Cabot Early Opportunities Issue: August 16, 2023

Stocks in This Issue

Rising Yields Squash Summer Rally

Now that the Q2 earnings season has mostly wound down (we still have a few off-cycle companies set to report in September) investor focus has returned to the dreaded “macro.”

Translation: that means interest rate policy, U.S. economic indicators, recession risk, geopolitics and other big-picture stuff.

Ugh.

One of the big stories lately has been the mounting federal budget deficit. That seems about a universe away from something we care about as investors in growth stocks.

But the reality is that everything is connected in the market. And as the bond market gets concerned about the deficit, longer-dated bond yields tick higher (10-year yield has risen back to 4.2%) to close the gap with short-term yields (2-year yield is at 4.96%).

This is bad for higher-growth, higher-valuation stocks.

It’s also the opposite scenario of what we want, and what we have been expecting to happen as we look forward to the Fed’s historic interest rate hiking cycle coming to an end.

In our bullish scenario, we’ve been thinking no more hikes and a likelihood of cuts starting in 2024. That scenario would mean short-term rates will come down relatively quickly with longer-term rates also ticking lower.

That’s typically a great setup for growthier stocks!

As always there are a lot of inputs into interest rate trends. And we’re not going down that rabbit hole any further today.

But suffice it to say if we want to point the finger at one specific thing that’s curbed market performance in August, it is higher yields.

We may get a little clarity on where interest rates (and yields, so therefore growth stocks) will go next week.

Fed Chair Jerome Powell will be speaking at the 2023 Economic Policy Symposium in Jackson Hole, which runs next Wednesday and Thursday.

His speech, Structural Shifts in the Global Economy, is sure to touch on the progress the Fed has made curbing inflation so far and what Fed officials are thinking is appropriate in the months ahead. Including when the Fed could start cutting rates, what is a “restrictive rate” nowadays, and if the Fed is considering raising its target rate above 2%.

Yeah, it’s boring stuff for most people. But I’m looking forward to it.

I think it would be VERY surprising if Powell doesn’t make it clear the Fed expects to start cutting rates in early 2024.

What to Do Now

The bull market ran into a brick wall in the seasonally slow month of August, driving us to sell a couple of winners (RACE and LUNG) to lock in profits.

While we’re not going to get too aggressive on the sell side just yet, we’re also not going to get too aggressive on the buy side.

Today we add two full positions and one half, basically continuing with the balanced approach that’s worked relatively well for us so far this year.

STOCKS

Academy Sports (ASO) ★ Top Pick ★

Academy Sports & Outdoor (ASO) is a value-oriented sporting goods and outdoor recreation company, similar to Dick’s Sporting Goods (DKS). But Academy is more focused on the South, Southeast and Midwest.

The company has 270 stores across 18 states (over a third are in Texas) and is trying to open 13 to 15 new stores each year.

Academy’s stores offer a wide range of products represented by national and private label brands, including Nike, The North Face, Asics, Adidas, Under Armour, Wilson, Rawlings and Callaway.

By segment, outdoors and apparel categories generate 31% and 28% of sales, respectively, while sports & recreation generates 21% and footwear generates 20%.

The company was a zero-growth business for a few years then had a huge growth spurt during the pandemic, with sales growing 18% in 2021 and another 19% in 2022.

Then things cooled off over the last twelve months as consumers spent more on travel and experiences. In the twelve months ending in April 2023, Academy’s revenue shrank 5.3%.

That trend isn’t set to reverse just yet. In fact, when the company reports Q2 fiscal 2024 results on September 7, analysts expect that revenue will have shrunk by 6.1% to $1.58 billion and EPS will be down 12%, to $2.02.

But things are set to get better.

According to Bank of America analysts, credit card data implies resilient consumers have been spending on pool, patio, grilling and outdoor cooking items.

