused on the automotive industry. The transaction positions Motorola for continued success by further sharpening our strategic focus on communication solutions that advance our vision of seamless mobility, including working aggressively, by the way, with auto suppliers in reaching seamless mobility into the automobile.
We had great wins in the government market in Q1, major contracts in mission-critical communication solutions. Motorola's leadership in the City of New York awarded Motorola a contract for a system to support the New York Fire Departments' dispatch voice traffic and to support communications of other city agencies; for Pierce County, Washington, an integrated voice and data system to improve mission-critical communications and enhance service for 675,000 people outside of Seattle; and in King County, Washington, metro transit operations -- which serve more than 1.7 million area residents, including the City of Seattle -- an integrated voice and data radio solutions to improve operational efficiencies.
Momentum for our MESH-enabled solutions continues in the quarter with 22 new orders, including several orders for the new 4.9 GHz MOTOMESH multi-radio broadband network, which leverages the newly licensed 4.9 GHz safety band. This is really exciting technology and MESH continues to drive some of the new thinking of what's going to happen in public safety.
In the enterprise activity, our Wireless Valley acquisition is being well-received by our customers. In December 2005, we made this acquisition, a leader of software solutions that enable efficient and effective design in management of wireless networks.
We also made a strategic decision to invest more heavily in next-generation enterprise technologies such as fixed mobility convergent solution architectures. Fixed mobile convergence enables key enterprise mobility capabilities through solutions that integrate mainstream mobile operating systems and support the industry standards and simple platforms.
Lastly, we began shipping our HC700-L, which is our entry into the commercial off-the-shelf rugged handheld computing market, and was introduced in the fourth quarter of 2005. Additionally, we’re building out our mobile computing channel by adding five new value-added resellers in the quarter to expand distribution capabilities for products, including the HC700-L.
For GEMS, we expect Q2 sales, operating earnings and operating margins to be up slightly versus prior year, and for the full year, we expect GEMS, excluding the auto business, to have its normal level of mid-teens operating margin and high-single-digit sales growth.
Moving on to Networks, as I said earlier, Networks was our big disappointment in Q1. We did not meet our targets. Sales declined in Asia, largely China, due to uncertainties in 3G licensing, shifts from CDMA to GSM, deferred revenue. We also had some shortfalls in Japan due to currency effects.
However, operators have announced increased spending in China for the remainder of 2000 and we expect to benefit from that. Excluding reorganization charges of $21 million, our operating margin declined to 10.7%. We did not slow down our increased investments in our future in high-growth businesses such as WiMax, Fiber-to-the-Premises, Softswitch and Canopy.
On a positive note, backlog increased by more than 10% and deferred revenue increased by more than 20% from the end of Q4. We initiated reorganization actions to achieve annualized net savings of approximately $70 million, which we will begin fully realizing in quarter four, 2006.
We had a lot of good market activity in the Canopy area. Products have been chosen by EarthLink and Google for their metro WiFi access deployment for the City of San Francisco. A major state in India has chosen Canopy for deployment of a statewide network. We will supply Vistream, an IP core network solution for MVNO’s in Germany. We continue to strengthen global leadership positions in push-to-talk over cellular, with recent contracts with Vodafone Spain and Public Telecommunications Corp. Yemen. To date, Motorola has 52 commercial deployments in 38 countries or territories.
We also signed a five-year agreement with MTC Namibia encompassing GSM, GPRS, EDGE and Canopy to enable service delivery through our hybrid cellular and alternate wireless broadband technology networks.
I also once again want to put out the investments we're making in the future revenues, and if you were at CGIA, or at Consumer Electronics, or at 3GSM showing CDMA Rev A technology, I think we were a hit both at the cable show and at the CGIA show with our MOTOWi4 WiMAX solutions in Canopy and cable Canopy, Softswitch push to everything, Fiber-to-the-Premises and Fiber to the Home, our M-Wallet initiatives and our service offerings with our new GAMA service delivery architecture, are the areas that I think are going to drive some of the good revenue in our Networks business.
In terms of our outlook for Q2, we expect Q2 sales to be flat and operating earnings and operating margin lower than prior year. Sequentially, we expect sales, operating earnings and operating margins to be up, though. 2005 was an unusual year that experienced a strong Q1, followed by lower revenue in the remaining quarters. 2006 is expected to follow the historical pattern of increased revenue growth as the year progresses, in part based on increased 2G CapEx spending by the China market. For the full year 2006, we expect sales up low to mid-single digit percentages, and operating margins to be within our target range of 12% to 15%.
