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Today, I present you an analysis of the Canadian-based Blackberry maker investors either love or love to hate: Research in Motion (RIMM).

First off, I'd like to say that next year is probably the most important one for RIM because it represents the unveiling of its Blackberry 10 smartphones, which has been delayed many times for over a year now.

If everything goes according to plan, on January 30, 2013, the Blackberry 10 devices will be available for customers, and all eyes will be on the sales numbers and of course, RIM's margins.

Let's start off with some historic sales and other relevant information considered in the discounted cash flow valuation, which will be followed by a specific target price depending on the scenario being used.

Subscriber Base

RIM's subscriber base was 77 million users by the end of fiscal 2012. The company's subscriber base is stabilizing around 80 million users, achieved in Q2 of fiscal 2013. Its subscriber base is currently 79 million users.

It's not easy to convince former Blackberry users to come back when they already have an iPhone or Android phone.

In order for that to happen, the BB10 will have to be so mind-blowing that everyone will want to use it, and unless there is some kind of magical device attached to it, I hardly see this happening.

RIM's devices sold in fiscal 2013, according to the company's quarterly reports:

(click images to enlarge)

Source: Annual Report, RIM.

On December 20, 2012, RIM released its Q3 fiscal 2013 earnings reports.

The bad news is that Q3 revenue was $2.7 billion, down 5% from $2.9 billion in the previous quarter, and down 47% from $5.2 billion in Q3 of fiscal 2012.

Products And Services

RIM's primary revenue is generated by the Blackberry wireless solution, comprised of smartphones and tablets, service and software. Blackberry service is provided through a combination of RIM's global Blackberry Infrastructure and the wireless networks of RIM's carrier partners.

The company's revenue mix for fiscal years 2012 and 2011 is as follows:

Revenue (U.S. millions)

March 3, 2012

%

February 26, 2011

%

Devices

$ 13,794

74.8%

$ 15,956

80.2%

Service

$ 4,086

22.2%

$ 3,197

16.1%

Software

$ 318

1.7%

$ 294

1.5%

Other

$ 237

1.3%

$ 460

2.3%

Total

$ 18,435

100.0%

$ 19,907

100.0%

RIM generates service revenues from billings to its Blackberry subscriber account base primarily from a monthly infrastructure access fee charged to a carrier or reseller, which the carrier or reseller in turn bills to the BlackBerry subscriber.

Given that many of RIM's competitors recover their infrastructure and services expense in alternate manners, RIM is facing greater pressure to reduce its infrastructure access fee.

Product Design, Engineering And Research And Development

As of March 3, 2012, RIM's research and development team consisted of approximately 6,100 full-time employees. Research and development expense was approximately $1.6 billion in fiscal 2012, compared to $1.4 billion in fiscal 2011.

Changes In High Places

RIM has experienced several changes to its board of directors and management during 2012, including the resignation of its previous co-CEO and co-chairs, the appointment of a new chair and a new President and CEO, the appointment of two new directors and the resignation of another, and the retirement of two of RIM's other executive officers. Also, RIM has hired a new COO and CMO.

Operations and marketing are vital areas for this company right now, as it will need to make a great marketing effort to drive up demand for its Blackberry 10 devices while reducing the company's cost of revenue, which has done nothing but climb related to revenue:

Fiscal year

2009

2010

2011

2012

2013

Cost of revenue to revenue

53.9%

56.0%

55.7%

64.3%

71.9%

Also, RIM's operating expenses have been steadily climbing related to revenue. This can worry shareholders if these ratios continue at these high levels for the last fiscal quarter of 2013.

RIM's shareholders hope that this expense hike better be related to its Blackberry 10 release on January 30, 2013 (if it does not get pushed back again).

Fiscal Year

2009

2010

2011

2012

2013

Operating Expenses to Revenue

21.5%

22.4%

21.0%

27.6%

42.7%

RIM will only generate more losses for investors, quarter after quarter, unless it adjusts to being a leaner company.

The CORE Program:

RIM expects its CORE (Cost Optimization and Resource Efficiency) program to save around $1 billion in fiscal 2013. It consists of streamlining of the Blackberry smartphone product portfolio, the optimization of the company's global manufacturing footprint, the outsourcing of global repair services, the alignment of the company's sales and marketing teams, and a reduction in the number of players in management.

