BlackBerry Investors Have To Be Cautious - Hardware Is The Main Concern

Mar.31.14 | About: BlackBerry Ltd. (BBRY)

Summary

BlackBerry returned itself to near break-even on an adjusted basis. Despite this fact, BlackBerry sold-off on the earnings beat.

Service revenue is heavily dependent on back-end services fees from smartphone sales. Without smartphone sales, service revenue will become heavily impaired.

My outward looking assumptions depend heavily on whether or not BlackBerry is able to skillfully launch new devices through its Foxconn partnership.

The market will price the stock higher if BlackBerry is able to report growing revenues as a result of better product execution.

I'm not surprised by the recent dump following BlackBerry's (NASDAQ:BBRY) quarterly earnings announcement for Q4 (ended on March 1st). In a previous article I warned investors of this fact:

The amount of time it takes to pull off a turnaround in a business that's primarily consumer-driven will be a long and drawn out struggle. First, you will see expenses drop, but you will see a further drop in revenue that will come along with it. You may not see results initially, and that will force weaker hands to dump the stock, which will in turn keep the stock from being an easy investment case over the short-term.

To summarize Q4 financial results, the company has been able to bring itself back to near break-even based on the adjusted EPS loss of $0.08 (the adjusted EPS is considered be the most accurate representation of earnings from operations).

I still have on-going concerns

By now, I'm going to assume the vast majority of you are well aware of the financial figures coming from the most recent quarterly report. However, if you're a little uncertain, there's a ton of articles on Seeking Alpha that go into a lot of depth about the topic, and if you're still a little uncertain, I definitely recommend reviewing the earnings call transcripts for further research.

In the most recent quarter, sales deceleration is definitely a key concern. Declining market share and unit shipments have a two-fold impact on two reporting segments (handsets, and services). The revenue breakdown for the most recent quarter was 37% hardware, 56% for services, and 7% software, according to the Q4 FY 2014 earnings release. The part that really worries me is the sheer amount of dependence that BlackBerry has on the services side of the business, and if you're wondering how BlackBerry earns revenue from services, I was able to find out by looking at BlackBerry's most recent quarterly filing.

According to BlackBerry:

The Company currently generates service revenue from billings to its BlackBerry subscriber account base that utilize BlackBerry 7 and prior BlackBerry operating systems primarily from a monthly infrastructure access fee (sometimes referred to as a "service access fee" or "SAF") charged to carriers or resellers, who in turn bill the BlackBerry subscriber. The SAF for consumer customers historically has been much lower than the SAF for enterprise customers, who receive a higher level of value-added security, encryption and other services by utilizing the Company's BES platform (page 138).

Basically, BlackBerry charges consumers back-end service fees to mobile distributors like Verizon (NYSE:VZ), AT&T (NYSE:T), and T-Mobile (NASDAQ:TMUS). Mobile carriers pay BlackBerry directly using the revenue generated from post-paid subscriptions. The service access fees are used to cover the cost of infrastructure, BBM Chat, Voice, Video, Channels, and Channels for brands. BlackBerry earns additional revenue from third-party application developers from the BlackBerry World application store, but unfortunately this is a small drop in the bucket as BlackBerry doesn't have significant market share to drive any meaningful volume through its application store.

This leaves us in a bit of a conundrum, because BlackBerry's success is heavily dependent on its ability to sell handsets. Even more troubling is that these back-end services fees represent a bigger share of revenue than the actual handsets themselves. Therefore, BlackBerry needs to stabilize its market positioning against competitors sooner rather than later. To do this John Chen has identified channel partners, reduced the amount of excess inventory in sales channels, and shared device development with third parties (Foxconn). The Foxconn (OTC:FXCOF) deal looks promising, because BlackBerry is able to build niche devices that can reach break-even. What that means is that BlackBerry's focus is no longer on being the most dominant smartphone OEM, but to be the most tactical when it comes to manufacturing efficiencies, and product distribution.

The Z3 is the first device that's been developed in partnership with Foxconn. I expect BlackBerry to develop and distribute more variations of the BlackBerry handset that can reach reasonable sales levels with limited inventory risk.

Outlook

In a previous article, I assumed BlackBerry could reduce operating expenditures and retain 1% global share. This would result in $5.67 billion in sales and $338 million in net income, which would result in a 5.9% net profit margin.

Analyst currently anticipate BlackBerry's revenue for fiscal year 2015 (ending in February) to come in at around $4.09 billion, which is below my anticipated 1% market share figure. Furthermore, my estimate only estimates the impact from the sale of BlackBerry handsets, and it doesn't include the impact from services and other business segments. Also, many of the handsets may actually be sold for less than a $300 ASP, and if a $200 ASP range were to emerge, BlackBerry would generate $3.78 billion in revenue on 18.9 million device shipments. So perhaps, BlackBerry may not even retain 1% global share, as mobile smartphone growth is heavily dependent on the expanding number of smartphone subscribers from China (which BlackBerry has almost no presence in).

Furthermore, BlackBerry also mentions that service revenues might not be as good going forward:

Many of the Company's competitors do not charge a SAF (service access fees), or equivalent fee as they recover their infrastructure and services expense in alternate manners. Thus, the Company has faced significant pressure to reduce its existing SAF especially for the consumer market. In response to these pressures, the Company has been implementing certain price reduction programs in an effort to maintain and grow its subscriber base (page 138).

Overall, BlackBerry's install base of mobile users is declining; BlackBerry has limited presence in the emerging markets. The service access fees that represent a good portion of service revenues will decline in response to weakening demand for next generation BlackBerry devices. While that's going on, BlackBerry is barely getting costs aligned for break-even, and may have to resort to further cost cutting if mobile shipments continue to decline.

Conclusion

BlackBerry's guidance indicates break-even for the remainder of the fiscal year. They didn't offer us any clarity on revenue, because there's no way to predict the future success of handsets that haven't even been sold yet. The long term growth trajectory is still heavily dependent on its handset business, and anyone mentioning services and software as a stop-gap for revenue erosion are dead-wrong as service revenue is heavily dependent on hardware sales.

Therefore, investors are making a bet on whether BlackBerry's new product development partnership with Foxconn will result in stabilizing market share and perhaps year-over-year unit growth. If unit shipments continue to decline in future quarters, the stock will decline further. It's still a hardware business; and while many believe BlackBerry can thrive without smartphones, that's simply not the case based on the way service revenues are earned.

Overall, I'd advise caution and I'd encourage investors to look for other alternatives like Sony (NYSE:SNE) or Microsoft (NASDAQ:MSFT). There will still be plenty of time to buy BlackBerry when market share stabilizes, but that time is not now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.