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Like many observers of (and investors in) the smartphone market, we have been anticipating BlackBerry's (NASDAQ:BBRY) Q1 2014 earnings release and conference call, for they would provide insight into how new BlackBerry 10 devices are faring. And like many observers and investors, the depth of BlackBerry's miss relative to consensus estimates surprised us, as well as other revelations the company provided (more on those later). However, one of the first things we went to after BlackBerry released its earnings was to its cash flow statements, and we were pleasantly surprised. The company generated $630 million of operating cash flow; while that was still down from the $711 million generated in Q1 2013, it was still a meaningful number, and suggests that BlackBerry's business may not be as bad as its critics believe. Furthermore, BlackBerry's balance of cash and investments rose to $3.071 billion, up 6.82% from Q4 2012's $2.875 billion. Based on the company's market capitalization as of the close of trading on June 28, over 56% of its market capitalization is in cash. Despite its headline troubles, BlackBerry has been able to continue generating cash, and has created a fortress balance sheet.

When we saw BlackBerry's increased balance of cash and investments, as well as the size of that balance relative to its market capitalization, we became intrigued. Surely there is value there, value that the market is missing. But as we examined the issue further, we came to a realization. Surely it isn't this easy? If BlackBerry's balance of cash and investments is as compelling as we believe, why are shares down nearly 28%? As we examined the issue in more detail, our opinion shifted. In this article, we will be focusing in depth not on BlackBerry's operating issues, which a number of people have covered in detail, but rather its balance sheet, and why things are not as well as they seem. In our view, if BlackBerry's trajectory fails to improve, its cash and investment balances, long seen as one of the pillars of the BlackBerry bullish thesis, is likely to begin exhibiting cracks, and thereby likely placing further pressure on the company's stock price. Unless otherwise noted, financial statistics and management commentary cited in this article will be derived from either BlackBerry's Q1 2014 earnings release or its Q1 2014 earnings call.

Brief Thoughts on Emotions and Rationality

BlackBerry, for a variety of reasons, is one of the stocks that tend to elicit meaningful reactions here on Seeking Alpha whenever a new piece of research is published on the company. We caution against such a reaction here. Our article is not meant to be an attack on the quality of the company's devices, either on a standalone basis or in relation to peers such as Apple (NASDAQ:AAPL), Nokia (NYSE:NOK), or Samsung (OTC:SSNLF). Although we are long Apple, we urge readers to set aside their emotions and examine BlackBerry's financial state in a rational manner. In this article, we will not make claims that Apple's iPhone is superior to the BlackBerry Z10, Q10, or any other device. Nor will be argue that Android phones are better emerging market devices (at the low and mid-end), or better-developed market devices (at the high end). We leave such judgments to the marketplace. This article will focus on BlackBerry's financials, and our view that unless the company can turn itself around (and as we will show, its cash flow does not suggest that Q1 was a solid quarter), its balance sheet will begin to deteriorate.

Many of BlackBerry's defenders may be users of the company's devices and services, and while we understand that customer loyalty is a key aspect in business, it has no place in investing. Investors must be able to separate any and all personal attachments to (or feelings against) a company when making an investment decision. There are myriad quality companies that most investors will never interact with directly over the course of their lives, and there are myriad quality companies that do nothing to create customer loyalty, all while maintaining their status as quality companies to invest in. We urge readers to separate their loyalty to BlackBerry and examine the company's finances through a neutral prism, and see the dangers to BlackBerry's balance sheet that lie ahead.

Isn't Year-Over-Year Revenue Growth a Good Sign?

BlackBerry's Q1 results missed on multiple key metrics, including revenue, EPS, and BlackBerry 10 shipments. For Q1 2014, the company posted revenues of $3.071 billion and a pro forma loss of 13 cents per share, missing revenue estimates by $260 million, and EPS estimates by 20 cents. Even when a 10-cent EPS charge tied to Venezuelan currency controls, and the accompanying inability to remit dollars back to BlackBerry (thereby making Venezuelan revenue ineligible to be recognized under GAAP), EPS and revenue would have still missed estimates, for Venezuela accounted for $72 million of revenue in Q1 2014, according to CFO Brian Bidulka (more on Venezuela a bit later). BlackBerry shipped 6.8 million units in Q1 2014, of which 40% were BlackBerry 10 devices, missing consensus estimates of more than 3 million BlackBerry 10 units.

