Cabot Top Ten Trader Issue: April 17, 2023

Still Holding Steady

The story of the broad market is much the same as it has been in recent weeks. To wit, rotation continues across several industry groups while the major averages remain stuck in a lateral range. There’s no denying that range-bound markets can be dull, but they’re not without their attractions. In fact, sideways markets tend to be ideal for stock picking, as there are always strong stocks to be found in an otherwise neutral environment. Thankfully, there are still quite a few stocks to be found in this category, even as many names continue to be kicked around by economic headlines and earnings news. On the latter score, things should start to heat up as we head further into the earnings season, though we’re not advising any major change in stance just yet. We’ll leave our Market Monitor at a level 5 today.

This week’s list includes some standout names across a bunch of industries, with several of them displaying the type of relative strength we like to see in a choppy market environment. Our Top Pick is Duolingo (DUOL), an app-based foreign language learning platform whose offerings should lead to years of rapid growth both from new users and from converting current free users.

Stock 1

BWX Technologies (BWXT)

Why the Strength
After years of being shunned in the wake of high-profile nuclear reactor accidents, nuclear power has stepped back into the limelight as an alternate energy source as more nations look for ways to reduce carbon emissions. BWX is a leading supplier of nuclear components and fuel, as well as technical and site services, to the U.S. government (its primary customer). Aside from its defense industry exposure, the firm also provides services to support governments in the operation of complex nuclear facilities and environmental restoration activities, and it supplies precision manufactured components, services and heavy water (CANDU) fuel for the commercial nuclear power industry. Much of the company’s revenue comes from engineering nuclear reactors for U.S. naval submarines, and it operates in three segments: Government Operations, Nuclear Power and Nuclear Services. A recent string of big contract wins is the reason for the stock’s strength, as BWX was awarded a contract from GE Hitachi Nuclear Energy for its BWRX-300 small modular reactor pressure vessel in late March. Last week, BWX scored even bigger wins when it secured a $430 million contract to purify and convert highly enriched uranium from the National Nuclear Security Administration, plus a massive $45 billion contract from the U.S. Energy Department to design and operate waste-receiving facilities and treatment operations. For 2022, the company posted revenue of $1.8 billion that rose 5% from a year ago, led by the Government Operations unit, with per-share earnings of $3.13 that were in-line with expectations. For 2023, management guided for “strong growth” in EBIDTA, and it sees Government Operations sales increasing to the mid-to-high single-digits.

Technical Analysis
BWXT managed to avoid the slowdown that plagued most uranium/nuclear stocks last year, in no small part due to its defense industry exposure. The stock participated in the sector-wide correction last April, diving nearly 20% from a high of 57 before bottoming in early May at 46. Shares spent the next five months grinding higher before gaining enough strength to take flight last October, with a series of impressively higher peaks and lows being established since then. If you want in, we’re OK nibbling here or (preferably) on a pullback.

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Stock 2

Darden Restaurants (DRI)

Why the Strength
Darden is a leader in casual dining, best known for the Olive Garden and LongHorn Steakhouse brands that generated 70% of its nearly $10 billion in sales last year. The story for Darden is its excellent execution of late, as the company has shown high customer satisfaction scores that have helped it offset some recent softness in Americans dining out. The business is also being helped by the ease in the employment crunch, with the company saying it has the highest level of per-store managers at its 1,850 restaurants that it has ever had. Additionally, employment costs have been easing over recent months, which has helped the bottom line. Darden has some fine dining chains (including the seafood and steak-focused Eddie V’s) and some smaller chains that are showing good growth (such as Yard House and Cheddar’s Scratch Kitchen), but management is emphasizing a “back to basics” approach this year. That means Olive Garden will continue to be the focus, at least in the near term, and that’s not a bad thing: the Italian-themed chain outpaced company-wide, same-store growth in 2022, with a 12% gain (unchanged from 2021). New location openings, meanwhile, are also a closely watched barometer of growth, as management wants to open 55 new restaurants across its brands this year. It’s also aiming to continue pandemic-era momentum toward take-out and delivery orders, which made up 33% of Olive Garden’s sales on Valentine’s Day alone (one of its busiest days of the year). Off-premise sales like that are heavily digital, with 62% of orders coming online or from an app. On that score, Darden expects its propriety app will allow it to improve margins on digital by avoiding high fees from third parties. For 2023, analysts see respectable sales and earnings growth of around 9%.

