Research in Motion (RIMM) has recently experienced a profound shift in its valuation. In fact, this past Friday, July 13th, RIMM shares rallied to an all time high with double the usual volume despite no apparent news. Since May 2007, RIMM shares have increased by approximately 75% (nearly tripled since beginning of 2006), with the bulk of its gains stemming from its Q1 earnings report in late June, which exceeded analyst results, along with a revised upward outlook. In addition, a few days later, the Company indicated that it won approval to sell its products in China, something RIMM had been seeking to do since May 2006.
While the results and news appear sound on the surface, the challenges RIMM will face in the future indicate things could be much more difficult than the market is currently pricing in. First, while China will provide a new market for RIMM, the level of that impact should not be overstated in terms of relevance. China has generally not respected intellectual property (“IP”) as evidenced by Disney-themed copycat amusement parks and rampant software/media/film piracy. As most RIMM followers are aware, RIMM’s trademark Blackberry will essentially be competing against a carbon copy of itself in the RedBerry, an established presence in China which is currently backed by China Unicom.
The large mobile market potential offered by China is not a RIMM-specific opportunity as other device providers will certainly partake in that market and the challenges in having the citizens, government, and even corporations of China respect foreign IP will be a significant challenge for RIMM, primarily because one could anticipate Chinese consumers would be inclined to purchase the cheaper RedBerry instead of RIMM’s Blackberry. In reality, RIMM may spend a good portion of its time engaged in patent litigation with RedBerry and fighting a difficult price war against other potentially illegal, yet unpunished, imitators that reverse engineer its technology and are thus able to sell clone devices for a significant discount.
RIMM 1-yr chart:
Next, while Q1 2007 earnings looked sound, the momentum appears largely driven by beating cautious analyst revenue and EPS expectations rather than really generating tremendous absolute results. Revenue growth was very strong but gross margins have already started to show degradation, underperforming analyst expectations. Q1 gross margins came in at under 52% while prior year was 53.5%. This is a considerable drop and when one considers that RIMM has not really launched the Curve in the same capacity as the Pearl, one could expect gross margins to further decline over time as the revenue mix continues to incorporate more consumer-driven hardware revenue as opposed to higher margin business/enterprise software.
What really drove the “beat” on the EPS side was RIMM getting its SG&A in line with its operating targets, having Q1 R&D come in lower than expected, and a lower tax rate. Current buyers should be aware that even the latest forward non-GAAP 2009 EPS revisions range from $7-$9.50, resulting in a P/E multiple of 24.0x-32.6x 2009 non-GAAP EPS. In addition, some analysts had admitted that they “missed” the run-up in RIMM shares due to underestimating certain parts of the Company’s business model and acceleration. It’s not atypical to overcompensate when reversing one’s opinion and thus go from a cautious view to excessively optimistic view. One could argue that at 12.0x P/S, when similar, well performing companies trade for less than half that multiple, reflects an overly optimistic view regarding the Company’s future prospects.
Further, for technology companies, gross margins are really the key value drivers and analysts and the market seem far too willing to overlook that aspect in regards to RIMM, preferring to solely focus on the “headline” revenue growth and EPS growth driven through a lower tax rate and operating expense management. Getting operating expenses in line was not just a pleasant surprise but was really a critical factor considering RIMM’s gross margins will likely deteriorate as more Blackberry consumer devices are introduced. Q1 gross margins came in below expectations and as other higher-end consumer devices are introduced, one could expect the $200 price point for RIMM’s consumer devices to be challenged, increasing margin pressure on the Company.
Nonetheless, the current stock trend has been difficult to short, especially if one’s time horizon is too limited and portfolio management not sound. While the stock’s valuation off pro-forma forward non-GAAP 2009 estimates, the China “news,” and strong recent Q1 results have led many buyers into RIMM shares, the concerns cited above regarding long-term gross margins stemming from product mix and price competition, the real China “opportunity,” and valuation may be shared by RIMM insiders who have taken full advantage of the generous prices paid by current RIMM buyers.
Current RIMM shareholders should be wary of the fact that those most intimately familiar with the Company’s prospects may realize RIMM is valued well beyond perfection, as evidenced by the significant cashing out of stock at recent price levels. Table I is from SEDI and covers insider related stock transactions (including option conversions) by insiders. Note that the prices are based off of RIMM’s Toronto Stock Exchange values. Further, the most recent transactions from last week would not be available due to number of days (~10) that typically pass before the transaction appears on SEDAR and the current trend leads one to believe there are far more insider sales that will be available on SEDI this coming week. Table I illustrates that RIMM buyers should be cautious at current prices when insiders seem so willing to part with their shares despite the rosy outlook.
Table I: RIMM Insider Equity Sales June 1 – July 13 2007
Disclosure: Author manages a hedge fund that is short out of the money RIMM puts, short out of the money RIMM calls, long RIMM puts, and owns a Blackberry 8700g