Investing Lessons from Research in Motion's Latest $500 Million Blunder...

Last week (on Friday after market close, no less – the time when companies send bad news they hope the market will forget about by Monday), Blackberry smartphone maker Research in Motion (RIMM) dropped a bombshell, announcing that not only was its Playbook line of tablet computers floundering – not news to anyone who watches these things – but that the company would incur a massive $485 million charge in Q3 from writing off excess Playbook inventory and expenses.

The amount was so staggering that many analysts and industry observers were left wondering exactly how the company could have screwed up so badly. However, given RIM's decline in its core smartphone market – it's been rapidly bleeding market share for a few years now – there was little chance the company could make a tablet play successful. While RIM's most ardent fans insisted that the company was simply down but not out, the writing has been on the wall for some time that this company has lost its mojo. This latest blunder teaches some important lessons that all technology investors should understand.

But first…

How RIM Got Here

Research in Motion makes the once über-popular Blackberry email phone. In 2005, you couldn't go anywhere without seeing a banker or business executive frantically thumbing away on one. But for the past few years, the rallying cry at headquarters has probably sounded a bit like, "Blackberry is dead! Long live the Blackberry!"

Blackberry's secret to its former success? Real-time communications and enterprise-grade features.

Prior to the Blackberry, getting email on the phone was a slow and tedious process. Blackberry made it easy and fast. Instead of polling servers every hour or so over a very slow connection and downloading everything, their servers pushed each email to the phone as soon as it arrived. No more getting an email an hour or more after it arrived – instant access on the mobile phone was a reality with the Blackberry. It may seem trivial in the age of the smartphone, but when it launched this was a huge differentiator.

RIM did the same for messaging, too. Thumbing out SMS messages on the popular alternative Nokia feature phones was a task best left to adroit pre-teens with little other choice in phones. For users with a Blackberry, not only was typing out messages easier, but its proprietary BBM (BlackBerry Messenger) app made the messaging experience much more like then-popular instant messaging programs on the computer, with real-time status and near-instant delivery.

RIM did both of these with support from its best partners: carriers and enterprise IT departments. Phone carriers loved Blackberry. They could sell data (much cheaper services to provide) on top of their voice plans to make extra profits. All they had to do was throw some Blackberry enterprise servers – conveniently managed by RIM itself – onto their network and voilà: real-time email and a flood of cash from users with a must-have desire for access on the go.

Enterprises were the same. IT departments could bolt Blackberry enterprise servers onto their corporate mail systems and RIM would help them beam email straight to the device by relaying it all through the company's fast and secure servers… simple to deploy and much better than the alternatives of the day. IT departments loved Blackberries.

Research in Motion meanwhile made profits two ways: from the sale of cheap and simple devices that just did email well, and by collecting big user-licensing fees from enterprise and carrier customers which anted up to provide the improved email service to their users. Buying the server meant you could only buy Blackberry phones. Buying a Blackberry meant you needed the server. A virtuous cycle if ever there was one.

But then along came Apple's iPhone. It's a story that does not need retelling other than how and when exactly the iPhone really became a threat to RIM.

When the iPhone was released, it had limited capabilities, really. Other than a much-improved web browser (a huge thing in its own right), it did not have any particular killer features to differentiate it. It did offer a sleek look and simple interface – big improvements over virtually all other confusing proprietary interfaces on the market before it. But that was not in and of itself a reason to buy a phone for most people, other than early adopters and diehard Apple fans.

Most important for RIM, though, email was still better on the Blackberry. The iPhone experience was great – a big, clear touchscreen for reading and (for those who didn't require a hardware keyboard) a decent touchscreen keyboard. But you could only get messages from low-security consumer email systems like Gmail and Hotmail. No work email on the iPhone. Not for enterprises using Microsoft Exchange, the most popular system by far. Those customers were stuck with Blackberry.

However, as Apple started providing updates to its phone over the ensuing months and years, it eventually made two critical choices that managed to turn Blackberry's strengths into weaknesses. The first was to address the email issues.

