While most market participants and analysts seem to universally hate the prospects of an investment in BlackBerry (BBRY), one of the best investors around seems to see tremendous value. A big reason for the disconnect is that most outside passive minority investors (OPMI) devote the majority of their analysis to the income statement, or are interested in the "story" of a company to take advantage of momentum, and BlackBerry is not very appealing by these metrics. Prem Watsa is a devoted and self-proclaimed follower of Benjamin Graham and is obsessed with obtaining an adequate margin of safety. On a technology-based company that is rapidly losing market share such as BlackBerry, that margin of safety can only be found on the balance sheet. In addition, by taking a control position in BlackBerry, Watsa & Company will be able minimize the cash burn through closing unprofitable and capital intensive business lines, in favor of businesses that can earn a better return on invested capital. I believe Watsa sees that there is very little downside at current prices assuming he can control the cash burn, and the upside is akin to a low-cost call option, providing an extremely attractive risk/reward opportunity.
On September 23rd, BlackBerry entered into a Letter of Intent with a consortium led by Fairfax Financial, where it would sell itself for $9 per share in cash, valuing the company at about $4.7 billion. The consortium would have a 6 week window to conduct due diligence, while Blackberry would also have the ability to shop itself to other potential buyers during the due diligence period, but would be subjected to a $0.30 per share breakup fee if they went with another buyer, assuming the consortium doesn't lower their bid below $9 per share. I wouldn't be surprised to see another buyer show interest at a slightly higher price similar to how the Dell process went, but I don't believe that you are going to see aggressive numbers as far as valuation goes. The due diligence process should be completed by November 4th. Fairfax Financial currently owns about 10% of BlackBerry shares, so the consortium would be responsible for buying the remaining 90% if they intend to move forward with the deal. The consortium is seeking financing from Bank of America (BAC) and the Bank of Montreal (BMO).
Both Google's (GOOG) acquisition of Motorola Mobility and Microsoft's (MSFT) acquisition of Nokia's (NOK) handset division highlight the incredible value of patents in the mobile space. When Nortel was in bankruptcy several years ago, BlackBerry paid $700MM for parts of its patent portfolio, and the value of its own patent portfolio has been estimated to be $1.5-$3.0 billion in addition to those Nortel patents. When you consider that the company recently announced that it should end the 2nd quarter with $2.6 billion of cash and no debt, it isn't hard to imagine that the $2.1 billion enterprise value could be financed using the patents as collateral. If that is indeed the case, Watsa would be using other people's money in addition to his 10% stake, to control a business with almost 75MM users and nearly $12 billion of trailing 12 month revenue. Projecting future revenues at this stage, with so much uncertainty about what the future business will look like is incredibly difficult, but if Watsa could get the company to earn 10% margins on $8 billion of revenue, an $8 billion enterprise value wouldn't be hard to imagine, which could lead to well in excess of 100% returns on his LBO investment.
Many commentators have drawn attention to the fact that the financing isn't yet in place to complete the deal and the consortium still has to complete its 6 week due diligence process. I'd certainly prefer a more iron-clad deal but Watsa was on the Board of Directors, and therefore had access to inside information. I believe the 6 week due diligence process is to get his perspective partners comfortable with the assets and the new business plan moving forward. Concerns over financing seem quite obscure considering the current environment where junk bonds are yielding 6-7% in many cases, and I believe that the patent portfolio could easily be used as collateral, and eventually be sold off in a worst case scenario. BlackBerry Management has actually done a very good job at preserving cash over the last few challenging years. Managing the cash burn is the critical part of this acquisition and is why in my opinion; Watsa and the consortium realize that they need to take control now. I'd suspect that BlackBerry will milk Emerging Markets on the low end for cash flow, and focus on the Enterprise and Government on the high end. Pulling out of the primary high end consumer market is a tough pill to swallow, but management under Watsa's leadership is likely to look at maximizing returns on invested capital, and clearly the company has lost its competitive advantages in that arena, so a withdrawal seems like the best way to preserve capital and to eventually improve margins.
On September 20th, BlackBerry announced extremely disappointing preliminary results for its 2nd quarter of Fiscal 2014. The company expects a GAAP net operating loss of approximately $950MM to $995MM, with the loss including a primarily non-cash, pre-tax inventory charge of approximately $930-$960MM, and a pre-tax restructuring charge of $72MM. BlackBerry expects to report revenue for the 2nd quarter of approximately $1.6 billion on sales of approximately 3.7MM smartphones, with 50% of revenue being service revenue. The company is also pairing its smartphone portfolio down from 6 devices to 4, focusing on the enterprise and prosumer-centric devices, including 2 high-end and 2 entry-level devices. As part of the restructuring plan, the company will be reducing its workforce by approximately 4,500 employees and is targeting a reduction of its operating expenditures by approximately 50%, by the end of Q1 Fiscal 2015. The only real positive note to the release was that the company is seeing increasing penetration of BlackBerry Enterprise Service 10 (BES 10) with more than 25,000 commercial and test severs installed to date, up from 19,000 in July 2013.
I wouldn't try and spin anything positive out of these numbers other than the fact that the company is aggressively reducing costs. Hewlett-Packard (HPQ) under the leadership of Meg Whitman is an excellent example of a company facing revenue declines, but that has still been able to improve its financial condition through cutting costs and allocating capital properly. BlackBerry is in worse shape than HPQ was but the steps required to right the ship aren't all that different. Watsa if one of my top five investors that I admire and I believe that he sees considerable upside through simply monetizing the existing assets and milking servicing cash flows, while everything else would be gravy.
Although there could be considerable upside through buying the stock if a "white knight" buyer comes in, I believe it smarter to simply bet that the merger will go through. This is the type of investment opportunity that Warren Buffett did when he was managing the Buffett Partnership L.P. where he got involved with "Generals", "Work-outs" and "Control Situations." This would qualify as a workout. Instead of buying the stock outright, I'd suggest selling the $9 January 2014 put for $1.05 per contract. Assuming the deal goes through at $9 or above, the investor would pocket the entire $105 premium on the maximum risk of $795 in 115 days. This equates to a 13.2% return on the maximum risk or 41% annualized. If the deal falls through, you will end up owning the stock at a breakeven of $7.95, which is likely less than the liquidation value, not accounting for significant future cash burn. If after the due diligence process, Watsa lowers the bid to $8.50 or something above $7.95, there is still the opportunity to profit. I like this strategy because it shouldn't be too dependent on the overall market, which I have concerns about, and the potential returns are extremely attractive. If you aren't willing to own the stock at that cheaper price, I obviously don't recommend getting involved in this arbitrage