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BlackBerry (NASDAQ:BBRY) announced its Q4 2013 results Thursday following many weeks of speculation, controversy and wild swings in the stock price. Top line revenue was slightly below expectations, but the bottom line handily beat expectations, showing a profit of $0.18 versus Street expectations of a $0.32 loss. Adjusting for a one-time expense related to the CORE program, and backing out the tax rebate, the final figures come out to about break even for the quarter - something that most analysts were not expecting to happen until 2015, if at all.

Sales of the Z10 phone were in line with the higher end of expectations at 1,000,000 units for the 1 month period between the launch and the end of the quarter. Considering that the phone was only available in about 25% of BlackBerry's worldwide markets, that figure is not too shabby. Overall phone sales were 6,000,000 compared to 6,900,000 in the previous quarter. Some of the overall sales decline can probably be accounted for by expected seasonal variations. However, it remains clear that sales of the older BB7 series phones are facing stiff competition from Android phones at the lower priced end of the market.

A decline in the number of subscribers (from 79 million to 76 million) was expected, though the rate seems to be accelerating. According to BlackBerry CEO Thorsten Heins, the decline in subscriber base is expected to continue into Q1,2014, with a "single digit" decrease anticipated. BlackBerry has recently announced plans to open up its BES10 system to users of Apple (NASDAQ:AAPL) and Android phones. Presumably, that move will reverse the decline in the subscriber base if it succeeds in attracting other users to the more secure BES10 system.

Approximately 55% of the Z10 sales were made to users who were switching from other operating systems. This is a very strong indication that the Z10 sales are not solely a result of pent-up demand, and that the strong sales are not coming from the existing BlackBerry customer base. It also indicates that early Z10 sales are being driven by consumers rather than enterprises. The Q10 keyboard phone, which is very popular among BlackBerry subscribers, is due to launch later this month. This, along with sales to enterprises, should ensure that the BB10 sales are sustainable for the medium term.

Perhaps the most surprising number in the results was an increase in gross margins from 30.4% to 40.1% of revenue. Revenue per phone sold has increased from $237 to $272. If we assume that the BB7 revenue per phone is unchanged from the previous quarter, the revenue per phone for the BB10 comes to $448. This seems reasonable, considering a retail price of $600 and a retail mark-up of 33%. The table below compares the last two quarters.

Q4

Q3

Revenue (millions)

$ 2,678

$ 2,727

Cost of sales

$ 1,603

$ 1,897

Gross margin

$ 1,075

$ 830

Gross margin %

40.1%

30.4%

Hardware

$ 1,634

$ 1,636

Software and services

$ 1,044

$ 1,091

Phones sold

6,000,000

6,900,000

BB7

5,000,000

6,900,000

BB10

1,000,000

-

Rev per phone

$ 272

$ 237

Rev per BB7

$ 237

$ 237

Rev per BB10

$ 448

If all of the improvements in gross margin were solely a result of a change in the sales mix of BB10 and BB7 phones, that would imply a margin on BB10 phones of about 63% and a base cost of only $165. That figure is probably too optimistic.

The BlackBerry CORE program, initiated last year, has produced about 1 billion dollars in operating cost savings. These savings have come partly from staff reductions, and partly from efficiencies and cost savings in the supply chain. It is possible, therefore that some of the gross margin improvement has come from cost reductions in the services business for the BB7 phones.

For the purpose of this analysis, I have set the gross margin on the BB10 at a more reasonable 40%, and adjusted the margins on the BB7 and the services to match the Q4, 2013 results.

In a previous article, I came up with a prediction of 1.5 million Z10 sales for Q4 2013 and long-term sales of 7 million per quarter. I did this by breaking the sales into three components - normal sales to BlackBerry users, pent-up demand and sales to users switching from other platforms. I have adjusted the model to match the actual sales of 1 million for February. The rates at which users were switching from other platforms has been kept the same, so the main effect was to reduce the sales generated by "pent-up" demand. The estimated sales are:

Estimated quarterly sales

Canada

900,000

UK

950,000

USA

1,910,000

UAE

260,000

Italy

80,000

Germany

260,000

France

340,000

Spain

340,000

Netherlands

80,000

Saudi Arabia

610,000

Australia

80,000

Others

170,000

Total

5,980,000

The predicted quarterly number now comes to 5.98 million. I have assumed a decline in service revenue to 90% of the Q4 service revenue, and a decline in BB7 sales to 1 million per quarter.

Plugging those numbers into a valuation model based on the margins calculated from the Q4 results gives the following quarterly results:

Projected future

Revenue (millions)

$ 3,856

Hardware

$ 2,916

Software and services

$ 940

Cost of sales

$ 1,701

Hardware

$ 977

Software and services

$ 724

Gross margin

$ 2,155

Gross margin %

55.9%

Operating expenses

Research and development

383

Selling, marketing and administration

785

Amortization

181

Income from operations

$ 806

Quarterly EBITDA

$ 987

Value (6 x annual EBITDA)

$ 23,700

Value per share

$ 44.95

How important is the U.S. launch? If I take out all of the projected U.S. sales, the valuation still comes to $27/share

To be worth $45/share, BlackBerry does not have to accomplish very much in the way of market share increases. In my financial analysis, the number of phones sold is only the same as Q3 2013. All BlackBerry needs to do is to carve out a small niche for itself and stay at the high end of the market, replacing sales of BB7 phones with sales of higher margin BB10 phones.

The Q4 results were a good indication that BlackBerry has turned things around, cash flow was good and there were no ugly surprises. The results were perhaps not spectacular enough to send the shorts running for cover, but they were good enough to establish the company as a solid prospect for the medium-term.

Source: BlackBerry: High Margins Are The Key To Success