Would you buy this company?

Suppose you find yourself at a party at a known value investor’s home. Like most people, value investors tend to associate with like-minded individuals and the party is comprised of other fundamental investors. The conversations quickly turn to the financial markets. One individual begins telling the story of a company he has come across. As others pick up on the story, the room becomes quieter and quieter until everyone is focused on this investor and the opportunity he has found. Like Ben Graham, he starts by describing the fundamentals of the company, rather than giving away the company’s name and attracting all of those pesky preconceived notions that his audience might have about the company.

First, the investor describes the company’s returns. As all the attendees of the party are well aware, a company that can take investors’ hard earned capital and earn strong returns is a company worthy of consideration. The investor makes the following points:

  • The company has been profitable for each of the last eight years.
  • For the last five years, the company has averaged Returns on Capital Employed of 36.1%.
  • For the last five years, the company has averaged Returns on Invested Capital of 46.4%.
  • For the last five years, the company has averaged Returns on Equity of 37%. A Dupont analysis shows that this has been driven largely by improving operating leverage (Revenues / Average Assets), rather than increasing leverage.
  • The company has generated free cash flows in excess of net income for seven out of the last eight years.

A listener interjects. “These historical annual returns look great, but perhaps a more pointed look at quarterly performance shows a more negative recent trend?”

The investor reaches into his pocket and pulls out a piece of paper, which he passes through the crowd. The paper shows annual returns for the last twelve years and quarterly returns for the last twelve quarters (click for full size).

 

Second, the investor describes the company’s stability. After all, great returns are one thing, but if the company is loaded with obligations a slight stumble could send it into a tailspin. Fortunately for listeners, this part of the investor’s story is quite short, for the company has no debt to speak of. In fact, the returns discusses in the first part of the investor’s story have been unlevered for the last three years, and for the ten preceding years were so lightly levered as to round down to zero (peak debt/equity was 2.2%, more than a decade ago).

“What about margins?” an onlooker asks. “Are the margins stable?”

The investor smiles, and suggests the onlooker wait a moment, as his question will be answered shortly.

Third, the investor discusses the company’s growth. The investor begins with the company’s top line growth. Rather than describe it, the investor extracts another piece of paper from his jacket pocket and passes it through the crowd.

 

“As you can see,” the investor says to the crowd, “the company’s revenue growth has been strong. To answer the previous question about margins, it does appear that there has been an ever so slight margin contraction since before the Great Recession, but margins have held relatively steady since the beginning of 2009.”

“That’s all fine and dandy,” shouts another onlooker, “but what about free cash flow? Everyone in the room knows that companies have a number of methods of manipulating the income statement to show revenues, margins and net income that don’t necessarily reflect reality.”

The investor smiles and says “Ah, I see you have been reading Financial Shenanigans.” With that, the investor passes around a third sheet of paper. “This sheet of paper shows both Free Cash Flow over time, and Free Cash Flow after Acquisitions. For you see, this company has been somewhat acquisitive, so I thought you would appreciate both measures.”

The crowd was filled with both delight and agitation. On the one hand, the company’s revenue growth, stable margins, strong returns and free cash flows clearly showed a great company. On the other hand, everyone in the room was well aware that great companies do not necessarily make great investments. Each carried a list in his or her pocket of wonderful companies that would be purchased at a moments notice – if only the shares went on sale.

The investor sensed the conflict. “Fear not, for I would not waste your valuable time. This wonderful company is priced attractively. In fact, it is currently trading at its lowest price in a half decade. And, in order to further alleviate your concerns, its recent dramatic fall is related not to its imminent collapse (despite what the media may say), but rather to a confused comparison between this company and one of its (many) competitors. The market is overreacting to the fact that this company is losing market share to one of its competitors. In fact, the media completely ignores the company’s returns, growth and stability as different ‘reporters’ busy themselves writing articles that fit a specific (empirically incorrect) thesis. The headlines read ‘Company is dead’, ‘Death spiral continues’, and the articles liken the company to recent bankruptcies, ignoring the fact that there are no similarities in financial metrics between this company and the flawed comparisons.”

“This is a classic case of missing the forest for the trees. While it is losing share of the market, the industry in which this company operates is growing so fast that even a smaller share of the much larger pie is a good place to be.” With that, the investor provided the following valuation metrics:

  • The company is trading at a trailing P/E of 4.11. However, when removing cash from the balance sheet, this P/E becomes a paltry 3.35x.
  • The company is trading at a P/B of just 1.41 – joining the ranks of very few other companies in history to generate returns and growth as shown above to be trading at just 41% over its book value.
  • The company’s free cash flow yield (ttm) is more than 36%.

