I'm now a proud part-owner of Apple, Inc.

When I sold down a significant portion of my RIMM (or BBRY now) last week at its recent peak before it took a 25% dive (it was luck, not skills), I thought I had to park the cash aside for some time. Yet, Mr Market handed me Apple straight away. How ironic it is. This was the time when Mr Market was very excited about RIMM but very grim on Apple. "Be Fearful When Others Are Greedy and Greedy When Others Are Fearful", said Warren Buffett famously. Usually you can only experience one half of this maxim. How rare it is that I experienced the whole thing back to back.


This is going to be a long post. Be warned.

The economics of mobile computing platforms

We all use the PC industry as a proxy to understand mobile platforms. The present war between iOS vs Android is so eerily similar to the war between Mac and Windows decades ago. Under this view, Apple is facing a serious dilemma. On one hand, Apple insists on making premium products without compromises and charging premium prices. On the other hand, the economics of platforms leads to "winner takes all". For a platform to survive, it requires market share. And only at a low price point and being open can a platform achieve mass adaptation. This was arguably the main factor that undid Mac 20 years ago.

However, this view is incomplete. There are subtle yet important differences between PC platforms and mobile platforms.

I argued before mobile platforms are less sticky than PC platforms. The stickiness of PC comes from the applications developed on the top of the platform's API. The API is the lock-in. But the nature of mobile apps is different and the switch cost of mobile devices is lower than PCs:

• Price of the apps are orders of magnitude lower.
• Most of the essential apps are cloud-based and the clients are free on all mobile platforms. Given the business models of these service providers (e.g. Amazon, Google Search, Facebook) who want ubiquitous access to their services, this won't change in foreseeable future.
• In order to protect their investments, many businesses will utilise portable HTML5 instead of native APIs to implement their business apps when the applications are not consumer facing and "snappiness" isn't the priority. (This has already happened on desktop applications for years. If you visit a bank, very likely you will see their desktop applications run on browsers which communicate to their back-office servers.)

Besides, there is a different form of lock-in in the broader ecosystem: the (cloud-based) services available exclusively on one platform. Examples of Apple's iCloud, Face Time and iMessage and RIM's Blackberry Messaging (this is going to change with BB10). Here, Apple has the advantage. It's not in Google's business interest to limit their services only to Android. Apple can employ exclusivity. Google won't.

Lastly, mobile devices are so much an extension of our public persona. They are displayed prominently in public. They are like watches and diamond rings. Brand recognition and brand loyalty are important drivers of repeated purchases. The trust and emotion associated with the brand are so fluid you can't called them lock-in. Yet they do attract long-term followers. (I shall talk more about this brand issue below.)

In a nutshell, the risk that iOS will be marginalised by Android because of the asymmetric  market share is lower than what it appears.

Valuation

Let's turn to the numbers.

Apple's trailing-twelve-month (ttm) earning is $41.75B. Current share price is $450 and total market cap $422B. Apple has $137B cash (inclusive of marketable securities). The way Apple structures it capital on the balance sheet tells us $97B of that is not needed for its operations. Let's assume all of this cash is trapped overseas and will incur a 20% tax in order to repatriate it back onshore. This leaves us $78B distributable cash. Removing this amount from its market cap gives us $344B enterprise value. This gives us a ttm P/E of 8.2x, or an earning yield of 12%. At this P/E, the market assumes Apple's earning will be going downhill from here.

Will Apple's earning go downhill?

Let's look at the bear case scenario that Apple won't introduce any new product categories. i.e. Apple will just rehash and incrementally improve its current product lineup. We further assume the profit centre is iOS products. We focus solely on iOS devices. i.e. iPhone and iPad.

We need to look at both sale volume and profit margin. Let's look at sale volume first.

Buyers of iOS devices fall in three groups: (1) non-consumers (i.e. people who never own a smart phone or tablet before), (2) existing iOS users who are upgrading and (3) buyers switching from different platforms (i.e. churning). At the moment a large portion of Apple's sales comes from non-consumers. But this will change some time in the future. When the market is saturated, the consumer mix will shift to mainly upgrades from existing customers. How about churning? Churning has been minimal. Apple users are immensely loyal. Satisfactory rate of iOS products is 90%. We assume the lost of existing customers and gain of new customers cancel out each other.

So we can rephrase the question: can Apple sustain the current sale volume if majority of the business is upgrades from repeated customers?

