Cabot Top Ten Trader Issue: August 21, 2023

Cautious but Flexible

From its July high to last Friday’s low, the Nasdaq pulled back almost nearly 9%, which is generally in line with some other “first corrections” in bull moves we’ve seen in the past, and the bounce since then is a good first step, especially considering some of the longer-term positives that remain in place. That said, there’s still much more to prove here: At this point, all of the major indexes we track are below their 50-day lines, leadership-type stocks have been hit hard and interest rates remain an issue (and, with a huge Fed speech at Jackson Hole on Friday, will be a focus this week). All in all, we’re open to anything, but we think a cautious stance remains your bet bet for now; ideally the market begins to get back in gear right quick, but we need to see more than a couple of up days to conclude that. We’ll pull our Market Monitor down to a level 5 while remaining flexible for whatever comes.

This week’s list is a mixed bag, with something for everyone. Our Top Pick is Arista Networks (ANET), which, after many starts and stops this year, appears as though it’s finally changing character, holding near new highs following a great Q2 report and outlook.

Stock 1

Alpha Metallurgical (AMR)

Why the Strength
While many Western countries pull back on coal consumption, demand for coal for industrial applications is on the rise in many Asian economies; indeed, China, India and Southeast Asian countries together are projected to account for a whopping 75% of coal consumed globally this year. Alpha Metallurgical is America’s largest producer and exporter of metallurgical, or “met,” coal used in steel production, with 22 underground and surface mining operations across Virginia and West Virginia. (The firm accounts for some 20% of total U.S. met coal production.) Production-related setbacks at two of Alpha’s key mines contributed to weaker-than-anticipated results in Q2; revenue of $858 million beat estimates but was 36% lower than a year ago, earnings of $12.16 a share missed estimates by 53 cents and adjusted EBITDA was 25% lower from the prior quarter. However, there were some positives in the Q2 report, including cash from operating activities that increased 80% sequentially and the announcement that production setbacks have been addressed with both of the problem mines now running at full operating capacity. And that should lead to a gusher of cash flow, as all of Alpha’s met coal tonnage is fully committed for the rest of this year, with over 70% locked in at good prices, while almost 30% of 2023 met tonnage is committed but not yet priced, and its thermal coal output is 100% committed and priced, too. Going forward, the top brass expects production this year to increase 9% above the average annual output of recent years, thanks to higher overseas demand—including war-related steel production. Add it up and, while likely coming back to Earth, Alpha’s earnings should remain elevated for a long time to come, and a lot of that is being returned to shareholders, with the share count down 10.3% in the first six months of the year.

Technical Analysis
AMR rode the wave of booming global energy prices during 2021-22 before running out of steam in June last year after hitting 180. But despite a sharp dip to 105 a month later, the stock quickly found its legs and climbed off the floor for the next several months, setting many higher lows and testing the 180 level a couple of times, too. After one more dip into May, AMR turned the corner, with a persistent advance to all-time highs. If you’re game, a bit more weakness should be buyable.

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Stock 2

AppLovin (APP)

Why the Strength
AppLovin specializes in identifying users online that mobile marketers want to target. The business had long succeeded at churning out free mobile games that attracted specific groups of players, effectively providing the business with ad inventory it sold to marketers. That approach was threatened by Apple’s move two years ago to restrict the ability of companies to track user activity, which makes it harder for AppLovin to know the profile of its users. In response, AppLovin threw its resources into upgrading its ad optimizing program, Axon, into an AI-powered 2.0 version, which uses machine learning to figure out quickly what tweaks in a marketing partner’s ads help attract the type of user they’re looking for. The move appears to be paying off much faster than expected. In the latest quarter, announced two weeks ago, Axon 2.0 was rolled out and it, and related software products, contributed $406 million of Applovin’s $750 million in sales. That blew past analyst expectations, reflecting mid-teens growth in the software side of Applovin’s business from the prior quarter and 28% growth over the prior-year period. The emphasis on ad targeting software is allowing AppLovin to shutter less effective free games without cratering revenue (hence the 3% overall sales dip last quarter), and the flip of the business to focus on AI software also means that AppLovin’s margins look like they will improve markedly. Last quarter, the Axon software side of the business generated EBITDA of $273 million, more than 80% of AppLovin’s total EBITDA, with a much higher margin than the games side. For the current quarter, management expects revenue to total $780 to $800 million with a total adjusted EBITDA margin of a whopping 40% to 45%. It’s an interesting turnaround-type story.

