The man with nothing to lose

Watsa tries to save a Canadian icon

 
(Illustration: Sean McCabe)
(Illustration: Sean McCabe)

Prem Watsa is used to being alone when it comes to his opinions. That’s how he makes money, in fact. The chairman and CEO of Fairfax Financial Holdings makes a point of challenging conventional investing wisdom, backing unloved companies or retrenching when others are spending freely. But he’s probably never been more alone than he is in his views on BlackBerry Ltd. For the past two years, Watsa has been one of its most vocal defenders as investors, customers and even business partners abandoned the once dominant smartphone maker. Fairfax is its biggest shareholder with a 9.9% stake, and Watsa is now digging in his heels even further. After stepping down from the board of directors in August, Watsa quickly put together a consortium set on buying BlackBerry and taking it private in a US$4.7-billion deal.

Watsa hailed the proposed transaction as an “exciting new private chapter for BlackBerry.” The market doubted the proposal, and BlackBerry’s stock price fell below the $9 per share Fairfax is offering. The two companies have only signed a letter of intent, and Fairfax has until Nov. 4 to complete its due diligence. The other members of the consortium are anonymous, and Fairfax is still negotiating financing. Pierre Ferragu, an analyst with Bernstein Research, wrote a report claiming the deal is “unlikely to close,” and suffers from a “lack of credibility.” Watsa, who rarely speaks to reporters, went on the offensive, telling multiple outlets that the equity portion of the financing is already oversubscribed, the deal will be completed, he won’t lower his bid and BlackBerry will be kept intact. (He declined to be interviewed for this article.)

On the surface, Watsa looks like a white knight, staking his company’s money and reputation on the conviction that BlackBerry can once again become a viable company. But a closer look at the proposal shows Watsa isn’t exactly the valiant hero: he’s simply protecting his existing investment. Fairfax is contributing only its stake to the buyout and has no plans to put more capital into BlackBerry. Watsa is asking the partners in the consortium to take on additional financial risk at a time when BlackBerry has never been in worse shape. “It’s a wonderful deal for him,” says Vic Alboini, CEO of Jaguar Financial, a BlackBerry shareholder—perhaps the shrewdest Watsa has put together. If it goes through, he has a shot at salvaging his investment and burnishing his reputation. If BlackBerry accepts a higher offer (private equity firm Cerberus Capital Management is rumoured to be sniffing around) he can not only cash out, but BlackBerry will have to pay Fairfax a breakup fee of at least $157 million. Either scenario is better than standing on the sidelines and watching his investment erode. Watsa is no white knight—he’s a man with nothing to lose.

It’s a cliché to refer to Watsa as the Warren Buffett of Canada. “In my experience, it was never used by anyone inside the company,” recalls a former employee. “It is a term that was created and took on a life of its own.” To reduce Watsa to a low-rent Canuck version of an investing legend is to miss what makes him unique. U.S. billionaire Wilbur Ross Jr., who participated in a Fairfax-led consortium to purchase a 35% stake in the Bank of Ireland in 2011, says Watsa has three “extraordinary” capabilities. “He is excellent on macroeconomic analysis and translating that into an investment thesis,” he wrote in an e-mail. “He adds value to a business by devising sometimes out-of-the-box strategies and tactics. Third, he is a very disciplined buyer and seller.” Looking at Watsa’s history, he has a higher risk tolerance than Buffett, too. “Making high-risk investments means you will sometimes get hurt, but on balance he has achieved hyper performance,” according to Ross.

Born in 1950 in India, Watsa studied chemical engineering at the Indian Institute of Technology. He wasn’t enamoured with the idea of being a chemical engineer, and he later moved to London, Ont., where his brother had already relocated, and earned an MBA from what’s now known as the Richard Ivey School of Business. He financed his way through the program by selling air conditioners and furnaces door-to-door. After graduating, Watsa joined insurance company Confederation Life as an investment analyst. His boss gave him a copy of The Intelligent Investor by Benjamin Graham, a book that would change his life. Graham is known as the father of value investing, and he encouraged a long-term approach over speculation and warned against following the herd. Watsa was enthralled. He later named his son Ben, who, not surprisingly, also grew up to be a value investor.

In 1984, Watsa struck out on his own and formed the Hamblin Watsa Investment Counsel with Tony Hamblin, a former boss from Confederation Life, and a handful of associates. He borrowed a page from Buffett’s playbook. (Watsa is a fan, and has attended Berkshire Hathaway annual meetings for 30 years.) Buffett owns insurance companies, and uses the float—the premiums collected from policyholders but not yet paid out—as an inexpensive source of capital to make investments. The following year, Watsa and his partners took over Markel Financial, a troubled Canadian trucking insurance company, and renamed it Fairfax Financial Holdings. Today, Fairfax owns property and casualty insurers around the world, and churned out more than $8 billion in revenue last year. It also holds majority stakes in William Ashley, Sporting Life and Prime Restaurants, which includes East Side Mario’s and Bier Markt. Hamblin Watsa serves as the brain trust within Fairfax that makes investment decisions.