Defenders of Blackberry will undoubtedly note that the company recorded revenue growth not only on a sequential basis, but on a year-over-year basis as well. Sequentially, revenues grew by 14.68%, and 9.34% year-over-year.

(click to enlarge)

As the chart above shows, sequential revenue growth was noted in all regions except Latin America, and even that region would have recorded growth if the company recognized $72 million of Venezuelan revenue. On a year-over-year basis, growth was driven by EMEA and Asia-Pacific sales, with North American revenue falling 4.16%, and Latin American revenue falling 22.59% (10.17% ex-Venezuela). It is undeniable that BlackBerry is growing its sales. However, when the source of this growth is examined in detail, the company's revenue growth becomes less impressive. Although hardware revenue soared 33% sequentially (and 30.69% year-over-year) to $2.181 billion (representing 71% of revenue, versus 60% in Q4 2013), the company's crucial service revenues declined 9% sequentially (16% when including the impact of Venezuela) to $794 million, driven by the sequential loss of 4 million subscribers (the company ended Q1 2014 with 72 million subscribers). More importantly, BlackBerry's service revenue declined 13.14% on a year-over year basis, even when adding back in the $72 million in Venezuelan service revenue that the company was unable to recognize.

The shift towards hardware sales lowered BlackBerry's pro forma gross margins to 36%, down from 40% in Q4 2013 (excluding the 200 bps impact of Venezuela's currency controls to gross margins), and down from pro forma gross margins of 39.4% in Q1 2013. BlackBerry's sales growth is coming at the cost of its profitability, and CEO Thorsten Heins noted that the upcoming Q5 will be a lower margin device, stating that, "it [the Q5] does have a different margin [stock] than the other products, but we are working to drive those efficiencies. And it's early in the cycle, and we're looking to get BES 10 deployed and rolled out as well." The Q5 is geared to select markets in the Asia-Pacific region, and although the company noted that it is seeing strong demand for it, CEO Thorsten Heins noted that it is too early to tell how the Q5 will fare. CFO Brian Bidulka dodged analyst questions related to hardware gross margins, specifically a question from Wells Fargo analyst Maynard Um related to hardware gross margins, which he believes declined sequentially. BlackBerry also took a meaningful step away from transparency by ending its practice of providing quarterly subscriber metrics, something we see as more negative than positive. In addition, the company declined to provide sales guidance for Q2 2014, and in our view, CEO Thorsten Heins' statement that the market is too volatile to provide guidance is not a sign of strength. At this critical juncture, it is imperative for BlackBerry to control the narrative surrounding the company (and by extension, its stock price), and a lack of subscriber guidance will increase uncertainty among the company's partners, customers, and investors. Given the questions regarding BlackBerry's viability (whether or not these questions are valid is irrelevant, for it is clear that they are out there), we believe the company needs to be as transparent as possible with its progress. Although we fully agree with CEO Thorsten Heins that true turnarounds take time, BlackBerry's business is not showing signs of truly turning itself around, and decreased transparency is not in the company's best interest.

BlackBerry's Cash Flow: Digging to Find the Source

When we first examined BlackBerry's earnings release, we were pleasantly surprised to see that the company had generated $630 million in operating cash flow, pushing its net cash and investments to $3.107 billion. However, upon further examination, BlackBerry's increase in cash and investments this quarter was due not to solid underlying fundamentals, but a meaningful benefit from one-time working capital changes, changes that the company will be unable to rely on in the future. Below is a reproduction of BlackBerry's Q1 2014 operating cash flow statement.

BlackBerry Operating Cash Flow, Q1 2013 and Q1 2014 (in Millions of $)

Q1 2013

Q1 2014

Net Loss

($518)

($84)

Amortization

$480

$399

Deferred Income Taxes

($16)

($6)

Income Taxes Payable

($1)

