Motorola Solutions, Inc. MSI
December 23, 2010 - 11:53pm EST by
ValueGuy
2010 2011
Price: 37.90 EPS $2.40 $2.53
Shares Out. (in M): 340 P/E 15.8x 15.0x
Market Cap (in $M): 12,875 P/FCF 13.8x 12.3x
Net Debt (in $M): -3,550 EBIT 1,021 1,077
TEV ($): 9,325 TEV/EBIT 9.1x 8.7x

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Description

MOT will split into two pieces on January 4th. The handset and set top box divisions will trade under the symbol MMI, and the mobile and enterprise radio business will trade under the symbol MSI. When issued trading began in MMI-W and MSI-W on 12/17/10.
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In 2011E, MSI will generate $8.1bn on the top line, $1.5bn in EBITDA and $1.05bn in free cash. Pro-forma for the spin and the receipt of monies associated with the sale of the Networks business to Nokia Siemens, MSI will have a $6.45bn cash balance. The $6.45bn is comprised of $5.3bn starting cash, $1bn in after tax proceeds from the sale of networks and $150mm from the run down of Networks receivables retained by MSI.  Debt at MSI will be $2.9bn, and so Net Debt will be a negative number $6.4bn - $2.9bn = - $3.55bn.  The market cap today is $38.00 x 340mm shares = $12.9bn. Market cap of $12.9bn plus Net Debt of -$3.55bn comes to a total enterprise value of $9.35bn.  So on a TEV/'11E EBITDA basis MSI trades at 6.2x (6.4x LTM).
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I would buy MSI because at $38 the downside is 16% (5x LTM) and the upside is 32% (9x LTM). Once the spin is complete MSI will have the opportunity to (1) initiate a dividend and/or (2) to sell the company.  MSI is all about stability of cash flow, yes, EBITDA may grow $50-$60mm next year (see pro-forma financial table).  But after 82 years what I like most about MSI is the quality of the franchise, its brand and the vital role its products play in institutions both public and private.
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MSI sells radios for first responders (police, fire, ambulance, etc), and portable radio devices for delivery persons and others who do sales or track assets in the field.  Government contracts run seven to ten years, and business devices are specially built for organizations that integrate them into their own computer systems.  For example, MSI built (and now services and supplies) the entire public emergency communication system for Australia along with 90% of North American state-wide and province-wide emergency radio system). About 65% of sales are to government (9% federal) and 35% are to businesses. For more on the business see Gary9's post from June on MOT, and the road show presentation posted to the MOT web site (http://files.shareholder.com/downloads/ABEA-2FO3VV/1096401855x0x426975/44a7ab5a-ecfd-47f6-b8cf-bcef51f1ad4e/Motorola_Solutions_Investor_Road_Show_-_Dec_2-10_2010.pdf). 
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In May of this year and again this month the company publicly hinted that it would consider paying a dividend after the spin, and that it had received pressure to do so from major shareholders. Motorola has also said that it has not had any conversations that would cloud the tax-free status of the spin, if indeed either of the two pieces were later sold/acquired.
