Friday, April 13, 2012

Research in Motion is absurdly cheap (RIMM)

(Ed: I'm flattered when someone plagiarised this post word for word after a full month I wrote it and published it on gurufocus. --18 May 12)

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?)

Upside

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.)

Catalysts

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)

17 comments:

  1. the bbm network has no viable long term value. it's totally dependent on the customer buying rimm devices. the bbm network can start to go into reverse as people abandon the platform. it has no independent value apart from BB devices. if customers abandon bb devices, as they are, they will leave bbm, as they are. your valuation is inflated. you can't take bbm and segment it as a viable stand alone business.

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    1. Hi mj,

      Very true. When I looked at the liquidation value, I did treat it as a run-off business. The figure can be inflated. We can play with the discount rate to cater for the decline.

      Delete
  2. you're assuming service business doesn't grow for three years. but also that it doesn't decline? have you thought about a scenario where it does decline?

    I don't see how a a p/e company could come in and say I just want to buy the services business. Wouldn't they also have to buy the "losses" of the device business? how much are losses worth?

    it's very difficult to value a technology company in decline on a sum of the parts basis. Why? How do you vale a moving target? Where is the business going?

    Rimm needs to do a massive restructuring to uncover a sustainable model. They have yet to lay out a plan as Elop did with Nokia late last year. And you see what happened to Nokia After the plan was put in place. It takes time. It takes 18 months for nokia before they get out of transition phase. rimm has not even started it's transition phase.

    What's the business going to look like in two years? All of the valuations I see of rimm never seem to model a scenario where they start to lose huge sums of money and they start eating into cash and investments.

    People said rimm was absurdly cheap at $30. Good luck. You may well be right.

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    1. Hi mj,

      You are absolutely right that they haven't had any solid plan at all. The visibility is zero. The investment case I laid out is an attempt to establish a floor of its valuation regardless what the future is.

      I'm being lazy here to just absorb the decline rate of BBM cash flow into the discount rate. Here is an judgement call how big the decline rate should be. We can definitely plug in 30% instead of 15%.

      But don't forget in the valuation, the BSE business, the 2000+ patents and its software portfolio (QNX, etc) have been written down to zero. If you look around, mainstram analysts valued the patents at $1-3 billion and the rest of the assets/businesses at $1-1.5m billion. So, we are talking about an additional $2-4.5 million margin of safety here.

      Regarding the "losses" of the device business, I agree with you it's likely the pontential buyer of BBM will need to buy it together with the handset business. One thing I do disagree is whether there is zero hope in its handset business. It's selling well outside US and Europe.

      I'll be interested to look at the $30 valuation. Do you still have the reference?

      Delete
  3. a number of valuations exist at the $30 range. In fact Prem Wasta of Fairfax invested initially at $40. It looked very cheap on the numbers at $40 because people assume it would never lose money and it was a stable device business that could earn $5 a share.

    The BES system is not that viable anymore. It is a closed system. Exhange server includes the functionality of BES as part of the package. I agree the patents have value and i believe that if they really cut away all the fat here that they could get down to a profitable niche business.

    However, their business in emerging markets is likely to take the same path as it did in North America. Android was just a couple of years behind in emerging markets; but it has a far far superior business model than rimm does overseas. Android is catching up and is advancing more rapidly as a a platform. The device business of rimm is over. they lost.

    QNX will never get off the ground imo, and rimm will have to choose to NATIVELY adopt either wp7/8 or Android to be a viable device maker. QNX has no ecosystem or apps. Making android work on QNX will never work in the marketplace. It's a kludge.

    Buying rimm stock before this massive transition of it's business is like buying nokia before they announced that the platform was burning.

    I agree this is not going to zero. there is a floor somewhere. And what could save this investment even at this price is a sale to the koreans, japanese, or chinese. I believe that they are the likely buyers of the company.

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    1. Do you have more scuttlebutts that BES is losing market? I'll be interested to hear.

      Regarding the $30 valuation, I would have these questions in mind: (1) is the metholodogy used to get the $30 figure more dependable or that used to get the $13 figure more dependable? (2) Is RIMM safer now than it was last year? (3) Are we confused price with intrinsic value? (That the current price at $13 doesn't mean $30 valuation is wrong.)

      It's been great discussions. Thanks.

      Delete
  4. why do you need to have QNX run alongside Android? because rimm spent a bunch of money on QNX and needs to save face? QNX is redundant.

    Amazon simply took open source Android and put a new UI on it. Rimm could do the same. Lenovo also did this. rimm could do this as well. You don't have to involved google to use android. rimm could copy the model of Amazon.

    Qnx does nothing that android can't do. They bought QNX because they did not want to admit failure. They wanted to control their own destiny. They were two years too late. Maybe three. They made the wrong move and that's why they are out.

    QNX will fail. They will eventually pull the plug. It's probably a fine OS. There were tons of better OS than Windows that are in the dust bin. Because they don't have an ecosystem.

    Elop wanted to get RIMM to adopt MEEGO so together they could create a third ecosystem. Rimm turned him down. Elop recognized that neither Meego nor QNX had a future without another large device maker joining the other. Google "elop battle of ecosystems". there are now three viable ones. ios android and wp7. There is no room for QNX.

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    1. I'm guilty of being lazy again here.