Technical Analysis
APP had a brutal 2022, closing out the year down nearly 90% on a combination of bearishness over the impact of privacy restrictions and a broad advertising slump. This year has been a strong reversal of much of those losses, with APP bursting above its 40-week line in May and riding its 10-week line higher. The earnings gap two weeks ago was a giant one, and so far APP is holding those gains. We think a normal exhale here could provide an opportunity for a small position.

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Stock 3

Arista Networks (ANET) ★ Top Pick ★

Why the Strength
Arista Networks supplies the infrastructure that makes the Internet go – switches, routers, cloud storage, relays and the like, especially high-speed gear used by the so-called Cloud Titans – Microsoft, Meta and similar behemoths that generate half of Arista yearly sales. That represents some customer concentration risk, but in recent years, that concentration has played to Arista’s benefit. The group had doubled its spending in 2022, leading to expectations that 2023 would see a sharp slowdown in Titan expenditures, and that appeared to be the case in the first quarter, when, though Arista still beat expectations, the firm’s outlook hit shares. But the swift emergence of generative AI helped to produce unexpectedly strong revenue in Q2 of $1.46 billion, up 39% from a year ago, and EPS of $1.58 (14 cents above expectations) as the Cloud Titans rushed to spend money to boost their networks for the massive amounts of data AI needs to consume. And this wasn’t a one-time thing, with current projections showing that 2023 could see 30% growth in spending by Arista’s largest customers, a significant bump over previous guidance. All this comes as the pandemic-related crunch in the availability of components is still something of an issue, but even as long lead times for parts still linger, this year promises to end up very strong—management expects total revenue to be $5.47 billion, which would be a 25% gain, while Wall Street consensus projects $6.17 a share of earnings, up 35%. To be fair, analysts see earnings up just 10% next year after two huge upticks in 2022-2023, but that could prove conservative as the real sales gains from AI-optimized networks (which Arista is testing with clients today) kicks in later in 2024.

Technical Analysis
ANET has been volatile this year as investors try to gauge the sales path ahead: Shares were whacked after Q1 earnings, then rallied strongly when AI stocks went nuts, only to chop lower through July, underperforming the market. But now the character may have finally changed—not only did ANET gap up strongly after its Q2 report, but the stock has held firm during the Nasdaq’s recent correction. We’re OK with a small buy here or on modest dips and a stop under the 50-day line.

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Stock 4

Baker Hughes (BKR)

Why the Strength
Oilfield players are one of the market’s strongest-performing segments right now as oil prices have started to percolate after a year of down action. Baker Hughes is one of the world’s largest providers of service and equipment for onshore and offshore oilfield operations across the lifecycle of a well, with product offerings in a few major segments: Well Construction, Completions, Intervention, and Measurements, Production Solutions and Subsea & Surface Pressure Systems. Additionally, the company’s Industrial & Energy Technology (IET) segment combines an array of technologies and services for industrial and energy customers. Although domestic onshore drilling activity has been tepid, international and offshore activity has been particularly strong of late. This has benefited Baker since around 70% of its oilfield services and equipment business is international, with about 40% exposed to offshore. Beyond that, Baker Hughes is a key supplier of gas turbines and related equipment, which play into the natural gas and liquified natural gas (LNG) booms. In the most recent quarter, the company reported $1.6 billion in gas tech equipment orders, driven by around $900 million of LNG-related awards, underscoring the size of the opportunity in this space. In Q2, the company grew total revenue by 25% to $6.3 billion and reported EPS of 39 cents that beat estimates by six cents. Management maintained a “constructive outlook” for global upstream spending for the rest of 2023 and raised estimates for overall IET orders by 9%, expecting new energy order momentum to remain strong into 2024. Wall Street sees bottom-line growth of 68% this year and 32% next; a 2.3% dividend yield is an added plus.