*
With $1.05bn of free cash MSI could handily afford to pay a $2.00/share x 340mm shares = $680mm dividend. The S&P 500 and S&P Industrial ETF both trade on 2% dividend yields (vs my personal 6% bogey), but share price is highly sensitive to yield assumptions below 4%. So, a dividend at say 4% in this case would imply ($2.00/4%) = $50 (+32%).
*
Private equity firms are (incredibly) able to borrow 5.5x net debt to EBTIDA these days with modest to non-existent amortization terms. This year Burger King was taken private in an LBO at 5.6x Net Debt to LTM EBITDA, Pactiv was done at 5.4x and Gymboree 5.2x (6.1x EBITDAR).  In an LBO of MSI, 5.5x Net Debt/EBITDA of $1.5bn would imply $8.25bn of leverage. That leverage coupled with a 40% equity check (amazingly not the top end of the range of an equity contribution for a deal this year) further implies a take out $13.75bn TEV, or 9.1x EBITDA. $13.75bn TEV plus net cash of $3.55bn = $17.3bn equity value/340mm shares, or about $51 (a similar outcome to that of a $2 dividend yielding 4%).  I have not run the IRR cacls, but roughly speaking an LBO looks doable.  Though most LBOs this year have been in the sub $3bn TEV range, FIS's $13bn TEV did not deter a private equity approach (albeit a failed one).
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Carl Ichan and related entities own 11.3% and control a seat on the board. As long as the Ichan Group owns 8% or more of MSI and abstains from leading or participating in any contested solicitation, MSI (and MMI) will include an Ichan representative in their slate of board nominees at the 2011, 2012 and 2013 annual meetings.  MSI has publicly commented that relations with Ichan are good, and that his presence has been positive.
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The Business:
Sales grow at 4-8%, EBITDA margins are in the 18-20% range, capex is 2% of sales and net working capital (ex cash and debt) is about 25% of sales.  Depreciation is also about 2% of sales, and amortization consists of ½ the amount of amortization formerly recorded in the Corporate segment of MOT ($85mm/2 = $42.5mm), and some legacy amortization from the Symbol acquisition ($220-$240mm/yr). That legacy amortization will disappear in 2012, leaving D&A roughly equal to capex in the out years. For the next several years MSI will have a 20% cash tax rate (35% for GAAP purposes) because it will use NOLs and tax credits retained from the spin-off.
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MSI 2006A 2007A 2008A 2009A 2010E 2011E 2012E
Revenue         6,413         8,244         8,228        7,169        7,757          8,106          8,592
EBIT         1,108             971           (343)            736            830          1,077          1,456
Charges             192             314         1,677            161            191                 -                   -  
Adj. EBIT         1,300         1,285         1,334            897        1,021          1,077          1,456
Symbol Amort.               21             241             230            220            220             220                  5
Guidance Op. Income         1,321         1,526         1,564        1,117        1,241          1,297          1,461
               
