Research In Motion: And now the hard part

Suddenly under siege, Research In Motion must adapt or be overtaken.

To truly appreciate what kind of obstacles and potential obliteration Research In Motion faces in the era of the iPhone and other “smartphone” competitors — not to mention how it might almost as easily continue to innovate, dominate and grow, grow, grow — you have to start with what co-CEO Jim Balsillie was doing 10 years ago.

The first-generation BlackBerry had only been on the market a short time. Few people had heard of it. Yet Balsillie was already well on his way to making sure it was a product and a brand everyone would know.

Balsillie was a relentless evangelist for the company’s first BlackBerry devices, meeting with executives, analysts, bankers — busy people who needed to be connected with each other and their data around the clock — and selling them on its virtues in hopes of signing them up as subscribers. It did not take long for the BlackBerry to become a staple in corporate and government offices in North America.

These days, RIM doesn’t rely on Balsillie’s travelling salesmanship to catch customers. The company has a marketing machine in his place. This fall it rolled out a slick campaign that says less about its products than it does about how the market is changing and how RIM is adapting.

A series of television ads, centred on the slogan “Love what you do,” features bright young things doing what they love: an indie rock band performing live; a group of teens breakdancing; a fashion designer presiding over her runway show. The BlackBerry itself barely appears. Instead, RIM is selling a lifestyle, one of success, but also something else: fun.

RIM’s message is the BlackBerry is for everyone — not just corporate types. While they still matter hugely to RIM, clearly it recognizes the future of the smartphone, its future, lies with individual consumers.

This puts RIM in unfamiliar territory. Take all the competition. The Waterloo, Ont., firm, which was co-founded by BlackBerry inventor and co-CEO Mike Lazaridis, essentially created the product category. For years it was the only reliable player in North America. Today, it’s mixing it up globally with traditional handset makers such as Nokia and Motorola, and newcomers are jumping in. Google announced in early January it would be selling its own smartphone, the Nexus One, in addition to having already developed Android, an operating system used by many handset makers. And then there’s the iPhone from Apple. The iPhone accounted for 13% of all smartphone sales in the past year, according to Gartner Inc., putting it third behind RIM, which held 20%, and market-leader Nokia, at 42%. The iPhone’s growth is impressive, considering it launched in only 2007. It has also set a precedent for what a consumer smartphone should be.

Since the iPhone’s arrival, not one new RIM handset has captured buyers’ attention in the same way. RIM’s sales keep climbing — its subscriber base jumped to 36 million from 21 million between late 2008 and 2009 — yet the company has made mostly small, evolutionary changes to an expanding product line that’s brought little particular notice.

The iPhone has also exposed other deficiencies. The Web browser on a BlackBerry is outdated, and there are fewer third-party applications available compared to other mobile devices. Some analysts contend these challenges are serious and could cause the company’s phenomenal growth to slow. In particular, investors expecting RIM to remain the knockout stock it’s been for a decade could be in for a surprise. “There will be a rude awakening soon,” says Neeraj Monga, executive vice-president and analyst at Veritas Investment Research in Toronto.

But that’s also been a common refrain for years — and RIM has consistently proven critics wrong. The company has achieved as much because management understands success requires more than a pretty device. Often ignored in any discussion about RIM’s future is that the company has cozied up to carriers like no other handset maker, helping to manage traffic to keep networks from overloading. RIM also tries to provide each carrier with a unique BlackBerry so wireless operators can stand out from competitors. “A lot of people totally underestimate RIM’s value proposition, which is security and bandwidth efficiency, and how important that is to the carrier,” says Gus Papageorgiou, managing director of technology research at Scotia Capital.

And so these are the factors that will determine who prevails in this defining phase of the smartphone market’s evolution. RIM still has momentum and certain inherent advantages. But in other areas, even its most bullish backers say it has fallen behind. Not that the latter is something Balsillie wants to hear. The Financial Times raised the issue with him last fall. “We changed the world,” he sniffed in reply. “And you frame it as a catch-up? I’m shocked.”

