Wednesday, October 2, 2013

BlackBerry Q2 MD&A: More Bad News But Not All Negative

Quietly on a Tuesday afternoon, BlackBerry released its full Q2 report on EDGAR. I had the opportunity to skim through the filing and found some interesting data points. Readers are welcome to read my analysis, but could skip to the conclusion if they want to a quick read on what is the outlook for BlackBerry's shares. The financial media quickly pointed at all the negatives in the report without painting a full picture of the company. That being said, the Q2 report was more negative so I'll start of with the negatives. 


The Negatives:

(1) Hardware Fiasco:

According to dictionary.com, the word fiasco is defined as "A Complete and Ignominious Failure" and those words describe perfectly the performance of BlackBerry's hardware division in Q2/2014. We already knew from the pre-announcement on September 20th that hardware had a 50% decline year-over-year but new details are also very disappointing (see chart below). Quarter-over-quarter, the region that saw the hardest decline was Latam and EMEA (Europe, Middle East, Africa).  Weakness was wide-spread in all of the regions, even in emerging markets such as EMEA and Latam where the BlackBerry brand was favoured . 

$ in millions
Q2/14
Q1/14
Q2/13
Y/Y
Q/Q
Canada
91
263
227
-59.9%
-65.4%
U.S.
323
498
641
-49.6%
-35.1%
North America
414
761
868
-52.3%
-45.6%
EMEA
686
1343
1087
-36.9%
-48.9%
Latam
196
449
520
-62.3%
-56.3%
Asia Pac
277
518
383
-27.7%
-46.5%

Another confusion in the quarter was the accounting for BB10 devices. According to the quarterly report, the company did NOT change its revenue recognition policy. However, BB10 devices did not meet the company's revenue recognition criteria. Under U.S. GAAP (BlackBerry reports under U.S. GAAP), one of the revenue criteria is for the price to be fixed and measurable. Given BlackBerry must deduct estimated return returns and sales incentives (marketing, rebates) to estimate net revenue, the final price is not fixed if return rates or sales incentives cannot be measured reasonably. BlackBerry had trouble selling its BB10 devices and cannot accurately forecast the return rates/sales incentives in order to book the BB10 revenue. Due to the low sell-through rates and additional sales incentives needed, the company decided to not book revenue on BB10 devices until they are sold in the channel as described below: 

"Where a right of return cannot be reasonably and reliably estimated, the Company recognizes revenue when the product sells through to an end user or the return period lapses.For shipments where the Company recognizes revenue when the product is sold through to an end user, the Company determines the point at which that happens based upon internally generated reporting indicating when the devices are activated on the Company’s relay infrastructure."

Nevertheless, the company expected the change in BB10 revenue recognition did not "materially" impact revenue and they merely deferred the BB10 revenue. As I stated in my prior post, the big $500 million jump in deferred revenue could account for some of the deferred BB10 revenue. 

The future outlook for the hardware division is not encouraging. Device sales may continue to decline and BB10 sales are not picking up. Based on the company's provided BB10 sell-through rates, I estimate around 3 million BB10 devices have sold through to end-users vs. company's old expectation for "tens of million" units. The company needs to re-position its devices to attack specific markets it wants to target. The decision to make Z10 a low-cost devices could boost near-term sales as the high selling price on Z10 was main factor why many consumers decided to buy Android phones or iPhones. The Q5 also needs further price reduction in order for the company to remain competitive in emerging markets.  

(2) Services Businesses Still in Decline:

Service revenue declined 8.8% quarter-over-quarter from $794 million last quarter to $724 million this quarter. However, both quarter included service revenue deferrals due to the currency crisis in Venezuela ($72 million last quarter and $67 million this quarter). Without the Venezuela currency impact, service revenue actually declined 11.5%. Going forward, the company project a 12% quarter-over-quarter decline in Q3/2014, which is much higher than the single-digit decline projected in prior quarters. The faster than expected decline in service revenue is attributable to lower device sales and the migration to BB10 devices which receive lower service revenue than older BB7 devices. 


(3) The Restructuring Process is Costly:


The company already announced a planed reduction of 4500 employees. In the Q2 report, the company further elaborated that this plan will cost $400 million ($0.76/share) over the next three quarters.  To help alleviate the financial strain, the company is putting up $122 million ($0.23/share) of assets up for sale immediately. 


The Positives: 

(1) Ample of Liquidity:


The company burned $500 million cash in the quarter;  however, the cash burn rate should decrease after the company cut expenses and cash is received from selling its massive inventory. Z10 devices are now worthless on the company's books (thanks to the $934 million inventory charge) and could be sold at very low prices to protect its market share and increase BlackBerry's cash flow. With nearly $2.5 billion of cash on hand and a $500 million tax refund in Q1/2015, BlackBerry does not face a liquidity problem and could survive for the next few quarters. However, if it does quickly restructure its businesses, the long-term survival of the company could be at risk. 


(2) Purchase Obligation Less of a Drag on Valuation: 


BlackBerry bears like to point at the $5.3 billion purchase obligation stated in the Q1/2014 report as drag on the company's valuation. In its new Q2 report, purchase obligation decreased significantly to only $3.1 billion and could be reduced further as the company further re-align its purchase obligation with expected demand for its products. 


(3) Lost Service Revenue can partially recover:

The company deferred $72 million of service revenues in Q1 and $67 million in Q2. Of the $72 million deferred last quarter, $25 million has now been collected and the company expect further payments. Therefore, the lost service revenue could partially recover although it may be difficult to recovery the full amount. 

(4) Channel Inventory is Reduced: 

Sell through this quarter was 5.9 million units vs. shipment of 3.7 million units, which decreased channel inventory by 2.2 million units. Usually shipments increase after channel inventory is decreased significantly, a slight positive for the next quarter. 

Conclusion: 

Overall, the Q2 report revealed a more negative picture but there are also some positives as well. The $9 preliminary offer from Fairfax is discounted by the market because Prem Watsa is still seeking financing. Nonetheless, investors should not doubt his 28-year track record at closing deals and making good on his promises despite negative developments. He will keep his word and the $9 offer will be finalized. Other bidders may emerged but the $9 offer price still represents a 16% gain from today's market price of $7.75. The headlines may not be friendly to BlackBerry and the future prospects of the company is not 100% positive, but it looks like the maximum point of pessimism has been reached on the stock.

UPDATE( 1:00pm EST), Dow Jones reported that there are "other parties" interested in BlackBerry including Cerberus Capital Management. It is more likely than not that maximum point of pessimism has been reached.

Source: BlackBerry Q2 Report 

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