Apple sold about 200m iOS devices in the last 12 months. The lifespan of mobile devices is about 2 years. So we need a 400m install base to sustain a refresh rate of 200m units per year once an equilibrium is established. I've estimated the current install base of iOS devices is about 350m units. What this means is it isn't far off for Apple's sale volume to become self-sustainable. No doubt the lifespan of mobile devices will eventually get longer. And the assumptions and approximations I use here can be off. But the important thing is the scale of the magnitude. It is within Apple's reach to become self-sustainable in sale volume.

What about profit margin?

If we reduce Apple's gross margin from the current 38% to 28%, Apple's revenue will drop 15% and its profit will be cut in half. Suddenly Apple's 8.2x P/E becomes 16.4x which doesn't look cheap anymore.

Profit margin is the real deal here. It's not that far-fetched Apple's gross margin can shrink to 28% level if competition pressure intensifies or production costs increase.

What are not properly priced in?

After all, maybe Apple's 8.2x multiple is justified. Given the risk of margin compression, maybe Apple is fair value at $450.

But there are a few things coming with Apple that we don't see on the shelves, on the balance sheets nor on the cash flow statements. These are the intangibles that are impossible to quantify. There are the values not properly accounted for in Apple's current price:

• Apple's brand
• its DNA and organisational processes
• growth potential in China
• new products

Let's address them one by one.

How valuable is Apple's brand?

How valuable is Apple's brand? I frankly don't know how to put a price on it. However, I want to point out three observations.

When Steve Jobs brought Apple back from the brink of bankruptcy, Apple introduced a stop-gap product to buy itself enough time to develop more innovative products. It was the iMac G3. What's striking about  iMac G3 is it possessed no major technological breakthrough. Its technical spec was not that different from its predecessor G3 All-in-one.

iMac G3

  

Mac G3 All-in-one

What iMac G3 had was a new look. Apple has mobilised its fans by just altering the look of a product. I'm not diminishing the importance of such industrial design. The creativity required is no less than the creative mind that conceived mass as energy. What I'm trying to point out, however, is that only a strong brand can utilise this to bring commercial success. (iPhone and iPad currently are available only in black and white. How much time can Apple buy if it merely offers different colours with only mild technological upgrades?)

The second thing I want to point out is triggered by an article I read on Financial Times about kids receiving iPods and iPads as their Christmas presents. This immediately reminded me one of Buffett's favourite businesses: See's Candy. Why See's Candy? Chocolate has no lock-in power. What See's Candy has is brand value. Let me quote Buffett: "[People] had taken a box [of See's Candy] on Valentine’s Day to some girl and she had kissed him… See’s Candies means getting kissed." It is not about the chocolate. It's about the emotion value and trust the brand brings. When you buy your nephew an iPad, it's not about the feature set, it's about the recognition of the Apple brand.

This brings me to my third observation.

Apple's products are more like fashion items than computers or consumer electronics. Take a look at this survey done in China recently:

Best brands for gifting by men (source: Hurun Chinese Luxury Consumer Survey 2013)

Best brands for gifting by women (source: Hurun Chinese Luxury Consumer Survey 2013)

Do you see what Apple's peers are in consumers' eyes? These are prestige brands deliver repeated sales on seasonal basis by altering "just the look". Apple is the only consumer electronic company on these lists. It is the monopoly in this market segment. And where is Android or Samsung? In terms of brand image iOS and Android are very different.

While we shouldn't read too much into the lists because they are not good representations of the whole market, they give us a different perspective of Apple's basis of competition. A $10 T-shirt I buy at Target is functionally the same as a $1000 T-shirt available at Louis Vuitton. But they are not directly competitors. That the $10 Tee has a 99% market share and the $1000 LV Tee has only 1% market share won't be a concern to an LV's investor. Similarly, to some extent, iOS and Android are not direct competitors.

In the hi-tech world, we are so afraid of disruptive innovations which result in better products. Yet no one is worried about such product disruptions faced by Louis Vuitton or Burberry. These companies have a product disruption cycles in months, not years, in the form of fashion cycles. Instead, what companies like Louis Vuitton will be worried about is disruption in the processes as what Zara has shown them, not disruption in the products. When we look back at Apple, don't we focus on the wrong thing if we are worried about the products? Shouldn't we pay more attention to the processes?

Organisational processes and Apple's DNA

Apple as an organisation excels in two things: operation efficiency and product development.

Apple is the king in efficiency. If you use cash conversion cycle as a metric, Apple is 50% more efficient than both Amazon and Dell. Stop for a moment and compare the logistic complexity that Apple faces with that of Amazon. Books don't involve co-ordinating multiple supplies. Books don't require assembling hundreds of components.

