Cabot Top Ten Trader Issue: July 3, 2023

A Bit of Rotation

Overall, the market’s action remains as close to pristine as you could hope for—the dip from two weeks ago was quickly erased, with just about every institutional-quality leading stock remaining in good shape and more joining the parade. Under the hood, there has been a touch of rotation, with some growth stocks chopping around while cyclical, construction and materials names perk up; believe it or not, some broader indexes actually popped to higher highs ahead of the Nasdaq, too. (There was also a slight dip in the number of highs in the late-week rush higher.) All in all, we wouldn’t be surprised if growth continued to catch its breath, as the recent pullback was very brief, but that’s short-term nitpicking: While dips and potholes will come, the bottom line is that the vast majority of top-down (trends of the indexes and sectors) and bottoms-up (action of leading stocks) evidence is bullish, so you should be, too. We’ll bump our Market Monitor up to a level 8, and think adding exposure (ideally on dips) makes sense.

This week’s list reflects the broadening we’re seeing out there, with a few tech names but many others from other corners of the market. Our Top Pick is ATI Inc. (ATI), a long-term winner in the aerospace and defense field whose stock just broke out.

Stock 1

Abercrombie & Fitch (ANF)

Why the Strength
In spite of signs that consumers in the U.S., Europe and China are spending less on clothing in the face of economic uncertainty, select premium fashion retailers are doing quite well this summer. Industry analysts attribute the success of companies in this category to having a distinctive brand that resonates with aspirational shoppers. Among the leaders in this space is Abercrombie & Fitch (covered in the June 5 report), which owns both the Hollister and Abercrombie brands that have long appealed to the hip teenage crowd. In recent years, however, the company has undergone a strategy change to place less emphasis on teens while broadening its appeal to include children and adults—with a special focus on those between ages 22 and 45—while expanding its clothing offerings to include office, special occasion wear and active apparel. Another key part of Abercrombie’s strategy is a move away from tourist-dependent flagship stores to a boutique model focused on smaller stores that appeal to local customers. Additionally, the firm is putting more emphasis on digital sales, which in Q1 helped Abercrombie win and retain customers thanks to a “seamless experience” in its stores, app and website, along with increased leverage of social media platforms (which management credits as being a “great channel” for millennial customers). Freight costs and inventories have also diminished in recent months, and that has contributed to a better margin outlook. Collectively, these improvements have Wall Street turning optimistic on Abercrombie, with one institution recently upping its outlook for the company (a reason for the stock’s latest strength). After clobbering estimates in the April quarter (39 cents vs estimates for a loss of five cents), analysts see the bottom line galloping higher in the quarters to come.

Technical Analysis
ANF refused to pull back to our buy range last month as its post-earnings rally was relentless, but we’re game to give it another try. The stock has pushed higher for six straight weeks, yet the move has been orderly and price never pulled too far above the 25-day line. Our take is (a) the power of this move should lead to higher prices over time, but (b) ANF is likely getting to a near-term point where it could shake out a bit. We’ll set our buy range down toward that 25-day line, thinking dips will prove buyable for this turnaround situation.

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Stock 2

ATI Inc. (ATI) ★ Top Pick ★

Why the Strength
ATI produces titanium- and nickel-based alloys, stainless steel and specialty components for the global aerospace and defense markets, with some of the biggest names in this sector among its clients—including Boeing, General Electric and Rolls-Royce. The company also serves the oil/gas and specialty energy spaces, but aerospace (and jet engines in particular) are ATI’s biggest market, comprising almost 60% of revenue in the latest quarter. Business is booming in this sector, as seen by the company’s recent (June 19) securing of an estimated $1.2 billion in new sales commitments from several (unnamed) aerospace and defense firms (a reason for the stock’s strength). These commitments represent an average of $200 million per year in estimated sales between 2024 and 2029, and ATI said the new commitments will be accommodated through already announced capital and capacity expansions to meet “unprecedented demand.” All of this follows a stellar Q1 earnings report in early May that kept the company to remain on track to meet its bullish long-term targets—and kept investor perception trending higher. Estimate-beating revenue of just over $1 billion soared 24% from a year ago, per-share earnings of 49 cents were in-line with the consensus and up 23%. Aerospace and defense revenue increased within both of the firm’s segments—High Performance Materials & Composites and Advanced Alloys & Solutions—with both businesses seeing 6% sequential sales boosts in Q1, driven mainly by growth in the commercial airframe market. Earning are expected to rise mid-teens this year and 25% next, while management sees EBITDA margins growing a few percentage points between now and 2025. It’s a solid aerospace story.

