Motorola Solutions (NYSE:MSI) has undergone significant transformations, such as exiting the handset market and repurchasing approximately 23.7 million shares from Carl Icahn. Currently, the company’s exclusive focus is on public safety and enterprise security, with their innovative APX NEXT two-way radio system contributing significantly to both topline and profitability growth. The surge in crime rates is fueling demand in the public security and surveillance markets. In light of these developments, I am initiating coverage with a ‘Buy’ rating and a fair value of $340 per share.

Growing Public Security and Surveillance Markets

Motorola has undergone accelerated growth in both organic revenue and adjusted operating profits in recent years. A key contributor to this growth is the APX NEXT, launched in October 2019. This public safety radio features LTE for enhanced communications and data-centric application services.

For context, Motorola sells land mobile radio systems to private networks, including emergency networks for police, fire, ambulance, and other mission-critical infrastructure such as oil, gas, and utilities. They currently operate more than 13,000 Land Mobile Radio networks globally. I believe these land mobile radio networks represent a strategic growth area for Motorola for the following reasons.

Firstly, these networks contribute significantly to the company’s profitability, providing a recurring business model, as the hardware is typically replaced every 7-8 years. This replacement cycle ensures a constant revenue stream for Motorola, as demonstrated by the success of the APX NEXT benefiting from the hardware replacement cycle.

Secondly, the rising crime rate has led to notable demands in public safety and security surveillance. Motorola addresses these demands by offering various solutions for video surveillance, including fixed video, cloud and premise body-worn camera video, in-car dash camera video, and license plate recognition, among others.

Lastly, in some networks, Motorola operates the network for its customers, generating recurring revenue from operations. This represents a stable revenue stream for the company.

Expand into Enterprise Safety Market

Some Chinese players, such as Hikvision and Dahua, are providing broadband video connection services in the enterprise market, offering solutions for enterprise safety management and security surveillance. The US government has already prohibited the use of federal grant money to purchase Hikvision and Dahua products; however, their products are still permissible in the enterprise market. I anticipate a potential ban on their use in the enterprise market sooner or later. The current geopolitical relationship between the US and China appears to be worsening over time, as the world’s top two strongest countries vie for global power. Additionally, there have been numerous incidents of intellectual property theft in recent years.

Motorola’s enterprise business is poised to benefit from the growing demand for security and access control solutions. At present, the enterprise market represents 25% of the group’s revenue, spanning utilities, mining, oil & gas, manufacturing, transportation, logistics, education, hospitality, and retail industries. A potential ban on these Chinese competitors in the enterprise market would serve as a significant catalyst.

Financial Results and Outlook

During Q3 FY23, they achieved a remarkable 7% organic revenue growth and a substantial 9.6% increase in adjusted profits. Year-to-date orders have surged by 11%, propelled by robust software and services performance, particularly from their innovative APX NEXT two-way smart radio systems. For the entire year, they have revised their guidance upwards for both topline and earnings. Specifically, they anticipate cash flow from operations to reach $1.9 billion, with revenue expected to fall within the range of $9.93 billion to $9.945 billion, and non-GAAP EPS projected between $11.65 and $11.70. This marks an exceptionally strong quarter. Given their robust growth in the first three quarters and the continued strength in APX NEXT sales, I believe the FY23 guidance is rather conservative.

During Q3 FY23 earnings call, they disclosed that they have received $600 million in APX NEXT orders since its introduction in late 2020, with $100 million of those orders delivered in Q3 FY23. They consider the replacement implementation successful in major cities and are now expanding into mid-sized and small cities. Consequently, I believe their APX NEXT has a substantial runway for growth, positioning it to drive both topline expansion and margin improvement in the coming years.

The table below summarizes their historical financial results, illustrating Motorola’s consistent delivery of accelerated topline and bottom-line growth in recent years.

In terms of their capital allocation strategy, Motorola plans to allocate 50% of its cash towards share repurchases, 30% towards dividends, and 20% towards capital expenditures. Notably, they operate a capital-light business, with capital expenditures accounting for less than 3% of total revenue.

Their balance sheet is robust, boasting a net debt leverage of just around 2x. Additionally, they have substantial liquidity on the balance sheet, providing ample capacity for potential tuck-in acquisitions.

Valuation

The valuation model’s assumptions align with their FY23 guidance, projecting a 9.2% revenue growth. Looking ahead, I assume a 9% organic revenue growth rate, consistent with their recent performance. I anticipate they will allocate 5% of revenue to acquisitions, contributing an additional 1.7% to revenue growth. This aligns with their long-term capital allocation strategy.

I envision that the APX NEXT and enterprise security market will remain key drivers of Motorola’s topline and profitability growth in the coming years. Their margin expansion is primarily propelled by operating leverage. According to my calculations, they are poised to achieve a 40 basis points annual margin improvement.

The model uses a 10% discount rate, 4% terminal growth, and a 23% tax rate, resulting in an estimated fair value of $340 per share.

Key risks

Supply Chain Issue: The primary supply constraint currently faced by the company is related to chips. During the earnings call, their management noted that lead times for certain chips have decreased to 25-26 weeks from previous levels that were twice as long. In a normal environment, these lead times should be around 15 or 16 weeks. While there has been some improvement in the supply chain constraints, they anticipate a $70 million favorable impact on their P&L for FY23. I expect further improvement in the supply of 40-nanometer chips in the near future, especially as the global economy begins to cool down.

CMA Investigation: The United Kingdom’s Competition and Markets Authority (CMA) has issued a final decision regarding Motorola’s Mobile Radio Network Services, seeking to impose price controls on Airwave, the private mobile radio communications network acquired by Motorola Solutions in 2016. In April 2023, Motorola announced its intention to appeal the decision. The UK’s competition watchdog estimates that Motorola could potentially generate nearly $1.6 billion in excess profits over a decade. The outcome remains uncertain, but if the CMA’s assessment is accurate, implying almost $160 million in excess profits annually, this would account for more than 3.8% of their total gross profits.

Conclusion

Having successfully transformed their business into a pure safety and security solution provider, Motorola Solutions is well-positioned to capitalize on the increasing demand for public security and surveillance amid rising crime rates. Accordingly, I am initiating coverage with a ‘Buy’ rating and a fair value of $340 per share.