Technical Analysis
DRI opened 2023 with a quick 10% rally before consolidating between 140 and 150. Shares edged out of that range with late March’s positive earnings call and look to have formed a new base at 150, with shares just hitting all-time highs. We think the latest dip should provide a nice entry point.

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Stock 3

Duolingo (DUOL) ★ Top Pick ★

Why the Strength
Want to learn a foreign language? More than 16 million people are using Duolingo to do just that, which represents a hefty rise of 62% for the business from a year ago. Duolingo is an app-based offering of free daily lessons in 43 languages, mostly for English speakers looking to improve their skills in another tongue, or for foreigners wanting to learn English. While lessons are free and don’t restrict users from continuing to advance (in exchange for ads on the app), the business mainly runs by getting enthusiasts to pay for an ad-free experience called Super Duolingo. The paid tier comes with other features to make lessons even easier, like the ability to review your mistakes. It saw 67% growth in 2022, to 4.2 million subscribers. In addition, users who are likely to become paying subscribers (namely once-daily users), as well as users of the app for seven days in a row, were up 27% and 54%, respectively, in Q4. Management says the second-language market is a $60 billion opportunity with lots of potential growth to build on last year’s $430 million revenue (up nearly 50% from a year ago), most of which came from subscriptions. Growth should also come from a move into providing formal language testing services, including for students who need to demonstrate proficiency, as well as using AI to power a new, higher-priced subscription tier, Duolingo Max. Management says revenue growth this year should look a lot like last year, and Wall Street expects the full-year top line to rise 34% to around $500 million. Duolingo isn’t profitable yet, but the per-share loss is expected to narrow considerably as the company improves its underlying margins, with analysts expecting positive earnings by 2025.

Technical Analysis
DUOL came public in July 2021 at 140 and rose to a peak price of 205 in September. Shares turned south from there, however, and continued falling until reaching 60 last May. Buyers came to the rescue from there, with a snap-back rally to the 200-day line at 110 following in early July. Another selling bout ensued in October, but this time DUOL established a higher low at year’s end, with the latest leg higher beginning around New Year’s. We’re OK taking a stab here or on dips of a couple of points.

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Stock 4

Freeport-McMoRan (FCX)

Why the Strength
A rebound in China’s manufacturing sector following last year’s lockdowns has surprised even the most optimistic forecasts, in turn pushing prices for key industrial metal copper to higher levels. Moreover, the acceleration of the energy transition in the U.S. and other countries is putting heavy demand on copper, which is used in electric vehicles (EVs), solar panels and other renewable energy infrastructure applications. This is where Freeport enters the picture. Aside from being a top 10 gold producer, the company is the world’s second-largest copper producer by output, with operations in several continents, and its earnings are highly leveraged to the red metal’s price, making it something of a copper pure play. Freeport posted sales volumes of over 4.2 billion recoverable pounds of the metal last year, a 10% improvement from 2021, as the transition to EVs (which use up to three times the amount of copper compared to traditional vehicles) kept demand buoyant. Freeport’s gold sales volumes, meanwhile, soared by an eye-opening 34% in 2022, and with the prices for both metals on the rise, the outlook for 2023 is looking especially sanguine, but copper is the key driver here. (Indeed, analysts estimate that copper demand will double by 2035, with one major Wall Street bank forecasting prices could rise by 22% this year, based largely on energy transition demand.) Going forward, the firm is expected to hold copper production steady at around 4.2 billion pounds over the next three years. Analysts expect modest revenue growth this year and a 5% sales bump in 2024, but this is likely to prove too conservative given that a.) global stockpiles of the metal are tight after just hitting an 18-year low, and b.) green energy demand is ramping up. Earnings are expected out on Friday (April 21).

