BlackBerry: What It Will Take For Profitability In FY2016

Aug.29.14 | About: BlackBerry Ltd. (BBRY)

Summary

Software revenues are expected to increase substantially, but will likely still only be the third largest contributor to gross margin in FY2016.

Hardware sales of 13 million units at 15% to 20% gross margin will help BlackBerry achieve profitability.

At that level of hardware sales, service revenues should remain at around $1.275 billion for FY2016.

This article aims to look at what is required for BlackBerry (NASDAQ:BBRY) to achieve profitability in FY2016. John Chen has stated that BlackBerry is still targeting break-even by the end of FY2015 and profitability during FY2016. Despite a focus on software sales, it appears that hardware sales and service revenues will still play a larger role in determining BlackBerry's profitability in FY2016, although this may change beyond that year.

A Scenario For A Profitable FY2016

The two biggest improvements affecting BlackBerry's financial prospects have been the reduction in operating expenses and the expected improvement in the gross margin of the hardware division. Operating expenses have been reduced to approximately $500 million per quarter or $2 billion per year. Hardware gross margins were negative in FY2013 and FY2014, with the cost of sales exceeding revenues by $2.5 billion in FY2014. However, hardware gross margins are expected to become positive again.

Downside risks for BlackBerry's profitability include a faster than expected decline in service revenues, a slow ramp-up of software revenue and hardware sales and/or gross margins that do not recover quickly enough.

Here's a scenario where BlackBerry can achieve at least limited profitability in FY2016:

($ Million)

FY2016

Hardware Gross Margin

$650

Service Gross Margin

$900

Software Gross Margin

$550

Total Gross Margin

$2,100

Operating Expenses + Interest Expense

$2,075

Click to enlarge

Hardware gross margin of $650 million, plus service gross margin of $900 million and software gross margin of $550 million would result in at least minimal profitability in FY2016 with operating expenses at $2 billion per year and interest expense of $75 million. There is also the other segment, which could also add to profitability, although I am uncertain about what sort of gross margins are typical for that segment. If the other segment adds $50 million to gross margin, profitability in this scenario would be around $75 million less any taxes.

Hardware Sales and Gross Margin

Reaching $650 million in hardware gross margin would require hardware sales of 13 million units at an ASP of around $250 to $300 and gross margins of 15% to 20%, averaging out to $50 in gross margin per phone. This gross margin percentage appears reasonable since HTC (OTC:HTCCY) and the Microsoft (NASDAQ:MSFT)/Nokia (NYSE:NOK) Lumia have averaged gross margins at or above that level despite heavy margin pressure.

Although that sales level of 3.25 million units per quarter is higher than Q1 FY2015's sell-through of 2.6 million units, there appears to be a decent chance that sales are bottoming out. The BlackBerry Z3 was only available in Indonesia at the end of last quarter, and before that the last major product launch was the high-end Z30 towards the end of Q3 FY2014. While BlackBerry is certainly not guaranteed to sell 3.25 million units per quarter going forward, the future expected launches along with expanded Z3 sales makes this target a reasonable prospect.

Service Revenues and Gross Margin

The decline in service revenue per subscriber appears to be slowing, with Q1 2015 at approximately the same level as Q4 2014 and only slightly below Q3 2014.

Fiscal Period

Service Revenues ($ Million)

Subscribers (Million)

$ Per Sub Per Quarter

Q1 2013

$1,003

78

$12.86

Q2 2013

$1,005

80

$12.56

Q3 2013

$974

79

$12.33

Q4 2013

$947

76

$12.46

Q1 2014

$794

72

$11.03

Q2 2014

$724

68

$10.65

Q3 2014

$632

63

$10.03

Q4 2014

$548

57

$9.61

Q1 2015

$489

50

$9.78

Click to enlarge

Note: Q1 2015 service revenues have been adjusted to remove effect of the $30 million in recovery from Venezuela.

Handset sales of 13 million units per year should also support average subscriber levels of between 30 million to 35 million during FY2016. Assuming that service revenue per subscriber per quarter can stay at current levels then 30 million to 35 million subscribers would lead to approximately $1.275 billion per year in service revenue. Service revenue per subscriber appears to have stabilized despite the general lack of service revenue from BlackBerry 10 consumer users. BlackBerry 10 enterprise users may still generate service revenue, so the high proportion of business users is likely keeping the revenue per subscriber levels stabilized.

If associated costs are $375 million per year, this would result in service gross margins equaling $900 million. This level of cost of sales is consistent with BlackBerry's comments about the majority of service costs being fixed costs.

Software Revenues and Gross Margin

The most uncertain factor is software revenue, which was only $235 million during FY2014. However, that included no contributions from BBM and no material contributions from BES 10. With the renewed focus on driving software revenue and also targeting $100 million in revenues from BBM in FY2016, this should increase substantially.

Although generally negative on BlackBerry, Macquarie still expected software revenues of $739 million during FY2017. Software gross margin of $550 million for FY2016 would require approximately $650 million in revenue at 85% gross margin. This appears to be an achievable target for FY2016, although it likely requires successful BBM monetization efforts plus a ramp-up in BES and QNX revenue.

Conclusion

BlackBerry's goal of profitability in FY2016 appears achievable if it can deliver hardware sales of around 13 million units at 15% to 20% gross margin along with software revenues of $650 million. Service revenues should remain high enough at that level of hardware sales to allow BlackBerry to achieve at least limited profitability without further operating expense cuts.

Despite the renewed focus on software, there is an expectation that hardware sales and services will still be larger drivers of gross margin during FY2016. This is expected to change as software revenues continue to grow.

Disclosure: The author is long BBRY.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.