Cabot Top Ten Trader Issue: June 26, 2023

Normal Pullback, but Watching Closely

The much-anticipated market dip finally arrived last week, bringing the big-cap indexes down about 1.5%, though broader indexes fared worse (2% to 3%). So far, when you look at the leadership of this market—the Nasdaq and leading individual stocks—the action has been completely normal, and in fact, seems to be producing some higher-odds entry points as names dip toward support. Once again, though, we need to keep a close eye on the broad market—the intermediate-term trend remains up, but it’s getting close to the edge, with another bad week possibly putting the broad market back in the soup. Overall, we like our positioning: We’ll leave our Market Monitor at a level 7 today given the action of the leaders and think some buying on the dip makes sense. But we’re watching things closely in case weak breadth causes the selling pressures to build.

This week’s list has a growing number of pullback-related setups. Our Top Pick is Confluent (CFLT), which has a great story and has pulled back reasonably after a powerful rally. It’s volatile, so start small and use a loose leash.

Stock 1

Alkermes (ALKS)

Why the Strength
Health experts are drawing attention to what they are calling the “other deadly pandemic” of mental illness, which afflicts nearly one billion people globally in some way, shape or form. Among the diseases contributing to the crisis are bipolar disorder and schizophrenia, both of which are top priorities for Alkermes. The company develops drug delivery technologies and owns several proprietary treatments for schizophrenia, addiction and Alzheimer’s, as well as multiple sclerosis and cancer. Among Alkermes’ psychiatric drugs are Vivitrol (for opioid and alcohol addiction) and Aristada and Lybalvi (antipsychotics). The company’s oncology pipeline includes nemvaleukin alfa, which is in Phase III testing for platinum-resistant ovarian cancer and mucosal melanoma; the firm plans to spin off the oncology business later this year on that drug’s potential as a “standalone thesis.” In neuroscience, the drug combination of olanzapine and samidorphan (Lybalvi) to treat olanzapine-associated weight gain for schizophrenia patients, schizophreniform disorder or bipolar I disorder, is in a Phase III trial that recently met its primary endpoint (a reason for the stock’s strength). Also contributing to the strength was a financial award received from Johnson & Johnson unit Janssen relating to a licensing dispute over drug technology, prompting Alkermes to substantially increase its 2023 top- and bottom-line outlook. Q1 results were mundane, but that hid some under-the-surface positives: Revenue in Q1 grew just 3% (due to Janssen’s prior partial licensing agreement termination), while per-share earnings were near breakeven, but Alkermes still grew revenue from its proprietary products by 25% from a year ago, led by Vivitrol sales. Thanks to the Janssen dispute resolution and the upcoming spinoff, analysts see explosive solid earnings growth ahead.

Technical Analysis
ALKS peaked in late 2021 and had an up-and-down pattern for the next year, with a dip to 22, a return to its old highs last summer and then another fall to the low 20s last fall. The advance from there was steady, and while ALKS has been yanked around by the market at times, it’s made higher highs—with the recent push from a test of the 50-day line bringing the stock back to its old peaks. We’ll set our buy range down a smidge.

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Stock 2

Braze (BRZE)

Why the Strength
Technology is vital to succeeding in today’s business world, but with all the new web and automation out there, there’s still a need for better, more efficient customer interaction tools that boost customer acquisition and engagement levels, all while keeping costs in check. That, in a nutshell, is where Braze is making hay: The company’s offerings use advanced data analytics to give clients the ability to have real-time, personalized interactions with customers, and those interactions are integrated across all channels (mobile, email, text, in-app messages, app notifications, etc.), resulting in prompts to do more with a firm’s brand—whether that’s signing up for something, watching a new show, trying out a new product and so on. (All in all, the platform sent 1.5 trillion messages last year.) It’s a simple idea, but it looks like Braze is doing it better than anyone else. Indeed, basically every consumer-facing operation is a potential client, and the names that have signed up are very impressive—Braze counts Burger King, Overstock, Gap, Sweetgreen, Grubhub, Venmo, Pizza Hut, KFC, Peaock, HBO Max, Nascar, Sephora, DraftKings, FanDuel, iHeartRadio, the NBA, GoFundMe, Proctor & Gamble, CVS, Goldman Sachs, Etsy and more as clients; all told, the firm has more than 1,800 clients, which is up 24% from a year ago, and those customers are buying more, with same-customer revenue growth of 22% in the latest quarter. Growth is likely to slow some as companies are tightening their purse strings, but even with that, 25%-ish top-line growth looks likely. Longer term, the firm’s leadership position in its field (including AI-enhanced offerings; it already uses this for email subject lines and images—effectively lowering the time needed to produce content) should continue to attract more big clients.

