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Evaluating BBRY Using Buffett's Arbitrage Strategy

October 02, 2013 | About:
BlackBerry (BBRY), the once-dominant maker of smartphones that fell on hard times in recent years, announced a $4.7 billion deal to go private a few days ago. Since then, a few of my friends have mentioned to me that the Fairfax and BBRY deal could be a very interesting situation. The announced deal is $4.7 billion; however, the market is putting a $4.15 billion price tag on BlackBerry as of October 1st. Therefore, I decided to take a closer look at this potential arbitrage situation.

In evaluating the current situation, I turned to the 1988 letter to shareholders from the Oracle of Omaha. In this letter, Buffett intelligently laid out the four questions that need to be evaluated in arbitrage situations:

(1) How likely is it that the promised event will indeed occur?

(2) How long will your money be tied up?

(3) What chance is there that something still better will transpire — a competing takeover bid, for example?

(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

Let's go through the questions one by one.

(1) How likely is it that the promised event will indeed occur?

Here is what Buffett wrote for the KKR-Arcata deal: "Appraising this arbitrage opportunity, we had to ask ourselves whether KKR would consummate the transaction since, among other things, its offer was contingent upon its obtaining 'satisfactory financing.' A clause of this kind is always dangerous for the seller: It offers an easy exit for a suitor whose ardor fades between proposal and marriage. However, we were not particularly worried about this possibility because KKR's past record for closing was good."

With the Fairfax and BlackBerry deal, one of the reasons Mr. Market is putting a discount on its value is because Fairfax has not obtained all the financing needed. This worry is warranted if the acquirer has an unsatisfactory track record. However, in 28 years, Fairfax has never retreated or walked away from a deal. So in my opinion, it is very likely that the promised event will indeed occur.

(2) How long will your money be tied up?

Fairfax will spend two months conducting due diligence of the company's financial statements. That due diligence is expected to be complete by Nov. 4, BlackBerry said in a statement. Assuming the due diligence is completed as expected, then allowing a couple days for final negotiation, we will have much better clarity with regards to whether the deal will be consummated or not and at what price in five to six weeks. It is a long time for Wall Street but for value investors, five to six weeks is almost as short as it can get.

(3) What chance is there that something still better will transpire — a competing takeover bid, for example?

From what I read, there could be other bidders who are interested in BlackBerry’s services business and operating system, but only few bidders in the handset unit. BlackBerry will also need to pay Fairfax a hefty breakup fee if they can find a better deal. So if a better deal is found, it has to be a few hundred million dollars more to cover the termination fee. Furthermore, BlackBerry's CEO Thorston Heins has a huge incentive to find another deal, not necessarily a better one though, because if he lost his job after a sale of the company (not dependent on the sale price), he will get a compensation package worth $55.6 million.

It seems that a deal, whether it is with Fairfax or not, is extremely likely given the incentives of participating parties.

(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc?

The market has factored in the possibility that the deal falls through. Should that be the case, the market will likely value BlackBerry the way it did before the announcement of the deal. How much? Nobody knows. From a balance sheet perspective, BlackBerry's latest quarterly filing shows that it has roughly $9 billion tangible assets and $4 billion liabilities. So net tangible assets is $5 billion, still higher than Fairfax's bid. Blackberry's intangible assets include its acquired technology and intellectual property. If we ask ourselves what the intangible assets might be worth, again, turning to the Oracle's wisdom, let's "coolly evaluate the intangible assets at somewhere between zero and a whole lot." However, with or without intangible assets, Blackberry should worth at least to the $4.7 billion bid by Fairfax.

So to sum it up, if everything turns out as expected and assuming that an investor purchases BlackBerry at today's price for $4.15 billion or $7.92 per share and that in six weeks and that the deal goes through, the investor will wind up with $4.7 billion or $9 per share, That's 13.6% in six weeks or more than 200% annualized.

Alternatively, one can do a conservative expected return calculation illustrated as following:

Let's say there is a 70% chance it will go through for at least $9. If the deal doesn't go through, let's assume BBRY drops to $7.

Expected return = 70%*1.08 - 30%*0.92 = $0.48 on $7.92 per today's closing price, or 6.06% in six weeks, or more than 66.5% annualized.

I think the odds are good. As the market keeps going up, this looks like a compelling work out.

About the author:


Rating: 4.2/5 (33 votes)

Comments

rdj1234
Rdj1234 - 10 months ago
I read this after reading your timely article 10/2/13 regarding # 3

(3) What chance is there that something still better will transpire — a competing takeover bid, for example?

TORONTO (Reuters) - BlackBerry Ltd has drawn interest from private equity group Cerberus and at least one other investor, CNBC said on Wednesday, quoting Dow Jones, which cited unnamed sources. Shares of BlackBerry jumped as the news hit, and were up 2.5 percent at $8.11 on Nasdaq.