Blackberry's "in" with IT departments put two great big targets on its back.

For one thing, the pervasiveness of the Blackberry Enterprise server was a constant thorn in the side of email system vendors like IBM and Microsoft. It was a constant reminder to IT departments of features they lacked out of the box, and an extra cost for the customer. With IT departments in a constant push to trim budgets, they demanded that the vendors add encryption and so-called "push" email that would get mail to the devices faster than was possible with the slow polling intervals most phones endured in checking for new mail.

All the vendors quickly responded to add these features, but the problem was that they couldn't make them work with Blackberry phones. RIM itself made sure of that, to protect its email server revenues. That left only a handful of less popular phones that were compatible… that is, until the iPhone added enterprise email support. Once that was the case, IT departments had a wildly popular phone supported out of the box with the email servers. They could get executives their "Crackberry" fix and save the company some money in the process by ridding themselves of Blackberry servers. In fact, since many users had already bought their own iPhones, many companies saw an opportunity to stop buying phones for employees and just open up their email to end users who buy their own phones, saving even more.

The other major move Apple made was to ditch the idea of a single-purpose device. Nokia made the best phones, many agreed. Blackberry made the best email devices. The iPhone? Initially just a good web-browsing phone – until Apple created the App Store.

When Apple relinquished a little bit of control and opened up to outside developers, the iPhone ceased being just a phone with web and email and truly became a general-purpose computer. You could play games, edit spreadsheets, get better messaging apps, watch videos, and much, much more. Apple realized what RIM did not – that by winning developers over it could make its phone appeal to vastly more users, save the expense of developing many of those apps themselves, lock in customers to its platform, and make a lot more money in the process. The App Store became Apple's equivalent to Enterprise Server revenue – the competitive advantage and the kicker on top of the phone sale. And it did it while making RIM's competitive advantage much less valuable.

What really lost the smartphone wars for Blackberry/RIM was its "Not Invented Here" mindset. Instead of embracing developers, the company initially responded by ignoring the demand for apps. Then it followed by hand-selecting a few apps to make half-baked experiences work on the phone. On the surface it was trying to play the 80/20 rule, getting Facebook and a few other super-popular apps running well enough on its device to not see mass defections.

Underneath there was a bigger problem: The phones had not been designed with apps in mind. The developer experience was awful. Building for RIM devices was slow and cumbersome. And it was downright impossible to reach all phones, because screen sizes and capabilities were all over the map.

RIM scrambled desperately, trying to build a new OS in-house. Later it scrapped that effort and bought a company called QNX in the hope that it could use that company's OS as a base for more app-friendly development. To date there are only a handful of QNX-based devices on the market – more are due soon – but even when they become more widely available, Blackberry will be starting from scratch, as all its users will need to upgrade to a new phone to have access to its app store.

In the meantime, Apple has built an insurmountable lead. More than 18 billion apps have been downloaded to iOS devices to date. Those users will never be able to switch back to Blackberry without losing their apps. And even Blackberry users can get their email on an iPhone these days, thanks to Microsoft and other email vendors.

By not embracing application developers, Research in Motion condemned its phones to quickly fall behind in terms of features available. One company simply cannot keep pace with thousands of outside companies producing tens of thousands of applications.

On top of all that, Google happened.

Copying the best part of Apple's phone model and Microsoft's PC model, and adding a little open-source twist of its own, Google suddenly surged to a dominant position in the smartphone landscape. Its Android operating system was open source. That means developers and device manufacturers both love it because it is easy to get and really cheap. And because so many device makers adopted it, phones are widely available and affordable. The net effect has been an explosion of demand for Android phones and thus for their app store as well. Just this week, Google announced it has reached 10 billion app downloads by its users:

Add those to Apple's 18 billion, and you have an awfully steep hill for RIM to climb.

Android and Apple's app platforms are also transferrable to their tablet devices with little work. RIM promises to provide the same with Blackberry 10, based on QNX, just as its Playbook tablet is. But it will be starting in the wrong direction, with its least-popular item the sole source of apps today.

