When BlackBerry announced its Q4 results on March 28 we celebrated a Street-beating earnings result. Even if you ignore the tax benefit that the company recorded, BlackBerry delivered much better financial results than expected.
A big part of that beat came from the gross margin line, which came in at 40% versus the low 30's estimates. In the financial press release, the company said the earnings improvement came from improved ASPs and higher margin on hardware.
Analyst estimates on Z10 gross margins differ widely. We have some analysts suggesting margins are 40% on the new hardware. Then we have others, such as GMP’s Deepak Kaushal, who believe Z10 margins started their journey closer to 20%, as I wrote about here.
After looking at the numbers more carefully, I think there is some validity to GMP’s view. I know from experience that BlackBerry usually sees weaker margins when a device first rolls out. Margins usually rise as production costs stabilize, volumes rise, and manufacturing yields improve. The company's own Chief Financial Officer, Brian Bidulka, has talked about this on conference calls, and any analyst worth his or her salt knows this history.
Anyway, 20% margin on the Z10 is not a disaster. It’s a starting point and I think it’s logical to expect it to rise towards 30% within 2 quarters of release. This is fairly normal for BlackBerry. But the important point, and one that no bear will argue, is that BlackBerry 10 margins are a huge step up from the essentially zero margin that BB7 was delivering recently. In fact, for a while BB7 devices were being sold at an estimated 5% negative margin. Double digit margin on the Z10? That’s a huge win to start.
BlackBerry 10 margins are a huge step up from the essentially zero margin that BB7 was delivering
Now let’s look a bit more closely at the numbers. Because I think the numbers back up GMP’s rationale for saying the Z10 isn’t the only reason gross margin climbed back to 40%.
I apologize if this gets too accounting-geeky for some of you, but accounting matters here. Gross margin is the percentage of dollars that are left once manufacturing costs are subtracted from revenue. Included in manufacturing costs are costs known as “amortization”.
Say you buy an expensive machine to manufacture devices. You write down the cost of that machine slightly every quarter, and you attribute that quarterly write down as an expense against manufacturing. That’s called “property plant and equipment” amortization. BlackBerry had $77 million of such amortization included in “costs of goods sold” (COGS) this quarter versus $87 million last quarter. That’s a tiny change, and helps boost gross margin by a whopping 0.4%. Not relevant.
The other kind of amortization on the COGS line is called “intangible”, meaning it’s a write down in the value of something you can’t physically touch. Usually, for BlackBerry, these are license agreements. Intellectual property is complicated, but BlackBerry uses its patent arsenal to offset the value of patent licenses it needs to buy from other companies. It enters into cross-licensing agreements, and these agreements usually mean that BlackBerry will pay a certain fee to another company based on the volume of shipments. When the shipments occur, the value of the license (paid in advance) is amortized.
If shipment volume decreases, the amortization expense also decreases, and depending on how the math shakes out, this may help margin. It just so happens that BlackBerry recorded only $136 million of intangible amortization on the COGS line in Q4, compared to $263 million in Q3. That’s a big difference, and one that isn’t explained solely by the decreased shipment volume of BB7 devices. So I have to believe the $127 change in COGS-related intangibles helped gross margin, possibly up to the full amount of 4.7%. That’s about half of the overall gross margin improvement explained right there. It has nothing to do with BB10.
Also, BlackBerry has been restructuring with its cost optimization program called CORE. In Q4, CORE expenses attributed to gross margin were negative $4 million. Yes, the company actually had a gross margin expense reversal in Q4, obviously realizing it spent less than it thought it had at the end of Q3. This compares to a $32 million charge to COGS in Q3, meaning the quarter-over-quarter difference was $36 million. That’s another 1.3% improvement in gross margin, and again, it has nothing to do with the Z10.
I hope that wasn’t too numbers heavy, but my point is this: Gross margin increased in Q4 in part due to the Z10, but also in part due to amortization and CORE expense changes. I believe gross margin has more room to climb simply because the Z10 is likely not at peak margin yet. Give it another couple of quarters.
In addition, the Q10 and other BB10 devices are coming. The mix will shift from BB7 towards BB10 quickly. This will help gross margins. I think this leaves BlackBerry’s income statement in a nice uptrend over this year.
That’s a good thing.