Blackberry – Forrest Gump’s New Fruit Company

Executive Summary

1. Context: An Autonomous Future of Driving.
2. Scope: In a non autonomous world, QNX was only an operating system that powered telematics and infotainment systems but in an autonomous world, the one we are heading into, QNX will also be the default communication service provider for autonomous vehicles.
3. Catalyst: Faster Adoption of Autonomous Vehicles – INTC/MBLY is a sign.
4. Timeframe: I’m all about that base – 4 years.

An Autonomous Future of Driving

It is obvious to me that we are headed into a world where cars are going to become devices we use rather that devices we operate. Cars will drive us around, not drivers. It is in this context that I think that Blackberry (NASDAQ: BBRY) is going to be one of the best turn-around stories we have seen in a long while but before I make my case let’s first look into the financial health of this company.

Blackberry is due to report earnings on April 7th and I will be waiting to eat up their financial statements but here’s what I’m really curious to find out: how are their margins evolving in their Software & Services segment. In their last report they reported total GAAP gross margin of 67%; Software & Services segment was at 80%. I can’t imagine that there must be anymore upside left in that number but so long as the downside is not too steep this business segment will be a game changer for Blackberry.

Blackberry’s market capitalization is around US $3.8 B, it is trading at a price/book of 1.40x and a price/sales of 1.93x. About 270 institutions own Blackberry shares, roughly 64% of the float is held by Institutional & Mutual Fund Owners, which implies a strong supportive investor base. On top of it, it is sitting on net cash of US $1 B, most of which is classified as Level 2 assets (the kind that’s not bad news).

Now that we have covered some ground on the financial health, let’s review the next most important thing: corporate governance. For good governance to exist, a prerequisite is for the governors to be aware of their SWOTs (strengths, weaknesses, opportunities, and threats). It is from this recognition that true success emanates. In the case of Blackberry, Mr. Chen and his team seem to have full control over their SWOTs, a case in point is that they are making record profit margins merely by reorganizing their business model away from hardware and toward software services.

Furthermore, as a testament to efficient use of capital, BlackBerry announced on August 26, 2016 that it was swapping out expensive debt and taking on cheaper debt leveraging on its strong relationship with its investor base, in this case: Fairfax. An excerpt from its press release below:

“Redemption of Existing Convertible Debentures and Issuance of New Convertible Debentures.

BlackBerry Limited (NASDAQ: BBRY; TSX: BB), a global leader in secure mobile communications, today announced the amendment of the indenture governing its 6% unsecured convertible debentures (BB.DB.U) (the “6% Debentures”) to permit optional redemption prior to November 13, 2016. Additionally, there will be an issuance of a notice of redemption to holders of the 6% Debentures pursuant to which BlackBerry will redeem the entire outstanding principal amount of the 6% Debentures on September 2, 2016 (the “Redemption Date”). As of the date hereof, approximately USD$1.245 billion aggregate principal amount of 6% Debentures remains outstanding.

The 6% Debentures will be redeemed on the Redemption Date at a redemption price of 106.7213% of the outstanding principal amount of the Debentures. The redemption price includes all of BlackBerry’s obligations in respect of principal and interest, and no additional amounts will be payable under the 6% Debentures. BlackBerry may revoke the redemption notice at any time prior to the close of business on the business day prior to the Redemption Date. The normal course issuer bid for the 6% Debentures announced by BlackBerry on August 4, 2016 will terminate upon the completion of the redemption.

Holders of 6% Debentures remain entitled to convert their 6% Debentures into common shares of BlackBerry (“Common Shares”) at a conversion price of USD$10.00 per Common Share at any time on or prior to September 1, 2016, pursuant to the terms of the 6% Debentures. Based on the conversion price, BlackBerry expects that none of the 6% Debentures will be converted.

BlackBerry also announced that it has entered into an agreement pursuant to which Fairfax Financial Holdings Limited (“Fairfax”) and other institutional investors will subscribe for 3.75% unsecured convertible debentures of BlackBerry (the “3.75% Debentures”) on a private placement basis for an aggregate subscription price of USD$605 million. The transaction is expected to be completed on September 2, 2016. The 3.75% Debentures will be convertible into common shares of BlackBerry at a price of USD$10.00 per Common Share and will be due on November 13, 2020. Based on the number of Common Shares currently outstanding, if all of the USD$605 million of 3.75% Debentures were converted, the Common Shares issued upon conversion would represent approximately 11.57% of the Common Shares outstanding after giving effect to the conversion. The other terms of the 3.75% Debentures are substantially identical to those of the 6% Debentures, except that the 3.75% Debentures are not redeemable prior to maturity.”

