Research In Motion: A Fair Shake?

Mar.26.12 | About: BlackBerry Ltd. (BBRY)

As aptly pointed out recently here at Seeking Alpha, Research In Motion (RIMM) has been criticized in the media for losing high-profile customers and for losing market share by a media seemingly bent on ignoring the company's large contract wins and its ongoing profitability and its solid balance sheet. Do share prices unfairly reflect a bias toward bad news? This article seeks to discuss the factors impacting the BlackBerry maker's current share price.

Markets Consist of Market Participants
Warren Buffett explained the relationship between short-term price and long-term value in his typically pithy style:

In the short term, the market is a popularity contest. In the long term, the market is a weighing machine.
Warren Buffett

This encapsulates two ideas. First, near-term share price is a result of market mechanics rather than the intrinsic qualities of the firm. In other words, in a rush of sellers at market price the stock can be pushed far below intrinsic value simply because insufficient buyers happen to be present in the market. This is true even when the sellers' motivations are unrelated to the intrinsic value of the underlying firm (e.g., a margin call brought on by completely unrelated investments, liquidity demands driven by unplanned-for debt maturity, etc.). The sheer number of buyers or sellers - that is, the popular desire to own/sell a firm - directly drives immediate-term prices. Second, near-term expectations are eventually resolved with demonstrated performance, which over time tend to cause pricing with a rational relation to intrinsic value.

Those who view Research In Motion as a sell presumably maintain an expectation that future results will be poor relative to other investment opportunities. If these market participants are large in number and wrong, this creates a fantastic buying opportunity for those who take the opposite view. Uncertainty as to what a company's future holds is a powerful force on prospective buyers. A person can be theoretically confident in either thesis, but unless their investment horizons are significantly different it is hard to imagine both could be proved right.

Casting my recollection back to the several quarters just following the dot-com burst, I recall seeing forum postings by people confident that my favorite tech company would fail. They provoked long investors by asking about the company's "cash burn rate." Look at a chart from the year 2000, and ask whether you'd invest in the company:
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The company lost 2/3 of its share value - including one day in which its share price dropped 50%. Only the worst dud would perform like this, right?

A Brief Look At Apple
The stock price graph above - the apparent loser in which you would not want to invest - is from none other than Apple Computer Inc., before it changed its name to Apple Inc. (NASDAQ:AAPL). The public saw the tech sector to be full of hot air and left the entire sector in droves, especially high-flying Apple after its embarrassing failure in the hardly sold Cube. To not sell, one had to possess one of two qualities.

First, one could possess utter ignorance of the frightful things at work around the company: its dependence on hit products, its exposure to flops, its dependence on PowerPC chips made only by Motorola (MOT) - which was less committed to the consumer machines Apple wanted to sell than to other products - its exposure to inventory risk, its exposure to volume purchasing contracts, its status as the sole vendor of a computer operating system that required developers to use a completely different set of instructions - not just at the level of the processor, but at the level of the application program interfaces on which developers depend - and its dependence on third-party developers who mostly knew that the only platform on which it was possible to make any money was sold by Microsoft (NASDAQ:MSFT), which opened 2000 with a market cap of nearly $600 Billion and was the unquestioned 800-lb gorilla of the software world. Apple, although exceeding $40 Billion before the crash, closed 2000 at about $10 Billion in market cap. Apple's own Steve Jobs had even recognized Apple had lost the desktop wars as early as 1996.

With this background, what other than obliviousness could induce an investor to remain exposed to - or even to buy more of - Apple's stock? The other possibility was an understanding of Apple's competitive strengths, and their value. Apple competed against a software system with a long history of horrible security, costly downtime from crashes, and enormous IT support overhead; users had become desperate to try a plausible alternative. Apple was in the midst of a transition to an operating system it had acquired when Apple bought NeXT, which had both the stability of Unix and the rapid application development environment of what Apple had come to call the Cocoa development environment. The improved Apple brand appealed to the user who wanted products to "just work", and Apple delivered that much better than the only other consumer operating system widely available. Apple's software development environment made possible sophisticated, slick-looking applications with development teams vastly smaller than required to produce similar products on competing systems. Apple's ownership of its operating system enabled it to keep money other hardware vendors had to send to Redmond, improving its margins at sufficiently-high volumes - an advantage that became larger and larger as its volumes grew.

In short, I bought Apple for the prospects offered by its NeXT-derived Unix operating system. It is this operating system that is now the backbone of not only its Mac line (which at present has outperformed the PC market as a whole 23 quarters in a row) but also the iPod Touch, iPhone, the iPad, and AppleTV. Apple is surely now the largest Unix vendor on the planet by volume.