Technical Analysis
BRZE came public at a great time for the company—but bad for shareholders—right near the market top in 2021, with shares falling from nearly 100 then to 27 in May and 23 in November. Frankly, the action after that wasn’t special, either, with the stock having trouble getting above its 40-week line this year and dipping back to 26 in early May. But now the sellers may finally be exhausted: After a modest bounce, BRZE gapped up on six times average volume (to nine-month highs) after earnings, and it’s held tight despite the market’s recent wobbles. It’ll be volatile, but a nibble on dips is fine by us.

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Stock 3

Confluent (CFLT) ★ Top Pick ★

Why the Strength
Every cycle usually has a couple of leading “tech infrastructure” plays, with new leaders in chips and networking often appearing every couple of years. Big Data, though, has been an outlier, with few storage stocks really joining the ranks of leadership. But we think Confluent could change that: The firm’s platform is the best at helping programmers use Apache Kafka, which is an open-source data processing software used by over 100,000 firms (and most big companies); in fact, the founders of Confluent created Kafka while at LinkedIn years ago. The details can be in the weeds, but the big idea here is that the firm’s offerings allow for a real-time data “streaming” operation that can be integrated with all of a client’s technology, so everyone can get real-time insights, updates and action items. (In Confluent’s words, its platform is becoming the central nervous system of a firm’s tech stack, with everything else connected to it and dependent on it.) The company does have an on-premise offering that’s still growing (up 16% in Q1), but the bigger opportunity is the cloud, which makes up 42% of revenues but expanded 89% last quarter—management made a point in the latest conference call saying that it’s developed better and cheaper ways to deliver that cloud service, which is a big competitive advantage. To be fair, growth is slowing somewhat here (mostly due to economic factors) and the bottom line is still in the red, but the opportunity is enormous (the top brass puts it at $60 billion) and operating income is expected to reach breakeven by year-end. Top-line growth of 30%-plus seems likely for a long time to come.

Technical Analysis
CFLT crashed from a post-IPO high of 95 in 2021 to a low of 16.5 last spring and spent forever building a big bottoming pattern; in early May, the stock was still sitting at 20. But then everything changed, with a powerful six-week advance that brought shares to 14-month highs. Now we see CFLT losing some altitude with the market—a pullback that has seen some volume selling and could go further, but overall seems well controlled compared to the prior advance. We’re OK starting a small position here or (preferably) on further dips.

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Stock 4

Datadog (DDOG)

Why the Strength
Artificial intelligence (AI) is all the rage, and it’s easy to see why: According to one estimate, AI could increase global economic output by a stunning $13 trillion in just the next few years. Of course, AI should also boost software sales related to the technology, and that’s where leading SaaS-based application performance management (APM) provider Datadog comes in. The company’s real-time monitoring and analytics platform has long helped IT departments quickly identify and fix performance and security issues among the swarm of disparate apps, networking gear and software platforms most firms use; Datadog’s offering relies heavily on AI to speed up the problem-solving process. Moreover, as cloud security threats become more common, the need for monitoring and security software is leading to higher sales for Datadog—a trend that was on full display in Q1, as the company posted stellar top- and bottom-line beats in the quarter (a big reason for the strength). Revenue of $482 million surged 33% year-on-year, and per-share earnings of 28 cents topped estimates by five cents, driven by continued new customer growth—particularly in cloud security—and “increased multi-product adoption” by existing clients. The company’s total annual recurring revenue (ARR, a key metric) exceeded $2 billion for the first time, and nearly 3,000 customers had an ARR of $100,000 or more (up 30%), which accounted for around 85% of Datadog’s sales. What’s more, over 80% of customers were using two or more products (unchanged), while 43% of customers were using four or more products (up 35%)—all of which shows the company’s platform continues to see greater adoption. Management believes AI will increase demand for compute and storage to train and run models; analysts agree and expect a 25% sales bump this year and next, with earnings also heading up. It’s not growing like it was a couple of years ago, but Datadog should be a winner in the AI move.