We'll get to the Playbook in a moment. But first we must note that RIM's downfall is not solely attributable to its lock-in to a business model that is under siege from a 360-degree competitive assault. The company made mistake after mistake, tarnishing its brand image and showcasing the major flaws of the platform for businesses and consumers alike. To list them all would make a novel, but a few key ones stand out clearly…

Massive service outages exposed the flaws in the central model of its email system for all to see. IT managers had to answer hard questions about disaster preparedness, outsourcing critical functions, and how they could not have a backup. This left IT departments in search of alternatives to the Blackberry, which they found in the combination of email systems they already owned and consumer smartphones like the iPhone.

A kerfuffle over security with the governments of both Saudi Arabia and India turned into an international issue when RIM exposed their attempts to coerce the company into letting them spy on encrypted emails. What the company intended as a demonstration of its independence and commitment to protection of customer data, as well as the quality of its encryption software, ultimately backfired. Again, IT departments were reminded of the system's centralized architecture and how that made the company an easy target for governments looking to subpoena information, shut down services, or just universally spy.

These drawbacks were revealed as acute risks for enterprises running their own email, leading them to pressure vendors like Microsoft to support mobile email better, and companies like Apple to build enterprise email, including encrypted email support, into their devices. Sensing the market opportunity, the competitors jumped in with both feet, preaching lack of dependence on RIM's proven shaky service and some isolation from that giant temptress of the surveillance state.

Simply put, RIM failed to recognize when its business model – proprietary, centralized, closed device, and server ecosystem – became its own worst enemy. And by the time the company finally saw the writing on the wall, it was too late.

The results have been astounding, with market share for RIM dropping from over 60% less than a decade ago to below 20% today. It's now dwarfed by both Apple and Google, with even Windows Mobile gaining against it.

(Click on image to enlarge)

The company's big hopes of resurgence were pinned not only on the back of the revived, developer-friendly smartphone platform but also on a grand entrance into the ultra-hot tablet computer market. However, the company brought some of its old business model thinking to the market with it and botched the rollout of its new product altogether.

The Playbook Problem

Which brings us to this week's news: the incredible, nearly half-billion-dollar write-off of Playbook expenses. The exact cause of the write-off is unknown, as RIM is not providing much in the way of details. No surprise there. But we can speculate. With the number that high, and estimates of the cost of the device – made by well-known ODM Quanta out of easily priced parts – running at only about $200 a pop, the latest news means than RIM could be looking at writing off as many as 2.4 million devices.

If this is the case, it could mean the company far overbought the devices. Or possibly, it had a minimum device commitment in its contract with Quanta, guaranteeing certain milestones that were never met. Either way, a massive strategic mistake was made.

The device's sales started off strong enough, as would be expected with an installed base of tens of millions of smartphone users. Among them are bound to be many remaining fans. The company reportedly sold 500,000 Playbooks during its first quarter of availability, but sales then fell off a cliff, to 250,000 in Q2 and just 150,000 in the most recent quarter. Even if initial sales levels had held up, RIM would have bought or guaranteed enough inventory for well over a year – completely unnecessary in today's "just in time" inventory world.

What's happened to hurt sales this much and stifle what looked like a promising launch? First and foremost is the device's bad design concept. To make a Playbook work, you must have a Blackberry. That limits the functionality of the device for many users and takes them entirely out of the market.

This as well as problems with the interface design and quality of the browser software led to many scathing reviews of the device online and in magazines and newspapers. Not all were bad, but those that were had to leave any well-informed consumer with lots of lingering doubts.

The device was also initially priced on par with the iPad, a media darling with high customer satisfaction ratings. That severely limited sales. Price drops helped a little, but RIM was not willing to let the price fall low enough to really set itself apart.

That was the case until the recent release of Amazon's Kindle Fire tablet. Priced at just $200, the device has effectively the same specifications as the Playbook and is made by the same ODM, but comes in at $300 less than the Playbook's original iPad-like price tag. The Kindle Fire has not been around long enough to dent sales significantly, but the pervasive rumors of an Amazon tablet cooled the market for non-Apple tablets for much of the summer and fall. And the Kindle Fire's lower price structure has also forced Blackberry to match it – dropping the Playbook price about $300, or 60%, in a few months' time.