Academy is also launching new footwear and apparel brands and has moved to the same targeted marketing platform that Lululemon (LULU) uses, called Treasure. These initiatives could add to growth next year.

That potential is supported by analyst estimates that suggest revenues will be down just 2.3% this fiscal year then rebound to grow 6.4% in fiscal 2025, when EPS could be up 11%.

The Stock

ASO came public at 13 on October 2, 2020, and closed right near its IPO price. The stock then ran up to 50 by the end of November 2021, after which it corrected back into the low-30s by March 2022. ASO got back into a groove last summer and, though there were a few soft spots along the way, shares ran to a new all-time high near 68 in April of this year. A nasty correction followed – ASO was below 50 heading into June – but shares moved higher again into the summer months before topping out at 60 just a few weeks ago. With ASO recently dipping to 55 we can use this opportunity to jump in. BUY

AppLovin’ (APP)

AppLovin’ (APP) operates a software-based platform that’s used by mobile app developers to improve the marketing and monetization of the apps they build.

Advertisers pay fees to use this software and connect ad publishers to get high-performing ads placed on mobile apps. That part of the business is going well - Software Platform revenue rose by 28% to $406 million in Q2 2023.

AppLovin’ also has a portfolio of free mobile game apps. It generates revenue by selling in-app content (virtual goods and ad inventory) within its first-party apps). This part of the business isn’t so strong – App revenue shrank by 25% to $344 million in Q2.

All in, Q2 revenue was down 3.4%, which might not sound that encouraging. But when you look under the hood and think about where things could go there’s plenty to like.

Most importantly, AppLovin’s main product, AXON, is a machine learning (ML) engine that matches users with ad content based on first-party engagement and transactional data. AXON 1.0 was good, but the new and improved AXON 2.0 (just launched in the middle of Q2), appears to be phenomenal.

Management says AXON 2.0 is extremely good at delivering value. It boosted revenue per install by 38% in Q2 due to a greater mix of high-yield apps. Better still, management sees years of growth potential should AXON continue working, which means growing inventory and attracting more advertisers, including some from new market segments.

The other part of this emerging story is that AXON 2.0 is a very profitable product and should help grow profit margins on software revenue over time. This is part of why adjusted EPS was $0.22 in Q2 versus a loss of -$0.06 in the same quarter last year, even with revenue being 3% lower.

The bottom line is analysts now see company revenue in 2023 rising by around 8% to $3.03 billion while EPS jumps to $0.64, up nicely from a loss of -$0.52 last year.

Go out into 2024 and revenue is seen up 11% to $3.36 billion while EPS shoots 73% higher, to $1.11.

The Stock

APP came public at 80 in April 2021, was up and down for a few months then ran to 110 before the end of the year. That was the top. As the bear market hit, APP went down, down, down, eventually landing just below 10 in late-2022. While there have been a few pullbacks this year APP has posted impressive performance, especially after earnings releases (+26% after Q2 release on 8/10). Shares have walked rather steadily up to the 40 level. We’ll step in here with a half-sized position. BUY HALF

Dutch Bros (BROS)

Dutch Bros (BROS) is a rapid-growth, drive-through coffee chain focused on fun, fast and excellent service.

I’ve been watching to see if the business can turn around after a few lackluster quarters in 2022, and the Q2 2023 report from last Tuesday was good enough to earn BROS a spot on our Watch List today.

The backstory is that brothers Dane and Travis Boersma started the company as a pushcart in Oregon in 1992 when they got out of the family’s dairy business.

Dutch Bros opened its first franchise in 2000 and now has 754 company-owned and franchised stores (including 38 opened in Q2) across 14 states.

The biggest presence is still in the northwest and California, but Dutch Bros is expanding across Arizona, Utah, Colorado, Texas and as far east as Tennessee.

The heart of the business is espresso-based beverages. But the menu has expanded to over 9,000 combinations of unique, customizable cold and hot beverages including smoothies, lemonades, teas, sodas and more.

