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Private investor. Former equity analyst at alternative investment manager.
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  • Blackberry: The Stars Are Aligning

    Article text goes here...

    Blackberry has become one of the more controversial companies among the financial media. While the prognosticators called for Blackberry's death 9 months ago, substantial progress has taken place since then that has refuted all doomsday predictions thus far. Blackberry was predicted not to make it to launch (and even if they did make it), they were said to have made it with very little cash in the bank to invest in working capital and marketing. We now know the company made it to launch with over $2.9 billion of cash, zero debt and has substantial ability to invest in both working capital and aggressive marketing. Very little meaningful information can be gleaned on the progress of the company from watching media pundits and hanging around chat boards. However, an incredible amount of valuable information can be gleaned by combing through the company's filings, conference call transcripts and closely examining the history and accuracy of analyst predictions (not to mention visiting stores oneself).

    I will avoid all discussion of the most generic bear arguments that are floating around. Namely, that there are not enough 'apps', that people are too embedded with iOS and/or Android, that gestures are too 'complicated', that people cannot live without a home button, there are no lineups on launch day, etc. Instead, I will focus on a few areas that are never discussed in the media because they require more analysis than simply wondering how the z10 sold on any given day. I believe Blackberry is firmly set up to exceed expectations for the bulk of FY2014 (beginning March 3, 2013) for the following reasons: 1) Sell-thru of Blackberry devices has been much greater than sell-in by Blackberry over each of the last 4 quarters, severely obfuscating the financial results. 2) Blackberry was profitable on a cash basis in the previous quarter (Q3 2013) selling very dated products. 3) CORE program has taken meaningful costs out of the business. 4) Blackberry will be less capital intensive going forward. 5) BES 10 could be a homerun. Finally, I look at what a pro-forma Q could look like.

    First Point - Sell-thru of Blackberry devices has been much greater than sell-in over each of the last 4 quarters.

    The chart below depicts the sell-in vs. sell-thru over each of the last 4 quarters:

     

    Blackberry

    Blackberry

    Surplus

     

    Shipments (NYSE:MM)

    Purchases (MM)

    (Drawdown)

    Q4 2012

    11.1

    13.6

    (2.5)

    Q1 2013

    7.8

    10.5

    (2.7)

    Q2 2013

    7.4

    10.4

    (3.0)

    Q3 2013

    6.9

    8.4

    (1.5)

    LTM

    33.2

    42.9

    (9.7)

    The column on the left shows the actual shipments data and is what is reported in their quarterly financial results. The column in the middle shows end-market purchases, which is the more relevant point for understanding true end-market demand. Blackberry has effectively been draining channel inventory over the last 4 quarters, by almost 10 million units. Given that normal channel inventory was in the 10-12 million unit level, it is fair to say Blackberry exited Q3 with almost no channel inventory. This is clearly unsustainable and also somewhat normal when transitioning to a new platform (turn inventory into cash to invest in new platform). Beginning very soon (possibly Q1), Blackberry will being doing the opposite of what this chart shows…namely, selling more units into the channel than are purchased to both satisfy end market demand and to rebuild the channels globally. This won't happen overnight but it will be a tailwind for the bulk of FY2014 and is not captured properly by analysts and not even talked about in the media. I believe Blackberry could be shipping north of 10mm total units in the May and November quarters. Most analysts are modelling in the 7mm unit range. I believe 10mm is conservative given its not far off current end market demand with a very aged platform, not to mention need to re-fill channels. The z10 has only launched with ~50 carriers thus far. Will get to 150 carriers by April and then the Q10 will start shipping in late April. When considering how to model a product refresh cycle, I always factor in true end-market purchases plus some level of channel inventory re-fills. Blackberry shipment figures (over last 4 Qs) are almost meaningless. I expect Q4 numbers to be similar to Q3 for units so would expect that Blackberry shipped approx. 28 million units for the fiscal year but there were closer to 37 million units purchased. The street is only modelling 30-33 million units for the next fiscal year which seems very low considering a new platform with fresh products.

    Second Point - Blackberry was profitable on a cash basis in Q3.

    Despite all the noise about cash burn, losses etc., Blackberry has effectively stabilized already from my perspective. Looking at the Q3 financials released last December, Blackberry reported revenues of $2.7Bn, gross margin of $830mm and a loss from continuing operations of $212mm. However, it is worth noting that there was approximately $530mm of non-cash amortization that flowed through the P&L that Q, a figure I believe is abnormally high and will come down. More importantly, only $180mm shows up as amortization on the P&L, the other $343mm flows through cost of sales which severely obfuscates the gross margins in my view. (This breakdown is only available in the 10K's, not the 10Q's). On an EBITDA basis, Blackberry generated close to +$300 million, which isn't bad given end of product cycle, lower margins sales etc…This is part of the reason you continue to see Blackberry generated cash despite showing accounting losses. Q4 numbers will probably show something similar - a slight accounting operating loss, but positive ebitda of $400mm+.

    Third Point - CORE Program

    When was the last time you heard CNBC talk about Blackberry's CORE program? That's what I thought. However, it's probably more important than anything mentioned on the show. Blackberry announced last Q that they have already cut $1 billion out of the system which consisted of major layoffs and streamlining within the organization and supply chain, and efficiencies in capital spending, etc. This is important because I now think of Blackberry having cash opex below the gross margin line of approx. $800-$850mm per quarter. This helps me formulate what I need to believe for them to drive profitability. With still $800mm plus of gross margin from the services and software business, it doesn't take much from the hardware biz to move them into nice profitability. Make an average of $60-75/device (average of high and low end products) per quarter and circa 8-9mm units and you get an extra $450-$600mm in gross profits. This will more than help offset a gradual decline in service revenues. The main takeaway here is that the company has right-sized the business to deal with some of the service revenue pressures. The bears like to talk about the declining service revenues but never discuss the $1 billion of take-out on the cost side.

