Research In Motion May Be Hurting but Plenty of Opportunity Remains

by: Against the Heard

We’ve Been Bears

For the longest time we have believed that the stars were aligned against Research In Motion (RIMM). It all started when RIM was a high-flying tech darling soaring to new heights as the financial crisis unfolded. The underlying thesis behind our bearishness was RIM’s exposure to the enterprise segment, mainly bankers and lawyers, who were facing the looming prospect of imminent layoffs. By our rough estimation, each banker or lawyer fired—and there were many—meant one less Blackberry and one fewer future customer.

The stock rightfully lost some of its momentum and sank with the rest of the market in 2008, only to rebound quite nicely. However, despite the rebound, a major competitive threat emerged in the form of the Apple (NASDAQ:AAPL) iPhone. The iPhone brought the perks of a smartphone to the retail consumer, as Apple cleverly crafted their new offering to cater to the demands of today’s franticly connected U.S. consumer. Meanwhile, RIM focused on their strengths—mainly security in the enterprise domain—while ignoring the broader opportunity and second wave of smart phone proliferation. This proved a costly mistake as the Google Android soon emerged as a second, more formidable foe.

This set the stage for a serious platform war in which RIM has clearly emerged as the underdog and more recently, an afterthought. So much so that the company is at a crucial inflection point while their stock price is down in the dumps. Two years ago no one would have thought we would be having the discussion as to whether or not RIM is on the brink of death; however, today it’s something that many are wondering. Now we’re all left asking whether RIM will face Palm’s fate, and if so, how long will it take?

The Platform War: A Case Study in What Not to Do

The key for RIM is not to win the platform war, but to position themselves in the competitive landscape as the best option for a high margin subset of customers—the enterprise user. How do they do this? Well there is a great template in what not to do in the form of Nokia (NYSE:NOK). Nokia invested heavily in the Symbian operating system in an attempt at relevancy in the platform war. Yet, after spending $3.9 billion in R&D for mobile in 2010 alone, the company has nothing to show for it (AllThingsD).

Not only did Nokia burn through piles of cash in the process, but in the end they still were left without their own OS platform. To make matters worse, Nokia followed up the failed Symbian initiative by inking a deal with Microsoft (NASDAQ:MSFT) that has Nokia hardware once again on the outside looking in at a relevant software platform. In the competitive smartphone arena, Nokia will first have to prove to customers that the Windows Mobile OS is a viable platform when compared to Apple and Android, and then that the hardware features are on par with the spate of offerings from the likes of Apple, HTC, Motorola (MOT), and yes, even RIM. Not an easy task.

RIM vs. Nokia: The Financials

At its present price, RIM trades with a current and forward P/E below that of Nokia’s. This is despite the fact that RIM has far better margins—a 23.3% EBIT margin last fiscal year for RIM vs. a 4.7% margin for Nokia—growing rather than shrinking sales, and a solid presence in the higher-margin US market compared to Nokia’s notable absence. Granted, Nokia has a strong balance sheet, but both companies face imminent margin contraction in the near-to-mid-term, plus Nokia is on the brink of shifting from profitable to accruing a loss. That will quickly eat at their balance sheet safety and puts in jeopardy their generous dividend.

Most importantly, even if RIM’s device margins shrink to those of Nokia’s current levels (which by our estimation, such a development would take more than 3 years attrition, and assumes no changes are made to RIM’s current business model), RIM’s service business would still be generating approximately $2.8 billion in EBIT by fairly conservative measures. At a 6.5x EBIT multiple, that results in a business valuation roughly equal to today’s prices (including today’s cash balance, and assuming no growth in cash).

Playbook Impact

Some thought that a strong tablet offering would change the fortunes at RIM; however, the Playbook has already dampened the enthusiasm of investors and customers alike, and its lack of success has fueled yet more selling in the stock. There are two net positives to take from the Playbook thus far. First is the initial hint that RIM is in fact willing to embrace at least part of the Android community via the integration of the Android Market into their tablet. Second, with the tablet itself they have demonstrated their unwillingness to fall prey to another generation of technology cannibalizing their demand base as they did with the iPhone. We would argue that the adoption curve of the Playbook for the corporate segment is probably early, but may actually exist. This may not have been a terrible move afterall, it merely lacks the excitement and enthusiasm behind Apple’s iPad.

What RIM Must Do

RIM needs to adopt the Android operating system entirely. This would instantly give the company the popular platform it craves and leave them in a position to make their strengths apparent. Contrary to popular belief, the Blackberry does actually have a loyal base of users who like the security, the keyboard and particularly Blackberry Messenger (BBM). These are some serious strengths which their smartphone brethren have yet to successfully replicate. BBM in particular generates a sense of community amongst Blackberry users that Apple and Google have yet to replicate (and not for lack of trying).

What makes the Android OS a particularly good fit for RIM is that it enables the company to forge its own identity. Each developer can customize the Android OS to fit the strengths of its phone, while loading it with whatever freeware and additions they may want in order to maximize performance for their target customer. This would enable RIM to clarify its identity in the smartphone space—becoming the premiere enterprise hardware provider once again. Outside of security, their focus can be exclusively on building and marketing the best hardware offerings. That’s a far easier and less costly task than competing on both the hardware and platform level.

Their secure services are in fact so secure that developing countries with more limited freedoms complain about their inability to spy on their citizens emails and phone calls (see: India and Saudi Arabia). Clearly in some developing markets, RIM will need to work within the confines of these “limitations.” However, here in these free United States, that is a major benefit highlighted by the recent spate of high-profile hackings at several Fortune 500 companies. As more users embrace smartphones and shift into the cloud, security (as it should) will now be seen as more important than ever.

The most important take-away here is that while RIM is certainly hurting today, and has no doubt made poor choices in the recent past, there is plenty of opportunity to right the ship before joining Palm in the graveyard of mobile device innovation.

Disclosure: We are long GOOG. We may initiate a position in RIMM in the next 72 hours.