On June 28, 2012, RIM announced that it would cut around 5,000 employees, representing around 30% of the total global workforce. All employees received severance packages and outplacement support. RIM incurred in $191 million in total pre-tax charges related to its CORE program in the nine months ended December 1, 2012, related to one-time employee termination benefits, facilities costs and manufacturing network simplification costs.

RIM expects to incur total restructuring-related charges of approximately $250 million by the end of fiscal 2013, primarily related to one-time employee termination benefits.

Amortization And Goodwill

Amortization and goodwill are two key drivers of EPS and cash flow for this company, as it had, as of December 1, 2012:

Intangible assets (in millions of dollars)

Cost

Accumulated Amortization

Net Book Value

Acquired technology

$457

$241

$216

Intellectual property

$4,410

$1,513

$2,897

$4,867

$1,754

$3,113

So expect these $3.1 billion dollars in intangible asset charges to continue eroding the company's EPS for the next few years.

The company expects the annual amortization expense to be the following:

Period

Amount

EPS impact

Fiscal Q4 2013

$357 million

$ (0.68)

Fiscal 2014

$1.0 billion

$ (1.91)

Fiscal 2015

$333 million

$ (0.64)

Fiscal 2016

$306 million

$ (0.58)

Fiscal 2017

$265 million

$ (0.51)

Source: RIM's fiscal 2013 Q3 report

While it does not necessarily mean RIM will post losses every quarter next year, charges for about $357 million next quarter and around $250 million for the following fiscal 2014 quarters are a heavy impact to be absorbed by any potential investor.

Be very wary of next quarter, where EPS will be reduced by $(0.68) because of these amortization expenses.

RIM could be easily affected by higher-than-expected amortization expenses due to payments for renewed licensing agreements, use of third-party intellectual property, software, messaging services and other Blackberry-related features.

Just check out the Goodwill charge and the impact it had on RIM's EPS on fiscal 2013 Q1:

Gross amount

Accumulated impairment losses

Net amount

Balance as at March 3, 2012

$659

$(355)

$304

Goodwill acquired through business combinations during the period

$31

$31

Goodwill impairment change

$(355)

$(355)

Balance as of December 1, 2012

$690

$(690)

0

These goodwill impairments may not look like much, but it changed RIM's fiscal 2013 Q1 EPS from ($0.99) to ($0.37) due to the "adjustment" of discounting the $335 million in goodwill impairment, which is $0.62 per share added back to its "adjusted" EPS.

Piotroski's F_Score

Check out my article on Piotroski's F_Score if you are new to this very useful tool.

Piotroski has nine fundamental signals to measure three areas of a companys financial condition: profitability, financial leverage/liquidity, and operating efficiency.

Each component can score either a 0 (bad) or a 1 (good). It is a binary system where a company can score anywhere between 0 and 9 and of course, the higher the score, the better the company's financial position.

Let's start with the profitability area:

1. ROA: Net income before extraordinary items, one point awarded if positive, zero otherwise. Score 0 for RIM.

2. CFO: Cash Flow from Operations, one point awarded if positive, zero otherwise. Score 1 for RIM and its amortization expense. This is a key area, if a company's operations do not provide positive cash flow, nothing will.

3. ΔROA: Current year's ROA less the prior year's ROA. One point awarded if positive, zero otherwise. Score 0 for RIM.

4. ACCRUAL: Current year's net income before extraordinary items less cash flow from operations. The indicator variable F-ACCRUAL equals one if CFO > ROA, zero otherwise. This is used because in 1996, Sloan showed that earnings driven by positive accrual adjustments (i.e., profits are greater than cash flow from operations) is a bad signal about future profitability and returns.Score 1 for RIM.

Next up is the liquidity/leverage area:

According to Piotroski, "three of the nine financial signals are designed to measure changes in capital structure and the firm's ability to meet future debt service obligations." Since RIM has no interest-bearing debt, this is the company's strong point.

5. ΔLEVER This variable captures the changes in the company's long-term debt levels.

By raising external capital, a financially distressed firm is signaling its inability to generate sufficient internal funds, aside from placing additional constraints on the firm's financial flexibility.

Piotroski gives one point to this variable if the company's leverage ratio fell relative to the previous year, and zero if it rose.

Score 1 for RIM.

6. ΔLIQUID: This variable measures the historical change in the firm's current ratio between the current and prior year. Improvement in liquidity adds one point to the score, because it is a good sign of the company's ability to service current debt obligations, zero points if the current ratio decreased.

Score 0 for RIM.

7. EQ-OFFER: This indicator will equal one if the firm did not issue common equity in the year preceding current year, zero otherwise.

