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Summary

  • The CORE program is still an important part of BlackBerry's strategy to stabilize the business.
  • To make an apples to apples comparison, I have to restate the income statement of the last five quarters.
  • The analysis of adjusted gross margin and adjusted total operating expenses provide useful information about BlackBerry's future.
  • John Chen walks the talk.

For "BlackBerry Scrutinized 1" go here.

In the last months, BlackBerry (NASDAQ:BBRY) has been bashed by the media due to the massive losses they reported in the last three quarters. Some of them were even predicting BlackBerry's bankruptcy in the following months, because they were focused on big losses recorded due to inventory write-downs, impairment of long live assets and debentures fair value adjustment.

While BlackBerry effectively reported huge losses, I have to make some clarifications on this topic. These losses are mainly non-cash. Moreover, in accounting, it is important to make a difference between GAAP and non-GAAP metrics (adjusted metrics). Otherwise, you are going to compare apples to oranges. This is why I restated the income statement of the last five quarters to make an apples to apples comparison.

In the first part of this article, I'm going to make a brief history of previous results to focus on non-recurring items (inventory write-downs, impairment of long lived assets, debentures fair value adjustment, recovery of inventory and charges related to the CORE program). In the second part of this article, I'm going to have a look at the CORE program, which was started by ex-CEO Thorsten Heins to cut costs. In the third part of this article, I'm going to restate the income statement on an adjusted basis to make an apples to apples comparison quarter over quarter. I'm also going to discuss the gross margin and total operating expenses specifically with some key findings.

Part 1: Brief history of non-recurring items

It is important to understand why BlackBerry reported such huge losses in the last three quarters before analyzing the items specifically and making an unbiased comparison quarter over quarter. The company made financial mistakes regarding the BB10 devices. Thorsten Heins thought he was going to sell "tens of million of Q10 devices" during the year 2013. Finally, the reality was totally different due to a disastrous marketing campaign. And the company recorded massive inventory write-downs to reflect the lack of sales. Now, let's make a brief history of previous non-recurring items.

  • In Q4 2013, BlackBerry reported a pre-tax charge of $29 million related to the CORE program.
  • In Q1 2014, the company recorded a pre-tax charge of $26 million related to the CORE program and a negative impact of $72 million from Venezuelan's service revenues, which impacted negatively the gross margin by 2%.
  • In Q2 2014, the company reported a pre-tax charge of $72 million related to the CORE program and an inventory write-down of $934 million related to Z10 devices.
  • In Q3 2014, the company recorded a pre-tax charge of $266 million resulting from the CORE program and the Strategic review, which was formed with the goal to sell the company. Moreover, the company reported impairment of long lived assets of $2.748 billion and an additional inventory write-down of $1.592 billion resulting from BB10 devices.
  • In Q4 2014, BlackBerry recorded a pre-tax charge of $148 million related to the CORE program. The company also recorded a loss of $382 million related to the debentures fair value, which is purely accounting practices. On the positive side, the company reported a recovery of inventory of $149 million related to previous inventory write-downs.

Part 2: CORE program scrutinized

In March 2012, BlackBerry launched the CORE (Cost Optimization and Resource Efficiency) program with the objective to reduce its cost structure and improve its supply chain. Currently, the program hasn't stop and will likely continue in the following quarters. Actually, that's an important part of John Chen's strategy to stabilize the business. In fact, John Chen wants to make BlackBerry profitable by fiscal year 2016. As a result BlackBerry CEO has to adapt the company's cost structure by decreasing the expenses. I will discuss later this topic in the operating expenses part with some interesting key findings.

The CORE program impacts three items of the income statement, namely cost of sales, Research & Development expenses and Selling, General & Administrative expenses. The majority of the CORE program charges is related to SG&A expenses as shown on the table above. In Q3 2014, the expenses increased a lot due to the strategic review, which was finally abandoned in November 2013 and leads to the departure of ex-CEO Thorsten Heins. As a result, John Chen came on board and started to implement its strategy to focus on enterprise, security and software.

For Q1 2015, I forecast a total charge for the CORE program of $140 million (pre-tax amount), a slight decrease in comparison with previous quarter of $148 million. While it is hard to forecast such an expense, I assume CORE charges to be in line with previous quarter relative to total adjusted operating expenses. Let me explain.

In Q4 2014, I calculate adjusted total operating expenses of $577 million, which excludes the CORE expenses. As a result, total CORE expenses come at 25.5% of adjusted total operating expenses. For Q1 2015, I assume the same % (i.e. 25.5%, based on total adjusted operating expenses of $547.83 million, forecasted for Q1 2015), which leads to $140 million of CORE expenses (25.5% of total adjusted operating expenses).

The CORE expenses are also tax deductible at a rate of 29%, which leads to total CORE expenses of $99.4 million after tax. I assume the same tax rate as previous quarter (29.05%).

Understanding of BlackBerry adjusted income statement: make an apples to apples comparison quarter over quarter

In the last quarters, BlackBerry reported many non-recurring items such as inventory write-downs, impairment of long lived assets, debentures fair value loss and recovery of inventory, which distorted the income statement and made a comparison impossible to do on a quarter basis. This is why I restate the income statement.

