After trading at distressed levels for most of the summer, shares of Research in Motion (RIMM) have staged a strong comeback since September. The company managed to deliver positive cash flow in Q2 despite substantial challenges, and also announced a January 30 launch date for the BlackBerry 10 platform, with devices to go on sale thereafter. This has driven RIM shares up from a 52-week low at $6.22 to a Friday close at $11.60. Yet most of the analyst community continues to believe that RIM's stock performance will turn out to be a "dead cat bounce" rather than a sustainable turnaround. The long-term prospects for the BB10 platform are admittedly uncertain, as the BlackBerry ecosystem will need to attract a substantial number of new users to remain viable given competitors' greater scale. However, over the next year or so, RIM will benefit from a customer upgrade cycle that will allow the company to exceed analyst targets for FY14. Initial BB10 sales may in turn boost developer support and help build momentum for a sustainable recovery. As a result, I believe that shares are still undervalued at this point, with a substantial margin of safety. Analysts are still too pessimistic about RIM's prospects.
To be fair, many of the analysts' concerns about RIM's performance are justified. Analysts have rightly questioned RIM's recent attempts to boost subscriber numbers by selling devices below cost in developing countries. The company hopes to make up the initial losses through service fees. Over the long term, RIM presumably believes that it will be able to move some of these users to more profitable devices, particularly as household income rises in major markets like Indonesia, India, South Africa, and the Philippines. However, the current strategy is clearly unsustainable.
With the launch of BB10, RIM's focus will return to developed markets. The company will attempt to drive profitable device sales there with the long awaited new OS. For CY2013, RIM is expected to target the mid-high end of the market with BB10-based devices, while current-generation BB7 devices will continue to cover the low end. Thus 2013 (FY14) BB10 sales should track roughly in line with developed market sales. To determine the likely level of BB10 sales next year, one must therefore analyze the potential for sales in developed markets.
BB10 Upgrade Potential for 2013
Over the past two years or so, the BlackBerry subscriber base in developed countries has been eroding. While this is obviously a bad thing, the plus side is that the vast majority of remaining BlackBerry users in developed countries are very loyal to the brand. In the U.S. specifically, BlackBerry sales have been particularly impacted by the February 2011 arrival of Apple's (AAPL) iPhone at Verizon (VZ), the country's largest wireless provider by subscriber count. The Verizon iPhone launch was confirmed in January 2011, with the iPhone 4 going on sale at Verizon the following month. Given the typical 2-year contract, this means that nearly all Verizon BlackBerry users who have wanted to switch to the iPhone have had the opportunity to do so by now. The launch of the new iPhone 5 has probably pulled away a few more BlackBerry users, but most Verizon customers who wanted to switch had already done so.
As a result, most current BlackBerry users are likely to remain within the ecosystem and will upgrade to a BB10. (To put it another way, why would somebody who has kept his/her BlackBerry this long decide to switch now?) Many users are already due for an upgrade but have been waiting for BB10, which has been expected for years at this point. I therefore project that at least 60% of current developed world BlackBerry users will upgrade to BB10 devices during the first year of availability.
Size of the Developed World User Base
There are very good statistics available for the number of U.S. BlackBerry users, but accounting for the rest of the developed world requires some interpolation. For the month of October, comScore reported that RIM's U.S. smartphone market share was still 7.8%, meaning that 9-10 million Americans currently use BlackBerries. This is down substantially from the peak in early 2011 (before the Verizon iPhone launch), when there were nearly 20 million BlackBerry users in the U.S. alone. RIM has maintained better market share in Canada, where it has a "home-field" advantage. BlackBerry still maintained 27% of the Canadian market as of a few months ago, which translates to at least 2.5 million additional users based on an overall smartphone market size of roughly 10 million. In the UK (the other member of RIM's big 3 markets), the company reported having 8.5 million BlackBerry users by the end of 2011. Assuming that number has dropped off over the course of this year, there are probably still 6-7 million UK BlackBerry users. For the top three markets, a relatively conservative estimate of the current subscriber base is 18 million (9 million U.S./2.5 million Canada/6.5 million UK).
For RIM's FY12, the company derived 60% of revenue from countries other than these three. Obviously, the majority of this revenue comes from the developing countries where RIM is rapidly expanding its market penetration. However, I think it is reasonable to assume that at least 1/5 of the remaining 62 million BlackBerry users are located in other developed countries (primarily continental Europe). This leads to an estimate of 30 million current BlackBerry subscribers in the developed world. If 60% of these users upgrade to BB10 in the first year, as posited above, this implies 18 million BB10 user upgrades in the developed world.
