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"In the long run we are all dead" - John Maynard Keynes

The winds of change have not been kind to BlackBerry (NASDAQ:BBRY) over the past several years. The mobile phone market has evolved to the company's detriment, potentially dealing a fatal blow to its long-term prospects as an independent entity.

However, in the meantime, the company is at the onset of the biggest upgrade cycle in the company's history. This is well-known by investors, but not well-regarded. In fact, even my company Pipeline Data has viewed the new product cycle with skepticism. Product reviews have been mixed, with most saying the BlackBerry 10 operating system shows promise, but still lags Android and Apple's (NASDAQ:AAPL) iOS.

We concur, but none of those points are relevant to a short thesis. Here's why:

1. The Z10 should be a modest success, but our research tells us the Q10 will be a home run. Based on proprietary survey work, most of the 76 million remaining BlackBerry customers love BlackBerry for its keyboard. Further, a large percentage dislike touch screens. In other words, a significant portion of the installed base has not only been waiting for a modern mobile operating system, they've been waiting for it to be featured on a QWERTY phone.

Thus, we submit that the Q10 (and later, the R10) will be the true arbiters of BBRY's future. Further, our research has determined that early demand for the Q10 is outstripping what BBRY has experienced for the Z10 by a wide margin.

Third-party data from ChangeWave Research suggests that the stock price underestimates how much gas is left in BlackBerry's tank. According to ChangeWave's home page, "For the second survey in a row, BlackBerry (7%) is registering a 3-pt uptick in planned buying." In other words, over the next 90 days, 7% of buyers who plan to buy a smartphone plan to buy a Blackerry.

7% doesn't sound like much to write home about, especially considering that this number was likely closer to 40% a few years ago. However, a few years ago, 40% was enough to justify a $150 share price. With the stock now trading for $14, let's calculate what 7% market share could mean for the stock.

First, looking at total worldwide demand, according to Gartner Group there were 207.7 million smartphones sold in Q4 of 2012 (up 38% versus Q4 of 2011. If another 200 million phones sell over the next 90 days, 7% share would represent 14 million BlackBerry smartphones.

This number matches up well against another study, released in February by YouGov plc. According to the study, 43% of existing BlackBerry customers planned on purchasing a new BlackBerry phone over the next 6-months. With 76 million customers worldwide, that 43% represents 32.7 million phone sales over the next six-months. That's 16.3 million per 3-months, pretty close to the 14 million figure we calculated above.

So, how does that stack up against Wall Street expectations? For that, we turned to the last BBRY earnings call. There, Wells Fargo's Maynard Um asked management about its guidance which implied "somewhere closer to around 3.5 million BlackBerry 10 units next quarter, which is only roughly about 23,000 units per carrier, which seems conservative."

Based on the data points we've collected and discussed, that appears to be a understatement. Solidifying this view on the earning call, BBRY management admitted that it is ramping up production to meet the high demand it is experiencing. We suspect that most retail investors are unaware of this. It is likely they are also unaware of the statistics and calculations outlined above -- it's easier to simply assume that BlackBerry's competitive woes mean that the stock should go lower.

That may prove true in the long-term. However, in the short-term, stocks react to performance versus earnings expectations. In that regard, the company seems to have more than enough cushion to top Wall Street's revenue estimates for the next several quarters.

The prospects for profitability are even more encouraging. Looking at BBRY's gross margin profile, you can see that it was forced to sell its hardware for below cost in fiscal 2013. However, there is tremendous leverage in its model, providing the potential for gross margins to move back into the 30s if and when its revenues ramp back up.

FY11FY12FY13
Hardware Revenue16,40014,0006,902
Hardware COGS10,50011,2177,060
Gross Margins36%20%-2%

Moving on to BBRY's operating structure, we have calculated that the incremental net income on each new BlackBerry phone will be approximately $80. This equates to about 15-cents of EPS for each million units of incremental new phone sales (cannibalization of older-phone sales is irrelevant, because the legacy line-up is not profitable).

