I don't think I need to introduce Research in Motion (RIMM), the Canadian maker of the Blackberry smartphones. RIMM is currently trading at around $13 with a total market cap of $6.8 billion.
A quick run down of RIMM's business: RIMM makes Blackberry smaretphones. Blackberry phones offer two distinct sets of features: (1) Blackberry Messaging (BBM) - This is basically instant messaging (IM) on phones. (2) Blackberry Enterprise Server (BES) - This is a corporate solution which provides remote phone administration and secure email connectivity ("push" service). Both BBM and BES relies on RIMM's global network infrastructure. Both BBM and BES are valuable franchises. BBM exhibits strong network effect. BES is sticky in corporate settings. If we dissect RIMM's market along these two technologies, we can see that RIMM serves 2 distinct groups of clients: (1) youngsters who use BBM and (2) large corporations which use BES.
The problems RIMM facing are well publicized. It's been losing market shares to both iPhones and Android phones. New phone models have been delayed because of delay in getting 4G LTE chips from Qualcomm. And its tablet offer Playbook has been a flop. Future prospect looks grim.
I initially looked at RIMM half a year ago. At the time, I didn't know how to establish a valuation with conviction as its cash flow was deteriorating fast. Since then, RIMM has lost 50% of its market value. What got me interested again was the news that Fairfax's Prem Watsa had doubled down on RIMM (now owning ~5%) and acquired a seat on the board, and Greenlight Capital's David Einhorn has bought a small stake in RIMM instead of shorting it.
I'm amazed by what I found. It's possible RIMM is a sinking ship, but it's a sinking ship stacked with gold bars on the deck in plain sight.
Fire Sale Value
The golden rule of investing is "don't lose money". What is the worse case scenario here? What I'm interested in is how much RIMM is worth if it is dissolved today and sells off its assets and businesses.
RIMM currently has a book value of $19 per share and a net tangible asset (NTA) value of $12 per share. i.e. RIMM is trading at 30% discount to its BV and very close to its NTA value. However, both of them may not be good measurements of RIMM's net worth. It is because RIMM is a technology company. Hard assets may not reflect its true value. (What use is a manufacturing plant which makes Palm PDA today?)
Here is how I calculate its liquidation value. Actually I've cheated. You will see why later. (All figures in million $USD except per share figures.)
Current assets (consists of mainly cash and account receivables), long term investments and total liabilities are straight off its balance sheet.You may argue that inventories have to be marked down significantly. But on the flipside, I mark PP&E down to zero. We only need an appoximation here.
Patents are valuable these days as strategic assets to technology companies for both offense and defense purposes. RIMM has ~2500 patents filed in United States. How to value them? Reports from analysts value them as low as $1 billion to as high as 10 billion, with a valuation of $2.5 billion widely quoted. There are also a number of recent comparable sales: Microsoft's purchase of Novell patents values the patents at $510k/patent. Google's purchase of Motorola Mobility, assuming patents are the primary assets, values them at $310k/patent (after backing out the $3 billion cash and $1.7 billion net operating loss tax benefits). Microsoft's more recent purchase of AOL patents value them at $1,320k/patent.
There are big price variations. How can we sure they were not overpaid out of panic? Besides, the quality of the patents counts. How can we be sure RIMM's patents are of similar quality? I've randomly sampled some of RIMM's patents and Motorola's patents on USPTO. I couldn't come up with a conclusive answer.
But RIMM was part of the consortium which purchased Nortel's patents for $4.5 billion in mid-2011. RIMM's share is ~$750m. This is a more reliable figure. If RIMM needs to sell this block of patents, it will be easier for RIMM to convince the buyer the other four guys in the room also thought this was a fair price. More importantly, these patents have been (hopefully) evaluated by experts in the consortium. This gives us more confidence in the quality. By entering only $750m in the above spreadsheet, I have effectively mark RIMM's own two thousand odd patents down to zero!