For outside observers, however, there is nothing shocking about an innovative company — even the flagship of the Canadian tech economy — fighting to maintain an edge as savvy competitors redefine the market. To prove its detractors wrong this time, RIM will have to find ways to beat those competitors at their own game.

In the rapidly changing world of technology, it’s easy to forget how many threats RIM has already vanquished. Back in the late 1990s, Motorola’s attempt to compete with RIM’s original two-way interactive messaging devices fell flat. Later, Nokia’s first smartphones did little to hinder RIM’s growth in North America. Microsoft launched an operating system for mobile devices in 2004, and offered free push e-mail for corporations, a direct assault on RIM’s core business. (“Push” means a message is sent immediately to a user’s handset without them having to retrieve it.) But the company kept growing. Then there was the NTC patent lawsuit, which cost huge amounts of time, energy and money to settle. Motorola attacked again in 2006 by purchasing Good Technology, a provider of push e-mail, hoping to integrate the service with its devices. The acquisition went nowhere. Motorola sold the company last year.

RIM prevailed largely because it managed to provide better products and services than its competitors, and because it was first to market. Its share price, which debuted at just over a dollar in 1997 and hit $149 in 2008, reflects both the success of the company and the uncertainty around it: the stock can be volatile. But even when it falls, RIM hasn’t necessarily stumbled.

In early January, RIM’s share price was about $68, down a full 26% since September when RIM missed analyst expectations in its second fiscal quarter. As is typical with RIM, the expectations were high, perhaps unrealistically so. “We’ve been so spoiled by RIM over the years killing expectations every quarter,” says Barry Richards a senior technology analyst with Paradigm Capital in Toronto. Analysts have tended to raise their numbers as RIM’s quarterly reporting dates draw closer, in part for fear of looking dim-witted if the company delivers another set of blockbuster results. “It ends up hurting the stock,” he adds. Expectations quickly become too high. If RIM turns in a positive but mediocre quarter, the stock will plummet, fuelling speculation that something is wrong with the company.

But inflated expectations aren’t the only worry this time out. Analysts are paying special attention to the average selling price (ASP) of the BlackBerry, which has historically been US$340. RIM reported an ASP of US$317 last quarter, and expects no change in the coming months. Prices are falling in part because consumers are far more cost-sensitive than RIM’s traditional business customers. A lower ASP could cause gross margins to shrink, forcing RIM to sell even more devices to maintain the level of profitability that partly accounts for its high market valuation. “Prices are declining at a faster rate than RIM is gaining volume,” says Monga at Veritas, who has a Sell rating on the stock.

All of which makes the consumer environment doubly challenging for RIM. Not only does the company have to fend off newcomers and become more consumer-oriented, it has to do it all while remaining the stellar growth company investors know, and avoid falling short of very high expectations.

The true effect of a lower ASP will be seen in the coming months. But the mere fact that so much attention is focused on that particular metric is an indication of how much the market is shifting.

“What’s made BlackBerry a fantastic platform over the last 10 years is not helping them in this new world,” says Pierre Ferragu, a senior research analyst with Sanford C. Bernstein in London. Push e-mail was revolutionary a decade ago. Now most devices can approximate it. The iPhone and many other makers’ handsets have also surpassed the BlackBerry when it comes to consumer-oriented features, such as Web browsing, video, gaming and applications. The BlackBerry is still thought of primarily as a device for work. “If you walk into any carrier store, the salesperson is tailored, if you want a consumer device that has applications, to push you to the iPhone or Android devices,” says Jeff Fidacaro, an analyst with Susquehanna International Group in New York. “RIM’s got the technology. They just don’t have the handsets and the marketing to educate the consumer about what they can do.”

