Motorola was written up twice as long ideas in 2010.  Gary9 wrote up MOT in June of ’10 as a Sum of the Parts.  ValueGuy wrote up MSI (Motorola Solutions, the legacy non-handset business) in December of ’10 as an inexpensive industrial company with capital structure catalysts.  MSI turned out to be a good investment – from December 23, 2010  to today MSI is up 32% versus up 6% for the S&P 500.

I believe that MSI is more compelling today than it was then, and I’m recommending it (again) as a long.

If you already know the story, start here, if not, skip down to the “thesis” section.

WHAT’S CHANGED?

Positives

-          MSI’s two segments have produced record revenue (Government grew 4.3% organically in 2011, and Enterprise grew 11% organically, ex iDEN )

-          Sales leverage and expense reductions led to record margins in 2011 (280 bps of consolidated margin expansion)

-          The company has exceeded guidance and consensus every quarter since the split

-          MSI generated $900 million of free cash flow in 2011 (ex voluntary pension contributions), excluding all working capital FCF was $1.25B

-          MSI has announced $3B in share repurchase authorizations, of which $2.5B has been spent (16% of the float, at $45 per share)

-          MSI initiated an 88c dividend last year (1.8% yield)

-          The so called “narrow banding” tailwind thesis in Government has begun to play out (becoming more significant this year, with 11% Government growth in the first quarter)

-          In February, the US Government agreed to fund the nationwide rollout of a First Responder LTE Network with an initial $7B over 10 years (funds 80% of the cost, implying $9B of total spending)

-          The Enterprise business continues to benefit from the secular trend towards supply chain and inventory efficiency with some large retail wins announced in 2011

Negatives

-          Low interest rates at the end of 2011 caused a jump in the pension unfunded status (to $2.6B, from $2.4B), which has increased the annual cash contribution requirements by ~$70m

THESIS

MSI is worth $60+ today valuing the business at 14x 2013 EPS of $3.80, plus year end net cash and cumulative dividends of $10.00.  I expect earnings to compound in the low 20%’s for at least the next four years  through a combination of 1) mid single digit growth in the core businesses, 2) Incremental revenue growth from LTE, and 3) massive, continued, relentless, share repurchase activity.  Specifically, I expect the company to repurchase an additional $6B of its shares over the next three and a half years (an additional 30% of outstanding).  Earnings growth should lead to 20%+ annual returns in the stock.

THE BUSINESSES - GOVERNMENT

Motorola Solutions operates two unique businesses reported as separate segments.  The Government segment (65% of revenue, 60% of EBITDA) sells communication systems primarily to first responders globally.  MSI dominates this market with 80%+ of the share (very consistent over time).

Communications systems sold to first responders is somewhat of a razor / razorblade business.  Motorola will bid contracts for a total communication system within a municipality (for example), providing everything from planning and design to infrastructure construction and training, all of which are relatively low margin sales. 

Once a network is built, municipalities begin to “add” radios / devices, which are significantly higher margin.  In a typical contract, radios are a small percentage of initial revenues (~15%) due partly to the size of the system (in terms of dollars) vis-à-vis the cost of the radios, but also due to the fact that the deployment of radios happens generally over a longer period of time.  Again, in a typical situation, MSI will sell a small number of radios to a municipality on the implementation of a new network.  Initially, counties / cities will roll out only a small number of radios to a single group of users (i.e. the County Sheriff).  Over time the cities within the county and various first responder groups (police, fire, etc) will begin rolling out radios to work on the new system.  This creates a tailwind of high margin recurring revenues for MSI.

A typical network lasts 15 to 20 years, and a typical radio lasts 5 to 7 years, so there is an average of three radio replacement cycles over the life of a network.  With new cycles come new radios, typically at higher price points (due to inflation + technological improvements) – this is a revenue / margin tailwind.

