Cabot Top Ten Trader Issue: April 3, 2023

Many Positives but Still Tricky

The market put on a constructive show last week, with most everything pushing higher—growth stocks led the way, but even the broad market perked up. Today was a bit sloppy, as the surprise OPEC supply cut hiked oil prices, brought some rotation ... and provided a reminder we’re still in a very news-driven environment. All in all the story remains mostly the same: There are positives, especially among growth titles, but the market is bifurcated and tricky, with a lot of stocks still in the doghouse. Don’t get us wrong, another week or two of upside could change things, but at this point, we think playing things mostly halfway (good amount of cash, some nibbling on strong names) is still the best stance. We’ll leave our Market Monitor at a level 5 tonight.

This week’s list is a bit more mixed than in recent weeks, with less growth and more cyclical and cheap situations. Our Top Pick is old friend Okta (OKTA), which isn’t growing as fast as the pandemic days but looks to have turned the corner (as have some other cybersecurity peers).

Stock 1

Apellis Pharmaceuticals (APLS)

Why the Strength
Geographic atrophy (GA) is an eye disease that damages the part of the retina responsible for clear vision and is a major cause of blindness in individuals over the age of 50, affecting over five million people globally. Biopharma firm Apellis, which is focused on developing novel gene therapies for rare diseases, just received FDA approval for a therapy that treats GA secondary to age-related macular degeneration (AMD). The new drug is called Syfovre and is actually a label extension of the company’s lead drug Empaveli (pegcetacoplan), which is also used to treat PNH—a rare disease that kills red blood cells (and which Apellis intends to establish as the first-line treatment for PNH patients). Under the new label, pegcetacoplan is used as an injection and represents a big opportunity for the company, given the growing demographic of potential GA patients. Wall Street thinks Syfovre could be a blockbuster, and several major institutions have raised their share price targets following the FDA’s approval; analysts see (currently tiny) sales ramping to $189 million this year and $500 million in 2024. Moreover, Apellis believes there are many other potential indications for pegcetacoplan, including cold agglutinin disease (CAD) and amyotrophic lateral sclerosis (ALS), and has other drugs in the pipeline. Most important of all, though, are the rumors that broke this weekend (just after we selected Apellis to be in Top Ten): The company is apparently garnering interest from many big pharma outfits, both in terms of a buyout or some sort of partnership/licensing deals—a sure sign the story here is for real.

Technical Analysis
APLS peaked back in the summer of 2021, returned to its highs last fall and then set up a more reasonable base-building effort, with the FDA approval causing a nice pop in February, and shares have traded calmly the past few weeks. The weekend rumors caused APLS to pop today, which represents a big breakout—of course, news-driven moves are tricky, but if you’re OK rolling the dice, we think a modest dip could provide an opportunity to nibble.

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Stock 2

Axcelis Technologies (ACLS)

Why the Strength
Chip stocks remain in favor and Axcelis Technologies continues to act like a fresh leader with equipment that appears perfectly suited (if not best in class) for the boom in power-hungry applications such as electric vehicles and advanced driver assist safety features, as well as things like AI, 5G and IoT. The firm’s ion implant offerings are in greater demand as chips become more complex (more implants per chip) and as power and efficiency demands increase; the firm calls itself the implant leader in high-growth specialty device market segments, with its Purion line of equipment perfectly suited for the current and coming boom in silicon carbide chips (SiC; key for EV use), the production of which should double every three years through at least 2027. Business has been very strong in recent years (see table), and while industry pressures are expected to cap growth over the next few quarters, (a) management still sees sales and earnings up in the high single digits this year, which is likely conservative, and more important (b) the top brass sees sales expanding by another 30% within two or three years, with free cash flow likely reaching $10 per share or so. There is a CEO transition going on, which is always something of a risk, but there’s little doubt Axcelis is in a great position to benefit from the power chip boom that’s just getting underway.

Technical Analysis
ACLS was really the first chip stock to break out during this run, doing so in early January after a tightening phase that put the finishing touches on a year-long consolidation. Shares stampeded higher into mid-February when some shaking and baking started—ACLS dipped wildly after Tesla made noise about not needing as many SiC chips, and there have been two more modest potholes since. The 10-week line held each time, though to be fair, the 135 area has been a tough nut to crack, too. Given the setup, we’ll set our buy range up from there, with a breakout likely ushering in the next run.

