Description

LONG - Motorola Inc. (MOT)

Date:                     6/9/10

Price:                     $6.66

Mkt Cap:              15.6 b

Debt:                     3.9 b

Cash:                     (8.5) b

EV:                         11.0 b

Thesis

Motorola (MOT) is a long because it is undervalued on a sum of the parts basis and will realize this discount through a spin-off over the next 9 months as well as through other likely value-unlocking transactions between now and 2011.

MOT is in the process of breaking up its 4 businesses. This will be accomplished through a spin-off of Mobile Devices and Home into a separate company, and a possible sale of the Networks business. These divestments will highlight the value of Enterprise Mobility Solutions which is the gem of the company and worth more than the current enterprise value by itself, essentially giving us the rest of the company for free. We also have confidence in the turnaround of Mobile Devices because the cost structure has been slashed, the new product portfolio is strong, it's headed the right direction strategically, and new management is the real deal.

The company has also indicated it is willing to consider dividends, buybacks, and/or other balance sheet transformations after the spin is completed. This is significant given it has more than $4.5 b of net cash.

Our valuation suggests a base/bull case of $8.40 - $11.00/share, representing 25-65% upside over the next 9-12 months with additional upside from balance sheet optimization (which is meaningful, but hard to quantify).

We also believe that downside is very limited, as even putting low multiples on low earnings estimates gets you to close to the current share price.

Business Description

Motorola today is a collection of 4 unrelated businesses:

Enterprise Mobility Solutions (75% of value): Makes 2-way radios for public safety and wireless security products for the government and other end markets. MOT has high market shares in their product lines and 30% of revenues are post-hardware sale services. Top line growth will be 5-8% with some margin expansion (current run-rate of ~17%).

Mobile Devices (7% of value): Handset business that brought us StarTAC and RAZR. The handset business has historically been hit driven and cyclical. When the RAZR began maturing at the end of 2006 MOT made the decision to spend a ton of money to maintain market share while developing their next hit but ended up empty handed and bloated (cost structure). The business has been in turn around mode since late 2006 and has gone from burning $1.0B+ annually to likely being profitable at the end of this year.

Home (11% of value): Largest set-top box manufacturer for cable/satellite (65% of sales) and related video and data hardware. Expectations are for modest top line shrinkage but EBIT growth given margin improvement and its stable dominant position in its markets. Home is being paired with Mobile devices in the spin to ballast the cash flow generation of SpinCo as Home is reliable while Mobile is cyclical.

Networks Mobility (7% of value): #5 global players in cell phone tower equipment (base stations, controllers, associated software and services). Networks bet with Sprint on WiMax which is faring poorly and is now not well positioned for future growth. Top line is declining ~10% but the business is being run for cash so EBITDA-capex margins have actually been increasing resulting in significant FCF. We believe Networks is being shopped and has appeal since scale is important in telco equipment manufacturing and Networks has a big customer list. Huawei (a Chinese company and #4 player) is a likely interested buyer but would face scrutiny from US regulators. We believe there is also interest from the other competitors as well as private equity.

Why the Opportunity Exists

• Investor fatigue - MOT has been a turnaround story for 4 long years and from $20/share. Many value investors are scarred from being in the stock at higher levels and aren't focusing on the fact that we are close to the finish line on an illumination of the value of EMS. A spin/sale will catalyze those to take a fresh look at the situation and help us realize fair value.
• Uncertainty over Mobile turnaround - There is some probability (low in our opinion) that the Mobile business cannot be turned around. Our checks confirm that Sanjay Jha (brought in from QCOM specifically to run Mobile) is an excellent operator. There has been significant progress made in right-sizing the cost structure and focusing the R&D on Smartphones using the Android OS. Jha is also very highly incented to get the spin-off done & Mobile turned around.
• Noisy financials - There have been multiple corporate structure changes in the past several years with adjusted numbers being released only recently. Before, investors had to take GAAP numbers and make significant adjustments. We think this complexity has masked the true valuation from the market and incented some to just wait for the spin-off before looking at the newco's.

Below is our valuation for each segment and how we roll that up to a consolidated value of $8.40-$11.00/share. Note that we think we are being conservative in our base and bull case assumptions as we will describe below:

"New MOT"

EMS - Revenue guidance is for mid-high single digits over the long term. We are at using a 5% CAGR for 2009-2011. Guidance for EBIT margin is for "up slightly" from the 15.5% they did in 2009. However, Q1 10 was up 200 bps and on the same run-rate as we saw in 2007 when EBIT margins were 16.8% for the year. Our base case of 17% EBIT margins therefore do not assume much more improvement than what we saw in Q1. There are no perfect comps but 9-10x EBIT seems reasonable for a high single digit EBIT grower with very high market share and barriers to entry.

