Research In Motion (RIMM) shares were hurt by last week’s earnings miss, lowered guidance, and falling profit margins. Many investors are trying to see if RIMM will follow the path that Nokia (NOK) has taken, or if RIMM will be able to stop the bleeding, maintain its core customer base, and keep its relevance in the face of what is shaping up to be a two-horse race between Apple (AAPL) and Google (GOOG).
I feel that there is a belief in the marketplace that in the near future, there will only be two or three smart phone platforms: iPhone, Android, and Windows (MSFT) Phone. If one subscribes to that belief, RIMM will try to fight for a few years to stay relevant while overspending on R&D, lowering prices, and destroying shareholder value. If indeed that is the case, RIMM should be in the dictionary under the definition of “value trap,” because it looks good across all of the metrics at which value investors look (Price/Earnings, Price/Book, ROE etc.) but it never rewards shareholders with the cash that justifies the valuation. Under this scenario, the share price will keep falling until the company is swallowed by a competitor ... and people who thought they had a cheap stock wonder why it keeps getting cheaper.
I do not subscribe to any of the above arguments with respect to RIMM, and I think there is a price, albeit lower than the current price, at which RIMM is an excellent value for patient investors. I will start by doing a quick Net-Present-Value analysis of RIMM and show that RIMM can be a solid investment without having to displace Apple or Google from the top of the smart phone standings. Information that I will use can be found in its June 16 earnings release or one of its previous releases.
The assumptions I use in this NPV come from its guidance, which calls for gross margins of 39%, revenue between $4.2-4.8 Billion, and EPS between $0.75-1.05 in Q2. It also gave full year EPS guidance of $5.25-6.00. Since it earned $1.33 in Q1, and I assume $0.80 in Q2, it will have to earn approximately $1.65 in Q3 and $1.72 in Q4 to reach EPS of $5.50, which is at the low end of the range it provided.
If my assumptions are correct, revenue will be about $6.1 Billion and $6.4 Billion in Q3 and Q4, respectively, with gross margins at 42%. I chose 42% because gross margins have historically been 44%, but the downturn in business will pressure margins down to 39% in Q2.
For the next seven years, I assumed slightly negative revenue growth, gross margins of 40%, flat operating expenses, and a 5% reduction in shares outstanding. Using these assumptions, I arrive at EPS of about $5.15 for the next seven years. At the current share price of $28, this amounts to a 12.5% annualized return if my overly simplistic model is accurate. Since this is a company in a slightly distressed state, and assumptions can vary dramatically, I feel that using a 20% required rate of return gives a larger margin for error, and yields a price of about $20 per share.
I think my above analysis uses some fairly conservative assumptions and leaves room for results that could surprise investors to the upside. For example, RIMM produces about $3 Billion of cash per year. With that cash, RIMM could engage in much more aggressive stock purchases, which would increase the EPS in the out years. Also, RIMM could initiate a dividend that would attract a whole different class of investors to the stock than now, and would reduce the risks of having the company waste cash on investor-unfriendly activities such as excess R&D. Also, with a market cap at around $14 Billion and a debt-free balance sheet, RIMM is a good candidate for a possible (I think unlikely) takeover or LBO.
While my analysis is conservative, it is by no means the worst case scenario. It is possible that business customers will abandon Blackberry products in favor of Apple or Google platforms; it is also possible that RIMM makes very poor decisions with respect to shareholders. It could continue losing pricing power, which will be reflected in lower gross margins, and could also overspend on R&D for the foreseeable future. If RIMM maintains R&D growth of 40%/year without a commensurate increase in revenue, all of my future EPS estimates will be too high and I don’t think investors will be very happy.
For RIMM, Q2 is an opportunity to fix its problems, so I will be looking forward to Q3’s earnings. If gross margins are below 40%, I think RIMM will have a real credibility issue with investors, and RIMM’s entire future should be questioned at that point. If RIMM’s gross margins are 41-43%, I think that is a good sign that it's gotten through a weak spot in its business. For now, I am not buying RIMM until it gets into the $20-22 range. If it never gets to my price, I will have no regrets, but I think it is worth a small investment in the low 20s.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.