Thursday, September 23, 2010

6 Reasons RIM Is A Buy Right Now

This article originally appeared at Cantech Letter, the online authority on Canadian Tech stocks.

The global smartphone market is growing at 30%+ per year. RIM is a huge player in this industry, and the company is benefiting from the industry's growth. Two weeks ago, it released a stellar 2nd quarter earnings report that blew away expectations. Nevertheless, the stock has lost almost 2/3 of its value over the last two years. As a result, the stock has now become a value opportunity, for the following six reasons:

1) Returns On Capital

RIM is highly profitable. Profitability is not about market share momentum, but that's what the market is focused on. Profitability is about generating returns on investment. RIM generates extremely strong returns, as its trailing twelve months return on average equity is 38%! (This is superior to Apple, though Apple is also in businesses other than phones, so a direct comparison is difficult. Google, on the other hand, gives Android software away free, currently generating nothing in the way of returns.)

A 38% return on equity is enormous. To put it in perspective, Google, Microsoft and Exxon, three very profitable companies at the moment, generate returns on equity of just over 20%.

2) Cheap

RIM's P/E is under 9, based on trailing twelve month firm earnings and the company's current market cap, following its recent share buybacks. This is extremely cheap for a company growing revenue 30% year-over-year that has outstanding returns on equity. As Joel Greenblatt has shown time and again, a stock with a high ROE and a low P/E is a recipe for success.

3) Safety in financial position

The company has no debt, and sits on a couple of billion dollars of cash. Furthermore, the company generates about a billion dollars in cash per quarter, leaving it free to make further return-generating investments or return cash to shareholders (of which it does both).

Often, companies see high returns on equity by levering up with debt. RIM generates the strong equity returns described above even though it typically carries a few billion dollars in cash!

4) New products

Right now, the company's earnings reports include costs associated with products not yet on the market (e.g. the company is reportedly coming out with a tablet computer in November). The company now spends $300 million per quarter in R&D, but the benefits (in the form of revenues) for the new products are obviously not yet reflected in the current financials, even though the costs are. As such, the company is even more profitable than it appears, as many of its current expenses are for future products.

5) Buybacks

The company knows its shares are cheap, and so it is reducing its outstanding share count at a price that is beneficial to current shareholders. In the first six months of this year, RIM has spent $2 billion buying back shares, whereas its market cap is only $25 billion.

6) Confirmation Bias

RIM blew earnings estimates away when it reported 2nd quarter results two weeks ago (revenues, units, prices, and earnings all beat expectations). But the market focused on two items, and kept the stock price down: 1) subscriber growth was lower than was guided, and 2) the company will no longer guide on ASP's and subscribers. The focus on these particular items is taking place because existing market sentiment on the company is already negative, and our tendency to be influenced by confirmation bias causes us to selectively place undue importance on items that confirm our original opinion. In this case, the market is negative on RIM, so it is focusing on any negative that it can find.

Market sentiment can change quickly, but it has not done so on this stock, despite the stellar earnings report. But the best time to invest is when market sentiment is negative, because that's when the investor is offered a great price. That time is now for Research In Motion.

For more on why RIM is not the next Palm, see this article.

24 comments:

Justin said...

hmmm...a bit out of the traditional value territory for sure at a P/B of just under 3.5. The question is can RIMM hold on to its existing share of a growing market? If it can do that and the market continues to grow at least 20% for the next few years then it would seem the stock could turn a bit positive.

I don’t support management buying back shares at these levels, especially with a ROE over 30%. That would seem like a poor use of shareholder cash. They should continue to reinvest in projects that can generate excellent returns like they have been doing or give the cash back to shareholders.

Finally, there is no margin of safety here….again in the traditional sense. You’re assuming growth as the margin of safety. This stock could be cut in half to $25 and still would not give common shareholders protection. At those levels though it could be a juicy takeover candidate.

It is seriously undervalued as compared to its peers by a wide margin though.

Can you address the margin of safety part of the equation a bit more?

tscott said...

It’s tough to call I think! I used to own RIM but after the torch, I switched camps. If the bears are right than a PE of 9 isn't really a steal. I read all the cell phone blogs and I am a bit of a techie. This new torch phone is pretty horrible. It got decent ratings from people like CNET because it is the best RIM phone ever. However compared to anything from Android and Apple it is freaking horrible. It would have been a great phone in 2008. Its screen resolution, processor, and form factor are terrible.

Now before you come at with me with the security and corporate IT arguments, I'd like to remind you that JP Morgan and 80% of the Fortune 100 companies are testing the iphone.

In addition, IT managers love having a unified system. And the new windows mobile may take some of the corporate market away.

If EPS falls 15% per year, from $6 and using a 10% discount rate, then this stock is worth $24. But who knows, they could make a great phone, the emerging markets are strong and its high market share makes it an attractive takeover target. I just don’t feel strongly enough to pick a side.

Ankit Gupta said...

How do I get data on insider transactions for RIMM? EDGAR had very limited information.

Dan said...