Technical Analysis
FCX mostly traded in line with the copper price last year, hitting a high mark in late March at 52 and turning south from there before bottoming at 25 in mid-July. The stock spent three months etching out a base, from which a blast-off occurred in October. The rally lost steam in January at 47 and FCX ground its way down to the 40-week line last month, where it found strong support. Shares have since climbed their way back toward the January peak, and while the copper price will play a role in further recovery, we’re OK grabbing some shares on minor weakness.

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Stock 5

Ingredion (INGR)

Why the Strength
The demand for savory and exotic flavors in food and drink items is steadily increasing even as consumer tastes continue to evolve. (By one estimate, the global ingredients market is expected to increase 8% annually between now and 2027.) As its name implies, Ingredion is a key supplier in this space, with over 850 product-related patents and trademarks in the specialty ingredient category. Its offerings include sweeteners, starches, nutrition ingredients and biomaterials that are used by customers in everyday products from foods and beverages to paper and pharmaceuticals. A major growth area for the company is nutraceutical products, as consumers increasingly demand higher nutritional content in their food. To that end, the firm offers carotenoids, oil-soluble vitamins and nutraceutical oils and other fortification options, along with vitamin tableting and encapsulation. The Q4 report revealed solid demand across all of Ingredion’s segments, with total revenue of $2 billion jumping 13% from a year ago, led by strong demand for texturizing, sugar reduction and higher-value industrial applications. The bottom line was equally strong, with per-share earnings of $1.65 beating estimates by 20 cents, while the full-year EPS increased 12%. Texturizing agents (which increase food stability while improving texture) are another big focus for the company moving ahead, and it completed one-third of a planned $160 million, multi-year global capacity expansion for specialty starches to strengthen its leadership position in this category. For full-year 2023, Ingredion expects earnings of around $8.10 per share (up around 10% if realized and in line with Wall Street’s expectations for both 2023 and the next two years). The Q1 report is due out May 3.

Technical Analysis
INGR hit a high water mark at 146 in early 2018, then fell into the meat grinder for the next two years. It hit bottom at 60 around the time of the pandemic-led crash in March 2020, but this marked a major turning point. Although the stock spent most of 2021/2022 treading water between 75 and 100, the start of this year witnessed another character change as buying interest picked up in January, followed by an earnings-related pullback in March with the 40-week line coming to the rescue. A bit more weakness would be tempting.

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Stock 6

Motorola Solutions (MSI)

Why the Strength
You’re likely familiar with the name Motorola, once known for its mobile phone division that was spun off into Motorola Mobility in 2011. What you may not know is that its successor, Motorola Solutions, is a major provider of equipment and solutions for utilities, law enforcement, medical and emergency services and other industries. The company sells its products and software through three segments: Land Mobile Radio (LMRs, or handheld walkie-talkies), Command Center Software and Video Security and Analytics. The LMR segment caters mainly to public safety and medical service organizations, while the Command Center Software division offers cloud-based software that collects info from field reports, 911 calls, dispatchers and other sources, supplying useful data for police and first responders. The Video Security and Analytics platform, meanwhile, offers surveillance systems using artificial intelligence (AI) that provide assistance for police officers (including license plate recognition systems and body cameras)—all of which are in heavy use today. The firm’s focus on the public safety sector is a key growth driver, as there is steadily rising demand in this space, and it has the added benefit of being relatively recession-proof (as spending here is driven mainly by government budgets, not economic cycles). A key catalyst for the recent strength was a Q4 report which saw the firm achieve record sales of $2.7 billion (up 17% from a year ago) and EPS of $3.60 that rose a stunning 26%. Adding to the upbeat outlook for Motorola Solutions are record backlog levels from government contracts, which the company said positions it “exceptionally well” going forward. Wall Street sees the bottom line ramping up in the low-teens percent for the next few years, partly driven by increased public sector spending. Earnings are expected out May 4.