I try to explain with a readable manner last quarter results (Q4 2014). I start with total sales of $976 million for the quarter. To that, I deduct the cost of sales of $423 million and I find the gross profit of $553 million (gross margin of 56.6%). But, the company reported a recovery of inventory of $149 million and a CORE program charge of $17 million, as I previously said. Therefore, I have to deduct the recovery of inventory and to add the charges related to the CORE program, to the cost of sales. As a result, I find an adjusted cost of sales of $ -555 million (i.e. -423 - 149 + 17), which corresponds to an adjusted gross profit of $421 million (adjusted gross margin of 43.14%).

Regarding the operating expenses, it is the same principle. As a first step, I start with the reported income statement numbers and then, I add the CORE expenses to the related expenses. As a result, adjusted R&D and SG&A decrease in value. As a second step, I sum up the debentures to 0, because this is a non-recurring item, used purely for accounting purpose. I don't forget to take into account the amortization, which doesn't change on an adjusted basis. Therefore, I find adjusted total operating expenses of $577 million (in comparison with total operating expenses of $1090 million) and an adjusted operating loss of $156 million. Afterwards, I add the investment income of $20 million to find the $176 million adjusted income from continuing operations before income taxes.

Afterwards, I have to deduct the tax benefit related to the CORE program, which increases the loss from continuing operations by $43 million, and to add the recovery of income taxes ($134 million) as well as the tax expense related to the recovery of inventory, which decreases the loss from continuing operations by $43 million. As a result, I find an adjusted income from continuing operations of $ -42 million and an adjusted net income of $ -42 million as well.

In previous quarter, BlackBerry made significant progress on an operating level. They reported an adjusted loss of $42 million, which represented a negative profit margin of 4.3%. To put things in perspective, the company reported an adjusted loss of $248 million (in Q2 2014) and $354 million (in Q3 2014), which represented a negative profit margin of 15.7% and 29.6%, respectively.

Gross Margin analysis

Gross margin was 56.6% for the quarter thanks to the recovery of inventory. But, it has to be deducted to make an apples to apples comparison quarter over quarter. After deducting the recovery of inventory and adding the charges related to the CORE program, BlackBerry reported an adjusted gross margin of 43% in comparison with an adjusted gross margin of 34% in previous quarter. This is mainly due to a higher Average Selling Price per device having increased by $251 to $277, as I said in my previous article.

Why BlackBerry is "ahead of target" from an operating expense point of view according to John Chen?

In last conference call, John Chen said:

"I'd like to just kind of focus on a few things that I feel pretty good about. The first thing is our operating expenses. It's on target and it's actually ahead of target and I understand the Company had made some statements in the past, and I think the numbers shown that we're about a quarter ahead of schedule at this point".

I agree with him and I show you why. If I have a look at the expenses, there is something very interesting to point out, they started to decrease faster than the revenues in Q4 2014. Let me explain. Total sales were $1573 million (in Q2 2014), $1193 million (in Q3 2014) and $976 million (in Q4 2014), having decreased by 24.16% (from Q2 to Q3) and 18.19% (from Q3 to Q4). Adjusted total operating expenses were $966 million (in Q2 2014), $823 million (in Q3 2014) and $577 million (in Q4 2014), having decreased by 17.37% (from Q2 to Q3) and 29.89% (from Q3 to Q4). While revenues decreased by 18% from Q3 to Q4, adjusted operating expenses tumbled by 30%.

This is the first step to make the cost cutting strategy successful. These improvements can be attributed to the management, which decreased the expenses to be in line with the decreased sales. In my opinion, the Foxconn deal is an important contributor to the decreased OPEX. This is another proof of John Chen's commitment to turnaround BlackBerry. He definitely walks the talk, which is in opposition with previous management team.

Furthermore, there are more positive news to come regarding the future of expenses. In fact, CIBC analyst Todd Coupland attended a meeting with CFO James Yersh two months ago and said to clients:

"Some of the intellectual property expenses linked to patent royalties BlackBerry pays out to third-parties are due to expire by November 2014. Blackberry's annual fixed costs for these are approximately $800-million, but are set to fall to zero".

These fixed expenses represented $800 million on an annual basis. As a result, BlackBerry could save $200 million every quarter.

Conclusion

I focus on income statement to show the early progress of the BlackBerry turnaround implemented by John Chen and the management team. In fact, adjusted gross margin increases and adjusted total operating expenses decreases, which is the first step to improve BlackBerry's financial situation. Moreover, there are more cost cutting to come as mentioned by Todd Coupland.

As I previously said, I do believe in John Chen's strategy because we can already see the early progress done to stabilize the company's business. Moreover, there are more good news to come with the release of the BlackBerry Z3 and EZ Pass program aiming to bring back enterprise customers to BES10.

Part 3 is coming.

Source: BlackBerry Scrutinized 2: Income Statement Analysis, Focus On Gross Margin And Operating Expenses