Cabot Top Ten Trader Issue: August 28, 2023

Remaining Patient

Last week had a couple of big news items (Nvidia’s earnings and Jackson Hole) and, not surprisingly, the market was all over the place, with some strong up action, a wild reversal and then some support after the Fed’s talk. All in all, we consider the shows of support modestly encouraging, along with the fact that sentiment has taken a sharp turn lower as the worries of the world come back into focus; in our view that will lead to a solid rally eventually. But nothing has really changed with the here and now: The intermediate-term trend of the major indexes and most stocks is pointed down (about two-thirds of names out there are below their 50-day lines, as well as half below their 200-day lines), with few names making any progress. That can obviously change—remaining flexible is key—but for now, we’re still patiently waiting for the buyers to retake control. We’ll leave our Market Monitor at a level 5 tonight.

This week’s list is another mixed set of stocks, though we like the fact that we’re seeing a few more positive earnings moves. Our Top Pick is Splunk (SPLK), which is trying to leave behind a multi-month range after its recent surge—aim for dips, start small and consider adding more if the stock/market improve from here.

Stock 1

Akamai (AKAM)

Why the Strength
According to a recent survey of multinational companies across several industries, account takeover—which typically involves unauthorized wire transfers or intellectual property theft—is a cyber crime that has affected 80% of respondents in the last 12 months, highlighting the need for stronger cybersecurity. Massachusetts-based Akamai operates a widely-used edge and cloud platform that makes it easy for businesses to develop and run applications and workloads while guarding against cyber threats. The rapid growth of Akamai’s security business was a big driver behind the company’s Q2 results, which saw revenue of $936 million (up 4% from a year ago) along with $223 million in free cash flow, which made up a whopping 25% of revenue. Security Solutions saw sales increase 17%, with its app and API security portfolio being the main drivers. Akamai’s Zero Trust enterprise security solution, Guardicore, also outperformed with numerous “significant” customer wins (including a leading global financial data provider). Akamai’s Compute Product segment saw revenue soar by 74% and secured notable wins, including a major U.S. airline and one of the world’s top gaming companies. Further, Akamai just obtained an investment-grade credit rating from two major ratings agencies, which the firm said would “further reinforce” its financial strength. This strength has allowed Akamai to make “substantial investments” in its enterprise security and cloud computing businesses, with some of the cash used to repurchase shares—including about $140 million worth in Q2 (with $700 million remaining on the buyback authorization; Q2’s share count was down 2% or so from a year ago). The strong results prompted management to raise 2023 revenue guidance to around $3.8 billion (up 5%), while Wall Street sees steady 10%-ish earnings growth and big margins for the next couple of years.

Technical Analysis
AKAM spent most of 2021 and early 2022 topping out before finally cracking last May, kicking off a decline that lasted 10 months. Interestingly, the stock didn’t have a bottoming process but simply picked up from there, rallying to the mid-90s by May, after which it formed a tidy nine-week launching pad with the 50-day line offering support. The earnings gap three weeks ago was bullish, as is AKAM’s resilience since then. If you’re game, aim for dips to enter and use a relatively tight leash.

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Stock 2

ChampionX (CHX)

Why the Strength
Production cuts by the major OPEC+ countries along with higher energy demand from a resilient U.S. economy (the Atlanta Fed’s now-cast has Q3 GDP running near 6%!) are providing a boost for energy prices and, thus, oilfield technology providers like ChampionX (covered in the July 24 issue). The company serves onshore and offshore oil customers by helping them improve the capacity and efficiency of their operations by offering drilling and reservoir technologies, as well as digital automation for oil/gas extraction. Chemical solutions that allow for increased oil extraction from established wells are the main story here: The firm’s Chemical Technologies segment experienced strong growth in the Gulf of Mexico in Q2 with key oil and gas customers, and it won contracts in several countries in the Middle East/North Africa relating to ChampionX’s corrosion inhibition chemicals. The chemical segment also secured a multi-year contract extension in offshore Western Australia with a global energy company, which ChampionX said opens the door for “further business growth with new asset start-ups in the next several years.” Total revenue in Q2 of almost $930 million was down 1% year-on-year due to shipment delays related to the Canadian wildfires and extended production turnaround times in the Gulf of Mexico. However, earnings of 49 cents a share beat estimates by 12% and soared an eye-opening 75% from a year ago, while EBITDA jumped 35% (a reason for the stock’s strength). Tellingly, cash flows in the first half of the year increased rapidly, and the company expects to convert at least 50% of its adjusted EBITDA to free cash flow for the rest of 2023 while returning at least 60% of free cash flow to shareholders (1.0% current dividend, share count down about 1% from a year ago). For Q3, management guided for sequential revenue and adjusted EBITDA increases of 5% and 9%, respectively, as the factors which impacted Q2 volumes resolve; Wall Street sees the bottom line lifting nicely through next year.

