When a stock is pricing the worst case scenario for the company, as long as anything goes right, there’s money to be made — and probably a lot. Back in January 2009 Apple (AAPL, Financial) shares were pricing such a scenario — at one point the stock traded at $78 a share. After factoring in the $25 billion in cash in the balance sheet, the deferred revenue from sales of iPhones (back then over 24 months), and the fact that stores around the world were packed with customers, the P/E of less than 10 (excluding cash) was essentially pricing a worst case scenario.
Research In Motion (RIMM, Financial) today is a similar example. I’m not arguing that RIMM will beat Apple, or that it will dominate the mobile market, or that it won’t see declining revenue. All I’m saying is that as long as anything goes right for the company, RIMM is trading at an absurdly low valuation. As Soros said, “My approach works not by making valid predictions but by allowing me to correct false ones." RIMM at $24 is a false prediction. Apple was my largest position in early 2008, I own an iPhone, and RIMM is now my biggest stake.
First, let me divert to clarify an important difference in the incentives of two different groups (both composed mostly of well-educated and smart people): sell-side analysts and investors. Sell-side analysts are compensated based on two things: a) generating research that is in demand and b) how close their price targets track share prices (mostly by how they get promoted or recruited). As long as an analysts gets it more right (less wrong) than their peers, they are rewarded.
This brings up an important issue. If a stock is trading at $25 a share and the most bullish estimate is $39 a share, an analyst has very little incentive to print a $70 a share target even if that’s what he objectively believes. The incentives will dissuade him from doing so. First, in the short run he will have to deal with skepticism and criticism from bosses, colleagues and clients. He will appear as insane to some, and as biased or too dramatic to others.
Second, even if he ends up being right he won’t gain much more by stating that his target is $70 a share, instead of $40 a share — in the end he was still the analyst with the closest target.
Third and most important, he can always adjust his targets (in as little as a few days as you’ll see below). So to him, printing a $70 a share target doesn’t make sense. The problem of sell-side analysts is not that they don’t know the company well — the problem is that incentives are misaligned and thus targets biased and useless.
Unlike sell-side analysts, investors have a high incentive to buy when the upside skews the expected return of an investment. If a reasonable upside scenario is $70 a share rather than $40 a share, this is very important. In addition, for those of us who believe in fundamental valuation, our fair value targets will move over time but probably not by much in the short term. Right now RIMM has that positive skew.
I state this difference because after going over so many of the recent downgrades for RIMM I cannot stop myself from thinking back to Apple a few years ago. Below I list sell-side research targets for Apple from Jan 2007 to July 2011. Apple is a good example to use because it has been beating estimates and launching successful products since 2007. So there should be no justified reason for a huge volatility in targets, especially in the short run.
The average target price that RBC Capital, Piper Jaffray, Citi, Deutsche Bank, Barclays, Sanford Bernstein, BMO Capital, and JPMorgan stated from January 2007 to December 2010 for AAPL is seen below. Remember that there is little material change in fundamental information intraquarter.
Dec ‘07, AAPL price $198, average recommendation $213
March ‘08, AAPL price $144, average recommendation $198 (as price came down, so did the ‘targets’)
June ‘08, AAPL price $167, average recommendation $228 (as price went up, so did the ‘targets’)
Sep ‘08, AAPL price $114, average recommendation $187 (as price came down, so did the ‘targets’)
Dec ‘08, AAPL price $85, average recommendation $142 (as price came down, so did the ‘targets’)
March ‘09, AAPL price $105, average recommendation $120
June ‘09, AAPL price $142, average recommendation $161 (as price went up, so did the ‘targets’)
Sep ‘09, AAPL price $185, average recommendation $209 (as price went up, so did the ‘targets’)
Dec ‘09, AAPL price $211, average recommendation $249 (as price went up, so did the ‘targets’)
March ‘10, AAPL price $235, average recommendation $271 (as price went up, so did the ‘targets’)
June ‘10, AAPL price $252, average recommendation $332 (as price went up, so did the ‘targets’)
Sep ‘10, AAPL price $284, average recommendation $354 (as price went up, so did the ‘targets’)
Dec ‘10, AAPL price $323, average recommendation $390 (as price went up, so did the ‘targets’)
If you drill down to the recommendations of specific sell-side analysts it looks even more ridiculous (I picked RBC Capital as an example — some of the others have similar behavior):
RBC Capital
05/05/08, AAPL price $185, target: $220
09/29/08, AAPL price $105, target: $140 (3 months later the analyst implies the business is worth 40% less)
10/22/08, AAPL price $97, target: $125 (after 23 days the analyst claims the business is worth 10% less)
01/15/09, AAPL price $84, target: $70 (this is the same analyst that 3 months ago had said the business was worth 80% more, and just 7 months before said the business was worth 200% more)
04/20/09, AAPL price $120, target: $95 (analyst keeps following the price trend, albeit slow to catch up)
04/23/09, AAPL price $125, target: $165 (analyst concludes 3 days later that the business should be worth 74% more!)
