Research In Motion June 55 Cal RIMM
November 23, 2005 - 7:40pm EST by
bedrock346
2005 2006
Price: 16.90 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 12,661 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Research In Motion (“RIMM”) develops and sells wireless mobile communications products. The Company’s primary product is the popular BlackBerry device. I believe the company is about to have a favorable outcome in its litigation with NTP. The market has assumed overly negative legal outcomes for the company and therein lies the opportunity.

RIMM’s stock declined from over $100 to the $50-60 range in less than a year. Investors dumped the stock both for fear of a legal judgment that could force the company to shut down suddenly and new competition that could commoditize RIMM’s products and undermine its growth prospects. With the psychology surrounding the stock turning increasingly negative, it seemed possible the market was exaggerating the importance of some of the legal issues surrounding the company and retained legal counsel to do due diligence. Our lawyer’s findings provided the basis for most of the legal reasoning contained below.

Earlier this year RIMM appeared to have its legal issues, most of which stemmed from a patent infringement case brought by NTP in the US District Court for the Eastern District of Virginia, definitively resolved. In March, RIMM and NTP issued a joint press release announcing that they had agreed to a binding term sheet settling the infringement suit. RIMM agreed to pay NTP a lump sum of $450 million to cover all past and future royalty payments. While $450 million is not a trivial sum for RIMM, the company had ample cash reserves and the settlement represented a one-time extraordinary charge. The agreement also eliminated the possibility of the US District Court imposing an injunction against RIMM barring the company from selling its products in the US (the District Court had previously issued such an injunction but stayed the ruling pending RIMM’s appeal). The very prospect of an injunction raised the possibility that the District judge could simply put RIMM out of business. RIMM stock rose almost 20% the day of the press release to close at just under $80.

Shockingly, in June of this year, RIMM announced that NTP had backed out of the seemingly closed settlement agreement. Legal uncertainty and the specter of an injunction returned to RIMM’s stock. It appears likely that NTP walked away from the deal, reasoning that it had negotiated a floor of $450 million and had nothing to lose in trying to win more from RIMM either in the courts or in another round of negotiations. However, the legal news over the recent months has been overwhelmingly in RIMM’s favor. The Federal Circuit Court of Appeals reversed or remanded the majority of the 16 counts of patent infringement found by the District Court. Furthermore, in a re-examination proceeding requested by RIMM, the US Patent Office issued an initial rejection of all claims of each of the patents asserted by NTP- essentially stating that NTP should never have even been granted any of its patents in the first place. The US government also filed a brief with the District Court asserting that an injunction against RIMM would hinder its functioning and was contrary to the public interest.

While the market has reacted very negatively to RIMM’s failure to achieve highly unlikely outcomes (such as immediate Supreme Court stay), it has given RIMM little credit for securing rulings that materially increase its negotiating leverage with NTP and the odds of a favorable ruling by the District Court judge (who still has current jurisdiction over the case). Within the next two to four weeks (see table on estimated timing of legal catalysts below), the District Court judge will likely rule on whether RIMM and NTP had a binding agreement to settle the suit. A ruling that the parties had a settlement would be very positive for RIMM’s stock. There is a strong possibility of such an outcome given that NTP was party to a joint press release announcing the agreement. My lawyer has advised me that it is highly unusual to walk away from a “binding” agreement, and very possible that the judge will simply enforce the deal that both sides have already agreed to. If the District Court judge rules that there is no such agreement, while this outcome is clearly bad for RIMM in the short-term, RIMM could still achieve a favorable outcome in the medium-term (within the next 6 to 7 months). Many RIMM analysts have incorrectly assumed that if the judge rules there was no agreement settling the suit the judge will then immediately move to issue an injunction. While the judge may issue an injunction, he may also decide, based on the rulings by the Court of Appeals, that RIMM owes far less in damages to NTP than the court initially awarded and an injunction is unwarranted. After all, the Appeals Court rejected or remanded the majority of patent infringement claims found by the District Court and instructed the District Court to reconsider the damage award in light of these reversals. (The judge may also be more reluctant to issue an injunction because of the US government’s assertion that an injunction is contrary to the public interest.) Additionally, since RIMM now infringes on less counts, RIMM’s claim to have a work around technology solution to NTP’s patents is more plausible, a factor which the District Court must also take into account when awarding damages.

