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10/1/2004
03:10 PM
William Schaff
William Schaff
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Taking Stock: RIM's Long-Term Outlook Is Hazy

RIM's stock has near-term potential as its upgrade cycle kicks in.

On some days, I hate my BlackBerry. On other days, it's an absolute technological miracle. The biggest problem is getting away from it. I just returned from Beijing. E-mail? No problem. Watching my portfolios entailed a click of my Bloomberg contact on the device. Soon, I'll be off to Europe, and most people won't know I've left the office.

Unfortunately, though Research In Motion's technology may be useful for the remote employee, the real question about the stock is whether or not it makes investment sense. This answer isn't nearly so clear. (Is anything these days?)

I think the stock may have some near-term potential as the excitement of its product-upgrade cycle kicks in. RIM shortly will launch its model 7290 handheld device in Europe. It features a quad-band phone, Bluetooth, and greater memory. All of us want the latest and greatest, so I predict revenue will look good over the next couple of quarters.

RIM is working with its distribution partners, mainly service providers, to push out more service features. Service providers have incentive to join in, as those features drive up usage of higher-margin data minutes through their networks.

The company is more than a handheld device maker. It takes quite a bit of effort to install a customized BlackBerry Enterprise Server to manage the corporate distribution of BlackBerry devices. This requires extensive roaming agreements for the wireless functionality to work across borders, and security issues must be addressed. RIM generates revenue from multiple sources. It makes sales from devices, but it also generates revenue from service agreements with other device manufacturers, as well as software licenses.

But the business is very competitive. Device hardware gross margins are always under pressure. Competition comes from both phone companies and handheld makers such as Handspring and Palm. I've rarely seen hardware gross margins rise in recent days. Also, as its business model moves toward more service agreements with other manufacturers with RIM features such as Nokia and Sony Ericsson, it's possible that the shift in operating margins to the positive may not fully offset declining margin and potential revenue loss from hardware sales.

Wall Street consensus for earnings is $1.82 in fiscal 2005 and $2.23 in fiscal 2006. At the current price of $77, shares are trading at 34.5 times estimates of 2006 earnings. Hardware revenue will make up about 70% of total revenue in 2005. Service revenue will probably approach 20% by the end of 2006. The balance will be software. There's also a large financial risk that the current price doesn't reflect: RIM's lawsuit with NTP for patent infringement, which may result in a substantial ongoing royalty payment for U.S. device sales. This would erode hardware margins and have a large impact on '05 and '06 earnings estimates. I believe traders will invest in the short term based on predictable upside revenue surprise versus consensus expectations on the upgrade cycle, but longer-term investors should be wary given the rich valuation and lack of discount for a potentially large negative surprise from the lawsuit.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.


To discuss this column with other readers, please visit William Schaff's forum on the Listening Post.

To find out more about William Schaff, please visit his page on the Listening Post.

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