When the analyst at BNP Paribas covering BlackBerry (NASDAQ:BBRY), Alexander Peterc, cut his rating on the company to "Underperform" from "Neutral" this past week, he claimed the main reason for his downgrade was the company's shrinking service revenues.
"Software and services are a vital profit pool for BlackBerry…. Threatening signs of disappearing legacy profit pools are already visible", Peterc wrote.
As a self-declared value investor, I am always on the lookout for companies that churn out predictable, recurring, annuity like revenue, for multiples that are within reason. For years, BBRY has enjoyed this model, charging users a fee for accessing their secure servers. This past quarter, BBRY generated $964M in service revenues, or about 36% of total revenues. In FY 2012, service revenue increased by 27% YOY, while device revenue decreased by 13% YOY. Over the course of some particularly difficult quarters, Jefferies analyst Peter Misek correctly pointed out that at best BBRY broke even on its hardware business, but it didn't matter, as long as service revenue kept coming in. Plus, we all know when the pure gain on the sales method of doing business, without the recurring revenue, goes wrong. If you don't believe me, take a look at Apple (NASDAQ:AAPL).
In BBRY's latest annual report, the viability of the company's service revenue is addressed (Page 50):
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 the Company's competitors recover their infrastructure and services expense in alternate manners, the Company is facing greater pressure to reduce its infrastructure access fees. In addition, the infrastructure access fees charged by the Company may also fall under pressure if the new products it launches do not utilize the network infrastructure in the same way or to the same extent as the Company's existing products. The Company is focused on developing an integrated services offering that leverages RIM's strengths such as BBM, security and manageability that will continue to generate service revenues. However, if the Company is unable to resist these competitive pressures or is unable to develop a compelling integrated services offering that will continue to generate service revenues and enable the Company to recover the costs associated with its network infrastructure, this could have a material adverse affect on the Company's results of operations and financial condition.
Clearly, service revenue has been a vital component of BBRY's earnings thus far, and the potential for its interruption is legitimate fodder for the bear case. BBRY's income statement has traditionally been dominated by hardware and service revenue, but as BES continues to gain steam, software revenue can earn a larger share of the pie.
Those who have been following the BBRY comeback story may recall that the potential loss of service revenue is far from a new concern. Actually, it was the main topic of discussion and the reason the stock dropped 20% after the earnings call in December 2012.
On that same December call, here is what Thorsten had to say about the future of service revenue:
Starting in the fourth quarter, we will begin seeing revenue from BlackBerry 10 devices. With the introduction of the BlackBerry 10 mobile computing platform, we will be transforming our service revenue model to reflect different usage levels of our network infrastructure and different value-added software security and service packages. So we plan to offer a range of security, mobile device and application management services in addition to communication services. We will position BlackBerry Enterprise service as the leading cross-platform enterprise mobile device management service and continue to invest in growth capabilities.
Subscribers that require enhanced services, including advanced security, mobile device management and other services, are expected to continue to generate monthly service revenue. Other subscribers who do not utilize such services are expected to generate less or no service revenue. However, I want to be very clear on this. Service revenues are not going away, but our business model and service offerings is going to evolve. Our vision is to position BlackBerry as the clear leader in the enterprise mobility market. While the mix and level of service fees revenue will change going forward and will be under pressure over the next year during this transition, but we are targeting to grow service revenue in smartphones, tablets and embedded application to a new offering with new partners and across platforms other than BlackBerry 10. We're making these changes to meet the competitive dynamics of the marketplace but more importantly, to allow us to pursue the broad opportunities in mobile computing that BlackBerry 10 and our infrastructure enables us to do.
Later, Thorsten got some CNBC airtime and further addressed the pressing concerns.
Morgan Stanley analyst Ehud Gelblum (bullish with a $22 target), who always seems to have a knack for asking the right questions, fired away (see page 8):
I just want to clarify a bunch of things around the structure of the service contract and the service ARPUs. So just to rattle off a couple of points, just to make sure I understand, the current service fees that you collect on BB7 and below, are those contracts in any long-term contracts? And when you're talking about moving to a new fee structure, does that impact any current BB7 subscribers or as long as they stay with their current BlackBerry, nothing changes for them? And then if they upgrade or if someone comes in to a BlackBerry 7 device, putting aside BlackBerry 10, does the new fee structure impact them, or are they still under the old -- the current structure right now of $4, $5, $6, $7? And then the other thing is that for people who are under the new fee structure and hopefully in answer to the first question we'll know if it's only BB10 device holders going forward or of it's existing BB7 or future BB7. But for anyone under the new subscription service, are we to understand that all services fees, whatever they may be, are going to be paid by the user and no longer paid by the carrier, as in the user will pay a fee, it will flow through the carrier to you but the carrier will no longer pay anything out of its own pocket?
To which Paul Carpino, the VP of Investor relations, replied:
Hey, that's a lot of questions in there. Generally right now, the company is sort of starting to roll out these plans on the service plans as we get into launching services and we'll provide more details around some of the activities that we'll be offering to the enterprises. We just aren't providing the detail on it that at this time, Ehud. I just -- you'll have to wait until we start to launch some of these services to get more detail.
I believe it was the tentative, ambiguous, reply that caught the market off guard, and sparked that massive sell-off.
BBRY bulls opine that the next wave of product will replace and exceed the service revenue of the past. Whether its building out the QNX platform, monetizing BES 10, BBM, and BlackBerry Channels, this company is picking the right battles and evolving its business. Just as the horse and buggy was replaced by the automobile, this company is thinking two or three steps ahead of the innovation curve. The problem, as always, is that sell side analysts (and short-term investors) don't have the foresight to see past the next quarter or two.
Analysts such as Mr. Peterc are doing their clients a disservice by regurgitating the same negative stories over and over; correctly, the market didn't have very much to say about his analysis, and the stock barely moved. It's a step above the fabricating of negative news, which certain analysts have been accused of, but I would opine it's nevertheless intellectually dishonest and misleading. Thankfully, the market has the final say, and will always be by definition, correct.
Disclosure: I am long BBRY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.