Although I tried to keep this blog mostly focused on investment strategy, I do want to comment on BlackBerry (BB/BBRY) because it is one of the my larger positions. I have held it for about 2 years. Despite significant improvements in the company's financials and operating performance, the stock price continues to languish because of extreme viewpoints between the bulls and bears on the company and its stock price. Moreover, the latest NASDAQ short report shows 91 million shares are shorted, a figure that no doubt has gone up since the June 23rd earnings report,
When I traveled to Waterloo on June 23rd for the annual shareholder meeting, I summarized the whole meeting into three takeaways, which I will explain below. Readers can view a recorded version here.
"The company continues to anticipate positive free cash flow. The company continues to target sustainable non-GAAP profitability some time in fiscal 2016." BlackBerry FQ1 2016 Outlook Statement
The outlook statement issued two weeks ago is much more positive than the one issued a year ago (see below). The "maintaining..cash flow" has been replaced with "positive FREE cash flow" [caps for emphasis].
"The Company anticipates maintaining its strong cash position, while increasingly looking for opportunities to prudently invest in growth. The Company is targeting break-even cash flow results by the end of fiscal 2015."
Furthermore, readers should take note the use of the word "sustainable" in the outlook statement. From his past interviews, Chen has indicated he would follow the same playbook he used at Sybase before. When he has achieved profitability after stopping the bleeding, he wants it stay there. He has achieved 55 consecutive profitable quarters after stabilizing Sybase and the progress he made at BlackBerry has been impressive. He is carefully laying the that strong foundation to support sustainable profitability.
With services revenues (SAF revenue) continues to decline at a rapid pace of 15% per quarter, execution risk is high. However, Chen's report card shown at the meeting displayed a good track record of execution in the past year.
- FY 2015 Break-even cash flow: Achieved. Of course, the cash balance increased significantly during the year from $2.7 billion to $3.1 billion by the end. However, since most of that was due to the land sales, the proper way to see the cash flow is consider the following:
- Reported FY 2015 Cash Flow from Operations was $813 million
- Capex consist of the $87 million for PP&E additions and $421 million for purchases of intangibles. Total $508 million.
- Land sales (from the Proceeds from PP&E sale line) was $348 million.
- Net cash outflow was $43 million. While still negative, it is a remarkable improvement from the first quarter when Chen here when he had to report a quarter (2/3 of the quarter he wasn't in charge) with cash outflow of $1 billion. It should be noted that the purchases of intangibles has been reduced to $11 million or 90% on an annualized run-rate basis in the latest quarter (FQ1 2016).
- FY 2015 Cost Reductions: Costs are down 58% (ex non-recurring items like restructuring charges) since Chen arrived. The cost base is well position for sustainable profitability. I expect it'll be around the $350 million level going forward.
- Launch New Products: Launched three new phones last year with new software offerings such as BES 12, Blend, VPN authentication, BBM Protected and BBM Meetings.
Chen has been consistent at delivering results. Although he gave hints he would like to see more revenue, he never formally targeted for revenue growth. The tone of the MD&A has been for "revenue stabilization", which quite different from outright growth. The rate of decline has slowed, which is encouraging.
Chen showed a pie-chart of the revenue mix in the recent FQ1 2016 quarter with 20% in software revenue. He said he'll need to "grow the size of the pie" since he understands the importance of replenishing the lost services revenues that are rapidly disappearing. While analysts were disappointed that the majority of the $137 million in software revenue was due to a patent licencing deal, $137 million in revenue (with gross margin around 90%) is still $137 million earned.
Chen has shown he has many ideas on how to get to his $500 million software goal for this fiscal year. First, he has grown the customer list of BES by another 400 customers, stealing notable customers like RBS from key competitors like Mobile Iron. Second, Chen told analysts that number of gold customers was roughly half of the installed base, which is a higher conversion rate than most expect. Expect those new gold customers to contribute to the future company. Lastly, the monetization of the patents could add considerable profitable dollars even if they are delivered in big lumps. Therefore, investors should watch that software line.
Takeaway #3: Watch IOT
Chen has been straightforward about his strategy of leveraging the company's security and productivity strength into the IOT. There is now over 60 million, up from the 50 million figure released in January, cars using the QNX software and there could be billions of more potential devices need a BlackBerry solution to connect safely and securely. While IOT is a promising trend, there has been many resistance against this trend because of privacy and security concerns [The Globe and Mail has a good article series on IOT which document this concern]. Since BlackBerry is known for its "privacy" and "security", I think it'll be a major player if it can partner with the right tech companies to deliver IOT solutions. It announced a partnership with Intel on a more advanced connected car system and I expect to see more of those going forward. Chen has utilize partnerships well on many fronts to improve the company's financial position and reduce internal resource needs.
