Wednesday, April 19, 2006

Motorola-Doing More Biz and Enjoying it Less

Yesterday, Motorola (MOT) announced its first first quarter financial results. Record handset shipments of 46.1 million units brought market share to 21% up a full 4.8 percentage points versus a year ago.

Gross margins for the quarter slipped to 30.1% versus last year's 32.6%. Operating profits were up only 3.4% YOY despite sales growth of 22.7%. Margin erosion was significant on the operating line with op. margin for this quarter at 8.9% versus last year's 10.6%. Gross margins have slipped each and every year since 2002 when they had peaked at 40.7%. On a recent quarterly basis, gross margins peaked in September of last year at 39.2%.

The tremendous growth in handsets and mobile devices is skewing revenues from this segment to 64% of the total versus last year's 54%. At the operating earnings level however, almost 79% of earnings are derived from this area. Operating margin deterioration at MOT is a function of segments other than handsets!

In some ways, the handset industry reminds me of what has occurred in the flat panel display industry, tremendous growth in units, tremendous growth in revenues, intense capital spending, but razor-thin margins. Competition remains intense. But I am very impressed with MOT's ability to gain market share as well as sustain operating margins despite what appears to be tremendous gross margin pressure.

The company bought back 37 million shares of stock for the quarter for about $815 million. Despite this, the diluted share count actually rose to 2.553 billion shares from last year's 2.487 billion, not exactly an effective buyback as I would assess. The company expects to complete the sale of its automotive electronic business to Continental AG for $1 billion in the second quarter.

From a valuation standpoint,it all comes down to one's belief in operating margin sustainability. The bulls seem to ascribe to the belief that 13% operating margins are feasible over the long run. This translates into a $30 target. If one ascribes to my view that Schumpeter's creative destruction economic principles will hold margins to 8%, the stock seems appropriately valued.

On an EV/EBIT basis, the stock seems reasonable at just over 10 times EBIT. Return on invested capital has improved significantly over the last few years with current returns up at 20%. On a FCF yield basis, the stock provides jalmost a 7% FCF yield.

Bottom-line, I think the market over-reacted to the earnings disappointment of yesterday. But the upside in my view is somewhat truncated to $25-$27.

Disclaimer: Neither I, my family, or clients have a position in MOT.


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