Revenue 3.2% 28.6% -0.2% -12.9% 8.2% 4.5% 6.0%
Adj. EBIT Mgn. 20.3% 15.6% 16.2% 12.5% 13.2% 13.3% 16.9%
"Op. Earnings" Mgn. 20.6% 18.5% 19.0% 15.6% 16.0% 16.0% 17.0%
               
Depr. (2% Sales)               92             167             158            152            155             162             172
MOT Corp. Amort./2               37               42               52              43              43               43               43
D&A (ex-Symbol)             129             209             210            195            198             205             214
Symbol Amort.               21             241             230            220            235             235                  5
Total D&A             150             450             440            415            433             440             219
               
EBITDA         1,450         1,735         1,774        1,312        1,454          1,517          1,675
% Margin 22.6% 21.0% 21.6% 18.3% 18.7% 18.7% 19.5%
               
Pension Exp.             433             380             (46)            121            135             135             135
OPEB Exp.               22               15               15              20              15               15               15
Total             455             395             (31)            141            150             150             150
               
EBITDA Ex-Ret. Exp.         1,905         2,130         1,743        1,453        1,604          1,667          1,825
% Margin 29.7% 25.8% 21.2% 20.3% 20.7% 20.6% 21.2%
               
Adj. EBIT (1-20%)                -           1,028         1,067            718            817             862          1,165
+ Total D&A                -               450             440            415            433             440             219
- CAPX (2% Sales)                -               165             165            141            171             162             172
- Chng W/C (25% Sales)                -               458                (4)          (265)            147               87             122
FCF               855         1,346        1,256            931          1,052          1,090
- Est. Dividend $2.00                -                  -                  -                 -              680             680             680
- Pens./OBEP Cont.                -               409             243            129            200             275             275
Residual Cash               446         1,103        1,127              51               97             135
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Revenue:
Management guided to 7-8% top line growth in 2010E, and 4-5% in 2011E. The phase out of iDen will reduce 2011E sales by about $100mm (-1.3% points of growth). So, without the iDen wind down sales would be growing closer to 4.5% +1.3% = 5.8%, which is in line with management's long term target of 6-8%. The recession pushed the top line down 12.9% in 2009 but in the 9ME 3Q10 sales have grown 8.2% and 4Q is seasonally the strongest for MSI. So, MSI is on track to meet 7-8% guidance for the year, and once adjusted, next year's lower range is still in keeping with the company's forecast of 6-8% top line expansion.
*
Cisco recently missed earnings estimates in part because of a slow down in public sector spending.  However, backlog at MSI in 3Q10 was up slightly on a year over year basis; and according to the company MSI did not experience the same problem as Cisco in 3Q10.
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Margins:
The company is guiding to a 16% Operating Earnings margin for both 2010E and 2011E. What are Operating Earnings? Operating Earnings are just MSI's term for EBIT, with non-recurring charges added back, and amortization added back from the from the 2007 acquisition of Symbol Technologies.  As mentioned before, amortization from the acquisition will disappear at the end of 2012. So, management would prefer that we ignore that amortization today.  In their presentations it's nicer to talk about a 15.6% Operating Earnings margin in 2009 than a 12.5% adjusted EBIT Margin, and given that EBITDA margins are the same 18.3%, it makes no difference.  Please see the EBITDA and EBITDA margin line items in the table below for a more familiar depiction of operating profitability over time.
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2011E margins will decline in 1Q11 and 2Q11 because $150-$200mm of cost previously allocated to MMI will remain at MSI.  However, the $150-$200mm of excess MMI costs will be completely eliminated by the end of 2Q11, according to management. So, even with what amounts to a 2% headwind (say $175mm of cost / $8.1bn of 2011E sales = 2.16%) management expects to have high enough margins in the back half of the year to deliver 16% for '10E.  The company's three year margin target is 18% (roughly 20.5% in EBITDA terms), which MSI has said should not be thought of as a ceiling.
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Pension:
Pension adjusted TEV/2011E EBITDA is one turn higher than the unadjusted multiple.  However, even with the pension and OPEB added to the gross debt balance, MSI still has a positive net cash position of roughly $900mm.  The company has decided to make $250-$300mm of annual cash contributions over the next seven years.  However, with 2/3 of pension assets globally in equities, those contributions could be curtailed should markets rally and the plan improve its funded status.  If free cash is $1.05bn, the dividend is ($2.00 x 340mm) = $680mm, and the pension contribution is $275mm, then $1.05bn - $680mm - $275mm= $95mm. MSI can pay the dividend, fund the pension and still have $95mm left over. The $95mm is of course in the context of the $3.55bn in net cash (or $900mm net cash if we include pension and OPEB as debt).  MSI is more inclined to contribute to the plan ratably over time, rather restoring it to fully funded status via a balloon contribution. Once monies go in they don't come back out to corporate, even if the plan is overfunded.  So, pension is important, we can't ignore it, but at the same time we can't get too paranoid about it. After a good year in the market we could look back, and oops, we passed on something that was cheap because the pension adjustment told us that at the time it looked expensive.
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Comparable Companies:
The best comps are not quite comps. MSI could be compared to CACI (6.4x '11E) and Harris Corp. (5.8x '11E). CACI has 7-8% EBITDA margins versus 18-20% at MSI. Harris has heavy exposure to the conflicts in Iraq and Afghanistan, and their multiple has been hit in the expectation that reduced hostilities will have a material affect on revenues.
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Conclusion:
I would buy MSI because it's a high quality franchise, and at $38 the downside is 16% (5x LTM) and the upside is 32% (9x LTM). Once the spin is complete MSI will have the opportunity to (1) initiate a dividend and/or (2) to sell the company.
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Go moto!

