Motorola Solutions Inc. (NYSE: MSI) fell 5% on 10/30/20 after the company delivered above-consensus 3Q20 adjusted EPS and revenue.
Motorola Solutions did report encouraging sequential momentum out of the depressed second quarter, when shutdowns prevented implementations and installations. Demand has begun to recover in markets including video security products and services. We expect civil agencies, and particularly police, to prioritize body cameras and related gear amid civil unrest and allegations of police misconduct.
MSI’s full-year results are heavily weighted to the final quarter. While we had been concerned about the potential for a sharp falloff in all-important 4Q sales and profits, MSI’s guidance was not as bad as a potential worst outcome might suggest. At the same time, the 4Q guidance still implies mid-single-digit declines in sales and adjusted EPS, and the guidance midpoints were below prereporting consensus expectations.
We downgraded MSI to HOLD in August 2020 on concerns about pressures on state and local government spending on first-responder solutions. MSI has done a good job defending its margins, with software and services contributing more richly to the mix. MSI stock has moved up from our downgrade price.
That said, we expect MSI to continue to struggle in a mixed demand environment, and look for the stock to perform roughly in line with the market in the near term.
MSI is down 2% so far in 2020, while its peer group is down 4%. MSI advanced 9% in 2017, while its peer group was up 7%.
For 3Q20, Motorola Solutions reported revenue of $1.87 billion, which was down 6% year-over-year and up 15% sequentially. Revenue was above management’s implied midpoint guidance of $1.82 billion, which was also the consensus forecast.
Over time, the former Motorola Inc. has pared away the components of a technology conglomerate, including its own semiconductor foundries, wireless and wireline network infrastructure equipment, consumer mobile phones, an RFID bar-coding unit, and other businesses to focus on one key end market. While Motorola Solutions is smaller than its predecessor company, its focus on first-responder networks and devices has created a strong and profitable company with clear market leadership.
That is impacting civil agencies’ ability to continue investing in integrated first-responder networks, precisely at a time when MSI’s solutions sets are at their most comprehensive and technologically advanced.
We believe the company will emerge from the pandemic as it went in, which is as the strongest player in the space. Demand has begun to recover in markets including video security products and services. We expect civil agencies, and particularly police, to prioritize body cameras and related gear amid civil unrest and allegations of police misconduct. For now, formerly steady-growth MSI is confronting negative top-line comps and the potential for those negative comparisons to extend into 2021 while also pressuring profits.
For 3Q20, Product revenue of $1.04 billion was down 9% annually. Service revenue of $824 million was down 3%. The slowdown in new equipment sales has longer-term implications, as it creates a smaller potential service base.
Product backlog of $2.9 billion declined 9% year-over-year in 3Q20. Product backlog is relatively stable and even edged up sequentially after declining across much of 2019 on the completion of two large system deployments in EMEA.
Services backlog of $7.8 billion was flat year-over-year but up $100 million on a sequential basis. The healthy backlog reinforces our long-term positive view of MSI. Although some existing product deals could be deferred or cancelled, the much larger services backlog tends to achieve high levels of fulfillment.
Beginning with 1Q20, MSI is categorizing revenue as North American (U.S. and Canada) and international (everywhere else). On a regional basis, North American revenue of $1.27 billion (68% of total) declined 4% annually but recovered by 16% sequentially. North American segment revenue was down in profession and commercial radio and public safety LMR. International revenue of $600 million (32% of total) was down 8% year-over-year, but also recovered a strong 14% sequentially.
On a segment basis for 3Q20, Products & Systems Integration revenue of $1.16 billion (62% of total) was down 14% year-over-year. Despite the tough environment, P&SI logged P25 system wins with the states of Wyoming and North Carolina and with U.S. federal and international agencies. Off the lower sales base, P&SI non-GAAP operating profit was down 27% year-over-year. The 3Q segment margin of 18.8% narrowed from 22.2% a year earlier, but recovered from 13.5% in 2Q20.
Services & Software (S&S) revenue of $705 million (38% of total) was up 9% annually. This business continues to see rising orders for S&S solutions supporting body-worn cameras, reflecting the current political climate. S&S non-GAAP operating income increased 17% year-over-year on improved volume leverage and overhead absorption. The segment operating margin rose 220 basis points year-over-year to 34.6% while narrowing sequentially from 35.1% in 2Q20.
For 4Q20, Motorola Solutions is modeling a revenue decline of 6.0%-5.5% from 4Q19. That translates to sales of $2.23-$2.25 billion. Sales at the midpoint would be up a normally seasonal 20% from 3Q20.
