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BlackBerry (NASDAQ:BBRY) has left a lot of investors with a black eye in the past few weeks, hiding from investors the degree of exposure they had to supplier commitments; masking poor sales of the Z10 handset by booking sales to carriers as revenue on the basis of a high degree of confidence they would not be subject to returns; and, surprising the market with a $1 billion loss arising from a reconciling of inventories and supplier commitments with what has turned out to be ultimate demand.

To make matters worse, the company has been less than forthcoming about the degree of its problems and cancelled its earnings conference call no doubt to avoid having to disclose just how many judgment calls management had made that were turning sour.

I have been a long time supporter of BlackBerry and a bull on its stock. That has been painful for me and I know it has been unpleasant for many others. The company today is in limbo, caught between a hastily announced and highly conditional effort to take BlackBerry private initiated by Fairfax Financial Inc. and a customer base that quite properly is asking what is going on and, in the meantime, deferring or cancelling orders.

BlackBerry's balance sheet as at August 31, 2013 shows faint hope.


(Click to enlarge)

Assets realizable on a forced liquidation include $1,181 million cash, $1,163 million short term investments; $1,743,000 accounts receivable; $223 million of other receivables and $462 million income taxes receivable. These total $4,772 million. Within the other assets on the balance sheet are real property and a patent portfolio which could be sold on liquidation.

The balance sheet also records inventories of $941 million which could provide about $470 million if BlackBerry could realize 50 cents on the dollar on disposal. In a bankruptcy filing, you might expect that BlackBerry assets would realize something like $5.2 billion in addition to what the intellectual property and real estate assets might garner in an orderly sale.

BlackBerry liabilities total $4.1 billion. You might add to that some $500 million in legal fees and insolvency related costs should BlackBerry file bankruptcy. What is left when that process is finished is thus some $700 million plus the proceeds of the sale of intellectual property (NYSE:IP). Estimates of the value of the BlackBerry patent portfolio are all over the map but it is within the range of possibilities to speculate that BlackBerry might receive $2 billion for the lot.

In an insolvency proceeding, the current 12,700 odd employees might get on average $100,000 severance although it could also be a lot less depending on where they live and the prevailing labour laws. At the high end, I think an estimated severance expense of $1.3 billion is conservative.

If these very crude assumptions are in the ballpark of sensibility, what shareholders might get from a bankruptcy filing is about $2.4 billion or $4.50 a share.

Assets and liabilities

Proceeds

Cash

$1,181

Short term investments

$1,743

Other receivables

$223

Taxes receivable

$473

Sub-total

$4,772

Inventories at 50% book

$470

Real estate assets

$1,000

Proceeds excluding IP

$6,242

Less: Liabilities

$4,084

Less: Legal and other

$500

Net realization excluding IP

$1,658

Value of IP

$2,000

Sub-total

$3,658

Severance expense

$1,300

Available to shareholders

$2,358

Per share

$4.50

On a takeover I think a sensible banking group would lend the buyer no more than $2.5 billion if they could get a first charge on the assets by merging the acquiring company with BlackBerry, pushing the debt into the acquired company. Such a loan would have adequate asset coverage if the bankers were persuaded that BlackBerry had a credible plan to operate without compromising its balance sheet further with ongoing losses. Such a plan is possible but it is not clear that management are facing reality at this point. In any event, the Fairfax bid at $9 requires funding of over $4.2 billion in addition to the Fairfax shares and, in my view, the likelihood of finding equity investors to fill the gap between a $2.5 billion loan and the $1.7 billion shortfall is remote.

In my view, the plan that has a chance is to shrink BlackBerry to a service business with a total liquidation of handset assets, personnel and real estate.

The service business could sustain BlackBerry if it does not squander what is perhaps its last opportunity. BlackBerry service revenues were reported to be approximately $800 million last quarter and I am guessing the service business enjoys margins of at least 80%. A $3 billion annual revenue service business with 80% gross margins and employing 8,000 to 9,000 persons would be profitable and self-sustaining. While the early quarters would have a lot of noise from the disposal of surplus assets and severance of thousands of personnel, the new BlackBerry would emerge with net income of several hundred million annually and a large tax loss carry forward. In my view, it would have a market value somewhere around revenue or about $6.00 a share. BlackBerry could also proceed to sell that portion of the patent portfolio unrelated to the service business which would add value and further bolster the balance sheet.

The BlackBerry board of directors has a difficult decision. They are faced with a tenuous bid by Fairfax of $9.00 a share which is a better result for share holders than insolvency or a drastic retrenchment into a pure services business. However, the offer seems unlikely to gain funding and could be a waste of precious time. Time is not on the side of the company since its ability to retain even service customers requires stability and the customers have options.

The board needs to decide and decide now. In my view, they should decide in favor of the drastic retrenchment and do it immediately. The directors are currently on a track to either sell the company or shrink to a smaller BlackBerry holding on to a limited number of handset models and a focus on corporate customers. This is a dangerous strategy and lacks credibility. Corporate customers may well be concerned about BlackBerry's viability as long as it continues to bet money that it can sell handsets profitably and the effort to do so will very likely result in their decision to abandon the platform altogether. On the other hand, a clear and uncluttered focus on services without the risk of another handset debacle might provide enough stability that BlackBerry can not only hold on to its existing service customers but over time build this business.

For investors, a BlackBerry share has become a very high risk piece of paper. If Fairfax is successful in finding funding, they could realize a 13% gain. If not, they are exposed to at least a 25% loss and in my view a more likely 45% loss on their shares. The loss could be much greater if BlackBerry management plays Don Quixote and tries to continue to build a BB10 handset business with no real possibility of success. This is a time for caution. If you must own the shares, buy puts at $6 to $8 a share as insurance. Alternatively, just step aside and watch the show.

I am long calls, a residual from my earlier enthusiasm for the company, and I am long puts which reflect my current views.

Disclosure: I am short BBRY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I hold both calls and puts on BlackBerry. The calls are a residue from an earlier bullish view. The puts reflect my views today.

Source: This May Be Time To Cash Out Of BlackBerry - Time Is Short