Why the Decline in RIM's Service Revenue Doesn't Matter

Mohammed is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

At the end of December, Research In Motion (NASDAQ: BBRY) released its financial results for Q3 FY 2013; a dive by the company's share price shortly followed. It wasn't due to bad results; on the contrary, the results were simply amazing. The company beat estimates both on the top and bottom line. EPS came in at a 22 cent loss versus the 35 cent loss that the Street was expecting. More importantly, the company was able to increase its cash position by $600 million, ending up with $2.9 billion in cash at the end of the quarter.

So, why the plunge? Well, it was due to remarks in the company’s conference call regarding its highly profitable service revenue. CEO Thorston Heins stated that RIM's service revenue may come under pressure in the coming months and that some of RIM's 80 million subscribers may generate no revenue at all. Even though details have yet to be made clear; analysts expect RIM's service revenue to decline anywhere from 30-64% over the next two years.

Service Revenue has helped RIM weather the tough times it has been going through lately; Service Revenue has also been on the upswing the past couple of years unlike RIM's hardware line of business. This quarter this highly profitable source of revenue made up 36% of RIM's Total Revenue; that is exactly the problem!

Take a look at this comparison between RIM's Revenue mix in Q3 FY 2009 vs. Q3 FY 2013:

<img src="/media/images/user_13227/rim-q3-2013_4_large.png" />

source: RIM's Earnings Releases

As you can see back in Q3 FY 2009, a fiscal year in which RIM made $1.9 Billion or $3.35 in Earnings and whose share price was trading at much higher levels, Service Revenues were only 1/3 of what they are today. 

So the question is, if service revenue has increased so much; why was RIMM so profitable back then and bleeding red ink today?

The Answer is in the charts below:

<img src="/media/images/user_13227/asp-rimm_large.png" />

As you can see from the line graph above Average Selling Price has been steadily decreasing over the past 4 years. This makes sense; RIMM's current Blackberry line is terribly outdated compared to Apple's (NASDAQ: AAPL) iPhones, devices powered by Google's (NASDAQ: GOOG) Android, and even Nokia's (NYSE: NOK) Lumia. 

The only way that RIMM can compete was on price. It had to deeply discount Blackberries in order to clear its inventory channels of and convert these devices into cash especially in emerging markets where RIM is still relatively strong and consumers there are extremely price sensitive. Many teenagers, another price sensitive group may also buy a cheap Blackberry for BBM while using another device such as an iPhone or a Samsung Galaxy S3 as their main smartphone, my brother being one of them.

So while RIM's quarterly service revenue has tripled due to the rise in RIM's subscriber base from 21 million in Q3 FY2009 to 79 million in Q3 FY 2013; RIMM generated much more revenue by selling higher priced hardware back then. In fact, the number of devices shipped in the two quarters is almost identical, but the Average Selling Price back then was much higher. RIM's current gross margin ($830 million) is also less than its Service and Software Revenue ($974 million) this quarter and since that type of Revenue is almost pure profit (85% margin), RIM's device business is most likely generating negative gross margins; A big clue being that they stopped publishing cost of sales figures for the different segments in recent financial filings as they had done in the past.

However, even if RIM's Service revenue suffers from a severe decline there is still opportunity to make a serious amount of money; Smartphones are a high margin product as can be seen from the table below:

<table> <tbody> <tr> <td> <p>Components/Hardware Elements </p> </td> <td> <p>Apple iPhone 5 16GB</p> </td> <td> <p>Samsung S11 Skyrocket</p> </td> <td> <p>Nokia Lumia 900</p> </td> </tr> <tr> <td> <p>Retail Pricing w/o contract</p> </td> <td> <p>$649</p> </td> <td> <p>$549 </p> </td> <td> <p>$449</p> </td> </tr> <tr> <td> <p>    Total BOM(Bill of Material) cost</p> </td> <td> <p>$199</p> </td> <td> <p>$235.5</p> </td> <td> <p>$209</p> </td> </tr> <tr> <td> <p>    Manufacturing Cost</p> </td> <td> <p>$8.00</p> </td> <td> <p>$8.00</p> </td> <td> <p>$8</p> </td> </tr> <tr> <td> <p>BOM + Manufacturing</p> </td> <td> <p>$207</p> </td> <td> <p>$243.5</p> </td> <td> <p>$217</p> </td> </tr> <tr> <td> <p>Difference</p> </td> <td> <p><strong>$442</strong></p> </td> <td> <p><strong>$305.5</strong></p> </td> <td> <p><strong>$232</strong></p> </td> </tr> </tbody> </table>

source: IHS isuppli

The support from mobile carriers will be crucial as not only carriers are instrumental in pushing smartphone sales, but most smartphones are not bought w/o contract as above; they are subsidized by the carrier and the true cost from the end user is masked. In fact it has been shown that the iPhone's market share is directly correlated to the prevalence of carrier subsidies. Tim Cook recently traveled to China to try to get the support of the world's largest carrier for the iPhone. The 700 million strong China Mobile currently does not carry the iPhone, but carries and subsidizes Nokia's new Lumia 920.  Aggressive carrier promotion also helped android gain significant market share. So it may stand to reason that RIM made the changes in its Service Line of Business in order to gain more carrier support before the launch of the BB10.

Foolish Bottom Line

It all boils down to one thing, the BB10, the success of which is vital for RIM's longevity. Sure, the Service segment is currently highly profitable, but who wants to invest in a company whose highly profitable line of business cannot cover its operating expenses and is prone to shrinking. If the changes in RIM's subscriber fees help catapult the BB10 to success, then the severe decline in the share price that followed the Conference Call was unjustified 

Pirlo0o owns Research In Motion. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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