I've learned something about the stock market over the past couple of weeks. If you make bold statements like Muddy Waters did with the claims of NQ Mobile's (NYSE:NQ) business being a fraud, you can really impact a stock. Just like how Muddy Waters claims NQ to be worth a "zero", I believe the $1 billion investment of 6% unsecured subordinated convertible debentures in lieu of the proposed $4.7B buyout made by Fairfax Financial and their associates will eventually lead to a total wipeout of all current BlackBerry (NASDAQ:BBRY) shareholders. BBRY is worth a zero, and will get there within five years.
Unlike Muddy Waters which used a lot of conjecture mixed in with some facts and research, I will use easily verifiable facts from the internet over the perilous cash position for BBRY and the past activities of Fairfax to show that a complete wipeout of BBRY stock is very possible.
The first thing I need to attack is BBRY's cash position. I was floored by this article claiming as part of their $16 target for BBRY a $4.50 value for cash. This takes into account only the simplest view of what cash is and completely ignores the company's obligations on and off its balance sheet. For the purpose of this working capital analysis I will ignore the convertible debentures as the $1B increase in cash is met with an equal $1B in liabilities so the net cash position remains unchanged.
Here is a link to BBRY's quarterly balance sheet provided by Google Finance. BBRY has $2,344 million in cash against 514.61M shares for $4.55 a share. Fine. But to get the true cash position, we must view that cash against the company's total obligations. Further review of the balance sheet shows $2,428M in net receivables for a total cash and receivables position of $4,772M.
On the liabilities side there is $1,130M of accounts payable and $1,909M of accrued liabilities for a total of $3,039 short term working capital obligations. The net of $4,772M and $3,039M is $1,733M or $3.36 per share in cash. The company's inventory of $941M is very likely to take a significant hit from writeoffs in the near future thanks to the low demand of BBRY's hardware and the change in direction of the company's business plan. The other current assets of $946M includes $250M of income tax assets and assets held for sale and the $834M of other liabilities is deferred revenue. In a liquidation scenario, it is likely that the income tax assets and assets held for sale would bring in a significant percentage of that $250M in the form of cash. However the other $696M would be much more likely to be used up in the course of business rather than have some sort of cash value associated with it. Given the writedowns that will occur in inventory and the operating loss that has occurred on recently recorded revenue, I think it is an apt assumption to conclude that the inventory, other current assets and deferred revenue will offset each other in a liquidation scenario.
The net amount of cash and receivables less the payables is $1,733M or $3.36 a share. But what many people ignore is BBRY's future off-balance sheet obligations that will further erode cash whether it is operating or in a liquidation scenario. The article "Analysts See A Cash Problem At BlackBerry" outline this concern quite eloquently:
Here's how Bernstein put it Thursday when the analysts downgraded the stock to "Underperform": "We believe BlackBerry is likely to burn close to $2 billion in the next 6 quarters on a standalone basis, leading the company into material liquidity problems.
The analysts based that conclusion on a reading of financials BlackBerry filed Tuesday with regulators. Bernstein says they revealed the company's cash position is "far worse" than expected. According to the filing, BlackBerry has $2.9 billion in purchase obligations and commitments, almost all of those coming due in less than a year. About $1.5 billion of those commitments are purchase orders with contract manufacturers, the filing said."
If BBRY has $2.9 billion in near-term purchase commitments with a much more murky business plan on how to generate revenue, needing Fairfax and associates' $1B in cash right now despite having over $2.3B cash on the balance sheet makes a lot of sense. BBRY is trying to get $1B in tax refunds but the success of this attempt or the timing of the cash is not known. There is a reason why many analysts have downgraded BBRY and value its cash position at zero. I have to agree with this assessment as it is apparent that the on and off-balance sheet arrangements along with any future restructuring costs are going to significantly erode what is left of the company's cash.
I certainly do not believe that the patents and remaining skeleton of BBRY's business is worth a zero. But now that there is unsecured debentures owned by Fairfax and associates thrown into the mix, there is a huge question mark as to where the value of those businesses and patents will go. I believe the next step in this strategy will be to wipe out shareholders as debtholders take over the entire business. My bold statement is based on research into Fairfax's prior dealings in similar unsecured debt securities and how the Canadian investing climate works in general. Why pay $4.7 billion for something when you can wait a few years and pay $1 billion for it?
Before getting into the specifics of Fairfax, I will give some context around the general Canadian investing environment. The article "Lenovo BlackBerry Bid Blocked by Canadian Government Over National Security Fears" shows that the Federal Government has a primary concern of national security. The desires of shareholders takes a back seat. The government does not care to see the highest bidder claiming BlackBerry, if that bidder is outside Canadian control. Fairfax would meet the qualification of being an eligible bidder. So whatever tactics it uses to get BBRY under its control would likely not see any backlash from the government.