And I don't have to elaborate on its product innovation side.

Achieving where Apple is at now at such a scale isn't what a single person can do. A lot of the values come from Apple's organisational processes. Or you can call it DNA or culture.

Growth potential in China

When we say Apple is fair valued at $450, we assume there isn't much head room for iPhone/iPad's market to grow. Look at mobile phones alone. Currently smart phones penetration in US is about 50-60%. Some projections suggest it will become saturated in around 2 years.

However, that's just US. Worldwide, smart phone penetration is 20-30%. Apple has been actively pursuing the China market. China will surpass US has Apple's largest geographical segment in a couple of years. Yet, the current share price implies it doesn't exist.

Product Pipeline

Tim Cook said in the recent conference call that Apple's product pipeline was "chock full". Ok, no one takes what management says at face value. Let's discount the "chock full pipeline" to "have something in the pipeline".

No matter how you cut it, it's a certainty that Apple has some new products in its development pipeline. No one will dare to bet otherwise. Given Apple's track record, there is also a fair chance these new products will have meaningful impact on Apple's bottom line. The only thing we don't know is what they are and when they will be available. This is the key uncertainty here. This is the kind of uncertainty Mr Market hates.

I read about a comment by a fund manager that he sold his Apple stake because of the uncertainty in Apple's product pipeline. Over and over again, Mr Market mistakes uncertainty as risk. If you agree that Apple, with its current product lineup, is fair valued, then what this pipeline uncertainty gives you is not risk but a valuable optionality, coming for free.

How important is (the absence of) Steve Jobs?

The Brooklyn Investor blog has two insight articles on Steve Jobs and Apple. (see here and here.)

I agree with them on many fronts. However, I take a more "anything has a price" view. i.e. Jobs is important to Apple at $700; he is less important at $450. To put it differently, true, a Jobs-less Apple isn't as valuable as an Apple with Jobs around. But we as investors can still do well as long as we pay a low price.

Pre-mortem: What has gone wrong?

It is now 2015. My investment in Apple has turned sour in 3 parallel universes in one form or another and my capital is permanently impaired. What has gone wrong?

Universe 1: Without Jobs around, internal bureaucracy mushrooms and destroys Apple's ability to execute anything effective. Apple becomes Sony or Microsoft.

Universe 2: The upgrade cycle of mobile phones and tablets slows down too soon and too much.

Universe 3: I've completely misjudged Apple's brand power. Mobile devices are tools. A cheap and good tool trumps an expensive and flashy one. Apple's profit margin evaporates.

This investment isn't without risk. To me, it has enough margin of safety and enough upside potential. This is a high quality business worth paying a fair price. You need to make the judgment yourself.

Closing

While researching Apple, a lot of things Buffett said about quality businesses popped up all over my head. Let me quote a couple of things Roger Lowenstein says about Buffett in "Buffett: The Making of An American Capitalist".

After Buffett scooped up the ailing Berkshire Hathaway in 1962, he bet big in American Express in 1964. This is what Lowenstein said:

His sleuthing led to two conclusions, both at odds with the prevailing wisdom: (1) American Express was not going down the tubes. (2) Its name was one of the great franchises in the world. Amex did not have a margin of safety in the Ben Graham sense of the world.... But Buffett was a type of asset the eluded Graham: the franchise value of Amex's name.... The loyalty of its customers could not be deduced from Graham's "simple statistical data"; it did not appear on the company's balance sheet...

When I accompanied my wife to a shopping mall one day, I paid a visit to the Apple Store there. This visit remained me what Lowenstein wrote about Buffett's viewing of Disney's Mary Poppins in 1965:

He saw that [the audience was] riveted to the picture, and he asked himself, in effect, what it would be worth to own a tiny bit of each of those people's ticket revenues -- for today and tomorrow and as many tomorrows as they kept coming back to Disney.

Over many days, I asked myself over and over again: wasn't Buffet describing Apple?

(Disclosure: Long AAPL, RIMM/BBRY)

The 10% FCF yield club

When a company's business is easy to understand, offers a 10% FCF yield, provides steady and predictable profit year-in-year-out without oversize Capex, I get excited. If it can grow its cash flow in line with nominal GDP growth, it can easily offer 15% p.a. return. 15% has been Buffett's hurdle rate throughout his investing life. This is the "good enough" mentality that both Warren Buffett and Ben Graham advocate. If it's good enough for Buffett, it should be good enough for me.

