Description

Thesis: RIMM is a structural short that will experience market share declines and severe margin pressure over the next few years.  We believe that profitability is likely to decline by 25% over the next 2yrs vs consensus expectations of 25-30% growth.  Assuming a 13x multiple of 2011E EPS implies 35%+ downside.

How it Plays Out

ASPs will decline from $320 to $250 by calendar yr 2011 vs consensus expectations of ~$270.  Due to market share losses, unit volumes will grow from 34m to 45m by 2011 vs consensus expectations of ~60m.  This will cause EBIT margins to decline from 22% to 16% vs consensus expectations of ~20%.  RIMM will generate EPS of $3/share in calendar yr 2011 (FCF will be even lower) which is 40% below consensus expectations. Assuming a 13x multiple implies 35%+ downside.

 What the Bulls Like: The bulls are focused on 4 key points:

• Rapidly growing smartphone market (20-25% annual volume growth) and RIMM is able to maintain its current market share (lose some share in US but gain share in WE/Latam)
• Enterprise opportunity still under-penetrated and RIMM should benefit as it has a dominant competitive position in enterprise
• Sustainable 20% EBIT margins due to increasing mix of service revenues (80% GMs) and steady ASP declines offset by similar declines in BOM costs
• Valuation looks compelling at 13x consensus estimates for calendar yr 2011

What the Bulls Are Missing 

• RIMM is Likely to Lose Significant Market Share as # of Competitors Increase from 2 to 8: The smartphone industry is at an inflection point in which it is transitioning from a market with 2 major competitors to 8 over the next 12 months. RIMM is at a competitive disadvantage in the consumer market due to its lack of innovation and poor multimedia functionality. RIMM is likely to experience a step function decline in market share as numerous Android and PALM OS products are launched on several carriers and the Iphone goes multi-carrier in Europe, Canada and potentially North America.
• Saturation in the Enterprise Market and Increasing Competition from Iphone: Our VAR indicates that the enterprise market is largely saturated in US/WE and that the Iphone is likely to take significant market share from RIMM over the next 12-24 months.
• Margin Pressure: Margin pressure will be driven by accelerated ASP declines and continued declines in services ARPU. Carriers are currently paying RIMM ~$250 in an upfront subsidy + ~$60 per yr in service fees/sub, a significant premium to competitive alternatives. RIMMs subsidy/service fee model is unsustainable and margins will decline moving forward as competition increases (more details below). In addition, RIMM is capitalizing R&D costs in order to keep ebit margins inflated. Over time, this will flow through the P&L as amortization expense increases.
• Valuation is not Compelling: The real multiple is 22x calendar yr 2011E EPS as consensus #s are 40% too high. FCF will be even lower as earnings quality is poor. This is very rich multiple for a business facing a secular decline in earnings power.

Key Points

RIMM is Massively Over-Earning:   We make 3 analogies to illustrate the extent to which RIMM is over-earning:

• RIMM is currently generating EBIT of $100/device sold vs EBIT of $70/device sold for Dell and EBIT of $10/device sold for Nokia. We believe that the value proposition of RIMMs smartphone's are somewhere in between the feature phones sold by Nokia and the servers/PCs sold by Dell and that over time RIMMs EBIT/device will likely fall to <$50.
• Based on analyst expectations, RIMM will generate ~$4.3b in EBIT in calendar year 2011. This is ~ 90% of what Nokia generated in EBIT over the past 12 months and Nokia has ~37% market share of the global mobile phone industry (vs 3% for RIMM).
• Based on analyst expectations, RIMM will generate ~$4.3b in EBIT in calendar year 2011. This is ~ 98% of what Dell and HPs PC business generated in combined EBIT over the past 12 months and together they have ~35% market share of the global PC industry.

Enterprise Market is Largely Saturated and Becoming More Competitive:  Growth in the enterprise market will decelerate as market penetration is getting increasingly saturated: 

• Our work indicates that mobile phone penetration of the corporate market in the US/Europe is ~40% and that will likely increase to ~50% over the next few years which implies a deceleration in market sub growth from 30-40%+ to ~10%. Our research also indicates the Iphone is positioned to take meaningful market share from RIMM.
• Penetration in ROW of employees generating $70k+ is ~8-10%. Based on our conversations with CTOs, penetration of this TAM is likely to increase slowly and thus will not have a material affect for many years.

Assuming RIMM was able to maintain market share in the enterprise market, we believe unit volume growth will decelerate from 30%+ to ~10%.  Our VAR indicates that RIMM is on the verge of losing significant market share to the Iphone over the next 12-24 months.  We believe these share losses will result in minimal corporate unit volume growth and potentially negative volume growth.

