The market continues to show contempt for Fairfax' fishy BlackBerry (BBRY) bid in the only way it can: by punishing the stock and offering one of the largest buyout arbitrage spreads in memory. Last week's $8 share price clearly indicates that the market does not take Watsa's $9 bid seriously.
The situation is complex and shareholders stand to be burned on all sides -- through insider machinations; through accounting curiosities that render the company's recent performance murky; and through erratic management decisions.
Prem Watsa is a venerable Canadian capitalist with a well-deserved reputation as an honest-dealing value investor. I believe it is likely that Watsa's BlackBerry bid is genuine and that he will succeed at financing the $9 deal. Thus, by going long BlackBerry shares, one stands to make a likely 12.5% return in two months with a chance for a higher bid to come through in the interim.
On the other hand, Watsa's bid is highly unusual and the market clearly smells something fishy. In my view, two accounting red flags and serious governance questions have been raised in the past two weeks. BlackBerry's approach to revenue recognition has shifted, calling either past earnings into question or delaying recognition of revenues which would otherwise have accrued to this quarter. The sizable inventory write-off was not adequately explained to shareholders, nor were the liabilities that triggered them apparent in the Q1 balance sheet. Management's decision to cancel the Q2 conference call at a time when investors are confused, doubtful, and filled with highly pertinent questions is concerning. In all this curious behavior, I think it is possible a major problem will emerge to send the stock tumbling toward oblivion in what George Soros likes to call a far-from-equilibrium situation.
Three Things to Note:
1. There is value in the Company
According to the books, the company continues to hold $2.6B cash and investments with no debt. Current assets cover all liabilities 1.6 times. The remaining PPE, intangibles and long term investments have a book value of $6B.
The company still holds property, plant and equipment valued at $2.1B on the balance sheet, a significant portion of which is Canadian real estate, held at acquisition cost less depreciation (note that Waterloo real estate prices have approximately doubled in the past ten years, partly based on BBRY's influence).
The company's secure mobile device management service continues to have value as a going concern in the years ahead. This segment is profitable, cost-efficient to maintain, and remains essential to millions of business users currently committed to BlackBerry systems.
The patent portfolio is worth at least $1B and perhaps considerably more.
The massively-discounted inventory should now be sellable at competitive prices.
It is, therefore, entirely possible for Watsa to demonstrate $4.7B value in the company to his financiers.
2. Accounting Red Flags
What were the origins of the $965M Z10 Inventory Charge? In theSeptember 27 Earning Results Announcement BlackBerry has vaguely described it as a charge against inventory and supply commitments. Given that BlackBerry had only $887M inventory on its Balance Sheet at the end of Q1, and given that it had been expecting to sell the Q10 intoabsolutely phenomenal demand, and considering that it still has inventory of Q10s, BB7 Devices, Playbooks, Z30s, and accessories, it is hard to understand where Z10 losses of this size came from, especially considering that inventory on the balance sheet has still increased to $941M in the quarter.
Without explanation, the company appears to have changed its revenue recognition approach, a red flag in tumultuous times:
"During the second quarter the company recognized hardware revenue on approximately 3.7 million BlackBerry smartphones. Most of the units recognized are BlackBerry 7 devices, in part because certain BlackBerry 10 devices that were shipped in the second quarter of fiscal 2014 will not be recognized until those devices are sold through to end customers. During the quarter, approximately 5.9 million BlackBerry smartphones were sold through to end customers, which included shipments made prior to the second quarter and which reduced the Company's inventory in the channel."
Source: Q2 Earnings Release
This appears to say that 2.2M end user sales occurred this quarter for which revenues had already been aggressively recognized in past quarters. But the company is no longer aggressively recognizing revenues in this way. This transition from aggressive to conservative accounting would create a formidable gap in revenues regardless of the actual performance during the quarter.
Since the company provides no information about how many BB10 units were shipped that would have been recognized as sales using the previous revenue recognition scheme, we have no way to calibrate the actual performance this quarter relative to other quarters. The company is storing value in inventory that it once would have recorded as sales.
This could mean a few things. The company could be exaggerating its losses this quarter, stowing away value for the future. The Q2 disaster, while bad, may appear more severe than it actually is. Alternatively, this accounting change may have been implemented to correct for inappropriate past revenue recognition -- namely, revenue recognized on shipped but unsold Z10's from past quarters. It seems plausible that the $965M Z10 write-down may be the outcome of the phenomenon that was alleged by Detwiler Fenton and other bears in April: that Z10s were not selling, were being returned at extraordinary rates, and that BlackBerry was failing to represent commitments to buy back unsold or returned phones as a liability on its balance sheet. If these allegations prove to have been the source of the giant Z10 Inventory Charge, there may be a case that management deliberately misled shareholders in thepress releases which followed those April allegations.
"BlackBerry wishes to respond to media coverage today regarding speculation that there have been abnormally high levels of returns of BlackBerry Z10 devices. This is absolutely false. Our data shows that return rates for BlackBerry Z10 devices both in the U.S. and on a global basis are in line with or better than our expectations and are consistent with return rates for other premium smartphones in the market today."
3. Governance Red Flags
The decision to cancel the Q2 conference call after presenting such questionable and terrible financial results is troubling. With an offer on the table that a value-minded shareholder would have scoffed at a few weeks ago, the details of this quarter's financial loss are extremely important. Management's lack of transparency at this moment represents an alarming governance problem.
Watsa is operating with considerable material inside information which he gleaned as a director of the corporation. As a director he also held a fiduciary duty to all shareholders. He has stated on the record that he views the company to be worth considerably more than $9 per share. If, believing the company to be worth more than $9, Watsa prepared any of this low offer while still serving as director, he may have breached his fiduciary duty to non-Fairfax shareholders.
Given significant personal relationships between Heins, Watsa, Lazaridis, and the Board, it is necessary to question arms-reach status and insider information associated with this bid to ensure the board is rightly acting in shareholders' best interest. An example of this queer situation is that Watsa both helped establish Heins' $55M golden parachute as a member of the compensation committee, and also persuaded Heins to sell him the company at a price well-below book value.
My Speculative Trade:
Adding up these curiosities, I think Fairfax' bid is serious. I expect Watsa will try his best to purchase the company at $9 and I think there is enough value in the company for him to persuade his financiers. To this end, I think it is sound to buy stock or purchase $8.00 call options, expecting the stock to be trading at $9 or more within a few months.
However, I think it is entirely plausible that the deal will fail with Watsa voluntarily walking away or failing to find financing. If this happens, it will mark a major strike against the firm's value: a renowned value investor with complete access to the company's books would have failed to find $9 of private value in the company. If this happens, it is doubtful the market will continue to value it at $8. Further, the curious accounting red flags or the clear governance concerns may lead to a big problem, producing an all-out doom spiral. To bet on full-out collapse is cheap. I suggest partly hedging the precarious long position by buying heaps of nearly free put options at $5 or less.
With this trade, the speculator can earn the 12.5% spread in the likely case the $9 bid firms up in November, while having an opportunity to reap great returns if a superior bid emerges, while having limited hedging in the event this fishy business reveals a whale of a problem.
Get long. Get short. BlackBerry at $8 ain't right. These are interesting times.
Additional disclosure: I may initiate a short position at any moment.
By Black Spruce
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