Speculation is mounting that there will be a takeover bid or auction for BlackBerry (BBRY) soon. However, earlier in mid-August, Pacific Crest's James Faucette mentioned that BlackBerry had $5.3 billion in off-balance sheet purchase obligations, which he believes will limit the premium that buyers are willing to pay for BlackBerry. We are going to examine these off-balance sheet purchase obligations and assess what it means for BlackBerry and for potential offers.
What Are The Contractual Obligations?
BlackBerry has $147 million in operating lease obligations and $5.17 billion in purchase obligations and commitments. The operating lease obligations are for various facilities such as the office it recently leased in New York City. The rent for those facilities will end up affecting operating expenses such as selling, marketing and administration each quarter.
The $5.17 billion in purchase obligations and commitments includes $4.3 billion in purchase orders with contract manufacturers, with the remaining balance consisting mostly of contracts with suppliers of raw materials and licensing agreements. The purchase obligations and commitments will turn into inventory on the balance sheet, and then change from inventory to cost of sales once they are sold to carriers and distributors.
The $5.3 billion in contractual obligations seems huge when compared to the $3.1 billion in cash, cash, equivalents and investments that BlackBerry has. However, the main $5.17 billion portion related to purchase obligations and commitments actually reflects part of BlackBerry's expectations for hardware cost of sales over the next six to twelve months. The best way of assessing whether this level of purchase obligations is going to be an issue is by comparing it to historical purchase obligations levels as they relate to forward hardware cost of sales.
Historical Purchase Obligation Levels
Here is a look at historical purchase obligation levels along with inventory levels and hardware and other cost of sales over the following twelve months. For example, at the end of Q4 FY2009, inventory was $682 million, purchase obligations was $4.228 billion, and cost of sales in FY2010 was $7.979 billion. This gives us a ratio of 61.5% for combined purchase obligations and inventory divided by hardware cost of sales for the twelve months following the end of Q4 FY2009. While cost of sales includes non-manufacturing related items such as carrier salesperson incentives, manufacturing costs would make up the majority of cost of sales, and it gives us a good way to compare across periods.
This ratio gives us a picture of how sales are running relative to expectations. When BlackBerry's growth was still very strong, the ratio was around 50-60%. The ratio reached around 100% when BlackBerry's growth reached a plateau and purchase commitments were made for a PlayBook launch, which later required a $485 million write-off.
(click to enlarge)The ratio decreased to 78% one year ago as BlackBerry reduced legacy BlackBerry purchase commitments but had not made significant BlackBerry 10 related purchases yet. We don't have forward twelve month cost of sales for Q4 FY2013 and Q1 FY2014 yet, but can note that while inventory increased significantly between Q4 FY2013 and Q1 FY2014, purchase obligations decreased by a more significant amount.
Chance of Write-Offs
The combined value of inventory and purchase obligations was $6.057 billion at the end of Q1 FY2014. We are also assuming that the cost of sales for the other category is $100 million over 12 months. Under a stronger than expected sales scenario, we are setting a ratio of 60%, which implies hardware cost of sales over the next four quarters of $10 billion or 9.15 million units sold per quarter at the Q1 FY2014 cost of sales of $273 per unit. This is a ratio that would be close to what BlackBerry had when it was growing strongly.
For the scenario where sales meet expectations, we are estimating a ratio of 75%, which implies hardware cost of sales over the next four quarters of $8.1 billion or 7.30 million units sold per quarter. This is a ratio that is around what BlackBerry had once it had reduced its purchase commitments to a more reasonable level after the PlayBook problems.
For the scenario where low sales create a chance of a write off, we are estimating a ratio of 100%, which implies hardware cost of sales over the next four quarters of $6 billion or 5.46 million units sold per quarter. A higher mix of BlackBerry 10 units may reduce the number of units required to be sold. This ratio is at levels seen when growth stalled and PlayBook sales were much less than expected.
Hardware Cost of Sales ($ Million)
Annual Units Required at Current Cost of Sales Per Unit (Million)
Quarterly Units Required at Current Cost of Sales Per Unit (Million)
Chance of Write-Off
There were 6.8 million units sold during Q1 FY2014. If sales continue at that run rate over the next four quarters, it will be below expectations but better than the danger zone where there appears to be a good chance of write-offs. Sales during Q2 FY2014 are generally expected to be tepid, but Q3 FY2014 has the benefit of holiday season sales and the launch of the Z30. It is unknown what BlackBerry's plans for Q4 FY2014 and Q1 FY2015 are, but we would estimate that sales of less than 5 million units in Q2 FY2014 would indicate a potential danger of some future write-offs. However, it should also be noted that while the company wide ratio was around 90-100% before the PlayBook write-off, the ratio for the PlayBook was likely well over 200% based on projected sales rates when the write-off occurred. Hence a ratio of 100% without particular products being much higher than that would probably just result in low margins instead of a write-off.
Effect On Purchase Value
The effect of the purchase obligations on BlackBerry's purchase price depends on what a potential acquirer plans on doing with the hardware division. If the acquirer plans on keeping the hardware division, then the purchase obligations will have limited effect on purchase value, except if sales figures are poor enough to suggest significant upcoming write-offs.
If the acquirer does not intend to keep the hardware division long term, then the amount of purchase obligations will weigh into the calculations of how much it would cost to wind up the hardware business. It is unknown what the cost to cancel the contracts would be, although with some other contract manufacturer contracts, the cost is related to how much component inventory the contract manufacturer has purchased and what loss it will take on reselling that component inventory. In such a scenario, it seems probable that the cost of shutting down the hardware business will be considerably less than the $6 billion in inventory and purchase commitments at the end of Q1 FY2014 (which would likely be below $5 billion by the time an offer is made and voted on). BMO's Tim Long estimates the cost of winding down the hardware business at $800 million.
The level of inventory and purchase obligations seems moderately higher in relation to forward sales than BlackBerry was likely aiming for, but at this point does not seem to be high enough to trigger write-offs. BlackBerry reportedly is scaling back build plans, which should help bring inventory and purchase obligations better in line with targeted levels.
The effect of the purchase obligations on an acquisition price would depend on the purchaser's plans for the hardware division. The purchase obligations are not at a level that would deter a purchaser that is interested in keeping the hardware division. It may have an effect on the price that a purchaser who plans to wind down the hardware division is willing to pay, but the effect will certainly be much lower than $5-6 billion. We would imagine that such a wind down would likely take place over some time rather than an immediate announcement that would damage sales.