Cabot Top Ten Trader Issue: February 13, 2023

Normal So Far

After living through 2022, we’re certainly not going to whistle past any market graveyards, so our antennae are up when it comes to the market’s recent wobble—should the sellers dig in (possibly if January inflation comes in higher than expected) and some leaders or indexes crack, we’ll pare back. But instead of guessing what may come, it’s best to just go with the evidence in front of you, and so far, everything looks normal: The intermediate-term trend is still up, few (if any) leadership stocks have cracked support and the broad market remains in fine shape. That doesn’t necessarily mean we’d be piling in here, but we continue to lean bullish, with the odds favoring this pullback giving way to higher prices. We’ll leave our Market Monitor at a level 7 today.

This week’s list is very mixed, with everything from growth to turnaround to cyclical and mega-cap to small-cap. With the chip sector looking peppy, our Top Pick is Allegro MicroSystems (ALGM), which quacks like a new growth leader. The stock is extended here, but dips of a couple of points would be enticing.

Stock 1

Allegro MicroSystems (ALGM) ★ Top Pick ★

Why the Strength
Allegro makes magnetic sensor integrated circuits, power ICs and photonics components, all of which are used in things like eye-friendly lasers and solar panel inverters. But its primary market is automobiles: The first two product segments are seeing strong growth as automakers hunger for more chips needed to power advanced assisted driver systems (ADAS) and chips that can better handle greater electrical demands in electric vehicles. Allegro’s Q3 sales released two weeks ago showed a 33% year-over-year rise to $249 million, at the high end of management’s guidance. Four-fifths of the growth came from automotive, where the expansion of ADAS features from luxury models to even entry-level models means more sales for chip makers. For instance, a pickup truck model Allegro sells into has tripled the amount of company content in just three years, to $12 a unit – real money considering the scale of production. Such demand has management saying the current fiscal year (ending in March) will produce sales of $970 million, a 26% gain over fiscal 2022. The longer-term outlook is brightening too, with the company recently winning the rights to supply a steering system for an unnamed U.S. manufacturer’s model and multiple systems for a China EV maker. Big picture, EV growth is key: Allegro sees its addressable market at $90 of component sales per EV produced, and global EV manufacturing is expected to grow 30% over the next year, with growth accelerating in subsequent years. The company disclosed that large China OEM Geely is a customer, as are a dozen major players including Ford, Tesla and Mercedes. Allegro’s own pandemic supply chain troubles appear behind it and the company is whittling down the sales backlog, lowers lead times for new orders. Wall Street sees only modest growth the next few quarters, but the stock doesn’t believe it.

Technical Analysis
ALGM came public in late 2020 and hit a peak near 35 early the next year; after a correction, shares tested that area in late 2021 before being rejected again. Then came the bear phase last year, but after a low in October near 20, ALGM changed character—shares spiked back toward that old resistance, tightened up for a few weeks and decisively broke out two weeks ago on huge volume. It certainly looks like a leader; the next dip should be buyable.

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Stock 2

Boeing (BA)

Why the Strength
Boeing (and its aerospace peers) have a history of trending in a big way when conditions turn up—and that’s one reason why (in spite of it being a mega-cap name) we think the stock can run. Indeed, while a number of Wall Street investment banks are predicting a “mild recession” for 2023, Boeing is one of the few not worried at all by recession prospects due to its enormous order book. What’s more, the firm’s lingering (but shrinking) supply chain and labor issues would likely be helped by an economic slowdown, helping its suppliers alleviate worker shortages. In any case, the company has over $400 billion worth of back orders for over 4,500 commercial planes, including the Boeing 737 and the 787 Dreamliner, which will take years to fill at current production rates, putting it in the enviable position of being able to achieve growth through backlog fulfillment. Another trend in Boeing’s favor is the recent surge in global travel following the pandemic-era slump, and airlines are scurrying to meet demand by placing new orders. (Boeing last year received 217 orders for wide-body planes, the most since 2014, including a whopping 100 of its 787s from United Airlines, which has an option to buy 100 more.) To further meet that demand, Boeing is developing the 777X, which will be the world’s largest and most efficient twin-engine jet when it is introduced (planned for 2025). On the financial front, Q4 revenue of $20 billion was up 35%, while commercial airplane revenue soared 94%. The bottom line is much choppier due to many factors, but this is becoming a free cash flow story: Boeing generated nearly $3 billion of free cash flow last year as a whole, and the top brass is expecting around $4 billion in 2023 (about $6.70 per share), despite Wall Street looking for a breakeven-ish earnings result—and, importantly, the firm thinks $10 billion of annual free cash flow by 2025/2026 is possible as production rates improve. If the top brass executes, Boeing’s going to spin off mountains of cash in the quarters ahead.