Additionally, there seems to be consensus (from MSI, consultants and analysts) around the idea the existing infrastructure in the US, on average, is past due to for refresh averaging well over 15 years for existing networks.  That’s where the “narrow banding” shift creates an additional secular tailwind.

 The FCC has mandated that all public safety and commercial users of “land mobile” radio systems must cease operating 25 kHz and begin operating at 12.5 kHz by January of 2013 (actually, the FCC is saying municipalities must be showing progress towards complying by early 2013).  The intent of the switch is to free up spectrum for additional users / technology.  The reality of the switch is that municipalities and commercial radio users must install new systems and buy new radios. 

It is believed that less than half of municipal and commercial users have addressed the issue.  That’s beginning to change.  In the first quarter of 2012 Government revenue posted 11% organic growth, due primarily to a boost in systems installations.  Customers are waking up to the switch, and are beginning to install new systems.  That creates an infrastructure tailwind in the short term and a radio tailwind in the medium term. 

As a result of all of the above, the core Government business has a clear runway to mid single digits in the medium term (call it five years).

LONG TERM EVOLUTION (LTE)

In February, President Obama signed the Payroll Tax Credit Bill, which, among other things, allocated spectrum to, and funding for ($7 billion) a nationwide broadband network (i.e. LTE) for first responders.  The funding will take place over 10 years (beginning in early 2013).  The $7B will cover 80% of the cost with the remaining 20% to be funded by the municipalities creating an initial $9 billion opportunity.  This is ONLY related to the network / systems build out, this does not include the devices that will inevitably be used on the new network.

It is unclear what MSI’s share of the LTE market will be.  The company has been aggressively spending on R&D over the last five years in preparation for this network, but admittedly it is a new world, and MSI may not maintain the same level of dominance it has had in traditional radios.  To help the estimation process, we can look to LTE contracts that have already been won.   According to Pierre Ferragu at Bernstein, there have been 5 LTE awards in the US – MSI won three of those contracts (60%) with a dollar value equal to 80% of the market (“Motorola Solutions: Sizing The Public Safety LTE Upside” from 3/6/12).  So far, MSI seems to be maintaining market share.

We don’t know exactly how much money MSI will make as a result of this, and perhaps more importantly we don’t know when they will make it.  Management has talked about a $1.5B “pipeline” they can see today, the impact of which we will begin to be seen in 2013.

GOVERNMENT FINANCIALS

I believe 3.5% core growth to be very conservative.  I also believe my assumption for the incremental sales from LTE will prove to be very conservative.  For the flow through, since separation from Motorola the company has consistently exceeded 35% (including in the ‘system heavy’ first quarter of 2012 where the flow through was 37%).

THE BUSINESSES - ENTERPRISE

The Enterprise segment (35% of Revenue, 40% of EBITDA) manufactures “ruggedized” mobile devices used for supply chain and inventory management.  Most of this business is the old Symbol Technologies which MOT acquired in early 2007.  Symbol was best known for laser barcode scanners, for which MSI enjoys a dominant market share today (something in the 60% range).  Growth from this segment has come from the proliferation of “mobile data capture” devices, which greatly improves inventory efficiency.  Fed Ex and UPS use these devices when moving packages around the country.  Macy’s and Home Depot give these devices to salespeople so they can better update and turn inventory. 

For MSI, about 2/3s of the business is the “back of house” as I call it, or the line worker in a warehouse using a handheld device which includes a scanner.  Motorola dominates that market.  It is reaching saturation globally, but should continue to grow volumes with the growth in eCommerce (more shipping, which is good for MSI) and grow price at least with inflation (like the Government segment, the product life is 4 to 5 years and replacements are typically more expensive).

