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!