Research in Motion Insiders Cashing Out On The Back of New Buyers

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

Comments

[Asif Suria:]

To add a couple of points to Amit's outstanding write-up,

1. RIMM is as much a software company as a device company. It charges businesses $4,000 for its enterprise software and the price goes up as the number of users go up.

2. RIMM started to shift its focus towards consumers with the introduction of the Pearl. However soon after the announcement of the Apple iPhone, the price of the Pearl started dropping dramatically and if the iPhone continues to garner market share in its segment, RIMM's margins are going to deteriorate.

3. There are other psychological elements in play here including investors/customers attachment to their CrackBerrys and the announcement of a stock split. I have discussed the effects of stock splits in the June 2006 edition of SINLetter.

I have been tempted to either short RIMM or go long put options but am glad I held off. This may be a good time to go long out of money puts in view of insider sales.

Voluntary Disclosure: I own no positions in RIMM right now but do own a Blackberry 8700.

2007 Jul 16 03:37 AM

[John Lazerow:]

Where do you see insider sales? I have looked on Edgar, Sedar, Bloomberg and cannot find any insider sales recently.

2007 Jul 16 10:18 AM

[moosebump:]

sedi.ca

2007 Jul 17 11:11 AM

[Hayweed:]

You left out that Basille wants to buy a hockey team which means he will probably sell shares in the future.
SEC investigation is still ongoing.
Management credibility when they thought opion issue was a $25 million problem that later became $250 milliion.

Biggest problem is that everyone seems to put a rosy look out for Rimm future sales. While business users will continue to buy Blackberrys do consumers really want the pearl and the curve in contrast to the iPhone.

2007 Jul 17 11:09 AM

[Christopher...:]

While all these reasons make sense, I don't think your short will play out they way you want. Earnings quality issues and insider sales are interesting, but the market doesn't really care about those issues right now.

You are trying to short a momentum stock without an identifiable catalyst. Good luck!

2007 Jul 17 12:30 PM

[cayman:]

I don't thint kmost people are thinking that far or much when buying RIMM these days. It's a momentum play. Look at GOOG, AAPL, and even INTC also coming back from the dead. Musical chairs anyone.

2007 Jul 17 12:35 PM

[John Lazerow:]

it's a momentum play because their business has momentum, and will for some time to come. this is a nascent industry people - and there is plenty of growth for rim and apple, the only value added smartphone makers at this time.

in the context of rim selling less than 10 million devices per year, over 100 million smartphones sold each year (and growing 25%/year), distribution through 300 carriers in over 100 countries, and the best secure mobile data platform out there, i like my chances in rim vs anyone else. iphone needs to get outside of 1 carrier in 1 country to even begin to affect BB.

and i have been doing a lot of thinking about rim, mostly that i am glad i have owned it since last year. and since i have been long aapl and goog as well, i would say you need to think about each of their businesses, get your hands dirty in their filings and financial releases to see why they are performing - and not post thoughtless remarks.

2007 Jul 17 12:52 PM

[Tom B:]

I'd sure sell before July 25th-- that's when Apple reports, right?

2007 Jul 17 01:26 PM

[Amit Chokshi_:]

You're right but the implied vol for those options is high so there's a lot more "meat" to the premium and with a stock that's run up as hard as it has recently, I felt comfortable setting up a short straddle (short time expiry too) and then subsidizing it for later dated long puts. I would not set up a naked short on this.

2007 Jul 17 01:40 PM

[Hayweed:]

While all of this is true the market does not seem to care. I reviewed the RIMM releases on sedi and noted that Basille is an accountant and yet their options backdating/low balling occured under his watch. It appears that they kept minimal records and there was no compensation committee. Everyone made a huge deal about Apple and Jobs on their backdating but from what I can read from Rimm's own reports/notes the Rimm option deal appears to be a whole lot more of a unfair deal to shareholders. Check the option adjustments they made and you will either be shocked or will laugh at the tiny change they made. I am not saying that it was illegal or wrong but the SEC made it a formal inquiry and the Rimm financials note it as a problem. If the SEC does come down hard on this one, look out below. I also note the huge amount of options that he and the co-ceo received in 2004 at what appears to be way below any price for that year.

2007 Jul 18 11:21 PM