And finally, as we talked earlier and announced earlier, we made a major reorganization combining our GEMS and Networks into one segment, the Networks and Enterprise Segment. We believe this will give us better alignment of product roadmaps and improved go-to-market coordination, growth, capturing new market opportunities in network convergence, enterprise mobility, services, end-to-end network infrastructure and next-generation network solutions, and synergies in improved cost structure, simple processes and greater efficiencies.
Sitting, in fact, here today, I'd like to thank Adrian Nemcek. Adrian has been with Motorola over 30 years and has done just a phenomenal job and a great track record in those 30 years. A few years ago, he took over this Network business. Most people said, you know, it wasn't going to go anywhere, it was losing money with no market share, and in just a matter of a couple of years, we've got a great business with great profits and revenue, and I think as you'll see as this year continues, Networks will do very well. And more importantly, Adrian has positioned us for the future with investments on Wireline and WiMAX and Softswitch, and some of these I talked about, so I want to publicly acknowledge him and thank him for everything he has done.
Finally, in the Connected Home area, a really great quarter for Dan and his team. Just awesome. In our Connected Home Segment, sales were up 7% due to the demand, increased demand for HD and DVR Set-Tops. Excluding the reorganization charges, operatings increased 205% and operating margin was 8.2%. We initiated reorganization actions in the supply chain area to achieve annualized savings of approximately $30 million, which we will begin fully realizing in Q4 2006. A great quarter for Dan and his team.
Highlights -- as I said earlier, we had a quarterly record for digital shipments, increased in all markets across all major product categories, with a 38% increase over Q1 '05 and a 48% increase over Q4 '05. Total number of digital entertainment devices now exceeded 44 million cumulatively. Kreatel's Linux-based set-top platform complements our existing end-to-end digital video delivery and set-top solutions.
We continue to work very closely with Verizon on their deployment of the FiOS TV. Verizon has launched FiOS TV in 16 Texas communities and publicly announced that they have captured 30% market share in Keller, Texas. Verizon is using an end-to-end video network designed, built and installed by Motorola. This network includes a Motorola video head end, network transportation and video set-top products.
In voice and data, the total number of modems shipped now exceeds 35 million cumulatively, continued leadership in this space. Technologies continue to break down the barrier between home and wireless phone service, with the products like our residential seamless gateway. And Motorola's technology chosen as the basis for DOCSIS 3.0-compatible broadband network in Singapore, the first such nationwide network in Asia-Pacific.
I think the Connected Home will belong to Motorola, is belonging to Motorola today, driving seamless mobility, video and solutions today. If you were at either the cable show or you were at the CTIA, watching the Follow Me TV, watching the Mobile Me demos, connecting DVRs to cell phones and back again, I think is the future and how we're bringing together the seamless mobility vision between Dan's operation and Ron's operation. Stay tuned -- I think we’re uniquely positioned to deliver true convergence between the mobile world and the home.
In terms of the outlook, sales up versus the prior year, operating earnings up versus the prior year and operating margins up versus the prior year. In summary, Q1, as I said, good year. We did have that one issue in the Networks area in Asia, which I think we'll see better results in the second half of this year. Overall, market share, again, in many of our businesses, revenue up, profit up, cash flow; solid, balance sheet; really solid, cost structure -- we're making some improvements in that area, and you’ll see some of that realization in the second half of this year, but revenue per employee is going up.
Innovation -- we're putting the right money in R&D in the right spaces, and our outlook, as I said earlier, is positive for the future. With that, I'd like to thank you very much and open it up for questions.
Now before we take your questions, we'd like to ask that each of you please limit yourself to one question and to avoid multiple-part questions. We only do this to help ensure that in the limited time available, as many of you as possible will have an opportunity to ask your question. Your cooperation is appreciated. Operator, please instruct our audience on how to pose their questions to us.
Thank you. Ladies and gentlemen, if you would like to register a question, please press star, then the number 1 on the telephone. If your question has been answered and you would like to withdraw your registration, please press the pound key. If you are using a speaker phone, please lift your handset before answering your request. One moment, please, for the first question.
Your first question comes from the line of Mark Sue, with RBC Capital Markets.
Mark Sue - RBC Capital Markets
Ed, can you help us understand if the delay in 3G infrastructure has translated into an uptake in handset shipments in China? Are we seeing an upgrade cycle in China for 2G?
And just separately, just a thought on what your potential share might be once 3G does come around in China?
I am going to let Ron take a shot. My own take is -- I was just over there recently -- there’s China benefiting from connecting the unconnected, number one and, you know, the more products and the more people we can reach, the more people are going to buy our kind of products. We also went in there really heavily, and again, I think we've telegraphed this about a year ago, you know, my thought and Ron's thought, and we’re so aligned on this, that scale matters in this business.
