A Gaping Hole in BlackBerry’s Turnaround

Investors already know that BlackBerry‘s (TSX:BB, Nasdaq:BBRY) turnaround is very much riding on the success or failure of BlackBerry 10. While focus remains intently on BlackBerry 10 unit volumes, which came in at 2.7 million last quarter, there’s still a gaping hole in BlackBerry’s potential turnaround: service revenue.

Concerns over BlackBerry’s transition in its services business have been prevalent since December when the company acknowledged that the new BlackBerry 10 platform would have an adverse impact on consumer-related services revenue. However, the importance of the services business and the pressure it faces cannot be overstated.

The main attraction
As the hardware business has declined over the years, BlackBerry’s gross profitability has become entirely reliant on the services business. As recently as fiscal  2011, hardware contributed over two-thirds of all gross profit, with services accounting for the rest. In fiscal 2013, hardware has fallen into negative gross margin territory, which means that services are paying the bills right now.

BB gross profits

Source: BlackBerry. Fiscal years shown.

BlackBerry only discloses its mix of cost of sales in annual reports, so a similar gross profit breakdown is not available for the most recent quarter. Overall gross margin did improve to 34%, largely thanks to BlackBerry 10 devices, but inevitably the highly profitable services business whose gross margin tends to hover around 85% was still the bulk of gross profits.

A consumer-oriented hole
Since BlackBerry 10 devices use generic data plans offered by mobile operators instead of BlackBerry Internet Service, or BIS, plans, and the goal is to transition entirely to the new platform, the consumer side of services revenue will eventually decline to zero over time.

As this revenue stream dries up, BlackBerry is hoping to explore alternative routes of service monetization to compensate, primarily within the enterprise. CEO Thorsten Heins reiterated that BlackBerry has no interest of being a “device-only” business, and that its value lies in being an end-to-end provider that includes the device.

On the consumer side, BlackBerry is seeking advertising revenue within the consumer-oriented BlackBerry Messenger Channels. The company will also hope to take a cut of content sales like apps sold through BlackBerry World, but this offers negligible profitability at best.

When 100% market share still wouldn’t be enough
There are some opportunities within the mobile device management, or MDM, market. The most vocal Street bull, Jefferies analyst Peter Misek, has based[EN1]  part of his bullish thesis and $22 price target on BlackBerry tapping the MDM market. Even after the earnings plunge, Misek defended[EN2]  the stance and said BlackBerry has “got to get the MDM market.”

The challenge is that the overall MDM market still pales in comparison to the levels of lost revenue that BlackBerry needs to make up for. Gartner estimates[EN3]  that the MDM market, which is highly competitive, will reach $784 million this year. That’s with over 125 competitors playing in the space. Even if BlackBerry were to theoretically grab 100% market share, which isn’t possible, it doesn’t compare to the $3.7 billion in service revenue that the company has generated over the past 12 months.

At the same time, competition is so intense that the MDM market will face rapid commoditization and margin pressures, even as BlackBerry lags leaders like Citrix, Good Technology, or SAP, among others. Gartner analyst John Girard goes as far as to predict that the MDM market “is going to die,” being replaced by mobile application management.

Can’t live without services
The vast majority of smartphone vendors these days fail to generate positive operating income. BlackBerry isn’t a hardware-only company, but its hardware operations are unlikely to attain sustainable profitability ever again. Meanwhile, its services business is under heavy pressure due to the transition towards BlackBerry 10 and the company is on a strict timetable to grow BlackBerry Enterprise Server, or BES, and its MDM platform.

Without a thriving services business, there is no turnaround for BlackBerry.

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Fool contributor Evan Niu does not own shares in any of the companies mentioned.  The Motley Fool does not own shares in any of the companies mentioned. 


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