Research In Motion RIMM S
March 08, 2007 - 2:53pm EST by
hkup881
2007 2008
Price: 137.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 25,400 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT
Borrow Cost: NA

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Description

There are roughly 6.5 billion people on our planet and more than half of them live on less than $2 a day. The cell phone industry expects to produce around 1.050 billion phones this year or roughly a phone for every two people who can afford one. The average consumer upgrades his phone every two to three years. Based on these casual numbers, one can assume that the cell phone industry has reached full saturation, especially because some people will never purchase one. The laws of economics are very simple in this situation; the leading players will engage in a vicious price war in an effort to gain market share and sell more units at lower margins. In the most recent quarters, we have seen this process begin—it will only accelerate as there is ample excess capacity in the industry.

 

Technology is a brutally competitive business. A few large players often dominate each sector. While these players are not always the innovators or early leaders, they have  seemingly limitless capital at their disposal and can use that capital to gain the advantage on their nimbler foes. For the small player, true prosperity is often elusive since all profits must be reinvested in research and development just to maintain their competitive edge against the larger competitors. Often, this is futile because technology adapts so rapidly that last generation’s technology is often replaced by the next generation’s.

 

The only time that true prosperity is achieved is when a company is either too small to matter to the larger companies in the sector, protected by patents, or has a first-mover advantage. Research in Motion (RIMM:Nasdaq), producer of the ubiquitous Blackberry phone, has all three of these in its favor, but this is about to change. For some time, RIMM was too small to matter to cell phone companies. Now with nearly two billion in revenue in the past twelve months, it’s come onto everyone’s radar. In particular, in a world with rapidly declining gross margins, RIMM’s 45.7% margin on handhelds is the envy of the industry. Patents are only as good as the ability to continue to adapt. RIMM’s small size means that its R&D budget will never be able to keep up with competitors intent on seizing its fat margins. Finally, first-mover advantage is difficult to quantify. RIMM clearly has a large installed base of loyal users—however, one must wonder how loyal they will remain at the much lower price points that will soon be introduced by competitors. To keep these clients, RIMM will need to cut costs and give up the margins which are the reason that it currently trades at 30X and 5.9X what ‘hopeful’ analysts estimate earnings and revenues in 2008 to be. Either it loses its customers or its margins. It probably loses both. As a business, it is doomed. There is little chance the company comes close to those analyst estimates anyway.

 

Below, I compared RIMM with three of its larger competitors over the past 12 months. These figures are not exact since as there is some estimation used in breaking out margins in companies with multiple divisions, but the difference between RIMM and its competition should be obvious.

 

 

 

TTM handheld revs ($ millions)

TTM gross on handsets (%)

TTM R&D ($ millions)

Handset ASP ($)

Market Cap ($ millions)

RIMM

1,926

45.7

212

350

25,800

Motorola

28,383

9.5

4,106

118.72

44,870

Nokia

32,721

13.3

5,144

117.48

87,060

Samsung

18,300

10

6,540

175

114,979

TTM= Trailing Twelve Months

ASP= Average Selling Price

 

Looking at revenues first, RIMM is tiny, yet its margins are massive. This is because the average selling price per blackberry last quarter was $350 and the competition received about a third of that. When looking at R&D expense, you can see how dwarfed RIMM truly is in the coming technology arms race. Ironically, when it comes to market cap, RIMM is up there in the big leagues. RIMM is at six percent of Nokia’s revenues but 30% of its market cap. I would call it overvalued, even in the best of times. Times are about to change.

 

Betting against a company is difficult, but the laws of economics rarely exempt a business in a situation like this. RIMM’s margins will revert to industry averages. The end result will be a phone that sells for about a third of what a standard Blackberry now costs. Without the excessive margins that it currently enjoys, R&D will swallow all profits. It is hard to tell when this will happen and for this reason, I recommend purchasing two year puts on the company (I own the Jan 09 100,110,120 puts). However, I have an inkling that the competitive environment has become more difficult in just the last three months. Motorola recently introduced the Q Phone, Samsung now has the BlackJack Smartphone, products from Treo are now more competitive, Apple has a new product due out this summer which many consider to be superior, and even Hewlett Packard has entered the fray with the iPAQ. It cannot be long before Nokia, Sony, and others have competing products as well. In response to new competition, rebates on Blackberries have increased along with the number of advertised sales at various phone companies. In a saturated cell phone market, everyone will gun for the one area that is actually growing, smart phones with QWERTY keyboards. One must wonder why it is that having a QWERTY keyboard should allow a phone to have margins that are four times the industry norm. One must also wonder why no one has put out a competing product until recently. It shouldn’t be that difficult. My guess is the wonder will end soon, because from a 30,000-foot view of the sector, competitors are coming out of the woodwork. You can almost hear the margins getting crunched down towards industry norms.

 

RIMM does have a valuable residual revenue stream from existing clients from the software and servicing side. However, as a percentage of total EBIT, it is somewhat irrelevant. Moreover, the rate of growth in these two segments is already slowing while handsets remain strong currently. The real issue is total handsets sold, and handset margins as they account for almost three quarters of total revenues.

 
Some of you may say that this competition has always been just around the corner, and it has never really materialized. This is true, but the competitors never really put the effort in that they are currently. They never targeted the large businesses like they are now. They barely even tried to market to consumers with the exception of PALM. I think that really competitive pressures will only become more prevalent moving forwards. I think we can already see this in the increased rebates that RIMM is now offering. Soon I think they will be forced to make across the board cuts at major vendors. In this business, it’s what Cingular pushes their consumers on that matters. Brand name only goes so far. RIMM will have to cut sale prices if they want their product to be the one pushed by sales men at kiosks. Cell phone companies are at a different spot in the food chain from most technology companies that can compete just on product quality. Having a flashy new product won’t matter if Motorola wants to gun for you because Motorola can make deals on other products to induce the Cingulars of the world to push their Q.

 

This will be the rare VIC that does not have any projections. Projections are just too hard. There’s no way to know what margins in 2009 will be, or what revenues will look like. I think it’s safe to say that both will be lower. In particular, RIMM benefited from a massive product upgrade cycle in 2007 that skewed results higher than normal. During the most recent quarter, 51% of all handheld units sold were replacements for existing customers and this equates to a replacement cycle of 1.3 years for existing customers. This was largely a result of existing clients upgrading into the newly released 8100 pearl and to a lesser extent the 8700 model phone. I think that the replacement rate will begin to lengthen going forward, which will only add to the wind in RIMM’s face.

 

Finally, I’d like to add that this is an obscenely expensive stock. Even if business continues to hum along, I think buying the Jan ‘09 110 put for 13.5 will still probably pay you well. If you are concerned about the expensive price of the puts, you can write some Jan ’09 170 calls like I have. You can get about 1.5 put for every call you write if you want to do it for even money. You can also short common, but like most shorts, you get the best prices right before the business really turns. There are probably another quarter or two of decent earnings. Being short, means the stock could run in your face. I prefer the leisure of owning long dated puts. That way i don't have to worry if last quarter or next quarter is the top.

 

I apologize for giving few numbers. This is a concept stock to both the buyers and guys betting against it like me. No one knows what 2009 will look like, but looking at past fads in the technology space, you can get an inkling that it will not be pleasant for RIMM now that the big boys have woken up and decided to play along.

 
Disclosure: I own puts and am short calls of various strikes and expirations.

Catalyst

Margin pressure from new competition. Obscene valuation.
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