Friday, December 16, 2011

Living within your limits: Thoughts on Research In Motion (RIM)

I have a sixteen-year old daughter who calls me "old man" and while I know she is using the term lovingly (of course.. I believe the best about my kids), the moniker still strikes home as a reminder that I am older and that age brings limits that I can choose to ignore at my own peril. I know that I can no longer go to bed late and get up early, that I have to watch what I eat and that I need my reading glasses to read restaurant menus. As I watched Research in Motion (RIM) go through painful contortions in the financial markets yesterday, I was reminded that companies also go through an aging process, and how they deal with the limits that come with age determines their value to investors.

RIM has had a pretty good run as a company, but they have a problem. Their core technology which powers the Blackberry is a cash cow but it is one that faces corrosion in market share, as smart phone users turn to Androids and iPhones, with their more open operating systems and extensive app libraries. As the CEO of RIM, you have two choices.
  1. Go for growth: You can invest hefty portions of the cash flows from your core technology back into the business in R&D and new products, hoping for a breakthrough, but you are competing against two companies, Apple and Google, that have more resources and imagination than you do. You may be able to eke out growth but the amounts you would have to reinvest to generate that growth may make it a losing proposition for your stockholders.
  2. Go for cash: You can accept the reality that you have a product with a limited life but solid cash flows. You invest just enough to keep this product on its feet and a cash flow generator for the near future, and give up on new products and technologies.  You also change your capital structure and dividend policy to reflect your new status as a limited life, cash cow: use more debt in your financing and you return more of your cash to stockholders as dividends or stock buybacks. You are, in effect, liquidating yourself over time, and while your stock price will approach zero by the end of the Blackberry's life, your investors would have collected enough cash flows not to care.
So, what are the value implications of your choice? In the fiscal year ended February 2011, RIM reported pre-tax operating income of $4.6 billion and net income of $3.4 billion, but this income was after R&D expenses of $$1.4 billion. While their earnings has plummeted in the last two quarters (operating income in the 12 months ended November 2011 was down to $3.4 billion), and some of the drop can be attributed to a loss of market share for Blackberries, the drop was accentuated by losses on new products such as the Playbook tablet.  In fact, let's be conservative and assume that the operating income in 2012 will come in at less than $ 2.5 billion and that RIM, if it gives up on developing new products, can cut $ 1 billion out of R&D. (The remaining $400 million or more can go to maintaining the Blackberry Franchise). That would translate into a base pre-tax operating income of roughly $ 3.5 billion and after-tax cash flows of $3 billion. Assume further that you can milk the franchise for five more years, losing 20% of your customers each year. On an after-tax basis, using a tax rate of 30% and a cost of capital of 9% (which is the cut off for the top quartile of US companies), you get a value of about $8.125 billion. At its current market capitalization of $7.3 billion and enterprise value of $ 6 billion, that would make RIM a bargain (under valued by about $2 billion). In fact, make your own estimates and judgments, using this spreadsheet. So, what can go wrong? If managers continue to operate under the delusion that they can recreate their glory days and invest on that presumption, they can very easily wipe out the $ 2 billion difference. In fact, I think that the market is building in the expectation that RIM will continue  not to act its age, investing as if it were a growth company, whose glory days lie ahead of it.

As a potential stockholder in RIM, here is my unsolicited advice to the management of the company. Rather than fight the critiques of your product (that it is closed, corporate and limited), embrace them. In fact, I have names for your next few models: the Boring Blackberry, the Blackberry Funsucker and the Blackberry Stolid. Let's face it! The primary market for Blackberries is composed of paranoid (often with good reason) corporate entities that worry about their employees revealing business secrets and playing games on their iPhone and Android Apps, and you will appeal to them with your "cant have fun with these" Blackberries. Disband your research and development teams, forget about product revamps and don't even dream about more Playbooks. In effect, accept that you are an "old company" and behave like one. Your stockholders will be deeply grateful!


Angad Guglani said...

Great article Prof Damodaran! My question is where does RIM's 9 billion dollar equity fit into the equation? At the end of their 5 or so year life cycle, wouldn't RIM liquidate their assets and return the cash to their shareholders? If that is the case RIM could be valued as a bond rather than an equity.

Aswath Damodaran said...

The dollar equity is an accounting value. I have actually assumed that RIM"s value comes entirely from the cash flows generated on the Blackberry and that the liquidation value for its assets is close to zero. Conservative...Maybe... But I don't need a liquidation value to justify $8 billion. If there is any liquidation value, it would be gravy.

Mike said...

Hi Professor,

Great article.

I have a question: Currently, RIMM does not pay dividends. Do you suggest that they start paying dividends? Will you be a buyer of RIMM if it starts paying dividend?

Aswath Damodaran said...

In fact, I am going further. I want them to pay liquidating dividends, i.e., dividends that exceed their earnings. If they do and they stop trying so hard to be a growth company, I would buy the stock.

