Don't pick BlackBerry

Its slower cash burn is encouraging, but we remain concerned about end-market demand.

Brian Colello, CPA 21 June, 2014 | 2:50AM
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  BlackBerry  BBRY reported decent but not overwhelming fiscal 2015 first-quarter results that indicate its turnaround to cash flow break-even by the end of the fiscal year is underway. We're encouraged by BlackBerry's slower cash burn (excluding one-time cash windfalls), but in the long term, we remain much more concerned about end-market demand for the company's handsets and services. We didn't see much from this earnings report to lessen our concerns. We are likely to maintain our $7 (all figures are in U.S. dollars) fair value estimate and Morningstar Economic Moat Rating of none.

Quarterly revenue was $966 million, just below street consensus and down 1% sequentially. The firm sold 1.6 million handsets in the quarter to retailers (1.0 million of which use its current BB10 operating system) and 2.6 million handsets to end customers. Although the May quarter is typically slow for smartphone demand, the firm's Z3 launch in Indonesia didn't appear to make much of a dent in BlackBerry's results. The majority of revenue (54%) again came from service revenue, mostly earned on service access fees on legacy BlackBerry 7 subscribers.

BlackBerry broke even on an operating profit basis; gross margins improved modestly but the bigger earnings boost came from an adjustment to the value of the firm's convertible debt. The cash balance rose by $429 million to $3.1 billion, thanks to proceeds of $287 million on the sale of real estate and receipt of a $397 million tax refund. Excluding these items, BlackBerry's cash burn of only $255 million was perhaps the biggest highlight of the quarter and shows signs that the firm may in fact reach cash flow break-even by the end of fiscal 2015. We continue to believe that such a target is achievable, but after the company shrinks the balance sheet and right sizes the business as much as possible, we remain skeptical that its transformation will ultimately conclude with a rise to excess returns on invested capital or an economic moat.

Leading position long gone

We see no chance that BlackBerry will re-emerge as a leading smartphone maker. In our view, any investment thesis in the firm is based on a bet that the company can transform itself into an extremely niche smartphone supplier to enterprises and government agencies, adequately monetize its variety of software assets, or both. Even after the firm's turnaround plans are finished, we would remain skeptical that the company can do much better than break even in the long term, and we don't see a compelling risk/reward profile for the company today.

BlackBerry's missteps came years ago, when the firm failed to react to the threat of web-enabled smartphones with robust app stores and developer support, such as   Apple's  AAPL iOS and Google's   Google  GOOG Android platforms. BlackBerry's expertise in secure email and enterprise-based solutions were not enough to keep customers tied to the ecosystem as devices with even more capabilities hit the market. Today, both customers and businesses are overwhelmingly choosing devices with strong ecosystems like iOS and Android, with corporations shifting to a bring-your-own-device model by addressing email and security on their employees' devices, rather than pushing BlackBerries onto their employees. We see no chance of BlackBerry building a comparable ecosystem anytime soon.

BlackBerry may still hold some valuable assets, such as BlackBerry Messenger, enterprise software, and QNX. Yet its ability to monetize and profit from these first two assets remains questionable, at best, even though startups with similar offerings are growing at much faster paces. QNX may be a leading software platform in automotive infotainment systems, but revenue isn't yet meaningful. BlackBerry may still reinvent its hardware business to supply highly secure devices to enterprises and governments that value topnotch security, although market share will be a rounding error at best when compared with the smartphone market as a whole.

Lack of switching costs means no moat

We believe BlackBerry does not have an economic moat, as moats among handset hardware makers have historically been hard to come by. Several different firms, including BlackBerry, have been king of the handset hill, such as Nokia NOK with its dominance in basic handsets sold around the globe and Motorola with its popular line of Razr handsets. However, none of these firms were able to develop significant switching costs or network effects that would encourage customers to buy their next-generation phones.

BlackBerry may have come closest with BlackBerry Messenger, which allowed BlackBerry users to chat for free with one another. However, as a wave of popular new touchscreen phones like Apple's iPhone and a variety of Google's Android-based devices emerged, BlackBerry devices, with their physical keyboards, smaller screens, and slower processors, became outdated. The network effects and switching costs associated with BlackBerry Messenger were not enough for BlackBerry to retain its user base, especially in the U.S.

Also, in enterprise markets, BlackBerry used to have some switching costs associated with security features around BlackBerry and data on BlackBerry's networks that made it extremely popular with corporations. However, a growing number of enterprises are adopting a bring-your-own-device mobile data model. Instead of pushing BlackBerry devices onto their employees, a growing number of CIOs are building security measures around devices that customers already own, such as iPhones and Android-based handsets. In a booming smartphone market, BlackBerry's unit shipment declines indicate that these switching costs have not helped the firm retain its previously strong position in the enterprise market. Therefore, we do not assign the firm an economic moat rating.

