Blackberry and margin of safety

I have been analyzing Blackberry (TSX: BB) on-and-off since their last quarterly report disaster and gained a rather wide comprehension of the challenges facing the mobile sector. It is almost reminiscent of what happened in the personal computer space in the 1990’s, with the notable exception that in terms of marketing, mobile vendors (Canada: Telus, Bell, Rogers, USA: AT&T, T-Mobile, Sprint, Verizon, etc.) become a material consideration in terms of consumer acceptance of handheld devices. While in the PC-space, people would just purchase their computers outright (with the obligatory Microsoft Windows license), typically people purchase their handheld devices on an opaque financing plan where you pay the implicit fee of the phone that is baked into the monthly payment for mobile phone service.

Blackberry stock has been hammered over the past few years – any investor in the stock from 2011 and earlier is guaranteed to be in a loss situation:

bbry

Still, as many market participants are aware, from a financial perspective, at current valuations Blackberry is not that in rough shape – despite having a market cap of $5 billion at Friday’s close, they have about $2.8 billion cash in the bank, and still have a very significant revenue base, and most importantly, their technology platform is still top-notch and relevant. It appears the challenge at this point is from a marketing perspective.

None of these financial metrics are a secret and thus should not be a material consideration in terms of a purchase decision unless if one believes the market is somehow misreading the financial statements (which I do not believe is the case). Rather, the relevant variable to consider is whether Blackberry will retain some sort of presence in the market that will enable it to be profitable, whether it is through technical or marketing clout.

I generally do not believe that it is a requirement to be the mass-market leader in order to be profitable – rather, if they can continue carving out their typical niche in the corporate-type sector that they should continue to survive with acceptable profitability. Right now, Samsung through their Google Android offerings are mopping up the consumer market, but the industry is very flighty – Apple iPhone was all the rage a couple years ago, and tomorrow, who knows?

According to some survey data (and this was a quickly pulled off link from the internet and is not designed to be authoritative by any means and is strictly USA geography), Android controls about 50% of the market, and iPhone controls about 40%, and Blackberry is currently at around 5%. This could go up or down, but intuitively it is not a stretch to think that in the future more than 1/20 phones sold could be a Blackberry.

While the rumour last Friday about them potentially going private gave their stock a boost, I highly suspect that such rumours are simply about some hedge fund creating the news piece to allow it to bail out of an outsized position. I also doubt the regulatory environment would enable this transaction to occur.

Prem Watsa, through Fairfax, has a 9.9% stake in the company and also is sitting on the board of directors. He has a savvy, contrarian mind, and although the investment is probably somewhat out of his niche, I’m going to guess that he did have some staffers that are more in tune with the industry to give him some good advice on this one. His purchase price was considerably higher than existing valuations.

I’ve written about Blackberry (RIMM) before (link) and made a comment on analyst expectations – how important it is for potential investors to be purchasing when the expectations are low rather than high. In my June 2012 post, I noted the following estimates:

rimm

Today, we have the following estimates (noting the significant notch down after the last quarter update!):

rimm-expectations

Now, these are estimates that are getting close to worth investing in – mainly the February 2015 estimate of the company losing 80 cents a share (or about $410 million!). This is not a lofty goal for the company to achieve if they can maintain some sort of market presence. The number does assume a significant amount of erosion of the current customer base.

I am factoring in a high probability for the rest of 2013 that the company will continue to languish in the upper single digits as institutional investors attempt to offload shares for tax loss purposes and also the investors that invested into BBRY for the turnaround story likely will have their backs broken and will bail out – what fund manager wants to confess to holding this dog in their 2013 statements? However, the investment story at present is more compelling from a risk/reward ratio today than it has been over the past two years and I will be keeping a very sharp eye out for a potential entry. Obviously I’d like to see more negative sentiment baked into the stock price, and I certainly wouldn’t want to be paying any potential “takeover and go private” premium and will wait for this to blow over before considering my options.

Also not helping is my outlook on the macroscopic side of the market, which I believe is getting frothy on the equity side.

Tim Hortons financial engineering

I noted with some amusement that some shareholders of Tim Hortons have been clamoring for the company to financially leverage itself (via the Globe and Mail). I am not an investor in Tim Hortons and will likely never be, but I took a brief look at the financial metrics driving the company.

One can assume the company in Canada is relatively mature. There seemingly is a per capita rate of Tim Hortons of one per ten people. This has been the case in almost any region in the country I have been in.

So the push southward is a logical strategic focus for the company, except for the fact that they can’t gain any traction in the USA. I find this to be a curious phenomena since this is one of the few cultural differentiators between Canada and the USA that I can think of – intuitively there shouldn’t be any reason Tim Horton’s can’t be as successful in the USA, but there is seemingly something wrong with their product mix.

As such, when looking at the financial state of the situation, the company is trading at approximately 20 times earnings and they have succumbed to the vocal shareholders calling for a share buyback. Right now, Tim Horton’s debt level is $530 million, which is a relatively safe level given their cash flow generation (for the first half of the year, operational cash flow is at $258 million and free cash flow at $171 million). Also note that the company does give out a 26 cent quarterly dividend, which took out another $79 million in cash for the first half of the year. The proposal to lever the company another $900 million to do a buyback will not accomplish much other than destroying shareholder value and making the company as a whole more financially brittle.

I do not think $1.4 billion in debt is an unsafe amount of money for the company (although it is at the upper end of the threshold I would accept if I was on the board of directors), but it does seem unnecessary to exercise this buyback at existing valuations.