Technical Analysis
BA crashed in 2020, and the vaccine-induced rally petered out in early 2021, leading to a couple of dips back into the 120 range last year. But Q3 earnings in October changed the tune, with the stock quickly rallying to multi-month highs in November and pushing higher into early January. Now we see a tight, tidy consolidation as the moving averages catch up—we think BA is a good risk/reward entry here, with a stop in the mid-190s.

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Stock 3

Insulet (PODD)

Why the Strength
Insulet is a leader in the insulin pump market, which is both big and also relatively underpenetrated, with many people (upwards of 95%!) still using fingersticks to manually get their insulin tallies. Insulet thinks its current market is 11 million people (growing to 14 million by 2024). The firm has always done good business, and its latest offering (the Omnipod 5) looks like a hit: It has no needles or tubes, is wearable and discreet, has a new algorithm that uses “micro-dose” technology that leads to best-in-class time within a proper insulin range (the system even learns how to personalize treatment schedules for better results) and is available through a variety of channels (including pharmacies). The device showed big “time in range” improvements among all age groups, so much so that the device is even approved for two-year-olds (!) and is taking share from competitors like Tandem. Right now it’s mainly a U.S. growth story—last year, Insulet’s Omnipod business likely grew 30%-ish percent, though it was flat overseas, but that’ll likely change as the E.U. approved the Omnipod 5 last September, so sales there should ramp as the marketing team expands. Analysts see the top line up 16% this year while earnings surge, but both could easily prove conservative. Q4 earnings are due February 23.

Technical Analysis
PODD was nailed in the first half of last year like everything else (325 to 181), and after a summer rally, shares pulled back again (higher low) into October. But then PODD exploded back toward its all-time highs (both before and after the Q3 report) in just a couple of weeks, leading to another, tighter, well-controlled rest. It’s aggressive, but we’re OK starting a small position here and buying more if earnings are well received.

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Stock 4

New Relic (NEWR)

Why the Strength
New Relic develops cloud-based software to help website owners and software engineers track the performance and reliability of their sites and apps, providing them with more value from their data with an all-in-one observability platform. With companies across many sectors reducing enterprise software spending, last week’s release of New Relic’s fiscal Q3 results (ending December 31) was a breath of fresh air in what has been a lackluster earnings season for the cloud space. The firm managed to gain 800 new paying customers in the quarter (which included names like Pandora, Hong Kong Airport Authority and Veritas) while adding 1,100 new active customers in the past year. Revenue of $240 million increased 18% from a year ago, while per-share earnings of 32 cents beat estimates by 17 cents. But the big focus was the strong pace of New Relic’s customer growth, bringing with it the firm’s largest-ever sequential increase in committed revenue in Q3. On that score, management sees a “significant opportunity” ahead in view of the expanding base of new and existing customers and the increasing value of the platform. New Relic also said revenue and operating margin growth is accelerating after profitability turned the corner in Q2, driven by its engineering team’s focus on cloud optimization and architectural improvements. Going forward, the top brass guided for revenue of around $241 million in fiscal Q4 (up 17% if realized) and $924 million for fiscal 2023 (up 18%)—both in line with Wall Street’s estimates, but likely conservative given the customer growth momentum. Meanwhile, fiscal 2024 should see earnings soar.

