Paul Zimbardo's  Instablog

In the two years that I have followed Research in Motion (RIMM), there have been three consistencies: high revenue growth, extreme stock price volatility, and unrealistic analyst expectations. In those two years, I have remained bullish overall; however, I have moved in-and-out of the stock repeatedly and I believe that the market is giving investors a gift with RIMM’s current valuation.

To recap RIMM’s most recent quarter, second quarter EPS beat expectations by $.03 however revenue increased only 37% when the market was expecting 40%. As a result, shares plummeted approximately 25% in a matter of days. Seeing these tremendous expectations, I bought puts on RIMM and profited handsomely. Unlike many of its peers, RIMM increased its top line dramatically and was highly profitable but it merely failed to grow fast enough to match its inflated stock price. Was RIMM worth $88 in September? No. Is RIMM worth only $65 today? Unlikely.

Long term investors who can weather the volatility are presented with a tremendous opportunity to buy RIMM. Whenever one discusses RIMM, it is inevitable that the analysis must address Apple (AAPL). I currently own Apple as well as RIMM; however, I find RIMM to be more attractive at its current valuation. Whereas AAPL is trading at a PE of 32.44, RIMM has a PE of 18.54. I must caution that RIMM trades at a significant premium to FCF: 83.65% versus 20.51. The intent of this article is not to debate which is a better investment but I felt it was necessary to at least proactively mention this. There are no rules that you cannot own both Apple and RIMM!

Now that I have laid the framework, I will present the support for my valuation. Based upon RIMM’s compound earnings growth rates over the last five, three, and single-year periods, I forecasted growth rates for the next five years. I began with what I felt to be conservative growth rates, and then I slashed them all by five percent per year to enhance the margin of safety. Utilizing the average growth rates for the three and five year periods, I utilized a DCF analysis assuming an 11% discount rate. This benchmark may be high in light of the current environment but again, I prefer to strengthen the margin of safety. Lastly, I took the intermediate and long-term valuations and I weighted the lower of the two more to once again be conservative (notice a theme?). As a result, I computed an 18-month price target for RIMM of $76.44, which is an approximate 14% discount to RIMM’s current price of $65.77. The calculations are summarized below:

Now I am sure you are wondering what to do with this wealth of information presented above. Despite believing that RIMM is decently undervalued, I do not believe that it will appreciate significantly in the short-term. The market is highly volatile and your guess is as good as mine what will happen on a daily basis. What I believe makes RIMM extremely attractive right now is the value of the put options. I have highlighted four different put options that you can invest in depending on your risk tolerance.

First, if you are new to put options, a fellow contributor, Mr. Hickey has done a tremendous job in explaining how to use put options. Here is one of his articles that I suggest as a starting point.

Naturally there is also a wealth of information available on the topic elsewhere on the Internet. I have personally sold the November 65 puts last week for $1.90. If they expire worthless I earn $180 after commission for approximately 35 days worth of exposure. This requires that I set aside $6,500 so my return is 2.77% over the time period, or almost 30% on an annualized basis! If I am called away, I get to keep the $180 and buy RIMM at an attractive price. This then presents the opportunity to sell covered calls but that is a whole different topic! RIMM fell in price late in the week so now you can sell these options for even higher prices than I did. In sum, the choice of which put to sell is yours, or perhaps you prefer to just buy RIMM outright, but based upon the above analysis, I believe that Research in Motion is a superb long-term investment. Regardless of your strategy, go out and put RIMM in play!

Sources: Motley Fool, Reuters, Seeking Alpha, TDAmeritrade, and Yahoo Finance

Disclosures: I am long AAPL and RIMM. I am short RIMM Nov. 65 Puts.

Who doesn’t enjoy receiving free stuff? I know that I like the occasional “freebie” whether it is a taste of Starbucks’ (SBUX) newest flavor or merely checking my free Yahoo Mail (YHOO). Free is a powerful word. I am sure that many of you started to read the story just because the word “free” is in the title (actually it is there twice, but whose counting?) and were intrigued with possible thoughts that I might be giving away something for free! I will begin by apologizing because I have no free goods to offer. What is even better than receiving free products and services? Investing in companies that can actually profit from these business models. When a company is able to at least partially remove price from the equation, you have a fierce competitor, and one that I would consider adding to my portfolio. Hopefully I have been able to keep your attention.