Although this success has now propelled Apple to the lofty position of the most valuable company on the planet, and made its name the most valuable brand in the world, these things were neither obvious in 2000 nor likely to be priced in to the stock by a market whose participants had become keenly aware of the risks besetting the firm and little evidence where its as-yet unrealized opportunity could lead. So Apple's price crashed in 2000 and languished thereafter while the world - burned once by Apple's fickle price - ignored the firm's successes.

Is RIMM's Price Fair?
Research In Motion in 2012, like Apple in 2000, faces both opportunity and risk. Unlike Apple in 2000 - for which we have the advantage of 12 years of subsequent history - we cannot know how Research In Motion in 2012 will perform for the following 12 years. We are thrust back into the realm of expectation - of anticipation and doubt. After all, is Research In Motion enjoying unsung success in the UK, or is its recent large-scale deployment in a British insurer merely an artifact of a success that is confined to the UK? (Or evidence that the British insurer was locked into legacy Flash applications that even its maker Adobe will no longer support?) This is the sort of uncertainty that can impact market participants' decisions, and thereby the prices to which the market will press shares.

In its favor, Research In Motion is debt free. It has both an accounting profit and free cash flow. It has large institutional customers with volume subscriptions to services on which the company enjoys recurring post-sales revenue. It has significant growth in developing countries, and enjoys use by people with significant security concerns because the keys to its encrypted proprietary messaging system are unavailable except to the participants in the communication. It has great strengths in some markets; until recently, it was the #1 smartphone vendor in its home country of Canada. Demand for its products in the developing world is booming.

Research In Motion also faces risks. Its profit per share has declined from its peak in 2010, and by the time of this writing has fallen by about two thirds. Corporate Bring-Your-Own-Device programs menace institutional BlackBerry sales. A host of third-party mobile device management tools (ever heard of Air-Watch?), including not only Microsoft but also newcomer Xerox (NYSE:XRX), threaten sales of the company's device-management back-end software, despite Research In Motion changing tack to accommodate non-exclusivity in enterprise by supporting competitors' products. Research In Motion hopes to expand smartphone sales and tablets in China, whose repressive government can hardly be expected to welcome the company's secure communications and is likely to impose regulatory barriers if the technology obtains significant use. Even if the government does nothing to interfere with the company's products, it faces potent competitors: Microsoft has declared that it will lead the phone market in China, and though 16% of Apple's massive revenue comes from China, that fraction is enjoying huge growth.

Overhanging risks affect excitement to buy, and lower the threshold for investors' decision to sell. At a trailing P/E near 3, RIMM shares reflect a market that prices in quite a bit of risk.

The Importance of the Ecosystem
Research In Motion faces another risk. The utility of computers - including handheld computers - depends on the applications that are available for them. Attracting third-party developers is essential to making a platform more valuable than the software written by its manufacturer. Recently, Microsoft - which made a high-profile plea to attract WebOS developers to its own platform - suffered a blow when the developer of the #1-selling application on Windows Phone 7 announced that it would not support Microsoft's phone platform in its next software title because it wasn't sufficiently profitable. This is the inverse of the situation between Microsoft and Apple in the late 1990s, when "everybody knew" Apple's platform was dead and dedicated resources to the obvious winner, thus making Apple's platform increasingly harder to sell. The effect is no less real.

RIMM's share of the smartphone isn't yet as beaten-down as Microsoft's, but the fact that such a major player as Microsoft can find its platform abandoned by the developer of its #1 application on the basis that the platform isn't generating enough money to make sales worthwhile raises fear for everyone else competing against Apple's iOS and Google's (NASDAQ:GOOG) Android. And platforms are at war. During the long-running exchanges between Adobe (NASDAQ:ADBE) and Apple regarding the suitability of Adobe's Flash for mobile devices, firm after firm announced transition from Flash to HTML5, and Adobe's platform share plummeted. One month after Research In Motion unveiled its new BBX platform (the name of which promptly changed to BlackBerry 10) with support for Adobe Flash, Adobe itself ceased support for Flash on mobile devices. Flash, a longtime part of the web developer's arsenal of reliable development platforms, had been killed in the fastest growing market on the planet.

Will BlackBerry OS v10 do better? Unlike Flash, BBv10 doesn't depend on a vendor permitting it to run: like Apple deciding to ship Safari based on WebKit, Research in Motion can ship its development environment on every device it sells. Like Apple, it can try to get developers to write specifically for its platform using its native tools -- for the best performance, but also the least portability. It's nice if the developers are invested in the platform, right? Then again, like Microsoft's phone OS, BBv10 will have to attract and keep developers based on the financial viability of the platform. What are the metrics for third-party application purchase by BlackBerry users?