Long dated in the money options are the best way to establish a RIMM position. The options limit some of the downside risk should RIMM lose the case and get an injunction enforced against them, or should their business erode from competitive threats. The table below illustrates possible payouts for a favorable outcome:

Assumed RIMM Stock Price:$80 $90 $100
June 55 Calls- $16.90 65% 124% 183%
June 60 Calls- $13.70 73% 146% 219%
June 65 Calls- $11.15 79% 169% 258%
Assumptions: RIMM stock @ $66.28, options retain 50% of premium post legal settlement, call prices are mid-point of bid / ask spread


Since options expire, our due diligence focused not only on the likely outcome of the litigation but also the timing. We believe that matters will be settled in RIMM’s favor within the next three to six months. The District Court judge has explicitly stated that he intends to move aggressively to settle the case so I am confident in an expedited (as far as legal matters go) resolution of the case. The table below provides timing estimates for potential legal catalysts for the stock:


Event Likely Timing
District Court Rules whether RIMM & NTP had settlement Next 15-30 days
If District Court rules no settlement in place, District Court will resolve other procedural and legal issues remanded by the Federal Circuit (including injunction) 90-180 days post settlement ruling
NTP & RIMM reach new negotiated settlement 90-180 days post settlement ruling
Supreme Court ruling on Cert. Petition (whether Supreme Court will take the case) February / March 2006
US Patent Office (District Court Judge may or may not take under consideration)
Final Re-exam Action by US Patent Office Next 180 days
Patent Board of Appeals (if NTP appeals unfavorable ruling) Late 2006
Federal Circuit Court of Appeals (if NTP appeals unfavorable ruling) 2007

Since the stock has declined dramatically on perceived set-backs on the legal front, a positive outcome should drive the stock meaningfully higher. The short-term nature of this investment also partially insulates investors from the technology and competitive dynamic risks inherent in RIMM. There are strong bull and bear arguments to be made for RIMM’s prospects. The bull case is as follows: RIMM has a sizable market share lead in an area that is experiencing explosive growth and has been introducing a series of new products to strong reviews. It is worth noting that RIMM has only 3 to 4 million subscribers in a market that as noted technology investor, Roger McNamee, recently observed in Barron’s could be as big as 150mm subscribers. Even if the market growth doesn’t pan out, like users of Nextel’s walkie talkie most of RIMM’s users are business customers who verge on the addicted to its product and are thus less likely to switch providers even at a lower cost (not unlike Apple’s Ipod for music). At a mid to high teens P/E, you aren’t paying much for that growth potential. Bears would say that Microsoft is just getting serious about the space and they are about to do to RIMM what they did to the Mac. Maybe, but they have been trying to penetrate this space for over 9 years - without much to show for it. In addition, well funded competitors like Good Technology, Palm and Nokia are all after RIMM’s market. I won’t pretend to know what the market will look like in two years and beyond, but its is doubtful RIMM will be over-run by competitors in the next two quarters, which is the timeframe we expect our legal thesis to play out. And like Microsoft, these competitors have been trying for years to beat RIMM without much traction.


RIMM’s valuation is not unreasonable on a P/E basis. Its trades only at 17x next year’s earnings and 21x this year’s excluding a $450mm NTP payment, which we believe is the most likely outcome – not bad for 30 percent projected earning’s growth, and not crazy even if they only do the $2.58 for the next two years – flat growth. Why is the valuation important if we are investing primarily on a legal outcome? For starters, this club is called the value investors club, so valuation matters to the thesis. I would not make the some investment were this say Google or Amazon as their valuations provide absolutely no margin of safety. The table below summarizes the valuation for RIMM:


Current Stock Price $66.28
Cash / Share (net of $450mm NTP Payout) $8.15
Cash / Share (no NTP Payout) $10.43

2006 EPS Est. (FY End 2/06) $2.58
P / E (Cash net of $450m) 22.5x
P / E (Cash no NTP Payout) 21.6x

2007 EPS Est. (FY End 2/07) $3.40
P / E (Cash net of $450m) 17.1x
P / E (Cash no NTP Payout) 16.4x

Catalyst

The district court judge has said that he would like to get this case off his docket as soon as possible. The easiest way for him to do that would be to enforce the $450mm “binding” agreement. I think enforcement is the most likely outcome, and it could happen any day. The stock should run between 10-30 points on that news given that it lost approximately 30 points due to legal uncertainty. I favor the deep in the money June 55 calls since they have the most intrinsic value of the options on our matrix, creating the common at closer to current trading levels and giving protection against time decay should the outcome be closer to six months than one month – though you have less downside protection should the business be damaged by competitive threats. RIMM is no longer a 50 P/E high flying stock. At current levels, the burden of proof is on the bears, and longs have a very positive catalyst on the horizon. A 14 point move to $80 would provide a 65% return on our matrix, which to paraphrase Joel Greenblatt’s new book, would be a highly satisfactory outcome.
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