Motorola Mobility Spin-off

The impending spin-off of Motorola Mobility looks like it hasn’t seen much of a breakdown online, so I figure I’ll give it a go. It’s still a long way off and a lot of details have yet to be finalized, but the spin-off has enough going for it to place it on the “promising at a price” list.

The Mobile Devices division continued its steady crawl towards profitability last quarter but since we can’t really know with any confidence when it will turn the corner or how much it will earn, it might be most helpful to look at what we can know now with some certainty: the assets on hand and (a lesson from Joel Greenblatt) the self-interests of major players.

Pro Forma Book Value: $5,437M (courtesy of a $3.5B cash transfer from Motorola, Inc.)

Tangible Book Value: $4,145M

The assets (detailed here) are pretty straightforward, so let’s move on to the major players.

Exhibit A: Dr. Sanjay Jha, CEO

An interesting clause in Dr. Jha’s contract regards the Post-Separation Equity Award (aka the Big Payday). Details are here:

The mundane part: When the spinoff takes place, he will receive “an amount that, together with his Inducement Awards, represents between 1.8% and 3% ownership of the new Mobile Devices entity.”

The interesting part: The percentage is determined by a sliding scale that awards a declining share of the company to Dr. Jha as market cap rises. If the resulting company is worth $6 billion or less, his options account for 3%. If it’s worth more, he receives a portion determined by the following equation:

3% x ($6 billion / Market Cap) = received share, with 1.8% presumably being the floor.

This means that $10 billion is the magic number for Mr. Jha – the point at which it becomes more profitable to him for the company to be valued above $6 billion. Anywhere between $6-10B and his share actually loses value. This creates a funny set of what you might think of as “dumbell incentives.” The spinoff needs to go really, really well (almost twice book, 2.5x tangible, for a company that currently does not make money) or…not that well at all. And really, if you think long-term, there’s not any incentive for Jha to take the “larger” payoff – it would almost halve his ownership stake in exchange for a greater short-term profit that he could only cash in by selling off his already slimmed-down ownership share. His options are set by the average closing price of the first 15 days.

Coincidentally, the base market cap used in his contract is pretty close to the company’s pro forma book value (1.104x to be precise). Since that book value is largely tangible – and since that tangible value is mostly cash – there might be opportunity in the future.

Because the book value is pretty solid (65% cash!) Motorola Mobility might look like a good deal if it starts to trade at a discount to book. I think this is a distinct possibility for a couple reasons:

1. The aforementioned management de-incentives.

If the spinoff elicits a collective “meh” from investors, Mr. Jha will be a happy camper.

2. The question mark regarding the division’s future prospects.

Motorola’s mobile division has been losing money and market share for years. Back in 2007 Carl Icahn (more on him later…) started buying a big stake in Motorola to push for the sale of this division. Jha seems to have done wonders for the division and has almost restored its profitability, but a lot of investors don’t seem to be sure how it will perform. Check this morningstar summary as an example. A cynic might even point out that Jha has an incentive to delay any return to profitability until after the spinoff.

Exhibit B: Carl C. Icahn, shareholder activist

Some investors, however, are quite sure how things will go. Icahn has backed that bet by making big purchases in recent months. By purchasing now, Icahn is demonstrating a lot of faith in both divisions. His early purchases were the necessary precursor to his proxy fights. He needed to make the investment in order to have enough power to agitate for big changes.

And he succeeded…and still kept buying shares. From what I can tell he’s increased his position by about 62M shares (30%) since Motorola announced the spin-off. That’s key: the announcement meant “victory,” so if he felt that only the core business was worth owning then why expand his stake now? Since the spin-off announcement he’s added to his position several times, meaning that he feels comfortable paying for a piece of both businesses rather than just one or the other. It feels unlikely that he’s planning to dump the Mobility half because his overall share is so huge (11%) that it would be hard to unload the spin-off stock without tanking the price. He’s not a magic eight ball, but it’s an encouraging sign from someone who is plugged in to the business at the highest levels. [Plus, if I’m wrong and he does dump it, that puts even more downward pressure on the price.]

So, where will it go?

That’s a tough question, which is why Dr. Jha’s contract is so interesting. If the new company trades at a discount to book value, then investors are provided with a margin of safety. A deep enough discount means that it doesn’t need to do anything but return to trading at book value to reward investors. But since Jha has been earning his keep so far, it’s worthwhile to examine how the company might be valued if it becomes profitable again. That’s especially true considering that the company has reoriented itself to pursue the higher-profit smartphone market.

It’s hard to tell exactly what competitors sell for P/B-wise because the biggest mobile competitors are all part of larger businesses (Apple, Research in Motion, etc.) with significant revenues from other sources. Those two sell for 6x and 4.11x book respectively. Both companies are highly profitable – which Motorola Mobility certainly is not at this point – so that’s way too high in any case. Nokia, which is substantially less profitable and sells for a more modest 2.14x, might make a beter valuation comparison. Cell phone sales provide the lion’s share of the company’s income, so it’s also a good comparison in that respect.

What can Motorola Mobility aim for? Somewhere in the neighborhood of 1.4x isn’t unreasonable once it turns a profit. That’s only 2/3 of Nokia’s P/B without even adjusting for the fact that a significant portion of Nokia’s assets are associated with the company’s other (much less productive) divisions.

Like I said, it’s still pretty early, but I feel like there’s potential here.

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