07/22/09, AAPL price $156, target: $190 (stock goes up, so does the target)
And it keeps going like this...
Soros has written extensively about the reflexivity issue in the markets. With companies like RIMM or Apple, that are very well known to retail investors, sell-side analysts contribute immensely to a positive feedback loop. If the stock price goes down, analysts will adjust downward. This causes some investors to sell prematurely and the shares to drop even further. This in turn triggers more analysts to revise their estimates downward, which causes further price pressure. An on an on... until the trend is reverted. Just like in a bubble.
There are clear fundamental issues and questions with RIMM. It should’ve never been a $144 stock, and maybe should be valued between $50 a share and $70 a share. (To put in perspective, at $75 a share RIMM would be trading at 12x P/E. Nokia right now trades at 18x P/E. One could make similar pessimistic scenarios for Nokia).
More than 20 downward revisions in the last month is a bit extreme. For this stock to be trading at 3.9x P/E (less than 3x if you exclude cash) also strikes me as overly pessimistic. No debt, $3 billion in cash. Even if you assume that earnings will drop 50% in the following year and that only the international division grows, it is much more attractive than Infosys and other international tech companies. Today, Netflix (NFLX) is worth more than RIMM yet produces less than a tenth of the income. Facebook is worth six times RIMM yet RIMM produces more five times higher income than Facebook (which means you pay 30 times more for FB).
At the time RIMM last reported earnings, I didn’t own the stock and was not following it. As the stock crashed I poured over the financials and I realized year-over-year revenue and net income grew. In fact, earnings beat analyst estimates and they also announced a buyback (5% of shares outstanding). But because they revised year guidance downward the market panicked. As Buffett’s has often said, "Be fearful when others are greedy, and greedy when others are fearful."
There are bad scenarios for RIMM and they have been very well documented. At this price all of them are priced in. So let’s focus on a few possibilities that could happen. I’m not predicting anything — but as long as anything turns out a little bit better than expected the shares have significant upside ($60 a share is not an unreasonable scenario — that is a 150% or more return).
- Order of Playbook tablets by a government or large institution.
- Playbook is the only tablet that has received FIPS from the U.S. government.
- Russia has stated that it might ban the iPad from government use because of security concerns.
- Playbook is the only tablet to have received approval from the Australian authority for government use.
- RIMM’s international growth continues to do well (year-over-year revenue growth from international markets was 67%. India is seeing good success with the new Blackberries).
- Management teams up with a PE firm for a buyout of the business.
- Microsoft (MSFT, Financial), Google (GOOG, Financial), Infosys, IBM (IBM), Nokia, Samsung, Amazon (AMZN, Financial), Cisco (CSCO), Facebook or any other company takes it over. Not unreasonable when you realize that RIMM just fired 11% of the workforce and the COO is retiring. Ballmer dodged a question about a takeover of RIMM. After Microsoft acquired Skype it let go a good portion of the employees.
- RIMM splits the business in two and unlocks value (as suggested by an analyst).
- RIMM increases buyback or starts issuing a dividend.
- As Mark McKechnie, an analyst at ThinkEquity, suggested, the company opens up its secure network operations center, or NOC, to other smartphone platforms.