The company has been growing locations very quickly (150 units expected to open in 2023, 155 in 2024 and 170 in 2025).

This pace of growth comes with costs (building, staffing, and ingredient costs have all gone up) so ramping up volumes at new locations is critical, as is controlling costs.

Dutch Bros has been challenged on both fronts in recent quarters. Partly because it went in so hard in Texas and California, moving from 7 (TX) and 89 (CA) units in mid-2021 to 156 (TX) and 154 (CA) as of mid-2023. That’s a heck of a jump.

The bottom line is average unit volume has been around $1.7 million, which is a few hundred thousand lower than what investors expect. Store density likely has something to do with that as customers often have more than one Dutch Bros within striking distance.

New leadership in the form of incoming CEO (as of January 2024) Christine Barone (Starbucks, True Food Kitchen, Bain & Co.) and new CMO Tana Davila, combined with a more surgical approach to managing build costs, leases, new products, drink pricing and promotional strategy, appears to be drawing new money into the stock.

Second-quarter revenue grew 38% on the back of 3.8% same-store sales growth (versus 2% expected). Profitability was a bright spot, with EPS of $0.13 beating by $0.07.

Drink prices are going up 4% for a total increase of 6% this year (in line with industry averages). With labor costs leveling out and commodities costs easing there is considerable potential here for revenue and EPS growth to come in better than expected.

On that front, analysts are currently looking for revenue to grow 30% to $958 million this year and for EPS of $0.14 ($0.02 lower than last year). In 2024 revenue is seen up 26% to $1.2 billion and EPS is seen up 85% to $0.25.

The Stock

BROS came public at 23 in September 2021 and jumped 60% the first day. Shares traded as high as 81.4 a month and a half later. BROS then pulled back, stabilized, then plunged 65% over a couple days to an intra-day low of 20.5 after the Q1 2021 earnings report. The stock has been choppy since then with a few rallies that just haven’t sustained momentum. With the management shakeup and more scrutiny on operations, cost control and price increases, I think there’s a good chance this time is different. But we’ll give BROS some time on the Watch List to prove itself before taking a swing. WATCH

Freshworks (FRSH)

Freshworks (FRSH) is a software company specializing in customer service, IT and CRM solutions that help businesses improve customer relationships and employee satisfaction.

The company was started in India in 2010 and still has the majority of its employee base located there, despite moving its headquarters to California in 2018. The India-based workforce drives about a 75% cost advantage in R&D relative to competitors.

Freshworks’ main product is Freshdesk, an omnichannel customer support solution. Based on the success of Freshdesk the company launched Freshservice, an IT service management platform.

It also offers Freshsales for sales automation and Freshmarketer for marketing automation.

As you’d expect, the company is playing with AI and has developed AI tools branded under the name “Freddy.” Its latest AI offering ties together a few solutions that had a strong beta launch in June and piqued investor interest on the Q2 earnings call on August 1.

Those solutions include Freddy Self Service, Freddy Copilot and Freddy Insights. They build on generative AI upgrades that had already been shown to cut customer service agent time by up to 80%.

They’re now being packaged into a new Customer Service Suite, part of management’s strategy to raise prices as both new and renewing customers appear to be willing to pay a little more for generative AI capabilities.

That momentum was seen in Q2 when Freshworks beat expectations to deliver revenue of $145 million (+19.5%) and EPS of $0.07 (a $0.05 beat).

Looking forward, analysts are looking for revenue to grow 19% this year and another 22% in 2024. Moreover, Freshworks is now profitable. EPS should be around $0.20 this year and $0.26 in 2024.

All that said, there is upside potential as the new generative AI tools are just beginning to creep into forward estimates.

We’ll put FRSH on our Watch List today and consider adding it to the portfolio down the road.