The intense competition prompted Citigroup Global Markets analyst Jim Suva to downgrade RIM to Sell last fall. He pointed to the threat from Google’s Android operating system, and criticized RIM for making “minor evolutions at a time when the industry and competition is seeing major revolutions.” RIM’s one recent attempt to reinvent the BlackBerry handset, the Storm, was hardly a hit. Released in 2008, it was the first touch-screen BlackBerry. Reviewers complained about the poor interface, buggy software and lack of Wi-Fi. “How did this thing ever reach the market?” asked influential tech writer David Pogue in The New York Times. RIM has since fixed the problems with the release of the Storm 2, but the ordeal seems to indicate what critics have often said about the company: radical change does not come easily for RIM.

Balsillie told analysts during conference calls this past year to expect big things in 2010. At times, he sounded a little starry-eyed talking about smartphones. “You are going to see these as plasma TVs, very, very soon, as well as personal media players and social networking and personal game machines and phones,” he said in September. Many industry watchers expect RIM to soon release a “slider,” a handset that incorporates both a touch-screen and a physical keyboard. That way, RIM can capitalize on the touch-screen trend without alienating traditional users who prefer a keyboard. While the concept is not original, a slider would bring new life to RIM’s product portfolio. But hardware is only part of the equation.

RIM’s bigger problem is software, particularly the Web browser. The stripped-down, mobile version of the Web available on the BlackBerry is like the Internet circa 1998. The iPhone, on the other hand, replicates browsing on a desktop. RIM’s management knows this. Last August, they bought Torch Mobile, a small firm that has developed a browser for the Windows Mobile operating system, to give RIM the expertise to help it improve. A new RIM browser is likely later this year or the next, but success is not guaranteed.

A large part of the challenge is that RIM has to protect its current advantages while matching the competition. Rich Web browsing typically eats up lots of bandwidth, yet a key RIM selling point with carriers is that the BlackBerry is the most data-efficient smartphone. In order to keep this advantage, RIM has to maintain data efficiency while offering browsing comparable to the rich, immersive experience on the iPhone — and that is not easy. “On a wireless network, you don’t have infinite capacity,” says Scotia Capital’s Papageorgiou. “You have to be very, very careful about how you manage that traffic.”

RIM is also a step or more behind the iPhone and Android devices when it comes to applications. Software developed by third parties is immensely popular on the iPhone, spawning a cottage industry of developers. There are more than 100,000 apps available for the iPhone, approximately 17,000 for Android devices, but only about 4,300 for the BlackBerry — even though RIM allows developers to keep a bigger chunk of the revenue than Apple. Programmers shy away from the BlackBerry because writing an application for it is far more difficult than writing one for the iPhone or an Android phone — in part because there are at least five different BlackBerry models with variations beyond that in each category.

RIM has attempted to appease developers with new tools, such as allowing them to integrate advertising into apps, but the variety of devices will always mean some extra work compared to Apple’s singular iPhone. That could be problematic as the smartphone market evolves. “The pace of innovation is on the software and services front rather than on the hardware,” says Deepak Chopra, a technology analyst at Genuity Capital Markets. “The changes will be in terms of how the devices are used.”

If anything, the smartphone market is starting to resemble the development of personal computers. Decades ago, Apple’s restrictive environment for software development for Macintosh computers pushed more programmers to create software for the Microsoft Windows operating systems, which were available on a variety of PCs. Consumers chose the devices for which they could get more software, which is why Apple computers remain a small portion of the market today. “I wonder sometimes if Steve Jobs is not thinking back to his Mac versus Windows days and thinking, ‘Well, I’m going to have the most apps this time,'” says Michael Mace a principal at technology advisers Rubicon Consulting in California. Google, whose Android platform has proliferated across a range of handsets, could beat them both. By 2012, research firm Gartner predicts the Android operating system will be running on 18% of devices globally. The Blackberry stands to lose share, dropping more than 7% to 13.9%, just barely ahead of the iPhone.

It’s not yet clear what role applications will play in the sale of smartphones long-term. Rubicon surveyed users in the U.S. in 2009 to determine their preferences. BlackBerry devotees identified e-mail as their No. 1 priority; iPhone users chose Web browsing. The ability to add new software ranked only No. 4. The survey was conducted in April, however, before Apple’s marketing machine kicked in to promote apps. “The question is whether the priorities are going to change now,” Mace says. If so, RIM could be in trouble.