“Furthermore,” the investor says, “I have been able to justify the current price under only the most pessimistic of scenarios, including unprecedented margin contract and a near complete collapse of the company’s growth from the strong levels discussed above, to negative growth indicating contraction. In more realistic scenarios, which indicate the continued growth of this company’s market, but a declining share for this company, the company is vastly undervalued, providing upside in excess of 100%.”

“But there is a benefit to the market’s overreaction” continued the investor. “The collapse of the company’s share price has lit a fire under management. Management has announced that it would reduce expenses to improve its already impressive margins, and that the company would use its sizable cash hoard to repurchase a significant portion of the company.”

“So, now that I have told you about this magnificent company, would you want to buy it?” asked the investor.

The members of the crowd began nodding their heads. Yes, indeed they would want to buy this company. “Please, just tell us the ticker!” shouted a man in the back.

“Ah, I was sure you would have guessed by now. The ticker is RIMM.”

 

Author Disclosure: Long RIMM

Talk to Frank about Research in Motion

  • Mmel

    This was a great post.  Though as soon as I saw that P/E I knew who it was.  I have been trying harder and harder to analyze companies without looking at price/valuation, but most sites make it so difficult.  The way they arrange pages, you would think that the most recent price is the only number that matters.

    • Anonymous

      Maybe skip the sites like Yahoo Finance or Google Finance and head straight
      to the company’s filings?

      Frank Voisin

      • Analyst

        Hi Frank,
        Great article..I’ve been interested in these large cap tech names. Stocks like MSFT and CSCO are cheap and safe, and then you have NOK and RIMM which are very cheap but safety is in question. I do think RIMM is cheap enough that its worth the risk (although it was cheaper 2 days ago!)…If you buy a stock at a 5x multiple, even if profit forecasts fall 50% you are still getting a pretty cheap 10x multiple..worth the risk.
        I’ve sat in meetings wit my company recently and noticed the large amount of people still using blackberry…

        • Anonymous

          Reminds me of the person falling from the 10 story window. Feels great for the first 9 floors, all the vitals are normal…And then…

          • cfel

            Hey Frank great write up.  I am almost caught up in the apple/android hype, and as i view myself as a value investor i deserve a slap in the face.  This article was a nice slap in the face.  I think that their future rides on the new phones they are churning out, but i think that they have a lot of existing customers who are unlikely to switch, they are currently a passive cash cow too from their fees from telcos.

            Everyone says their a contrarian, until the herd changes direction and then the contrarians look crazy.

  • Dc Sass

    Use earnings in 2014-2015. If you expect it to be $2, it’d be a 13 P/E today, which isn’t attractive.

    • Anonymous

      The investor says that only in the most pessimistic scenarios can the
      current price be justified. The point is, these pessimistic scenarios do not
      accord with the company’s actual performance, and only seem to make sense if
      you believe the media’s portrayal of RIMM to be accurate, which is
      empirically *not* the case. Rather than accepting what the media says, I’ve
      shown the actual performance and I see nothing to suggest a company in a
      “death spiral.”

      Frank Voisin

  • Postboxster

    Sorry, but it is never a good idea to take a rearview mentality with a tech company. I would never judge their business position just by historic accounting numbers. Valuation is focused on “future” cash flows, earnings etc. !!!

    Best wishes,

    Nell 

    • Anonymous

      Hi Nell,

      Yes, companies are valued based on the present value of expected net future
      cash inflows. This is finance 101. I am not sure if you thought this comment
      was insightful or otherwise helpful. It was neither. There is no “rearview
      mentality” in this post. I do not suggest that the company’s historical
      growth rate will continue into the future forever.

      The point of the article was to show that the way the media portrays RIMM
      today is very different from the company’s actual performance. The key word
      in the first sentence above is “expected,” and the media’s portrayal affects
      the expectations of investors. There is absolutely no justification for
      saying that RIMM is in a “death spiral” or that RIMM is “dead” when the
      company continues to earn returns that would make people jump up and down
      with excitement in any other industry.