$0

Stock-based Compensation

$25

$20

Impairment of Goodwill

$335

$0

Other

$11

$25

Net Changes in Working Capital

$395

$276

Operating Cash Flow

$711

$630

As the chart above shows, net changes in working capital was the 2nd most meaningful contributor to BlackBerry's operating cash flow this quarter. However, as the company disclosed in its Q1 2014 earnings release, the receipt of a $564 million tax refund drove this favorable change, a one-time benefit without which the company's operating cash flow would have been far lower. BlackBerry ended Q1 2014 with just $33 million in income taxes receivable, meaning that the company will be unable to prop up future quarter cash flow with such a payment. Other working capital items were meaningful drags on cash flow, most notably a negative $284 million impact related to inventory tied to BlackBerry 10 launch efforts, as well as a $196 million decrease in deferred revenue. A $183 million increase in accounts receivable can be explained by the company's sequential increase in revenue (Venezuelan accounts receivable account for 5% of BlackBerry's total, and CFO Brian Bidulka noted that the company received some payments after the end of the quarter). In addition, $223 million of cash flow was generated by an increase in accounts payable and accrued liabilities. Lastly, BlackBerry's $630 million in operating cash flow fails to take into account the $418 million spent on PP&E and intangible assets ($83 million for PP&E and $335 million for intangible assets). When these are taken into account, and without the company's $564 million tax refund, BlackBerry would have burned hundreds of millions in cash this quarter.

Notably, analysts pressured CFO Brian Bidulka about the company's cash flow, for many saw that without the recognition of $564 million in income tax refunds, BlackBerry's operating cash flow would be far lower. As with questions related to hardware gross margin, CFO Brian Bidulka evaded giving a direct answer as to whether or not BlackBerry will avoid burning cash in Q2 2013 or subsequent quarters, stating that,

"Just on your comment, we fully anticipated that with the launch of these products [BlackBerry 10 devices] we were going to, as it relates to working capital, consume some working capital as it relates to investing in these launches. And as we move forward, we think we have the right financial strength for the long term execution on the launch of these products. So as we work through it we'll continue to look at how do we optimize and manage our working capital going forward."

In our view, such a response does not engender confidence in BlackBerry's ability to avoid cash burn in upcoming quarters, particularly in light of the company's miss relative to expectations this quarter. Although BlackBerry does hold over $2.5 billion in accounts receivable on its balance sheet (and $265 million in "other receivables"), it also holds $3.09 billion in accounts payable and accrued liabilities, meaning that unless the company can see a meaningful pickup in its business, it will fail to maintain its inflow of accounts receivable at a rate fast enough to offset necessary payments on its accounts payable. What of the company's patents? And its property? Although these are certainly valuable assets (especially BlackBerry's patents), we believe that selling them for the sole purpose of generating cash to fund the company's operations is not a sign of strength. These assets, if they are indeed to be sold, must be sold from a position of strength, not for the sole purpose of raising funds for working capital purposes. There is also a danger within BlackBerry's inventory stock. In Q1 2014, this served as a $284 million drag on operating cash flow. During Q2 2014, BlackBerry will likely be building and taking inventory off many BlackBerry 10 devices (as well as older models), should these fail to sell as well as the company's internal projections suggest, the company will likely be left with hundreds of millions in new inventory that will become increasingly difficult to sell, placing even further pressure on the company's balance sheet.

Why Does Cash Flow Matter?

Many of BlackBerry's defenders may wonder why the issue of the quality of the company's cash flow mattes. After all, with over $3.1 billion in cash and investments, BlackBerry has ample capital to pay its liabilities and invest further into launch of BlackBerry 10 devices. The answer lies in the equity markets. Given that nearly 136 million shares of BlackBerry traded on a day when the stock fell nearly 28%, it is clear that many investors were selling. We believe that those investors that chose to hold on did so in large part because of the company's balance sheet. After all, if the company's balance of cash and investments is growing, then surely things are not as bad as they seem? However, a closer analysis of BlackBerry's financial statements, as shown above, reveals that the company's Q1 cash flow was driven by unsustainable working capital changes, not fundamental strength.

BlackBerry's cash flow matters because if and when the company begins to burn cash, it will place even deeper cracks into one of the last remaining pillars for the bullish thesis regarding BlackBerry. With channel checks conducted by Pacific Crest indicating that Q10 shipments at both Verizon (NYSE:VZ) and T-Mobile (NYSE:TMUS) are faring little better than those for the Z10, we believe that it is increasingly likely that BlackBerry will be unable to stave off cash burn in Q2 2012, something that will likely put pressure on the company's shares in its own right, to say nothing of its fundamental performance.

Conclusions

Investors considering adding to or initiating positions in BlackBerry at these levels should tread carefully. Although the company's balance sheet may seem attractive at this point in time, BlackBerry was able to increase its balance of cash and investments only via one-time working capital benefits, and its balance sheet will likely be put under increased pressure in this quarter and the quarters to come. Should the company begin burning cash, perhaps the most crucial pillar of the BlackBerry bullish thesis will begin to crack, something that will almost certainly exacerbate the pressure on the company's share price.

Disclosure: I am long AAPL, VOD, VZ, TMUS. 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.