Opinion

RIM: Limited Downside Risk With Unlimited Upside Potential

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Research In Motion’s worst days may be behind them. The company recently announced BlackBerry 10 gained FIPS certification before release, which caused a 10% spike in their shares.

More recently, RIM has announced they will unveil the first two BlackBerry 10 phones on January 30th, 2013. Some analysts have predicted the stock should trend hire as excitement builds.

Here’s how Seeking Alpha describes why BlackBerry 10 could make RIM an interesting play:

The stock appears to have bottomed out on the 24th of September and has been putting in a series of higher lows since then. This type of formation is bullish as it usually indicates that the stock is ready to trend higher.

The huge short position makes this stock an even more compelling play now, because if Blackberry 10 is received well on the 30th of January, it could trigger a short squeeze. The stock surged almost 7% after the company’s announcement that the Blackberry 10 would be available on the 30th of January. When it announced that 50 carriers were lab testing BB10, the stock tacked on over 10% from its low to its high before pulling back. The short percentage of float has moved up roughly six percentage points from its June reading of 13.7% to its current reading of 19.6%. Thus, a decent reception to the BB10 on the launch date could very well lead to a short squeeze. On the other hand, there is always the chance that things might not work out as planned. Therefore, it is best to implement a strategy that provides one with unlimited upside potential, but limits your downside risk. One way to achieve this is to write a bull put spread and then use the credit to purchase calls. With a bull put spread you simultaneously sell one out of the money put and purchase one put that is farther out of the money for a net credit. The maximum gain is achieved if the price of the stock trades at or above the highest strike price. Your total risk is equivalent to the spread between the two strike prices. This would only occur if the stock closed at or below the lower strike price. However, the credit obtained from writing the spread will be used to purchase call options. The calls will provide investors with unlimited upside potential, while the bull put spread will strictly limit your downside risk.

Benefits of a bull put spread

  1. It limits your losses if the stock suddenly plunges. Your loss is limited to the total differences between the strike prices of your short put (the put you sold) and long put (the put you purchased).
  2. The ability to profit even if the stock barely budges in price.
  3. The risk is significantly lower than writing a naked put as your maximum downside is limited by the put option you purchased.
  4. The capital requirements are significantly less. With a cash secured put you would need to have enough cash in your account to back the sale of the put. If you sold a put with a strike at $65, you would need to have $6500 in the account. With the bull put spread, your capital requirement is limited to the spread between the two strike prices.
  5. In the event the stock declines, an investor can buy to close the short put position and continue to lock in gains from the long put as the price of the underlying stock drops.

Reasons to be bullish on Research In Motion:

  1. It has a strong free cash flow yield of almost 53%.
  2. The board of directors authorized a share buy back program of up to 5% of the company’s outstanding shares.
  3. It is trading over 50% below book. The current book value stands at $18.15.
  4. The short percentage of float stood at 13.7% in June. As of Oct 15, 2012 this figure has risen to 19.6%, which makes it a very good candidate for a short squeeze. If the phone is received well on the 30th of January, it could be the driver that leads to a very nice short squeeze.
  5. International markets could prove to be a lucrative source of new income. In the previous quarter 52% of the company’s total revenue came from international sources. It has sales distribution networks with over 565 wireless carriers in over 175 countries.
  6. At the end of the 2nd quarter, its subscriber base grew to 80 million, which represents a year over year increase of 35%.
  7. Analysts are projecting growth rates of 10% per annum for the next five years.
  8. A good quick and current ratio of 1.7 and 2.20 respectively.
  9. A long-term debt to equity ratio of 0.00.
  10. Zack’s has a projected 3-5 year EPS growth rate of 13%.
  11. In a sign that Blackberry 10 might receive a decent reception, Analysts have been raising revenue estimates for RIM. The current mean estimate stands at $2.62 billion.
  12. Research In Motion won an important U.S. security certification which will allow the Blackberry 10 to be used by government agencies. This is the first time the company device has been certified prior to its launch.

Talking about the security features of the device, “What differentiates BlackBerry is that it integrates end-to-end security, and includes certified encryption algorithms for data at rest and data in transit. No other mobile solution has achieved the level of security accreditation that the BlackBerry solution has.

Data of value

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When a stock is trading above the EPS and EPS consensus estimate line, it is a bullish phase, and the outlook is for higher prices. While the stock is still trading below the EPS consensus estimates, the line has started to trend upwards and this suggests that the worst could be behind the company.