Companies that raise external capital could be signaling their inability to generate sufficient internal funds to service future obligations. This indicator variable will equal one if the company did not issue common equity the previous year, zero if it did. Score 0 for RIM.

Finally, we have the operating efficiency area.

8. ΔMARGIN: The firm's current gross margin ratio. An improvement in margins signifies a potential improvement in factor costs, a reduction of inventory costs, or a rise in the price of the firm's product. F-ΔMargin will equal one if the company's margin is equal to or greater than the previous year's gross margin, zero otherwise. Score 0 for RIM.

9. ΔTURN: The firm's current year asset turnover ratio (sales/beginning of the year assets) less the prior year's asset turnover ratio. An improvement in asset turnover signifies greater productivity from the asset base. This can come from more efficient operations (fewer assets generate the same amount of sales) or an increase in sales, which could also signify improved market conditions for the company's products. Score 0 for RIM.

RIM scored 3 out of 9, making it an almost-automatic sell.

These were the results by component:

1. ROA

0

2.CFO

1

3. ΔROA

0

4. ACCRUAL

1

5. ΔLEVER

1

6. ΔLIQUID

0

7. EQ_OFFER

0

8. ΔMARGIN

0

9. ΔTURN

0

To be fair, the equity offering could have been a 1 since the amount of shares increased year over year was less than 1 million shares.

So basically, RIM did not score lower because it still has no debt and its operation still generates cash flow despite having a net loss in its income statement, mainly due to amortization expenses.

The DCF Valuation

Remember that a company's value and share price is derived from its ability to generate cash flows, not EPS, so RIM must present a compelling case in order for investors to buy its shares.

I valued RIM using three scenarios, the "business as usual" scenario, the "optimistic" scenario and the "pessimist" scenario.

These have the following assumptions and have a price tag on the share price related to it.

First off, we have the summary graph:

RIM shares could not be valued with EBITDA x8 or with the Graham Formula, since its EPS is negative and I do expect it to continue being so for at least two quarters.

The "business as usual" scenario assumes:

  • The "CORE" program achieves at least $1 billion in savings by the end of Fiscal 2013.
  • Blackberry 10 devices are well-received and RIM's revenue year over year growth is: 35% in fiscal 2014, 20% in 2015, and 10% revenue growth from fiscal 2016 to perpetuity.

In RIM's peak in fiscal 2010 and 2011, its sales grew 35% and 33%, respectively. This meant growing revenues from $11.1 billion in fiscal 2013 to about $19.9 billion in fiscal 2016.

  • The gross margin grows from 28.1% to 40% in fiscal 2014 and then falls to 38% for the next two years, and then stays at 35%. For comparison purposes, Apple (AAPL) has gross margins that have hovered around 40% since 2009, and currently stands at 43.8%.
  • The SG&A expenses fall from 42.7% to 28% of sales in fiscal 2014, 26%, 25% for two years and then remain at 23% of sales. This would be mainly related to its CORE program success.
  • The Operating cash flows will be much higher than net income, since amortization and depreciation expenses will be added back since they are "virtual" expenses. All three scenarios share this assumption.
  • Investing cash flows will range between $(1.889) and $(2.194) billion each year.
  • The Investing cash flows for RIM have ranged between $(1.470) and $($3.024) billion from 2009 to Q3 fiscal 2013.
  • I used a 10% discount rate for all scenarios, since investors have other opportunities in other companies that generate more cash flow.
  • Cash flows for RIM, which have ranged from $(0.349) billion in fiscal 2009 to $0.716 in fiscal 2010, will range from $0.245 to $0.889 from fiscal 2014 to fiscal 2017, and are all positive.

The price tag reached is $7.51, representing a 36.5% drop from current closing price as of December 26, 2012 of $11.825.

The "optimistic" scenario assumes:

  • The "CORE" program achieves at least $1.5 billion in savings by the end of fiscal 2013.
  • Blackberry 10 devices are a massive hit and RIM achieves the following revenue year over year growth: 50% in fiscal 2014, 20% in 2015, 15% growth in fiscal 2016 and 2017, and 10% revenue growth to perpetuity.

In RIM's peak in fiscal 2010 and 2011, its sales grew 35% and 33%, respectively. This meant growing sales from no less than $11.1 billion to $19.9 billion in two years. This scenario assumes RIM will achieve $29.3 billion in sales in Fiscal 2018, a new record for the company every year starting in fiscal 2015.