Although it can be assured that Tim Hortons will exist in some form in the indefinite future, will it always be as profitable as it is currently? I would steer clear of the shares.

Kinross and other gold producers

I note today that Kinross (TSX: K) announced quarterly results but also eliminated their semi-annual dividend, citing uncertainty in the gold market (not to mention the company’s rather large debt burden).

Whenever you see corporations eliminate dividends, there is typically an adverse market reaction because management is signalling the fortunes of the company are not sufficient to sustain the dividend. There are frequent opportunities to profit from this if you believe the conditions that caused the dividend termination are short-term in nature. Another factor that accelerates the price decline is that dividend funds (or other mutual funds) that have in their portfolio management guidelines the requirement to only be invested in companies with dividends will be getting their robotic traders to sell shares to the market, which will also put downward price pressure on the stock.

Strictly in terms of financial theory, two identical companies, one pay a dividend and one not paying a dividend, should be trading at identical values (after adjusting for tax implications of shareholders and the associated reduction of balance sheet equity for the dividends given). However, the market has a very deep perception difference between income-yielding instruments and non-income yielding instruments – there is quite a high premium these days on income-bearing investments even when it makes no sense.

I note that after today’s quarterly report from Kinross that the stock is down about 3%, which is less than one would expect given the announcement. This might suggest that a bottom is forming around here, but I am far from being an expert analyst on gold mining companies, and I’m not about to become one in the next month. A lot of these companies have deep issues with cost containment – even though the underlying commodity price has skyrocketed from prices 10 years ago, the costs to extract the resource seemingly climb up at the same rate!

Investors should also be warned that commodities can trade under marginal costs of extraction much longer than one would intuitively expect!

Finally, recall that these resources all tend to fall into cyclical traps. The general public never catches wind until most of the hype has been priced into the respective shares. Recall in the past decade:

2006: Uranium
2008: Potash
2010: Lithium
2011: Rare Earths, Gold/Silver
2013: Bitcoins

Next is…?

Genworth MI – Q2-2013 report

Genworth MI (TSX: MIC) reported second quarter results yesterday. They continue being a cash generation machine, with the latest quarter reporting a 0.12% delinquency rate on mortgages and a 43% combined ratio. With this and some investment gains, the company was able to report $88 million in operating income, or 89 cents per share.

Severity on claims was also down to 30%, from 34% a couple quarters ago.

The only negative a discriminating investor could see is the amount of insurance written this quarter was down about 40% (translating into net premiums written down by 22%), but this is strictly due to the federal government’s intervention on mortgage rules. It will also have a corresponding positive impact on claim frequency as the insurance pool will be of higher quality. It should be important to note that insurance companies make profits on underwriting risks that are priced below actual risk, not on sales volume.

On the balance sheet side, the company remains overcapitalized and has commenced its share repurchase since early May; they bought back 2.01 million shares at an average price of $24.88/share. This was a very astute purchase. It is likely they will keep repurchasing shares from the market until the buyback is exhausted, which will likely be at the end of the third quarter at the rate they are going. After that, they will probably look at the share price before deciding whether to increase the buyback or just give out a special dividend. Tangible book value at the end of Q2-2013 is $29.48/share.

Otherwise, there is not too much to report in this quarter report that hasn’t already been covered in previous reports of Genworth MI. While it is not the screaming value buy it was back last year when it was trading at $18/share, at $28/share, it is still undervalued and the share price still represents a degree of skepticism on the Canadian real estate market and the fortunes of the parent subsidiary that owns 57.4% of Genworth MI (Genworth Financial, NYSE: GNW). As long as one does not forecast some precipitous collapse in the real estate market (which will occur if unemployment rises suddenly) or interest rates start to rise rapidly (which would cause a country-wide devaluation of real estate assets), I still am amazed that this company has traded under $30/share for so long. It will get there.

Investors are also paid to wait, with a 32 cent dividend, which represents a 4.57% yield at a $28 share price.

As people are aware, there are two major players in the Canadian mortgage insurance market: the 100% federally-owned CMHC, and Genworth MI. Both entities are making insane amounts of profits for their shareholders (in the former case, for the public, in the latter for the shareholders) and it is rather reassuring to know that there is alignment between the government’s interests and the company’s – mainly keeping the premiums for mortgage insurance considerably higher than what appears to be needed. This is obtaining duopoly-style pricing without all the media attention. Finally, investors in Genworth MI also have to take into consideration the motivations of the parent subsidiary, which currently seems to be in the role of a passive investor at the moment that is clipping dividend coupons and cashing out shares as needed (this is in proportion to the buyback). Whether Genworth MI gives out its cash as dividends or as a share buyback does not make too much difference to me, although back at $25/share I was quite happy to see the shares repurchased. At $28, lesser so, but the breakeven point would be $30 for me, where I’d believe it would generate more value for dividends to be the conduit for excess cash.

Suffice to say, I am still long and am not interested in selling at current prices. They are still trading at less than tangible book value and generated $1.85/share in cash for the first half of the year. Why would anybody want to sell unless if they are panic-stricken?

Junk debt is being accumulated

It is very evident that money is once again flowing into junk debt. I am finding every piece of junk debt securities being bidded up over the past week. Amazing what happens when the Federal Reserve talks about not wanting to ease up on quantitative easing – liquidity and party-time again for everybody! Back to the strategy of borrowing at 1%, and buy up those 8% junk debt securities and skim the spread… until the music stops.

Of course, I do not endorse or condemn this strategy – it will work, until it stops working. Such are the markets we are currently in.