You've got to be big. You've got to be global. You've got to be at all price points if you want to be around five years from now. And we have a lot of work to do in China, in India, Southeast Asia -- areas that perhaps we weren't as strong back in 2000, 2001, 2002.
And I know it's a lot of investment. You've got to put in the distribution channels, you've got to put in the marketing, you've got to put in the salespeople, you've got to put in the advertising, and you see that in our sales and marketing costs, while maintaining growth in operating earnings. And I've got to give credit to Ron and his team, they did it.
So what we’re seeing there is, again, products like MING, products like some of the low-end products, the RAZR products are just catching on there. And we're upgrading. They have one of the shortest in the top tier individuals in that marketplace, every six to nine months, they do turn over products. We’re reaching more people. We're upgrading people that want the iconic products. And I think we’re benefiting from that. I think the 3G thing will just help us even more because I think we've got some great products in that area. Ron, why don't you add your thoughts on it?
Given that the North Asia market is not subsidized, I do not believe that the push out of UMTS in that market is causing any additional upgrade cycle right now. Having said that, I think the upgrade cycle in North Asia right now is very, very strong, and we're seeing that across the RAZR and the Linux-Java line.
Could we have the next question, please?
Your next question comes from Ittai Kidron with CIBC World Markets.
Ittai Kidron - CIBC World Markets
Hi, guys. The question is to Ron. On the Mobile Devices operating margin, it seems that on a pro forma basis quarter over quarter, your margin was flat at around 11%. Clearly, you have made significant improvement on the units -- I mean, the numbers are really impressive.
That said, at what point does the growth in the shipments overwhelm also the investment that you are making in the business, such that we will see a more rapid expansion of the operating margin in that business unit?
Every quarter, the first thing that I solve for is being able to create as many operating earnings dollars as I possibly can. A secondary effect when I look at that is gaining share, what ASP’s are and what OE percent is. And in all of those cases, year over year, I'm trying to make those better.
One of the data points that Ed talked about is we actually expanded gross margin percent Q4 of last year to Q1 of this year in a market where you are picking up 2 points of share sequentially, 5 points of share year over year. To expand gross margins shows all of the things that Stu Reed and his team are doing from a supply chain perspective.
We took that extra 1% that we saved from a gross margin perspective and we invested it into the distribution channels in Russia, China, India, and we think that is going to pay off for us long term.
Again, Q2, Q3 and Q4, we'll solve for operating earnings dollars first, keeping in check those things to show year-over-year expansion.
But we’re also, you know, I’ll add to it, in the good old U.S., we're into Sprint now for the first time in I don't know how long. We’re number one at Verizon. All these are investments that we have to make, but again, and I don't want to give too much of our strategy, certainly, to our competitors, but it’s scale.
It matters five years from now or three years from now to be big in India, to be big in Southeast Asia, China, have the marketing, have the distribution, have the people, have the service and support. And here in the United States, to be with T-Mobile, Cingular, but also Verizon and Sprint, as well as the other carriers -- so I think Ron has got it dialed in right.
We are making the investments, we are solving for trying to increase OE year over year and growing our market share. And this is why this quarter is so special in terms of what we've been able to accomplish.
Could we have the next question, please?
Your next question comes from Inderbir Singh with Prudential. Please proceed with your question.
Inderbir Singh - Prudential
Thank you very much. I just wanted to ask you about the Networks business and some of the work that you're doing there to try to restructure that, and whether you feel that you can comment on the consolidation that you are seeing in the telecom equipment space, Lucent Alcatel, for example, and whether that affects your Networks business in some way. And do you anticipate Motorola perhaps participating in any sort of consolidation going forward? Thanks.
Yeah, Inder, and sometimes you've got one plus one and you get three. We had a great year last year in the Networks business. Gosh, you know, we had great earnings, great revenue, and again, this quarter. I think we're off to just prove it over the next few quarters. It's not indicative of anything other than what we’ve said. We have some issues in Asia that we have to go address.
And we think with what we see this quarter and what we see for the second half of this year, when we turn to the numbers that we've kind of given you out before, and we continue to acquire companies and invest in some of the things that we think are going to be the major revenue sources over the next few years.
I think there’s going to be some of that consolidation. I am glad it’s happening, so it takes a lot of these things off the table. I think I'm not going to comment on any of the rumors or any of the things you hear about. I think our actions speak. We continue to invest our dollars into some of the newer companies, as well as into shifting resources inside the company on areas like WiMAX and some of the other things we talked about, Softswitch and others.
So I think we're well-positioned. We've got to play it out. We think we have a great strategy. The consolidation also, by the way, the reorg was planned well last year before Q1 happened. In fact, at the height of the best quarter in Network is when Greg, I and Adrian talked among ourselves and said we have so much synergy on mesh network, so much synergy on WiMAX, so much synergy on some of the things that were going on in the public safety market, the enterprise market and the wireless market, that we decided to put those things together and get some costs out of the system, as well as speed and simplicity into the product line.