Technical Analysis
BKR hit a snag around 40 last March, then turtled to 20 within six months. The initial rally from last September’s low hit resistance at 32 in November, with a tedious multi-month consolidation setting the stage for a climb back toward the old high. More recently, we’re impressed with the very tight action despite the market’s wobbles, a sign that the stock is likely under accumulation. We’re fine starting small here with a tight-ish stop.

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Stock 5

BridgeBio Pharma (BBIO)

Why the Strength
BridgeBio is focused on finding treatments for patients who suffer from Mendelian diseases (which arise from defects in a single gene). The story revolves around the firm’s lead drug candidate, dubbed acoramidis, which treats the rare chronic disease transthyretin amyloid cardiomyopathy (ATTR-CM), a contributor to heart failure. Positive results from a Phase III trial for ATTR-CM were recently released that showed a “highly statistically significant” relative risk reduction of 50% for the frequency of cardiovascular-related hospitalizations (the reason for the stock’s strength), and the company plans to file for U.S. regulatory approval by the end of this year. ATTR-CM is thought to afflict over 150,000 patients in the U.S. alone, and the global market is estimated to grow to $20 billion by the end of the decade, so the opportunities here are immense. The company also just presented results from a Phase II trial of the cancer drug infigratinib in children with achondroplasia (a contributor to dwarfism), demonstrating potentially best-in-class efficacy and a well-tolerated safety profile, while results for a late-stage trial for the treatment of a rare form of hypoparathyroidism are due in the first half of next year. Although the company is basically in the development stage, it enjoys a substantial cash position to fund operations, and the approval of acoramidis is expected to offer huge sales opportunities while catering to a “significant” patient population with limited treatment options. As a result, a major investment bank recently named BridgeBio as one of its top healthcare picks for the second half of 2023. Analysts see the top line reaching $104 million next year, but that’s basically a wild guess—long term, the potential is big.

Technical Analysis
BBIO crashed and burned in late 2021 and early 2022, bottoming at 5 in May and still hanging around the 7 area near year-end. The stock rallied powerfully early this year, rising as high as 20 in March before building a proper launching pad into last month. Then came the trial results, which sent BBIO soaring, and while the stock has sagged over the past three weeks with the market, it doesn’t look out of character. It’s aggressive, but we’re OK with a small position here and a loose stop.

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Stock 6

Civitas Resources (CIVI)

Why the Strength
Civitas was one of the small/mid-cap winners of the prior boom in oil explorers, with some of the industry’s best economics, cash flow margins and shareholder return plans. The only problem was the scope of its operation: Civitas focused solely on the Denver-Julesberg field in Colorado, which presented some execution risk (getting wells approved) and, more important, capped the firm’s overall potential (“only” 500 wells left that had solid returns at $70 oil). But that’s now changed: Civitas made a bold move in the spring to buy 68,000 acres in the Delaware and Midland Basins for $4.7 billion that will boost the firm’s production by 60%! That led to a slug of new debt ($2.7 billion worth, though the firm had no net debt before this and plans to sell $300 million of non-core assets within the next year) and issuing some stock—and more importantly, management believes that, at $70 oil and $3.50 gas, free cash flow per share will rise 35% in 2024 while dividends would lift 20% from where they would have been. At first the market was unsure about it, but as time has passed, as oil prices have perked up and as Civitas has continued to execute (even with lower commodity prices, free cash flow was $189 million in Q2, or $2.33 per share—leading to a quarterly dividend of $1.74 per share), the market is warming up the fact that Civitas will be cranking out solid cash flow for a long time to come, all while quickly paying down debt to a reasonable level. It’s not as well known as the bigger players, but 590 funds are on board and the big acquisition should attract a bunch more.