RIMM is at a Competitive Disadvantage in Consumer Market: RIMM built its success by offering a push email solution that allowed it to gain share in the enterprise market.  As consumer demand has transitioned towards multi-media functionality and as email has become increasingly commoditized, RIMMs lack of innovation has put it in a very poor competitive position in the consumer market.   This will continue to be a significant headwind as RIMM isn't planning to release its new web based browser until 2H 2010.

RIMM has experienced declines in gross and ebit margins of 10% and 6%, respectively over the past 3yrs as growth has increasingly come from the consumer market.  With 65-70% of unit sales and 70-75% of unit sales growth coming from the consumer market today, RIMM is likely to experience continued deterioration in ASPs and margins moving forward.

Inflection Point in Smartphone Competitive Dynamics in 2010:  The smartphone market is at an inflection point in which it is transitioning from a market with two major competitors (RIMM and AAPL) to 8 as PALM launches its WebOS products and as MOT/LG/Samsung/Sony Ericson/HTC all launch Android products. In addition, the Iphone is currently going multi-carrier in Europe and is likely to go multi-carrier in the US in 2H 2010.  2010 may be the most competitive year ever in the mobile phone market which will put significant pressure on RIMMs ASP, unit sales and margins as it enters this period with a disadvantaged product portfolio.

Profitability Likely to Decline Over Next 1-3yrs:  RIMM is likely to experience annual volume growth of ~10%, annual ASP declines of 10-15% and annual service ARPU declines of ~15% over the next few years.  This will result in approximately flat revenues and 16% EBIT margins (500-600bps deterioration).  EPS will decline from a current run-rate of ~$4/share to ~$3/share by 2011 vs analyst expectations of ~$5/share.

• Unit Volumes: In calendar year 2011, RIMM will generate ~40-45m unit sales vs the current run rate of ~34m units and vs analyst expectations of 60m even in the face of smartphone market penetration increasing from 25% to 50% in US/Europe and from ~5 to 10% in latam/Asia
• a. We believe that RIMMs share of the smartphone market could easily decline to ~25% in the US (from ~50%) and 10% (from ~15%) in Europe over the next 2yrs. RIMM has been able to maintain such high share because it has had limited competition. As an example, RIMM currently has ~20% smartphone share on ATT and that continues to decline in the face of iphone competition while it has ~75%+ smartphone share on VZ in the face of limited competition. Early channel checks indicate RIMM is already losing significant market share since the launch of numerous new Android phones. Competition will continue to intensify in the next 12 months. We assume RIMM is able to maintain 40% smartphone share in Latam and get to 5% smartphone share in Asia.
• ASPs/ARPU: ASPs will decline from ~$320 to $250 over the next 2 yrs and monthly service ARPU will decline from $5.25 to $3.75.
• a. ASP declines accelerate: Android is offering its OS for free and they may also be paying the carrier/handset manufacturer a financial incentive. We believe the value of the OS is ~$25/device and they may be offering additional financial incentives of ~$25-50/device (you should confirm this as we have received conflicting data points). This will put pressure on RIMMs upfront subsidy as Android products gain traction and offer carrier's better economics.
• Service ARPU declines: As RIMMs subscriber base transitions from enterprise to consumer, monthly ARPU will be under pressure as RIMM gets $3-5 per sub/month for consumer subs and $5-8 for enterprise subs. In addition, Iphone's increased focus on the "back end" will put pressure on RIMM's monthly service fees and could cause them to completely disappear (25-30% of gross profit).
• Margins: As volume growth decelerates and ASP/ARPU declines accelerate, margins will be squeezed. Gross margins will decline from 44% to 41% over the next 2yrs and Ebit margins will decline from 22% to 16%. Margins will be under further pressure looking forward from 2011 as the market is increasingly commoditized.

Recent Signposts

• Lack of innovation and new web browser not coming until 2H 2010
• Channel checks indicate 50%+ of unit sales on VZ are under BOGO (buy one, get one free) program making effective retail price well <$100
• Guidance to an ASP of $320 for FY 3Q 10 which is down 7% QoQ
• Enterprise net sub adds started declining two quarters ago and declined 50% YoY in 2Q 10
• Early channel checks indicate strong adoption of Android products
• Poor earnings quality

Risks

• Competitive products don't get strong adoption and smartphone market grows faster than expected
• RIMMs BBM functionality gains traction and allows RIMM to maintain share in the consumer market
• RIMM is able to maintain market share in the enterprise
• RIMM can take significant market share in latam/asia and smartphone market growth accelerates in those regions

Catalyst

1) Launch of additional Android products on VZ

2) Iphone going multi-carrier

3) Iphone taking increased share in the enterprise market

4) Carriers pushing back on RIMM subsidies/service fees

5) RIMM misses analyst expectations for FY 2011