(Reporting by Alastair Sharp; Editing by Gerald E. McCormick)

RDJ

P.S. iSOFT – Using John Paulson’s Merger Arbitrage Checklist here on Gurufocus combined with Buffett's list might help lower the chance of arbitrages blowing up.
jsoumilas
Jsoumilas premium member - 10 months ago
Excellent article. Thank you.
20punches
20punches - 10 months ago
Rdj 1234- Thanks for your comment. I won't be surprised if another bidder jumps in later. By the way, where is this John Paulson's Merger Arbitrage Checklist? Is it on gurufocus? I can't find it.

20punches
20punches - 10 months ago
Jsoumilas - Thanks for your comments. Glad you liked the article.
20punches
20punches - 10 months ago
Thank you so much, RDJ. That was super helpful!
SeaBud
SeaBud premium member - 10 months ago
I do not disagree with the premise of the article. However, I think you are undervaluing one negative possibility. You seem to think that the acquisition is binary (it will or will not happen). This is not complete. The price offered by Fairfax can be lowered, and absent a higher offer (accounting for the fee that will have to be paid Fairfax if such an offer is accepted), said lower Fairfax offer will lower the average investors return (but not Fairfax's returne, as they are paying themselves).

If BBerry continues to go down the crapper over the due diligence period, I would not be shocked to see the offer price go down (say 25% chance). I think it HIGHLY unlikely that another bidder will buy as the cash flow to turn this business around and uncertain break up fee is an overwhelming problem for private capital, leaving only market players (ie, LG, Samsung) who trade volume, not ecosystems. Thus, within reason, whatever Fairfax offers will be the price an investor gets.

Ultimately, my guess is your assessment is correct and the offered price will be paid, but if Fairfax is bringing in coinvestors the pain of BBerry's numbers may cause them to reduce their offer knowing they have little competition for the deal. I think this carries a little more risk than presented and I will not touch it. But I respect the thesis.
Cap2c
Cap2c premium member - 10 months ago


Here is the most compelling reason to believe this deal will happen...Prem Watsa in an interview with the associated press said:

"We've got a track record of 28 years of completing what we've done. We've never re-negotiated." He was on the board of BBRY for quite some time up until just recently.

His attorneys were probably aghast when he said the above in an interview because you can bet your bottom dollar that if the deal doesn't happen at $9, they'll have to deal with a slew of class action suits.
20punches
20punches - 10 months ago
SeaBud: I appreciate your comments. It is a real possibility, although in my opinion a remote one, that FairFax could lower the bid. Thanks for pointing that out. Although this is missing in my thesis, I think my point number 4 indirectly incorporates the possibility of BBRY falls say to $7. I don't know what will happen but the expected return seems to justify a position. I won't touch BBRY either if not for the Fairfax deal.
20punches
20punches - 10 months ago
Cap2c - That was a respectable statement from Watsa. It just shows the confidence he has in Canada's No.1 brand. Personally I think $4.7 billion is a fair price based on a balance sheet analysis. Thanks for your comments.
ecotycoon
Ecotycoon premium member - 10 months ago
Great article Jianing7978, we think the same :) feel quite greedy when i've notice this arbitrage opportunity too.

1-Fairfax are famous for signing contract on an handshake.

2-Fairfax stand for Fair and acquisition, Fair price acquisition for the benefit of both parties.

If they say they agree for 9$ a share this mean in my opinion a 99% chance they will acquire the business for 9$ a share meaning close to a 15% return. Sound safe to me when the overall market is expect to return around 2% on an historical basis.

20punches
20punches - 10 months ago
Ecotycoon: Thanks for commenting. I totally agree with you:) The market seems to think otherwise though and I've seen a few analysts raising serious questions regarding the viability of the $9 offer but none of them has taken into consideration Watsa's past record. That baffles me.
chihin
Chihin - 10 months ago
Noted this phrase in the writeup: "That's 13.6% in six weeks or more than 200% annualized."

Assuming no counterbidder appears, are we assuming that Fairfax actually complete the deal and pay shareholders the $9 in 6 weeks, i.e., around 4 November 2013?

Or am I missing something important here?
20punches
20punches - 10 months ago
Chihin: I probably should clarify that a little better. I am not assuming Fairfax will actually complete the deal in 6 weeks. My point was in 6 weeks, we will have more clarify and less doubt, thus removing the uncertainty discount that is currently priced in BBRY's stock. So let's say around Nov 4th 2013, Fairfax announces that it has pulled all the financing needed and will sign a definitive agreement, I would think the market will then fully recognize the $9 deal and BBRY should be trading around $9. Thanks for pointing that out.
junming82
Junming82 premium member - 10 months ago
It would be very interesting to see how it all pans out as there have been reports that Blackberry is in talk with Cisco, Google and SAP to sell them all or parts of itself. Such a deal would be an alternative to the preliminary agreement reached weeks ago with a group, led by BlackBerry’s biggest shareholder, Fairfax Financial Holdings, to take the company private for about US$4.7 billion (S$5.86 billion), a bid which has faced some scepticism because of financing questions.

________________________________________________________________________________​___

Disclaimer: This is not a buy or sell stock tip. Please do your own research.