The remaining 1/3 of the business is what I call the “front of house” or retailers using mobile devices as a “force multiplier”, seeking to gain efficiencies in inventory management and payroll.  There is a very tangible and almost immediate ROI on the implementation of these products from increased inventory turns, and also from reduced payroll.  A good recent example is Home Depot – yesterday on its first quarter call, the HD CEO talked about the roll out of “(smart) phones” to all salespeople – these are MSI devices.  They allow salespeople to “float” around the store and have immediate and up to date inventory checks in the palm of their hand.  This has three implications for HD: 1) Sales – with immediate answers on inventory, sales conversion improves; 2) Customer satisfaction – customers get answers immediately, satisfaction goes up and 3) Fewer salespeople needed – since the salesperson doesn’t have to go into the back and check if they have supply of something, the time to serve is reduced and thus the need for employee count is reduced to achieve the same coverage.

The “front of house” is where the real growth is today, and it is still unclear who is going to win longer term, but it is clear that the pie is growing (and growing, and growing).  Listening to calls such as Home Depot yesterday (which uses  MSI products) and Lowe’s last quarter (which is testing Apple products) it becomes clear that there is a pretty significant secular trend towards efficiency, which fits right into MSI’s sweet spot.

Management and analysts believe this is a high single digit grower over the medium term due primarily to incremental volume.  Margins are substantial (22% EBITDA margin, with ~40% incremental margins), and returns on capital in this business are excellent at ~20%.

In 2012, growth will be a bit more challenged in this segment due to the secular decline of iDEN, a legacy “push to talk” cell phone technology.  Management estimates the lost sales to be ~$70m in 2012, about half of which came in the first quarter leading to a slight decline in total Enterprise revenue.  Despite this, the expectation is still for high single digit growth for the full year.

ENTERPRISE FINANCIALS

EUROPE

I feel obliged to talk briefly about Europe given it is the crisis du jour.  MSI has 21% of revenues coming from “EMEA”, and has said that total exposure to traditional Western Europe is closer to ~10% of revenues.  Of that, I believe the Government segment (which is much less economically sensitive) is 2/3s and the Enterprise segment is about 1/3.  In a disastrous European situation, only about 3 to 5% of your consolidated revenue is at risk.  If that revenue were to go to zero tomorrow, the consolidated business should still grow in 2012.   

CAPITAL STRUCTURE

MSI exited the relationship with Motorola Mobility in January of 2011 with a substantial pile of cash.  At the end of 2011 net cash was $3.6B or $11.30 per share (on the then share count).  Management has made three commitments with regard to the capital structure:

1)      That MSI would spend ~45% of operating cash flow on repurchases / M&A (mostly repurchases)

2)      MSI would spend ~30% of operating cash flow on dividends (currently spending ~22%)

3)      To get to ~1x Net Debt to EBITDA by 2014 (2x Adjusted Net Debt to EBITDA, which includes pension)

MSI will generate ~$1.2B of operating cash flow this year, growing to $1.6B by 2015.  That will require $2.5B of cumulative share repurchases (17% of the current market cap) and $1.6B of cumulative dividends ($5.50 on the current share count).

Additionally, to fulfill the third obligation, management will need to spend an additional $4 billion on share repurchase through 2014 (2011 net cash of $3.6B, plus $2B in 2014 EBITDA, minus $1.3B repurchased in the first quarter).

The repurchase activity puts a huge bid underneath MSI for the next three years and provides a significant boost to earnings growth.

OTHER CONSIDERATIONS

MSI does have a significant pension with ~$2.6B in gross unfunded liabilities.  Somewhat offsetting that is a $1.4B NOL that should be substantially used up in the next four years.  The pension is frozen and the NOL was a legacy asset from investments MSI made in the handset business.

I’m valuing the business on an earnings / free cash flow basis.  My estimates above assume the current cash impact of the pension persists into perpetuity (which is a conservative assumption in my opinion given insanely low interest rates).  Additionally, my earnings DO NOT include any benefit from the NOL’s.  I am using a 34.5% tax rate in my earnings estimates (versus the 20% MSI will be paying).  I accrue the tax savings and use the cash to buy back stock.

CONSOLIDATED FINANCIALS