Tuesday 17 April 2012

Research In Motion (RIMM) – Dirt Cheap But Worth Your Bet?

Pre-words: 
This post is written not to discuss whether we think Blackberry will survive or not given what had happened. Nor is it written to debate on whether IPhones or Android Phones will take over the smartphone world.
But rather, it is to simply show you how amazingly cheap the company is traded at, given the company’s financial position and the amount of cash flows they are still churning out. 

Picture this: Just 1 year ago, RIMM is valued at $38Bn in the market. Fast forward till today, at a share price of $13.32, you can buyout the company with just $7Bn!

Income Statement:

Net Income
1164
+
Cost Optimization
96
+
Service Disruption
42
+
Inventory Provision
387
+
Goodwill Impairment
273
Adj. Net Income
1962
EPS
 $3.74
P/E
3.56

For their fiscal year ended March 3, 2012, RIMM reported a net income of $1164 mils and EPS of $2.22, which was a drop of almost 65% from their previous year of EPS $6.34. However, digging deeper into the numbers, there is substantial amount of one-time expenses incurred through the year and includes the items shown above. (We shall not go deeper into each items, you can read further in the annual report.)

After adjusting for all the one-time expenses, we arrive at a net income of $1,962 mils, which translate to an EPS of $3.74 and P/E of just 3.56. Although still a substantial drop from previous year peak earnings, the adjusted EPS shows how low they are being valued at in the market. At current price level, you are getting a company with 28% in earnings yield.



Furthermore, taking the average from 2005 to 2010, the historical P/E the company use to trade at is 21.65. This is way above today’s multiples of just 3.56, and if they ever trades back up to their historical level, that’s a return of almost 500%!

Cash-flow
If you take a look at their cash-flow statements, RIMM is still churning out good money and their latest year operating cash flow is almost $2.9Bn. Amortization of their PPE is $0.637Bn, and intangibles of $0.459Bn, which adds to a total of about $1.1Bn in maintenance Capex that is required to sustain the business going forward. This will give us a FCFs of almost $1.8Bn a year if revenue remains at current level, giving you a company with FCFs yield of 26%!

Balance Sheet:
On their books, RIMM has Cash & Cash Equivalents of $1.5Bn, Short-term Investments of $0.25Bn, and Long-term Investments of $0.34Bn, giving a total of about $2.1Bn in liquid assets. This translates to a per share of $4.03, which is 30% of the current share price of $13.32. With no debts on their books, essentially, the market is valuing the company at only $5Bn.



The above table shows the historical P/B for the past decade. Taking the average from 2001 – 2006 and 2008 – 2010, we have an average P/B of 3.98. With current equity of $10Bn, RIMM has a book value per share of $19.27. This translates to a price to book value of only 0.69. 

If we breakdown the equity, RIMM has $0.3Bn in goodwill, and $3.3Bn in intangibles. To be on the conservative side, we take away the goodwill and intangibles, leaving us with a tangible equity of about $6.5Bn, which translates to $12.42 per share and a price to tangible book of 1.07.

Valuation
If you are still not convinced on how dirt cheap RIMM is being valued at in the market, let us summarize.

At a price of $13.32, you are buying a company that is trading at 0.69 price to book, 1.07 price to tangible book, with a FCFs yield of 26%. Even with today’s dismal results, they are earning a return on tangible equity of 18% and adjusted return on tangible equity of 30% if the one-time charges are added back.

Factoring in their liquid assets of almost $2.1Bn, they are only valued at $5Bn in the market. With a FCFs of $1.8Bn per year, the company can take themselves private in 2.8 years time. (Please tell us how crazy is that.)  

Bonus - Potential Catalyst
An added bonus to owning shares of RIMM, we have our dear Prem Watsa, the Canadian Warren Buffet, doing his best for the shareholders. He owns a huge stake in RIMM and in recent months, had bought even more shares of the company. He was elected to the board and could be the driver behind many of the moves made by the company recently. A new CEO was installed and they are exploring strategic opportunities that include partnerships, joint ventures, licensing, etc.

(P.S. To Prem Watsa, why don't you consider buying out RIMM?)

Sunday 15 April 2012

Portfolio Updates

As quoted by Warren Buffett, “Diversification is protection against ignorance.”

We are almost done with our portfolio allocation. This is the portfolio that we would gladly hold for at least the next decade, unless, our valuations are reached much earlier and there exist even more undervalued opportunities to invest in.

The proportion of our stakes show how convicted we are in the positions we held.
We believe in the concentration of great ideas.