Catalyst

1. MSI-W will trade regular way on Monday, January 4th
2. The CEO of MSI has said the board would likely consider the matter of a dividend after the close of the sale of the Networks business in 1Q11.
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    Description

    MOT will split into two pieces on January 4th. The handset and set top box divisions will trade under the symbol MMI, and the mobile and enterprise radio business will trade under the symbol MSI. When issued trading began in MMI-W and MSI-W on 12/17/10.
    *
    In 2011E, MSI will generate $8.1bn on the top line, $1.5bn in EBITDA and $1.05bn in free cash. Pro-forma for the spin and the receipt of monies associated with the sale of the Networks business to Nokia Siemens, MSI will have a $6.45bn cash balance. The $6.45bn is comprised of $5.3bn starting cash, $1bn in after tax proceeds from the sale of networks and $150mm from the run down of Networks receivables retained by MSI.  Debt at MSI will be $2.9bn, and so Net Debt will be a negative number $6.4bn - $2.9bn = - $3.55bn.  The market cap today is $38.00 x 340mm shares = $12.9bn. Market cap of $12.9bn plus Net Debt of -$3.55bn comes to a total enterprise value of $9.35bn.  So on a TEV/'11E EBITDA basis MSI trades at 6.2x (6.4x LTM).
    *
    I would buy MSI because at $38 the downside is 16% (5x LTM) and the upside is 32% (9x LTM). Once the spin is complete MSI will have the opportunity to (1) initiate a dividend and/or (2) to sell the company.  MSI is all about stability of cash flow, yes, EBITDA may grow $50-$60mm next year (see pro-forma financial table).  But after 82 years what I like most about MSI is the quality of the franchise, its brand and the vital role its products play in institutions both public and private.
    *
    MSI sells radios for first responders (police, fire, ambulance, etc), and portable radio devices for delivery persons and others who do sales or track assets in the field.  Government contracts run seven to ten years, and business devices are specially built for organizations that integrate them into their own computer systems.  For example, MSI built (and now services and supplies) the entire public emergency communication system for Australia along with 90% of North American state-wide and province-wide emergency radio system). About 65% of sales are to government (9% federal) and 35% are to businesses. For more on the business see Gary9's post from June on MOT, and the road show presentation posted to the MOT web site (http://files.shareholder.com/downloads/ABEA-2FO3VV/1096401855x0x426975/44a7ab5a-ecfd-47f6-b8cf-bcef51f1ad4e/Motorola_Solutions_Investor_Road_Show_-_Dec_2-10_2010.pdf). 
    *
    In May of this year and again this month the company publicly hinted that it would consider paying a dividend after the spin, and that it had received pressure to do so from major shareholders. Motorola has also said that it has not had any conversations that would cloud the tax-free status of the spin, if indeed either of the two pieces were later sold/acquired.
    *
    With $1.05bn of free cash MSI could handily afford to pay a $2.00/share x 340mm shares = $680mm dividend. The S&P 500 and S&P Industrial ETF both trade on 2% dividend yields (vs my personal 6% bogey), but share price is highly sensitive to yield assumptions below 4%. So, a dividend at say 4% in this case would imply ($2.00/4%) = $50 (+32%).
    *
    Private equity firms are (incredibly) able to borrow 5.5x net debt to EBTIDA these days with modest to non-existent amortization terms. This year Burger King was taken private in an LBO at 5.6x Net Debt to LTM EBITDA, Pactiv was done at 5.4x and Gymboree 5.2x (6.1x EBITDAR).  In an LBO of MSI, 5.5x Net Debt/EBITDA of $1.5bn would imply $8.25bn of leverage. That leverage coupled with a 40% equity check (amazingly not the top end of the range of an equity contribution for a deal this year) further implies a take out $13.75bn TEV, or 9.1x EBITDA. $13.75bn TEV plus net cash of $3.55bn = $17.3bn equity value/340mm shares, or about $51 (a similar outcome to that of a $2 dividend yielding 4%).  I have not run the IRR cacls, but roughly speaking an LBO looks doable.  Though most LBOs this year have been in the sub $3bn TEV range, FIS's $13bn TEV did not deter a private equity approach (albeit a failed one).
    *
    Carl Ichan and related entities own 11.3% and control a seat on the board. As long as the Ichan Group owns 8% or more of MSI and abstains from leading or participating in any contested solicitation, MSI (and MMI) will include an Ichan representative in their slate of board nominees at the 2011, 2012 and 2013 annual meetings.  MSI has publicly commented that relations with Ichan are good, and that his presence has been positive.
    *
    The Business:
    Sales grow at 4-8%, EBITDA margins are in the 18-20% range, capex is 2% of sales and net working capital (ex cash and debt) is about 25% of sales.  Depreciation is also about 2% of sales, and amortization consists of ½ the amount of amortization formerly recorded in the Corporate segment of MOT ($85mm/2 = $42.5mm), and some legacy amortization from the Symbol acquisition ($220-$240mm/yr). That legacy amortization will disappear in 2012, leaving D&A roughly equal to capex in the out years. For the next several years MSI will have a 20% cash tax rate (35% for GAAP purposes) because it will use NOLs and tax credits retained from the spin-off.
    *
    MSI 2006A 2007A 2008A 2009A 2010E 2011E 2012E
    Revenue         6,413         8,244         8,228        7,169        7,757          8,106          8,592
    EBIT         1,108             971           (343)            736            830          1,077          1,456
    Charges             192             314         1,677            161            191                 -                   -  
    Adj. EBIT         1,300         1,285         1,334            897        1,021          1,077          1,456
    Symbol Amort.               21             241             230            220            220             220                  5
    Guidance Op. Income         1,321         1,526         1,564        1,117        1,241          1,297          1,461
                   
