Hopefully, it's not too late for me to change my stance on BlackBerry (BBRY). Coming out of BlackBerry's earnings release for Q3 fiscal year 2014 (fiscal year ends in the first quarter of 2014), I was a little skeptical of John Chen. If the company does in fact transition from being a down trodden tech bomb to a profitable service and handset company, BlackBerry could merit a much larger market capitalization than the pithy $4.8 billion market cap it currently trades at.
By now, there's no point in mentioning the riskiness of owning the company. We know that it's a high beta name, and that if a turnaround does in fact materialize, volatility and short covering will go through the roof. So, in a sense, I'm changing my stance, because I don't want to look the idiot telling people to sell at the bottom, and buy at tops.
BlackBerry no longer a value trap?
BlackBerry has been a value stock for quite a while now. Admittedly, I tend to avoid value stocks, because I mistake value opportunities for value traps. For me to change my opinion, the underlying momentum in a business has to change even if the underlying assets are worth more than the market value for the shares. So in a sense, the short squeeze rally we recently saw was driven by the limited upside for short-sellers as the risk to reward to being a BlackBerry short has drastically changed in the past quarter.
I gave John Chen's restructuring plan a decent chance at success in an earlier article. The outsourcing of manufacturing to Foxconn (OTC:FXCOF) should lower production costs and inventory risks. I also expect BlackBerry to reach a 50% reduction in operating expenditure by Q1 2015. The reduction in operating expenses and cost of revenue will happen rapidly.
BlackBerry has been doing damage control following the release of BlackBerry Z10 and Z30. The products couldn't garner any traction, and we soon realized that BlackBerry over produced handsets. I could live with a 50% reduction in revenue, if there was a 50% reduction in device production. In the most recent quarter, the cost of revenue was higher than revenue, which came as a result from write-downs on inventory. This meant that BlackBerry recorded a loss on unsold handsets. This means that BlackBerry has low expectation of recouping the production cost that went into those unsold handsets. Therefore, for BlackBerry to earn a profit in future quarters, it will need to reduce the number of unsold handsets significantly.
How much profit will BlackBerry earn from handsets in 2014?
In 2014, I expect global shipments of smartphone devices to reach 1.89 billion based on Gartner estimates. I expect BlackBerry's market share to decline by 41.6% in the next fiscal year, and average selling prices to decline from $400 to $300. The decline in average selling prices comes as a result of John Chen's decision to market mid-end rather than high-end devices.
I estimate that BlackBerry's market share will decline to 1% by the end of calendar year 2014. When considering the bill of materials for mid to low-end devices is around $150 to $200, BlackBerry's device business should return to profitability assuming all handsets are sold. At 1% global market share, BlackBerry should be able to sell 18.9 million devices in calendar year 2014. I assume that BlackBerry will sell handsets at $300 implying $5.67 billion in sales. Gross profit per device will be $150; therefore gross profit should be $2.85 billion. Assuming BlackBerry's operating expenditures decline by 50%, and operating expenses should be $2.33 billion for calendar year 2014. This leaves us with $520 million in operating income, and $338 million net income (35% tax rate).
The handset division may be able to hold onto a higher percentage of global market share depending on the effectiveness of advertising, or the consumer's response to lower pricing. After running the numbers I believe that BlackBerry could earn profit from its handset business by the end of calendar year 2014. The consensus earnings estimate for fiscal year 2015 is a loss of $1.37 per share. I expect earnings per share to exceed $.64 for fiscal year 2015, which would be a significant beat on earnings.
The risk to owning BlackBerry is whether or not it can continue to compete with stronger ecosystems in the face of declining market share. If BlackBerry cannot retain 1-0.5% global market share, BlackBerry may have no choice but to exit the handset business.
BlackBerry's market share has consistently declined over the past five years, the decline in market share needs to pivot and turn positive, for BlackBerry's handset business to generate long-term earnings growth. Even if EPS were to turn positive in FY 2015, the real question is whether or not positive earnings will become a sustainable trend.
For now I expect a significant earnings beat, which will cause the stock to skyrocket 2-4 quarters down the road. Therefore, BlackBerry is a solid buy, and is no longer a value trap.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.