Vignesh said...

Great Article Prof, but why havent you discussed the possibility of RIM divesting its equity in favour of either google or apple? since google went for motorola and apple doesnt go for big companies maybe nokia? Or the possibility of a major phone company taking up a small stake and help RIM with its strategy?

anant krish said...

Interesting article professor!

But shouldn't RIM also be thinking of using its cash to acquire new technologies through acquisitions? I mean, if the company is in a position to pay a liquidating dividend, shouldn't it look towards survivability by looking for external technologies?

If u take the case of Apple, many of their technologies (including the latest 'Siri') were obtained through acquisitions. Hence, I believe that RIM would use its cash to sustain itself rather than choose to go out of business without a fight.

Liron said...

Hi Prof Damodaran,

Thanks for an excellent article.
I'm probably missing something, but are you assuming that by reducing the customer base by 20%, operating income would drop by 20% as well? Wouldn't you expect some fixed costs that would cause the operating income to drop faster than the revenue (customer base)?

Thanks again!

Unknown said...

Excellent article, professor.

"But shouldn't RIM also be thinking of using its cash to acquire new technologies through acquisitions?"

I don't think so. At IMN (Imation) directors are being accused of throwing good money after bad in desperate acquisitions.

Why would I believe that RIM would be any good at acquisitions? Couldn't I just buy shares in other companies myself, if I thought they were any good? Can I really be expected to believe that RIM would be able to have "synergies" or what-have-you through acquisitions, or would that just be a load of management flim-flam?

Aswath Damodaran said...

Vignesh: You cannot divest equity. You can divest assets. In fact, the $8 billion value is my estimate for the Blackberry franchise, if they chose to divest it. They would then have to liquidate immediately.
Anant: Acquisitions cost money. You can buy growth, but if you pay too much (which I what I think they will end up doing), it will hurt stockholders, not help them.
Liron: Your point about fixed costs is a good one. I assumed that operating income would drop 20% a year, which is gory, but that may happen with only a 15% loss of customers each year.

Liron said...

Thanks for the answer Prof.
Do you perceive 20% annual drop in operating income to be gory?
From yesterday's report the drop is 74%. Even if we add back the playbook inventory mark down fiasco of $485M and the excess amortization of $31M, you still get a drop of 32% in the operating income.

I'm just wondering if this is not one of those cases where a company that looked cheap at 30$ earlier this year, looks cheap today at 13$ and would look cheap all the way down as fundamentals deteriorate with market cap.
Also, on the M&A front there seem to be less buyers these days, after Google took on Moto, Microsoft built an alliance with Nokia and HP is out of the buying frenzy. Perhaps Sony is a candidate, after leaving the Sony-Ericsson partnership.

Mike said...
This comment has been removed by the author.
Mike said...

Thank you Professor for a candid discussion. Your points make sense from the point of view of Finance, but might not make Economic sense (Economics:People respond to incentives).

Have you considered what kind of incentives do the RIMM management and board have? Do the current incentives favor what you have suggested? Most likely, they do not.

My guess is that the incentives for the management are more aligned towards wasting its capital and resources, as they are in many companies. As the pie gets smaller, the management will take a larger percentage of the pie and the investors will get a smaller piece.

This situation can change if minds like you join forces and become activist investors.

Any thoughts?

Aswath Damodaran said...

It's all finance. My post was from the perspective of what's good for stockholders. Yours is that the financial interests of management may diverge. In this case, I think that it is more ego than money that is getting in the way. The top managers at RIM own large chunks of the company....

dshahinian said...

Hi Prof Damodaran,

Why didn't you add back D&A to your After-tax adj. operating income? Is D&A baked into the R&D figure?


Himanshu Kundoo said...

Prof Damodaran.

brilliant subject and great perspective.
But i feel technology stocks can loose their market share in a way quicker rate than 20% par se if they dont innovate.

If RIM starts paying off equity holders(change their dividend policy) analyst will pick it and valuation will take a strong beating.

I believe RIM should now try to cater more to developing markets where iphones and galaxy tabs are quite expensive and Blackberry still holds it charm(Like indian markets).

This way they can generate cash flows for a longer period of time and try to get a technological breakthrough.

and yes from a share holders perspective where i believe growth is zero(in fact in this particular case negative) why would i keep that stock until unless its dirt cheep( book value is more than market value).


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Pranav Pratap Singh said...

Dear Prof.,
Could you tell a bit more about paying liquidation dividends by taking debt and changing capital structure of the company. Will the cost of capital change accordingly to reflect increase in risk of default, and an additional benefit to shareholders acrrue because of tax benefit on payment of interest?

Aswath Damodaran said...

There will be a small value increase from the tax benefits of dividends. The bigger benefit will come from the stoppage of new investments that effectively waste money and destroy value.

Anupam said...

