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Value Investing In Canada: The Good, The Bad & The Ugly

A specialty pharmaceuticals company based in Montréal, Québec, Knight Therapeutics stands out as a carbon copy of Jonathan Goodman’s first venture, Paladin Labs, listed at $1,50 a share in 1995 and sold to Endo nineteen years later for $151 a share.

As part of the deal, Knight was spun-off with the rights to distribute a drug for treating a rare parasitic infection. It then went on to raise $685 million – the latest round at a richer valuation than today’s stock price – and pocket $179 million in profits through several astute transactions.

The son of pharmacist turned successful entrepreneur Morris Goodman, Jonathan grew up reading prescriptions and trade press from breakfast to bedtime – and it shows, as the man lives and breathes the pharma business. When the time came to strike out on his own, he devised a business model in licensing niche or late-stage products for markets overlooked – because deemed too small – by pharma majors, such as Canada or Israel.

His unrevolutionary but field-tested playbook consists in identifying unaddressed needs in the attractive specialty pharmacy segment, searching for the right target to licence on the right terms NPV-wise, before sifting through the arcane approval and marketing process. In short, being rational, sweating the small stuff and grinding it out.

Simple in theory one might say, but in practice it seems that in the pharma business – and money management likewise – the basic act of working yields a competitive advantage by itself.

Knight also runs a portfolio of debt and equity securities related to pharma funds and companies. Beyond being – most likely –  sound investments, these deals satisfy a strategic purpose, as they offer a perfect leeway to secure profitable licensing rights out of the group of investees.

A straight shooter who suffers no fools, Goodman keeps demonstrating outstanding skills for capital allocation. His various sermons about patience, prudence, shunning leverage and waiting for the right valuations – ideally when an urgent seller unloads good assets in distress – read like value porn, and clearly flow through the way business is conducted at Knight.

You don’t have to swing at everything — you can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, “Swing, you bum!”.

Yet Warren Buffett’s famous quote rings large with current state of affairs. Investors have manifested fatigue over waiting for large acquisitions, and many bailed out. Goodman – as the main shareholder – said a myriad of times that he was running the company “for his grandchildren”, that he wasn’t keen on laying down cash in a sellers’ market, etc. but the point has proven unreceivable in a world feverishly oriented towards excitement and fast money.

As a consequence, the recent sell-off offers placid investors the opportunity to hop in alongside a phenomenal entrepreneur in a burgeoning business at roughly book value – or even slightly less once adjusted. Should the Paladin-like call option fail to happen, the fortress balance sheet – made of $979 million in cash, cash equivalents and securities, for only $13 million in liabilities –  provides a compelling margin of safety.

(Long GUD at an average price of CAD $7,90 a share.)

Enter the bad and the ugly in the same company: BlackBerry, whose management keeps bombarding investors and the press alike with a deluge of triumphant but groundless – if not outright misleading – communications.

Beyond the headlines, the dreadful reality is that turnaround in hardware failed, while monetization of patents persists elusive and push into software doesn’t return any profit. At $13 a share, adjusted for potential dilution and net cash position, the company trades for $6 billion. What do we get for that price? Let’s unroll a basic sum-of-the-parts to figure it out.

As the hardware revenue now comes close to nil – $62 million for the first nine months of 2017, versus $5 billion five years ago – we shall give no goodwill to the brand and count this segment for zero.

Meanwhile, the patent portfolio value is likely eroding at a fast clip. Excluding remarkable one-time wins such as the Qualcomm case, the segment has generated $127 million in revenue last year, and $138 million for the first nine months of 2017.

On a hopeful basis of $150 million in revenue per year and a profit margin of 50% – typical in the licensing business – we could assign a no less hopeful multiple of ten to this bottom line, and value the intellectual property segment at $750 million – admittedly not watchmaker’s work, but better being roughly right than precisely wrong.

(For the record, in late 2014 I valued the IP portfolio on a private market basis at roughly $2 billion).

BlackBerry’s mobile management solution is the leader of a sluggish $4 billion market – laboriously growing by 10 to 15% per year – in which nobody makes any money. Competition is intense and revenue per user tiny, so profit margins aren’t exactly what you’d expect them to be when you hear the magic word “software”.

However, the business may hold value for a larger player such as Microsoft or SAP, should the latter be determined to scale it up as part of a comprehensive service offering. Assigning a reasonable multiple of two times revenue – precisely what BlackBerry paid to acquire its former competitor Good Technologies, then in deep financial distress despite being the market leader – the mobile management business would be worth $700 million, more or less its reproduction value following the streak of acquisitions it took to build it up.

We’re still $4,5 billion short of current market valuation, and thus left to assume that QNX – allegedly the crown jewel among BlackBerry’s assets – has seen its value grow twenty-three-fold since its acquisition from Harman for $200 million in 2010.

Installed in 60 million vehicles, QNX generates $150 million in revenue per year – a stagnant performance since 2015. So we’re talking about a pitiful $2,5 per unit. Should we accept to drink management’s Kool-Aid and bet on the prospect that QNX is going to take over the buzzy “connected car” market, we might equally acknowledge that a growing, promising software venture can be valued between five and ten times revenue. So QNX would have to bring in $400 to $800 million to warrant its current valuation.

That won’t happen unless the base of installed vehicles or revenue per unit expand dramatically. Not to cut the ground from under dreamers’ feet, but if there’s money to be made in this market, BlackBerry won’t be alone in trying to seize the opportunity. Indeed, a formidable competition is already lining up – Google, Apple, Baidu, etc.

The company also owns a bunch of other miscellaneous assets – Messenger, Radar, Certicom, Paratek, a stake in NantWorks, etc. – but since none of these yields any profit, better to count them as a whole for zero. In that respect, according to the prudent hypotheses laid down above – workable at will – an investment at this price entails highly confident expectations about QNX’s prospects.

On a side note, extra caution should be exercised towards the uber-promotional communications released week in, week out. As my mentor used to say back in the days, with so much time being spent on TV, one has to wonder where John Chen still finds the time to run his company.

(No position.)

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