Technical Analysis
After tightening up in April and May, CHX took flight in June, acted well after last month’s earnings and has resisted broad market-related headwinds during the past few weeks. The past month’s action has been largely constructive as the stock has been able to consolidate the recent gains while remaining north of its old highs and as the 50-day line catches up. We’re fine nibbling here or on minor weakness.

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Stock 3

Chart Industries (GTLS)

Why the Strength
Chart Industries is a story about building the infrastructure for the green energy transition, but it’s also one of investor perception, where an acquisition was boo’d loudly by the market late last year, but today, investors are seeing the light. The firm makes all kinds of equipment and provides all kinds of maintenance for many new energy-type projects, from (often huge) LNG projects to carbon capture to hydrogen facilities to water and wastewater treatment to specialty gases to mining (for metals used in electrification) and more, and business was always solid—and the buyout of Howden (leading to $4 billion of financing in the teeth of a bear market) looks to have broadened Chart’s geographic reach (especially internationally) and, importantly, brought tons of recurring aftermarket, service and repair work (which was 44% of that outfit’s revenue). It took a while for the market to trust the synergy projections and debt reduction plan, but as the months have passed, it’s looking like Chart’s future is very bright: In Q2, the firm set records for backlog (both for Chart and Howden), total orders, sales, margins, EBITDA and free cash flow, leading to a lift in the 2023 earnings outlook (free cash flow should be near $7 per share, too). And management sees the good times continuing down the road, too, with an early 2024 outlook for $1.3 billion of EBITDA, up more than 60% from this year, all while it pays down debt (it recently agreed to sell off a division for $300 million; now sees debt at less than 3x cash flow by the middle of next year; the firm won’t do any material cash acquisitions until that figure is under 2.5x). Of course, at its heart, this is a down-the-food-chain story, so if some customers really tighten their belts, orders could dry up. But Chart’s business is much more diversified now, and if anything, demand has been coming in stronger than expected for many quarters now. The more it executes, the better investor perception should get.

Technical Analysis
GTLS crashed last November on the Howden acquisition, and six months later, the stock had fallen another 20% as everyone who wanted out, got out. But while the stock still has overhead to chew through, it’s acting like a totally different animal since Memorial Day, with a persistent uptrend through July and a modest, controlled dip to the 50-day line during the market’s correction. We’ll set our buy range up from here, thinking a solid rebound could mark the end of the rest period.

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Stock 4

Fabrinet (FN)

Why the Strength
Fabrinet manufactures highly specialized components for electronic manufacturing and precision optical instruments – think lasers, automotive components and medical devices. It sells equipment under its own name and as a contract manufacturer for other brands. Over the past decade, the manufacturing and optical markets average out to be steady growers – about middle single digits for each on an annualized basis, though there can be ups and downs, like this past year which saw flat to down orders in most of the Fabrinet’s markets. In that light, the business did better than expected in its quarterly report that was released last week. Revenue rose 12% on the year to $665.9 million, while earnings per share were $1.86, also ahead of consensus. Fabrinet aims to grow at double the rate of its end markets, so performance was surprisingly strong. Fabrinet appears to be in a good position because the vast majority of its customers are equipment giants including Nvidia, which accounts for 13% of sales, third after Cisco (16%) and Lumentum (15%). The rise of AI is starting to really push demand for its equipment, including big orders for Fabrinet’s 800-gigabyte routers that can handle data-hungry AI services. That has management hopeful for a good year ahead despite the fact that many customers continue to pull in. The bright spots outweigh the worries: Automotive should be strong as the industry boosts orders after suffering a long component crunch from the pandemic, and along with AI-induced growth, the company is expecting high single-digit growth over the next couple of quarters, with early views looking for accelerating growth beyond that.