Hi Professor, thanks for the article. So let me play the devil's advocate. The number of subscribers to BBM has been growing steadily and those recurring revenues are over $4billion annually and the margins are high. Hardware business is a cash drain. QNX platform is taking off.
So what if RIM breaks up into three companies:
NewcoA: The NOC/BBM/BES business, open to all devices from all platforms. Potential market of a billion devices.
NewcoB: QNX platform. Compare it to Android. License it to all hardware vendors. Remember QNX is used in autos as well.
NewcoC: Hardware Business (make those gadgets).

NewcoA will ofcourse be the most valuable asset. If they do this, could the value of the firm be maximized? Could it be more than the liquidation value as you suggested?

Also, reports in respected outlets suggested that Amazon was looking at RIM this past summer when the stock was at 30ish. So if one takes just 40-50% premium (Google paid 75% premium for MMI), we are looking at north of $42 that Amazon was probably willing to pay. But we dont know anything concrete about this.

But I agree with you about this management team, esp. the two co-founding CEOs. IMHO, they may have reached their level of incompetence and living in a distorted reality universe and have not grown up and compounding the mistake by not admitting that they let Apple and Google walk away with the prize. Also compared to Apple, Google and Microsoft, RIM is a rounding error in terms of sheer size. Wont RIM be better off in the hands of more resourceful company?

Will the Canadian government step in some form to save its flagship company or will we see a replay of Nortel?

Will this board wake up, esp. Prof. Martin who seems the right person to take on such bold initiative and either sell the company or break it into pieces but if these two things are not possible, then follow your recomnmendation?

mche2450 said...

Hello professor. I appreciate your insight into RIM's plight, but I think you have been living in America too long and have looked at this issue in an American vaccuum.

Firstly, your comment that "Apple and Google, have more resources and imagination than you do" is an argument that I never would have thought you would make. As tough as I believe it is to judge imagination objectively, I will make one statement in RIM's defence: RIM invented the smartphone, so they should get some credit for their inventiveness. Also, your projections show a smartphone market that is the same as today 5 years from now, when 2 years ago RIM dominated the market. Are you expecting the market to remain in its current state for that long?

Secondly, RIM's stock price has followed the subscriber base in the US only. What about the Rest of the World (ROW). Currently, RIM is the #1 phone in Mexcio, Indonesia, Turkey, South Africa, Chile, Nigeria and Sri Lanka. So although earnings have been hurt in the short term by erosion in America only. Does the rest of the world count for anything? Here is an article that backs up this point:

Lastly, you really trash RIM's management. Shouldn't they get some credit for actually owning a large portion of the business (10%) and therefore making them different from most professional managed corporations. Also, RIM's mangement took the company from 0 in 1998 to the largest company in Canada, shouldn't their experience count for anything?

Please let me know what you think.

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Rajiv said...

Your comments are refreshing and counter intuitive, but having said that, I believe your analysis is an OVER-SIMPLIFICATION of the whole situation.

I find it hard to believe that even if RIM concedes that it is nearing the end, it will be able to retain its customers, employees, partners and financiers for another 5 years, albeit with a 20% loss each year. I think they are all going to leave RIM estranged in no time.

I am afraid, if RIM were to act upon this advice, it would be suicidal as it is certain to doom. Moreover, it’s not going to take 5 years for that to happen, six to eight quarters is all it will take.

Anupam said...

I have been thinking about you wrote some more. Reminds me of when Michael S. Dell infamously adviced Apple to liquidate and return cash to the shareholders in 1998ish. If Apple would have listened, that would have been an advice that would have costed $470 billion. Only in foreign Policy such magnitude of loss is made on wrong advice.

Have you looked at Research in Motion's new operating system QNX that can run a number of devicees including phones and tablets? In your own place of birth: India, have you seen the die-hard brand loyalty Blackberry commands?
I think liquidation would be as foolish an idea as Apple liquidating in 1998. RIM should partner with a bigger company or split up. This company's potential is huge.

We will see who is right in 3 years.

I have learnt a lot from your writings on corporate finance in general. Thank you

Anonymous said...

There is a third option. Rather than attempting to be an innovation leader chasing after the broadest consumer market, RIMM could implement a market segmentation strategy. Instead of chasing consumers, they could push security, redundancy, and target corporate customers and individuals who need security.

Does anyone remember the old style RIM pagers that allowed you to text on a proprietary frequency with less bandwidth? Those devices could be 50 miles away from a tower and still get a message through. During an earthquake or other emergency, those pagers were the only devices that continued to work while the cell network collapsed. That is one reason governments love them. Instead of allowing messaging over SMS only, couldn't they design in some proprietary bandwidth technology to allow messaging at further distance, with greater reliability and redundancy?

I am not sure what the differentiation should be, but my instincts tell me they could design something 85% as good as Android, but with unique features that are important to key customers. In the end, they would implement your runoff strategy for the consumer market, and then refocus their R&D to capture a smaller and more segmented market in which they could dominate.

Anonymous said...

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