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April 19, 2006

Motorola: Mixed Quarter, Negative Reaction Deserved

I didn’t like what I read in Motorola's press release or heard on the conference call. I am now looking for an exit price. However, I think the decline so far today is too severe relative to my concerns and to my view of the Street's analysis of the quarter. Consequently, I plan to sit tight for a couple of days and see if I can get a somewhat higher price.

MOT fell short in several areas in the quarter. First, despite massive handset sales of 46.1 units, average selling prices fell an unexpected $7 to $139. This led to a lower operating margin in the handset business than I expected. Second, the Networks business continues to underperform. It had a lousy quarter. Third, the normally reliable Government business had a shortfall. Fourth, guidance called for an incremental $300-500 million in revenue relative to current estimates but EPS only in line with current estimates. The implication is that issues that cropped up in margins in 1Q will recur in 2Q. Finally, the company is back to taking lots of restructuring charges.

By far what matters most to MOT investors is health of the handset business. I believe that it is concern about handsets, rather than the Networks shortfall or other factors that lead to the sell-off in the shares yesterday....

Management stated that gross margins in handsets were actually above expectations but the company chose to reinvest 100 basis points of gross margin into distribution in order to build for continued market share gains. This is a plausible explanation and based on the several million unit upside in handset sales it appears to have had an immediate payoff. However, the mix in handset sales did not shift heavily in favor of emerging markets where management said that most of the investment was made. In fact, sales of "thin" phones were unusually strong again this quarter. Even though thin phones are selling quite well in emerging markets, to me, this says that pricing in established markets like the US and Europe for products like the RAZR and the SLVR is falling more than I previously expected. In the US, you can buy a RAZR for $49 to $99 with most plans and at most service providers. I have to think that MOT's investment of gross margin dollars was used to buy share for its high end phones. Given lots of copycats on the market, this strategy probably makes sense. However, I think it raises the risk profile for ASPs over the balance of 2006.

Looking ahead, my concern is that handsets might be more competitive than expected, limiting the margin upside. Management said that they would trade margin percentage for margin dollars. I can accept that, especially if it boosts long-term competitive positioning. However, this is a different story than management has been pushing over the last year when operating margin expansion was the goal. I don’t like the shifting strategy and I fear that what really happened is that management went for market share and when it saw the financial outcome, the strategy changed. Now, MOT has brought ASPs for thin phones down and it might not be able to lift them. This strategy requires continuing above expectation growth in global handset sales and more successful new product introductions. Possible, but it adds risks.

Overall, I expect MOT will perform strongly in a financial sense over the balance of the year. I also think that recent handset market share gains will hold and maybe even build. Restructuring actions will help corporate operating margins later this year, especially in 4Q. Guidance for 2Q on EPS might prove to be low. For all these reasons, I think MOT shares are overreacting today.

However, as outlined above I don’t like the apparent shift in strategy in the handset business. It raises the risk profile of MOT as an investment. This lowers the risk-return tradeoff and makes the shares less attractive to me. For that reason, I am looking for an exit.

Posted by Steve Birenberg at April 19, 2006 02:00 PM in MOT