Next, the BBM network. This consists of a user base and the underlying technologies and network infrastructure. The user base is still growing. Number of subscriptions grown from $50 million to $75 million last year. My first thought was this network was comparable to the Skype network. Microsoft paid $8 billion for Skype. Skype had about 170 million active users. BBM has about 75 million subscribers. Let's say BBM is only half as valuable as Skype on a per user basis. Then, BBM will be worth $2b. But this is very imprecise. (Half? Why half, not a quarter? And didn't people say Microsoft overpaid?)
Can we do better? BMM generates cash flow. Users pay a monthly subscription fee to use BBM. BBM provides annuity kind of incomes. I read elsewhere RIMM gets $2-4 per month per user. (I can't verify this as RIMM does not disclose its revenue details down to this level. One thing we know though is RIMM's service revenue grew by $1b last year. With a 25m user base growth, it works out to be about $6 per month per user. But I suspect this includes also BES revenue.) Let's say RIM is making $1 profit per user per month and the user base doesn't grow anymore. RIMM's gross margin on services is 85%. So this is implying a 25-50% net margin which is high but believable. Let's also assume RIMM can milk it for 3 years. With a 15% discount rate, I also get a $2 billion figure. [Ed: The 15% takes care of both time value of money and decline of subscriptions. A sign of laziness on my part...]
Now, if we simply stop here and add up what we've got so far, we have $12.76 per share liquidation value, effectively the current stock price. Not only we have marked down its handset business, which has been very profitable, to merely its inventory value on the book, we have also excluded two very valuable assets in this valuation: (1) RIMM's own patent portfolio and (2) RIMM's BES franchise. And this is where I've cheated. I don't attempt to value them. And we don't have to if we are interested in finding out our downside. We have built up layers of margin of safety at every step. RIMM's true liquidation value should be higher than this. It's hard to see we won't get our money back in case RIMM fails as a company. (Did I mention RIMM has another 2000 odd pending patents?)
Stop for a moment and consider RIMM's business in the last 10 years. It's been extremely profitable. Even the much hated 2011 result which included some material non-cash write downs (goodwill and inventories) still commanded a 12% ROE, without using any debt. ROE was 20-40% in the previous years. BBM user base is still growing. Handset sales is still going strong in emerging markets.
If we ignore the current noises, I think it's absurd RIMM is trading at the current price level. I don't know exactly what the upside is. And we don't have to know. When we watch our downside, the upside will take care of itself. But if you really want to push to speculate the possibilities, I would say, if RIMM can just maintain the current profit level, its stock price can easily double at a P/E of 12x. But we are looking at a trough year. If RIMM can fix its problems and improve its profitability, it will be a multiple-bagger.
Challenges and opportunities
It's understandable the market generally fears RIMM will fade in obscurity very quickly like Palm did a few years back. Besides, production issues have forced RIMM to delay the release of its new generation of phones powered by the brand new QNX OS. This damaged RIMM's its revenue and gave its competitors a window of opportunity to steal its loyal customers.
How likely will RIMM fade in obscuirty?
I think the comparison to Palm is flawed. RIMM has 2 franchises, BES and BBM, with lock-in power that Palm didn't have. They may not stop from RIMM fading into obscurity if the management doesn't do anything. But they can slow down the deterioration and give the management enough breathing space to fix their problems.
Besides, these franchise are immensely profitable. While service sales makes up only 24% of the revenue, it makes up 57% of the profit. Since service revenue commands way higher gross margin (85%) than hardware sales (20%), the significant drop in sales figures is masking the profit growth in the BES and BBM.
RIMM should give these 2 franchises 120% of its attention.
BES is a corporate IT solution. It doesn't have to be coupled to Blackberry phones. In actual fact, RIMM has introduced new technologies last year (called "Fusion") to make BES work with other phones. RIMM is a trusted brand and the biggest player in this space. If RIMM is to sell off this business, BES will be very valuable to people like Microsoft, Oracle and IBM. Not only the revenue stream, but also the client relationship.
