RIM: Recent Rally Has Eroded Margin Of Safety Significantly

| About: BlackBerry Ltd. (BBRY)

In March of this year we profiled Research in Motion (RIMM) and with just over a month to go before the release of Blackberry 10, we thought it would be worthwhile to update our rationale. To summarize our earlier investment thesis, we believe that there are three primary ways that an investment in RIMM can be successful. The first way would be if the company was bought out by a well-capitalized company such as Microsoft (NASDAQ:MSFT) or Facebook (NASDAQ:FB) that has the financial resources to aggressively market and promote RIMM's innovative BB10 platform. The second way that RIMM could win would be if the BB10 introduction is enormously successful allowing the company to win market share. We believe that it is very possible that RIMM can win market share, particularly in emerging markets where it maintains a strong presence despite weaker margins. The third way that RIMM can be attractive as an investment at current prices would be through the monetization of its patent portfolio and cash, in combination with stable free cash flow generation from the operating business. This would take some time to play out but if the company attains a reasonable amount of success so that the company doesn't drain cash, the current price is so pessimistic that it might allow investors to eke out a slight gain, or at least not lose too much.

RIMM clearly made a huge blunder by having such an enormous amount of time lapse from the time BB7 was introduced, to the late January introduction of BB10. This forced the company to kill its margins in an effort to cut down on inventory and maintain stability in its user base. This strategy was mostly successful outside of the United States, particularly in emerging markets where texting is very big, and browsing online is still developing. One of BB10's greatest innovations seems to be the improved browser functionality, which will be critical to the company's success in winning back former customers. During this time Apple (NASDAQ:AAPL) and Google's (NASDAQ:GOOG) iOS and Android platforms emerged as truly dominant platforms, garnering an enormous market share. While many people might believe that this duopoly is bullet proof I would tend to disagree.

First of all there are very few switching costs to changing operating systems on the mobile phone. Most apps are free and the paid ones aren't very expensive. App developers are increasingly able to introduce the apps on multiple platforms, and it seems that many of the key developers are willing to work with both Windows and Blackberry in this regard. I personally use a Motorola Droid RAZR MAXX and I can tell you that although I love the large screen, there is nothing that I couldn't replace at very little cost. Now I'm not trying to extrapolate my user experience to all users, but the mobile operating system at this point is not nearly as ingrained into users' everyday lives as Windows is to the PC for instance. Obviously Apple has an amazing fan club and has posted one of the greatest decades of innovation in U.S. business history, but I do believe that smartphones and tablets are becoming more and more commoditized markets at an amazingly rapid pace. Examples of this are in the similarities between the hardware of Samsung, Apple, HTC and other developers. The full impact of this shift hasn't hit gross margins to the extent that it will in the future, but the history of technology hardware is littered with similar experiences and I see no reason why this would be different. I also believe that service providers such as AT&T (NYSE:T) and Verizon (NYSE:VZ) have a lot of incentive to promote non-Apple operating systems because of the large subsidies that the companies have had to pay on customer iPhone purchases. The first-mover advantage AT&T had is obviously gone so the iPhone has really become a zero sum game at this point, as the increased data usage that came with it is now par for the course on all smartphones.

RIMM will be facing these same headwinds in terms of gross margins on hardware, but the uniqueness of the BB10 platform is based on its core security and application management functionalities. If RIMM can win a reasonable market share, then eventually the service fees from the BB10 will be a key source of overall profitability for the firm. I'd expect gross margins on devices to be lower than they were in previous iterations of Blackberry phones because of the changing industry dynamics, and the decline in bargaining power with service providers due to RIMM's lost market share. RIMM sold off after-hours on Thursday largely because of ambiguous but alarming statements pertaining to service fees. It sounds like as the shift to BB10 occurs, service contracts will have different menu offerings, and the most basic and popular service contracts for consumers and smaller companies will now generate very little revenue for RIMM. Larger enterprises that require more security, mobile device and application management functions will have the more expensive plans obviously, but in combination with declining gross margins on the headsets, any loss of the profitable servicing revenue could result in greater losses and cash drain depending on the severity of the decline. While it is a tremendous positive that 150 carriers have begun their lab entry process with BB 10, I believe that the company has had to reduce the fees it charges due to weakening in its competitive position. Ultimately the long-term service fee revenue will largely be based on the adoption rates of the BB10 platform, and the integration progression into the more advanced service offerings.