Saturday 14 April 2012

Teaser: How to ruin a wonderful, gargantuan business like AIG?

Based on the 2007 Annual Report, SIG's notional exposure to AIGFP supersenior Credit Default Swaps (CDS) portfolio is $527bn, in exchange for about $200mn of premiums (or revenues) per annum. Total premiums in 2007, by the way, is $79bn.

*Notes:
(1) It's unbelieveable that they called the CDS portfolio 'supersenior'!
(2) $527bn is more than 5 times shareholders' equity, then in 2007.
(3) Maybe, the AIG meltdown in 2008 is not so black-swan-like after all.

Thursday 5 April 2012

Why invest in AIG common stock when you can invest in AIG warrants?


An OUTDATED article (written on 24 Feb 2012) that is still relevant in today’s context.

Sypnosis:
With a modest intrinsic value per share of $60 based on a price/normalized earnings of 15x, the yield on AIG common stock is 120%. But why invest in the common stock when you can invest in the warrants with a maturity date on 19 Jan 2021 that would yield much bigger gains as book value and earnings would continue to grow at a modest rate in 9 years time?

Assuming a very conservative 6% CAGR growth in AIG’s book value and earnings, the intrinsic value per share 9 years later would be in the range of $100. While the 9-year yield on common stock becomes 270%, the warrants have a yield of 610%! Forget about AIG common stock; Consider the warrants!

Readers should note that our investment thesis and hence, the format of our article on BofA warrants is similar to that of AIG warrants, in which we have previously written in the article titled ‘Why invest in Bank of America common stock when you can invest in BofA warrants?’. The similarities of both AIG and BofA include (1) a business that has minimum leverage/excess liquidity due to the actions taken during the 2008 financial crisis, (2) have bad loans/investments written off (or be taken care of) and (3) the underlying share prices of the warrants have a dramatic upside potential when the respective business cycle turns.

Introduction on AIG common stock. As of 24 Feb 2012, AIG common stock has a share price of $29, with a book value per share of approximately $45 on 1,797 million of shares outstanding. As the annual earnings power in the past three years has been masked by (1) huge interest expenses (due to the government loan), (2) unfavorable market valuations in the investment portfolio mainly due to mortgage backed securities and the like, (3) catastrophic insurance losses, (4) insurance reserve strengthening and (5) goodwill impairments, we have adjusted the profit excluding these items and consequently, the normalized profit after tax is $4 per share. All these translate to P/B of 0.64x and P/normalized earnings of 7.25x.

(More on how we have calculated the normalized profit after tax, we have factored in a combined ratio of 108% (2006-2007 figures) on a low annual premium volume of $48bn (2010 figure) and a net investment income/premiums ratio of 37% (2006,2007 and 2009 figures) and a 30% tax figure.)



A modest intrinsic value per share of $60. The above table shows the past P/B and P/E that AIG common stock has been trading for the past 10 years. The average P/B and P/E of 1.89x and 16.86x is calculated based on the Dec 2003-2006 figures (Dec 2001-2002 figures are unrealistic). If a range of intrinsic value estimates is calculated based on past average P/B and P/E, there exists a profit potential of 100-200%. My estimated intrinsic value per share of $60, therefore, is modest. (The author suggests you do the calculations yourself – and be amazed!)

More on AIG. The recapitalization has more-or-less been completed as AIG has repaid government debt through asset sales and the bulk of the toxic assets have been written off through special vehicles in Maiden Lane 2 & 3 that have been put in place to absorb these assets. Forget about the Old AIG. The current AIG is a New AIG with (1) plenty of liquidity, (2) little or no debt, (3) assumed-to-be-undervalued mortgage-backed assets in its investment portfolio, (4) under-utilized insurance assets as certain wholesale channels are still off-bounds due to the AIG meltdown saga in 2008 and (5) $25bn or $14 per share of deferred tax asset to be utilized which is not found on the balance sheet (hence, not in GAAP book value calculation). All these points to both an undervalued GAAP book value per share of $45 and normalized earnings per share of $4.

If, through verification, you are stupefied by how undervalued AIG common stock is, you can forget about AIG common stock; Consider AIG warrants:

Introduction on AIG warrants. Unlike the typical short-dated warrant which is no different from a bet on a horse-race or a soccer-match, AIG warrants are long-dated with a maturity date on 19 Jan 2021 or approximately 9 more years before maturity. The current warrants price is $7.77, with a strike price of $45 (approximately equal to BV per share). The break-even share price, therefore, would be $52.77.