Despite the company’s success, Watsa has always kept a low profile. He was eventually forced into the public eye when hedge funds started shorting Fairfax’s stock, causing it to nose-dive more than 50% between 2002 and early 2003. The short sellers persisted for years, and Watsa eventually came to believe the hedge funds were conspiring together to spread false information about Fairfax. In 2006, the company launched litigation against a handful of hedge funds, but since then, all but one of the firms was dismissed as a defendant. Fairfax’s reputation survived intact, and its stock has returned nearly 145% over the past decade.

Watsa has also avoided the limelight because, by most accounts, he’s a genuinely humble guy. In speeches, Watsa attributes a lot of his success to good fortune and prefers to shift the focus onto his investing team. His annual letters to shareholders are rife with shout-outs to colleagues. Sometimes the subjects of Watsa’s enthusiasm are a little puzzled at the recognition. Last year, Watsa praised Van Hoisington and Lacy Hunt, who work for an investment company in Texas. “Whenever we worry about inflation or rising rates, we call 1-800-Van-Lacy!!” he wrote. “We are just government bond managers for a couple of Fairfax’s [subsidiaries],” Hoisington said in an e-mail. “We have had some success in our field which is why, I guess, that Mr. Watsa mentioned us.”

His letters provide one of the best windows into his personality and investing views. He tone is buoyant, avuncular and even a little corny. The letters are littered with exclamation points, sometimes two (or three) in a row, and he loves to champion Fairfax’s holdings, particularly William Ashley and Sporting Life: “Whenever you shop at their stores, please mention that you are a Fairfax shareholder—you will get an extra smile!!”

For years, Watsa didn’t have a lot to brag about. The period between 1999 and 2005 are what he refers to as Fairfax’s “biblical seven lean years.” The trouble started when Fairfax spent $1.4 billion to acquire a pair of U.S. insurance companies. Both companies were in rough shape, and it took years to sort out the mess. Fairfax posted its first ever annual loss of $346 million in 2001.

To make matters worse, Fairfax was missing out on the stock rally the followed the tech crash. Watsa was wary about equities, and held large amounts of government bonds and cash. He also believed the mortgage-lending frenzy in the U.S. would ultimately have severe consequences, and used credit default swaps to essentially bet against the market’s continued strength. The position cost Fairfax more than $200 million for the first few years, but it finally paid off when the market cratered in 2008. “Our investment team has produced exceptional returns in many of the years over the past 23—but none like in 2008!” Watsa wrote that year. While other firms were swimming in losses, Fairfax posted a profit of $1.47 billion, its best ever year, and one it has yet to match.

That bet is the quintessential Watsa move: contrarian, smart and lucrative, provided one can stomach the pain in the short term. He takes the same approach when looking at individual companies. In 2008, Montreal toy maker Mega Brands was in crisis after acquiring a U.S. firm called Rose Art Industries, whose product, Magnetix, proved defective. Loose parts were linked to numerous injured toddlers and one death. Mega Brands faced a huge product recall and mounting legal bills. Investors fled, and the company desperately sought cash. Watsa was interested, and met with Mega Brands CEO Marc Bertrand. “Prem was very focused on what the issue was, how do we get around the issue, and what can the future be like,” Bertrand recalls. Mega Brand’s core product line of construction blocks was unaffected, and Bertrand explained the market was still strong. Fairfax provided a $64-million lifeline and, in 2010, helped to recapitalize the company another time. Since then, the stock has increased by nearly 60%, and Mega Brands has returned to profitability.

Watsa has his share of duds, too. Forestry company AbitibiBowater Inc. cost Fairfax $336 million when it filed for creditor protection a few years ago. Then Fairfax took a $121-million impairment charge on Canwest Global Communications when the media conglomerate went bankrupt in 2009, followed a $175-million charge on its investment in Torstar Corp. that same year.

Looking over Fairfax’s history, it’s evident the firm has shied away from technology companies. The fast-moving industry generally makes it too risky for long-term value investors. That’s why his pursuit of BlackBerry is surprising. In 2011, Fairfax held a 2.25% stake in the company. Watsa spoke to Canadian Business that November about his investment, saying that he was incredulous the company had fallen out of favour with investors when it still earned billions in revenue and kept a large cash pile on its balance sheet. He felt the PlayBook tablet, widely considered a flop, could be saved. (BlackBerry has all but abandoned it.) He also praised co-CEOs Jim Balsillie and Mike Lazaridis. “We’re shareholders because of Mike and Jim,” he said. “Imagine putting someone else [in].…That’s risky. I wouldn’t invest in a company that did that.” Two months later, Lazaridis and Balsillie resigned as co-CEOs, Thorsten Heins took over, Watsa joined the board and Fairfax raised its stake to more than 5%.

Watsa has been circumspect about the plan for BlackBerry should the Fairfax consortium complete the deal, other than confirming that he wants to keep the company together, in Canada, and he believes it can be a viable competitor in the corporate market. The prospects look bleak, but it’s not impossible. “There’s always a die-hard group of users who like to stay on a platform,” says Mark McKechnie, an analyst with Evercore Partners. The question is how big that core group could be. BlackBerry no longer regularly reports how many subscribers it has, but it had 72 million as of June, down from a peak of 80 million last year.

