The Two Faces of RIM: How Do You Read It?

Research in Motion (RIMM) is no stranger to volatility following its quarterly earnings reports, and Thursday morning was no exception with the stock trading off more than 5%. On Wednesday evening, the Blackberry maker released results that were slightly weaker than analysts’ estimates and showed a further decline in average selling price per unit to $311. Earnings per share came in at $1.27 which was 27% higher than a year ago yet still trailed estimates by a penny. Revenue growth of 18% to $4.1 billion also missed expectations by a fairly significant margin, as shipments of about 10.5 million units fell half a million shy of analysts’ projections. The company’s co-CEO Jim Balsillie admits that the smart phone market competition continues to be stiff, but they are pleased with their market share leading position adding another 4.9 million subscribers in the quarter.

While there were some disappointments in the previous quarter, the company also issued guidance for the current quarter that was above Wall Street’s view. For the first quarter of 2011 RIM expects sales of $4.25 to $4.45 billion and gross margin slipping to 45.7%. This expectation translates into EPS of $1.31 to $1.38 on net subscriber gains of 4.9 to 5.2 million. Analysts were anticipating $1.23 per share on revenue of $4.33 billion, so clearly the company is more optimistic about the current quarter than the analysts. What is an investor to make of the new data and the positive guidance?

On the one hand, RIM explains that the disappointing revenue in the fourth quarter was really due to a one-time inventory adjustment by a wireless carrier. If that is the case, we believe this is a very bullish report by Research in Motion and shows that while margins may continue to be squeezed they are expanding their grasp on the enterprise market worldwide. Despite the inventory adjustments, RIM still grew earnings by 27% and their market share remains impressive. Margin expectations for the year ahead (45.7%) are actually holding up better than analysts’ expected. We would expect some decline in margins as the company expands its presence in emerging markets, and that we believe is worthwhile venture. In previous quarterly conference calls, Mr. Balsillie has referred to this strategy as a “land-grab”, and we think there is still plenty of land for the taking in both emerging markets and still decent opportunities for growth in developed economies as well.

However, there are certainly reasons for concern as the average selling price for RIM smart phones continues to plummet. Internal estimates had expected an ASP of $320, but reality was a good bit lower at $311. Expectations are for further deterioration in this metric to $305 to $310 in the first quarter. In addition, costs are rising; Research & Development rose 46.4% and SG&A were 22.4% larger than a year ago. The increased spending in R&D is not necessarily a bad thing, as RIM will need to continue to improve their offering in this extremely competitive market. Additionally, there are concerns that RIM is losing steam in the North America market; the most important at this time.

Wall Street analysts are split on their view of the quarter with Goldman Sachs (GS) downgrading the stock to a Sell due to pricing. However, Barclays (BCS) and UBS (UBS) have raised estimates and price targets based on the news, and RBC Capital Markets’ Mike Abramsky reaffirmed his Top Pick rating and a $120 price target (he remains the most bullish on the stock). Coming into the report, the analyst community was overall bullish on RIM with a median price target of $90 per share. According to Yahoo finance, the number of analysts with a bullish rating is 27 versus only 5 with a bearish view on the stock this month.

At Ockham, we continue to believe the stock is Undervalued and we are not dissuaded by the quarter just ended. The stock continues to have huge growth potential, and it is already a market leader. Earnings are growing very nicely, despite some give away in ASP and gross margin. When looking at the market’s historical valuation of RIMM, we can demonstrate further reasoning why it is price to deliver above average returns. For example, RIMM has normally traded for a price-to-cash earnings multiple of 15.3x to 43.4x, but the current metric falls below that range at 14.8x. Similarly, with a price-to-sales ratio of 2.61x, the stock looks rather undervalued compared to the historically normal range of 3.43x to 10.44x. Now, to be clear, we would not expect Research in Motion to achieve anywhere near the top end of those historical valuation ranges, but if it were able to meet the bottom end of the ranges, based on current fundamentals, we would expect a price $86 per share.

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

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