The metrics for BlackBerry app purchases will turn on the metrics for BlackBerry operating system access. Developers' programs won't run except on the operating system for which they're written, and native BBX applications will run only on devices that support BBX. BlackBerry's software update page suggests that the latest software version is 7.1. Halfway through last year, the OS update story was pretty bad for BlackBerry devices: less than 20% were using OS 6, half of users were on the prior-generation OS, and over 30% were on an operating system two versions old. Worse, most users' devices could not run the then-current operating system, leaving users who wanted modern applications with the choice to buy a new device ... which might not be a BlackBerry. Already Research In Motion has released an OS version 7, but its next-generation version ten has slipped in schedule to cost it the back-to-school season just as momentum seems to be turning against it with carriers (who've also become stingier with monthly subscription sharing). At the time of this writing, the author was unable to locate current information about the extent of the BlackBerry installed base that either runs OS v.7 or owns hardware capable of running the next version of the OS, due later this year. Has Research In Motion closed the gap with its installed base's access to modern BlackBerry applications, or not?

The good news is that Research In Motion has a successful BlackBerry application market ("App World") that has shipped 2 billion applications and offers a powerful carrot to users: 69% of applications require OS 6.0 or higher. Developers have a means to sell applications to users that appears to work, which is something one may wonder about Google's application market. But with the mobile application market so dominated by Apple, Research In Motion may be in for a lot of work attracting and retaining developers as it revolutionizes its programming environment. Even with Android's nearly half-billion applications to choose from in the Google Play (the name changed from Android Market), its store isn't the store developers bank on for revenue. Is beating Google Play in application revenue enough to keep the BlackBerry platform attractive to developers? Will BBv10 gain critical mass among consumers? Will BBv10 apps be mostly Android ports running in the run-time platform? Will the BlackBerry development environment close the gaps that frustrate developers (more than one) and offer feature parity with other platforms' developer tools? How aggressively must the BlackBerry be defended from efforts by Microsoft to take customers and developers while BBv10 is en route, and Windows 8 begins to ship?

Clearly, there is a subset of BlackBerry customers that has a current operating system and buys applications, or its App World would not be second to Apple's App Store. One might ask about the vintage of BlackBerry hardware currently in circulation and whether it will support the next operating system, but the rate at which people replace phones suggests that if a new BlackBerry device is compelling, users otherwise satisfied with their service will upgrade. And that's the question: are BlackBerry customers satisfied? Comparing anyone else's satisfaction to Apple's may be unfair, but repeated service outages may have cost Research In Motion the confidence of customers who require services on which they can depend.

If BlackBerry's platform has a future so certain, why must it give away hardware to developers? When Apple was desperate to make a success of its intended transition of its Mac line from PowerPC to Intel chips, it didn't give away hardware but rented dev boxes to developers for $999 (for 18 months). The last time anyone at Apple made any noise about possibly giving me free access to hardware, they were under the mistaken impression I was in a position to contribute kernel code. (I explained before it went too far.)

Fear Affects Price
Since the price of a company is theoretically the present value of its future cash flows, doubts about the future cash flows have a dramatic impact on price. This is not unfair, this is the market in action. This is one of the factors that can give an investor with clear vision the opportunity to make purchases at a substantial discount to intrinsic value. (Sadly, the distinction between 'clear vision' and misplaced confidence is obvious only certain with the benefit of hindsight.)

The antidote to fear is not hope - one can become outrageously overconfident and make heinous errors through untimely and excessive purchase. The antidote is reason. This article paints a cogent picture of Research In Motion as a profitable company with growing earnings that makes sensible strategic acquisitions that put valuable tech into BlackBerry products. The argument that "staying the course" doesn't mean inactivity but pursuit of a path of improvement is easy to appreciate. Unfortunately, the article has the dissatisfying twist that the BlackBerry that was to be the first to carry the technology obtained from the QNX acquisition has been cancelled and the whole BBv10 release pushed toward year-end. And the article concludes thusly:

I saw no value in RIMM when analysts were pushing it as a buy the last few years and was happy to hang on to my Apple stock and watch it grow at the expense of RIMM and others. But now that RIMM stock has plummeted I believe it is a better investment than Apple going forward. RIMM will never regain its former market share and be anything close to Apple in the smart phone market, but its growth potential I believe outweighs that of Apple. Apple's stock price will be hard-pressed to double despite their many opportunities for growth in expanding markets and globally with tablets and new innovation. RIMM on the other hand has ample opportunity to do so. It is much easier to go from a 10% market share to 15% than it is to go from 50% to 75%.
Tony Boulos

And there, the reason seems so much less convincing. The historic corporate profit has grown annually, but can the proof of future growth really be to grasp the hope that, being smaller, the company will be nimbler? And is that profit really still growing? Wolfram Alpha offers this look at the company's trailing-twelve-month performance:
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$4.26 per share was attractive last year, but what of the company's falling quarterly per-share earnings?