Thus far in 2012, RIMM has done a good job protecting its strong cash position. This was accomplished through a $1 billion expense cutting effort, which was achieved one quarter earlier than expected, inventory drawdowns and margin-sacrificing sales to maintain the user base. Evidence of these efforts is the fact that the user base at the end of Q3 was approximately 79MM, which was down slightly from the 2nd quarter but up about 2MM from the beginning of the fiscal year. North America was the biggest source of declines in terms of users, but there is significant potential to pick up market share from a much lower starting point in the region. It is pretty amazing that the company even did this well when you consider the high level of innovation that has occurred in the smartphone market since the BB7 introduction several years back.

RIMM ended the 3rd quarter with $6.3 billion of current assets versus $2.863 billion of current liabilities. Only $785MM of those assets are inventory so the prospects of a large inventory related write-down seem quite low. RIMM has $2.612 billion in PP&E, $278MM in long-term investments and $3.272 billion in intangible assets. While normally I am very skeptical about intangible assets, much of RIMM's are associated with valuable patents, which are in high demand in this competitive smartphone market. I believe the patent value could be anywhere between $1.5 billion to $3 billion in a liquidation. Those long-term assets are contrasted against only $228MM of long-term liabilities pertaining to taxes. Shareholder equity was $9.342 billion as of December 1st and cash and investments were $2.938 billion, while there were 524,852MM shares outstanding. Book value was about $17.80 per share while net cash per share was $5.60. Valuing the intangibles at $1.5 billion would add $2.85 per share to the cash value, and a $3 billion patent valuation would increase the value to $5.70 per share. Obviously a write-down of the intangible assets to anything below $3.272 billion would reduce book value, but the monetization of the assets would reduce uncertainty and enhance the financial cushion. While these net asset values provide some cushion for RIMM allowing the company to survive these short-term difficulties, the ultimate value of the business will be defined by the success of the BB10 platform.

I'm not going to focus too much on the recent earnings report other than to say the company is treading water, and now represents a call option on the BB10 platform. I made the case before that Microsoft would have been well served to buy RIMM when the company had a $5 billion market capitalization. I believe that the acquisition would be a cheap way to remove a competing operating system, and that it would be possible to team up to win market share in the Enterprise. I also made the case that corporate IT departments would be more likely to embrace the BB10 platform if they knew a financial fortress of a company such as Microsoft would leverage its balance sheet into supporting the combined entity's offerings. This possibility looks to be quite remote over the short-term and obviously presents numerous integration risks and issues. It is very unclear if BB10, Windows or neither system will emerge as a 3rd viable mobile operating system. I'm starting to think that Facebook might be a more realistic acquirer and I believe Mark Zuckerberg would be smart to use his inflated stock instead of cash to pull it off.

At this point I believe RIMM is an extremely speculative bet. I'm a buyer in the $7-9 range, but I've reduced my comfort with the stock because of the continuous delays that plagued the BB10 release. While I expected RIMM to struggle this year, the fact that the company missed out on the holiday season is a huge negative that I believe weakened its negotiating leverage with carriers. We have had tiny stock positions in RIMM, which we are down on currently, and we sold a variety of put and covered call options, which we've actually been able to exit at reasonable profits as the stock climbed to the $13-$14 range again. I believe that if the BB10 platform is successful the stock could increase to $30-$40, so holding a tiny percentage of one's portfolio in this type of speculative play has a reasonable risk/reward ratio, particularly if you agree with my assertion that a take-out is a possibility. By dollar cost averaging when the stock declined to the mid-single digits we were able to generate some profits on what had been a losing position, and if the stock got back to those levels without any material negative developments we would likely look to do the same thing. Prem Watsa was a large buyer at those levels and I believe his presence in the board of directors is very encouraging. Licensing the BB10 system could ultimately be a large source of future high-margin profits, but first the company must execute the introduction of the new platform successfully to prove its worth. Regardless of what happens, Research in Motion should prove to be an excellent case-study of a "fallen angel" that will either be reborn or lost in the fast moving history of smartphone technology.

Disclosure: I am long RIMM, MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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