To do a little math, if all of the 3.75% debentures were to be converted to common shares I’d imagine that the logic behind this conversion would most likely stem from an appreciation of the common stock to levels that exceed the US $10 conversion price. So there would have to be a 43% gain to common shareholders, from current prices, for them to then get diluted by 12%; not a bad deal for the shareholders. Little wonder then that Mr. Prem Watsa seized on this opportunity. It also echoes a strong voice of confidence in favor of the management.

As a shareholder, I’d have to conclude that the company is being governed extremely well.

The Reorganization

Any turn around is only as good as the fall that preceded it. Remember Balboa vs Apollo! Blackberry fell hard; they utterly failed as a smart phone company. In my story, Apple is Apollo, Blackberry is Balboa.

Blackberry is no longer a hardware company. The reorganization of the business has resulted in the emergence of three major business segments: 1) Software and Services, 2) Mobility Solutions, and 3) Service Access Fees. A little under 25% of the Q3-17 revenues came from each of the latter two segments, more than half of the revenues in Q3-17 came from the Software and Services segment. Their QNX business falls under the Software and Services category, and this is the business segment that’s getting me excited. The mobility solutions segment, which is mainly comprised of Blackberry’s deal with TCL Communication, in my view, is like having a fat tail optionality: it may pay out big or might not pay out at all. Its paying out is entirely hinged on a chance occurrence, in Blackberry’s case: for them to make any meaningful money in this segment, the chance occurrence is a sudden surge in demand for TCL/Blackberry phones. Hard to see but if Samsung’s phones keep exploding then maybe consumers will have little choice but to look towards TCL/Blackberry to capture that coveted 2nd spot in smartphones. The SAF segment mainly includes service access fees charged to subscribers using its legacy blackberry operating systems (any business segment that has the word legacy associated with it doesn’t seem exciting from a growth point of view), the gross margin in this segment was around 71% in Q3-17, still behind the gross margin of Software and Services, which was around 80%.

As per Blackberry’s Q3-17 release: “Software & Services segment revenue, which includes fees from licensed enterprise software, client access licenses, maintenance and upgrades, software licensing revenues (other than device software licensing revenues), technology licensing revenues, and technical support revenues, was unchanged at $164 million, or 54.5% of segment revenue, in the third quarter of fiscal 2017, compared to $164 million, or 29.4% of segment revenue, in the third quarter of fiscal 2016. The comparable level of revenue was primarily attributable to the acquisitions of Good Technology and AtHoc Inc. midway through the third quarter of fiscal 2016 as well as an increase in revenues generated from QNX, which was offset by a decrease in technology licensing revenue. The Company generated $8 million in technology licensing revenue in the third quarter of fiscal 2017. The Company’s Software & Services segment revenue, excluding IP licensing and professional services revenue, was approximately 80% recurring (subscription based) in the third quarter of fiscal 2017.”

Their margins are improving significantly and it is not at all by fluke. Every bit of it seems to be part of a brilliantly orchestrated plan by Mr. John Chen and his team. Not only have they successfully transitioned away from a hardware oriented business model to a software services oriented one, they are also sitting on a potential gold mine called QNX. Judging by improving corporate governance, or improving margins, alone one can make a strong case for owning Blackberry but in my view, the real reason to own Blackberry is to acquire a call option on QNX.

QNX – In An Age of Autonomous Driving

A quick tutorial on microkernels: At its heart, QNX is a microkernel (a kernel is an operating system, a microkernel is just a smaller operating system) operating system that has evolved from what was originally developed by a Canadian company called Quantum Software Systems in 1982. When an operating system is constructed on a microkernel architecture, like QNX is, each operating system is not fully loaded with all the capabilities intended for that operating system. It is only limited to the most basic capabilities and for everything else the operating system is designed to communicate with other operating systems and draw upon their resources to complete its own tasks. The basic capabilities that are usually loaded are: address management, thread management, and communication management. Address management is a primal need of every operating system, without this it does not know how to compartmentalize. Thread management, in layman terms, is its ability to execute simple lines of code. Communication management is its ability to communicate between different processes within its own operating system and with other operating systems to draw upon their resources. So, by design, QNX, which is already installed in over 60 million vehicles of different makes and types worldwide, is positioned to become the default communication service provider between autonomous vehicles in an autonomous world.

