Is BlackBerry (BBRY) really a buyout candidate? BlackBerry has been a takeover candidate (see this recent article and this older article for examples) for a while now, but any potential acquirer needs some assurance that the business is stabilizing and can return to profit in the near future. As such, let's take a look at recent operating trends in the underlying business to get an idea if there is any stabilization. Surely the stock price, having fallen from the 80's three years ago to $14 now, is pricing in a good deal of negativity. But is it pricing in enough negativity?
I have seen many instances where even with signs of a genuine turnaround in operating performance, sometimes the stock can languish for a while. Just take a look at Nautilus (NLS), which spent several years going through a restructuring that brought its stock from the $30's down to $1 and even with a return to profitability the stock was only at $2.50 last fall. Fast-forward 6 months and the NLS is now up 3-fold. The signs were there for 6 to 12 months, though, before it got going: improving gross margins and positively trending operating income.
If I am going to invest in a potential turnaround, I need something that shows me either a clearly defined path to profitability and positive trends in operating income and margins or I need a company whose sum of parts is worth more than the whole. As of right now, I see neither of those in BlackBerry.
The next quarter or two will be crucial for BBRY as the launch of their newest phone, the Blackberry Z10, will be reflected in quarterly results. While operating trends are important in making a successful turnaround investment, they aren't required. Oftentimes, the sum of a company's parts is worth more than the whole and that makes it a good investment. Perfect examples of these are Sony (SNE) and Nokia (NOK). I invested in these at $11 and $2.50, respectively, because the sum of their parts was worth more than what the market was pricing the entire company at. I wrote about these in my articles Buy Sony Hand Over Fist and Nokia Will Outperform Apple.
Because BBRY is largely a cellphone manufacturer, I would classify their business as undiversified and not a candidate for a sum of parts investment opportunity. There really are only two parts you need to be concerned with: the smartphone division and net cash.
Generally, businesses with several divisions in varying businesses are good candidates for a sum of parts mispricing opportunity because the market focuses too much on a poorly performing division and correspondingly undervalues the other divisions (think Sony with TVs or Nokia with cellphones). That is, the market typically assigns too low of a valuation on other divisions within the company that could potentially be spun out or liquidated at higher values and this is where the opportunity lies. With BBRY, I don't see this opportunity, so it comes down to showing a turnaround in operations. And this starts with improving / stabilizing gross margins and operating income.
Let's take a look at recent trends in gross margins:
The above trend in margins is quite negative. The past three quarters' average gross margins is 28.1%, even lower than the trailing twelve-months margin. However, margins in Q4 of 2012 did pick up from 26% to 30.4%, so it might be an early sign that things are turning around. However, this is not enough evidence for me to believe in a potential turnaround. I would need to see another 2 to 3 quarters of stabilizing or improving margins to believe things have gotten better.
On a valuation perspective, let's take a look at the company's price to sales compared to its peers since BBRY is still operating at a loss, making valuations relative to earnings a moot point:
Apple (AAPL): 2.78
Hewlett-Packard (HPQ): 0.37
Dell (DELL): 0.44
On the open market, BlackBerry is worth $7.3 billion. Trailing twelve-months sales are $12.59 billion. After backing out net cash of $2.5 billion, you get a valuation of $4.8 billion. This results in a price-to-sales of 0.58 or 0.38 net of cash. A price-to-sales of 0.38 would be on the lower end of the above competitors; however, keep in mind all of the above companies except HPQ have significant positive net cash balances. So BBRY is actually overvalued on this metric when compared to its peers (obviously excluding AAPL, which rightfully deserves a higher multiple).
Additionally, each one of its competitors is currently profitable, except Nokia. However, even Nokia is expected to return to a profit this year. BBRY, by comparison, had negative operating income in the trailing twelve months of $1.37 billion and the consensus estimate for 2013 through 2016 is for more losses. I'm the first to throw out analyst estimates, though, but by this measure it's easy to see that the stock could have a good deal of risk going forward until it shows it can return to profitability. I'd argue that of the above stocks, NOK is the most undervalued because of the sum of its parts and because it is on the path to return to profitability in the near term.
So what is the catalyst?
Well, clearly BBRY investors are pinning their hopes on the Blackberry Z10, its newest smartphone. Blackberry bulls point to the user interface (UI) being superior to that of the iPhone or Windows-based phones while bears are pointing to a few comparisons with the older Galaxy S3 from Samsung (GM:SSNLF) and with Nokia's new Lumia 920 that show the Z10 as being at least slightly inferior in terms of features. I've written previously about the side-by-side comparisons of the Z10 and the S3 and from all looks, it does seem like the phone is at most on par with the S3 and probably a little inferior to it. Either way, it doesn't strike me as being a must have phone but I've been wrong before on consumers' tastes before.
Analysts seem pessimistic on the Z10 launch, which could be a good thing. Just today Goldman Sachs (GS) downgraded the stock based on channel checks it did with the Z10 launch. I've often written about how calls from Goldman often mark inflection points in stocks (i.e., recommending shorting something when it's time to go long and vice versa). A classic example of this was their call to sell NOK when it was right near its lows last summer, only to find out later that they were acquiring shares in SEC filings. However, the results of the Z10 launch are still unknown.
CONCLUSION: Hold off for Now
While I'm all for investing in beaten down companies and industries, I honestly don't see any clear signs of improving operations in BBRY. The company has pared down costs but revenues have dropped quite a bit, so cost cutting was required. The valuation on a price to sales comparison with its peers isn't enticing enough for me. And the company doesn't have any hidden mispriced assets that make it a good sum of parts play. Instead, I want to wait for a couple of quarters to see some signs of improvement in gross margins. With the stock up 100% from its lows and trading at a price-to-sales ratio almost double that of NOK, I'd rather be invested in that than BBRY. I think there is a high risk of a large pullback in the future if the trend in gross margins over the past 5 years continues and for that reason, I'd prefer to wait for signs of improvement. I think there is too much risk being long right now. And I think any potential suitor is thinking the same thing.