MSI restored its full-year guidance in mid-July. Motorola Solutions now expects 2020 revenue to be down about 6.5% annually, after guiding for a 7% decline in July. The new guidance implies sales of about $7.375 billion. The company also projected non-GAAP earnings of $7.52-$7.58 per diluted share, after guiding to $7.40-$7.52 in July. EPS at the revised midpoint would be down 5%.
EARNINGS & GROWTH ANALYSIS
Which was down 6% year-over-year and up 15% sequentially. Revenue was above management’s implied midpoint guidance of $1.82 billion, which was also the consensus forecast.
Non-GAAP earnings of $1.95 per diluted share were down 5% year-over-year though up $0.46 sequentially; above the midpoint guidance of $1.75.
For 2019, revenue of $7.89 billion increased 7% annually from $7.34 billion in 2018.
For 4Q20, Motorola Solutions projects a year-over-year revenue decline of 6.0%-5.5%. That translates to sales of $2.23-$2.25 billion. Sales at the midpoint level would be up a normally seasonal 20% from 3Q20. The company is also modeling non-GAAP EPS of $2.71-$2.76. At the midpoint, adjusted EPS would be down 7%-8% year-over-year.
MSI restored full-year guidance in mid-July. It now expects 2020 revenue to be down about 6.5% annually, after guiding for a 7% decline in July. The new guidance implies sales of about $7.375 billion.
FINANCIAL STRENGTH & DIVIDEND
The acquisition of Airwave subtracted approximately $1 billion from cash. Motorola Solutions’ $2 billion modified ‘Dutch Auction’ share tender and the $1 billion investment by Silver Lake Partners restored cash to MSI’s balance sheet.
MSI typically strengthens its cash holdings in 4Q; cash then works lower in the other three quarters. However, cash declined sequentially in 4Q19 as the company continued its shareholder return program and worked to reduce debt. Instead, MSI bolstered cash and liquidity in 1Q20 by drawing down a portion of its revolving credit facility.
The tender was completed on 9/3/15 and reduced the share base by about 30 million shares. The 2.0% convertible issued to Silver Lake increases the diluted share base for CSE calculations.
Capital allocation in 2017 was $1.3 billion, including $370 million in dividends and $483 million of share buybacks. In July 2016, MSI’s board announced a $2 billion share repurchase authorization. MSI spent $842 million buying back shares in 2016.
MANAGEMENT & RISKS
Greg Brown, former co-CEO of Motorola Inc., is chairman and CEO of Motorola Solutions. In June 2020, MSI named Jason Winkler as CFO effective 7/1/20. He replaced Gino Bonanotte, who had been in the CFO role since 2013.
The Airwave purchase added international risks, such as devaluation in the home currency (pound sterling) following Brexit. We believe such risks are mitigated by the long-term importance of leveraging MSI’s expertise in domestic civil networks into international markets. Motorola Solutions has indicated that it intends to invest in niche and bolt-on acquisitions supporting its core competencies. There is a risk the company will overpay for assets, particularly in international markets where political risk is added.
The major risk from the disposition of Enterprise is that MSI has become an inherently smaller and potentially slower-growing company. We believe that this risk has been offset by the divestiture of non-synergistic businesses. Motorola is also benefiting from management’s ability to focus fully on civil agency and government purchases, and from the allocation of sale proceeds to shareholder returns.
Other risks for Motorola Solutions include a potential decline in spending by state and local authorities on first-responder solutions. Given that the company is much less diverse, it is highly dependent on its first-responder business for profits. Mitigating that risk is the fact that governments are loath to cut spending on agencies that safeguard human life and community security, especially when spending on other services (e.g., libraries, parks & recreation) can often be cut more easily.
Motorola Solutions was formed in January 2011 following the spinoff of Motorola Mobility and sale of most of the networks business. In October 2014, MSI completed the sale of its Enterprise business, including RFID handheld devices, mobile computing, advanced data capture, and the iDEN business. In 2016, MSI acquired UK-based Airwave Systems.
MSI stock now trades at modest premiums to most communications equipment peers; we believe that the premium is warranted given the long-term stability of the company’s end markets.
Declines in fair value are often indicative of additional share price pressures.
We expect MSI to continue to struggle in a mixed demand environment, and look for the stock to perform roughly in line with the market in the near term. As such, we are maintaining our near-term HOLD rating while reiterating our long-term BUY rating.