I'm going to let maybe Greg say a few words.
Yeah, just to add to Ed's comments, too, obviously putting these two organizations together, they’re both infrastructure businesses, they’re both systems and end-to-end solutions businesses, both have a high services content, so by putting them together, by definition, we are a stronger infrastructure provider just by the combination.
That said, you've seen us, as we have already articulated in the call, took out about 650 jobs in the combination of engineering and G&A and other positions this past quarter. That makes us a stronger organization.
Moving forward, I think the GSM and CDMA and iDEN franchises remain very solid for us going forward, and we will look on a consolidated basis to optimize the engineering, improve the G&A, lower the cost structure of this combined business. And I agree with Ed, I think we're well-positioned going forward.
And one last thing I’ll say, so we can just – it’s just philosophical in how to build businesses and run companies. You know, three years ago, our Mobile Devices business was mired into number three, four -- two, three, four, five -- in the middle of a pack. With the right focus, with leadership, with investments, with having a great strategy, you can see what you can do in a very short period of time, and in less than two years now, we're over 20% for the first time in seven years with a great, great franchise in this business.
You saw what Dan has done in Connected Home in just a very short time in terms of the unit counts, the growth in profits are reaching over 8% now. So I still am a big fan of what you can do organically. In the case of each of these areas, we picked up some acquisitions, smaller ones. We have added IP. We've redirected resources.
So I'm not telling you what I'm going to do or what we’re going to do forever or near term, but I think if you've got a great strategy, you've got great people and you can use your balance sheet effectively, you can do some amazing things, and I think you are seeing that play out in at least two of our businesses. And I think with what Adrian has put in place in Networks and what we are investing in that space, stay tuned.
Next question, please.
Our next question comes from the line of Susan Kalla, with Caris. Please proceed with your question.
Susan Kalla - Caris & Company
Could you tell us, give us an idea of how you manage the introduction of some of the new products over a short period of time?
A lot of sweat and pain and whatever -- no, no. I think it is one of the most remarkable things of our supply chain. I’m going to ask Ron to handle it, because I think you're referring to Mobile Devices.
If you would have told me when I joined here two-and-a-half years ago that we could do 90 million units in six months, with the supply chain, the forecasting systems, the processes, the engineering and NPI, and I think between what Ron has done and Stu Reed has done and the IT organizations, finance and everything else, it is remarkable to do something with such short product lifecycles. But Ron, I don't know if you have anything to add to that.
Yeah. I would think that the platforming work that we’ve done over the last couple of years, if you look at the sheer number of devices that we’re spinning off of the RAZR platform, that is clearly helping us from a time-to-market perspective.
One of the other products that Ed announced was RDIO. That has been spun off our C11x platform -- again, gives us unbelievably quick time to market. Our ability to ride those two platforms across all of the different technologies that they’re in is the biggest reason that we have been able to routinely hit our dates and get out as many products as we have been able to get out.
Next question, please.
Our next question comes from the line of Brantley Thompson with Goldman Sachs. Please proceed with your question.
Please proceed with your question.
Could we have another question, Operator?
Our next question comes from Tim Long with Banc of America. Please proceed with your question.
Tim Long - Banc of America
Thank you. If I could just go back to Mobile Devices and some of the investments you have been talking about in emerging markets. Ron, you talked about taking some of the gross margin improvement and investing that in the emerging markets, and I just want to tie that to Ed's comments about profitable growth, if you could just update us on what profitability looks like in those emerging markets if you include these extra investments.
And related to that, what inning are we in in those investments? Is this something that takes a year to get the distribution built out to match your largest competitor, who might have tens of thousands of points of presence in India and some of these places like China? So are we in the early innings of that or is this something that is a perpetual investment, or is it one year worth? And any data you can give us on the scope that you have in some of these markets and what you think you need to fully have it scoped out?
I would break the conversation up into a couple of points. First of all, even with the additional investments, these regions are accretive both at the gross margin, obviously, and at the operating earnings line, and it's good business.
Clearly, when we talk about the different markets, some of them are in different levels of maturity. Our Brazil strategy is we are as mature, if not significantly more mature, than any of our competitors. China, we're very, very into the late innings of being equally competitive with anybody else in the industry. I would say Russia is quick on the heels of the Chinese market of where we are from that distribution. And I think India is where we have the farthest to be able to go, and we're probably still in the early innings from that investment perspective.
I think if you look at the year-over-year share growth of Q1 of last year to Q1 of this year, we gained 12 points. So clearly, the relatively small amount of investment is paying back big dividends from a share perspective.
