Friday, September 27, 2013

BlackBerry's Q2 Press Release: No Surprises But There Are More Data Points

After BlackBerry's terrible pre-announcement last Friday, the earnings release today is almost a non-event. The main financial drivers were in-line with the pre-announcement so there were no real surprises to shareholders and analysts, although the media is still using the bad financials to create fancy headlines such as "BlackBerry loses $1 billion". 

Key Results:
  • Revenue was $1,573 million, slight below the guided $1.6 billion in the pre-announcement
  • Adjusted gross margin of 36.2%, slight above the mid-range of guided 35-37% in the pre-announcement. Adjusted gross margin adds back the $10 million restructuring charge and $934 million non-cash inventory/supplier commitment charge. Both were included in the Cost of Sales line on the Income Statement 
  • GAAP loss of $965 million (guided $950-995 million) or $0.47/share (guided $0.47-0.51)
  • Ending cash (plus investments) balance of $2,569 million at Q2/2014 vs. $3,071 million at Q1/2014
The figures did not surprise anyone but the press release today provided the latest financial statements. There are some interesting conclusion one can make based on them.

Q2 Income Statement:

The pre-announcement already warned everyone about terrible loss number for Q2. Nevertheless, there are some slight positive points about this bad quarter. I believe Prem Watsa understand these points as well when made his $9 offer.  
  • The 50% quarter-over-quarter (q/q) decrease in revenue is surprising. However, BB10 device sales are not recognized until they are sold to end-customers (the sell-through model vs. BlackBerry's old sell-in model). Deferred revenue had a big jump of $500 million  q/q on the balance sheet. If one assumes (this is a big assumption) that the $500 million reflected potential BB10 sales, then the  revenue decline would have been 33% q/q vs. the 50%. BB10 sales could have been greater than $500 million but I am using the $500 million jump in deferred revenue as a rough guide
  • Adjusted gross margin of 36.2% was 2.3% higher than last quarter's 33.9%, despite most of sales came from older BB7 devices. This implies that management was heavily discounting BB7 in previous quarter to drive BB10 sales. Now with BB10 sales slowing, removing those heavy BB7 discounts actually resulted in higher gross margin. Most corporations still order BB7 devices because BES 10 (the company's mobile device management service) lacks full backward integration to support BB7 devices. Removing BB7 discounts was actually a good idea
  • The Cost of Sales line contained a $934 million inventory charge. An inventory charge also reduces the carrying cost of inventory. If BlackBerry can sell those worthless inventory in the future, it will help boost revenue and cash flow. Taking a big bath this quarter is shifting future expenses up-front
  • The most interesting point I saw was if we adjust the one-time items and apply the guided 50% cut in operating expenses going forward, the company can money. i.e. take earnings before tax of -$1,438 million, add the $934 million inventory charge, add the $72 million restructuring charge and add the $450 million potential reduction in operating expense. The adjusted earnings before tax becomes $18 million. Therefore, BlackBerry can make money in the future if it downsizes significantly and become a niche player. The 13% reduction in operating expenses did little to offset the 50% decline in revenue this quarter. 
Given BlackBerry's financial performance, the company's ability to generate future earnings is questionable. Therefore, looking at the balance sheet is important because the valuation of the company is heavily dependent on what resources it owns. 

Q2 Balance Sheet:
  • Despite the $934 million charge, the ending inventory is $941 million, which is higher than last quarter's! Thus, most of the $934 million charge was related to the $5.3 billion off-balance sheet supply commitment. BlackBerry may have to take additional inventory charge in future quarters 
  • The increase in income tax receivable to $462 million from $33 million is positive given this will be a future cash-inflow once collected
  • Working capital management appears poor with cash conversion cycle at 94 days (highest in the past 8 quarters), but this number is likely to decrease based historical trend. The company's working capital position improved after it booked a $400 million charge relating to its PlayBook tablet
  • Book Value reduced to $16.06 and Tangible Book reduced to $9.38. Looks like Prem's offer is just slightly below Tangible Book
The current value of BlackBerry is balance sheet dependent. The balance sheet contains cash at $2,569 million, PP&E booked at $2,119 million and intangible assets (patents) at  $3,505 million. The market value of patents, a key valuation input for BlackBerry,  is quoted from $1-3 billion. 

As I stated in my prior post, I valued BlackBerry at $11.50 based on the Q1 balance sheet and gave no consideration for future earnings power (the ability to generate future earnings). After seeing the updated Q2 balance sheet, I will revised the figure down to ~$11. However, this valuation does not matter if no one wants to pay for it. Shareholders only have one offer at $9 on the table and it may be the best offer. 

Prem Watsa's $9 Conditional Offer:

The shares are trading almost $1 below the $9 offer price, implying the market is betting the deal may not go through. A 12.5% risk-arb spread looks too good to be true. Nonetheless, there was a 30% risk-arb spread on the Progress Energy deal and a 20% risk-arb spread on the Nexen deal because of uncertainty regarding government approval. Investors should remember that both deals were completed and risk arbitrageurs got their double digit returns.

Some analysts predict Prem may lower his $9 offer to squeeze existing shareholders. That could definitely happen, but there are some negative implications for him as well. If he does lower his offer, his reputation and credibility will be damaged. Prem and Fairfax need that good reputation and credibility for future deal making so trading a good reputation for money is foolish. As Buffett famously said: "Lose money, I'll be understanding. Lose a shred of reputation, I will be ruthless." I think Prem understand what Buffett meant  and put his reputation on the line when he announced that the takeover would be led by Fairfax (his firm).  

Therefore,I think the $9 is creditable despite the uncertainty. Looking at the balance sheet, it is less healthier than I expected so a higher offer is unlikely at this point, although a higher bid could emerge.


Source: BlackBerry 6-K filing 

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