After reading Free: The Future of a Radical Price by Chris Anderson, I am hard pressed to think of companies that do not participate in the “free economy” in some way. Companies that operate predominately in the digital realm are involved in free to a greater extent than those in the traditional brick-and-mortar world but exceptions do exist. The time I spent reading this book invaluably enhanced my understanding of the business models of numerous companies; therefore, it would be to your advantage to invest some time in reading this book. Fortunately this book is a delight to read and Mr. Anderson’s writing style is simultaneously vibrant and informative. You can put your fears to rest as you do not need to be either a tech geek or a financial scholar to understand this book. While the ideas presented are not truly as radical as the title proclaims (at least to those under twenty-five), they are still certainly worth your time. To provide an early example, if you are one of those investors who wonders not only how Google (GOOG) is able to stay in business, but how it generated over $20B in revenue in 2008, this is a must-read.

You may know Mr. Chris Anderson from his articles here on Seeking Alpha, from his work at WiReD magazine, or from his first book, The Long Tail. His most recent book Free goes into detail of companies that employ various free business models to different degrees. Mr. Anderson divides free into the following six categories: “Freemium” (giving away a basic product to spur sales of a premium version of the product), Advertising, Cross-Subsidies, Zero-Marginal Cost, Labor Exchange, and The Gift Economy. Some of these categories may be obvious (advertising) but for a primer on these categories, and the book in general, please check out an article from early 2008 by Mr. Anderson. These broad categories are further refined in the book.

These concepts are especially relevant given the current economic malaise. As consumers are becoming more reluctant to spend, why not invest in companies that profit from giving away products/services for free? In brief, you need to understand “how free works” to invest in companies that operate at least partially in the free space. The degrees of “free-dom” are different for different companies: for example, Wal-Mart’s (WMT) free is on a much smaller scale than competitor Costco’s (COST). Will understanding how companies that you invest in utilize free improve your investing decisions? Yes. Will learning more about business models and the strategies employed give you an advantage on other investors? Yes. Will reading this book substitute for fundamental research? No.

For investors trying to learn about how the free business model, many portions of the book are not directly relevant (although interesting tangents) and can be quickly skimmed. For example, Mr. Anderson goes into detail about the origins of the word “free”, the learning curve, the origins of the radio industry, and other concepts. These are appealing background sections for leisure readers but are not necessary if you are short on time. Also, these are some of the more technology heavy sections of the book that may require more background knowledge than the book as a whole.

I would be remiss to conclude this article without mentioning the controversy surrounding the book. It was discovered that Mr. Anderson quoted portions of this book from Wikipedia without proper citations. These omissions are addressed by Mr. Anderson on his blog. Regardless of your opinion on this issue, it does not take away from the valuable insights provided by the book.

Free is available at Amazon and Barnes & Nobles. In addition, the book is available as an audio book online via WiReD or iTunes for the low, low price of Free! There are also various excerpts available via Google Books.

Now that you understand why reading (or listening) to Free can help your investing, I have compiled a list of companies that operate to some extent in the free economy. The vast majority of the examples listed below come from Mr. Anderson’s book but I have supplemented it with personal examples of other publically traded companies. This is by no means an exhaustive list but this should serve as a representative starting point. With Mr. Anderson’s assistance, I narrowed down the company index considerably. The index below focuses on companies that uses free as a significant competitive advantage over peers. Given the economic climate, companies that implement free more than its competitors may be in a position to generate excess returns.

Company Index:

American Express (AXP) – Reward points/cash back

Amazon (AMZN) – Shipping, Zappos

Apple (AAPL) – Apple Store classes, free iTunes singles and applications

Coach (COH) and other luxury retails – Impact of knock-off, black-market products

Comcast (CMCSA) – DVR

Costco (COST) – In-store free product samples

eBay (EBAY) – Skype

General Electric (GE) – NBC and Hulu

Google (GOOG) – YouTube, search engine, Google Docs, Gmail, Google Maps, etc.

McDonalds (MCD) – Free products, sample days (Mocca Mondays recently)

Microsoft (MSFT) – Bing search, Facebook investment, free content on Xbox Live

New York Times (NYT) – Online paper

News Corporation (NWS) – Wall Street Journal (partially)

Ryanair (RYAAY) – Air travel

SIRIUS XM Radio (SIRI) – Free radio with subscription

Starbucks (SBUX) – Free WIFI, in-store free product samples, iTune songs of the week

Yahoo! (YHOO) – Flikr, search engine, Yahoo! Mail, etc.

