"Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks," according to Warren Buffett.
Translation: Value investors do not like to invest in companies that operate in an industry in which they are in a competitive disadvantage. This is because such companies will never be able to generate high enough operating margins and cash flows to pay for labour, materials and capital and as a result will earn a return on invested capital that will be less than the cost of raising funds. They will destroy value rather than create value for the shareholders. The rational thing for such companies to do is to either exit the industry or shrink and become a niche player.
Two Canadian companies currently facing this dilemma, but following different routes, are BlackBerry Ltd. and Bombardier Inc.
BlackBerry invented the smartphone. It was a Canadian darling and one of the few Canadian companies with global appeal and following. When it ran into competitive troubles, however, it never asked for a government bailout. The bailout, so to speak, and related risks, were shouldered by private investors, particularly Fairfax Financial Holdings Ltd. They lent funds to the company in the form of convertible debentures – adding a lot of leverage to the company that, appropriately, had none before. That was a smart, but risky, move, if you come to think of it. Fairfax owns about 9 per cent of BlackBerry and if one adds its investment in convertibles bonds (assuming conversion), the potential ownership rises to about 15 per cent.
Next, BlackBerry shrank and has become a niche player. It unloaded the unprofitable handset manufacturing to Foxconn. It is now focusing on selling software and services to government and businesses for which security is of paramount importance – and area of strength for BlackBerry. It took a multibillion-dollar writedown of inventory and other assets, reducing significantly its excess capacity that was dragging down its asset turnover and return on invested capital. While BlackBerry is not out of the woods yet, this strategy seems to have started to pay off with growth in the most recent quarter beating analysts' projections.
Switch over to Bombardier now. The Bombardier/Beaudoin families own about 13 per cent of the company's shares – (even though they hold about 54 per cent of the voting power). In other words, the two families own about the same economic interest in Bombardier as Fairfax potentially owns in BlackBerry. But the approaches these investors have followed are diagrammatically opposite.
Bombardier, similar to BlackBerry's plight, has been in an industry in which they are in a competitive disadvantage. Bombardier cannot compete with the likes of Boeing, Airbus or even Embraer and is a much riskier company given the inappropriately high leverage the company has versus its key competitors. According to S&P Capital IQ, Bombardier's 2015 return on capital is 3.3 per cent versus an average 13.7 per cent for its key competitors. Its operating margin – a key measure of a company's competitive stance – is 1.8 per cent versus 11.4 per cent; and its cash-flow-to-sales ratio 0.1 per cent versus 10.7 per cent. Historical averages show similar patterns reinforcing Bombardier's competitive disadvantage compared with its key competitors.
Finally, its debt-to-capital ratio is 181 per cent versus 53 per cent for Boeing, 40 per cent for Airbus and 45 per cent for Embraer. However, unlike BlackBerry, Bombardier is asking the government for a handout. The company has asked the Quebec government for over $1-billion in aid. And this is not the first time. The most recent request is Bombardier's 51st request for government assistance since 1966. Rather than investors being on the hook, it is the Canadian taxpayer who will be.
Bombardier is not an attractive company for value investors. It operates in an industry in which other companies have a competitive advantage and so being in the industry will destroy value for its shareholders. Moreover, it has too much debt for a company in this industry, which increases the company's financial risk and the probability of bankruptcy; it has a complex corporate structure and a dual-class share structure; and it has management and corporate governance of questionable value.
Throwing good money after bad will not solve Bombardier's problem. The Canadian governments at various levels seem to either not know this or chose to ignore it at taxpayers' expense. This is a classic case of politics trumping economic rationale and reality.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.