      When I said putting QNX on the top of Android, I should've said putting RIMM's "proprietary layer of software" on the top of Android. "QNX" was just easier to type. :-)

      That was interesting anecdote on MeeGo. Thanks. I learn something everyday.

      Delete
  5. ok so you are kind of admitting that QNX has to be replaced by a custom version of Android. qnx was a waste of capital.

    BES is a closed proprietary piece of software that enterprises use to manage BB devices. It is expensive because it is a closed system from a single source. There are other cheaper software packages that manage ios and android devices. Exchange also works with ios and android. BES as a platform is in runoff. as customers migrate away from BB devices, CIOs will rip out the expensive management platform and replace it with something far more economical.

    as far as $30 valuations, they were based on earnings projections of $4 and $5 a share. It goes without saying that paying $13 is better than paying $30 and $40. However, rimm business has gotten worse over the last year.

    Take a look at the chart of Nokia. It is now a $4 stock. Do you really think when it went to $13, down from $50 that anyone thought it would go to $4?

    Intrinsic value is a guess about the Future. Making a sum of the parts valuation on a Tech company is extremely difficult. they can go away.

    A value investor with a following made a post about NOK over at seekingalpha in oct 2010 when the stock was almost $11. At the time He did a very similar sum of the parts analysis of nok and thought it was very cheap. This is what I wrote at the about the same time. we saw things very differently.

    http://seekingalpha.com/article/236725-nokia-is-still-overvalued

    Nok is a perfect example of what happens to tech stocks that no longer have a viable technology. they go into a netherworld where growth stock investors abandon them and value investors don't buy because they can't predict where technology is going. They have no constituency. They can go to $4 because they begin to lose money and shareholder value is destroyed by burning cash and liquid investments, and writing down assets. Study the recent history of Nokia from about 2008 to 2012.

    thanks for the convo, best of luck. go with your convictions. you will learn a lot from this investment no matter what happens. cheers.

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    1. Thanks for the original analysis and the comments. It seems to me that RIMM is in a different position than NOK was a few years ago. RIMM started the smartphone while NOK missed completely a paradigm shift. RIMM needs to defend its position, which is much easier than entering new territory as NOK needed.

      Delete
  6. Agreed. Great analysis, esp. with the probing comments.

    I'm still bearish, because some of your "assets" strike me as very possibly the opposite - HERE and now. Prem on the Board, for example. Talk about a mistake made too often. Graham/Dodd can't be "tweaked" to apply to tech 80 years after it was formulated. In some ways, Newton to Einstein was "easier." ... So Prem "didn't have a clue," and now he's got to be bitter, and clamoring for cost cutting is more in keeping with aggressive cancer treatment - cut and cut and maybe we can keep x alive - than it is maintaining this as a "growth company" worthy of serious consideration as an acq. by other growth companies.

    You recognize that patents have a half life or something like that.

    So does a tech company that starts to stumble - and 2-4 years of stumbling is like the 100 Years War in this sphere. Their good "businesses" have had a bullseye on them all that time, and RIM has clearly not done well with its tech innovations for some time.

    The 1-week outage speaks volume about "taking one's eye off the ball."

    HP's experience with Palm will color (almost surely AS IT SHOULD) the real world valuation process.

    Last, not throwing Playbook under the bus marks Thorsten as the 2nd stringer promoted to a position he's colossally incapable of handling well. So, too, is the absence of deals - the high-level people exiting may not speak volumes, but the new hires in key roles DO. They cannot attract talent at a time that they need it desperately.

    Your analysis smacks of what Bain Capital and other p.e. firms might engage in - and that's probably a near fatal flaw. Maybe, you can "milk" a rolled steel operation, but things like BES and BBM are as different from that as night is from day.

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  7. Just read mj's 4/15 post, and it's exceptionally "on point," imo.

    And the news last night essentially validates it. More and more, this looks like Nokia in the low double digits - just as yesterday's fish is awfully hard to sell at "today's prices," yesterday's "electronics," once you get past overstock.com - have near-zero value, "unfair" though that may be.

    I think the o.p. said, "I'm just taking the inventory value as stated." The acquirers that RIM needs more than ever are more likely to value them properly - at much lower numbers. Nobody thought that going from BB5 or 6 to BB7 and then BB10 would be easy, but it appears that most people underestimated the task in North America and Europe.

    Yes, India and Indonesia are attractive markets, but to me this is more like old Amer. cars winding up in Cuba or Africa 10-30 years back - it may be a great business for a modern day pirate-type, but a Canadian company actually quite constrained by being that ... is not likely to out-sell one based in Korea or China for more than some number (smallish) of months.

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  8. Really well done article! Extremely thorough and I really like the amount of Margin of Safety you've put into your valuation.

    I'm pretty new to the value investing game (so I have a very weak understanding of the financials) so my primary thesis for investing in RIM was that if it's good enough for the great Prem Watsa @ $44; it's good enough for me @ $14.

    P.S. I was pretty pissed to see the gurufocus writer just outright copy your article without even as much as a shout out thanking you.

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  9. Yash,

    Do you still think the article is as thorough and full of a "Margin of Safety" now that the stuck plummeted to $7.50/sh now?

    Read mj's comments 2x and call me in the morning.

    The blogosphere value investors constantly overlook "network effects in reverse." And that takes all forms -- technology (RIMM, NOK), price competition (SVU), and mortgage originators (IndyMac circa 2007).

    Later,
    P

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  10. are you still long?

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