Networks - Revenue guidance is for down 10% in 2010. We assume this and then an acceleration to 12.5% revenue decline in 2011. For EBIT margins, guidance is for 10-11% in 2010 but Q1 was much higher at 14% margins. We assume no margin improvement from the 12% in 2009 and then 100 bps of erosion for 2011. We are using a very low 5x EBIT multiple for the value of the business given its declining nature offset by its ability to produce a lot of cash if it were to be run-off. Ericsson paid 1x sales for Nortel's assets which would imply 2x the valuation we are using. We do not tax-affect the hypothetical proceeds as it is our understanding that there is a large tax basis in the business.

"SpinCo"

Home - We are assuming flat revenues and 100 bps of EBIT margin improvement in 2011 vs. 2009. The 8.5x base case EBIT multiple implies a discount to the comps (ADTN and HLIT).

Mobile - a turn in Mobile accounts for the biggest swing in EBIT growth for MOT consolidated as they have the opportunity to go from losing $300+ mm in 2010 to making a profit in 2011. The company has guided to profitability by Q4 10 and the current quarterly trajectory certainly supports this guidance. Much of this turns on continued growth in their smartphone shipments, as smartphones are the most profitable and fastest growing part of the handset market. We take comfort here in the fact that after Q1 MOT increased their expected smartphone shipments for the year from 11.5 mm to 12.0 mm (at midpoint of guidance). They also have the deepest portfolio of smartphones of any Android-based vendor and deep carrier relationships, particularly in the US and China, their two biggest markets.

Our base case is below some of the more optimistic forecasts on the street but admittedly there is a wide variance for what people think Mobile will do in 2011. Importantly, even if the turnaround sputters, we think Mobile is worth a positive valuation vs. our bear case because Jha comes from QCOM and should know how to monetize Mobile's IP. As a sensitivity check, if Mobile is worth zero our base case valuation adjusts down 50 cents to ~$8.00/share, still 20% upside.

Consolidated Valuation

Consolidation - Our base case implies an 8.5x EBIT multiple or roughly 13x EPS (assuming a 20% cash tax rate) which seems conservative vs. what sentiment could mean for the valuation if we do get a turn in Mobile. Capex will be less than D&A going forward so FCF will be higher than EPS. We discount net cash by 25% as the market will probably not give us full credit unless there is a re-leveraging (50 cents of incremental value if you fully value the cash balance). We tax affect the $1.9b of net pension liability to get to $1.2 b and haircut the $3.2 b DTA/NOL to $1.3 b on a PV basis assuming 50-75% utilization given the difficulty in using $2.0 b of foreign DTA's and the length of time necessary to fully utilize the entire asset.

What are we playing for / how much can we lose?

Our base/bull case results in a valuation of $8.40-$11.00/share or 25-65% upside over the next 12 months with further upside from balance sheet optimization.

If we are wrong on the Mobile turnaround and haircut our assumptions on the other segments we see downside to $6.30/share in the bear case which implies an excellent risk/reward opportunity. Of course in a market like today's, things can deviate from fair value, but in the aggregate, the 6-12 month risk/reward is highly compelling.

Risks / What Happens to Make Us Wrong

• Turnaround of Mobile business fails and bleeds more cash before they give up and run it for IP, leaking material value. We try and account for this in our base case by assigning negative $420 mm of value to Mobile in our base case.
• Networks business cannot be sold and is put in run-off but continues to cloud EMS financials and the market does not give a full multiple to EMS. This would push out our time frame and lower our IRR but we would not lose money.

Timeline / Catalysts

• Filing of Form 10 (spin document) later this summer (this would be a signpost that timeline is on track).
• Spin-off of Mobile/Home in first quarter of 2011.
• Possible sale of Networks in the next 6-9 months.
• Balance sheet transformation (dividend, buyback, and/other other leverage) for New MOT in 2011. (The homerun would be a sale of EMS as there are numerous potential suitors given the quality of this business, such as GE, HON, LMT, GD, and potentially HPQ and others)

Catalyst

Filing of Form 10 (spin document) later this summer (this would be a signpost that timeline is on track).

Spin-off of Mobile/Home in first quarter of 2011.

Possible sale of Networks in the next 6-9 months.

Balance sheet transformation (dividend, buyback, and/other other leverage) for New MOT in 2011. (The homerun would be a sale of EMS as there are numerous potential suitors given the quality of this business, such as GE, HON, LMT, GD, and potentially HPQ and others)