Technical Analysis
ATI spent the final months of 2022 in a holding pattern following a summer rally before taking flight with the calendar flip. The rally brought shares up to 43 before they lost steam with the market, leading to another correction, this one running through May. But since tagging its 40-week line, ATI has changed character, with a spike higher into the middle of June and, last month, a good-volume push to new highs. We think the path of least resistance is up; we’re OK buying some here or (preferably) on dips.

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Stock 3

AZEK (AZEK)

Why the Strength
AZEK is one of the leaders in composite decking, trim, railing and the like, which are higher priced but offer lower long-term costs in terms of repair and maintenance. Thus, there is a longer-term play here, as the company’s core markets are still 40% to 75% wood, though that’s slowly converting over to composites, both via new building and via repair and remodeling activity. (AZEK expects 3% to 4% of its 11% long-term annual sales growth target to come from “wood conversion.”) That’s a positive tailwind, but it’s been overwhelmed by both the slowing residential and commercial housing and repair market, as well as an inventory glut last year—sales and especially margins have fallen off for the past three quarters, and for the fiscal year as a whole (ending in September), management still sees EBITDA down 15% or so. But most (if not all) of that decline is likely behind it—in May, the top brass said it expected EBITDA margins to begin rebounding starting this quarter, which has to do with better than feared demand but also normalized inventory levels that are restoring equilibrium to the industry. Throw in growing hopes that the Fed is near an end to their rate hike campaign (mortgage rates topped nine months ago) and a solid beat last quarter (18 cents vs. 13 expected) and investors see the writing on the wall: AZEK’s fundamental rebound is likely already underway, and Wall Street sees the bottom line lifting in a big way next fiscal year, with even those estimates likely to be conservative. There are obviously risks (interest rates, economy, etc.), but AZEK is a housing-related play with some long-term bullish factors that’s just starting what should be a new up leg.

Technical Analysis
AZEK came public in 2020, topped out for much of 2021 and hit the toboggan slide in 2022, falling about 70% from its highs by June and retesting its lows in October. Then came a solid run, with shares stretching well above their 40-week line into February—and that was followed by a normal-looking launching pad, with shares holding most of their off-the-bottom gains, capped by a recent move to 16-month highs. Volume’s been a bit light on the latest push higher, so we suggest aiming for dips if you want in.

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Stock 4

Dave & Buster’s (PLAY)

Why the Strength
A year ago, Dave & Buster’s acquired competitor Main Event, adding another 68 restaurant locations mainly in areas the chain hadn’t covered. The merger created a 210-location casual restaurant-entertainment hybrid, offering families arcades with games, plenty of big-screen TVs to watch sports and sit-down restaurant service. The company is led by a nearly completely new management team organized after the merger, blending long-time executives of both chains. Dave & Buster’s says it’s a unique proposition for families and investors, sitting between pure entertainment options like amusement parks and national casual restaurants that just offer food and beverage. It also believes it has a price advantage, offering a cheap night out for families making $100,000 a year or less, a segment that makes up 76% of their customers. The focus on middle- and low-income families crimped sales just a bit in the first quarter – the company missed on revenues by $7 million -- but the new management team has seen success in tightening up operations to boost profitability and margins. Indeed, Dave & Buster’s beat expectations on EPS with $1.45 and on EBITDA, too, which grew 30% in Q1. In 2022, the business earned EBITDA of $325 million – management says it sees a path to tripling that in five years through continued operations improvement (read: cost cuts) and new locations, including a just-signed agreement to franchise in Australia and the Middle East, which will be its first locations outside North America. Management doesn’t provide guidance, but Wall Street sees the bottom line up 28% this year and another 22% next. A reasonable valuation puts a nice bow on the story.