Value investing blog: http://valuestocksinvesting.blogspot.sg/

20punches
20punches - 10 months ago
Junming: Thanks for commenting. Blackberry has a very solid patent portfolio, especially in the mobile security area. I think Google, Samsung, Microsoft and Apple might all be interested in its intellectual properties. BBRY is burning cash but I can see a major handset producer acquireBlackberry and do a massive lay-off as well as a production line and corporate overhead integration to achieve synergy, like what Google did to Motorola.

SeaBud
SeaBud premium member - 9 months ago
Hate to go back to this and not doing it in an "I told you so sense", but this deal is falling thru and a lesson learned analysis is appropriate. Technology moves fast in both directions. I do not believe Buffett would have touched this with a 10 foot pole because the thesis was based on Fairfax paying money, not the value of the company. The cost of turning this enterprise around is an anchor for a company in a business that moves at lightening speed. This is not like a cigarette maker or soda maker - it is absolute crashing failure. As such, the perceived margin of safety never existed because the underlying business was not undervalued.
batbeer2
Batbeer2 premium member - 9 months ago
What we have here is a $3B company trading around NCAV.

- With roughly half its market cap in cash.

- With a highly regarded and shareholder friendly guru on the board.

It's been a year since I saw a stock that checked those boxes. It was called RIMM.

If memory serves, kfh227 submitted it for the contest. It doubled within months.

SeaBud
SeaBud premium member - 9 months ago
Relying on Fairfax as the definer of value was a mistake as I said a month ago. The value is never defined by what somebody will pay but by what something is.

I agree that now we have a company with half its market value in cash and enough cash, and a friend, to make a turn. However, BBRY is still bleeding cash and it is unclear how BBRY returns to the game and produces revenue.

I will be watching BBRY closely because if they can make a business play and even stabilize, this stock will do quite well. I invested in Nokia because they were valued at less than the network division plus cash - the handset business was free. In this case, the business must have some potential stabilization path (either handsets or bbry messaging) to be interesting and today I am not sure that exists. In other words, you may be buying 50 cents of cash for a dollar?....

Disclosure - long time in the telephony, technology industry and highly skeptical in general!
jsoumilas
Jsoumilas premium member - 9 months ago
Hello Ning Jia. Like you I believed that BBRY was a likely arbitrage situation. Unfortunately with the news yesterday, it did not turn out that way. What do you think of BBRY at this price? Is it likely that the company would be broken up? Is there value at this price?

John
altamami
Altamami premium member - 9 months ago
I definitely agree with this. On a value basis, BBRY is attractive. However, on a product, management, and future business outlook basis BBRY is still unclear at best.

AA
20punches
20punches - 9 months ago
SeaBud - I like your comments a lot. It's always nice to have someone looking at a situation from a different perspective.

As disappointed as I am with the outcome so far, at the time I was writing the article, the odds were good in my opinion and what happened last week was an alternative among a few, but unfortunately one that was the least favorable...... I don't think this is a deal that is destined to fail. If Fairfax can get 1 billion convertible bond financing, what made it not be able to get the $1.2 billion? So in my opinion, Fairfax was able to consummate the deal, but somehow didn't choose to.

Agreed on the perceived margin of safety may never exist. If BBRY's business keeps going down and it keeps burning cash, in a few years, it may very well no longer exist. I did my analysis before the deal and I know BBRY is not going to worth much in a few years if things don't turn. If wasn't for Watsa's bid, I wouldn't even consider BBRY. If Warren Buffett says Berkshire will buy BBRY for $4.7 billion, regardless of what BBRY is worth, would you buy BBRY at $4 billion? That was why I wrote this article. But I guess in the end, Watsa is not Buffett after all.

20punches
20punches - 9 months ago
Jsoumalis: As SeaBud has mentioned in his comments, the perceived margin of safety may never exist. One mistake that I have learned in my earlier mistakes is that you can't do the liquidation value analysis based on what's on the balance sheet today. You gotta look out a few years and ask if the company keeps going downhill and burn cash, what will the balance sheet look like in 3-5 years, or 10 years? In BBRY's case, what we have is a business that will likely to worth close to nothing in 5 years if things do not turn. So on a stand-along value basis, unless BBRY is liquidated within a year, the margin of safety based on asset value is not promising.

But is there a chance that BBRY is broken up and sold separately? I wouldn't rule that out. Just look at all the interested parties - Google, SAP, Qualcomm, Samsung, Lenovo and even Fairfax itself. It is too early to tell what is going to happen but I'm following BBRY closely as well.
20punches
20punches - 9 months ago
Batbeer2: I'd be pretty happy if history just rhymes:)

vgm
Vgm - 9 months ago
" Fairfax Financial Substantially Ups Its Stake In BlackBerry"

"Fairfax now holds 17.7 percent of outstanding shares of BlackBerry compared the 9.9 percent the firm owned when it was attempting to buy out BlackBerry."

https://businessincanada.com/2013/11/15/fairfax-financial-substantially-ups-its-stake-in-blackberry/

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