To be more precise, "forced" is actually too strong a word here. Apple wasn't compelled to lower iPad prices in response, after all. But the iPad is faster and a better quality device. Reviews of the iPad are glowing. And it works great on its own – no iPhone required. All the Kindle Fire really did was further expose how weak the value proposition is for the Playbook for anyone other than a hardcore Blackberry fan.

The Playbook's run is not over yet, of course. RIM has a big software update on the way to fix the glaring design flaws. But with its opening salvo a nearly complete miss, the company will need a miracle to catch up to market leaders Apple and Google (whose Android software also powers the Kindle Fire). They offer users access to millions of apps right out of the gate, leapfrogging RIM once again.

Caveat Investor

As an investor, it is important to take away a few lessons from Research in Motion's struggles. First and foremost, a company can rarely be successful in a new market when it's not successful in its core. And at the core, Research in Motion is a smartphone company that's losing the smartphone war.

Sure, Apple reinvented itself first through the iPod and then through the iPhone to the point that today more of its profits come from iOS devices than from Macs. But a few important things differentiate yesteryear's Apple from today's RIM.

One is that Apple had already successfully relaunched the Mac before the iPod came around. With the iMac and OSX, the company was growing market share once again in computers, and the extra profits could be put to use building the new businesses without rushing. And the core success let top brass focus on making the new ventures a success without worrying about the constant care and feeding of a struggling legacy product line. Add in the positive PR momentum and the story is complete – reviewers can gush about how good the gadget is instead of ending each article with musings about why the company is failing, thereby scaring away potential buyers.

In addition, the iPod did not require a Mac to be successful. The halo effect of excited iMac buyers and all the company's positive buzz at the time helped lift the iPod's sales (something that later reversed when the iPod became the top seller), but had the Mac lineup faltered during that time the iPod could have survived just fine without it. The Playbook, on the other hand, literally requires a Blackberry to work. With market share falling – and many of the users still left on the platform eyeing their neighbor's copy of Angry Birds on the iPhone or Android – that requirement immediately killed any hopes the company had of making the Playbook successful. Until that requirement is removed, the Playbook is dead in the water.

Finally, it's hard to turn around an aircraft carrier. In order for Research in Motion to truly compete with Apple and Google, the company needs to abandon its proprietary lock-in to the Blackberry server and the revenue stream that comes with it. The company must embrace phones that work with every email system equally well, instead of limiting its market to large enterprises on the hopes that security and speed alone keep them differentiated. Those hurdles are just too easy for competitors to jump, and without owning the core email system, RIM will always be vulnerable to competition from both sides of the platform. Instead, RIM needs to get developers on board with its platform, something that clearly still has not happened. Horrific developer accounts of working with the Playbook have made the rounds on the Internet ever since the device was released.

Instead of really tackling its core problems, Research in Motion is just throwing good money after bad. Proof in point: the company's response to the Playbook fiasco might have been to can the project and turn its undivided attention to stemming losses in its core business. But no. The company, in its own words, "now believes that an increase in promotional activity is required to drive sell-through [of the PlayBook] to customers." That is to say, RIM intends to follow up a bad product launch and a $485 million write-off with better commercials!

Granted, changing direction with a company of this size is difficult. It's much easier to keep doing what you are already doing than to radically alter course.

But so far, RIM hasn't really shown that it grasps the full extent of its problems. Without a more drastic change to its business model, the company is trying to steer with its hands tied behind its back. It's unprepared to endanger the revenue stream from the server business, in hopes of catching competitors that are now years ahead in consumer and developer adoption.

Research in Motion might redirect the ship yet, but the signs aren't promising… and even if they do effect a turnaround, they may just have waited too long.

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Bits and Bytes

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Alex Daley

Chief Technology Investment Strategist

Casey Research