Research in Motion (RIMM), the maker of Blackberry phones, has come to be a true "fallen angel" over the last year, with the stock dropping by 78% over the same period. The company's market share in the smart phone market has declined from 14.4% last year to 8.3% this year. Well-capitalized and innovative competitors Apple (AAPL) and Samsung (OTC:SSNLF) have out-innovated, and out-marketed the former industry leader. This type of leadership change is not uncommon in this rapidly changing consumer technology industry, which is why we require a large margin of safety to even get interested.
At TTCM, our strategy on RIMM is not based on predicting who will win market share over the next year, but is instead focused on the value that we are receiving for the price that we are willing to pay. To make the investment even safer we will utilize a simple options strategy to take advantage of the inherent volatility present in the market's perception of RIMM's prospects.
At $13.66, RIMM's market cap is about $7 Billion, and its enterprise value is approximately $6 Billion when you net out its $1 Billion net cash position. In the last 12 months, the company has generated $2.2 Billion of earnings and $4.33 Billion of EBITDA. This equates to an EV/EBITDA of 1.61, which is more in line with a highly leveraged print-only newspaper company, as opposed to a profitable franchise that still has a strong position particularly in the Enterprise and Government markets. RIMM's tangible book value is $7 Billion and its return on invested capital over the last 12 months is 24%. It is also important to note that RIMM has also invested in excess of $2.8 Billion in R&D over the last two years, which has weighed on earnings.
We believe that there are three primary possibilities to make money off RIMM at the current price. The first would be if it was bought out by a larger company such as a Microsoft (MSFT) or a Google (GOOG). Price is what you pay and value is what you get, and at this price RIMM would offer compelling value to increase market share, and to offer additional patent protection in the Patent War that we are seeing in this space. This could be the kind of transformational acquisition that Microsoft has been looking for; the benefit is that as opposed to paying up for the company, as it has in so many completed and attempted acquisitions, it will get a profitable franchise at a bargain price.
The second way to win with RIMM, when bought at these levels, is if it regains its footing and if the BB10, which is due out towards the end of this year, is truly the salvation that their new CEO Thorsten Heins believes it will be when he said it would be the "transformation of the Blackberry for the next decade."
RIMM is actually a lot stronger company at this stage in the game than Apple was a decade ago, and while I don't think the odds of it obtaining half the success that Apple has had in the last decade are very good, there is room in the smartphone market for more than just two competitors. RIMM has 75 million users, up 35% from last year and over 50% of revenue comes from outside the United States. If it can continue to stay relevant while the BB10 is being completed, and if that product line resonates, RIMM could potentially win back market share, and the investment could possibly be a 10-bagger over time.
The third way that we can win is through the monetization of RIMM's patents, and through the realization of the company's free cash flow stream. Not too long ago, RIMM acquired some patents from Nortel out of bankruptcy for $700MM. When you combine these patents with RIMM's other patent portfolio, the value is estimated to be between $1.5-$3.0 Billion. Due to the heavy stream of lawsuits involving Apple, Samsung, and Google among others, these patents have many potential suitors.
Assuming the company can obtain $2 Billion from a sale of the patents, and when we add its $1 Billion net cash position, we are really obtaining RIMM's future free cash flow stream for about $3 Billion. As stated before, RIMM generated $2.2 Billion of income and $4.3 Billion in EBITDA over the last year, so even if earnings were to decline by 50% this year, we would be buying the company for about 3 times earnings. This doesn't even include the $1.5 Billion in R&D spend over the last year which could be decreased if it isn't paying off in this type of worst-case scenario.
This 33% earnings yield is too attractive, given the company's strong opportunity to continue to generate free cash flow. The market's realization of the inherent value that the company possesses in terms of patents, balance sheet strength, and free cash flows will likely lead to reasonable share price appreciation from this level.
To make the investment even safer, you might employ a simple options strategy:
Buy 100 RIMM @ $13.66
Sell 1 January 2013 RIMM $13 put for $2.40 (299 days out)
Sell 1 January 2013 RIMM $17.50 call for $1.50 (299 days out)
Using this strategy, which we simply call "The Hybrid Strategy", you are left with three possibilities assuming you hold the options till expiration.
1) If RIMM expires above $17.50 in January of next year, you will make $384 on the stock appreciating, plus the $390 from the option premiums collected, resulting in a gain of $774 in 299 days. Your stock would be sold because your call will be exercised and your percentage gain would be 34% on your maximum risk of $2,276. The maximum risk is calculated by taking your breakeven price on the worst-case scenario of being exercised on your put, and owning 200 shares at a breakeven price of $11.38.
2) The worst case scenario is that RIMM will expire below $13 at expiration in January. If this were to happen your put would be exercised, your call would expire worthless thereby reducing your cost basis, and you would end up owning 200 shares of RIMM at a cost basis of $11.38. From there, you would have all of the upside or downside on the stock, but the obvious benefit is that you are buying the stock at a 17% discount to the price that you could buy it at today.
3) If RIMM's price at expiration is between $13 and $17.50, both of your options would expire worthless and you'd keep your stock. This would result in a 17% profit on the maximum risk of $2,276 in 299 days, plus or minus any gains or losses on the 100 shares of stock from $13.66. You'll still own your 100 shares and if you wanted to repeat the process next year you could.