Motorola Solutions (NYSE:MSI) was created when Motorola spun off their telecommunications division in 2011. With a 85% market share of radio communications for law enforcement and other first responders (FR), Motorola has used its dominant position in a fragmented customer base to control the market for first responder communications in North America. Motorola also has a worldwide presence selling broadband networks and equipment though numerous partnerships.
But it's time investors start to realize...
How Motorola Really Makes Its Money!
While Motorola's has many operating divisions, the bulk of its profits come from selling overpriced handsets into its single source contracts in the United States.... taking advantage of both tax payers and the first responder community. In fact, handset sales in the U.S. carry an 83.6% gross margin (see below), while device sales in Europe are at 9%.
Our analysis shows that U.S. device (handset) sales are contributing a whopping 76.7% of Motorola's bottom line.
From a series of articles reported by McClatchy last year:
"The industry giant has landed scores of sole-source radio contracts and wielded enough pricing power to sell its glitzy handsets for as much as $7,000 apiece, at a taxpayer cost of hundreds of millions, if not billions, of dollars that could have been saved in a more competitive market." (source)
Motorola Solutions has been coasting on a simple formula: Dote on police, fire and sheriff's departments, woo contracting officials, pursue every angle to gain a sole-source deal or an inside track, and where possible, embed equipment with proprietary features so it can't interact with competitors' products.
These tactics are borderline anti-competitive and definitely stand out in stark contrast to the new age of government approach to spending (source).
This is exactly what MSI does when supplying U.S. first responders with critical communications equipment.
What would President Trump say if Lockheed Martin (NYSE:LMT) was charging the U.S. Air Force five times what it charged the United Kingdom for an F-35?
"We're going out to bid in virtually every facet of our government. We are going to save a fortune."
We can publish pages upon pages of documentation, but to make things easy and understandable we present one clear example.
In 2016, the city of Chandler, Arizona, bought 30 APX 6000 Police Radios from Motorola... here is the contract (source):
After a "discount" Chandler paid $5, 200 a piece for this radio (source).
Compare this to the MTP-6550 radio sold to first responders in the U.K. (source).
Note the 6550 is their high-end product with a color screen, etc. Most police jurisdictions in the UK pay far less for their Motorola phones, for lower-end B/W screens. The highest-end phone that Motorola sells to the UK government is significantly cheaper than the lowest-end phone it sells to U.S. law enforcement agencies (source).
One former senior Motorola executive, who declined to be identified to avoid harming relationships, said that everybody knows that a cell phone costing a few hundred dollars is far more powerful than today's two-way emergency radios. He said that public safety agencies shouldn't be paying more than $800 for a "ruggedized cell phone.(source)
The reason why the UK and the rest of the world is less expensive is simple: Their LMR network (TETRA) is an open platform - Motorola faces competition to sell in these markets.
Competition on an Open Platform is Motorola's Kryptonite
Motorola's overseas units, operating in TETRA markets, generate gross profit margins LESS THAN HALF of it U.S. corporate average. The reason is that Motorola doesn't have monopoly control on the TETRA platform.
- Note: Motorola has been able to exploit the system because the vast majority of U.S. contracts are awarded on a local level. Yet, most are funded by government grants through DHS and/or the U.S. Department of Commerce, right from the US taxpayer.
In fact, Motorola has developed its own "in-house system" of procuring federal funding for these non-competitive, outdated, and overpriced projects.
Your Tax Dollars at Work
FirstNet: The Bomb for Motorola
FirstNet is a communications system for first responders proposed after the 9-11 disaster. That dark day stressed our first responder system on a national level like no other, exposing major vulnerabilities in our disaster infrastructure. Specifically, our first responders were grievously impacted by their inability to respond to the disaster across multiple jurisdictions.
The U.S. has moved (albeit slowly) to develop an independent, interoperable communication system for first responders. Finally, AT&T (NYSE:T) will likely begin the build out in 2017.
As the Federal government has a strong interest in stimulating competition and innovation in first responder communications, they are doing it through the support of FirstNet. Wilbur Ross, President Trump's appointed Secretary of Commerce who will oversee the major source of funding for local first responder communication systems, already has expressed his support for the project.
FirstNet represents the two words Motorola hates to hear: Competition and innovation.
Despite the obvious bullshit kicked by MSI management, it is no secret that they have lobbied long and hard to put the kibosh on FirstNet.
An especially lucid statement about FirstNet was just published in Police Chief Magazine, January 2017 edition:
Just as smart phones have created a new era of real-time information and connectivity for individuals, the FirstNet network will enable services, devices, and applications that provide the public safety community with the tools they need to save lives (source).