Technical Analysis
FN topped in late 2021 and then sank hard (75 last June), returned to its highs earlier this year (near 140), tanked again (to 90 in May) and then rallied back (133 in June/July). But, finally, the stock then put its wild ways behind it, changing character with a modest, controlled dip during the market correction—followed by last week’s massive-volume (heaviest weekly volume since 2019!) gap to new highs. It’s extended, but we like the power; a small position on dips is OK with us.

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Stock 5

Light & Wonder (LNW)

Why the Strength
Light & Wonder, formerly named Scientific Games, is the leading cross-platform global gaming provider known for its immersive casino, online and mobile games. Among its offerings are casino slot machines, tabletop games, lottery systems and digital gaming solutions, as well as perpetual licenses to gaming operators. The company operates through three segments: Gaming (new and used gaming machines and parts), SciPlay (mobile gaming) and iGaming (online casino betting). The trends have been solid for Light & Wonder of late, with video slot machine gambling at hubs like Las Vegas being unusually high this summer, with visits to Vegas recovering to 95% of the pre-pandemic 2019 level. Indeed, right now, all of the firm’s areas are doing great: Light & Wonder achieved a ninth consecutive quarter of growth in Q2 as revenue of $731 million increased 20% from a year ago, driven by “robust” Gaming machine sales (up 41%), while the SciPlay and iGaming segments each set quarterly revenue and EBITDA records. Another reason for the stock’s strength is the company’s recent full reunion with SciPlay (following the latter’s spinoff in 2019) after Light & Wonder acquired the remaining 17% equity interest. The top brass said the combined balance sheet would provide Light & Wonder with the “flexibility to optimize capital investments” to develop and launch new games across its multi-channel platform. Some of the recent earnings figures are affected by one-off factors, but more important is the future, where Wall Street sees consistent sales and cash flow growth for through 2024 and beyond.

Technical Analysis
After reaching a record high of 90 in late 2021, LNW took a hit with the rest of the market last year before registering a low at 40 last September. Shares snapped back nicely right after that, but effectively spent the following seven months grinding sideways while holding the 40-week line. The next leg up began in June, with a controlled advance that’s been gaining steam of late with the help of the Q2 report. Dips toward the 25-day line would be tempting.

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Stock 6

MoonLake Immunotherapy (MLTX)

Why the Strength
Switzerland-based MoonLake is a clinical-stage biopharmaceutical focused on next-level Nanobody technology (a new generation of antibody-derived targeted therapies) to treat inflammatory skin diseases. Nanobodies have a number of potential advantages over traditional antibodies, including enhanced tissue penetration, ease of manufacturing and the ability to design therapeutic molecules with multiple target combinations. The stock took flight in June on the heels of positive Phase II trial results for the company’s nanobody drug dubbed sonelokimab, which treats patients with moderate-to-severe hidradenitis suppurativa (HS), a rare chronic condition characterized by painful lumps deep under the patient’s skin. The study found that the treatment reached the highest clinical activity among all other therapies tested in similar trials, and with no safety issues, either; management said earlier this month it continues to make “significant progress” with the clinical development of the drug (longer-term top-line data is expected out in mid-October). The sanguine results prompted several major institutions to raise their price targets for MoonLake, and some believe sonelokimab could become the standard of care for treating HS patients with the potential to garner hundreds of millions in annual sales. Additionally, a recent Reuters report indicated the company is involved in early-stage talks with other drug makers for a potential sale (although not yet confirmed by MoonLake). There’s not much to report on the financial front as there are no sales yet, but the firm just raised $460 million in a public follow-on offering, providing them with “significant” new funds to advance sonelokimab’s development. It’s obviously a speculation, but if things go well, it could pay off big.

Technical Analysis
MLTX had a gigantic rally in June, but it’s actually been perking up for many months: Shares rallied nicely to start the year, zoomed to the mid-20s in early March and then built a nice base-on-base formation into late June—when the trial results launched the stock higher. Just as impressive is MLTX’s action during the market’s wobbles, as the stock has held its gains. We’ll set our entry point up from here, looking for a bounce off the 50-day line and a rebound after today’s shake lower.