Overall, I think Chen has the right strategy but the market has not rewarded the strategy yet because the revenue growth is still negative. He has executed well last year despite the tough operating environment. I look forward to his execution in fiscal 2016, which could be a key turning point in this BlackBerry turnaround.
What now after the 10%+ Share Price Decline After Earnings and Annual Meeting?
The stock declined on what has been perceived a weak earnings in the first quarter of the new fiscal 2016. However, I believe it was a decent quarter and the stock price decline is unjustified. I initially had a more negative view but after reading the MD&A and thinking about it from a second level, I believe the results aren't as bad as they appear. I will address two top concerns.
The stock initially rallied on the solid $137 million software but the stock dived when most of that number was revealed as licencing revenue, which are described as lumpy by Chen.
The concern here is about so called "core growth". Here is the math that Chen and his team fumbled a bit on the conference call:
- Looking the revenue lines, software revenue was $54 million in FQ1 2015. Chen said the BES business, one that analysts consider "core", grew 23-24% in FQ1 2016. That would get the $54 million figure up in the range of $66-68 million, which is lower than $74 million reported in the previous quarter (FQ4 2015).
- Although Chen is comfortable with the number, analysts don't like the negative Q/Q growth from $74 million to $66-68 million.
Although I would like to see growth above the $74 million last quarter, I am pleased to see the 400 new customer additions. They will no doubt add revenue in the following quarters and I was also pleased with the conversion rate from silver to gold. In the past the mix was 30/70 for gold/silver and now it's at 50/50. I know the analysts are in the rush to see revenue results but I think they should read the section on pg 19 of its 40F filed in March:
"..Customers typically undertake a significant valuation process...can result in a lengthy sales cycle.". For the readers familiar with accounting, GAAP rules say you can only record revenue when the sales cycle is complete.
Also, like I mentioned above, the extra $70 million or so of licencing revenue is significant. It shows BlackBerry has a deep patient portfolio that can generate a stream of cash payments from established tech companies like Cisco . Chen is hinting for more deals later in the fiscal year.
The hardware revenue of $263 million was disappointing given it was down from $379 million in the same quarter last year. However, hardware was operating with positive gross margin and there is limited inventory risk.
- In the last quarter before Thorsten Heins resigned, the hardware had a gross margin (my estimate) of -28% with 1.9 million devices recognized and ASP of $250. That means a gross profit of -$133 million on the hardware side. Even former Jim Balsillie admitted in a recent public appearance that "People thought we [RIM/BB] made money on handsets. It was all services money."
- In the latest quarter, the hardware had a gross margin of 2% with 1.1 million devices recognized and ASP of $240. That implies gross profit of $5.3 million. I would prefer $5.3 million than -$133 million but investors are not viewing in terms of gross profits. They prefer to see in revenue terms where the $475 million (1.9M x $250) is better than the $264 million (1.1M x $240).
As Jim mentioned, the old model was building devices and earn the service revenue. However, since Chen realized this is not a viable strategy anymore, he has to optimize the device business to make it at least slightly profitable, which meant it had to get smaller and rely on partners like Foxconn to reduce fixed costs. He is now improving those efficiencies by partnering with Wistron and Compel, which could be a sign of plans to ramp up future production. Moreover, he is also right that BlackBerry should not sell the device business because it is a key offering that complements its security value proposition and act as "first gate" to the enterprise customer as Chen likes to say.
A short technical note I would add is that the 90% year-over-year reduction in purchases of intangibles in the cash flow line. This means the cost of devices business, liscencing costs, has reduced significantly to reflect lower volumes. Since these costs are amortized over 2-3 years, the lifespan of the phone, the income statement's amortization line is much higher than in reality.
In a press release announcement the share buybacks, Chen inserted a quite interesting phase. I asked him about this the Shareholder Meeting but he won't directly comment on the undervaluation of the shares but he does indirectly hinted that he standby the statement below. I agree and I'll wait patiently. The biggest asset for an investor is patience. As Ben Graham said, "You don't want to turn this basic advantage into your biggest disadvantage."
"We intend to take advantage of our strong cash position to purchase our shares when the market price does not reflect what we view to be the underlying value and future prospects of our business, without adversely affecting our strategic initiatives"
Disclaimer: The author is long BB (TSX-listed shares). The author has added BB in the past 2 weeks and will continue buy if prices remain low.