The Stock

FRSH came public at 36 in September 2021 and after a strong start got caught up in the market’s correction. By mid-June of last year, the stock was trading around 12. After a quick dip to 10.5, FRSH seemed to stabilize and chopped sideways in the 11.5 to 18.6 range up until the Q2 earnings release on August 1. Shares shot 18.5% higher the next day and have held on to those gains since. With FRESH now back above 20, there’s a lot of room to run, but we’ll be a little conservative with the new name and just monitor for now. WATCH

Zillow Group (ZG)

Zillow Group (ZG) went on the Watch List last month. After the Q2 report showed progress with new products (touring, mortgage and listing showcase) and a realistic path to grow transaction share from 3% now to 6% by the end of 2025, the stock has earned a spot in our official portfolio.

Big picture, Zillow is still a way to play a potential uptick in home sales transactions in 2024 and beyond.

But it’s not just relying on a residential real estate market recovery to do the heavy lifting. The self-help story remains intact as Zillow’s various initiatives position the company to capture more of the market.

In addition to rental and mortgage lead generation web properties, Zillow owns the two most visited real estate web properties in the country, Zillow.com and Trulia.com.

These sites are hubs for potential buyers and renters to look at properties, make connections with agents and brokers, and get financing offers.

Zillow also has a slew of marketing and technology tools for the real estate industry and has been rolling out solutions to capture a greater share of the advertising dollars real estate agents spend online.

Through its various solutions, Zillow is trying to streamline transactions related to buying, selling, financing, and renting homes. It appears to be making progress, which means if transaction volume grows next year (when mortgage rates should start to fall) ZG could really take off.

In the second quarter (reported on August 2), Zillow beat on both the top and bottom lines, delivering revenue of $506 million ($33.4 million more than expected) and EPS of $0.39 ($0.20 more than expected).

Residential revenue fell 3% but did better than the broad market and beat analyst expectations while rental revenue grew by 28%, also beating expectations.

Putting the pieces together, analysts see revenue stabilizing after the company decided to get out of the home-buying market in 2021. Exiting that business means 2023 revenue will be down from last year.

But this streamlined business is set to grow revenue and EPS by 13% and 38%, respectively, in 2024. And that’s what investors that buy now are looking forward to.

The Stock

ZG came public in 2011 at (split adjusted) 6.2 and, like the housing market, is prone to big runs and good-sized pullbacks. Shares peaked at 51.4 in mid-2014, 65.4 in mid-2018 and 212.4 in early 2021. The 21-22 correction was as painful as they get. ZG suffered through a roughly 87% correction. Shares have acted much better this year. The stock broke above 40 in early January and has walked up into the low 50s since. BUY

Previously Recommended Stocks

On August 4 we sold Ferrari (RACE) and Pulmonx (LUNG) for gains of 7% and 21%, respectively.

Today we are trimming our Watch List to make room for new additions. We’re dropping Origin Materials (ORGN), Open Text (OTEX) and Shutterstock (SSTK).

An updated table of all stocks rated BUY, HOLD and WATCH as well as recent stocks SOLD, is included below.

Please note that stocks rated BUY are suitable for purchasing now. In all cases, and especially recent IPOs, I suggest averaging into every stock to spread out your cost basis.

For stocks rated BUY A HALF, you should average into a position size that’s roughly half the dollar value of your typical position. We may do this when stocks have little trading history (for instance, IPOs), when there is more uncertainty in the market or with a stock than normal, or if a stock has recently jumped higher.

Those rated HOLD are stocks that still look good and are recommended to be kept in a long-term oriented portfolio. Or they’ve pulled back a little and are under consideration for being dropped.

Stocks rated SOLD didn’t pan out, or the uptrend has run its course for the time being. They should be sold if you own them. SOLD stocks are listed in one monthly Issue, then they fall off the SOLD list.

Please use this list to keep up with my latest thinking, and don’t hesitate to email with any questions.

Active Positions

Recently Sold Positions

The next issue of Cabot Early Opportunities will be published on September 20, 2023.