So if you had to use a baseball analogy, we’re probably in the early third or fourth inning in the India market.
But I'd also say, you know, in fact, Ron and I were on some calls this last couple of weeks in emerging areas, even in Africa and other places, you know, I go back to what's happening around the world. Governments and agencies have figured out getting people connected is a way of starting to move GDP a lot faster.
So I think we’re in early stages of getting this world really making phone calls and eventually experiencing mobile communications. And I think it's why it’s a [final] opportunity for us with the kind of products, the scale we have today and the distribution channels we're putting in place. So stay tuned. Next.
Our next question comes from the line of Edward Snyder with Charter Equity Research. Please proceed with your question.
Edward Snyder - Charter Equity Research
Thank you very much. Obviously, you're struggling in Networks, and part of that is due to the transition or the momentum moving away from CDMA to GSM. It's clear that China is spending a lot more money on GSM. Latin America is moving away from that. You're reorganizing that division. Is it reasonable to expect that you're going to see revenue growth back to a more normal level in Networks, or can we expect margins to go mostly on cost cuts for this foreseeable future for that business?
Well, just like Greg’s answer said, I think we struggled this quarter on Networks, and I always – we’ll take the good with the not good, and we didn't execute in Networks. But, you know, it is in the Far East. It is mostly Asia. Again, the U.S. guys made their numbers, Europe made their numbers. iDEN actually was good in the U.S. We did have a shift from CDMA, actually, to GSM in China, but those orders were just delayed and we’re going to get the bulk of that stuff and we feel very good about that, certainly India, also in Japan.
So we do expect revenue increase during Q2. I just gave you that guidance. We also expect the second half of the year to increase, and we expect our OE to return to its normal levels. I still think this is a very good business. And I think with some of the newer technologies we're putting in place, it's even going to be better over the next several years. But Greg, why don't you just --
I would agree. I mean, obviously, we have a strong infrastructure position in China with a number of the wireless carriers. While there has been some shift from CDMA to GSM, I think we’re generally well-positioned to capitalize on that. As Ed referred, we expect the second half of this year spending in China on infrastructure, GSM and some CDMA to increase, and we expect to participate in that.
So despite the fact that it was a sluggish quarter, I do think we're reasonably well-positioned to capitalize on the expanded CapEx and OpEx expenditures planned by some of the mobile carriers in China in the second half.
Next question, please.
Our next question comes from Daryl Armstrong with Citigroup. Please proceed with your question.
Daryl Armstrong - Citigroup
As you guys continue to make investments in the emerging markets and starting to see some benefits in terms of market share gains, have you detected any unusual competitive response from the [inaudible] in those markets?
Daryl, we're losing you. I can't -- I hope you have a good question, because we can't hear you here.
Daryl Armstrong - Citigroup
Can you hear me better now?
Yes, I can hear you. You must be using a Motorola product.
Daryl Armstrong - Citigroup
Well, a question for the handset division. As you guys make the investments within the emerging markets, and by the unit numbers, it definitely seems like you're starting to see some benefit, have you detected any competitive actions or competitive response from the dominant vendor within those markets or to a certain extent, has the competitive environment remained relatively stable?
I think I'll tell you it was the other way around this quarter. I think we were the ones that were making the actions and taking the market share, but go ahead, Ron.
Yeah, I believe that the strength of our portfolio has enabled us to keep our pricing strong across these markets. I think some competitors with a less exciting product portfolio have dropped price time and time after again. But it really hasn't had much effect on our business.
Our next question comes from Maynard Um with UBS. Please proceed with your question.
Maynard Um - UBS
Hi, thanks, just a point of clarification. On the Mobile Devices side, did you indicate market share and sales up sequentially and year over year?
What we said was sequentially, the market share would be up Q1 to Q2. What we said is the operating earnings, both in dollars and percent, would be up year over year.
Our next question comes from the line of Michael Ounjian with Credit Suisse.
Michael Ounjian - Credit Suisse
Thanks. In both the Networks and the Government and Enterprise business, it looks like you're looking for some solid improvement on the operating margin sequentially, if I'm interpreting the year over year guidance right. Can we just talk a little bit about what's driving that? Is it really just operating leverage with more revenues, or are there some investments that were in Q1 that probably won't be followed through, or be required to follow through in Q2?
Yeah, I think if you look at the businesses disaggregated for a minute, on an operating basis, we were up 50 basis points on an OE margin to 11.6% -- this is a GEMS perspective. And while revenue growth was a little over 2%, as Ed referred, it was pretty much all attributable to softness in the federal market. So state and local was strong, EMEA was strong, Latin America, Asia. So in terms of improved operating margins in GEMS, I think it is more of a leverage standpoint as federal spending returns to more historic levels.