And why are the company's competitors doomed, again? Huge markets lay before the principal players in the smartphone space, with large populations having yet to acquire a cell phone and a major change as the majority of cell phones become smartphones. Share is not the goal, but profit. In an exploding market like cell phones in China, or the global evolution of cell phones into smartphones, why would a company with large share not experience large growth in both units and profits? Why exactly should one believe Apple (or any competitor) doomed to decelerating sales? And why is it easier to go from 10% to 15% than from 10% to 0.10%? Size does not prove growth impossible any more than smallness guarantees growth. Sometimes, size enhances competitiveness.

Reason can dispel doubt, but let's not fool ourselves: sometimes reason gives one reason to doubt.

No Overnight Cure
The article that inspired this one suggested that a number of actions on the part of management could set the stock in the right place. For example, spending $4 Billion to buy 200 million shares of Research In Motion for $20 apiece. Unfortunately, Research In Motion hasn't got $4 Billion; as of the last-reported quarter, it has under a billion and a half. Assuming the bull thesis is correct and Research In Motion will continue to grow subscribers and profits globally, why pay $20 per share when one could retire so many more shares by paying $14 or less? Warren Buffett has certainly got the right of this in his recently-published letter to shareholders in Berkshire Hathaway's (NYSE:BRK.B) 2011 Annual Report: when you own for the long-term a company that is making share repurchases, you want the stock to languish while those repurchases are made so your long-term results are better. Scaring off shorts with a big $20 bid will just reduce the long-term per-share earnings concentration otherwise available for the money.

The hypothesis that Research in Motion will "easily post $3 billion in profits in a year or two" looked much better in early 2011 than now. With quarterly earnings down over the year from $1.79 to $0.51 - and possibly still falling - one might make bets on whether in a year or two the company will still be making one billion a year. With only one model of BBv10 device apparently in the pipeline, the company won't be hitting numerous price points to scavenge the most possible profit from potential customers. With a major software revision in the works, the BlackBerry maker's App World may be fractured into segments based on mutually incompatible operating system versions. If this problem is "solved" through emulation layers, will customers get the experience the company wants them to get from the new OS?

And will the company do what its customers with mission-critical services do, and implement a comprehensive disaster recovery solution that prevents customer outages? If not, will it instead concentrate on the consumer market where loss of an IM client or a delayed voicemail is less likely to be an emergency? Do consumers willingly tolerate unreliable service, either?

Conclusion
Both Apple and Research In Motion face uncertainty from Microsoft's Windows 8 phones and tablets, and from Google's continuously-developing Android environment and application market. The question for investors is harsh but simple: for a given investment available for a company in this sector, which if any is likeliest to outcompete the alternatives? To understand that with depth, unfortunately, requires enormous dedication to numerous technologies and business strategies in use by the numerous parties involved in making each of the competing products a success. The question is simple, but the answer decidedly complex. A case can be made for many answers. Which to believe is the investor's problem.

The question addressed in this article isn't whether the media distorts the news on Research In Motion, but whether the price of the stock is unfair as a result of what is reported. The media, of course, distorts virtually everything: publishers typically make their real money from advertisements, making entertainment a high-margin business, whereas the truth is expensive to obtain, difficult to perceive, murderous to convey, and often uninteresting to read. It is in this world of distortions that markets price everything from grapes to gasoline.

A company with several quarters of consistently negative earnings growth might fairly be priced with a trailing P/E of 3 or worse, but if it is on the cusp of a major turnaround the time may be a fantastic to buy. In order to risk funds in either direction, investors must ascertain whether Research In Motion in 2012 is approaching the position of Apple in 1997 or that of Sun Microsystems in 2003. If the decision feels challenging, another investment may seem more attractive; a buyer may simply pass.

The question for those who do invest is whether Research In Motion is misspriced - and if so, in which direction.

Disclosure: I am long AAPL, BRK.B. The author has been short RIMM as a consequence of entering a long/short position of AAPL/RIMM while the article Apple: The Long and the Short Of It was pending. This short position is subject to being partially or fully closed on or before the next options expiration date by virtue of put options that, if exercised by their holders, would close the short position at $14.