      Frank Voisin

      • Postboxster

        Sorry, I dont want to give you Finance 101 lessons.  
        I just nailed the problem in your “value” thesis for RIMM. You are taking historical and current performance charts as an estimate of future returns for RIMM. This is simply wrong. RIMM is a tech company that operates in a quickly changing environment. They wasted precious money in R&D while Google changed the smartphone business in a radical manner. Now the intelligent part of a smartphone is a commodity. This is even a threat to apple if they cannot innovate. So here is your chance.. Now give me and your eager audience a Business 101 lesson why RIMM is here to stay!? ;-)

        Best wishes,

        Nell

         

  • Aalexa1

    This is kinda laughable. An analysis of RIMM should focus strictly on the competitive threat from Android and Apple. RIMM has had great numbers in the past , but now they are competing with Steve Jobs AND a competitor that is giving away their product for free!

    Its spurious to just look at the numbers without confronting head on the competitive pressures they are facing. 

    Additionally, if you look deeper, you will see that growth stalled this quarter, sales are declining in North America, and every developer and his mom are developing for Android, not blackberry. 

    This is the very epitome of a value trap….. until it gets to a $9b market cap, which is the current book value of the company.

    • Anonymous

      Hi Aalexa1,

      RIMM has been competing with AAPL for three years. Check out their
      performance over that period. This is clearly not a company in a death
      spiral. Yes, future growth will not look like past growth, but the entire
      market is growing fast enough that even as RIMM loses market share, it will
      still experience *some* growth. The current market price is only justified
      if you assume they start falling as fast as they grew, and there is no
      evidence to support that occurring, other than a bunch of alarmist news
      articles which also lack any empirical support.

      Frank Voisin

  • Matt Monday

    good analysis and investment….. if you dont like money. 

  • http://blog.tjl.name/ timl2k11

    I think your article really shows signs of “tunnel vision”. A laser like focus on technicals. What you seem to be missing is context. IMO, I can’t prove this, RIMM dove nor just because it lowered and than missed guidance, but that in it’s quarterly conference call it was quite apparent that it’s co-CEO’s were very dysfunctional with their heads stuck in the sand. Investors saw a huge disconnect between what the CEO’s had to say and reality. One would hope that if the stock falls even farther and RIMM’s business deteriorates at an ever faster rate that the board would revolt and find a competent person to run the company… but this gets to the other cotext that is lacking RIMM is getting squeezed from two sides by Apple and all the companies involved in Android. Investors see the writing on the wall (context) that the technicals do not show.

    • Anonymous

      By “technicals” do you mean fundamentals? And by “fundamentals,” I mean
      those things that drive corporate valuation (decidedly not included in this
      category are media headlines and baseless arguments that fail to point to a
      single unbiased metric of corporate performance).

      You are entitled to your own opinion, but you are not entitled to your own
      facts (Moynihan).

      Point to something that isn’t qualitative and biased, and maybe I’ll see
      your point.

      Frank Voisin

      • Postboxster

        When i read such responses it reminds me of a behavioural flaw.. Confirmation bias ..Confirmation bias is a behavioural flaw of human beings by which once we have made a decision (of any kind), we tend to actively seek information that will confirm our decision. Without realising it, we emphasise information which reinforces our view whilst tending to downplay, avoid or even ignore contradictory information. 

        I love Franks articles, but it is a tragedy that he seems to be affected by such a behavioural issue. I guess it is not a good idea to write about companies where one is in any way committed (long or short).

        Best wishes,

        Nell

        Disclosure:

        RIMM – no position

  • GsCBS2010

    Nicely written Frank! Sometimes in value investing you have to look pastvaluation and make a good assessment about the companies’ future competitive positions. I find valuation to be only one part of the puzzle, to which I have fallen victim to with RIMM.Yes, I do believe RIMM is cheap and I do believe that RIMM will add 75+ million users over the next couple of years, but we cannot have great conviction that this will be so. Is their product far superior? I would say it doesn’t matter right now…the herd will do what it is told and, unfortunately, AAPL is telling the herd what products (apps & hardware) they want. Eventually, I do believe, this will change, it always does, but for now AAPL is (unfortunately for us) dominating.What about management? have they been honest? why not warn prior to latest release? they had the chance…$7.50 to $6-5.60? but who cares about the numbers, I don’t. What I do care about is how management handled the situation, which in my opinion puts their credibility into question. Why lie  45 days before the quarter and reaffirm the full year guidance? seems very mismanaged…For me, this has been a humbling experience in value investing. One thing that I’ve learned with RIMM is that value investing doesn’t really work on popular stocks like RIMM, because when the herd turns against you these types of stocks will make you look really stupid. I guess that’s why the greatest stewards of money just stay away.The only way I see this story turning around is seeing an activist try to make the Co-CEO’s honest…but that is a strategy in HOPE not investing…happy investing!G

  • Anonymous

    The only thing in a death spiral is the American media.

