A Tough Call

27 Jul

Stable market share positions among the main players in an industry combined with high returns on capital typically are evidence of a long-term competitive advantage. I made a mistake by not weighting this heavily enough in my initial assessment of Motorola (MOT) several months ago. I also did not consider enough the unpredictability of mobile phone industry dynamics. While MOT benefits from scale in distribution, relationships, and the ability to spread fixed costs, including as R&D and advertising, over a larger revenue base than its smaller competitors, the short product cycles and the need to continually innovate products, combined with a smaller, more powerful group of buyers (mobile phone companies that have been consolidating) have made the company’s plight that much more difficult.

In late 2006, I made a buy decision on Motorola (prior to the disclosure that Icahn was involved) based primarily on a few facts: 20% of its market value was in cash, and this cash could be used, among other things, to wipe out its debt and buy back loads of shares. Over the past few years the company had generated copious amounts of free cash flow and that looked reasonably certain to continue. But I soon found that the stock price was down for a good reason. Management had turned to the dark side – managing for market share, not profitability. Profits quickly turned to losses and cash flow evaporated when pricing power faded and unit sales slumped. In March, I sold July call options on the stock. So after being called out a few days ago the investment netted at breakeven (loss on the stock, gain on the option). Over this same period, the S&P 500 was up over 5%, so I consider that the opportunity cost of the investment in Motorola.

The company will probably recover and thrive again. But I came to the conclusion that I am not smart enough to figure out when that will be or how it will occur. If they come out with another product line as revolutionary as the RZR, certainly profits will return in spades. But after that phone comes on the market they’ll need another one to follow it. And now that Apple (AAPL) has entered the mobile phone space, the competition for innovative products is even more fierce. Overall, the visibility of the industry is low to me. So if in a few years I see the stock at double its current price, it won’t faze me because it fell outside my circle of competence. The uncertainty of the commodity cell phone business no longer makes Motorola the no-brainer that I like to see in a stock before I pull the trigger.

Full disclosure: No positions in the companies mentioned.


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