The other footnote on fed was, as you may know, the federal budget wasn't even approved until I think it was December 29th. So spending flow-through on fed didn't really happen until the very end of Q1 and is now picking up this quarter with a couple of orders.
So I think it’s a combination of leverage on the GEMS side, and then you're right, we’ll get some consolidation and cost savings as we put the two businesses together. Clearly from a G&A perspective, I think there will be engineering optimization, things like network management, base station development and the like, and we will continue to invest in some of the exciting technology and growth areas, whether it be mesh or Canopy or wireless broadband. I mean, clearly, that's a tentacle of business that is very attractive for us from a Motorola perspective. So it’s a combination of both.
Our next question comes from Tal Liani with Merrill Lynch. Please proceed with your question.
Tal Liani - Merrill Lynch
You mentioned a lot of improvement in the handset division year over year, which we could attribute to improvement throughout the last four or even eight quarters. I want to focus, though, on what happened sequentially in the quarter.
In the quarter, that high end went up from 13 to 18 million units and low end was around flat. Your ASP’s went down from 146 to 141, and your operating margin, although improved sequentially, improved less than what I would think in a quarter that high end is growing so substantially. What led to this ASP decline and why is margin not improving more substantially on a sequential basis?
I would separate the two questions. Gross margins went up from Q4 to Q1. Therefore, if our sales and marketing expense would have been the same, we would have seen an additional point of flow-through. We took that additional point in order to be able to develop more the China, the Russia, the India and other markets so that we can continue to fuel the growth for Q2, Q3, Q4, and quite honestly, all of 2007.
When you look at the statement you made as the high-tier numbers went up, now what we gave you was how many slim-phones we sold in Q4 versus how many slim-phones we sold in Q1. There's lots of other mid- and high-tier phones that we're selling besides the slim-phones in Q4. I was just giving you a slim-phone comparison.
Our general mix, Q4 to Q1, low-tier, mid-tier and high-tier, was just about the same. The additional million or so units that we picked up was predominately more in the high-growth markets with a lower ASP, and therefore, our ASP’s tended down about 3 to 4 points.
Next question, please.
Our next question comes from Hasan Imam with Thomas Weisel Partners. Please proceed with your question.
Hasan Imam - Thomas Weisel Partners
Thanks. Terrific unit performance in handsets, congrats. A number of your competitors are coming out with high-end slim handsets, including a number of SLVR and RAZR look-alikes. I'm just wondering, do you expect price concessions at the high end going forward to maintain share?
I would break it up into a couple of points. Let me first talk about our competition copying our designs. That's actually how I would like them to spend their time, because when they’re doing that, they’re not doing anything innovative. I’ll take my time to do the innovative stuff to come in above them in the high and the mid-tier.
When you follow somebody into a market, it's very, very difficult to ever catch up from a unit perspective, and therefore our cost structure will enable us to drive price points in the mid-tier on our slim line as we refresh that with even greater high-end innovative devices.
I like, as Ron said, I've always liked being a thought leader and setting the strategy and agenda. There's lots and lots and lots of other MP3 players out there, but there's only one iPod. And there's lots and lots of slim-phones out there, but there will only be one RAZR.
And we have established a brand now. The brand has many different instantiations of RAZRs and not only colors, but different functionalities and different form factors, like SLVRs, and we've got a lot of surprises.
Again, while they're copying our designs -- and we would be glad to license it to them if they want -- we're innovating the future on new ones. So I'm not trying to be glib about it. We take it very seriously. We look at our competitors. But if you were at the [TPA] show, you saw all the new PEBL flavors and all the new RAZR flavors and all the new SLVR flavors and the MING in Europe and the RDIO product and the other things we've got coming out. And as Ron said, stay tuned for the second half of this year.
So we like what we're doing, but you know, we always start every day with our customers, and then right after that, we start with our competition. So we take it all very seriously. And we all are going to compete very effectively in the marketplace. But you know, the consumers out there want the value. They want the iconic product, and I think we've got a brand now that people want and we feel very good about our position in the marketplace.
Next question, please.
Our next question comes from John Bucher with Harris Nesbitt. Please proceed with your question.
John Bucher - Harris Nesbitt
John Bucher, Harris Nesbitt. A question for you on the platforming strategy. I think you mentioned that you've got HSDPA product coming out in Japan in the third quarter and the rest of world after that. Is that a by-product of your platforming strategy, even though I think it was a co-development project with DoCoMo?
And also, what sort of upgrade catalyst do you think the HSDPA feature is going to be in handsets? Thank you.
