- BlackBerry struggled with communicating its device strategy on its earnings call.
- At this point, it seems highly probable that the hardware business won't recover.
- However, given enough time, the software business will ramp up to meaningful revenues thus driving the valuation higher.
BlackBerry (NASDAQ:BBRY) reported earnings on April 1st 2016 with very little fanfare. The company’s CEO, John Chen, really struggled on the earnings conference call when conveying the organic growth rate of software relative to the acquired growth from various acquisitions. However, this specific earnings call was pretty insightful and confirmed my suspicion that software revenue would, at least, offset the decline in service access fees (SAF). However, the path to recovery is proving to be a little more convoluted, as there wasn’t a meaningful uptick in device ASPs (average selling price) following the launch of Priv, which basically implies that BBRY’s latest product launch turned out to be a flop.
The CEO alluded to further price reductions on the Priv, which also wasn’t well received. Because, if BlackBerry’s flagship Android product cannot be competitive, we then have to wonder what will? The Priv was supposed to turnaround the device division, but now we’re facing a BlackBerry that’s no longer competitive in the high-end of the market. The launch of the iPhone SE at a $400 price point further complicates issues, as the device is superior in terms of hardware and branding and comes at a price that’s significantly cheaper. When I mean significantly cheaper, I mean $300 cheaper for a product category that has high demand elasticity (sensitivity to pricing).
In other words, BlackBerry may need to move the Priv down to a sub-$500 price point despite raving reviews among BlackBerry fanatics. In the minds of most mainstream consumers, a tactile keyboard with better security features isn’t worth the current price point. Furthermore, the pre-existing base of BlackBerry users hasn’t adopted the device in droves, so we don’t get the benefit of refresh or market share gains. In other words, investors need to turn their attention and focus elsewhere, because the hardware isn’t going to recover.
When I modeled out my assumptions on BlackBerry, I figured the Priv would be a meaningful driver for sales, as it had the potential to gain new adopters. However, the loyalty to other product ecosystems has only intensified over the years, which diminished any possibility of recovery. Furthermore, the weak FY’16 comps should have translated to a better FY’17 in terms of hardware sales assuming a new device could drive either defections from other brands or refresh demand. However, given the weak results in Q1’16, I have to anticipate further declines in the hardware segment, as BlackBerry could not deliver strengthening sales comparisons after the release of its current flagship device.
Initially, there were rumors floating that BlackBerry Priv sales were limited because of supply chain issues. However, four months into the launch, the “supply issues” should have been resolved by now. So, the issue seems purely isolated to demand. While John tried to soothe investors on the call by mentioning that he could build out an enterprise sales channel, I believe there are limitations to this strategy given the number of employees who bring their own device to work, and the transition to enterprise mobility management. In fact, BlackBerry’s Enterprise Services 12 (BES 12) software suite cannibalizes the need for a separate device for work, so there are limitations to the number of enterprise devices that could even be sold.
The poor execution on the device front dampens my expectations on consolidated revenue in FY’17. The company will need to deliver material gains on the software front to offset the decline in hardware and SAF. But, that doesn’t seem likely given guidance of 30% software revenue growth, which is slightly lower than my previous estimate. I’m still anticipating robust software growth in excess of management commentary given the market potential of EMM and the open field opportunity for BlackBerry’s proprietary software.
Also, margins on the BES 12 suite are comparable to SAF, so the replacement revenue from software has favorable implications on the P&L statement. But, despite the incrementally positive news on software, the company’s cost structure/revenue mix is heavily dependent on hardware. Until the hardware business either becomes insignificant and is eclipsed by software or the ramp in software significantly outpaces the decline in both hardware/SAF BlackBerry stock won’t move above $10.
Source: Alex Cho
I’ve revised my estimate on BlackBerry significantly lower. I’m operating off a pro-forma net income figure to model out my end-of-five-year valuation at $26.5 billion. The average pro-forma net income growth for the foreseeable five-years is 11.65%, which is significantly lower than what I had originally anticipated as I now anticipate both the hardware and SAF segment to decline at a consistent pace over the next five-years. Hardware will probably regress to a $250 million/year business based on the current trajectory of sequential declines. I don’t anticipate the business to reach zero, as BlackBerry will still sell phones to enthusiast users and corporate end-users, but the level of investment will decline, which implies that BlackBerry will sell aged/legacy handset models as discontinuation of newer models is highly likely over the next three-years.
Even so, I anticipate the transition to software to drive material earnings growth in the FY’19 and FY’20 timeframe. The transition to software means much higher profitability, I model a 20% and 25% pro-forma net profit margin for FY’19 and FY’20 respectively, which is why an inflection point in operating results seems far more likely at a far later point. To arrive at an intrinsic value estimate in future years, I input a margin assumption that seems reasonable when compared to other software companies. Needless to say, profitability probably won't materialize for a couple years, but to arrive at an averaged growth assumption, I arbitrarily assign a profit figure even in years where BlackBerry's profitability will either report a small loss or a small profit. I use this adjustment for companies in an inflection or investment period to value the business.
In the near-term, I can’t come up with a compelling argument for investing in BlackBerry company.
I discount BlackBerry’s end of five-year value using a WACC of 41.73%. I combine the company’s current WACC of 9.08% plus the net differential between my five-year growth estimate and the consensus long-term growth estimate to arrive at the combined WACC. My pro-forma net income growth of 11.65% has a net differential of 32.65% from the current consensus estimate of -21% for five-year growth. I combine the current WACC plus the 32.65% differential to arrive at the 41.73% WACC to fairly represent my bias and downside risk relative to the consensus.
I then discount the $26.5 billion valuation by 41.73% over five-years to arrive at a present value of $3.77 billion, or $7.23 per share. BlackBerry has no immediate catalyst to drive the valuation higher.
I’m downgrading the stock to a sell, and I'm lowering my price target to $7.23 from $12.86. I believe my near-term estimate accurately reflects the current thought process of the investor base. However, I also believe that my long-term estimate reflects the strategic shift to software as accurately as possible. Needless to say, I’ve been wrong on BlackBerry in the past year, so to reconcile my optimism I’m moving to a more bearish stance. I now anticipate near zero hardware revenue and $2.3 billion in software revenue by FY’20. Assuming I am correct on my stance, the stock will likely recover at some distant point in the future. However, at the present moment, this stock is by definition dead money.
If you have the patience you could wait around for the next five-years, but returns on the stock won’t materialize for quite a while. I don’t anticipate the stock to re-test $10 for a couple years. So, it makes more sense to invest into other names and revisit BlackBerry when it’s primarily a software company.