Research In Motion's Costs Are on the Rise

The BlackBerry maker says its margins will contract in the current quarter as it spends more to produce snazzy new devices

by Arik Hesseldahl

Research In Motion (RIMM) gave investors a jolt when it reported quarterly earnings on Sept. 25. Margins in the current period will shrink and earnings won't match analysts' forecasts as the company steps up spending on newfangled devices, the BlackBerry maker said, sending shares plummeting more than 19% in extended trading.

Even as RIM said sales increased 88% and profit surged 72% in the quarter that ended Aug. 30, it also said gross margins will narrow to 47% from 54% last quarter. The company also said earnings will be 89¢ to 97¢ a share, compared with analysts' average expectations for earnings of 98¢.

RIM's report eased fears that the company will lose subscribers as a result of the financial crisis that's led to bankruptcy for Lehman Brothers, Bank of America's (BAC) purchase of Merrill Lynch (MER), and the near-collapse of insurer AIG (AIG). Traders and bankers are among the most avid users of the BlackBerry. Indeed, RIM added 2.6 million subscribers and sold 6.1 million units as consumers in growing numbers ditch conventional cell phones for smartphones that handle e-mail, text messaging, and Web navigation.

Apple Upping the Ante

But RIM's numbers also revived concern that in the face of competition from Apple (AAPL), RIM will incur higher expenses as it makes products snazzier. "Apple is really pushing the envelope and now RIM is responding with higher-quality displays and touchscreens, and that is pushing up" costs, says Samuel Wilson, an analyst at JMP Securities (JMP) in San Francisco.

On a conference call with analysts, co-CEO Jim Balsillie conceded that some of the company's newer products will cost more to produce. RIM announced its first flip phone, the Pearl Flip, (BusinessWeek.com, 9/11/08) with T-Mobile (DT) on Sept. 10. It unveiled its first 3G phone, the BlackBerry Bold, with AT&T (T) before that. And a new device called the Storm, said to be a touchscreen device similar to Apple's iPhone, is expected to debut with Verizon Wireless (VZ) in early October.

Over time, RIM will reduce the production costs on those handsets and make them more profitably, which should restore gross margins to higher levels, Balsillie said. "We feel very good about the long-term gross margin picture," he said.

Targeting New Smartphone Users

He added that the company needs to act fast to win customers who are upgrading to smartphones. "Strategically, it's going to be about adoption right now," he said. "As you assess this business and get close to it, you see there is a massive disruption going on. It's all about catalyzing adoption through this stage and into the next couple quarters.…If we give up ground now for short-term gratification, that's not in the interests of our shareholders. Not even close."

Even as the cost of making devices goes up, wireless carriers are coming under increasing pressure to cut the subsidies that they have traditionally paid manufacturers like RIM and Apple.

RIM's stock had risen 82¢ to 97.53 on Sept. 25, but it was still down more than 34% from a recent multimonth high of 147.55 on June 19. Much of the drop had been fueled by concerns about competition from Apple and worries about increased costs, as well as news of spreading financial contagion among Wall Street firms that employ legions of BlackBerry users.

RIM ended the quarter with 19 million active subscribers, and said it expects to add 3 million new users in the current quarter. The challenge now is for the company to add those customers more profitably.

Hesseldahl is a reporter for BusinessWeek.com.