Investors are increasingly turning to dividend stocks as the financial collapse of the past year has made many investors more risk-averse. Even in light of the recent positive economic indicators and corporate earnings, there is still significant uncertainty surrounding the direction of the stock market. For the stockholder, investment returns come from two portions: capital gains and dividends. In today’s business environment capital gains, even for financially sound companies, are far from certain while dividends from such companies are more assured and recur with frequency (usually quarterly). This knowledge may lead investors to merely run a stock screener to invest in those stocks paying the highest dividend yield and sleep well picturing the relentless flow of dividend checks filling the mailbox. If only it were that easy.

Garmin Ltd. (GRMN) is a company that specializes in global positioning systems (“GPS”) technology, specifically stand-alone GPS receivers for automobiles. In fact, Garmin is so synonymous with GPS technology that Garmin is the first result on Google (GOOG) when searching for “GPS”. After appreciating from the single digits in 2002 to reaching its all-time high of 125.68 in late October 2007, Garmin stockholders have watched Garmin’s share price plummet to 14.40 before stabilizing in the low twenties. In 2009, Garmin is down 45.0% whereas the S&P500 is down “only” 26.6%. This previous high-flier has certainly fallen out of favor on Wall Street but was this just a case of heightened expectations crashing down as the economy weakened, or were there fundamental problems behind the decline? Also, were there any signals that could have alerted investors that Garmin’s stock price in October 2007 was unjustified?

AT&T (T) presents an above-average opportunity for at least the second half of 2009 because of its continued growth prospects with the reduced price iPhone/iPhone 3GS, attractive valuation, and remarkable yield. These characteristics outweigh my fears related to the uncertainty surrounding the Department of Justice probes and risks that AT&T will lose its exclusive contract with Apple (AAPL)for future iPhones to Verizon (VZ)or another competitor. Fundamentally this is a sound company that just happens to be surrounded by a lot of market noise.

The iPhone growth story has been written and reported ad nauseam so I will keep this brief: the iPhone trumps the competition. RIMM is a great company with a strong business (and growing consumer) presence but it lacks the breadth of apps or ease of use to really compete with the iPhone. Palm’s (PALM) Pre is the talk of the town but it will have severe difficulty breaching Apple’s walled garden or being able to reach critical mass with consumers. There is little debate that the iPhone has been anointed as the de-facto popular smart phone right now so investors may as well enjoy the ride similar to MOT (MOT) during the Razor craze (take note of MOT’s chart before, during, and after the Razor era for a warning tale).

In terms of valuation, with a trailing PE of less than 12 and forward PE of less than 11, I believe that AT&T’s growth is being underestimated. Despite sales being relatively flat TTM and the economy still uncertain, I cannot fathom T’s EPS growth falling by half as some analysts predict. While the liquidity ratios are lower than I usually like for stocks I recommend (.5 quick and .6 current), they are in-line with the industry averages: with a market cap well in excess of $100B, this should not even be an issue.

The return on assets and on investment are both greater than the industry averages (4.8 and 7.8 versus 4.1 and 7.3, respectively) indicating management effectiveness yet the company is trading at a twenty-five basis point discount of price-to-book. The only additional thing that I would like to see management do is repurchase some shares but with the yield, I cannot complain.

The dividend yield in excess of 6.7% is robust and appears safe, although the payout ratio over 75 is entering the danger zone. Given the fact that cash from continuing operations alone is virtually high enough to cover all other cash obligations, you have a certified cash cow; however, I do not envision T raising its dividend much (if at all) in the future. The yield is already significantly higher than historic averages and I anticipate capital expenditures to ramp up as T continued to develop/expand its network to keep pace with the iPhone traffic.

In closing, I do not believe that the DoJ inquires will have a material impact on AT&T, although I do see the elevated uncertainty slowing its stock price appreciation in the coming months (but, hey, that’s what the meaty yield is for!). These type of exclusive agreements are nothing new and have existed for entertainment software (read: videogames) since the birth of the industry. With the economy in such poor shape and talk of a second stimulus, I hardly think investigating the telecom industry and luxury phone contracts will become a priority. AT&T should be able to keep its exclusivity with Apple because AT&T needs Apple and is far more willing to subsidize its phones than other carriers would be. Now that AT&T has eaten from Apple’s growth tree, I do not see them giving that growth up very easily. At the very worst, AT&T has lots of new subscribers locked-in with two-year contracts that should lessen the blow of potentially losing the exclusive contact.