It's 8:15 on a glorious Southern California morning, and I'm waiting to hear Jeff Ubben, managing director and founder of ValueAct, speak.
ValueAct is one of my favorite activist investors. They've built a reputation as gentlemen activists, but their returns precede them, 13.5% since inception. Ubben fits the profile: He's well-coiffed and articulate, sprinkles his opening remarks with well-read mentions, and shows a tendency toward polite contrarianism.
He moved from New York to San Francisco to get away from Wall Street. Where value constructionists favor valuation over business quality, he's rigorously focused on good businesses at good prices. He references his friendship with Jonah Lehrer, avid commentator on neuroscience and behavioral economics, and likens ValueAct's vetting process to flight school.
His investment idea, the product of a recent company split, doesn't disappoint.
A quarrelsome couple
Ubben's pick, Motorola Solutions (NYSE: MSI ) , arises from onetime behemoth Motorola. Legacy Motorola history is best-known for its foray into mobile phones, the company's hit-and-miss spell of four-lettered phones (RAZR, ROKR, and, most notably, FAIL), and the resulting margin fluctuations.
For its erstwhile checkered history, Motorola's more than just cellphones.
Motorola split into two businesses just about six months ago -- Motorola Mobility (NYSE: MMI ) and Motorola Solutions -- unveiling a moaty pearl (Solutions) to the world. Company splits resemble divorces: They're messy, confusing, and initially yield as many questions as answers. A litany of one-time charges, legacies of mismanaged conglomerates, and lack of historical financials obscure the earnings power of the underlying business units. The result is somewhat predictable -- cheap stocks.
A divorce and reinvention
Motorola Solutions suits the ValueAct mold; it's a very good business. The company makes its living in two spaces: radios and communication equipment for emergency responders, and mobile computers (and associated infrastructure) used for logistics and supply chain management.
Economies of scale, switching costs, and network effects are huge sources of competitive advantage in the radio biz. Interoperability in radios is key, because first responders need to be able to talk to each other. Once they've installed a given platform, it makes switching a challenge, to say the least.
The same applies to the enterprise division, to a lesser degree. Inventory management tools, the associated mobile computers, and related infrastructure communicate across many layers of IT infrastructure -- helping companies manage the supply chain from the truck to management office. Implementations are long and unwieldy, and once built into system infrastructure, hard to switch out.
A phoenix rising
To my eye, Motorola Solutions' relative newness as a stand-alone public company, the legacy of Motorola's cellular business, and split-related confusion have rendered it a cheap stock, despite the quality of its business lines. I see three sources of possible upside:
- An overcapitalized balance sheet: You know companies with too much debt. Motorola Solutions has the opposite problem: too much cash. After the sale of its networks division, the company will be sitting on $7.2 billion of cash and investments (a good chunk of which sits overseas), against $2.7 billion of debt and a $1.8 billion pension obligation. Typically, companies of Motorola Solutions' caliber, and stable cash-generating profile, carry more debt.
Management intends to give clarity on the company's capital structure next quarter. My guess is they'll return some of the cash via dividends or repurchase, which should accrue value to shareholders and pop the shares.
- Misunderstood earnings power: On last year's numbers, Motorola Solutions reported 9.9% operating margins. Management says it can produce midteens operating margins. This makes sense. Conglomerates are typically fatty enterprises, and once turned loose, subsidiary companies are managed with efficiency in mind. Of Solutions' peers, Harris (NYSE: HRS ) earned 18% operating margins and Honeywell's (NYSE: HON ) automation and control solutions segment attained 13% operating margins in 2010 (and the enterprise division's predecessor, Symbol Technologies, posted a 9.3% operating margin in 2006). That makes a midteens threshold seem attainable, if not easily exceeded.
- A dose of ugly: 65% of Solutions revenues come from government institutions -- municipalities, states, and federal. Amid concerns over budgets, the market has reasonably doubted whether these expenses will be deferred. From indications, that's not the case: Government revenues grew 5% in the first quarter and 9% in the fourth quarter. It makes sense: Communications equipment for first responders is not a place to mince dollars and cents.
Add it up
At 12 times my estimate of free cash flow (after deducting Motorola's net cash position), Ubben's recommendation seems a very interesting gambit. It's one I'll be spending some quality time on.