Technical Analysis
PLAY hit 52 in March 2021 and dipped as low as 30 in late 2021—and the stock has been in that range ever since. That said, after endless tests and holds of support in the 30 to 33 area in the past year, the Q1 earnings report has certainly changed things: The stock gapped up after the report in June, and followed that up with another surge soon after, and while shares have been herky-jerky since then, they’re perched near multi-month highs. We like the power following the endless consolidation—you can start small here and look to average up if the buyers remain in control.

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Stock 5

DraftKings (DKNG)

Why the Strength
If you’re a believer in the online sports betting industry (and, to a lesser extent, online casino gambling, dubbed iGaming), then you should be a believer in DraftKings, the top investable dog in that fight. Indeed, while these sectors have come a long way in recent years, there’s still a lot of runway ahead: At the end of March, DraftKings’ sports betting offering is now live in 22 states that represent 46% of the U.S. population, while 12 more states (with 24% of the population) are pushing legislation through the system; for iGaming, it’s live in just five states with another five in process of legalization. Moreover, it’s not like DraftKings is solely dependent on new legalization efforts—in Q1, users who came in from 2018 to 2021 wagered more than 25% more money from a year ago (!) while unique users increased in the double digits. Plus, with newer state launches, the firm is garnering far more users right off the bat, which obviously increases margins and scale. Beyond that, though, is the attraction that the Wild West phase of the sector has ended—gone are ridiculous sign-on bonuses and marketing spend, replaced by lower marketing costs ... and even with that the firm has seen lower customer churn. The result is still-rapid revenue growth (81% in Q1, though likely to tamp down to the 40% to 50% range in Q2 and Q3) and cash flow that is quickly approaching breakeven (will hit breakeven in Q2, though will still be in the red for 2023 as a whole). Obviously, there’s still competition and management has to execute, but if all goes well, DraftKings could be an emerging blue chip-type of name.

Technical Analysis
DKNG bottomed out for many months last year, ramped earlier this year and etched a nice base—the stock never broke the 50-day line, and the early-May earnings gap was obviously a good sign. However, since then, DKNG has done more chopping than advancing, though it’s held its 25-day line the entire time and, now, is testing some resistance. You can nibble here with a tight stop and add more on decisive strength.

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Stock 6

Lam Research (LRCX)

Why the Strength
Lam is a major provider of the equipment used by makers of memory chips—including advanced DRAM and NAND flash chips—a market that has been suffering from shutdown-induced oversupply. Despite this, Lam has managed to stay strong thanks to its exposure to the white-hot trends of artificial intelligence (AI) and electric vehicles (EVs). This was highlighted at a recent investor conference when Lam said it’s seeing increased demand for high bandwidth, memory-related tools that are needed to put chips together in an AI system, while devices used in automotive applications were said to be one of Lam’s “fastest growing segments,” with management noting that EVs can have almost twice as many microchips as traditional vehicles. Lam also said generative AI, AI servers and autonomous driving are all “major demand drivers” for chip manufacturers while providing “secular tailwinds” for the company. But memory chip manufacturing is still one of Lam’s biggest end markets, and despite the chip glut, many industry members expect this market to recover in the second half of 2023 (including Micron’s CEO, who thinks the memory chip market has already bottomed out). On this score, Lam recently announced another large foundry and logic customer that has selected the firm’s hardware for DRAM chip production. Foundry-related system sales, meanwhile, hit record levels in the March quarter. And while the firm expects June quarter sales of just over $3 billion (down 32% year-on-year), it continues to generate robust free cash flow, which it’s using for buybacks and dividends (a 1.1% yield). Wall Street’s 2023 expectations for Lam are meager, but as the memory market rebounds and as AI takes hold, it’s likely earnings estimates will move up.