Good article to reiterate the value being dismissed by general market sentiment. Many people don't understand that RIM does not need to 'beat' Apple or Android to be a profitable company (and an even more profitable stock). Another misunderstanding is the market share losses by RIM in North America, currently about half of RIM's revenue is coming from outside the US. Many 'analysts' are not seeing the big picture.

widemoatinvesting said...

If I bought the whole of RIMM at today's prices and owners earnings stay at this level, it would take me 9-12 years to get all my principal back. At that point, what would my business be worth?

For me, it is very hard to say, given that just five years ago, for the fiscal year ending in Feb 06, RIMM had 2B in revs and 380m in earnings (acc. to Morningstar).

Going back further, in 2001, could I have reasonably predicted RIMM's competitive position today? Unfortunately not, so intuition tells me I probably can't predict it for 2019 either.

So, too hard for me, at least at today's prices.

Paul said...

Ankit,


Try this site. It's the Canadian version of the SEC. Thanks to Saj for showing me this earlier.

http://www.sedar.com/search/search_en.htm

Paul said...

Justin,

I agree with you. The stock looks cheap compared to competitors, but I don't see the margin of safety.

Technology is a hit and miss
field. Three years ago, there was so stopping RIM. Now, there is no stopping Apple. Who knows where we'll be 3 years from now!

I believe Saj's thinking for margin of safety is that the company is growing so quickly that it is cheap given those prospects. Traditional value metrics will look at book value, price to book, p/e, etc. I believe Saj talked about how cheap it was minus the cash on it's books, so maybe with that in mind, it'll come closer to meet those other metrics.

The stock has a ton of analyst coverage, so it's not something I would be able to add a lot of value on.

Paul said...

Ankit,

Try this site:

http://www.sedar.com/homepage_en.htm

Credit goes to Saj. He told me about it a while back

Anonymous said...

hi saj,

"Google, on the other hand, gives Android software away free, currently generating nothing in the way of returns."

are you serious about this? ;-)

here's a view from Google CFO:

“Android cost isn’t material for the company,” Google CFO Patrick Pichette noted. He said that it’s important to remember that perhaps the key products for Android — the phone hardware — isn’t developed by Google at all. Droid X, for example, was entirely an investment by Motorola to make the device. “The entire ecosystem is exploding,” Pichette said.

“I think the most important thing beyond the growth is that the most popular app is a browser,” Jonathan Rosenberg, Google’s SVP of Product Management, added. And what do people do there? They search — more than they ever have, Rosenberg continued. In fact, he says that search on Android devices grew 300% in the first half of 2010. Rosenberg also added that mobile search growth across the board is up some 500% in the past two years from a traffic perspective. “Android is an accelerator of that,” Rosenberg concluded."

(reference: http://techcrunch.com/2010/07/15/android-costs/)

im pretty sure that Google makes money with android!

1. hardware is a low return business
2. software can be a high return business, but google offers a business model that makes it very hard to compete with! they give the software for free, but monetize its uses! (e.g. search)

can anyone run some numbers on google!? ..maybe its cheap? ;-)

best wishes,

nell

Saj Karsan said...

Hi guys,

Good discussion!

Hi Justin, I agree that this stock is somewhat different from most of the stocks discussed on this site. It is less "Ben Graham-esque" and more "Greenblatt-esque", in that the margin of safety is not in the form of inventory or A/R, but instead in the form of earnings power, relative to price. It's not alone on this site, however, as GameStop is another example.

I disagree about how cash should be deployed. I do agree that when ROE is high, the company should retain the cash it needs to continue to pursue its strategy. However, cash left over after growth needs are met should not be forced into investments management is not confident about. That cash should be returned. Whether that takes place via dividend or buyback should be based on the tax environment and whether the shares are good value. Buybacks at this level will turn out to be a phenomenal investment if the company continues to remain this profitable in the coming years.

Hi Nell, whether Android or somebody else makes the software, the user is still using Google's other products, so at this point it's not clear what Android is adding. In the future, that may change as Android incorporates local advertising into these devices, but they're not quite there yet.

Anonymous said...

hi saj,

"whether Android or somebody else makes the software, the user is still using Google's other products, so at this point it's not clear what Android is adding."

> i disagree, because it is clear that > android adds more "search
> clicks" (from mobile clients) to
> googles business.

In the future, that may change as Android incorporates local advertising into these devices, but they're not quite there yet.

> i disagree, because today advertising > is included in some apps.

best wishes,

nell

Anonymous said...

Dear Nell,

I don't know if you realized how people that are using the smart phones to browse the internet are the same people on google on their PCs or Macs. So in that sense Google may be not expanding their advertisement targets. And last time i checked over 95% of Google's revenue are from advertisements. So in this sense even with Andriod they may not gaining any much. If anythign this may be googles attempt to get their foot in the door to expand to another business.

valueinvestor2010 said...