Technical Analysis
NEWR was a big winner back in 2017/2018, and after a tough couple of years, looked ready to emerge in late 2021 when it gapped up huge on earnings—but that was the start of the bear market, and shares went right back down the chute, losing about two-thirds of their value by mid-2022. The summer rally was OK, but then came a nice, multi-month cup base, with selling really drying up in December and early January ... and then last week’s earnings move brought NEWR to its highest levels in a year. A pullback should provide a good opportunity to get in.

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Stock 5

Prometheus Biosciences (RXDX)

Why the Strength
Prometheus is a development-stage outfit that’s making precision therapies for immune-mediated diseases (those that stem from abnormal immune cell activity) using cutting-edge data science and machine analytics with the goal of ending the trial-and-failure treatment cycle. The company’s pipeline includes several drugs that are in various stages of testing for the treatment of the inflammatory bowel diseases ulcerative colitis (UC) and Crohn’s disease (CD). Its lead candidate, PRA023, is a potential blockbuster in Phase II of clinical trials with the possibility of billions in annual sales when it hits the market. The stock’s moonshot in December is a result of the latest trials for PRA023, which showed a remarkable 27% of UC patients treated with the drug reached the primary goal of clinical remission, compared with just under 2% of patients who took a placebo; about 37% of patients reached the study’s secondary goal of endoscopic improvement, versus 6% on placebo. Additionally, in a separate Phase II trial with Crohn’s disease patients, the clinical remission rate reached a jaw-dropping 49%! Management said it’s “beyond enthusiastic” with the results and plans to advance PRA023 into Phase III studies for both diseases sometime this year. Coming up behind that is PRA052, a potential first-in-class monoclonal antibody blocking the CD30 ligand; it was cleared by the FDA for a just-initiated Phase I study. As is typical with clinical-stage companies, Prometheus’ numbers are basically meaningless, with hardly any revenue and plenty of red ink. But the firm believes its cash holdings are sufficient to fund operating expenses until mid-2024. If all goes well, revenues could begin taking off in 2025. It’s an interesting speculation.

Technical Analysis
RXDX came public in April 2021 at 25 and went on some wild moves over the next year and a half, with a rally to 50, a plunge to 22, a move back to 60 and then a shakeout to the low 30s as the market and perception swung around. But December’s trial results have clearly changed RXDX’s character—shares catapulted up to 117 in just two days, and perhaps more impressively, have gone straight sideways in a tight-ish range since then. Don’t invest the rent money, but with the stock bouncing off its 50-day line, we’re OK with a small buy here and a loose stop.

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Stock 6

Rambus (RMBS)

Why the Strength
Rambus focuses on advanced silicon chips and intellectual property for data centers. Its products offer two primary benefits – working around bottlenecks of processing demand and superior data security. As the cloud and Internet of Things sectors expand, the number of connected devices has risen 10 billion in the past five years, to an estimated 27 billion now, all taxing server resources. Rambus is rolling out the next generation of its primary server chips on the new industry standard platform called DDR5; the company says its architecture allows for better CXL Memory Pooling, a term for resource sharing among processors and memory, which enables data servers to combine resources to speed data transfer. Secondly, data centers are prime targets for hackers, so 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 hard-wired on processors. Rambus makes money from all this in three ways – hardware sales, licensing fees and royalties from other chip makers who develop chips using Rambus’ intellectual property. For 2022, those pathways generated $454 million in revenue, up 39%, well outpacing the chip market as a whole. The roll out of Rambus’ DDR5 chips, starting later this year, should sustain strong sales growth for the foreseeable future, too—2023 should be a great year, with earnings soaring and sales pushing higher by 25% to 30%. It’s a unique story.