Technical Analysis
LRCX bottomed near 300 in October before rallying in two different waves to 550 or so in late January. Then came a nice 14-week basing structure (notice the super-tight range to finish off the base, a positive clue) that led to new recovery highs in May on a nice string of buying volume. Now LRCX has tightened up again, hanging out in the 600 to 650 area with no signs of distribution at all. We’re OK starting a position here or on modest weakness.

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Stock 7

MasTec (MTZ)

Why the Strength
Engineering and construction firms are notoriously tough to invest in, but we’re coming around to the view that many could be in the midst of a long-term growth wave—and MasTech is one of the best performers out there. A big driver here is the alternative energy sector, with the firm likely to see revenues there nearly double (and become its biggest segment) this year thanks to work on things like solar and wind farms, biomass facilities, carbon capture facilities and transport infrastructure. Next up is communications, which has always been a big business for the firm, with tons of 5G (which is still in the early-ish stages of deployment), small cell work and fiber to the home. Power delivery is just behind that, with grid modernization (partly due to the alternative energy boom, though also natural gas; the Dept. of Energy thinks a 60% increase in transmission systems will be needed in the U.S. by 2030!) and increased electric/gas distribution. And the firm still does a good business with oil and gas firms, with pipelines and the like still in demand. All told, the 18-month backlog here is big ($13.9 billion) and growing fast (up 31% from a year ago), while earnings are expected to kite higher for at least the next couple of years as EBITDA catapults to a new high this year. Throw in big potential down the road and expanding margins, and there’s a lot to like.

Technical Analysis
The most recent action says it all for MTZ—after gyrating for most of the time between mid January and mid April, shares have lifted nine weeks in a row, including a stretch of seven straight on above-average weekly volume, with the relative performance (RP) line hitting new multi-year highs, too. MTZ is extended here, so we’re setting our buy range lower, but we’re not expecting a big pullback given the persistent, strong upside power.

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Stock 8

Pure Storage (PSTG)

Why the Strength
Pure Storage is a cloud-based storage-as-a-service business, with an increasing amount of its money coming in not from one-time sales but from subscription tiers. While there are plenty of cloud storage offerings in the market, management says it’s different because Pure Storage offers only flash-drive storage, which is cheaper and 10 times more reliable than traditional spinning hard drives. The company says customers pay about 20 cents for a gigabyte of storage now, roughly half traditional provider charges, and as the business gets larger economies of scale should hammer that down to perhaps under 10 cents in a couple of years. The company also guarantees that the storage systems being used will continually be improved to stay technologically current. That allows Pure Storage to pitch corporate customers on abandoning their legacy data archiving operations and switching to Pure Storage to save money and risk, as well as making operations more sustainable (flash storage uses significantly less energy than older systems.) Pure Storage runs on its proprietary operating system, which supports big data analytics and AI applications that use massive amounts of stored information. Q1’s results were rough overall in what management said is a slow sales environment, but that masked some strength—subscription-based recurring revenue leapt nearly 30%, the top brass said its storage services had their best ever quarter (including the first sales of an exciting new offering) and, interestingly, the CEO predicted there would be no new hard disk drives sold within five years. Revenue growth should pick up a smidge starting in Q2, and investors are thinking the AI boomlet will lead to a quick and big rebound in demand down the road.

Technical Analysis
PSTG bumped its way downhill from early 2022 to the start of May, when growth stocks finally turned up. The initial rally was OK, and then when AI stocks got hot, this name got a lift. And then came the Q1 report which caused an explosion—PSTG soared 19% on the day and rallied above 38 in the days that followed before finally exhaling a bit. We think a bit more downside could be ahead, so we’ll set our buy range lower.