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Stock 7

Northern Oil & Gas (NOG)

Why the Strength
We missed our entry point with Northern Oil & Gas a month ago, but as the stock has settled down, we’ll take another swing at it as the sector remains strong and the story is unique: The firm calls itself a “real asset company,” as it’s the largest non-operated oil explorer out there, basically buying up minority stakes in various wells in three different basins (55% Williston, 33% Permian, 12% Marcellus; 60% oil and 40% gas overall), making it a leaner and more diversified operation but obviously giving it exposure to the lush cash flow seen in the sector. Also interesting is that, while many peers have reined in costs and production, Northern hasn’t been shy about adding to its portfolio—it closed a purchase in the Delaware Basin near the turn of the year ($132 million, 37% working interest, 80-plus wells); it recently closed a $168 million purchase to grab a 30% stake in 50-plus well over more than 10,000 acres in the Permian; and in mid-June, it announced its largest-ever acquisition ($500 million!), scooping up 29% working interest in nearly 100 wells over 5,600 net acres in the Delaware Basin. That has led to a share offering and more debt (that said, zero debt maturities until 2027), but all the purchases look to be accretive even at modest energy prices, and there’s no question the portfolio is doing well now. Plus, with CapEx expected to actually taper off in the second half of the year, already-solid free cash flow ($131 million in the first half of the year, $1.40 per share) should accelerate. It’s a good story, especially if oil prices creep higher from here.

Technical Analysis
NOG topped last summer and fell hard with most of its peers, but etched higher highs from there and finally formed a nice, tight, calm launching pad from mid-April into early July. The move after that took the stock to new highs up to nearly 43, and while it’s taken on some water since then, the dip has been modest and found some support near the 25-day line. We’re OK grabbing some NOG around here with a stop under the 50-day line.

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Stock 8

Palo Alto Networks (PANW)

Why the Strength
With the advent of artificial intelligence (AI), cyber-attacks are becoming increasing sophisticated and more expensive, threatening entire supply chains and leading to an avalanche of crime-related costs in recent years. Palo Alto (covered in the June 5 issue) is a leading player in the cybersecurity space and has positioned itself with a comprehensive platform for all types of online security, with a recent focus on providing security solutions for hybrid cloud and remote workforces. Wall Street held its collective breath prior to the release of Q4 earnings (ended July 31), with many analysts expecting big top- and bottom-line misses due to a “murky” macro backdrop (peer Fortinet was annihilated on earnings), and with at least one major institution questioning the timing of the release (two Friday’s ago after the close) as a potential “disaster.” However, those fears were allayed as Palo Alto announced another strong quarter, with EPS of $1.44 that beat estimates by 12% (up 80% from a year ago) and only a slight miss on revenue of $1.95 billion that increased 26% year-on-year, prompting several analysts to raise price targets (reasons for the stock’s strength). The results were partly driven by exceptional strength in the firm’s Cortex platform and Prisma Cloud bookings, but other metrics were equally upbeat, including billings growth of 18% in the quarter (and 23% for fiscal 2023), subscription sales rising 30% and remaining performance obligations (RPO) of nearly $11 billion also jumping 30%. Looking ahead, the top brass said its strategy hinges on selling more products to its largest customers (it saw larger deals outpace the overall business in Q4) and expects billings, revenue and per-share earnings growth to each come in around 20% for fiscal 2024 (ending next June). Palo Alto also sees the addressable market for its three cybersecurity platforms expanding by around 60% within the next three years, providing a sizable runway ahead. All in all, the growth story remains on track and free cash flow ($3 billion expected in 2024) is enticing.

Technical Analysis
PANW wasn’t the biggest leader of the May-June rally, but it broke out in mid-May and had a solid 30%-ish advance to its high in early July. The action after that was normal, but shares fell all the way back to their breakout level in early August as tech stocks were weak and Fortinet blew up. However, the quarterly report brought in the buyers, with PANW pushing back to its old highs last Monday before backing off. We’ll set our entry range up from here, thinking a resumption of the earnings move will prove bullish.