Technical Analysis
RMBS effectively topped near 30 in December 2021 and fell to 20 in the middle of last year before starting to round out a launching pad, with a tighter rest period near the 40-week line in September and October. Shares exploded higher from there, decisively breaking out into the upper 30s before pausing for a few weeks. But the buyers have been back at it all year, with any dips to the 25-day line finding support. We like the action, but advise targeting dips if you want in.

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Stock 7

Royal Caribbean (RCL)

Why the Strength
Travel stocks will always be cyclical, but they’re being bolstered by the slingshot of demand following the pandemic, cost cuts during the dry times and some structural supply issues that the pandemic wrought, which is keeping prices elevated. Cruise lines are squarely included in this boom, and in fact, were one of the last travel categories to shake off the virus—Royal Caribbean finally got all of its fleet up and running last June, with just 57% of cabins occupied in Q1 of last year (up to 95% by Q4). Indeed, Q4 saw a continued comeback in revenues (up 165% from a virus-affected Q4 2021), but the optimism here concerns the future: Not only was the firm nearly at capacity last quarter, but booking volumes have been very strong (well above 2019 levels, and that includes customer deposits), with the seven biggest booking weeks in Royal’s history occurring in November/December! Meanwhile, onboard spend per passenger was up 30% last year vs. pre-pandemic 2019 with trends remaining strong all year. The bottom line is that the company’s business is making up lost ground at light speed, with the firm’s guidance for 2023 very bullish—including all-time records of EBITDA and earnings in the mid-$3 per share range. And this is all happening with plenty of economic fears, too; if the economy actually perks up, business could come in even better than those estimates.

Technical Analysis
RCL topped out in the 80 to 100 area for most of 2021 and crashed into the low 30s last summer before finding a low. It hasn’t been dramatic, but the stock has worked its way back steadily since then, with a couple of potholes leading to renewed waves of buying. The action since the calendar flipped has been great, with Q4 earnings pushing the stock back toward its prior range. We think dips of a few points would be tempting.

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Stock 8

Seagate Technology (STX)

Why the Strength
Last year wasn’t a strong one for Seagate, one of the world’s top mass data storage providers, as its operating margins declined, due in part to a tough macroeconomic environment with particular economic weakness “in certain Asian regions” according to the top brass. But Seagate’s recent earnings suggested the storm clouds are breaking up as the firm posted impressive beats on both the top and bottom lines. Although the company’s revenue dropped nearly 40% from a year ago in fiscal Q2 (ending December 30), it beat analyst expectations by an eye-popping 42% (a reason for the strength). Per-share earnings of 16 cents, meanwhile, came in significantly lower than a year ago but topped the consensus by seven cents. Seagate further bolstered Wall Street’s enthusiasm by extending its decade-long trend of positive free cash flow, generating $172 million in Q2 and bringing its fiscal-year-to-date total to $284 million (about $1.35 per share in just two quarters). Most important was the outlook: Seagate now expects a steady recovery in the coming quarters, and part of the recovery story hinges on the trend of increasing demand among cloud customers for higher-capacity hard disk drives (HDD). Additionally, Seagate plans to launch the industry’s first 30+ terabyte (TB) product lineup this spring that uses heat-assisted magnetic recording technology, while ramping up production of its 22 TB hard drives for datacenters. (Seagate is also expected to release 50 TB drives down the road.) Analysts see China’s reopening as a big plus for Seagate in the coming quarters, with a big institution just bumping its price target for the stock. All in all, after going through the wringer, earnings should start to skyrocket in the quarters to come.

Technical Analysis
STX hit a long-term peak at 118 at the start of last year just as the bear market gained steam. From that point on, it was mostly a downhill struggle for the stock as the industry-wide bear, coupled with China’s lockdowns, dragged STX to a low of 47 by early November. Shares spent the next several weeks rounding out a bottom before reversing course; we’ve now seen seven up weeks in a row, highlighted by the earnings reaction a couple of weeks ago, with shares holding north of their 40-week line. If you want in, aim to enter on minor weakness.