Technical Analysis
After a strong showing during the pandemic years, MSI hit a long-term apex at 274 at the end of 2021 and promptly entered the dog house at the start of last year. By the time its bear market was over last June, the stock had been cut by almost 30%. However, a character change occurred soon thereafter, with MSI returning to the old high by early December. Four months of tightening followed, with shares recently cranking out a series of new highs. We’re fine nibbling on dips.

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Stock 7

Omnicom Group (OMC)

Why the Strength
Omnicom is a marketing and corporate communications giant—it’s the world’s second-largest advertising provider—with an ownership stake in some of the biggest ad agencies. Its branded networks and specialty firms provide advertising, strategic media planning and buying, digital and interactive marketing, public relations and other specialty communications services to over 5,000 clients globally (but with a major focus on North America and Europe). A strong Q4 is a key reason for the strength, as the company capped off the quarter with one of its biggest client wins of the year in the form of cosmetics juggernaut L’Oréal, which named Omnicom its U.S. media agency of record. Omnicom’s healthcare-focused segment also ended Q4 with significant new client wins, including pharma giant Merck, while luxury fashion firm Burberry was also added. For 2022, Omnicom posted full-year organic sales that grew 10% from the prior year, led by 10% growth in the U.K., along with earnings per share that improved 14%. The firm generated $1.7 billion in free cash flow last year (relatively unchanged from 2021), and returned more than 65% to shareholders in dividends and share repurchases. Management said that liquidity and the balance sheet remain “very strong” and that Omnicom would continue to put cash to use in the form of acquisitions and shareholder returns going forward. Wall Street sees modest 5%-ish top- and bottom-line growth this year based on macroeconomic headwinds, but Omnicom sees “strong demand” for its services in 2023, with its recent client wins expected to contribute to the bottom line starting in April. A 3% dividend yield ties a nice bow on this package. Earnings are expected out Tuesday (April 18).

Technical Analysis
OMC traveled a rocky path in 2022, starting the year on a high note and gapping substantially higher on earnings last February before peaking at 90. Shares went on a toboggan ride after that, ending up at 62 in early July. This is when the buyers came back in, and after three months of backing and filling—including a re-test of the July low—OMC entered autumn in a much better position with the strength continuing into this year. Last month’s shakeout was short-lived, and the stock has been tightening around the all-time high at 95. We’re OK nibbling here, though you might want to wait for this week’s anticipated Q1 report before starting a position.

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Stock 8

Rambus (RMBS)

Why the Strength
The race to capitalize on advances in artificial intelligence (AI) around natural language processing, such as ChatGPT, means data center servers are being pushed to their limits. Rambus is a leading maker of memory chips and security hardware for processors that advance data center connectivity and solve the bottleneck between memory and processing. Rambus’ edge is that its architecture allows better CXL Memory Pooling (a term for resource sharing among processors and memory), allowing servers to combine resources to speed data transfer. Its CXL Memory Interconnect platform is an emerging hardware standard the company is emphasizing, along with industry-wide, next-generation memory chip architecture called DDR5, which is being widely adopted by chipmakers this year. Rambus is seen as taking market share from other chip makers thanks to its quick execution on rolling out its DDR5 offerings. A second arm of the business is in server security. With data centers being prime targets for hackers, Rambus focuses a lot of effort on programming security, like eliminating vulnerabilities to fault injection, when errors are purposefully introduced to software to crack open firewalls, and physical security, where cryptography and anti-tampering defenses are hardwired on processors. Its third arm of revenue generation is royalties from IP used by other chip makers. That all amounted to $570 million in 2022 sales—a jaw-dropping 155% improvement from a year ago—with chip growth powering results. With the uncertain economic outlook, management is cautious and projecting Q1 sales to come in around $129 million, which would still be a 30% gain over the comparable quarter. Earnings are due out May 1.