  • The gross margin grows from 28.1% to 40% in fiscal 2014 until fiscal 2017, and then falls to 35% in fiscal 2018, disregarding all pricing wars and competition from Apple's iOS and all smartphones with Google's Android operating system.
  • The SG&A expenses fall from 42.7% in fiscal 2013 to 25% of sales in fiscal 2014 and 2015, and then fall even more to 18%. This means the SG&A expense will fall to $4.1 billion in fiscal 2014 and will never rise above $5.1 billion, which was its expense in fiscal 2012.
  • Investing cash flows will range between $(2.015) and $(2.931) billion each year.
  • The investing cash flows for RIM have ranged between $(1.470) and $(3.024) billion from 2009 to Q3 Fiscal 2013. These expenses are a bit higher than in the "business as usual" scenario because of higher expenses in acquisitions of intangible assets, patents and R&D needed to achieve this enormous sales growth.
  • Cash flows for RIM, which have ranged from $(0.349) billion in fiscal 2009 to $0.716 in fiscal 2010, will range from $1.129 billion to a high of $2.692 billion, and are all positive. This is a bit of a stretch of imagination unless Blackberry 10 devices are the hit described above and the company runs as efficiently as I stated above.

The price tag reached is $14.29, representing a 20.8% rise from current closing price as of December 26, 2012 of $11.825.

The "negative" scenario assumes:

  • The "CORE" program still achieves $1 billion in savings by the end of fiscal 2013.
  • Blackberry 10 devices are not very well received by the public and RIM achieves the following revenue year over year growth: 25% in fiscal 2014, 15% for 2015, 10% growth for fiscal 2016, 8% for 2017, and 5% revenue growth to perpetuity.

In RIM's peak in fiscal 2010 and 2011, it sales grew 35% and 33%, respectively.

  • The gross margin grows from 28.1% to 33% in fiscal 2014 and stay at that level until fiscal 2018.
  • The SG&A expenses fall from 42.7% to 30% of sales in fiscal 2014, and then fall even more to 25%.
  • Investing cash flows will range between $(1.77) and $(2.01) billion each year.
  • The investing cash flows for RIM have ranged between $(1.470) and $(3.024) billion from 2009 to Q3 fiscal 2013. These expenses are lower than in the "business as usual" scenario because of lower expenses in acquisitions of intangible assets, patents and R&D, all indicating RIM has finally accepted it is a small player in the smartphone world, only investing what is necessary to survive and keep its 5% market share.
  • Cash flows for RIM, which have ranged from $(0.349) billion in Fiscal 2009 to $0.716 in Fiscal 2010, will range from $0.01 billion to a high of $0.687 billion, and are all positive.

The price tag reached is $6.61, representing a 44.1% drop from current closing price as of December 26, 2012 of $11.825.

Market Share

We can see the current smartphone market share owned by RIM and its competitors with the help of Gartner's Worldwide Mobile Device Sales to end users by operating system in 3Q12 (thousands of units):

Worldwide Mobile Device Sales to End Users by Operating System in 3Q12 (Thousands of Units)

Operating System

3Q12

Units

3Q12 Market Share (%)

3Q11

Units

3Q11 Market Share (%)

Android

122,480.0

72.4

60,490.4

52.5

iOS

23,550.3

13.9

17,295.3

15.0

Research In Motion

8,946.8

5.3

12,701.1

11.0

Bada

5,054.7

3.0

2,478.5

2.2

Symbian

4,404.9

2.6

19,500.1

16.9

Microsoft

4,058.2

2.4

1,701.9

1.5

Others

683.7

0.4

1,018.1

0.9

Total

169,178.6

100.0

115,185.4

100.0

Source: Gartner.

If we check out the Gartner smartphone sales of approximately 169 million units, we can see that RIM had about 5.3% of market share, and assuming a 2.2% market share growth to 7.5% due to BB10 success (discounting cannibalization of users who will only buy BB10 and all others who will not buy any other Blackberry devices), RIM would sell about 12.7 million devices each quarter.

This would match the "optimistic" scenario in terms of sales, but it is difficult to achieve the margins described in said scenario, but not impossible. IDC forecasts RIM's market share to fall to 4% by 2016.

For the "business as usual" scenario to work in terms of smartphone market share, RIM would need to increase its market share to around 6.1%.

Both are possible. You will have to pick your scenario, but I like to be conservative, so I think the "Business as Usual" scenario will most likely play out.