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Stock 9

Splunk (SPLK) ★ Top Pick ★

Why the Strength
Splunk sells analysis tools for corporations to see and manage their real-time data across their IT networks, primarily for security purposes but also for gathering insights from internal data to generate new ideas. The business handily beat expectations in its second quarter, reported last Thursday. Revenue was $911 million, well ahead of $888 million forecasted, with earnings per share even stronger at 71 cents, fully 25 cents higher than consensus. Even though the macro environment wasn’t perfect, Splunk saw big demand from corporate customers who find they have to wrangle increasingly complex data situations given the explosion of information being stored and moved between multiple cloud environments—and looked at by more and more teams within an organization. This includes data generated by Internet of Things devices and sensors, which can be security weak spots and need to be monitored under the IT adage “if you can’t see it, you can’t secure it.” Splunk’s flexible architecture appears to give it an edge in getting large corporate customers to sign on, given the combination of older systems and many diverse newer data systems companies end up with. Business-wise, the firm’s move to a subscription model is progressing nicely: Customers with more than $1 million in annualized recurring revenue (ARR) – an annualized projection of their latest quarter of purchases – now number 834, with total ARR rising 16% and free cash flow in the past year was near $4.75 per share, way ahead of reported earnings. The momentum means full-year sales should lift to $3.95 billion this year, up from $3.65 billion last year. Longer term, management says the emergence of AI will improve their product offerings, envisioning Splunk AI deployed on corporate systems will enhance security and also the ability to locate and use internal information more effectively through natural language search capabilities.

Technical Analysis
SPLK topped well ahead of the market back in mid-2020, and bumped downhill until finally bottoming last September. The rally into February was solid, but that ran into a wall, too, leading to a multi-month up-and-down period that left the stock near its 40-week line two weeks ago. But the Q2 report was well received, with SPLK gapping to its highest level since August of last year and actually seeing some upside follow-through since. All told we like the setup—minor weakness would be tempting.

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Stock 10

Yeti Holdings (YETI)

Why the Strength
Yeti likely needs no introduction, as it’s positioned itself as the leading brand in high-quality coolers (42% of sales), drinkware (55% of sales) and various other outdoor leisure products—that was a boon during the pandemic as outdoor gatherings around the fire pit or grill became more commonplace, but with various new products, expansion internationally and more distribution (both in-store and direct-to-consumer online), growth was able to remain solid. But starting in the middle of last year, potholes appeared, starting with crimped margins (likely due to some knock-off products), and then came issues with quality control: Yeti stopped selling a few smaller coolers that had magnet issues and began a voluntary recall, which, combined with an iffier retail environment in general, led to sales and earnings shrinkage, partly due to loss reserves being built up for returns/exchanges and probably also because of some near-term damage to the brand. That said, the hits have been relatively modest (after seeing earnings per share ramp from $1.06 per share to $2.60 in two years, they’re set to decline to just $2.29 this year), and the stock is strong because the Q2 report pointed to the end of the soft patch—Yeti’s sales lifted 2% in the quarter (adjusted for the recall), with some areas (direct-to-consumer up 4%; drinkware up 8%) doing much better than expected, which in turn led to stronger margins and earnings (57 cents per share was 10 cents above expectations). Analysts still see sales and earnings off some in Q3, but (a) that’s probably conservative, and (b) growth is set to resume in Q4, with the help of some new and re-released products (replacements for the aforementioned recalled coolers) coming out. All in all, Yeti is a powerful consumer brand that looks like a mini-turnaround situation.

Technical Analysis
YETI was a big winner in the post-pandemic rally but then gave up a lot of that move during the bear, falling from 109 to 28 before bottoming out last fall. Shares popped back on earnings soon after that and pushed up to the 50 area, but that area beat back a couple of rally attempts, leading to a long sideways phase. Now, though, YETI may be waking up—the stock rallied on earnings three weeks ago (heaviest weekly volume in two years) and has traded firmly since despite some major potholes in retail stocks. We’ll set our buy range down a smidge from here, where there should be solid support.

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Previously Recommended Stocks

The next Cabot Top Ten Trader issue will be published on September 5, 2023.