What's interesting here though is I started looking at one company which led my thoughts onto another company which led me onto another one... And I ended up indecisive....

Let's start with Lamar Advertising.

Lamar Advertising

• Company: Lamar Advertising (NASDAQ:LAMR)
• Market Cap: $2.55B
• TTM FCF yield: 9%
• Business: The 3rd largest billboard advertising provider in US
• Moats: Nothing can replace billboards for brand-awareness advertising. Highway Beautification Act (1965) limits the number of billboards that can be built. This is pretty close to Buffett's "toll booth" type of business.
• Positives: A gradual recovering US economy will improve both occupany and rates. LAMR will also be able to refinance some of its debts in the coming years with lower interest rates.
• Negatives: Cyclical business. Very high debt. FCF interest cover is only 2.2x. But the mgmt has been prudently using all of the FCF to pay down its debts in the last 3 years. Yet, there is no gaurantee the mgmt won't do another debt-fueled acquisition in the future.

My biggest hesitation here is the 2.2x interest cover. It is quite a stretch on my comfort level. While LAMR's cashflow was pretty stable through the GFC, considered that its advertising contracts are typically less than a year long, I'm not sure how much shock such a highly levered balance sheet can take. My issue here is safety.

While I was thinking about LAMR's advertising business, I remembered another advertising related company.

Omnicom Group

• Company: Omnicom Group (NASDAQ:OMC)
• Market Cap: $13.2B
• TTM FCF yield: 10%
• Business: Advertising agent
• Moats: Ad agent is a service business.When marketing campaigns get more and more complicated, the value of an Ad agent increases. Its moat resides in its sticky customer relationship. (e.g. Apple has been staying with one agent since Jobs returned. You can't say that for its semi suppliers. Btw, Apple's ad agent belongs to OMC.)
• Positives: Although debt/equity is ~1.0, interest cover is a comfortable 10x. 
• Negatives: This is cyclical business and profit moves in tandem with the economy. OMC has significant exposure in Europe. This is both a plus and minus. When Europe's problems fade, we shall see growth. But it may take years.

Next, I remembered Dun & Bradstreet Corp, which was beaten down badly in May after it released its disappointing FY2012 guidance.


Dun & Bradstreet Corp

• Company: Dun & Bradstreet (NYSE:DNB)
• Market Cap: $3.22B
• TTM FCF yield: 8.75%
• Business: Data provider of business records and credit history
• Moats: When the database you provide is essential to other people to conduct their businesses and when its size gets to a certain critical mass, its economics benefits from a form of network effect and becomes self-sustainable. This is the kind of business an idiot can run.
• Positives: But DNB's mgmt are not idiots. They don't chase unattractive growth for the sake of it. They return cash back to investors in the form of share buybacks.
• Negatives: Business isn't growing in the recent years. Can it really grow in line with the economy?

At this point, I asked myself, why all these troubles? Why don't I just add more to my existing Microsoft position?

Microsoft Corp

• Company: Microsoft Corp (NASDAQ:MSFT)
• Market Cap: $252B
• TTM FCF yield: 11%
• Business: software
• Moats: MSFT has 2 undeniable franchises: Windows and Office. Both are essentially annuity kind of business.
• Positives: Truck load of cash. ROE in the range of 40% without using debt. Growing steadily 8-12% p.a. over many years. On the corporate front, Windows 7 upgrade cycle will accelerate in these 2 years. On the consumer front, Windows 8 sales will provide additional revenues.
• Negatives: Given its size, growing will become harder and harder. Cloud-based computing and mobile computing both threaten MSFT's franchises. There is also the risk the mgmt will destroy value on poor acquisitions.

I'm pretty comfortable MSFT can defend its turf. It may even be able to leverage its dominance into offering more cloud-based solutions and mobile solutions than everyone can imagine.

No matter how I cut it, MSFT looks like a superior investment to the rest. My conviction is high.

Charlie Munger always says diversification is diworsification. My dilemma here is whether I should diversify in order to reduce my exposure to one single company. No matter how high my conviction is, there are always "unknown unknowns". There is also this unhelpful thought urging me to divest: "Earning outstanding returns requires hardwork. If I keep on adding to just the same old position and not spending time to dig deep into other companies, I'm not working hard enough." (I haven't yet done in depth analyses of some of these other companies. If I end up staying with MSFT, this won't be the best use of my brain power and time.)

I'm really interested in your thoughts!

 (Disclosure: Long MSFT)

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)