Technical Analysis
DDOG was in the doghouse all last year after peaking in late 2021, falling from 200 to a low of 61 this January—and it really wasn’t able to bounce much after that, capped by its falling 40-week line and retesting its lows in March and April. But DDOG finally tightened up, and we’ve seen a change in character in recent weeks, with the stock enjoying three very big-volume up weeks to kick off a six-week advance, and a modest three-week retreat since. We’re OK snagging some shares here with a stop in the low 80s.

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Stock 5

Extreme Networks (EXTR)

Why the Strength
One of the linchpins of the artificial intelligence (AI) revolution is cloud networking, which greatly increases speed and facilitates automation while providing the computing resources and infrastructure needed to train and deploy AI models at scale. A key player in this field is California-based Extreme Networks, a provider of high-speed networking software and firmware solutions for data centers and service provider networks, offering solutions both in the cloud and on-premise. Improving supply chain conditions, along with an improvement to the company’s competitive position, drove record results during fiscal Q3 (2023), led by a 16% year-on-year revenue increase, to $333 million. New subscription bookings jumped 29% and recurring revenue from software-as-a-service (SaaS) grew 22%, while subscription-related deferred revenue was up almost 40%. (The fact that Extreme has a big recurring revenue component adds reliability to the results; the company has been solidly profitable since at least 2016). The solid bookings trend was led by government and education customers, which accounted for over 35% of the total, with additional big wins in the retail sector (15% of bookings), and with manufacturing (10%) and sports and entertainment (under 10%) bringing up the rear. Elsewhere, services and subscription revenue rose 5%, driven largely by cloud subscription sales (up 30%). The sanguine results resulted in strong free cash flow, which enable the firm to repurchase $25 million of stock and reduce debt by 42%. While growth won’t be explosive, Wall Street sees the top line lifting 12% to 16% this year and next, while earnings continue to power ahead. A reasonable valuation (22x this year’s estimate) helps. It’s not a liquid leader, but Extreme is in the middle of a solid growth phase that should get a lift from the AI boomlet.

Technical Analysis
EXTR topped with everything else in late 2021 and got hit into the middle of last year, but it impressed by running to new highs by year-end—certainly a rarity in the tech and networking sector. The last few months have seen shares take some hits, including a big dip in April on a poorly timed analyst downgrade—that proved to be a shakeout, though, with EXTR breaking out May 31 and racing higher. We’ll set our buy range a touch lower, thinking the current dip could go further.

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Stock 6

Monday.com (MNDY)

Why the Strength
Monday.com is showing strong follow-through on an excellent first quarter reported late last month. The company makes intuitive software for improving workflow and automating tasks, a system Monday.com calls a “work operating system”—and the big idea here is that it’s for the non-IT crowd, including salespeople, creatives, human resources and marketing pros. The pitch is that workers feel increasingly overwhelmed by the number and complexity of software packages and the many tasks they and their teammates handle. Monday.com helps by serving as an app layer connecting many of the programs workers use, such as Salesforce, Zoom, Slack and Gmail. By linking disparate systems, it streamlines team communication with instant synced messaging, while adding the ability to customize project management and data sharing as needed. The system offers features users find familiar, like the ability to drag and drop columns and events around a virtual whiteboard. Monday.com has built its business by offering a free tier to small businesses and growing into subscription revenue as clients grow and sign up for additional functions. (The company’s new CRM offering is growing five times as fast as its overall platform.) That’s worked well, but Wall Street senses the company is gaining traction in selling directly into already established ventures. (Clients accounting for more than $50,000 in recurring annual revenue have leapt 75% from a year ago, to 1,683.) That helped first-quarter sales leap 50% year on year to $162 million. The company is rolling out a new version of its database to all its customers over 2023 that speeds up load times and will be able to offer advances the company is making in AI capabilities down the line. This quarter, look for sales of $169 million and EPS of 17 cents, and for the year as a whole, Monday expects to be profitable—two years ahead of schedule.