On Dec. 22, BlackBerry users in North and South America experienced a disaster. Well, a disaster for them, anyway: for much of the day they were unable to send and receive e-mail. This was the second such outage in less than a week. RIM later said a software upgrade might have been responsible for the disruptions. The failures generated some bad press, but such problems are rare glitches in what is otherwise a very long record of reliable service — one reason why RIM has an edge over competitors.

The company is the only handset manufacturer to operate its own data-processing centres. Every byte of information sent via BlackBerry passes through RIM’s servers, which can strip out viruses and ensure sensitive information is kept safe. No other handset manufacturer provides that level of security, which is why the BlackBerry is the smartphone of choice for businesses and government — and how RIM managed to add 4.4 million new corporate subscribers in fiscal 2009, through the heart of the recession.

But RIM does far more than provide added security. The company’s data centres also help carriers manage traffic, and employ proprietary compression technology to force more information over the networks. In a world where bandwidth is scarce, RIM offers a valuable service, saving carriers money and keeping networks running smoothly. This also earns RIM a tidy revenue stream, anywhere from $3 to $10 per subscriber per month — approximately US$1.4 billion in its last fiscal year. It would cost competitors billions to build the kind of data-processing infrastructure RIM operates, and none have seemed keen to do so.

Balsillie is adamant RIM’s role in managing traffic for carriers will only increase as smartphones become more data-hungry. In the company’s most recent conference call in December, he called the rapid growth in data transfer unsustainable. “We’ve been preaching this for a while, and we said you have to ration your scarce capacity thoughtfully,” he said. “There’s a reckoning going on right now.”

Just look at AT&T, the only carrier of the iPhone in the U.S. Customers in New York and San Francisco are plagued with dropped calls and poor connectivity because iPhones gobble up so much capacity that users are severely taxing AT&T’s network. The company is even considering incentives to encourage users to consume less data. Across the pond, the head of O2, the U.K.’s largest carrier and until recently the only provider of the iPhone in the country, actually apologized in late December to customers in London experiencing the same problems.

RIM, meanwhile, has always positioned itself as a faithful companion to carriers. Companies such as Verizon and Bell are obsessed with differentiating themselves from competitors to get subscribers. They all want the latest handset — preferably if rivals don’t have it. RIM caters to this need by trying to provide each carrier with something unique. “They find a way to be everybody’s friend,” says Richards at Paradigm Capital. Having so many different handsets may frustrate app developers, but carriers love it — and they are the ones who buy and market the devices. Take the Storm. Critics trashed it, but the Storm series was the seventh-best-selling product line in the U.S. late last year. Why? “Because Verizon marketed it like crazy,” Papageorgiou says.

RIM’s relationship with carriers and network expertise have a lot to do with why BlackBerry sales continued unabated this past year, despite the competition. Though RIM’s dominance is threatened and there are problems to deal with, the company remains strong. Still, advances in technology are unpredictable. Analyst Ferragu met with Lazaridis roughly 10 years ago and heard him explain why offering the best mobile messaging and e-mail would turn RIM into a dominant player. The next day, Ferragu met with Palm founder Jeff Hawkins, who had previously invented the Palm Pilot and was then working on the prototype for the company’s first smartphone, the Treo. Hawkins believed the perfect keyboard, usable with thumbs and not a stylus, would give Palm an edge. “Wrong answer, Jeff,” says Ferragu.

Lazaridis was correct to focus on the technology behind wireless communication. A relative newcomer, he beat out an established inventor running a large, successful company. The anecdote not only shows his genius, but also that anyone, anywhere, can dethrone a king. With the smartphone market becoming more competitive and consumer-oriented, a bet on RIM has become a bet on the unknown. “These guys were geniuses 10 years ago,” Ferragu says. “Now you have to bet they are going to be geniuses a second time.”