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Stock 3

Baidu (BIDU)

Why the Strength
The leading search engine in mainland China is benefitting from that country’s late emergence from pandemic restrictions – incidents of the disease peaked about a year ago, according to official data, two years later than in the U.S. Often called the “Google of China,” Baidu similarly benefits from the high-margin search engine ad market. With some 70% of market share in the country, ad spending on sectors such as travel, healthcare and e-commerce are likely just starting to reaccelerate, with Baidu probably on track to generate 134 billion renminbi (about $19.5 billion) in revenue and $9.56 net income per share this year. That represents only modest growth from last year, but expectations are that it’s the first step in what should be accelerating revenue and earnings ahead. There are also nascent hopes that the company’s own AI-chat bot answer to ChatGPT, called Ernie Bot, can extend its Internet stronghold in China. It’s a pricey effort, but Baidu’s size should enable it to make the large investment into AI technology that other competitors can’t meet. It’s all part of a broad effort from Baidu to invest in AI services, including AI-cloud services. Baidu is also increasingly moving into areas besides the browser, with a heavy emphasis on autonomous driving technology plus various software-driven services for business, including using AI to power industrial inspections and optimizing operations of China’s many coal-fired power plants. For the near term, though, Baidu is mainly a COVID reopening play. With ad sales contributing 79% of revenue, consumer activity remains core to its business – China’s reopening is in its young stages and early 2023 data shows fast growth in China’s smaller cities, where people are most anxious to get out and about.

Technical Analysis
BIDU has been volatile over the past two years, as reopening hopes and government clampdown fears swung shares from an all-time high of 355 in February 2021 to a 13-year low of 78 in November. The four-month rally after that was great, and the mid-March test of the 40-week line held, making the past few weeks look like a normal rest period. Like a lot of names, we’d keep it small here, and then consider adding on any decisive move to new recovery highs down the road.

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Stock 4

Builders FirstSource (BLDR)

Why the Strength
Builders FirstSource will never be a household name, but it’s a major cog in the homebuilding industry: Thanks to organic growth and many tuck-in acquisitions (14 of them since 2021, often to expand geographically and the breadth of its product line), the firm is the largest supplier of structural building products for residential construction, repair and remodeling. (About 70% of sales are linked to single-family construction, with multi-family making up 11% and repair/remodel 19%.) About a quarter of the firm’s sales are still commodity-based, but FirstSource has been building its (higher margin) value-added offerings (manufactured goods, windows, doors, millwork); along with cost cuts and efficiencies, that should decrease the ups and downs in business over time. That said, the story here is that (a) the housing market’s slide could be tamer than expected with mortgage rates likely having hit their highs, and (b) earnings, while expected to fall sharply, should remain elevated (about twice 2020’s total and three times 2019’s), which should keep cash flow healthy—which, in turn, should allow the firm to stay active on the M&A front (likely at cheaper valuations given industry conditions) and continue their active share buyback program (share count down about 20% last year vs 2021). To be fair, there’s plenty of variability here depending on housing starts and commodity prices, but the firm has a history of topping expectations, so the odds favor current estimates will prove light. Builders FirstSource is a housing-leveraged play but also has an M&A and share buyback angle to keep investors interested.

Technical Analysis
BLDR has generally followed the housing sector in the past year, topping in late 2021, sinking into May, enjoying a summer rally and then spending most of the rest of 2022 firming up. Shares lifted to multi-month highs soon after the calendar flipped, and while it’s been choppy since, BLDR has held its 10-week line despite the market’s shenanigans and has again ratcheted back toward its highs. We’ll set our buy range down a smidge, thinking a little more rest could be in order.

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Stock 5

Impinj (PI)

Why the Strength
Impinj has been slogging through the muck for a few months, but the stock is still near its high and the story seems as high potential as ever (albeit with some risks). The company is technically a chip firm, but in reality, growth is tied to the Internet of Things—Impinj has radio identification endpoint ICs (it dubs them RAIN) that cost just pennies each but can be attached to trillions of items and allow them to be tracked automatically; RAIN is battery-free, can work without a line of sight and can be read at rapid speed—all of which is perfectly suited to increase efficiencies/cut fraud in the retail arena, not to mention allow for better inventory and supply chain visibility. The company also offers scanners, gateways and authentication software, too; in total, with trillions of items shipped and sold globally each year, Impinj thinks it’s just scratching the surface of its potential having shipped 60 to 70 billion so far. The aforementioned risk is customer concentration—one big European retailer is a big customer indirectly, as a couple of OEM’s combined make up half of revenue. Thus, any snafu there could be very painful, but to this point, Impinj has actually been capacity-constrained (endpoint IC demand has outpaced supply in a huge way for many quarters in a row) and management is forecasting another big year of growth in 2023; Wall Street sees sales up 39% and earnings up more than 60% this year, with 20% to 30% growth likely in 2024. If the top brass is successful in landing a couple big clients, the upside could be huge.

Technical Analysis
PI went down the chute in the first half of 2022 with everything else but returned to its highs by August and, after a two-month dip, soared to virgin turf in October. The action since then hasn’t been bad, but it’s been very choppy—shares were up and down for another couple of months, and after moving higher in January, gyrated between 120 and 140 (ballpark) in February and March. You could just wait for a decisive move above 143 or so, but we’re also OK starting small here with a stop under 120, and adding more on any breakout that comes.