Technical Analysis
CIVI followed the path of many peers, with a big run into the middle of last year and a big slip after that, but the stock never really was in a true downtrend, with higher lows over the following few months. The April-through-June consolidation was nice and tight, and while there has been volatility, CIVI has moved out to new (dividend-adjusted) high ground and is up six weeks in a row. If you’re game, aim for dips of a couple of points.

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Stock 7

Fastly (FSLY)

Why the Strength
Cloud stocks aren’t the hot performers they were a couple of years ago, but edge-cloud platform leader Fastly (covered in the July 17 issue) is starting to regain some of its lost luster. The company continues to execute well on its initiatives to simplify its go-to-market strategy, while increasing innovation and streamlining costs throughout its business. This was made apparent when Fastly revealed that in Q2, customers spent an eye-popping 23% more for its offerings than they did a year ago. Additionally, the firm boasted a best-in-class trailing 12-month customer net retention rate (basically a same-store sales metric) of 116% while adding 11 new high-spending enterprise customers—nine of which were major retailers—with these clients spending 3% more than the prior quarter. These metrics contributed to solid Q2 revenue growth of 20%, to $123 million (up 4% sequentially). And while the firm reported an earnings loss of four cents a share, it beat its own guidance and topped estimates by 6 cents, while adjusted EBITDA turned positive in the quarter (all reasons for the stock’s latest strength). The upbeat results garnered praise from Wall Street, with several major institutions raising target prices and with one institution asserting that Fastly is “well positioned to gain share in content delivery.” The top brass said the growth was made possible by Fastly’s platform expansion, which allowed the firm to cross-sell more functionality and traffic to existing customers, prompting it to raise the 2023 revenue outlook by $10 million (to around $500 million) while reiterating previous earnings guidance for a full-year loss of around 24 cents a share—a big improvement from last year’s 60-cent EPS loss. Analysts expect 20%-ish sales growth in the next few years and see positive EPS by the end of 2024 with EBITDA improving, too.

Technical Analysis
FSLY has held its own since our last write-up over a month ago, basically breaking even in the last five weeks, which is impressive during the tech stock decline. Just as important is that the stock has acted how it “should,” respecting key support near the 50-day line, reacting very well to earnings (not many in its space have) and pulling back normally in recent days to the 25-day line. As we did once before, we’re going to set our buy range up a bit, thinking a strong upmove could kick off a solid run.

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Stock 8

New Oriental Education (EDU)

Why the Strength
New Oriental is the top provider of private educational services in China and offers a wide range of programs, services and products, including language training, overseas and domestic test preparation courses, as well as online education. Its network includes 85 dedicated schools, nearly 750 learning centers and a nationwide network of online and offline bookstores through nearly 200 third-party distributors. The company garnered attention back in April when the bottom line leapt into the black thanks to a “favorable environment of recovery” as China’s pandemic-era lockdowns subsided. Interest faded a bit after that, but the stock is back on Wall Street’s radar after a stellar fiscal Q4 (ending in May) earnings report which saw revenue of $861 million soar 64% year-on-year and earnings of 37 cents a share (up from a loss a year ago) thanks to continued “strong post-COVID recovery of demand” and better-than-expected margins. Interestingly, the company is expanding its strategic focus, recently setting up an e-commerce platform to explore opportunities in China’s booming “live streaming plus travel,” which involves from-home virtual tourism that encourages customers to book actual travel plans or purchase products related to the destination. (The platform also serves to offer top-quality agriculture products under a private label, as well as to promote “cultural tourism.”) That’s a bit out there, but the core is still New Oriental’s educational offerings, where it’s also launched several new initiatives, including non-academic tutoring courses across 60 Chinese cities focused on cultivating students’ innovative and comprehending abilities. Going forward, the company said it plans to integrate artificial intelligence (AI) in its new educational and product offerings. Wall Street sees a solid earnings upturn over the next couple of years.