Yeah, the HSDPA device that we're bringing out in Q3 and the ones that we're bringing out in Q4 are all built on the freescale platform that we’ve been developing for a significant number of years, even though the specific execution of it in the Japanese market was in conjunction with DoCoMo.
I believe that from an upgrade cycle, we’re still in a space where the carriers are getting excited about these devices predominately to be able to leverage their networks from traditional voice and data services. I do believe as we roll through 2007 that things like video, things like music, things like gaming will continue, things like email will continue to drive data. I still think in the second half of this year we’re driven by traditional use cases.
Just a reminder to everyone that Dan Moloney, who runs our Connected Home business, is here with us. So if any of you have Connected Home questions, we’d love to hear them. Next question, please.
Our next question comes from Christin Armacost with Glazer Capital. Please proceed with your question.
Christin Armacost - Glazer Capital
Thank you. I wanted to ask when you expect to get a $200 3G handset on the market? And do you expect to ship more new handsets in the second half of the year than the first?
We today are already supporting the market with a below $200 handset, the E770 -- and it is doing quite well -- and we will have additional launches in the second half of this year. Those launches will be greater than the launches in the second half of last year.
Our next question comes from Jeff Kvaal with Lehman Brothers. Please proceed with your question.
Jeff Kvaal - Lehman Brothers
Thanks very much. Ron, Ed, I'm wondering a little bit about the trajectory of operating margins in the phone business. It sounds as though you have a little bit more leverage to play with on the gross margin line. To what extent should we see that flowing through into operating margins, or will you continue to invest that extra bit into improving your distribution channel and brand and what have you?
The message that I gave all of you last year is that year over year, we would expand operating earnings percent while gaining share. That's the exact same message for this year. And if you look at Q3 and Q4 of last year, we were in the 11% range. So to increase operating earnings year over year, we would actually have to be above 11%, okay, to some extent, in the second half of this year. This will be a balanced approach as we go trying to pick up a little bit of share each quarter sequentially in 2006 while making sure our operating earnings percent is greater last year over this year.
Having said that, if you step back for a second and you look Q1 of last year to Q1 of this year, we increased operating earnings in the Mobile Device business by a quarter of a billion dollars. So, yes, one was 10%, the other one was 11%, but a quarter of a billion dollars in operating earnings is a significant number.
Next question, please.
Our next question comes from Richard Windsor with Nomura Securities. Please proceed with your question.
Richard Windsor - Nomura Securities
I was wondering if you could talk about, now that you've given some Networks guidance for the full year, could you talk about how dependent that is on any 3G licenses that are issued in China and what actually are you including from China in terms of your Networks guidance for 2006? Thank you.
I don't think right now -- and this is always the $64 question, is when is 3G licenses. We now think these are mostly outside of 2006. Again, I don't have any knowledge from the Chinese government, but I was just over there and I think the prevailing thought is there may be some awards quote at the end of the year, but I don't think you're going to get revenue.
So the outlook we've given you and the numbers we've put together for the world don't factor much of that in there. I think what happened is with the 3G uncertainty for the major carriers that have been over there, they themselves with DDC… how do you pronounce it… CDMA and with 3G -- I think there were some delays in capital spending on GSM and CDMA.
I think that's all becoming clear now that 3G won't happen right now. The expansion in the consumer base is growing rapidly, so I think you're going to see some capital expenditures around GSM this quarter and next quarter as we move towards next year for the GSM contract. So I think we’ve built in the latter as opposed to 3G awards. I don't know, Greg, if you want to add to that.
Yes, I agree. I just met with some of the carriers a week-and-a-half ago, and Ed’s right. We’re really not assuming or expecting anything from 3G licenses from a planning perspective in '06. We met with the carriers and instead we're talking about infrastructure expansion between now and the end of the year and participating in that in kind.
We have time for one more question.
Your next question comes from Scott Coleman with Morgan Stanley. Please proceed with your question.
Scott Coleman - Morgan Stanley
Great, thank you. One clarification and then perhaps a question. Ron, if I heard you correctly, you said you're going to launch more handsets in the second half of '06 than you did in the second half of 2005, and if I remember correctly you did almost 40 handsets in the second half of last year, is that right?
The question that I answered was your UMTS portfolio, were you going to put out more phones in the second half of this year than before, and that’s the question I gave an answer to.
Scott Coleman - Morgan Stanley
Okay, thank you, I didn't catch that it was specific to UMTS. And then…
Scott, we lost you. Operator?
Please proceed with your question.
Can you reconnect him?
Scott Coleman - Morgan Stanley
Hey, Ed, can you hear me?
Now I can, yeah.