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Stock 6

Jabil (JBL)

Why the Strength
Contract manufacturing, where companies outsource the making of products or components, is in high demand, particularly in electronics. That space alone is expected to see 10% annual growth through the end of the decade thanks to increased adoption of contract production in areas such as semiconductors, automotive, cloud computing and renewable energy. Jabil (covered in the January 17 report) is one of the world’s largest suppliers of electronic manufacturing services, including electronics design engineering, packaging and consulting services for clients across several major industries (including the ones just mentioned). Strength in higher-margin businesses like renewable energy generation and healthcare, plus the electric vehicle (EV) transition, drove an 8% top-line increase in fiscal Q2 (ending February 28), to just over $8 billion. Earnings of $1.88, meanwhile, beat estimates by three cents and free cash flow of $112 million showed drastic improvement from last year’s fiscal Q2, putting the company on track to reach its goal of exceeding $900 million in cash flow for the fiscal year ending in August (well above $6.50 per share) while increasing margins. The company noted that the inventory problems that plagued 2022 are abating and said long-term trends like onshoring (to allow manufacturing to be closer to customers) and EVs, 5G and cloud will drive “solid year-over-year growth.” Management believes automotive revenue will jump 42% in 2023 and said the outlook for the renewable energy infrastructure business has improved notably since December, projecting double-digit sales growth from this area. Growth isn’t massive but should be reliable (high single digits) and the valuation is low (11x earnings).

Technical Analysis
JBL built a big consolidation last year, leading to the breakout and follow-though for the first few weeks of 2023. Then came the market’s bank-related dip, causing a huge shakeout in JBL—it knocked us out of our position with shares diving well below their 50-day line. But the buyers came right back, with the stock rebounding all way to new highs last week, We think the sellers are likely out; dips of a couple of points would be intriguing.

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Stock 7

Marathon Petroleum (MPC)

Why the Strength
After a boom year for travel in 2022, analysts are predicting demand will remain strong this year, with U.S. gasoline consumption expected to increase despite a soft economy. This is contributing to above-average gas and distillate prices, hence a big reason for Marathon Petroleum’s strength. The company is an integrated downstream energy company and operator of the nation’s largest refining system, with a capacity of nearly three million barrels per day and processing a variety of light and heavy crude (as well as transportation fuels, petrochemicals, propane and other natural gas liquids). The firm is enjoying a big boost from wide crack spreads—the price difference between a barrel of crude oil and the fuel products made from it—which showed in the Q4 results. Revenue of $40 billion was up 13% from a year ago, with per-share earnings of $6.65 beating estimates by a buck. All of that led to record cash flow levels, led by strength in the Refining and Marketing segment, which saw adjusted EBITDA soar 200% in Q4 (up nearly 450% for all of 2022!), driven by higher margins. (Marathon’s midstream business, meanwhile, grew 7% for the year.) The top brass emphasized that the demand for transportation fuels remains “robust” and said its bullish outlook for 2023 is supported by a sizable decrease in global refining capacity in the last couple of years. Management also expects capital spending will decrease this year, which should help keep cash flow elevated, and it remains committed to shareholder returns: The share count was down a ridiculous 23% in Q4 from a year ago, with $7.6 billion of buyback authorization still available. Earnings are expected to come down but remain at 2x to 3x pre-pandemic levels.

Technical Analysis
MPC has been in a long-term uptrend since the vaccine blastoff in November 2020, so it’s not in the first inning of its overall advance—nevertheless, the buyers remain in control, with dips (often sharp ones) being arrested in short order. In recent months, MPC fells sharply in early December but recovered, and now has basically moved straight sideways for the past nine weeks. We suggest targeting weakness if you want in.

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Stock 8

Okta (OKTA) ★ Top Pick ★

Why the Strength
Identity access management (IAM) vendor Okta is in the midst of a retooling to cut customer churn and restrain costs. Wall Street sees things are on the right track after two surprising quarters where growth remained solid and (in Q4) the bottom line leapt into the black, and with management projecting a profit for 2023 as a whole. Okta is a leader in IAM, a form of workplace security that benefits from the growth in remote and hybrid work situations, where network security can’t be as tightly controlled as when everyone showed up in the office. Okta’s cloud-based software verifies the user and the device used to access a business’ network in a less cumbersome manner than alternatives; like most software outfits, it uses a subscription business model, leading to solid recurring revenue. It’s a field with a lot of competitors, including giants like Microsoft and Oracle. But Okta has always been a leader and, while it has seen a good bit of turnover in its traditional small- and medium-sized customer base, it’s still managing to grow sales at a healthy clip – Q4 revenue was up 33% to $510 million. More encouragingly, the company has made good strides in growing larger customers (those that generate $100,000 or more annual revenue), seeing that group grow 29% to 3,930 clients. Much of Okta’s difficulties have come from digesting its $6.5 billion acquisition of Auth0 in 2022, a move that gave Okta more of the market but created trouble with cannibalizing customers and merging sales forces. Integration pains appear to be mostly behind it, though, which is creating space for the company to expand into adjacent services, such as privilege access management and identity governance. Sales are likely to grow in the 17% to 20% range going forward, but earnings and free cash flow are expected to kite higher.