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Stock 9

Valaris (VAL)

Why the Strength
Valaris was formed in 2019 via the merger of Rowan and Ensco, though that didn’t stop it from going into Chapter 11 a year and a half later (something a few other industry peers did as well). But the new entity emerged lean and mean in mid-2021 (it now has more cash than debt), and with the sector’s recovery, limited rig supply and the resilience in oil prices (still near $80 despite recession fears), business is picking up a big way. Valaris has around three dozen, high-quality ships on the water with another dozen-ish having been stacked (sitting idle) but could be restarted when conditions are right … and conditions are improving by the month. In its latest fleet status report, the firm said it has nearly $2.4 billion of contracted backlog (up 5.6% from the end of October), and that doesn’t count its 50% ownership stake of a drilling venture with Saudi oil giant Aramco, which itself has a $1.47 billion backlog. However, the big idea here is if the market remains tight and oil prices remain elevated, cash flow could go bananas: Even if industry utilization is 10% lower than 2014 and dayrates (charged by Valaris for its rigs) are 20%-plus lower than that industry peak, Valaris’ EBITDA could total north of 20% of the current market cap—and if conditions return to 2014 levels down the road, that figure could rise to 44%! Obviously, if oil prices collapse all bets are off, but given the dry times before, the odds favor a prolonged period of buoyant results for drillers. Earnings are due February 21.

Technical Analysis
VAL has been generally moving higher since late 2021, albeit with some sharp pullbacks along the way, including last year’s very big mid-year dip from 63 to 37 in just a few weeks. But, while it wasn’t smooth, VAL rebounded from there and has recently stretched to all-time highs near 80. Given that earnings are coming up and the stock’s character, we’ll set our buy range down a bit.

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Stock 10

Wesco International (WCC)

Why the Strength
Wesco is one of the biggest electrical parts suppliers in North America and a key supply chain solutions provider for businesses across many sectors, with a catalog of 1.5 million products and facilities in more than 50 countries. A growth trend in U.S. non-residential construction, along with increasing investments in public sector infrastructure, are big reasons for Wesco’s strength while contributing to the company’s record backlog and elevated earnings. Wesco is also benefiting from an expanding demand for network infrastructure and security solutions by cloud providers, data centers and hyperscale projects. Sales and profit growth were evident in all three of Wesco’s segments—Electrical and Electronics (EES), Communications and Security (CSS) and Utility and Broadband (UBS)—in Q3: Total revenue of $5.4 billion rose 14% from a year ago with organic sales growth of 17%. Earnings of $4.49 per share beat estimates by 7 cents and the firm posted record adjusted EBITDA that rose 40%. By segment, EES revenue increased 15%, driven by strong construction sales; CSS sales were up 10%, driven by wireless and network infrastructure growth, while UBS sales were “exceptionally strong” (up 29%), driven by grid modernization, as well as green energy and electrification. The top brass sees Wesco transforming into a growth company, thanks in part to recent acquisitions that have helped it expand its cross-sell program and opportunity pipeline; at the very least, these moves are expected to keep earnings sky-high after 2022’s step-function move higher. The next big event is tomorrow morning, when the firm will report Q4 results (more on that below).

Technical Analysis
After a strong post-shutdown run that saw WCC run all the way to 140 in November 2021, WCC entered a prolonged sideways move—there was a dip to 100 last summer and a few brief probes above 140, but net-net shares made no progress from the 2021 high until three weeks ago. Now WCC appears to be ready to go … if earnings, which come out tomorrow morning, are pleasing. A big gap down would obviously be bad, but we’ll set our buy range in this area, thinking a modest reaction in either direction should present an entry opportunity.

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The next Cabot Top Ten Trader issue will be published on February 21, 2023.