Technical Analysis
MNDY is owned by “only” 206 funds, so the stock can be super volatile (it moves around eight points per day from high to low!), and indeed, shares etched a wild bottoming pattern for many months before rallying into February. Shares took a big hit again with the market in March and April, but the action since then has been enticing—MNDY soared on giant volume both before and after its quarterly report, and the past three weeks have seen a normal (albeit choppy) rest, with the stock giving up little of its gains. We’re OK buying some here or on dips, but keep it small and use a loose leash given the volatility.

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Stock 7

Netflix (NFLX)

Why the Strength
After years of emphasizing subscriber gains, Netflix is now focusing on revenue and earnings growth. A key has been a crackdown on subscriber password sharing that started in May, in which the business uses location data to push users not in the same house to pay for separate accounts. Early indications point to it working well, with data from streaming industry researcher Antenna reporting that average Netflix subscriber sign-ups hit 73,000 a day. Granted, that sample is very limited, covering just a four-day period in May, but the rate is twice the average of what Netflix saw the prior two months. (The ratio of sign-ups to cancellations rose, too.) The push for new subscribers comes after a November 2022 move to offer an ad-supported $7 per month basic plan, which is $3 less than the service’s cheapest ad-free tier. About a quarter of new customers are choosing the ad-supported offering, which the company expects will probably be revenue-neutral. The streaming business is incredibly competitive, but investors appear to be thinking Netflix will be one of the survivors as services proliferate. Last week, one news report said Netflix has considered acquiring Paramount, the renamed CBS that has seen lots of ups and downs shifting to a streaming-first business model. That may not come to fruition – the report suggests any deal is dormant – but it shows Netflix has resources to put to use. The company also announced it will spend $2.5 billion on beefing up its market position in South Korea, which has produced worldwide hits like Squid Game. So far, the writers’ strike that has shut down TV and movie production doesn’t seem to be impacting business. After an earnings dip last year, Wall Street seems the bottom line returning to growth in Q3 and accelerating through 2024.

Technical Analysis
NFLX staged a nice rebound after a punishing bear decline, rallying from the 170 area near its lows last spring to 380 or so in January (which, believe it or not, was still 45% off its 2021 high). Then came a great-looking launching pad, with NFLX tightening up in early May and breaking out nicely later that month. The run since then was solid (six straight up weeks), and the latest retrenchment has been normal so far. Further dips would be tempting.

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Stock 8

ServiceNow (NOW)

Why the Strength
ServiceNow (covered in the May 30 issue) already enjoys a leading position in the IT service management (ITSM) software space, with a more than 40% market share. Not content with that, the company is expanding its footprint in other areas of tech, including cyber security, risk management and operations management. The expansion is designed to capture the growing demand in these end markets related to the ongoing digital transformation, and ServiceNow is viewed as a premier platform for end-to-end digital transformation. Obviously adding to the potential is generative artificial intelligence (AI), which an increasing number of companies view as essential to remaining competitive in the coming years (and which ServiceNow sees as providing up to an 80% value increase for its customers). On that front, ServiceNow recently partnered with tech giant Nvidia to use the latter’s GPU software to train proprietary generative AI algorithms for ServiceNow’s digital workflow management platform—a move some analysts are calling a “revolutionary” improvement to its current solutions. Earlier this month, the company unveiled a new generative AI solution called Now Assist for Virtual Agent, a chatbot that uses machine learning to deliver more direct, relevant and conversational responses to questions, as well as to connect exchanges to digital workflows across the Now Platform. The firm also agreed to acquire AI-powered platform G2K, which will enable ServiceNow to add G2K’s smart IoT technology to the Now Platform to help retail and other industries improve operational efficiency. Wall Street sees 25%-ish earnings growth for the next several years.

Technical Analysis
NOW was in a funk for most of 2022, but the calendar flip reinvigorated the stock, starting with a pop to 495 in January. Three-and-a-half months of base-building followed, with the 200-day line serving as support for much of that time. The stock broke free in May and we’ve been pleased with the action since then. It’s not the fastest mover but we think NOW is a good risk/reward around here.