Total BB10 Sales Estimates and Financial Performance
According to a sensitivity analysis performed by Tavis McCourt of Raymond James, RIM only needs to sell 18 million BB10 devices in FY14 to break even. Based on McCourt's own revenue/earnings estimates for FY14, he appears to expect roughly half that number of BB10 sales. This appears to be based on what I consider a poor comparison to Nokia's (NOK) troubles this year with its transition to Microsoft's (MSFT) Windows Phone platform. The remaining BlackBerry users, who are generally enthusiastic about the brand, will not abandon RIM in the same way that Symbian users moved to Android and iOS rather than Windows Phone. Nokia did not have a comparable base of loyal users, and also had no commonality between the old OS and the new one.
Since BB10 officially launches on January 30, some early sales and channel fill will likely occur in the current fiscal year (which ends on March 1). However, that will probably be offset by additional channel fill that will come in FY14. Moreover, my estimate of 18 million upgrade units does not include sales to new smartphone users, "conquests" of other platform users, and developing world BB10 sales. Those sales are likely to be a fairly small proportion of first-year BB10 sales (perhaps 5 million in FY14, with upside to 10 million or beyond if the devices are well received), but they provide a significant cushion in the event of lower profitability per device or a lower upgrade rate.
Pulling everything together, I expect BB10 unit sales of approximately 25 million in FY14 (including sell-in). While the company will also likely sell at least 20 million BB7 units, these will not add to the bottom line, and may be slightly dilutive. Extrapolating from McCourt's analysis, 25 million BB10 device sales would lead to a profit of $1.09/share in FY14. However, McCourt's FY14 gross margin and operating expense assumptions, at 30% for BB10 devices and $4.05 billion respectively, are excessively pessimistic in my opinion (and substantially worse than consensus). The operating expense annual run-rate, excluding restructuring charges, has been $4.2 billion recently, and the CORE cost cutting program will result in $400-$500 million in annual operating expense savings next year. Even with additional marketing support for BB10, I still expect FY14 operating expenses to be around $3.9 billion. More importantly, supply chain improvements from the CORE program should allow RIM to achieve gross margins of at least 35% on BB10 devices. This is still well below the iPhone gross margin, which is in the mid-50% range. This provides further earnings upside of perhaps $500 million.
Pulling this all together, I expect EPS of approximately $2 for FY14. There could be substantial variability in that figure depending on sales levels, ASPs (average selling prices), and gross margins. However, I think that there is upside to that number if BB10 is able to attract new users to the BlackBerry ecosystem, as well as the obvious downside if users continue to abandon BlackBerry in favor of other platforms. It should be noted that Peter Misek of Jefferies recently suggested that FY14 EPS could exceed $4 in an upside scenario. That said, I think $3 is more reasonable as a best-case scenario: Misek's higher EPS figure relies on total hardware gross margins in the mid-20% range, which seems implausible (my estimates assume hardware gross margins near 20%).
The major downside scenario for RIM is that current BlackBerry users continue to switch to other platforms despite the introduction of BB10, while the new platform fails to compete with iOS and Google's (GOOG) Android for new users. It is well known that BB10 is starting from way behind in terms of its "app ecosystem". While BB10 will take the BlackBerry browser from the slowest smartphone browser to the fastest, users who want to use more than web, e-mail, and messaging may continue to spurn the BlackBerry ecosystem. There is some evidence for this view: a recent report from Morgan Stanley suggested that only 5% of respondents expect to upgrade to a BB10 device, and also noted that only 9% of developers surveyed by IDC in August were very interested in developing for BB10.
However, while these are valid concerns, I do not think they provide an accurate view of BB10's potential. Current BlackBerry users already skew toward those who do not need/want "apps," and so their decisions to upgrade will not be heavily influenced by BB10's deficiencies in that regard. Moreover, the survey results are likely to be skewed against BB10 given that Apple iPhone 5 speculation has been rife this entire year, whereas BB10 has a much lower public profile. As RIM ramps up the BB10 marketing campaign in the next few months, I expect consumer interest in BB10 to be activated. By next spring or summer at the latest, I would expect higher consumer interest in BB10 to be observable in surveys.
Despite subscriber losses in the developed world, RIM still has roughly 30 million developed-country subscribers (out of a total user base of 80 million). Most of the remaining users are loyal BlackBerry enthusiasts, and many have been waiting for the release of BB10 to upgrade. I expect roughly 18 million BB10 device sales from this group alone in the first year after the platform's release. This should be sufficient to bring RIM back to break-even in FY14, above the current analyst consensus. BB10 sales to middle and upper class consumers in developing markets and to new smartphone users (or conquests) in the developed world should provide a minimum of 5-10 million of additional device sales. This should help RIM deliver EPS of $2 in FY14.
Even if the upgrade rate is lower than I project, RIM should not have trouble reaching breakeven in FY14. The upside scenario of $3 in EPS thus makes shares very attractive at current levels (less than 4X forward earnings and roughly 1X tangible book value). I expect RIM shares to continue their recent rally on the introduction of BB10 and a return to profitability in Q1FY14. Accordingly, I believe the shares have upside to $25 over the next year.
Disclosure: I am long RIMM, AAPL.