Only a month or so ago, shares of Research In Motion looked wildly overvalued, trading at about 100 times profit estimates for the current year and about 50 times next year’s targets. Then a surprising thing happened: The Waterloo, Ont.-based wireless products maker turned in a stronger-than-expected third quarter, and more than doubled its profit forecast for the current quarter.
All of a sudden, the stock looked to be only somewhat overvalued, rather than egregiously overvalued. In fact, for a brief moment, it looked almost reasonable. So what did RIM stock do? It rocketed even higher, to the point where the shares are almost as overvalued as they were a month ago. Even when RIM took advantage of this runup and announced a massive share issue, the stock faltered only briefly.
In most cases, when a company says it is planning to issue close to $1-billion worth of new stock, the existing shares go down because of the dilution factor. After a share issue, the profit that would have been allocated to existing shareholders gets spread out over a bigger group, which reduces share profit.
Do RIM investors care? Apparently not. The stock briefly dipped on Thursday after the news, and then resumed its northward trajectory on Friday, climbing more than 7 per cent at one point — adding almost $450-million (U.S.) to RIM’s market value. Since mid-December, the share price has soared more than 60 per cent.
The justification for all this, of course, is that RIM, maker of the popular BlackBerry communications device, doubled its profit forecast for the current quarter — and so most analysts more than doubled their stock price targets. No one seemed troubled that RIM’s earlier forecasts were so off base, presumably because the miss was on the upside rather than the downside (no harm, no foul).
But analysts didn’t boost their estimates for just this quarter — they doubled their forecasts for the whole of this year and next year as well (forecasts “adjusted” to remove things such as litigation costs and options expenses, of course). Now the same oversized multiples the stock traded at before are being applied to these new estimates.
U.S. investment brokerage Bear Stearns & Co. Inc., for example, has a stock price target of $91, a 20-per-cent jump from the current price, and more than 100 per cent higher than a month ago. That’s 93 times the brokerage adjusted or “pro forma” profit target for this year, and 36 times its estimate for next year. And the 36-times figure for next year is only because Bear Stearns expects RIM to boost its annual profit by more than 150 per cent. The following year, the brokerage expects RIM’s profit to be more than triple this year’s.
If you look at profits that conform to U.S. generally accepted accounting principles — that is, profits that include a variety of expenses that “pro forma” profits do not — the picture is scarier. Bear Stearns’ $91 target becomes 171 times this year’s profit estimate and almost 50 times next year’s. Even Friday’s stock price of $76 works out to about 40 times estimates (45 times if you include option expenses).
And what about the dilution? Bear Stearns kept its $91 target despite the prospect of dilution because its target is based on share profit (pro forma) plus the value of cash on hand — and while the profit goes down as a result of the issue, the amount of cash goes up. But does having a lot of cash really make RIM’s operations that much more valuable?
RIM says having more money will make it look more financially secure and enhance the possibility of partnerships and big contracts, which is no doubt true — and it will allow RIM to cope with higher demand. But it’s a bit of a stretch to say that the entire $738-million it will raise with the issue should be added to the company’s profit for valuation purposes.
If you leave the cash out and look at RIM’s cash flow from actual operations, the picture isn’t all that rosy. In the nine months to November, RIM’s profit totalled $10.2-million, but only $3.3-million came from its core business — almost 70 per cent came from investments. And if RIM had expensed its stock options, it would have reported a loss of about $3.6-million for that nine-month period.
Yet, still the stock climbs. After RIM revised its profit forecast, Toronto-based Orion Securities Inc. more than doubled its 2005 profit estimate, noting the stock was selling for a mere 25 times that estimate. That was two days before Christmas, when the stock was $46 on the Nasdaq Stock Market, and Orion had a price target of $65 (up from its earlier target of $44).
The next day, the stock jumped more than 50 per cent, plowing through Orion’s target. On Friday, it closed at $76.25 on Nasdaq. Now, it is trading at more than 30 times RIM’s 2005 profit estimate — and that’s an estimate that assumes RIM’s operating profit will rise 230 per cent in 2005.
Can lightning strike twice? It had better, because only another sudden doubling of profit forecasts will make RIM’s stock look even remotely reasonable.