Growth – at what cost?

I recently ran into someone who commented on the past year in the market.  We are just back to where we were a year ago, he commented.  I decided to look at what has actually transpired in the markets’ perception of what to pay for assets in varying economic scenarios.  To do so, I decided to look at one of the best run companies.

Research in Motion (RIM) is a company that we all know and many of us use its products daily.  It is a true success story from its inception to the ubiquity of its products in our lives.  Its vision has changed the way in which we operate and has enabled business to be more connected, thereby offering a very valuable service to everyone.  I cannot comment strongly enough on the magnitude of its impact.  When I think of truly great and visionary companies, this one easily comes to mind.  And, even better, it is a Canadian company.  That’s about the company, now about the stock.

The stock today is around $70.  At its bottom it was $50 and at its recent peak was $90.  So we are almost exactly half way between the 2 points.  My view is always that at these extreme points in time the stock prices are arbitrary figures and only represent what investors believe is the outlook at that exact point in time.  The real value of a company is much more difficult to measure but what most use is a multiple of the returns it produces for its shareholders in terms of growth in assets, earnings and shareholder’s equity.  In Rim’s case there are 573 million shares outstanding and every trading day a value is put on the company by the price per share paid and multiplying this by the number of shares outstanding to get the market capitalization.   We will look at the valuations at these pivotal moments in time:   the 2008 high; the March 2009 bottom and a recent peak in September 2009 as well as today.

But before that, let’s discuss some quantitative attributes of RIM, the company.  The company is large with a phenomenal balance sheet, no debt and around $2bn in cash (that’s around $3.50 per share).  It has high profitability, high returns to shareholders and strong growth.  These are attributes that any investor should gladly pay for.  In summary, it is a truly great company.  But at what price?

Today Research in Motion is valued at C$42bn.  (all figures are approximate and in Canadian $).  It is valued at 3 times sales of $14b and 18x earnings of $4.00   Rim is a truly exceptional company in my view – it has a very high return on equity (28%) and grows around 25% per year.  Its net margin is 17%, which would put it at the top of companies in terms of profitability.  As well, it has a great balance sheet.   Truly phenomenal and there is no debate about this.

At its peak in March 2008 the stock market valued the company at $86bn.  At that time it had $6bn a year in sales (now it has more than $3bn a quarter in sales!) making the price to sales ratio at a whopping 14x.  The p/E or the price the market was wiling to pay for $1 of earnings was 66x or $66 for each $1.  The rest of the financial metrics were similar to today – cash on the balance sheet was the same, there was no debt, etc.   One year later in  March 2009  (at the market bottom) RIM was valued at just $29bn down 66%,  a price to sales of just 2x  and a p/e of 15x.  It still had all the other things mentioned above – high profitability and high growth.   But the market wouldn’t pay much for that because it couldn’t see forward and know what RIM was going to earn.  Visibility was unclear – would anyone ever buy another blackberry?  No visibility = uncertainty, something no one is willing to pay for.

At its recent peak on September 23^rd,    RIM was trading at C$90 and had a market value of $52bn.  The market was willing to pay 4x sales and a p/e of 22.5x.  ROE was just as high and earnings growth was still at 25% and the balance sheet, as always, was superb.

So, what has happened since then?  Well, expectations have clearly changed.   They were high for the quarterly results and investors were disappointed.  If you read the most recent quarterly statement it actually reads almost word for word to many of the previous ones:  “the breakdown of sales was 81% devices.... New subscribers totalled 3.8million.  Cash was $2.5bn. Revenues were up 27%“    all sounds very good.   So what has changed from September 23^rd, just 12 days ago?

Today, RIM’s value (as determined by the stock market) is $40bn.  Its p/e is 17.5x and its growth is still 25%.  It is stuck in no man’s land between very expensive (March 2008) and very cheap (March 2009).  It is cheap but not very cheap.  A bit like the whole market.  We know what we are buying; we just don’t know what we should pay for it.  We know it’s not cheap but we don’t know what the correct price is; there are just too many pieces to the puzzle that are missing, for example, what is the sustainable growth rate for sales and earnings.  We cannot know the answer to this, what we do know is that this company is a phenomenal machine.