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Stock 9

Rambus (RMBS)

Why the Strength
Memory capacity and speed are becoming the main obstacles in the development and training of new artificial intelligence (AI) models, but Rambus’ cutting-edge offerings are helping to alleviate this. Rambus (covered in the April 17 issue) is a leading fabless provider of memory chips and security hardware for processors that advance data center connectivity, solving the bottleneck between memory and processing. It calling card is Compute Express Link (CXL) memory technology, which enables servers to combine resources and speed up data transfer between main processors (hosts) and accelerators. Another expanding market for Rambus is the next-generation Double Data Rate 5 (DDR5) memory chip architecture, which is being widely adopted by chip makers this year due to its augmented memory capacity. Already Rambus has established a leading position in the DDR5 market, which is heavily used in AI, and the company sees it as a growth driver going forward. On a related note, Rambus is partnering with IBM to develop new AI memory solutions for use in AI accelerators that combine DRAM with other technologies to create high-capacity memories at lower costs, a collaboration Rambus said has enabled it to make “good progress” on future server generations for years to come. On the financial front, the numbers are a bit hard to interpret (different types of revenue and weird expense accounting), but sales and earnings are headed up, with analysts seeing the top line rising 27% this year as earnings continue their growth path.

Technical Analysis
RMBS actually broke out last November, way ahead of most stocks, which was a clue good things were in store. From there the stock mostly rode its 10-week line higher, albeit with plenty of dips and rest periods, before going vertical in May when AI stocks first went nuts. The four-week pullback was tedious but normal, and RMBS saw solid accumulation last week. We’re OK grabbing some shares here with a stop under the recent low.

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Stock 10

TechnipFMC (FTI)

Why the Strength
Remotely operated vehicles (ROVs) are making worldwide headlines in the wake of the disaster involving the OceanGate submersible (which was just located and recovered using an ROV). The news also underscores how the technology is being used to explore ocean depths for oil and gas deposits, as well as in other subsea applications—such as repairing underwater equipment—thus allowing companies to reach depths not possible with divers. U.K.-based TechnipFMC is a global leader in traditional and renewable energy solutions, providing design, engineering and manufacturing of the systems used to access energy resources on land and at sea—including what are regarded as the world’s most advanced ROVs, manipulator arms and exploration subs. In Q1, the company reported “robust” inbound orders for both its subsea and surface technology segments; while per-share earnings were a penny, up from a tiny loss last year, revenue of $1.7 billion grew 10% in the quarter and adjusted EBITDA grew 3%, driven by “solid” operational performance—all of this occurring while the offshore drilling market segment remains sluggish. The company garnered $2.5 billion in subsea orders which, along with integrated Engineering, Procurement, Construction, and Installation (iEPCI), accounted for 70% of its orders. However, this is really about what comes next: FTI’s backlog increased 19% (up 13% sequentially) to $11 billion, and management said it’s “confident” given the “high quality opportunities” the firm is pursuing that Q1 likely wasn’t the quarterly peak for this year’s iEPCI orders; it also expects record subsea orders of more than $8 billion this year (around $2 billion of which has been contracted in just the last six weeks!). And all of that means the bottom line is headed up—Wall Street sees earnings near 50 cents per share this year and over a dollar next, and both are probably conservative.

Technical Analysis
Oil stocks have been laggards for months, so when FTI showed up on our Top Ten screens, it certainly caught our eye. The stock acted well into the end of February before correcting in March with the market/banking crisis, falling quickly from 16 to 12—but that was the low, with a couple of higher bottoms in early May and June before FTI perked up. And now, after some tightness, shares have shown real strength, surging to new price highs. We’re intrigued—we’re OK snagging a few shares around here with a stop in the mid 14s.

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Previously Recommended Stocks

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