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RIM (RIMM) - Cheap or Not?

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Federico F
May 18, 2012
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Intro: A quick run down of RIMM's business: RIMM makes Blackberry smartphones. 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 two distinct groups of clients: (1) youngsters who use BBM and (2) large corporations which use BES.

The problems RIMM is facing are well publicized. It's been losing market share 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 offering 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 approximately 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.

Prem Watsa is bullish on RIMM

Prem Watsa started to buy Research-In-Motion in the third quarter of 2010. He bought about 2 million shares when the stock was trading in the $50s. He then added to his position as the stock price collapsed to the $40s then $30s and $20s in 2011. The last time he bought was January of 2012. He doubled down on his position and bought another 14 million shares. We estimate that his cost per share is around $30. He owns 26.8 million shares as of January 2012, which is about 5% of the shares outstanding. At the current price of around $12 a share, Prem Watsa has had more than $400 million of paper loss with his position in Research-In-Motion.

New Blackberry 10 – potential catalyst

Struggling smartphone manufacturer Research In Motion Ltd.has unveiled a prototype of its much awaited next-generation Blackberry 10 operating system. The new operating system will be much more user friendly and is expected to be loaded with more applications compared to its legacy smartphones.

Research In Motion is facing severe problems due to an increasingly competitive landscape, primarily from Apple Inc.’s iPhone and from other smartphone manufacturers which run Google Inc.’s Android platform. The primary reason for Research In Motion's huge market share loss in the high-end smartphone segment is the lack of applications in its legacy handsets.

Even in the lucrative emerging markets, Research In Motion is facing pricing pressure from Taiwanese and Chinese handset manufacturers. We believe the company is betting on its new Blackberry 10 OS to be a potential game-changer for them.

The new operating system is based on QNX software, which is compatible with various open-source coding language, and also runs certain applications from its existing smartphone. The new software is designed to simplify the task of application and content developer.

The company is working with several application developers like Endomondo and Gameloft to develop content and applications for its upcoming smartphone. Research In Motion purchased Swedish user interface company Cascades in 2010, which develops high resolution applications.

Though Research In Motion is yet to come up with the device, it is expected to be launched as a touch screen device rather than its very own Alpha Dev platform and is seen as a potential competitor to the iPhone.

RIMM officially introduced and demoed its next-gen operating system, BB10. The OS homescreen featured what RIMM calls Cascades. The Cascade UI Framework, which resembles Windows’ tiles, is at the heart of BB10”²s focus on simplifying the flow of the experience throughout the OS. RIMM highlighted the ability to move between apps without exiting an app to open a new one – a common iOS and Android complaint – and BB10”²s ability to run apps in the background. RIMM also highlighted BB10”²s use of gestures to improve simple actions like text editing and app navigation and highlighted the significant investment it has made to provide a superior touchscreen typing experience, consistent with the Blackberry tradition. In terms of timing, RIMM stated that progress on BB10 is good and it remains on track to introduce BB10 devices later this year.

Mobile Fusion is currently only offered inside the corporate firewall, but within the next year RIMM expects to offer hosted and cloud options. RIMM is also working to enhance its third-party device capabilities and expects to offer BES-level network connectivity and security for third-party devices, like iPhones and Androids. The last step in the roadmap, for which no timeline was given, is the ability to segregate and secure corporate data on third-party employee-owned devices.

To sum up, Blackberry 10 is in early stages and the competition will have new offerings in the market when BB10 smartphones arrive later this year, but that could be the last opportunity for BB to gain traction. In additon, The Mobile Fusion roadmap, another solid potential launch, could help RIMM stem churn in the enterprise space and looks like a good step toward creating a robust offering in the device management space.

Although it is early, I think the OS could be interesting.

RIM seems to be gaining traction with developers, and several partners were able to the port their apps from iOS or Android in a day. I think that if the porting process is that easy, RIM has a chance of gaining more critical mass with app developers.

A core thesis we hold regarding smartphones and the larger mobile market is that the three major players will each have a presence across handsets, tablets, notebooks and TV. Each of the three majors has this, or at least has a foothold into each of these segments. RIM’s position lies only on the smartphone side, with no tablet presence and no plans to do anything on the notebook/desktop/TV side. We feel this will further deter consumers from adopting the new OS.

We think BB10 would have to offer better functionality than iOS/Android/Windows Phone, or be much cheaper, or perhaps offer sleeker hardware, unique applications or features. Without any of those things, sales will be minimal. RIM is not really a software company, but its main competitors are, and now it’s trying to play catch-up in an area that doesn’t play to RIM’s core strengths. RIM has had two historical strengths, bulletproof mobile email and impressive keyboards. Other smartphone providers have caught up for the most part on the email side (Blackberry still does some things with email though, that others can’t), and keyboards have mostly disappeared from the smartphone landscape (except for Blackberry models). This has forced RIM to create an entirely new OS and hope its approach can be on par with what is currently in the market.

Valuation and Final View

There is a great value investor that shares his view in his blog. I think that some parts of his RIM analysis are worth sharing.

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?)

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 flip side, I mark PP&E down to zero. We only need an approximation here.

Patents are valuable these days as strategic assets to technology companies for both offense and defense purposes. RIMM has approximately 2,500 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 $510,000 per patent. Google's purchase of Motorola Mobility, assuming patents are the primary assets, values them at $310,000 per 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 values them at $1,320,000 per patent.

There are big price variations. How can we sure they were not overpaid for 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 approximately $750 million. 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 $750 million in the above spreadsheet, I have effectively marked RIMM's own 2,000-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 $2 billion. 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 to 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 $1 billion last year. With a 25 million 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 to 50% net margin which is high but believable. Let's also assume RIMM can milk it for three 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 2,000-odd pending patents?)
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