Motorola's lobbying campaign got so bad that it prompted a scathing letter from Senator Jay Rockefeller (West Virginia):
I will not stand by while your company continues to defend a business plan solely because you are unwilling to make the investments and commitments necessary to be a true competitor on the new level playing field for public safety communications equipment ... (source)
As stated clearly in Motorola's risk factors, in their 10-K:
Longer term, MSI's opportunities to sell LTE equipment and related services in this space will be substantially impacted by: (1) the deployment model being developed by FirstNet, which has been heading in a direction more favorable to commercial carriers...
(4) FirstNet's stated intent to reduce handset prices....
How the U.S. Government Can R egulate the "Motorola Monopoly"
Just like the pharmaceutical industry was a problem already known by Congress, so is the "Motorola Monopoly."
Congresswoman Anna Eshoo, who serves on the U.S. House Energy Subcommittee on Communications and Technology stated in a report to Congress:
"$5,000 public safety radios are out, o-u-t, so there is - I don't even - I don't want to hear about them anymore. As far as I am concerned, they don't exist, and I don't think any of the dollars that are being provided should go to anything... like that. That is yesterday. (source)
As suggested by knowledgeable stakeholders in the space, the U.S. Department of Commerce can easily access a list of all the DHS grants to state and local agencies that have selected Motorola as their vendor for public safety equipment and devices, and assure these bids were competitive.
The Department of Commerce has already explored this issue in the past and it will be on no secret to them that taxpayers are being exploited.
Any appearance that there would be a fair, competitive bidding process was a ruse - Steve Overacker, Contra Costa County's then telecommunications manager.
With or without government regulation or even FirstNet, the days of Motorola's closed end business are numbered.
"The change that Motorola is getting hit with is no less substantial than what hit IBM or Kodak. It's a technology wave - Steve Koman, a former Motorola employee, consultant to the city of Charlotte, N.C. (source)
Push-to-Talk" is Motorola's Rapidly Obsolescing Secret Sauce
Motorola has maintained its near- monopoly on the U.S.'s first responder market with its proprietary LMR channel for "push-to-talk" (e.g. "walkie-talkie") functionality, which first responders have long relied upon. But technology advances are rapidly enabling cell phones to transmit voice communications as fast and reliably as two-way radios, a development that eventually will crumble the company's radio franchise.
Just last week South Korea, which has completely updated its police communications in anticipation of the 2018 Olympics, launched an advanced push to talk solution over an LTE Network (source).
Later this month in Barcelona's Wireless World, many vendors, including Nokia (NYSE:NOK), will be showcasing their Mission Critical Push-to-Talk Technology, which will make Motorola's $5K handsets stand out in stark contrast as a thing of the past.
The chart below was prepared for Fairfax County, Virginia, to assess the cost of Motorola's LMR vs. an advanced LTE system. This shows you exactly where the industry is moving:
The Dirty Verdict
What are the actual financial impacts for investors as Motorola loses its monopoly pricing power on U.S. handsets? What happens to its valuation? Let's start here. In European markets, Motorola competes with Nokia's and Ericson's (NASDAQ:ERIC) equipment. How does it compare with those companies on an EBITDA basis?
Here's our analysis of the massive gross margin discrepancy when comparing Motorola's business in Germany and the U.S.
Through either government scrutiny or just evolution of technology, MSI gross margins on its US handset business WILL be cut in half or more in the coming years.
We think that MSI's gross margins on handsets are likely to re-base to the mid-30s, and head toward single digits, in line with its own European margins for handset makers that face greater competition. Using this "normalized" earnings level, we see MSI generating around $3.50 of normalized earnings. As the market recognizes the secular pressures on MSI, we see the multiple re-rating to 12x to reflect a more commoditized handset maker. This places MSI shares 50% lower than its current trading value.
Or you can look at it this way. Just by losing half the gross margin in its monopoly-priced U.S. proprietary handset business, MSI's gross profit company-wide falls nearly 40%. (We're still valuing its services and competitive products business generously).
This is our homework that extrapolates the gross margin impact on EBITDA.
Once a lower multiple more comparable to Nokia and Ericcson is considered, this stock faces a 78% downside risk.
Note: There is no way that MSI should ever deserve a multiple higher than Nokia who was identified as No.1 vendor of 4G public safety technology by Current Analysis in global study of 100 operators (source).
With the arrival of the Trump Administration, and its management style of introducing business-style negotiations into the government's contracting for goods and services, plus the maturing and emergence of open-platform FirstNet, it appears the no lobbying, high paid consultants, football tickets, golf outings or Las Vegas conferences can overcome the forces driving competition and innovation.
Reflecting on our "F-35" comparison from early in this piece, at least the F-35 represents a state-of-the-art technology product of U.S. industry. Ironically, Motorola's LMR-P25 platform deployed in the U.S. is older than either the LMR-Tetra deployed in the U.K. or the LTE technology employed in Europe. Just like drugs, we pay more in the U.S. But unlike drugs, we get less.
When Motorola transforms itself into a services company, shareholders will not be happy with contracting gross margins and multiples.
Disclosure: I am/we are short MSI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.