Hi Saj first of all congrats on a really tremendous blog. Some of your stuff is positively super :-).
Coming to RIM I just had a few queries on RIM in specific and and technology in general
1)Do you think RIM can outspend Google/Apple in a war of attrition, don't they have massive cash reserves?
2)Is RIM a possible buyout target for other Tech giants like IBM/HP/Microsoft etc
3)Is RIM's decline structural or cyclic (Remember Kodak v/s Digital Cameras)
IMHO RIM is a good fit for a bigger firm, but on it's own life might be difficult. Plus I am fairly useless at predicting a difference in structural/cyclic changes for technology firms,so looking for guidance.
However,would be great if you can give some insights
Thanks
Onkar

Saj Karsan said...

Thanks, Onkar. To answer your questions:

1) None of these companies is going to spend more than they make (with the exception of an acquisition), so all the spend is coming out of revenues. It makes more sense to compare these companies by R&D spend, or R&D spend as a percent of revenue

2) It could be; I really have no value to add as to how likely a scenario this is

3) I'm not sure there is a decline. Sales are up, profits are up, return on capital is up, and the entire industry is growing. These companies will continue to jockey for market share points, but there probably won't be any declines for any of these companies until industry growth stabilizes.

Anonymous said...

@anonymous ;-)

they are expanding search clicks from home to mobile life. so i think they are expanding business with android ;-)

@valueinvestor2010

3 companies at war, but it is interesting to look at what they risk! ..RIMM is risking to lose footprint in its home turf - smartphones! ..e.g. google is just expanding its business without risking much ..in my view googles business model is far superior to RIMM ..and at current valuations i would prefer google ;-)

@saj

nice market share gains from android ;-) http://tech.fortune.cnn.com/2010/10/05/android-passes-blackberry-and-iphone-among-recent-smartphone-purchases/?source=yahoo_quote

best wishes, nell

Anonymous said...

google:

7% earnings yield, >100% roic

superior business model, rising market share, multiple products (like gmail, search, android etc.)

rimm:

13% earnings yield, >50% roic

declining market share, playbooks etc ;-)

so we should buy RIMM??

..sorry but this makes no business sense to me ;-)

best wishes,

nell

Saj Karsan said...

Hi Nell,

Google is an outstanding company. But as you pointed out, you are paying twice as much for every unit of earnings, at the current stock prices of these companies. What were you trying to show there?

Also, how are you calculating that ROIC number to be greater than 100%? That doesn't make a whole lot of sense to me.

Anonymous said...

hi saj,

a) i just want to know why you think that 13% earnings yield in a declining business is so much better than 7% earnings yield in a fantastic business! at what point is the business model of a company more decisive than just some earnings yield?? is earnings yield of 7% for a fantastic business not fantastic? ;-)

b) fy09 - google

cash roic = ebit * (1-tax rate (~40%)) + depreciation - investments in working capital and capex / (adj. working capital + net fixed assets)

ebit = $8312MM
depreciation = $1240MM
change adj. working capital = -$349MM
working capital = $26419MM
excess cash = $21737MM (cash + mkt.securities - current liabilities)
adj. working capital = $4682MM
net fixed assets = $4682MM
invested capital = adj. working capital + net fixed assets = $5456MM

roic = 5069/5456 = ~100%

..and now please your numbers? ;-)

best wishes,

nell

Saj Karsan said...

Hi Nell,

1) I disagree that it's a declining business. I view it as buying a growing business at a P/E well under 10.

2) In your cash ROIC calculation, you are ignoring all investments other than fixed and WC in the denominator. Google has spent lots of money on acquisitions and therefore has a lot of Goodwill. By ignoring it in the denominator, you are not considering how much capital has actually been employed.

Also, the formula you employ would be very lumpy from year to year. Last year Google made a $3.3B acquisition which would totally change the numerator and thus the calculation result.

For this reason, I much prefer regular ROIC, or EBIT*(1-tax)/(debt+equity). For Google, it comes out to 20%, but you can debate about whether cash should be included in the denominator.

Anonymous said...

hi saj,

a) it would not be at pe under 10, if we would both agree ;-)

b) yes, i use cash roic to measure "operating" performance ..even better would be incremental cash roic ;-) ..im not sure if 3B of goodwill is such a big issue ..it is just 10% of net cash ..and im pretty sure that even after adjusting for goodwill, it is still handsome above cost of captial ;-) i prefer cash measures, because cash is a fact and profits just an opinion (for taxes) ..your measure mixes operating and financial performance (like returns on pension plans, deferred taxes etc.) ..i want a clear look on operations ;-)

best wishes,

nell

ps: thanks for your comments.. i learned alot ;-)

Anonymous said...

Good call.

Anonymous said...

Saj,

Any updates to your analysis on RIM's valuation given recent developments? Also, do you have any insights on a takeover as a catalyst for unlocking shareholder value?

Saj Karsan said...

Hi Anon,

I have no idea about any catalyst potential. The only update on my thoughts, I would say, is the idea that execution risk is much higher, because whatever moat the company may have had is being eroded very quickly in the US

Anonymous said...

Thanks Saj.

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