- Sale of patents to Google or other interested parties.
Just like Apple at $78 was absurd, RIMM at anything under $35 also is. “History never repeats itself, but it often rhymes.”
Research In Motion (RIMM, Financial) today is a similar example. I’m not arguing that RIMM will beat Apple, or that it will dominate the mobile market, or that it won’t see declining revenue. All I’m saying is that as long as anything goes right for the company, RIMM is trading at an absurdly low valuation. As Soros said, “My approach works not by making valid predictions but by allowing me to correct false ones." RIMM at $24 is a false prediction. Apple was my largest position in early 2008, I own an iPhone, and RIMM is now my biggest stake.
First, let me divert to clarify an important difference in the incentives of two different groups (both composed mostly of well-educated and smart people): sell-side analysts and investors. Sell-side analysts are compensated based on two things: a) generating research that is in demand and b) how close their price targets track share prices (mostly by how they get promoted or recruited). As long as an analysts gets it more right (less wrong) than their peers, they are rewarded.
This brings up an important issue. If a stock is trading at $25 a share and the most bullish estimate is $39 a share, an analyst has very little incentive to print a $70 a share target even if that’s what he objectively believes. The incentives will dissuade him from doing so. First, in the short run he will have to deal with skepticism and criticism from bosses, colleagues and clients. He will appear as insane to some, and as biased or too dramatic to others.
Second, even if he ends up being right he won’t gain much more by stating that his target is $70 a share, instead of $40 a share — in the end he was still the analyst with the closest target.
Third and most important, he can always adjust his targets (in as little as a few days as you’ll see below). So to him, printing a $70 a share target doesn’t make sense. The problem of sell-side analysts is not that they don’t know the company well — the problem is that incentives are misaligned and thus targets biased and useless.
Unlike sell-side analysts, investors have a high incentive to buy when the upside skews the expected return of an investment. If a reasonable upside scenario is $70 a share rather than $40 a share, this is very important. In addition, for those of us who believe in fundamental valuation, our fair value targets will move over time but probably not by much in the short term. Right now RIMM has that positive skew.
I state this difference because after going over so many of the recent downgrades for RIMM I cannot stop myself from thinking back to Apple a few years ago. Below I list sell-side research targets for Apple from Jan 2007 to July 2011. Apple is a good example to use because it has been beating estimates and launching successful products since 2007. So there should be no justified reason for a huge volatility in targets, especially in the short run.
The average target price that RBC Capital, Piper Jaffray, Citi, Deutsche Bank, Barclays, Sanford Bernstein, BMO Capital, and JPMorgan stated from January 2007 to December 2010 for AAPL is seen below. Remember that there is little material change in fundamental information intraquarter.
Dec ‘07, AAPL price $198, average recommendation $213
March ‘08, AAPL price $144, average recommendation $198 (as price came down, so did the ‘targets’)
June ‘08, AAPL price $167, average recommendation $228 (as price went up, so did the ‘targets’)
Sep ‘08, AAPL price $114, average recommendation $187 (as price came down, so did the ‘targets’)
Dec ‘08, AAPL price $85, average recommendation $142 (as price came down, so did the ‘targets’)
March ‘09, AAPL price $105, average recommendation $120
June ‘09, AAPL price $142, average recommendation $161 (as price went up, so did the ‘targets’)
Sep ‘09, AAPL price $185, average recommendation $209 (as price went up, so did the ‘targets’)
Dec ‘09, AAPL price $211, average recommendation $249 (as price went up, so did the ‘targets’)
March ‘10, AAPL price $235, average recommendation $271 (as price went up, so did the ‘targets’)
June ‘10, AAPL price $252, average recommendation $332 (as price went up, so did the ‘targets’)
Sep ‘10, AAPL price $284, average recommendation $354 (as price went up, so did the ‘targets’)
Dec ‘10, AAPL price $323, average recommendation $390 (as price went up, so did the ‘targets’)
If you drill down to the recommendations of specific sell-side analysts it looks even more ridiculous (I picked RBC Capital as an example — some of the others have similar behavior):
RBC Capital
05/05/08, AAPL price $185, target: $220
09/29/08, AAPL price $105, target: $140 (3 months later the analyst implies the business is worth 40% less)
10/22/08, AAPL price $97, target: $125 (after 23 days the analyst claims the business is worth 10% less)
01/15/09, AAPL price $84, target: $70 (this is the same analyst that 3 months ago had said the business was worth 80% more, and just 7 months before said the business was worth 200% more)
04/20/09, AAPL price $120, target: $95 (analyst keeps following the price trend, albeit slow to catch up)
04/23/09, AAPL price $125, target: $165 (analyst concludes 3 days later that the business should be worth 74% more!)