Harman International Industries, the owner of brands like AKG Acoustics, AMX, Crown Audio, Harman/Kardon, Infinity, JBL, JBL Professional, Lexicon, Mark Levinson, Martin, Revel, Soundcraft, Studer, etc., which produced products for automakers, consumers and enterprises worldwide, acquired QNX in 2004 and expanded the use of QNX in automobiles beyond telematics, into infotainment systems and navigation systems, in a multitude of cars of different makes, and types.

In a non autonomous world, QNX was only an operating system that powered telematics and infotainment systems but in an autonomous world, the one we are heading into, QNX will also be the way autonomous cars communicate in the future. When Research in Motion (RIM: that’s what Blackberry was called then) acquired QNX in 2010, their rationale was the integration of smartphones to cars via the infotainment systems that QNX was already in. They must have had no idea how important QNX would become if it was able to control communication of all autonomous vehicles although credit should be given where credit is due and it is due to Mr. Mike Lazaridis, the then President and Co-CEO of RIM, who had this to say about the acquisition: “In addition to our interests in expanding the opportunities for QNX in the automotive sector and other markets, we believe the planned acquisition of QNX will also bring other value to RIM in terms of supporting certain unannounced product plans for intelligent peripherals, adding valuable intellectual property to RIM’s portfolio and providing long-term synergies for the companies based on the significant and complementary OS expertise that exists within the RIM and QNX teams today.”

Faster Adoption of Autonomous Vehicles

Inter-Vehicular-Communication will be key for accident free roads.

Intel’s expensive bid for Mobileye is a sign of how desperately everyone is chasing after the autonomous space. For a very good reason.

Today, inter-vehicular-communication is mainly governed by inter-driver-communication because it is mostly us, humans, driving around and we have developed a system of communication that allows us to communicate with other drivers on the street and share the road safely. In the future, when most vehicles on the street will be autonomous, inter-vehicular-communication will matter a lot more and will be a lot different than our communication methods of today. Car makers will want to pack their cars with all sorts of new technology and will have to rely on a few operating systems to perform several key functions. Companies like Tesla, Google, and Uber are pushing the boundaries with such ferocity that conventional car-makers are constantly playing catch up rather than leading the way in innovation. Most car-makers will be too consumed developing their own autonomous driving operating systems, or integrating a third party service like Google’s or Uber’s but either way they will want to spend much more time developing their autonomous driving cars and much less time developing new infotainment systems or new navigational systems or new communication systems; every car-maker is likely to do what every other car-maker does, outsource that part of the supply chain that they can’t add any value to.

In such an environment QNX will emerge as the default operating system in automobiles for infotainment, navigation, and communication. Through QNX, Blackberry has positioned itself as a strong software service provider and by extension as a dominant future player in inter-vehicular-communication. As of the end of 2016, around 60 million cars worldwide, across different makes and types, used QNX as one of their operating systems. In essence, in my view, a bet on Blackberry is a bet on faster adoption of autonomous vehicles.

Here’s the Kicker

Referring back to the earlier tutorial on microkernels, because QNX was designed in a microkernel architecture, it has built-in technology that enables communication between QNX kernels on separate devices. This functionality, which was originally conceived as a means to minimize the necessity of loading every single operating system with all necessary capabilities, is the key that also allows the operating system on one device to access the operating system services of other devices. Now do you get the picture? Most cars in the future will most likely have QNX as one of their car’s main operating systems, QNX kernels in one car will be able to freely communicate with all other cars simultaneously. The applications are innumerable, QNX could be the traffic controller of the autonomous driving world; accidents could truly become a thing of the past.

Market Chatter (The Risk) – Is This A Fruit Company?

• Blackberry signing a deal with Ford has been both overblown as well as butchered. The bull camp (http://www.autoblog.com/2016/11/01/ford-blackberry-qnx-partnership-autonomous-cars/) seems to be dolled up on the idea that Blackberry is going to get involved in the development of autonomous driving technology and the bear camp (http://seekingalpha.com/article/4047576-ford-blackberry-autonomous-vehicles-real-story) seems to be taking solace by pointing out that this is not what’s happening, in the process missing the entire point. The bullish story here is the penetration of QNX as the default OS in cars. It will be heartening to see Blackberry sign such deals with all major car-makers.
• Class action lawsuit: there is a pending class action lawsuit against Blackberry filed by its ex-employees on account of wrongful termination. If there is any truth to the allegations then its shameful what Blackberry did, all I can hope for is that management does right and moves on. Big things await!
• Apple poaches Blackberry’s QNX team: When I first read this I thought this was bearish news. I thought: “Apple going after Blackberry’s talent, no way Blackberry can compete with Apple’s resources in talent retention”. My next thought: “Why the hell is Apple poaching Blackberry’s QNX team in the first place!” With resources like Apple’s the world is the limit and if they are taking an interest in QNX they must surely be smelling what I’m smelling. Do you smelllll, what the Rock’s cooking?