Some people will still scoff at me and say, surely I don't think this can happen. A lot of people thought that way about another former Canadian blue chip stock, Yellow Media (OTC:YLWDF) five years ago. But this former multi-billion dollar market cap company essentially wiped out its old shareholders in a CBCA recapitalization that took place nearly two years before most people agreed that it would even default on its debt due in 2014.
There are a lot of parallels between BBRY in late 2013 and Yellow Media in 2008. The Yellow Pages print business was in decline and a drastic shift (to online) was needed. Shareholders did not pay much attention to the looming debt due several years away and thought it would never be a problem to refinance as the company was always operationally profitable and cash flow positive. They were wrong as in the two years leading up to the recapitalization on December 20, 2012, the stock price declined from well over $5 to just pennies. The current price of YLWDF at $14 values the old shares at just 7 cents thanks to a 200-for-1 reverse split as part of the recapitalization. For those Canadian investors (and a couple of American ones) who are familiar with the Yellow Pages story, you know there are a lot of similarities between it and what BBRY has become. No matter how much more volume BBRY gets in the US over the BB listing on the TSX, BlackBerry is a Canadian company and is susceptible to the same issues that have plagued the share prices of other struggling companies before it.
Now with that out of the way, I will get into the specifics of Fairfax's history and why that shows BBRY is at risk of being a total loss for shareholders. First the details of the debt issue:
Under the terms of the transaction, the Purchasers will subscribe for U.S. $1 billion aggregate principal amount of 6% unsecured subordinated convertible debentures (the "Debentures") convertible into common shares of BlackBerry at a price of U.S. $10.00 per common share (the "Transaction"), a 28.7% premium to the closing price of BlackBerry common shares on November 1, 2013. The Debentures have a term of seven years. Based on the number of common shares currently outstanding, if all of the U.S. $1 billion of Debentures were converted, the common shares issued upon conversion would represent approximately 16% of the common shares outstanding after giving effect to the conversion.
The idea that this is unsecured subordinated convertible debt has thrown a few people off on the false belief that because of its name, this is somehow a goodwill gesture done by Fairfax and associates and they don't really have much claims and don't feel the company is at risk of insolvency. I could explain why this is wrong, or I could just go ahead and show my example.
I refer to the article titled "Fairfax Financial buying AbitibiBowater's bonds" which is about Fairfax buying into the debt of the company now referred to as Resolute Forest Products (NYSE:RFP). From this article:
Fairfax is buying the five-year bonds with an 8 per cent interest rate. This interest can be paid in the form of additional debentures at a 10 per cent rate.
The debt issue is convertible into AbitibiBowater common shares at $10 per share, and Fairfax will appoint two directors to the AbitibiBowater board.
If the debentures were fully converted, Fairfax would hold 35 million new shares of AbitibiBowater, which currently has 52.6 million shares outstanding.
The transaction is subject to various conditions including success in the rest of the company's $1.4 billion financial restructuring.
AbitibiBowater stock leaped 41.4 per cent, or $4.04 (Canadian), to close at $13.79 in Toronto yesterday.
While AbitibiBowater was a lot further along it terms of its solvency issues than BBRY is today, there are undeniable similarities between these debentures and the BBRY ones. The convertible feature was at a price premium to AbitibiBowater's stock, at least before the announcement. So investors who get excited over the conversion premium on BBRY's debentures really have no reason to be excited. It is a pretty standard feature.
While at the time of the investment, AbitibiBowater shareholders were ecstatic as the stock price rose over 40%. However, two years later those shareholders were completely wiped out as unsecured creditors took over the reorganized company's stock, of which Fairfax is now a significant shareholder thanks to the deal. In addition to the AbitibiBowater story, Fairfax has shown a propensity to buy into debt and equity of distressed assets such as newspaper businesses.
Investors in distressed assets, particularly debt assets are known to be interested in liquidating the target company and parceling out the assets to achieve their return on investment. BBRY is a prime target for this. The only problem for BlackBerry shareholders is that Fairfax has shown a history of being willing to invest in distressed debt for the purpose of claiming equity positions in the reorganized company. Is BlackBerry anything like AbitibiBowater? Not at the moment, but we shall see what happens in a couple of years. The $4.7 billion plan to take BBRY private failed. So what would be the next logical step? Try to take it private through a CCAA process as a debtholder and do it for just a fraction of the price you were originally willing to pay. Anybody who thinks it can't happen should have a conversation with the old Yellow Pages shareholders from a few years ago.
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.
Additional disclosure: I have a beneficial short position through put options.