Two Options Plays Ahead of RIM Earnings

Research In Motion RIMM has declined nearly 70% in the past year. At these levels, RIM may look attractive to the value investor. RIM reports earnings Thursday, June 28, but management has warned that it will experience an operating loss for the quarter. BlackBerry's share of the U.S market has significantly declined. RIM, which had grown to $20 billion in fiscal 2011, now has a market capitalization of only $4.74 billion. Analysts expect operating losses for the next few quarters. RIM management has stopped providing quantitative guidance. RIM was recently downgraded by Morgan Stanley MS. Given management's discussion of the issues present in the company prior to the downgrade, it is difficult to understand why the downgrade would cause the stock to decline more than 8% on Monday. Before its downgrade, Morgan Stanley waited for the stock price to decline about 70% and for management to state that it expects an operating loss for the quarter. Investors who sold on the downgrade may have overreacted to what could be viewed as late and irrelevant news. The 8% decline may be further indication of extreme overselling. RIM has a short interest ratio of 3.36. Moreover, RIM has hired JP Morgan JPM and RBC Capital to explore its financial options. RIM at $8.95 a share may have significant upside. There are several upside catalysts involving the company restructuring itself and discontinuing unprofitable business segments that may result in more than 30% appreciation of RIM shares. For instance, the company could be bought out by any one of several larger players in the space. If all assets were to be acquired, the purchase may be at a premium to book value. If acquired at book value today, the stock would be worth more than $20 a share. A buyout would mean upside of more than 100%. Moreover, the company is considering splitting its business in two parts. This would separate its deteriorating handset manufacturing division from its messaging network. The handset division could be listed as a separate company or sold altogether. Potential buyers include Amazon.com AMZN and Facebook FB. Another option is to sell a stake of the company to a larger technology firm such as Microsoft MSFT. Investors should hope that the company executes on one of these strategic options. Lastly, RIM may stage a turnaround with its new product, the BB10. While the company may turnaround this segment of the business, investors should hope that the company discontinues the handset device business because it likely will remain unprofitable in the near term. Since a new operating system will be released, potential customers will put their purchase on hold until the release of BB10. At the moment, the BlackBerry 10 smartphone is expected to launch in the latter part of 2012. Investors should hope that the BB10 will be released before the holiday season. This all may explain why the company is trading at a discount to its sum-of-the-parts valuation and why some investors remain bearish. RIM has achieved success in foreign and emerging markets. RIM's foreign business segment and investments in emerging markets should be viewed as a going concern. Sales outside of the United States accounted for 77% of revenue in 2012 compared to 61% in 2011, and 42% in 2010. Non-U.S. sales increased from 12 billion in 2011 to 14 billion in the past 12 months. However, RIM is under pressure because of its lost market share within the U.S. Sales in the U.S. for the past 12 months were 4.18 billion, down from 7.82 billion in 2011. In RIM's case, undertaking asset-based valuation is beneficial. Analyzing both a base-case scenario and a distressed liquidation outcome may provide an indication as to a potential floor for the stock price. When examining the balance sheet, RIM is trading at a significant discount to book value and net tangible assets (Net Tangible Assets = Total Assets – Intangible Assets – Liabilities). RIM has a price-to-book of 0.47 and a price-to-net tangible assets of 0.73. If an assumption is made that at a minimum RIM should be trading at net tangible assets per share, the stock would be worth $12.42 a share. In a distressed liquidation case, investors have little downside risk. Assuming a 100% write-down on RIM's patents and all intangible assets, a 50% write-down on inventory, and a 50% write-down on Property, Plant & Equipment, net tangible book value per share would be $8.84. Keep in mind that RIM's inventory value of 1.027 billion already includes a 432 million provision for excess and obsolete inventory. Furthermore, assuming the patents are worthless makes this a very conservative outcome. Investors likely have discounted the stock below its tangible net asset value because the company may continue unprofitable operations for an extended period. Furthermore, investors must take into account the cost of downsizing, which would include severance packages for fired employees. This would diminish RIM's cash, causing net tangible assets to decrease. Investors can use options to take either an aggressive bullish stance or a more conservative bullish stance. For aggressive investors who believe within the next 115 days the company will engage in one of the strategic options, such as selling off some of their valuable assets, a call spread should be placed on RIM stock. Investors should buy call options with Oct. 12 expiration. Buying a call with a strike price of 9 for 1.33 and selling a call with a strike price of 11 for 0.61 results in a net debit of 0.72. The breakeven point at expiration is $9.72. Profits are capped if the stock exceeds $11 a share. If the stock trades above $11 at expiration, investors can expect a return on investment of 177% in only 115 days. When annualized, the max profit provides a compounded return of over 2,400%. Investors should determine whether the return outweighs the risk, which is the debit paid for the transaction. For more conservative investors who feel that the stock already has been beaten down too far, and who see a potential floor of $7 a share, selling a put spread makes more sense. Understanding that over time operating losses will decline RIM's asset base, investors should sell a put expiring in August with a strike price 7 for 0.29. To complete the spread, investors should purchase a put also expiring in August but with a strike price of 6 for 0.15. The trade results in a net credit of 0.14. As long as RIM stock does not decline by more than 22% in the next 52 days, the trade will provide a return on investment of 14% (excluding commissions). When annualized, this provides a compounded return of 150.8%. Investors should keep in mind that the options strategies described above include Thursday's earnings announcement, in which it may report a loss worse than expected. This would cause further declines in the stock.