BlackBerry has some intellectual property around wireless patents, but reports indicate that other wireless players like Nokia and Motorola Mobility (acquired by Google) have far more wireless intellectual property. Further, this IP has not stemmed BlackBerry's market share losses in recent years, nor has it resulted in high-margin licensing revenue or boosted returns on invested capital to an adequate level. The company owns some interesting business segments, like QNX, a leader in software used in automotive infotainment systems. However, BlackBerry's software sales have been relatively minor in the past, and we would need to see stronger evidence of meaningful revenue and profitability from the firm's software businesses before we can consider using these assets as a basis for a moat.

Risk is very high

We view BlackBerry as a highly risky, volatile investment over the next couple of years as the firm strives to execute on its turnaround plan and re-emerge as a software provider and niche supplier of highly secure handsets used by enterprises and government clients. In hardware, we continue to foresee hefty market share losses as consumers gravitate to other ecosystems (and especially Android), and we fear that BlackBerry may be surpassed by rivals at some of its most important clients, such as the U.S. government. In software, we remain highly skeptical that the firm will be able to adequately monetize its BBM and BES software, which were previously given away for free alongside device sales. Other larger or faster-growing rivals compete against both businesses, and we think there is a good chance that neither platform brings the company back to profitability. Although QNX is a leader in software used in automotive infotainment systems today, revenue has not been material to date, and both Apple and Android have their eyes set on the car software market, perhaps rendering QNX a layer of relatively valueless middleware. All the while, BlackBerry should continue to burn cash until its turnaround plan is complete, especially if high-margin BB7 service revenue declines at an even sharper pace.

Stewardship has been poor

In light of BlackBerry's freefall from smartphone industry leader yesterday to life support today, we must consider the management team to be poor stewards of shareholder capital until proved otherwise.

BlackBerry's rise and fall were supervised by longtime co-CEOs Jim Balsillie and Mike Lazaridis until January 2012. The pair built the firm into a top handset manufacturer but later struggled to adapt to the shift toward web-enabled devices with robust app stores and developer support as built by Apple and various Android partners in recent years. In response, BlackBerry's first full touchscreen device, the BlackBerry Storm, was a flop, and the firm was unable to develop a compelling alternative to these devices thereafter. Under Thorsten Heins, who took over as CEO thereafter, BlackBerry 10 encountered several delays and was launched after the holiday season in 2013, allowing more consumers to gravitate to other devices. While BB10 was a nice operating system, in our view, the firm's efforts were too little, too late. Ultimately, we think management's missteps were made years ago when the firm failed to deliver a robust, web-enabled device that could have effectively combated the threats posed by Apple and Android.

Since November 2013, BlackBerry has been led by interim CEO John Chen, who is also executive chairman of the board of directors. BlackBerry bulls continue to point to the faith and trust they have in Chen, based on his ability to spin a struggling tech firm, Sybase, into a company that was sold to SAP for $5.8 billion in 2010. While we think that Chen is doing a fine job thus far, we don't believe he has made any stunning, innovative moves to improve BlackBerry's position.

Chen intends to focus the company on four main business units: handset devices, enterprise software and services, BBM, and QNX. Perhaps Chen's most popular decision to date was to strike a five-year partnership with Foxconn to outsource handset production and even some device research and development efforts to the manufacturing company. Such a deal lowers BlackBerry's risk of carrying obsolete inventory, as well as its fixed cost structure for future production. Chen also reiterated a focus on QWERTY keyboard devices, rather than full-touchscreen products like the Z10 that flopped in 2013, as he hopes to hold on to loyal customers that prefer keyboard devices (and vigorously fight off potential keyboard threats like Typo's proposed QWERTY case for the iPhone). Although Chen will focus on selling devices into the enterprise, the company will still attempt to hang on to consumer markets in certain countries where the BlackBerry brand is still popular, like Indonesia. Finally, in enterprise software, the company expects to release BES12 this year, which will be a cross-platform solution that integrates older software like BES10 and BES5 into one common platform that will allow IT departments to manage all types of mobile devices, including iPhones and Android phones.

We think Chen is making solid but not revolutionary moves. These are all product and supply decisions made by the firm, while our main concerns about BlackBerry stem from the demand side of the equation. Chen has reiterated that BlackBerry is a stable business with a solid cash cushion that will be around for the long haul. We agree with this assessment, as the firm should stave off bankruptcy. Yet we remain skeptical that BlackBerry can significantly reinvigorate demand for any of its products or services to the point that it can comfortably generate solid profitability in the long term.

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About Author

Brian Colello, CPA

Brian Colello, CPA  Brian Colello, CPA, is director of technology, media, and telecom equity research for Morningstar.

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