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Stock 9

Terex (TEX)

Why the Strength
Hundreds of millions of dollars have been earmarked in cities around the U.S. this year for building and improvements, thanks to a federal infrastructure spending bill that has accelerated the non-residential segment of the construction market—particularly large projects. Seeing a notable growth spurt from this trend is Terex (covered in the March 13 issue), which specializes in aerial work platforms (AWPs) like scissor lifts and cranes that are used to help workers safely deliver tools and materials to high places in construction projects; it’s also a big player in materials processing machinery (crushers, chippers and shredders) and mixers (mainly cement trucks). With healthy consolidated bookings of $1.3 billion that extend well into 2024, plus a backlog of over $4 billion (roughly three times higher than normalized levels), Terex reported “strong growth” and “tailwinds” across all four of its major segments in Q1. AWP sales increased 24% year-on-year on higher demand, and the company said its construction vehicle network continues to boom. It’s also seeing “robust” demand among independent and public power utilities, while hospital-related business rose to $48 million in the quarter, up 33% from a year ago. Total revenue increased 23%, while per-share earnings of $1.60 beat estimates by a whopping 56 cents; indeed, analyst estimates for this year have moved from the upper $4 range to $6 since that Q1 report. Moving forward, Terex anticipates higher volumes in Q2 and Q3 with sales expected to be fairly consistent in both quarters. Management said an improving supply chain will help with the fulfillment of the elevated backlog. A modest valuation (11x on what could be conservative estimates) and 1.1% yield put a bow on the package.

Technical Analysis
TEX staged a remarkable comeback in the second half of 2022 and into this year’s Q1, rallying from its bear lows to a high near 60. But then came the March banking-induced dip that took every economically sensitive name down, and this stock was no exception, with a sharp dip to 42. But the 40-week line held, a bottom was built, and now TEX is marching higher again. We’re OK with a nibble during this rest period, and possibly adding more on a powerful move above 60.

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Stock 10

United Airlines (UAL)

Why the Strength
The bust of the pandemic has turned into a super-boom post-pandemic period for airline companies, which are seeing earnings reach ridiculous levels—and it appears these elevated earnings levels have some staying power, not just because of big travel demand but because of some potentially longer-term issues (staffing being the big one, especially for pilots; United expects to offer its pilots’ union an “industry-leading” contract soon) that could keep supply growth limited, all while costs remain in check. United Airlines is obviously one of the big boys of the sector, and results of late have been terrific: Revenues have lifted a whopping 51% in each of the past two quarters, due equally to capacity growth and higher prices (seat miles flown and revenue per seat mile were both up 23% in Q1). While the bottom line was in the red last quarter, that’s not unusual for Q1, the loss was only a quarter of 2022’s tally. More important was that management continued to pound the bullish table—back in April, the top brass thought Q2 earnings could be north of $3.50 per share, and despite some issues they reiterated their outlook for $10 to $12 in earnings for the full year, though Wall Street is a bit less sanguine, seeing earnings of “only” $9.35 this year. (Right now, the firm is using a bunch of that cash flow to retire debt, with the total down $4.3 billion in the past 12 months.) Since then, there were some industry reports of softening demand in May, but that seemed to go away when peer Delta (written about here last week) bumped guidance in early June, saying revenues and margins would be stronger than expected, which basically reaffirmed the earnings story for the sector as a whole. The economy is obviously the X factor here, but while business travel is slow, there are few signs that leisure travel is slackening at all. As far as cyclical names go, we like it.

Technical Analysis
UAL was nothing special until January of this year, when a rush of buying in the stock (and the group as a whole) drove it to seven-month highs. Still, the market had issues, with the breakout attempt failing in early March, leading to a big drop when regional banks went over the falls. The good news is that UAL held its 40-week line in April, perked up in May and now has shown solid (albeit low volume), persistent upside action this month. The tame, tight retreat in recent days looks tidy—if you want in, you can do so here.

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Previously Recommended Stocks

The next Cabot Top Ten Trader issue will be published on July 3, 2023.