Technical Analysis
The remote work boom of the pandemic drove OKTA to an all-time high of 290 two years ago, but cost concerns and the bear market ground shares down over time to 44 in October. Interestingly, there was no real bottom-building effort, with the stock’s positive reaction to earnings last December kicking off a steady uptrend—bolstered by yet another earnings surge five weeks ago. The tight trading since then is constructive; we’re OK buying some here or (preferably) on dips.

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Stock 9

Onsemi (ON)

Why the Strength
A continued push toward electric vehicles (EVs) and clean energy systems is an enormous growth catalyst for companies that supply the semiconductors needed to power them. Onsemi is a leader in this space, with a focus on intelligent power and sensing technologies for the automotive and industrial end markets. The silicon carbide (SiC) chips that Onsemi manufactures (and which can operate at higher voltages and temperatures than traditional silicon-based chips) are in high demand right now since they’re used to power sustainable energy grids, industrial automation, EVs, 5G and cloud infrastructure. Last month, the company announced a partnership with BMW for Onsemi’s EliteSiC technology in the car maker’s electric drivetrains for a 400V DC Bus. Onsemi’s technology is also supporting the rapidly increasing demand for BMW’s premium EVs, and the firm also just announced an ultra-low power, automotive-grade microcontroller for wireless applications to be used by many vehicle manufacturers, who are increasingly favoring wireless connectivity to reduce the cost and weight of excess cabling. To be fair, other parts of the business (mostly consumer-related) aren’t doing as hot, and the firm is still on a path to exit many lower-margin segments that will crimp margins this year. But that will be a good thing over time, with a focus on ramping SiC production to support long-term supply agreements, which is what big inventors are focused on—Q4 was marked by record automotive revenue that grew a whopping 54%, in turn contributing to record 2022 sales of over $8 billion (up 24%). This year will be a transition, but the valuation is reasonable (15x trailing earnings) and growth should resume later this year and should carry on for a long time.

Technical Analysis
ON had a tough correction into July of last year, but it quickly ramped to all-time highs in the summer, and while the going has been very choppy since then because of the market, shares have etched higher highs and lows over time. And now we see some tightness (four tight weekly closes) followed by some good-volume accumulation last week. We’re OK with a nibble here and averaging up if ON pushes above 87 or so.

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Stock 10

Quanta Services (PWR)

Why the Strength
The ongoing transition from fossil fuels to more environmentally friendly energy solutions will require a massive upgrade to electricity grids, providing a huge opportunity to companies that deal with that sector’s infrastructure. Quanta is a major player in this space and provides end-to-end solutions in the electric power sector, building generating stations and substations, as well as transmission lines for pipeline, industrial and telecom customers. Through its ownership of Blattner Holdings, it also offers utility-scale renewable energy infrastructure solutions, giving Quanta major exposure to the energy transition. A solid fourth quarter and a record-setting 2022 across several key metrics is the reason for the stock’s strength: Revenue was $4.4 billion in Q4, a 13% increase from a year ago, and full-year sales of $17 billion rose 30%, while Q4 per-share earnings of $1.68 topped estimates by seven cents. Leading the charge was the company’s electric power infrastructure solutions segment, which increased market share while seeing sales rise more than 50% in both Q4 and 2022. Underground utility solutions increased 25% in Q4 and 2022, and renewable energy solutions improved 22% in both periods. Free cash flow increased over 200% for 2022, and Quanta finished the year with a record backlog of $24 billion—which the firm expects to significantly increase in 2023 as renewable energy orders pour in. Going forward, management guided for 2023 revenue to come in around $19 billion at the top end of the range, up 12% if realized, and believes the tailwinds driving sales are very durable and can create multiyear earnings growth potential (with a rough target of doubling earnings from 2022 to 2026). Wall Street sees mid-teens bottom-line growth for the next few years.

Technical Analysis
PWR isn’t going to knock your socks off with the speed of its advance, but shares have performed very well during the past few years—the post-vaccine rally in late 2020 and most of 2021 was outstanding, but even during last year’s bear, the stock made progress, albeit with plenty of pullbacks and rest periods along the way. More recently, PWR popped to new highs in mid-February, held its 10-week line during the market’s bank drop and nosed to new closing highs last week. Dips would be tempting.

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Previously Recommended Stocks

The next Cabot Top Ten Trader issue will be published on April 10, 2023.