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Research In Motion's Margins Are Moving in the Wrong Direction


There's a big difference between a good company and a good investment.

Research In Motion (RIMM) will be reporting its third fiscal quarter after the close tonight. Most of The Street is expecting the results to be in-line with prior guidance and I have no reason to believe that that will not be the case.

However, investors need to make a realistic assessment of Research In Motion's future. From my perspective, it's going to be a rocky road and I'd be looking for greener pastures in which to play.

Don't get me wrong, Research In Motion has been a great company that transformed a niche market into a great investment for many. But, that market is changing in a number of ways and none of them are positive.

Obviously, the smartphone market has gotten much more crowded over the last year or so. While a Research In Motion bull would argue that the new competition has expanded the market and created a much larger opportunity, we haven't seen that translate into better numbers for the company.

In fact, the guidance provided for third fiscal quarter on the last conference call was clearly disappointing. Adding to those concerns was the confirmation of a slower outlook found in the company's SEC filings.

As you can see in the graph below, the company's purchase commitments (one year or less) at contract manufacturers tended to track revenue fairly closely until the last two quarters. Since May, there's been a noticeable change in the trajectory. Maybe there's a logical explanation and we'll see it spike up again in the next filing but I don't like what I see.

What may be more troubling for investors is taking place on the margin side.

Most bears on the name have argued for some time that Research In Motion will experience margin compression that will hurt earnings. As you can see in the graph below, Research In Motion's gross margins have dropped by about 11% points over the last several years. You would expect that as the company launches more low-end models targeting the consumer segment.

Keep in mind that during the bulk of this period many component costs were quite weak and, therefore, bolstering margins. This issue is a common focus of the Q&A on conference calls as analysts try to ascertain whether the margin compression has ceased and if we'll see a rebound.

The quick answers to those questions are no and no because the very same competition that's impacting growth will also provide relentless pressure on gross margins.

Five years ago, Research In Motion was essentially the only game in town providing road warriors with mobile email access. Given the advantage that the service provided, its employers were more than willing to pay for it. But Research In Motion is no longer the only corporate mobile email solution (but still number one) and the market has moved well beyond those who can write it off as a business expense.

No company can maintain a margin premium versus its competitors over time when they're selling the same basic functionality. Don't take my word for it, look at the next graph below.

It's a comparison of Dell (DELL) and Compaq's (HPQ) gross margins over the 10 years ending 1999. When the competition's gross margins are 10% to 15% points below yours, you've got a problem.

There's no place to go but down unless you have something everyone wants and no one else has. It took almost a decade to hit Compaq but I seriously doubt it will take that long this time around.

Remember, there's a big difference between a good company and a good investment. It's not inconceivable for Research In Motion to see top-line growth over the near term if it plays its pricing cards correctly. However, with the competitive landscape now changed and component prices stable-to-up, revenue growth may not easily translate into earnings growth.

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No positions in stocks mentioned.
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