While BBM is an instant messaging service, it shares the characters of a social network. BBM is popular in pockets of population. This shows its network effort among small social circles. It will be a strategic fit for any existing social networks: Google+, Facebook and LinkedIn.
We may not be able to decouple it from Blackberry phones (i.e. offer it on other phones) without damaging both the phone brand and the BBM brand. At one point I thought RIMM may simply ditch its handset business and focus on its services, moving the BBM and BSE franchises onto other phone platforms. But it appears RIMM does have pockets of loyal customers. Its phones are actually selling well in Latin America and Asian countries. The falling sales data in United States and worrying trend in Europe are masking its growth in Latin America and Asian countries.
The battle RIMM is facing at the moment is a battle on OS platforms, a battle on the ecosystems. With two ecosystems (iOS and Android) dominating the market, it's tremendously difficult to maintain a third one. We learned in the desktop OS battle that whoever commanded the biggest pool of the applications commanded the market.
I believe RIMM can actually sidestep this battle and the management can then give its full attention to strengthen its franchises. What they have to do is to make Android apps run natively on their phones. Technically, this may require re-implementing QNX to run on the top of Android. This may not be the only solution to its ecosystem problem. But this is the simplest. This is effectively what Amazon has done. Nokia is arguably going down a similar route too, with the exception that it's selected Windows instead of Android. (Whether it's a wise choice will be a topic of another post.)
But in reality RIMM is doing it the other way round. RIMM is making Android apps run on the top of its OS. While this is not my preferred choice, this may work too. And I won't fault their thinking. This will probably be too late to change course without causing damages both internally and externally. How well it will pan out will depend a lot on how trouble-free it is for both app developers and consumers to bring Android apps onto Blackberry devices. (At the moment, sadly, it's not.)
Co-founders Mike Lazaridis and Jim Balsillie resigned from their posts as co-chairmen of the board and co-Chief Executive Officers in January. This removed one obstacle for RIMM to break away from its engineering root and explore different strategic directions. (Don't get me wrong. It was no small task to grow RIMM into the current form. Both Jazaridis and Balsillie have done a very respectable job. It's just that being the founders makes it hard for them to decouple their affection from cool-headed decision-makings when the competition landscape has shifted.) While the new CEO Thorsten Heins is largely untested, his promise to explore all strategic directions is encouraging.
We need to have the faith that the management won't destroy the value by burning its assets. Its history doesn't stack up well here. But it offers a bit of comfort that RIMM has started cost cutting initiatives.
Time is of essence here. While value in RIMM's patent portfolio and the value in BBM and BSE franchises won't evaporate overnight, they will deteriorate over time quickly. If RIMM can't fix its problems in a year, our investment thesis will quickly reduce to simply the liquidation scenario. It is good to see they now have a sense of urgency. We also have activists like Prem Watsa on the board (and on the strategy committee) to keep things in check. [Ed: I should've emphasized, the presence of Watsa is pivotal in the entire investment case. Without a strong capital allocator on the board, the company can forever lose its path.]
High uncertainty, low risk
This can be a bumpy ride. Profits can fall further in the next few quarters if hardware sales don't pick up. Stock price can fall further in tandem. Visibility is low and no one can predict what will happen to RIMM. Will it be broken up like Palm was? Will it sell off pieces of its businesses or assets? Will the Canadian government veto an acquisition by a foreign firm on national security ground? Will it form strategic partnerships with other big boys? Will it stay in one piece?
No one knows.
But the risk of permanent impairment to our capital is low because we can establish a pretty solid floor on the valuation. On the flip side, the stock price will pop if anything good happens to RIMM.
This is a classic "head I win, tail I don't lose much" risk/reward profile.
The market sentiment is at its maximum pessimism. Short ratio is at its highest. One really needs the nerve to believe one's facts are right and one's reasonings are right.
(Disclosure: Long RIMM, ORCL & MSFT)