    Revenue 3.2% 28.6% -0.2% -12.9% 8.2% 4.5% 6.0%
    Adj. EBIT Mgn. 20.3% 15.6% 16.2% 12.5% 13.2% 13.3% 16.9%
    "Op. Earnings" Mgn. 20.6% 18.5% 19.0% 15.6% 16.0% 16.0% 17.0%
                   
    Depr. (2% Sales)               92             167             158            152            155             162             172
    MOT Corp. Amort./2               37               42               52              43              43               43               43
    D&A (ex-Symbol)             129             209             210            195            198             205             214
    Symbol Amort.               21             241             230            220            235             235                  5
    Total D&A             150             450             440            415            433             440             219
                   
    EBITDA         1,450         1,735         1,774        1,312        1,454          1,517          1,675
    % Margin 22.6% 21.0% 21.6% 18.3% 18.7% 18.7% 19.5%
                   
    Pension Exp.             433             380             (46)            121            135             135             135
    OPEB Exp.               22               15               15              20              15               15               15
    Total             455             395             (31)            141            150             150             150
                   
    EBITDA Ex-Ret. Exp.         1,905         2,130         1,743        1,453        1,604          1,667          1,825
    % Margin 29.7% 25.8% 21.2% 20.3% 20.7% 20.6% 21.2%
                   
