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Is BlackBerry is in the midst of a successful turnaround, or headed for financial distress?

Although there are many companies in better or worse financial shape than BlackBerry (NASDAQ:BBRY), there are few where the Bulls and the Bears seem so venomously opposed. Most investors seem to believe share price will either tank or skyrocket.

Corporate Turnaround

Turnarounds are a slow processes and success is difficult to predict. However, below are the indicators worth watching and how BlackBerry currently fairs.

  • Profitability - Although one quarter is not enough to establish a trend, another positive quarter should demonstrate BlackBerry's ability to earn a profit.
  • Cash Flow and Reserves - This was never an issue for BlackBerry.
  • Gross Sales - Unfortunately for BlackBerry, sales as currently reported are still declining quarter over quarter and this will continue if BB7 sales decrease faster than BB10 sales increase.
  • Turnover - Financial statements have never shown problems with accounts payable or receivable turnover. Inventory turnover (once channel stuffing is calculated in), which was a problem, improved as of the last quarterly.
  • Market Share - Hard numbers provided in previous financial statements confirmed that market share was still dropping and information reported since then has been mixed.
  • Resource Optimization / Overhead - BlackBerry has taken significant steps to optimize efficiency. The last quarterly report suggested margins were now among the highest in the industry. Some analysts have questioned if these gains were real or if they were artificial due to one-time adjustments so this point is worth watching.
  • Research & Development - BlackBerry is in the midst of its largest roll-out ever including transitioning to an entirely new platform (BB7 to BB10), multiple new devices, transitioning its services platform to multivendor and expanding QNX functionality to include paid services. So far all of these initiatives seem to be proceeding smoothly.
  • Financial Stability - BlackBerry has never had problems repaying debt, paying employee benefits, performing plant maintenance, or replacing manufacturing machinery in a timely fashion.
  • Corporate Moral - Staff is much more upbeat lately. Employees of all levels are encouraged to voice their ideas openly and a slew of new social activities are being offered to employees by the company. This time last year staff was depressed about the future of the company and felt left out.
  • Clear Vision - Thorsten Heins has clearly articulated where he sees the company headed, and has done a good job selling his vision. However, what's missing are the details of how the changes will contribute to the bottom line.

Overall signs are positive, but there are enough concerns to warrant caution until more information is available. Things to watch for in the June 28, quarterly report are:

  • Has the decline in gross revenue stopped?
  • Has the decline in market share stopped?
  • Has cash flow remained positive?
  • Have cash reserves been preserved?
  • Have gross margins been maintained?
  • Have clues been provided regarding how BlackBerry intends to monetize 'Free' multi-platform BBM?

Earnings per Share (EPS) is of course important, and may have a significant impact on the market short term, but from a long-term perspective the above points will provide better insight into the status of the turnaround.

Subscriber base has long been suggested as a good indicator of BlackBerry's health. However, due to changes in BlackBerry's service model, this is no longer the case. Value will be limited to primarily just indicating the number of subscribers still with BB7 devices.

Financial Distress

In a bid to resolve this conundrum, NYU Professor Edward Altman introduced the Z-score formula in the late 1960s. Rather than search for a single best ratio, Altman built a model that distills five key performance ratios into a single score. As it turns out, the Z-score gives investors a pretty good snapshot of corporate financial health. Here we look at how to calculate the Z-score and how investors can use it to help make buy and sell decisions.

Here is the formula (for manufacturing firms), which is built out of the five weighted financial ratios:

Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:

A = Working Capital / Total Assets
B = Retained Earnings / Total Assets
C = Earnings Before Interest & Tax / Total Assets
D = Market Value of Equity / Total Liabilities
E = Sales / Total Assets

Strictly speaking, the lower the score, the higher the odds are that a company is headed for bankruptcy. A Z-score of lower than 1.8, in particular, indicates that the company is heading for bankruptcy. Companies with scores above 3 are unlikely to enter bankruptcy. Scores in between 1.8 and 3 lie in a gray area.

I believe the Z Score is as good a litmus test as to the overall financial health of a manufacturer. Those who criticize it overlook that it works best for capital intensive firms such as manufacturers, and not as well for service organizations.

BlackBerry's current Z Score works out to around 2.5, which indicates a company could go either way.

Why Hold BlackBerry?

In addition to the points raised previously, the company has in its favor:

  • No debt (nearly $3 Billion in Cash Reserves);
  • Strong loyal customer base;
  • Growing breadth of competitive mobile devices;
  • Leadership position within certain niche markets (security and keyboard); and
  • Substantial number of applications.

Why Short BlackBerry?

A year ago, when many the shorts entered the market, BlackBerry's future looked pretty grim.

  • Products were outdated and the timelines for replacement products kept slipping;
  • Major marketing and design blunders doomed the only new innovative product to failure (PlayBook);
  • Market share was in free fall;
  • Share price was in a free fall;
  • Management was bloated and overhead excessive;
  • Competitors were soon to be granted DoD security approval with the resulting loss of one of its competitive edges; and
  • Above all, a clear corporate vision was missing.

Times are looking up, but don't overlook that:

  • BlackBerry has yet to raise EPS to a level justifying even the current share price (Price x Earnings ratio is out of line even using current average projected earnings);
  • The last financial statements showed revenue and subscriber base still in decline, despite the BB10 launch and an industry growth rate of 30%;
  • Recent reports regarding market penetration have been mixed with some suggesting even those which were initially positive (such as the U.K.) have since shown signs of subsequent decline; and
  • Sector margins are under pressure, due to declining product differentiation and new low cost market entrants (Chinese Manufacturers).

Add in speculation that the overall stock market is due for a downward adjustment (some are predicting as large as 30%), and that volatile stock (like BlackBerry) tend to overshoot market corrections, and the short position makes a little more sense. Remember it is easy to cover a short position with call options off the money to protect against any major upswing.

Corporate Transformation

BlackBerry's shift from device manufacturer to software and service provider may (and personally I believe will) be BlackBerry's savior, BUT the fact remains that many companies, which try to enter new markets fail. Also, consider in the case of BBM that:

  • The market has firmly established competitors with deep pockets (such as Microsoft and Google);
  • Although BBM may have 60 Million subscribers, WhatsApp has over 200 Million; and
  • BlackBerry has not indicated how it intends to monetize 'Free BBM.'

Some try to parallel BlackBerry's shift from hardware to services and support with IBM getting out of the PC game. However, the difference is that IBM was never defined by the hardware it sold; it was defined by offering complete reliable 'solutions' to businesses. Divesting PC manufacturing simply allowed IBM to get out of building 'commodity goods' and focus instead on its core strengths, service and support.

Conclusion

Although midterm prospects are definitely looking up for BlackBerry, it is too early to call what will happen longer term as signs are mixed. If the next few quarters are positive, most of the naysayer's should stop questioning if the turnaround can be sustained and share price should stabilize.

The gamble every investor makes standing on the sidelines until the future is known is that they miss out on the substantial gains possible with speculative stock. BlackBerry could end up being the most undervalued stock of the year... or then again might not.

Although I remain long, I appreciate why BlackBerry is so highly shorted.

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.

Source: BlackBerry Longs Versus Shorts