    Fourth Point - Blackberry will be much less capital intensive going forward

    One of the more subtle areas where costs ballooned at Blackberry was in fixed asset and intangible investments. The chart below highlights the trend:

    Amortization ($MM)

    2010

    2011

    2012

    2013Q1

    2013Q2

    2013Q3

    COGS

     

    489

    952

    304

    337

    343

    PPE

     

    438

    571

    176

    184

    180

    Total Amortization

    616

    927

    1523

    480

    521

    523

    Total amortization has ballooned from $616 million in 2010 to $1.5Bn in 2012 and is on track to exceed $2.1Bn in FY 2013. I've separated the amortization between COGS (Cost of Sales) and PPE (fixed assets), which is important because you can't see the full amortization amount on the P&L, as it is 'hidden' in COGS. Why is this important? Well, if you look at 2011, only $489 million of amortization was in COGS as an expense. This year, it will be closer to $1.3Bn. That's a swing of over $800mm which is a lot on a share count of 524mm. Even though it's 'non-cash', it's an expense on the P&L and depresses gross margins and earnings. You see this added back on the cash flow statement and is one of the reasons you still see a high cash flow from operations despite low reported earnings. Blackberry has very unusually high amortization today because of huge intangible purchases in FY2012 and Capex north of $1Bn. I believe both of those numbers will change dramatically. Blackberry spent $2.2Bn on intangibles in 2012 vs. just $557mm and $421mm in 2011 and 2010, respectively. A large chunk of this was their share in the Nortel patents costing $775mm, but there were others. It's important for two reasons: 1) huge cash outlay 2) intangibles get amortized quickly so this is why you see such a huge increase. I don't see them spending anywhere near this going forward. In fact, the CFO said in a conference call that prepaid licensing agreements are roughly $225mm per quarter or close to $1Bn/year. I expect that to be the norm, not $2.2bn. Capital expenditures will also come down a lot. CFO also claimed quarterly Capex in the $75mm level, or $300-$350mm per year, down significantly from the $1bn/yr. over the last couple years. I think both of these will have a big impact on earnings in a couple Q's. Once intangible and capex spending normalizes to $1.5bn/yr. level from the $3.2Bn outlay in 2012, you will see a similar drop in amortization expense from the $2.1bn level back down to $1.2-$1.4bn level….a big boost to reported eps and a huge cash savings.

    Fifth Point - BES 10 could be a homerun

    The Blackberry Enterprise Service 10, or "BES 10" is also rarely talked about but could be a source of significant upside simply by allaying fears on the service revenue side. The BES 10 product will be the enterprise platform for the Blackberry 10 platform of products but will also have the capability of managing third party Android and iOS devices. Blackberry has announced functionality that will provide a workspace on an iPhone device and access to the Blackberry infrastructure. Something similar will be available for Android. This is huge because Blackberry servers are still in 90% of the fortune 500 and gov'ts to manage blackberry devices. If they can get upgrades to BES 10 and collect monthly service revenue from iOS and Android devices within enterprises as well, it could be tremendously lucrative. I know a lot of people that would love to have blackberry email and security on their iPhones. It's still very early to tell and the fully baked product won't be available until June, but the progress seems good. 1600 organizations had downloaded free software as of Feb 5th, with that number having jumped to 4200 in early March. If the progress continues and they get a decent conversion, there is major upside. None of the analysts are modelling any success here.

    What could a Pro-Forma Blackberry Q look like?

    Using fairly conservative assumptions, a pro-forma Blackberry Q looks reasonably attractive. A blend of higher margin Q and Z10 products with lower margin mid and low tier products with a reduced service gross margin profile. While one can always question assumptions, I don't believe these are aggressive once the full portfolio is rolled out.

    Pro-Forma Scenario

       

    Revenues

     

    Units (MM)

    ASP$

    ($MM)

    Blackberry 10 (Z&Q)

    3.5

    525

    1,838

    Blackberry 10 (Mid to Low)

    6.0

    275

    1,650

    Total

       

    3,488

         

    Gross Margin

       

    BB 10 (Z&Q)

     

    3.5

    150

    525

    BB7 & Below

    6.0

    40

    240

    Total

       

    765

         

    Service

       

    614

         

    Other

       

    50

         

    Total GM

       

    1,429

         

    OPEX

        

    R&D

       

    350

    SG&A

       

    500

    Amort

       

    180

    Total

       

    1,030

         

    Op Inc./(loss)

      

    399

         

    Taxes - 25%

       

    100

         

    EAT

       

    299

         

    EPS (Quarterly)

       

    $0.57

         

    EPS (Annual Basis)

       

    $2.28

    Summary

    There are lots of reasons to be positive on Blackberry. These only represent some of the points that don't get a lot of discussion. I've defected from the iPhone 4S to the Z10. I'm impressed with the new products and the new management team. The stars seem to be aligning for Blackberry. Even some of the bearish analysts have turned, but there are many more to come.

    Disclosure: I am long BBRY.

    Tags: BBRY
    Mar 24 11:26 PM | Link | 7 Comments
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