McKechnie estimates BlackBerry’s user base could shrink all the way down to 30 million and the company would still be able to eke out a profit, provided it cuts costs aggressively and reduces its head count. But keeping BlackBerry together, even in a much smaller form, strikes others as unrealistic. The company’s handset business is falling apart quickly and may never stabilize. Blackberry sold only 5.9 million smartphones in the past quarter (it recognized revenue on 3.7 million), down 20% from a year ago. “BlackBerry has nowhere near the scale to be in the handset business at this point,” says Mike Genovese, a senior analyst with MKM Partners.

The best option, according to many analysts, is to wind down or sell the money-losing hardware division. The company’s real value lies in BlackBerry’s services business. It manages traffic on its own secure network infrastructure, and still generates a large amount of cash through subscriber fees and by helping corporate IT departments manage smartphones and tablets within their organizations. The latter area, mobile device management, is a burgeoning field now that corporations have to securely keep track of thousands of devices from different manufacturers running different operating systems. IT departments require a system to oversee them all, and perform functions such as installing or removing apps across the network, or wiping smartphones clean when they’re lost or stolen. BlackBerry has been doing this for as long as it’s been making smartphones, and maintains a decent reputation for security and reliability. Still, a handful of other companies now provide the same service, and BlackBerry is feeling the competition. It only recently opened up its platform, BlackBerry Enterprise Service 10, to support Android and Apple products, whereas other firms have been doing so for years. The company reported last month that 25,000 of its BES 10 servers had been deployed, up from 19,000 in July. However, in a recent SEC filing, BlackBerry reported that competing products and delays in the launch of certain features are causing a “slower than anticipated rate of adoption.” Scott Thompson, an analyst at FBR Capital Markets, notes that while the situation is tough, the service business holds the most potential. “Maybe longer term, you can turn this thing around,” he says.

Even farther into the future, there may be potential in the QNX software the company acquired in 2010 as the basis of its BlackBerry 10 operating system. QNX has many industrial applications, and is employed in high-speed trains, power plants and automobiles. It could serve as a platform in the nascent field of machine-to-machine technology, as devices like parking meters and toasters are equipped with Internet connectivity. “That’s going to be absolutely important in terms of where they go from here,” Alboini from Jaguar Financial says.

BlackBerry Messenger could provide yet another opportunity, if the company can figure out how to make money from it. The instant messaging service is still used by millions of BlackBerry subscribers, and some investors and analysts have called for the company to spin off BBM for years. BlackBerry took a step in that direction earlier this year when it announced it would launch BBM for Apple and Android. (That launch has since been delayed.) BlackBerry would be going up against other similar services, such as WhatsApp, which charges an annual subscription fee of just under a dollar after one year. “This is an addressable market that’s real,” says James Faucette, an analyst at Pacific Crest Securities. “But I don’t think there’s any company you can point to and say, this is a business model that works.” Charging $1 per year per subscriber amounts to paltry profits, he says.

With all of these challenges and uncertainties, is BlackBerry really worth $9 a share today? As a value investor, Watsa is primarily concerned with getting a good price. In making a bid for the entire company, the Fairfax consortium gets access to BlackBerry’s cash pile—$2.6 billion as of the last quarter, though its quickly declining. That’s a smart move from his perspective, since the cash can be used to pay back any loans required to finance the buyout, limiting the cost for Fairfax and its partners. Analysts are nevertheless divided on the company’s worth. One wildcard is BlackBerry’s patent portfolio. Gus Papageorgiou at Scotiabank wrote recently the company’s 5,136 patents could be worth $2.25 billion, reasoning that BlackBerry has filed almost as many patents as Apple during the smartphone boom, and these patents have a lifespan of roughly 12 years. That’s partly why he values BlackBerry at more than $10 a share, suggesting Watsa is getting a steal.

But patents are really only worth as much as someone is willing to pay for them. “The war to stockpile patents has largely waned,” says Bill Kreher, an analyst with Edward Jones. Google purchased Motorola for $12.5 billion partly to get access to its patents. Microsoft, through its acquisition of Nokia, is now well-supplied. Other research firms, such as MKM Partners and Canaccord Genuity, peg the company at only $7 a share, arguing the business is deteriorating too fast to justify Watsa’s price.

Watsa is no fool, of course. Because of his former position on the board, he has a level of knowledge about the company that no one on the outside has. Even so, it’s hard to overlook Fairfax’s decision to not contribute any more cash for the proposed buyout of BlackBerry. Perhaps Watsa is keeping in mind Fairfax’s 15 guiding principles. “We encourage calculated risk taking,” states one. “It is all right to fail but we should learn from our mistakes.” BlackBerry’s decline certainly makes Watsa’s gamble on the company look like a mistake so far. By throwing together a last-ditch buyout attempt, he at least has a chance to prevent it from becoming an even bigger one.

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