  • Josh

    I am also long RIMM and believe that there is still plenty of room in emerging markets and in pre-paid along with existing sales at the carrier level.  One other point to consider, RIMM could use the Android software if their upcoming QNX software turns out to be a dud. 

  • Kyle Smith39331

    There are parts of technology that are mean reverting and there are parts that are mean repelling — unfortunately for rimm they are in a mean repelling part. Blackberry is a platform type of technology that remains strong in corporate accounts due to their software being behind the firewall. Trouble is a lot of the growth over the last few years involved selling to consumers where blackberry is now at an insurmountable disadvantage to android and phone. Those other platforms have too much volume and developer support to overcome — platforms are all about volume.

    First blackberry will shrink back to it’s corporate stronghold and then even that will erode over time.

    Could you get a nice move out of rimm at some point? Sure secular decline is never a straight line — that would make it too easy. Rimm is only a trading stock — never think it is a long term investment because long term is about decline. Industry economics are too powerful. Tech investors understand and that is why the valuation is seductively attractive.

    Good luck on your trade — just be careful to have a stop loss.

    • http://pulse.yahoo.com/_6S5ISVYHKT5KPTV5O2LSTEN2PI J

      I have to agree. Once a technology product loses popularity, the company is done for. The same happened to Motorola with their Razor phone, Yahoo search engine, AOL, Novell etc. Even a better product does not mean success. The technology game is about keeping your products in the news and popular among certain groups. Blackberry needs to develop a competitive touchscreen, give it away for free with free service to certain people, and start an advertising campaign. Get rid of the old button keypad and go 100% touchscreen.

    • alex

      Yup I agree with Kyle here. Frank I enjoyed the write but RIMM doesn’t have the technology or platform to handle the network or ecosystem created by Android and iOS. This is a winner takes all situation, like what happened with Windows on the PC in the early 90′s. The market will never revalue this company higher unless it begins to grow again.

  • Atlantis

    Rather than argue with the market, I would rather go with what the chart is telling me, right now it saps stay away from RIMM.
    If your arguments are correct and the market start to recognize it, the chart will turn and there will be plenty of time to buy it when its on the way up. Just my 2 cents…

  • http://twitter.com/TimIsgro Tim Isgro

    Frank,

    Your presentation of the facts is well thought-out and gets to the point on RIMM: this is a *very* profitable company that can be bought at a 25% earnings yield.

    I just hope management wakes up and allocates cash correctly. IMO, a sizable buyback would be smart. (Here, any future potential declining margins due to competition might actually help the case, lowering that great ROE and forcing management to see the benefit of buybacks.)

    The swarm of negative comments here should bolster your conviction. Nice work.

  • LEAPfrog

    Multiples on the Google/MMI deal are steep and seem to add even more support to your argument, Frank.  [Although, I read that the rationale for the deal centers around the MMI patents.  Supposedly, RIMM's patent portfolio has some holes in it].

    It seems like this situation may be one where there is a significant upside (if the only thing that happens over the next few years is that the market revalues the company in line with peers, the price increase would be substantial, even off of lower sales/profitability numbers) combined with a remote possibility of disaster (the death spiral scenario discussed by many on this chain).  If you agree with that statement, do you consider LEAPs a viable way to go long here? 

    • Anonymous

      There may be interesting LEAP strategies for RIMM, though it looks to me like the market has already priced in massive volatility for the company’s options so I have gone straight equity. May be worth your while to talk to someone knowledgeable about assessing the more advanced options strategies to see if there might be a good opportunity.

      Frank Voisin

  • http://jonathanaclark.blogspot.com/ JAC

    I’m really enjoying your blog and enjoying making a few bucks off of a call like RIMM. What a delightfully irreverent, and more importantly correct, pick that has me up about 18% so far. Thanks!

    • Anonymous

      Hi JAC

      Glad that worked out for you!

      Frank Voisin

      • JAC

        Yikes, ugly numbers from RIMM last night…any update to your analysis based on the release?

  • Confidential

    Could it be that RIM turns to be the worst value trap of all time? Or can an acquisition save this exceptional firm from its management team?

  • Anon

    Any updates on your RIMM analysis?

  • Kevin

    Yeah an update would be really appreciated

  • G-Money

    At this point do you think someone would come in and buy them for the IP?

  • Anon

    If you could do it all over again, would you?

  • Anon

    Frank,

    Any updates on your RIMM analysis? Any insights would be much appreciated.