It is very hard to see RIM regaining lost market share by simply putting out a RIM device that is very similar to its competitors. I think it will be mildly received by customers at best, nothing revolutionary.

I weighted these scenarios with the following possibilities:

A 50% probability for the "Business as Usual" scenario playing out was given.

A 25% probability for the "Optimistic" scenario, giving RIM a higher chance at success than I really think is possible given its brand-image deterioration over the past few years.

A 25% probability for the "Negative" scenario playing out was given.

Weighted DCF Price Target

These weighted probabilities result in my expected price for RIM for December 31, 2013 of: $8.98.

This is a 24.1% drop in price as of the close today.

Standard & Poor's has a $12 12-month price target for RIM.

I am very glad I do not own any RIM shares, but I would sell them if I had them. I would be very careful to short it, as short interest has only grown previous to the BB10 release (chart courtesy of Schaeffer Research):

A short-squeeze day, such as today, where shares went up more than 11%, is not unlikely, especially with January 30th fast approaching.

Traders should be looking to sell $15/$16 call spreads for December 2013 if shares cross above the $14 mark at any time, since the fundamentals do not support a higher price unless this company really comes back to life with its BB10 devices and goes toe-to-toe with Apple and Google, which I see as highly unlikely.

ROIC

I will use the "business as usual" scenario for the ROIC forecast. Remember that the return on invested capital (ROIC) is mainly composed of capital turnover and margin.

I expect capital turnover to be higher than in fiscal 2013 because of the release of BB10 devices, when ROIC bottomed because of higher expenses, but I expect it to continue being higher than it currently is, mainly driven by a more efficient operation and a profitable operation in fiscal year 2014 and on.

If this works out the way I laid it out in the assumptions, RIM will create value for shareholders in the coming years, however, I do not recommend going long at this price, as the company is currently valued in a middle ground between the "Business as Usual" scenario and the "Positive" scenario.

The long play ship has currently sailed, and will only come back with the shares below $9.

Current Analysts' Forecasts

For those of you who like to use EPS as a source of potential investment ideas, here is a current list of forecasts for RIM. Remember that amortization charges and the release of BB10 will change these estimates considerably, and that is why they differ from big losses to big profits from fiscal 2014 and on.

Yearly earnings forecasts

Fiscal
Year End

Consensus
EPS* Forecast

High EPS*
Forecast

Low EPS*
Forecast

Number of
Estimates

Over the Last 4 Weeks
Number of Revisions
Up Down

Feb 2013

-1.21

-0.93

-1.63

29

12

8

Feb 2014

-0.55

1.05

-2.82

34

11

12

Feb 2015

-0.69

0.86

-2.02

6

1

0

Feb 2016

0.79

0.79

0.79

1

0

0

Quarterly earnings forecasts

Fiscal
Quarter End

Consensus
EPS* Forecast

High EPS*
Forecast

Low EPS*
Forecast

Number of
Estimates

Over the Last 4 Weeks
Number of Revisions
Up Down

Feb 2013

-0.29

0

-0.52

29

7

12

May 2013

-0.16

0.25

-0.52

25

7

10

Aug 2013

-0.15

0.33

-0.67

25

4

13

Nov 2013

-0.11

0.43

-0.76

25

6

10

Feb 2014

-0.13

0.33

-0.88

25

5

10

Source: Nasdaq Earnings Forecast

Final Thoughts

So in the end, it all comes down to whether RIM's executives will be able to generate enough demand for the BB10 and trim operations enough to cope with the new, slimmer structure of the company. This company has many people saying it will go bankrupt, and many others hoping BB10 will resuscitate it back to life.

I think a middle ground is not only possible, but the most probable, where RIM survives as a small player, having around 5-6% of total smartphone market share, but not being able to compete again with the players that have beat it: Apple and Google.

I do not think this company will go bankrupt, since it has no debt and will take a few quarters of disappointing sales for it to get acquired by one of its competitors, which I believe to be the ultimate fate for RIM, mainly for the patents and some market share.

Keep an eye out for the last quarterly report of fiscal 2013, where the company's future may very well be written. I, for one, can't wait for it.

In the meantime, avoid being suckered into buying the shares.

Betting on the turnaround of a company competing in one of the most aggressive sectors out there, depending highly on innovation and brand loyalty is very dangerous. There is a lot of optimism built into RIM's shares, expectations are higher than I thought before analyzing RIM's financial statements. Buyers beware.

Source: Research In Motion Share Valuation: Buyers Beware