Downside risk is zero? Based on the current price and long-term nature of the warrants, we believe the downside risk is close to zero, if not zero. Of course, the authors disregard opportunity cost in their argument that follows. The payoff structure of a warrant is such that the investor of AIG warrants will lose its capital if the share price of AIG falls below $52.77. Assuming a very conservative 6% CAGR growth in AIG’s book value and earnings, the intrinsic value per share 9 years later would be in the range of $100. The break-even share price of $52.77 is approximately 48% below the estimated intrinsic value of $100, 9 years later. (Book value per share and EPS would increase to $76 and $6.75 respectively. At the break-even share price of $52.77, the P/B becomes 0.69x and P/E becomes 7.8x.) What is the probability that on 19 Jan 2021, AIG share price would fall below $52.77 or trading below P/B of 0.69x and P/E of 7.8x?

An awesome 9-year yield of 610% on the warrants! Now on the upside: With an estimated 9-years-later intrinsic value per share of $100, P/B and P/E would become 1.33x and 15x respectively. The main flaw in our argument is, of course, earnings and book value do not compound at a rate of 6% per annum moving forward. However, with a conservative ROE of 10% moving forward and a well-known fact that AIG retains the bulk of the earnings, my projected growth is absolutely conservative. Assuming our argument is not flawed, the warrants will yield an awesome 610%! (AIG common stock, meanwhile, only yield 245% though)

What if, on 19 Jan 2021, the price of AIG common stock is not 1.33x, but 3.00x of book value? With an estimated book value of $76 on 19 Jan 2021, the warrants would have a yield of 2255%!

Confessions of the authors: We have no idea why we have such a huge stake in BofA warrants. See http://valueground.blogspot.com/p/portfolio.html to understand why.

Monday 2 April 2012

BAC Warrants - Dividend Adjusted Strike Price

A reader of our blog posted the following:

“…I think you missed an important feature of the BAC warrants - they lower the exercise price for quarterly dividends in excess of a penny. This is huge…”

In our article, we have left out this portion as the prospective returns are already so high. But since it is mentioned, we shall explore this further.

A little background on the BAC Warrants A:
Unlike normal warrants, there is a clause in them that allows for any dividends paid that are above $0.01 to be subtracted from the strike price.

The table below shows the potential enhanced yield using conservative estimations on BAC’s PTPP and dividend payouts in the future.


Payout ratio
PTPP
Dividend
Adj Strike Price
Enhanced Yield
2011
2.04%
27000
 $0.04
 $13.30
0%
2012
1.84%
30000
 $0.04
 $13.30
0%
2013
10%
35000
 $0.25
 $13.09
5%
2014
15%
40000
 $0.44
 $12.69
14%
2015
20%
50000
 $0.73
 $12.00
29%
2016
26%
53000
 $1.02
 $11.02
51%
2017
26%
56180
 $1.08
 $9.98
74%
2018
26%
59551
 $1.15
 $8.88
99%
 

We have decided to use adjusted PTPP instead of net income as in recent years, provisions have gone up quite significantly. As discussed in the previous article, the normalized PTPP would be in the range of $50B. Historical dividend payout has been about 26.5% of PTPP.

As shown in the table, the dividend payout of $0.04 in 2011 is only about 2.04% of BAC’s adjusted PTPP of 27000. In our calculations, we have assumed BAC’s historical dividend payout of 26.5% would only be restored in year 2016. And for their normalized PTPP of $50B, it would only be reached in year 2015 with subsequent years of CAGR 6%.

Using these estimations, the strike price would be adjusted lower from $13.30 to $8.88 by the end of 2018. This would provide an enhance yield of almost 100%!

The best part of these warrants is that they are long-dated compared to many other warrants out in the market. This would give BAC plenty of time to start paying out higher dividends.

Enjoy playing with the numbers and you will be amazed by how much more the enhanced yield could be! 

Sunday 1 April 2012

Moving Towards Our Ideal Portfolio

What we meant by ideal portfolio would come as a shock to many who preaches diversification.
(Take a look at the changes in our portfolio composition till date and you will know why.)

We have been really busy paring down some of our minor stakes and using that to reinvest in our most compelling ideas. Though some of our minor stakes are still way below our valuation, the opportunities at hand, we believe, provides far greater upside.

Capital allocation is always about allocating resources to the best opportunities. Hence, we never understood the rationale of putting one's resources over a spread of ideas. For us, the concentration of great ideas is the key towards maximizing returns.