Scott Coleman - Morgan Stanley
Great, thanks, I appreciate the effort. On the Networks side, you know, you've been very clear that for your handset business that being a scale player is important to success longer term. This is the second quarter in a row where profitability has been disappointing in your Networks business. I think it's fair to consider it subscale relative to the competition. Why is scale less important in Networks than it is in handsets on a global basis?
Well, I think we were operating at very, very high operating margins, and we've kind of guided for the last year, as far as I can remember, back to 12% to 15% as the number. And we did hit that last quarter as we invested more in things like WiMAX and other new business opportunities that we were going after. So we were comfortable with that and we did hit it in Q4. I felt more comfortable there.
Yes, I think you need some scale in the Networks business, depending on which part of the Networks business. We have scale in GSM and CDMA. The question is 3G, obviously, and I think we’re positioned well for China in that space.
The real question is catching the next wave, and I think there is a next wave around Wireline and around 802-16 and IMS and Softswitch, and that's where we are putting a lot of the dollars.
We had an option. We saw the quarter, mid-quarter, starting to get a little bit tentative and we could have certainly shut down investments in some of those new opportunities where we chose not to. So I think we've got a strategy. I'd rather not give it all out and say – I’m with you. You certainly need to be a player in that space worldwide. I think we've got a good foundation, a good customer base to grow the future. I think we’re adding some companies that we have in the past year, and you can see I think more of that happening. So this is an area of focus right now.
I would not look at this quarter as indicative of something as systemic with this business. We know where the problems were. We like what happened in the U.S. We like what happened in Europe. We liked what happened in the Middle East and Africa. And we have created the scale in Mobile Devices, again, looking at that. We have created the scale in Connected Home, and look what we're doing in that space. I think we have a strategy. I think Greg is going to be able to articulate that at the analysts' meeting a little bit more, even though I think by the analysts' meeting I think things will improve in this area. I don't know. Greg, do you want to say anything?
Yeah, I agree. Scale does matter and we do have solid franchises, as Ed referred to, in CDMA and GSM. But it is also market position. And if you add the infrastructure businesses of iDEN, obviously, and Public Safety, we have great scale and very strong market position. When you put these two infrastructure businesses together, you get some density and girth and meat to an infrastructure business in combination with public and private that I think gives us a very good opportunity on a public-private roadmap, some exciting things from a technology standpoint, and a staying power from a cash generation and retained earnings standpoint.
So I think I'll share more at the earnings at the FAM conference, but I think clearly putting the two infrastructure businesses together makes us stronger. That said, moving forward, we’ll see how things develop.
And I'll just put in my commercial -- and you've heard me on this, and this is my own personal philosophy -- running out and doing some big plus big is not the answer either. I don't necessarily subscribe to those. I don't think you get anywhere with that. I think there are ways through organically focusing on the right things and certainly smaller acquisitions and doing things that are catching the next wave, you can do some amazing things, and I think we’ve proven that now in a couple of our businesses here.
So I think the idea of scale for scale's sake is not the right answer, but I’ll let other companies prove me wrong on that. Right now, I think we know what to do here, and stay tuned.
I think if it was more systemic in nature across the business, I would be coming here with a different story. We had some issues in Asia that frankly surprised us, having went through the quarter. This was not our forecast coming into the quarter, and we have delivered on every forecast in every business for the last nine quarters. This one didn't and it was in one geography. So let's stay tuned and we’ll revisit this during the quarter, maybe, or certainly next quarter.
All right, thank you all for participating in this conference call. During this call, we have made a number of forward-looking statements. Forward-looking statements are any statements that are not historical facts. These forward-looking statements are based on the current expectations of Motorola and there can be no assurance that such expectations will prove to be correct.
Such forward-looking statements include but are not limited to our comments and answers related to the following topics: guidance for Motorola's sales and earnings per share for the second quarter of 2006; Motorola's expected effective tax rate; shares outstanding and stock compensation expense for the second quarter of 2006; expectations regarding the volume and impact of our stock repurchase program; expectations regarding collection of additional amounts by the Company relating to Telsim; the expected completion, proceeds and financial impact of pending acquisitions and divestitures; expenses and financial impact relating to the Company's ongoing reorganization activities; future sales, profitability, operating earnings, operating margin and market share for each of Motorola's segments; expectations for Motorola's future operating margin and various factors in its improvement; expected timing for the announcement, launch and shipment of new products; the sales impact and pricing of new products; expectations for the size of the worldwide handset and infrastructure markets.
Because forward-looking statements involve risks and uncertainties, Motorola's actual results could differ materially from those stated in the forward-looking statements. Information about factors that could cause such differences can be found in this afternoon's press release on pages 19 through 27 in Item 1A of Motorola's 2005 Annual Report on a Form 10-K and on Motorola's other SEC filings.
Thank you again for participating in today's conference call.
Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.
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