I’m All About That Base – Don’t Bury The Berry!

No amount of bullish hyperbole can justify buying if the price isn’t right but when you have a hypothesis and the price is right, yum! On the price chart there is a beautiful base that has been forming since mid-2012. That is a base of over 4 years which means that our investment horizon should be, at least, 4 more years from today. This ought to be a value picker’s dream chart.

When I plot the price chart in conjunction with the Deviation from Mean chart (see below), I see an even more bullish picture emerging. While the price has been forming a 4 year long base, the price’s deviation from mean has been making higher highs and higher lows (second panel in the chart below) since 2012, implying the build up of a strong bullish momentum.

Please click on the chart above for a bigger chart

The Opportunity

I want to stress that the opportunity here is not that QNX will increase market penetration and therefore drive up revenues but that the increased market penetration of QNX will enable a whole new stream of revenue for Blackberry. Currently, the market is pricing Blackberry on the notion that QNX is just another software service that will generate perpetual royalty style revenues just like all the other software services of Blackberry. What the market is missing is that in an autonomous world, QNX will be called upon to serve additional functions that will generate additional streams of revenue for Blackberry.

What the market is pricing in:

	SOFTWARE	MOBILITY	SAF	QNX	SEGMENT TOTAL
REVENUE	164.00	70.00	67.00		301.00
COST OF GOODS SOLD	33.00	39.00	19.00		91.00
GROSS MARGIN	131.00	31.00	48.00		210.00
OPERATING EXPENSES	91.00	26.00	1.00		118.00
OPERATING INCOME	40.00	5.00	47.00		92.00

What the market should be pricing in for an autonomous world:

	SOFTWARE	MOBILITY	SAF	QNX II	SEGMENT TOTAL
REVENUE	164.00	70.00	67.00	27.33	328.33
COST OF GOODS SOLD	33.00	39.00	19.00	5.50	96.50
GROSS MARGIN	131.00	31.00	48.00	21.83	231.83
OPERATING EXPENSES	91.00	26.00	1.00		118.00
OPERATING INCOME	40.00	5.00	47.00	21.83	113.83

My assumptions for the model above:

1. QNX is roughly a third of the Software & Services segment.
2. Increased use cases of QNX (QNX II) in an autonomous world should be able to add at least an additional 50 cents for every dollar of revenue generated by QNX.
3. Operating expenses resulting from this additional use case should be negligible considering that it is only an expansion of the use case of an existing product.

So, just based on a revised valuation for QNX, without even discounting for any additional market penetration of QNX, Blackberry’s share price seems to be undervalued by around 24%.

There are approximately 250 million automotive vehicles in the US alone and over 1 billion cars worldwide; even if we assumed that QNX could aim to be in a quarter of the cars worldwide over the next four years that is a growth, in market penetration, of over 300%. So, even if we assumed that QNX will increase market penetration by 100% while all other segments have no growth at all, our model would look like this:

	SOFTWARE	MOBILITY	SAF	QNX	SEGMENT TOTAL
REVENUE	218.67	70.00	67.00	36.44	392.11
COST OF GOODS SOLD	44.00	39.00	19.00	7.33	109.33
GROSS MARGIN	174.67	31.00	48.00	29.11	282.78
OPERATING EXPENSES	121.33	26.00	1.00		148.33
OPERATING INCOME	53.33	5.00	47.00	29.11	134.44

Based on our model we expect Blackberry to be undervalued by over 45%.

Happy Trading!

Disclosure: We are long Blackberry. Rigel Mercantile Limited specializes in Macro Research and Systematic Trading. The views expressed above are our discretionary ideas that we have arrived at using discretionary analysis and therefore are limited to our discretionary portfolios only. Our systematic strategies may or may not have a position (long or short) in the securities mentioned above. Under no circumstances should the information contained herein be used or considered as an offer to sell, or a solicitation of an offer to purchase, any security or investment service. The information presented herein is presented in summary form and is, therefore, subject to qualification and further explanation.