Technical Analysis
From a high near 200 (!), EDU crashed to the 8 to 10 range last spring and then spent the next many months jaggedly working its way back to 47 in January. Like many names, the stock then went on to build a proper structure, with EDU chopping sideways as the 40-week line caught up. Shares kicked into gear last month with a powerful move to new recovery highs, and the recent retreat has been orderly and come on tame volume. We’re fine with a small stake around here and a stop near the 50-day line.

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Stock 9

Tradeweb Markets (TW)

Why the Strength
Tradeweb is a small, growing, behind-the-scenes player in financial markets all around the world. The firm was founded in 1996 to build and operate electronic marketplaces and currently has operations in 65 countries and transacts more than $1.2 trillion of instruments annually; it plays all sides (dealers trading with clients, dealers trading with dealers, and even financial advisors trading with retail clients) among a variety of asset classes (rates, credit, equities and money market funds). Growth has been solid over the years across all segments, though the biggest pieces of the pie involve rates (interest rate swaps, government bonds and mortgages) and credit (corporate and municipal bonds, as well as credit default swaps), which combined make up more than three-quarters of revenue. Big picture, growing debt loads, increases in interest rates (and interest rate volatility) and renewed popularity of money market funds (revenues small but up 30% in Q2) have kept trading volumes up, as has the steady move toward the electronic trading of debt instruments (more marketplaces being set up), resulting in a nicely growing business with huge margins. In Q2, revenue was up 5% and earnings rose 11%, though EBITDA margins came in at a whopping 52.5% (!) and free cash flow totaled around $2.70 per share during the past 12 months, well ahead of earnings. There’s nothing revolutionary here, but Tradeweb is a solid, highly profitable business that should see rising volumes and more new opportunities in the era of higher and more volatile interest rates. Earnings have grown steadily for years, and analysts see that continuing.

Technical Analysis
TW reached the century mark in late 2021 but fell all the way 51.5 last October before finally turning the corner, rallying back to 76 in January. Then came a long basing period, with shares banging on their 40-week line (and the 67 area) multiple times before shaking out a bit in early July. Now TW is looking better, with a rush higher after the shakeout, a strong move up on earnings and some tight action despite the market’s wobbles. Dips back toward 80 would set up a decent risk/reward situation.

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Stock 10

Vertiv Holdings (VRT)

Why the Strength
Vertiv Holdings is one of the market’s fresher leaders that most have never heard of. The company has always done a good business in data center infrastructure, and now it looks like a classic picks-and-shovels player in the coming AI wars. It supplies all sorts of wares to its clients, though a big driver seems to be thermal solutions (it says it has the widest portfolio of solutions in the industry), keeping all of the newer, more powerful technology (all of which produces greater amount of heat than before) at the right temperature so that performance is optimal. That should be a huge opportunity as AI means a greater amount of powerful IT equipment is needed, and Vertiv is a key player both in traditional air cooling and also in liquid cooling solutions, which supposedly do an even better job. As for the business itself, it’s been subject to continuing supply chain issues, but those are easing (one of the reasons margins and earnings have busted loose on the upside), and investors are thinking business is set to accelerate as the AI buildout gets underway. As it stands now, growth is picking up a bit (organic sales up 20% in the latest quarter), management is boosting estimates and the valuation (22 times this year’s estimates, which are likely conservative) helps the cause—and, again, all of that is before much of an AI-related boost, with the top brass saying in the latest conference call that it’s already having discussions with clients that want to make sure they can secure supply down the road. We like it.

Technical Analysis
VRT imploded during the bear with everything else, and really wasn’t looking like a new leader through April. But the AI boomlet changed everything, with the stock completely changing character—shares immediately ran up 10 weeks in a row and actually pushed a bit higher after that. And then VRT went wild again, gapping up on Q2 earnings and, so far, has held most of the move. We’ll set our buy range down a bit from here, thinking further dips should find support.

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Previously Recommended Stocks

The next Cabot Top Ten Trader issue will be published on August 28, 2023.