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Valuation on BlackBerry Stock Is a Tough Pill to Swallow

BB stock isn't worth much more than $9

By Luke Lango, InvestorPlace Contributor

Valuation on BB Stock Is a Tough Pill to Swallow

Source: Shutterstock

It is official.

BlackBerry (NYSE:BB) is out of smartphone game. Apple (NASDAQ:AAPL) has won. BlackBerry has lost. The era of BlackBerry smartphones is coming to a close.

But that isn’t necessarily a bad thing for BB stock. On the contrary, it is actually a good thing. The writing was on the wall for BlackBerry to lose the smartphone race for some time now. That is why back in late 2013, contrarian CEO John Chen took over at BlackBerry with the intention of pivoting the company from smartphone hardware to connected-things software and services.

The pivot has played out beautifully. The hardware business is near zero, and the software and services business is growing at a double-digit clip. Margins are improving, and the company is finally recording profits. In response, BB stock has gone from below $6 in late 2013 to $10 today.

But, this rally has come under fire recently thanks to slowing growth in the software business. Unfortunately, thanks to what has become a super-charged valuation on BB stock, a slowdown in the software business could present huge headwinds for this stock.

Here’s a deeper look.

The BlackBerry Turnaround Has Worked

At its core, the BlackBerry turnaround has worked.

Chen took over in 2013 with one goal in mind: To make BlackBerry a software and services company with broad exposure to the connected-things market.

He has done just that. The hardware phone business has dwindled into nothing, while essentially 90% of the revenue today comes from software and services. That business is growing at a double-digit pace (up 14% last quarter), thanks mostly to the company’s leading software-security platform which has applications to various different connected-device markets.

During this transition, margins have improved thanks to the shift from low-margin hardware sales to high-margin software sales. Gross margins were 76% last quarter, and still improving, versus 67% a year ago and 53% two years ago. Operating margins are also trending higher, and BB has actually reported nine consecutive quarters with positive non-GAAP operating profits.

In total, then, it is safe to say that Chen has masterfully executed a successful turnaround at BlackBerry. The low-margin phone business is dead. The high-margin software business is growing and projects to keep growing thanks to exposure to multiple secular growth markets. Most importantly, overall profitability is up.

But There Are Problems Going Forward

Although the BlackBerry turnaround has worked, that doesn’t necessarily imply further upside for BB stock.

Instead, I actually think BB stock will fall from here. Why? Because the valuation got ahead of itself. Now, growth is slowing. This will cause the valuation to come back down and the stock to drop.

BlackBerry’s software pivot does give the company broad exposure to multiple secular growth markets through providing security solutions for connected devices of all sorts. While this provides a promising long-term growth narrative, growth in this business is presently slowing. Last year, software and services revenue rose 14%. This year, that growth is projected to be just 8-10%.

Thus, on a go-forward basis, it looks like total revenue growth will be stuck in the 5-10% range. That just isn’t enough to warrant the present stock price.

Assuming 5-10% revenue growth over the next several years, and that BB hits its long-term margin targets of 80-85% gross margins and 20-25% operating margins in five years, then I think BB can do about $0.50 in earnings per share in fiscal 2024.

Even an ultra-aggressive Facebook (NASDAQ:FB) type multiple of 25 forward earnings implies a fiscal 2023 end-price target of just $12.50. Discounted back by 10% per year, that equates to a fiscal 2019 end-price target for BB stock of below $9.

Bottom Line on BB Stock

The turnaround worked.

But that doesn’t make BB stock a buy here and now.

On the contrary, turnaround optimism caused the valuation on BB stock to get too big, too fast. Now, software growth is slowing, and that will inevitably pull the valuation and stock lower.

As of this writing, Luke Lango was long AAPL and FB. 

Article printed from InvestorPlace Media, https://investorplace.com/2018/07/valuation-on-blackberry-stock-is-a-tough-pill-to-swallow/.

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