BlackBerry Z10

Last night I came across an article about BlackBerry published on Seeking Alpha. In case you aren't familiar with the site, it's one of the leading sites where anyone can submit investing articles. Many of the articles are of excellent quality. But some are written by people who don't understand accounting, financials, technology or other critical aspects of the topic they are writing about. And if you take their "analysis" at face value you'll absorb information that is totally wrong.

And in this case, the writer of this article falls in to the camp of not understanding how to look at gross margins. Since every BlackBerry investor is thinking about hardware margins on the Z10 (and soon Q10), this stuff matters.

The writer begins his article by proclaiming BlackBerry will now have higher gross margins than Apple. His justification? Remember those reports talking about the cost of components to make a Z10? This list, often referred to as a "bill of materials" (BOM), came to a total of $154. Not knowing any better, this author has taken the typical $600 off-contract price of the Z10 and subtracted $154, arriving at a $446 gross profit number.

Sorry. This is not even close. It's so far from the truth in so many ways. BlackBerry is not earning a 74% gross margin on Z10 sales. This number is so far beyond any reasonable sanity test that I stopped reading. No value in going further.

Gross margin is the ratio of gross profit to revenue. It's expressed as a percentage. So if something costs $15 to make and sells for $30, then we say it has a 50% gross margin. The only two things you need to know are total cost to manufacture and total revenue.

In the case of smartphones, the cost to manufacture is significantly higher than the bill of materials (BOM). Sure, the pile of components to manufacture the Z10 might cost only $154. But those parts have to be assembled by a contract manufacturer. This is called "conversion cost" in the business, and it's obviously not free.

The biggest contract manufacturers (also called EMS companies, for Electronic Manufacturing Services) which include Hon Hai, Flextronics, Jabil, and Celestica, don't work for free. The most visible part of their work may be the component assembly. They've got complex "pick and place" equipment, surface mount reflow ovens (for soldering) and much more.

But even before manufacturing happens, these guys do all sorts of work helping vendors design for manufacturability. They help source components. They hold inventory on behalf of the vendor. They take certain inventory risks. Then after manufacturing is done they often to product testing, software loading and other fulfillment activities. None of this is free. It all goes on top of the $154 bag of parts, reducing gross profit.

And let's not forget the other material costs. Doesn't the Z10 come in a nice box? Doesn't it come with a micro fiber pouch? How about that charger and USB cable, or the headphones? All of those things cost money and they are not accounted for in the BOM analysis that you see.

Then you have shipping costs. Fedex (or whoever) don't move products around the world for BlackBerry out of the goodness of their hearts. Getting handsets from manufacturer to fulfillment center to retail costs money.

This is why we have seen BlackBerry lose money in recent quarters despite having an ASP (average selling price) of about $230. This says that the all-inclusive costs of building the average BlackBerry handset are slightly above $230. That's for older BlackBerry 7 hardware too, not the Z10.

Last but not least, we have to look at the revenue line. BlackBerry likely does not sell the Z10 to its partners for $600. That is the off-contract price we see as a consumer. Do you really believe carriers sell devices, off contract, at cost? Are they in the business of making no money? Of course not.

Most analysts assume that the ASP on the Z10 is closer to $500. So if you're paying $600 at the store, the retailer might be making $100. Obviously if you pay $199 on contract, the carrier is subsidizing it by about $300, but making that money back (plus a healthy return) based on the lifetime value of the data plan you take on that contract.

Bottom line: When you see something that looks crazy, it probably is. BlackBerry doesn't earn 75% gross margin on the Z10, and Apple doesn't earn that high of a margin on the iPhone 5. Nobody makes that kind of margin on smartphone hardware.

As much as professional analysts take a lot of heat from the general public, their estimates (when it comes to near term financials) are pretty reasonable. They are pretty smart people and it's a pretty competitive field.