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How does Research In Motion hold up against the competition?

The company will be compared against key competitors using key metrics such as P/E, quarterly revenue growth, operating margins, PEG, etc. This will give you further insight into the company, and it could also help you determine if it is the right play for you. If you find that a competitor makes for a better play, you could use the same strategy we have outlined in this article.

RIMM (AAPL) (GOOG) (NOK)
Quarterly revenue growth -0.31 0.27 0.45 -0.19
Revenue 15.05B 156.51B 47.54B 41.61B
Gross Margin 0.29 0.44 0.60 0.27
EBITDA 1.95B 58.52B 15.85B -911.47M
Operating Margin 0.01 0.35 0.28 -0.06
Net Income -613.00M 41.73B 10.56B -5.67B
EPS -1.17 44.15 31.91 -1.53
P/E N/A 12.26 20.46 N/A
PEG (5 yr expected): -1.29 0.51 1.25 7.78
P/S 0.28 3.35 4.61 0.24

Technical outlook

In trading above $8.00 and managing to hold above this level for several days, it has demonstrated that it is establishing a new level of support. It has been trying to trade above $8.00 since the end of July, but each attempt to trade above this level failed. On the 1st of November, it finally traded above this zone and has managed to hold onto its gain since then. Another bullish development comes from the higher lows it has been establishing, since it bottomed out on the 24th of September. One could argue that it also completed a double bottom formation on the 24th of September. A double bottom formation combined with a series of higher lows is a pretty bullish development and usually signals that the stock has bottomed out and is ready to trend higher. As the stock in the process of establishing new level of support at $8.00, the prospects of it testing the $6.50-$7.00 ranges is not so bright, but it could still test $7.50 before trending higher. As long as it does not close below $8.00 on a weekly basis the short-term outlook will remain bullish. A weekly close above $10.00 will be a very significant development and indicate that the stock is ready to trade to and past the $12.00 ranges. Consider waiting for a test of $8.00 before putting this strategy to play.

Suggested strategy

We are first going to write a bull put spread and then the proceeds from this spread are going to be used to purchase calls.

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The March 2013, 8.00 puts are trading in the $1.08-1.10 ranges. If the stock pulls back to the stated ranges, the options should trade in the $1.35-$1.45 ranges. We will assume that the puts can be sold at $1.35 or better.

The March 2013, 6.00 puts are trading in the $0.36- $0.38 ranges. If the stock pulls back to the stated ranges ($8.00 or better), the options should trade in the $0.45-$0.55 ranges. For this example, we will assume that the puts can be purchased at $0.55 or better. After the transaction is complete, you will have a net credit of $80.00. If you are happy with just writing a bull put spread, you could stop here. Your total risk in this case will be $120.00, and your maximum gain will be $80.00 for a return of 66% in roughly four months.

As it is our goal to leverage our position in RIM, we will be using the credit to purchase calls.

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Our aim here is not to put up any fresh money but to use the credit from writing the spread to fund the purchase of the call options. The March 2013, 10 calls are trading in the $0.85-$0.88 ranges. If the stock pulls back to the $8.00 ranges these calls should trade in the $0.70-$0.80 ranges. We will assume that the calls can be purchased at $0.80 or better. For each bull put spread you write, you will be in a position to purchase one call.

Transaction Details

  1. After you write the bull put spread and purchase the call you will have a net credit of $80.00
  2. Your maximum risk is $200.
  3. Your breakeven point is $8.00
  4. Your maximum profit potential is unlimited due to the call purchased. Technically there is no limit as to how high the stock could rally.

Conclusion

It looks like the worst news is already priced in the stock as it has been putting in a series of higher lows since the 24th of September. Additionally, each piece of good news has pushed the stock higher, and for the most part it has managed to hold onto these gains. The short percentage of float is 19.6%, and this makes this stock a great candidate for a short squeeze. The strategy we have outlined is a great way to establish a long position in Research In Motion without taking on too much risk. The call side of the strategy provides you with the ability to lock in unlimited gains if the stock takes off. The bull put spread limits your total risk to $200.00.

Do not abuse this strategy as there is always a chance that the shares could be assigned to your account. The hedge you have in place via the long put will not prevent the shares from being put into your account. Consider booking some profits when the options are showing gains in the 60%-100% ranges or if the stock trades to the $12.00 ranges.

Options tables from yahoofinance.com.

Disclaimer

It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies - let the buyer beware.







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