Taking all of this into account, if just 26% of BBRY's installed base upgrades over a 12-month period, EPS run rate should hit $3.00.

That number could prove conservative. The smart phone replacement cycle typically spans 2-3 years. That implies 33-50% annual uptake from the legacy installed base. Also, despite all of the company's woes of the past two years, it actually has 25% more subscribers now than it did at the end of fiscal 2011. Two major drivers of this include corporate / government mandates and the BlackBerry's beloved QWERTY keyboard.

In the corporate / government sector, CIOs still love BlackBerry. Its security, management, and reliability are still major differentiators. As for its keyboard, even bearish investors have to admit that this is likely one of the main things that have kept BlackBerry customers from switching to Apple or Samsung. Personally, I prefer touch screens, but there's a strong percentage of consumers who hate them...and love their BlackBerry keyboard. One of our key industry contacts summed it up as such:

"Much of BlackBerry's installed base hates touch screens. They're dying for a better browser and a decent apps selection, but don't want to give up their QWERTY keyboard. Anyone in the installed base with the disposable income will upgrade when the Q-10 (and R-10) become available to them. Most of these 80 million people have no frame of reference with regard to Android or iOS. Considering what they're using now, they're going to love the BlackBerry 10 OS.

There are also people like this on Apple devices today. A fair number will come back to BlackBerry over time.

Corporate IT is watching closely as well. A number of big enterprise CIOs are BlackBerry fans. Many were forced to cave into employees' demand for iPhones and went BYOD, but they lose sleep every night thinking about the security risk. Given a good excuse I expect many of them to go back to BlackBerry-only for all employees. I think BB10 is that excuse.

Don't get me wrong, I personally don't think BBRY will ever challenge Apple and Samsung again, but they have a strong base of customers and still have more to offer corporations and the government sector. That's more than enough to keep them well-fed for years to come."

Thus, it's not hard to envision a scenario where upwards of 100% of BlackBerry's current subscribers upgrade to the Q10 or R10 over time. They will also win some percentage of feature-phone users who will look to upgrade to a smartphone in the coming years (along with a spattering of unhappy iPhone and Android users, including former BlackBerry disciples who grew tired of waiting for a modern operating system).

Under this perfect-world scenario, BBRY would generate over $12 in EPS. Of course, we're not predicting this, but it lends more credence to the possibility of EPS reaching a $3.00 run rate in the coming quarters. Keep in mind, our $3.00 estimate excludes the potential impact of sales to new customers. According to our models, each 1% annual gain in installed base market share will produce upwards of $1.50 in EPS. Finally, lest we forget, $3.00 would still only represent half of what BBRY earned in fiscal 2011.

As far as profitable companies go, some of BBRY's current metrics are sitting at levels that have historically been very favorable for investors. Its market cap is $7.5 billion, but with nearly $3 billion in cash, its enterprise value is just $4.5 billion ($8.75 per share). That gives it an EV/R&D ratio of 3, which puts it among the lowest 1% of profitable public companies. From an earnings perspective, if the company achieves $3.00 in EPS, an enterprise P/E of 8 would give it a $24 EV. Add back the net cash and we're looking at a $30+ stock.

Conclusions

With the fundamental outlook improving and short sellers representing 35% of the float, the path of least resistance is clearly to the upside. Specifically, we believe that two strong quarters will be more than enough to spark a massive short squeeze. The chart, currently in a consolidation pattern, also appears set to break to the upside.

To be clear, this doesn't mean that BlackBerry will regain its past luster. However, with a high of $150 and a low of $6, the trick is calculating the valuation that accurately reflects BlackBerry's current risk/reward profile. Thus, while skepticism is still justified, BBRY's valuation seems to only reflect the risk. Considering all data we have collected, we now believe that BBRY will breech the $20 level in the coming months, rising more than 50% from current levels and more than triple its 52-week low.

Source: BlackBerry Bear Case Is Flawed - Shares Should Double