Motorola Solutions ( MSI ) announced a weak set of second quarter results on March 5 as revenues fell 7% and operating profits declined by over 30% over the same period last year due to lower demand in key regions, especially North America, where the impact of narrowbanding from prior years continues to weigh on the business. However, the company was able to reduce its operating costs by about $49 million in Q2 over the prior year quarter on account of its ongoing cost-cutting initiatives and lower incentive pay compensation expenses. In fact, taking cognizance of its recent performance and potential for further improvement, the company revised its earlier target of shaving off $200 million in operating costs to $300 million by the end of next year. This means that total operating expenses of the company are likely to come down from $2 billion in 2013 to about $1.7 billion by the end of 2015.
In accordance with its plans to sell off majority of its enterprise business to Zebra Technologies, Motorola reported the enterprise revenues, other than iDEN, under discontinued operations in its recent earnings report and changed its reporting segments to "Products" and "Services" from the earlier segments of "Government" and "Enterprise". The Products division, contributing about 64% of the company's total sales, consists of an extensive portfolio of network infrastructure, devices and software products, including iDEN products, ASTRO, dimetra and broadband products such as LTE. In the second quarter, product sales declined by over 10% year-over-year (y-o-y) to $887 million owing to sluggish demand in North America, Australia and China. On the other hand. the Services segment consists of integration services including iDEN services, lifecycle management services, managed services and solutions services for public safety as well as private communication networks. Division sales were $506 million in Q2, reflecting a marginal decline compared to the same period last year.
Our $65 price estimate for Motorola is about 5% ahead of the current market price.
Product Sales Decline on Weak Demand in North America
One of the biggest reasons that Motorola mentions for its top line under-performance last quarter is lower product sales in North America. The company had acknowledged in the first quarter this year that it underestimated the impact of narrowbanding in the previous years, which had led to record performances in 2012 and 2011. Motorola's product revenues in those years were boosted by the narrowbanding mandate issued by the Federal Communications Commission (FCC), which necessitated a switch to a more efficient spectrum band for public safety operations.
With most of the narrowbanding-related equipment upgrades now complete and government agencies going slow on their capital spending, Motorola's North American products business faces near-term growth concerns. Notwithstanding the continued weakness in North America, Motorola's performance was impressive in Europe, Africa and Latin America where sales grew in double-digits.
Public Safety LTE to Drive Sales
Going forward, we see the adoption of LTE for public safety use along with the broader trend of analog-to-digital shift in the U.S. and internationally, as the key drivers of Motorola's value. U.S. public safety spending in the coming years will be bolstered by the job creation bill passed in 2012 that reallocated the D Block spectrum for public safety use and provided a funding of $7 billion to build out a nationwide network over eight years. We expect Motorola to benefit from the stickiness of its government customers as well as its strong market position and large installed base of security devices to grab a big chunk of that market going forward.
The Los Angeles Regional Interoperable Communication System Authority (LA-RICS) selected Motorola to develop a 4G LTE based Public Safety Broadband Network (PSBN) for public safety agencies in the Los Angeles region in March this year. The company is progressing well with this $175 million project which is expected to generate about $50 million in revenue in the latter half of this year. In addition, the company's first quarter launch of APX 7000L, its first two-way portable radio that works both on legacy LMR (Land Mobile Radio) and next-generation 4G LTE networks, bolsters our view that Motorola has positioned itself strongly to benefit from the LTE transition in the years to come.
Gross Margins to Improve in 2014
The company has been successful in driving efficiency through its operations over the last couple of years, and expects to accelerate those efforts in the coming quarters. Despite the top line concerns and significant operating leverage in the business, Motorola expects operating margins to improve by almost a percentage point to 18.5% in 2014, benefiting mostly from the cost controls in place as well as the $300 million in cost cuts expected over the next two years. Going forward, we expect improving operational efficiency to more than offset the margin decline that could result from rising competition in the coming years, as rivals increasingly address the ongoing transition of public safety networks from analog-to-digital.
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