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It is a sign of how negative expectations for BlackBerry (NASDAQ:BBRY) have become that it was down over 4% in pre-market trading Friday due to worries that its Q2 FY2014 earnings report would provide even worse news than the already dismal earnings warning. BlackBerry's share price rebounded to finish Friday up 1% after the earnings report was only about as bad as expected.

Since BlackBerry cancelled its conference call, we are left to dissect its earnings report on our own. More clarity will hopefully be provided by some of the detailed information in the MD&A, but in the meantime, here is a look at some of the more interesting items from the earnings report.

Working Capital

Working capital fell from $3.681 billion to $2.786 billion, a decrease of $895 million from last quarter. Deferred revenue increased by $488 million from Q1 FY2014 and other current assets increased by $356 million from Q1 FY 2014. The deferred revenue account includes the revenue that can't be recognized for BlackBerry 10 units shipped into the channel. The other current assets account likely includes deferred cost of goods sold, which is for those unrecognized BlackBerry 10 shipments as well.

If BlackBerry can recognize that revenue in the future, then the effective decrease in working capital may have been $763 million instead. However, since BlackBerry has not recognized revenue on those units due to uncertainty about the return rate, there is no guarantee that those units will sell-through and be counted as revenue. Another item affecting working capital is the inventory writeoff. We currently do not know how much inventory (and thus working capital) was affected by the writeoff as opposed to future purchase obligations and commitments. That information should be in the MD&A.

More Information About Deferred Revenue and COGS

Deferred revenue increased from $346 million at the end of Q1 FY2014 to $834 million at the end of Q2 FY2014. This is an increase of $488 million. If the average selling price for BlackBerry 10 devices during the quarter would have been $400, then the increase in deferred revenue represents shipments of 1.2 million BlackBerry 10 units that it can't recognize yet. BlackBerry's revenue recognition policy indicates that a deferral of hardware revenue could occur when return rates are uncertain and likely very high. The increase of $356 million in other current assets may represent deferred cost of goods sold for those 1.2 million units, which would be around $300 per unit. There may be other factors that impact deferred revenue and deferred cost of goods sold, but BlackBerry has not historically given a detailed breakdown of what affects those two accounts.

If BlackBerry had been able to recognize those BlackBerry 10 shipments, we probably would have seen something similar to the following results (excluding the impact of the inventory provision and CORE charges):

$ Million

Actual

Adjusted

Revenue

1573

2061

Cost of Sales

1003

1359

Gross Margin

570

702

Operating Expenses

996

996

Operating Loss

-426

-294

These results are slightly better, but with an operating loss of $294 million even while recognizing those BlackBerry 10 shipments, it is apparent that BlackBerry needs to continue restructuring quickly.

Revenue Breakdown

Based on the percentages given in the Q2 FY2014 earnings release, service revenues are down from $794 million to approximately $723 million this quarter. This represents a decrease of 9%, which is within (albeit at the high-end of) BlackBerry's guidance for a single digit decline during its Q1 FY2014 conference call. It is assumed that BlackBerry is still not recognizing Venezuelan service revenue due to the uncertainty around collecting it, although more details about that will likely be in the MD&A.

Revenue Source

$ Million

Hardware

771

Service

723

Software and Other

79

ASP

ASP is estimated at $208 based on 3.7 million units and $771 million in hardware revenues. This ASP is one of the lowest ever for BlackBerry, and does confirm that nearly all of the 3.7 million units shipped and recognized as revenue were BlackBerry 7 devices.

It also appears that BlackBerry lost approximately $100 million on hardware sales based on its typical service and software margins of around 85%. While BlackBerry will make that money back via future service revenues, the negative device margins are troubling since BlackBerry had appeared to get BlackBerry 7 margins close to breakeven in prior quarters.

Inventory

Despite the $934 million writeoff, inventory still rose from $887 million at the end of Q1 FY2014 to $941 million at the end of Q2 FY2014. We will need to look for additional information in the MD&A to see how much of the writeoff affected future purchase commitments versus current inventory. This inventory number would appear to show that inventory likely increased by over a million units though, given that Z10 units would have been revalued at a low amount.

Income Taxes Receivable and Future Cash Flow

Due to its heavy losses and large writeoff, BlackBerry's income taxes receivable increased by $429 million. This will help it slow the rate of cash burn over the next year as it seeks to restructure operations.

If business keeps trending the way it is going, it appears that the effective future rate of cash burn (after incorporating income tax refunds) will be around $200 to $300 million per quarter, plus any additional cash costs related to writeoffs and restructuring charges.

Conclusion

BlackBerry's Q2 FY2014 report does not contain any major surprises so far, although the high remaining level of inventory is troubling. Combined with the inability to recognize BlackBerry 10 shipments as revenues due to high and uncertain rates of return, this could potentially lead to further writeoffs of other device inventory in the future. Close attention should be paid to the level of future purchase commitments in the MD&A.

As for BlackBerry's cash position, we estimate that it should be able to complete restructuring in Q1 FY2015 with around $1.5 billion to $2 billion cash remaining, although that is subject to whether it can sell its inventory at least at cost.

We are still holding BlackBerry, although we may take steps to hedge our position for November, as there is substantial downside if the Fairfax bid is withdrawn.

Source: BlackBerry: Digging Into The Q2 FY2014 Earnings Report