Technical Analysis
RMBS broke long-term resistance to set fresh all-time highs in March, which suggests the 46 area should be a floor here. Shares are extending a two-and-a-half-year run after exiting a trading range that held back any meaningful gains for a decade, and the move still looks to have legs. Recent consolidation around 50 offers a tempting entry point if you want to take a swing, though a minor pullback is preferred.

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Stock 9

Tractor Supply (TSCO)

Why the Strength
Tractor Supply fits a niche for rural shoppers—think a bit of hardware big box mixed with some pet care chain and a dash of strip mall clothing store. It also offers more unique products, like light farm equipment and gun safes. There are 2,066 Tractor Supply stores (plus another 81 being relabeled this year from a late-2022 acquisition of a smaller competitor) that are 15,500 square feet on average. The company has had positive sales growth every year since being founded 31 years ago. Analysts expect 2023 to be fairly typical with high-single-digit growth overall as same-store sales are forecast to gain around 4%, with two or three more points coming from new stores. The chain is moving toward becoming more of a lifestyle-type destination instead of a supply store for gentlemen farmers. Indeed, half its $14 billion sales last year came from pet supplies, veterinary services and livestock gear, and another 21% came from toys and seasonal gifts with tools, clothes (7%) and agricultural products (3%) rounding out the rest. The lifestyle focus is drawing in younger customers, especially Millennials, who management says are staying in rural areas longer than prior generations. To optimize stores, the company is doing a refit to provide more space to higher-margin products like pet supplies and power tools. (It’s also adding a 4,000-square-foot garden center to many locations.) About 15% of stores have a garden center now with expectations that three-quarters of locations will eventually get one. Tractor Supply plans to fill out the U.S. with another 650 stores over the next decade, with expansion to international markets an option. For 2023, recent supply chain efficiencies should keep costs roughly level to last year, leading to improving margins and a projected EPS of $10.51 (up 8% if realized). Earnings are due out April 27.

Technical Analysis
TSCO has been on a steady uptrend the past five years, with the most recent leg higher coming after a mid-2022 consolidation between 175 and 225. Strong Q4 earnings announced in late January gapped shares back up to a long-term high at 240. The stock has lately been tightening around this level, and if you’re game you can scoop up a few shares here or on dips.

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Stock 10

Visa (V)

Why the Strength
It may seem like digital payments are everywhere, but 85% of the $25 trillion spent annually around the globe is still conducted in cash. That provides a long growth runway for payment processors like Visa. Even in the U.S., most transactions under $10 are cash, a target area for the company to grow its presence. Best known as the payments processor for credit cards, Visa stands to benefit from transactions where a card isn’t present—think paying with a linked card through your phone—which can benefit small transactions. Card-not-present is an area Visa has higher market share than when a card is present. Plus, all those transactions provide Visa with another currency it aims to grow on, namely customer data. In fact, the ability to provide its enterprise clients with more data on their customers is a way for Visa to expand its presence in the payments operations at companies, which tend to use multiple banks and processors (depending on the function). Data insights also help to offer new services that play to consumers’ desire for less friction in buying things, capabilities like scheme tokens, which replace the need for a card number at all, and hosting loyalty points programs. Such value-added business is expected to account for around 20% of Visa’s anticipated $32 billion revenue for 2023. At the same time, the company still relies on traditional business drivers like travel, restaurants and shopping—all of which have exceeded pre-COVID levels in the U.S. and Europe. Elsewhere, Asia is still a rebound play for the company, given travel is still at just 90% of pre-pandemic levels in China. Barring a sharp change in economic activity, Visa should see net income rise 13% this year, to $8.49 a share. Earnings are due out April 25.

Technical Analysis
After a 15-month slump, V recaptured its 40-week line in November and has consistently held that long-term support—including a pullback last month that was stopped at it. Buying volume has been good in its recent leg higher, giving shares some momentum out of a range of congestion. A pullback should provide a decent opportunity to nab some shares.

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Previously Recommended Stocks

The next Cabot Top Ten Trader issue will be published on April 24, 2023.