    Adj. EBIT (1-20%)                -           1,028         1,067            718            817             862          1,165
    + Total D&A                -               450             440            415            433             440             219
    - CAPX (2% Sales)                -               165             165            141            171             162             172
    - Chng W/C (25% Sales)                -               458                (4)          (265)            147               87             122
    FCF               855         1,346        1,256            931          1,052          1,090
    - Est. Dividend $2.00                -                  -                  -                 -              680             680             680
    - Pens./OBEP Cont.                -               409             243            129            200             275             275
    Residual Cash               446         1,103        1,127              51               97             135
    *
    Revenue:
    Management guided to 7-8% top line growth in 2010E, and 4-5% in 2011E. The phase out of iDen will reduce 2011E sales by about $100mm (-1.3% points of growth). So, without the iDen wind down sales would be growing closer to 4.5% +1.3% = 5.8%, which is in line with management's long term target of 6-8%. The recession pushed the top line down 12.9% in 2009 but in the 9ME 3Q10 sales have grown 8.2% and 4Q is seasonally the strongest for MSI. So, MSI is on track to meet 7-8% guidance for the year, and once adjusted, next year's lower range is still in keeping with the company's forecast of 6-8% top line expansion.
    *
    Cisco recently missed earnings estimates in part because of a slow down in public sector spending.  However, backlog at MSI in 3Q10 was up slightly on a year over year basis; and according to the company MSI did not experience the same problem as Cisco in 3Q10.
    *
    Margins:
    The company is guiding to a 16% Operating Earnings margin for both 2010E and 2011E. What are Operating Earnings? Operating Earnings are just MSI's term for EBIT, with non-recurring charges added back, and amortization added back from the from the 2007 acquisition of Symbol Technologies.  As mentioned before, amortization from the acquisition will disappear at the end of 2012. So, management would prefer that we ignore that amortization today.  In their presentations it's nicer to talk about a 15.6% Operating Earnings margin in 2009 than a 12.5% adjusted EBIT Margin, and given that EBITDA margins are the same 18.3%, it makes no difference.  Please see the EBITDA and EBITDA margin line items in the table below for a more familiar depiction of operating profitability over time.
    *
    2011E margins will decline in 1Q11 and 2Q11 because $150-$200mm of cost previously allocated to MMI will remain at MSI.  However, the $150-$200mm of excess MMI costs will be completely eliminated by the end of 2Q11, according to management. So, even with what amounts to a 2% headwind (say $175mm of cost / $8.1bn of 2011E sales = 2.16%) management expects to have high enough margins in the back half of the year to deliver 16% for '10E.  The company's three year margin target is 18% (roughly 20.5% in EBITDA terms), which MSI has said should not be thought of as a ceiling.
    *
    Pension:
    Pension adjusted TEV/2011E EBITDA is one turn higher than the unadjusted multiple.  However, even with the pension and OPEB added to the gross debt balance, MSI still has a positive net cash position of roughly $900mm.  The company has decided to make $250-$300mm of annual cash contributions over the next seven years.  However, with 2/3 of pension assets globally in equities, those contributions could be curtailed should markets rally and the plan improve its funded status.  If free cash is $1.05bn, the dividend is ($2.00 x 340mm) = $680mm, and the pension contribution is $275mm, then $1.05bn - $680mm - $275mm= $95mm. MSI can pay the dividend, fund the pension and still have $95mm left over. The $95mm is of course in the context of the $3.55bn in net cash (or $900mm net cash if we include pension and OPEB as debt).  MSI is more inclined to contribute to the plan ratably over time, rather restoring it to fully funded status via a balloon contribution. Once monies go in they don't come back out to corporate, even if the plan is overfunded.  So, pension is important, we can't ignore it, but at the same time we can't get too paranoid about it. After a good year in the market we could look back, and oops, we passed on something that was cheap because the pension adjustment told us that at the time it looked expensive.
    *
    Comparable Companies:
    The best comps are not quite comps. MSI could be compared to CACI (6.4x '11E) and Harris Corp. (5.8x '11E). CACI has 7-8% EBITDA margins versus 18-20% at MSI. Harris has heavy exposure to the conflicts in Iraq and Afghanistan, and their multiple has been hit in the expectation that reduced hostilities will have a material affect on revenues.
    *
    Conclusion:
    I would buy MSI because it's a high quality franchise, and at $38 the downside is 16% (5x LTM) and the upside is 32% (9x LTM). Once the spin is complete MSI will have the opportunity to (1) initiate a dividend and/or (2) to sell the company.
    *
    Go moto!

    Catalyst

    1. MSI-W will trade regular way on Monday, January 4th
    2. The CEO of MSI has said the board would likely consider the matter of a dividend after the close of the sale of the Networks business in 1Q11.
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