07/22/09, AAPL price $156, target: $190 (stock goes up, so does the target)
And it keeps going like this...
Soros has written extensively about the reflexivity issue in the markets. With companies like RIMM or Apple, that are very well known to retail investors, sell-side analysts contribute immensely to a positive feedback loop. If the stock price goes down, analysts will adjust downward. This causes some investors to sell prematurely and the shares to drop even further. This in turn triggers more analysts to revise their estimates downward, which causes further price pressure. An on an on... until the trend is reverted. Just like in a bubble.
There are clear fundamental issues and questions with RIMM. It should’ve never been a $144 stock, and maybe should be valued between $50 a share and $70 a share. (To put in perspective, at $75 a share RIMM would be trading at 12x P/E. Nokia right now trades at 18x P/E. One could make similar pessimistic scenarios for Nokia).
More than 20 downward revisions in the last month is a bit extreme. For this stock to be trading at 3.9x P/E (less than 3x if you exclude cash) also strikes me as overly pessimistic. No debt, $3 billion in cash. Even if you assume that earnings will drop 50% in the following year and that only the international division grows, it is much more attractive than Infosys and other international tech companies. Today, Netflix (NFLX) is worth more than RIMM yet produces less than a tenth of the income. Facebook is worth six times RIMM yet RIMM produces more five times higher income than Facebook (which means you pay 30 times more for FB).
At the time RIMM last reported earnings, I didn’t own the stock and was not following it. As the stock crashed I poured over the financials and I realized year-over-year revenue and net income grew. In fact, earnings beat analyst estimates and they also announced a buyback (5% of shares outstanding). But because they revised year guidance downward the market panicked. As Buffett’s has often said, "Be fearful when others are greedy, and greedy when others are fearful."
There are bad scenarios for RIMM and they have been very well documented. At this price all of them are priced in. So let’s focus on a few possibilities that could happen. I’m not predicting anything — but as long as anything turns out a little bit better than expected the shares have significant upside ($60 a share is not an unreasonable scenario — that is a 150% or more return).
- Order of Playbook tablets by a government or large institution.
- Playbook is the only tablet that has received FIPS from the U.S. government.
- Russia has stated that it might ban the iPad from government use because of security concerns.
- Playbook is the only tablet to have received approval from the Australian authority for government use.
- RIMM’s international growth continues to do well (year-over-year revenue growth from international markets was 67%. India is seeing good success with the new Blackberries).
- Management teams up with a PE firm for a buyout of the business.
- Microsoft (MSFT, Financial), Google (GOOG, Financial), Infosys, IBM (IBM), Nokia, Samsung, Amazon (AMZN, Financial), Cisco (CSCO), Facebook or any other company takes it over. Not unreasonable when you realize that RIMM just fired 11% of the workforce and the COO is retiring. Ballmer dodged a question about a takeover of RIMM. After Microsoft acquired Skype it let go a good portion of the employees.
- RIMM splits the business in two and unlocks value (as suggested by an analyst).
- RIMM increases buyback or starts issuing a dividend.
- As Mark McKechnie, an analyst at ThinkEquity, suggested, the company opens up its secure network operations center, or NOC, to other smartphone platforms.
- Sale of patents to Google or other interested parties.
Just like Apple at $78 was absurd, RIMM at anything under $35 also is. “History never repeats itself, but it often rhymes.”
