Cabot Top Ten Trader Issue: November 13, 2023

Looking for More Confirmation

Last week was a split tape, with the big-cap indexes continuing their thrust higher, along with many potential leading stocks, with a bunch building on their moves from two weeks ago and others beginning to emerge. That said, the broad market remains a soft spot, with small and mid-caps dipping and the new high (still small) and new low (still elevated) list telling us many stocks are rowing in different directions. Overall, the intermediate-term trend is effectively neutral, and we think what happens from here will tell the tale, with further broad strength indicating that a year-end rally (if not much more) is underway—though should the broad market infect the leadership, all bets are off. Right now, we’re more optimistic than not, but are simply looking for more confirmation on the upside; we’ll leave our Market Monitor at a level 5, but could move it higher quickly if things fall into place.

We think the most bullish thing the market has going for it is the action of individual stocks, a good number of which are beginning to percolate, and Top Ten is picking up on them, with many great charts this week. Our Top Pick is ServiceNow (NOW), which isn’t likely to be the fastest horse but definitely quacks like a liquid leading name.

Stock 1

Applovin (APP)

Why the Strength
Applovin’s AI-powered advertising optimization software, Axon 2.0, is blowing away expectations, allowing Applovin last week to post third-quarter revenue of $864 million, up 21% from last year and $65 million better than analyst consensus. Earnings per share of 30 cents also crushed expectations while EBITDA (a better profitability measure for this business) was up 63%. Management credited the increased profitability to Axon as well: The business has long specialized in using technology to identify online and mobile users that marketers want to target, and the success of Axon is proving that Applovin has successfully navigated a sea change in how it finds people to advertise to after privacy changes by phone makers (especially Apple) made its old method much less reliable. For the current quarter, management sees continued strength pushing sales to about $920 million, which would be a 31% gain, with further improvements in profitability metrics. Management also believes Axon 2.0 can open up new markets, with testing commencing on targeting users through web-connected televisions (dubbed CTV), where manufacturer privacy rules are much looser than on mobile devices. Applovin’s original business of authoring mobile games, as the basis of identifying and targeting demographics, has been going through a downsizing the past year to focus on the most cost-effective apps. It still produces significant sales, totaling $360 million last quarter, up 5% sequentially, and has decent EBITDA margins too, but it’s worth noting that more than 85% of EBITDA is from the software side of things, so apps are just a side show at this point. Management is making strides, too, in making the business more appealing for shareholders, buying back $1.2 billion of its shares the first three quarters (Q3 share count was down 5.7% from a year ago), part of an ongoing plan to use cash to support the shares. Wall Street sees lots more growth ahead as Axon continues to penetrate a giant opportunity.

Technical Analysis
APP crashed during the bear market but rebounded smartly as the new version of Axon began to crank out bigger and bigger numbers; shares rallied above their 10-week line for months until topping near 45 in September. The correction from there was sharp but reasonable given the run (23% over six weeks), and APP rebounded with the market—though the post-earnings action has been interesting, with an initial reversal, followed by Friday’s romp, followed again with today’s dip. All told, we’re setting our buy range up from here, looking for a breakout.

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Stock 2

Datadog (DDOG)

Why the Strength
Companies across nearly every industry are building cloud applications and services to deliver higher sales, productivity and cost savings, which is resulting in growth across the key metrics for cloud monitoring and analytics specialist Datadog. Despite an environment driven by economic uncertainty and some purse tightening, Datadog unleashed some solid numbers in its recent Q3 report last week. Revenue of almost $550 million increased 25% from a year ago, beating the company’s own estimates and halting a trend of decelerating sales from the prior six quarters. Earnings of 45 cents a share beat estimates by 11 cents, which prompted several Wall Street institutions to upgrade their outlooks (all reasons for the strength). Also important was that forward-looking billings lifted 30% and the company observed an “increasing preference” for its customers to sign multi-year deals and longer-term strategic partnerships. Indeed, there was also an acceleration in big-ticket (+$100,000) enterprise customer growth, up 22%, as well as a bullish trend in remaining performance obligations (RPO, a key metric that reveals all money owed to Datadog under contract in the future), which increased 54% to $1.5 billion, probably as a result of some newer, longer-term deals or extensions. And while management believes revenue is a better indicator of future business than billings and RPO, the enterprise customer growth trend should drive top line growth in the coming quarters as these clients are upsold the firm’s other offerings. Other metrics were equally encouraging, with free cash flow of $138 million that doubled and rose from 15% of revenue a year ago to 25% of Q3 sales. Moving ahead, Datadog believes it’s still in the early stages of the cloud transformation trend with plenty of runaway for future growth, guiding for Q4 revenue of around $566 million—up 20% if realized—though many are thinking the firm will again top its own estimate.

Technical Analysis
DDOG fell from 200 to 62 during the bear market, bottomed out for a few months and then had a nice run this spring back to 120. That said, the correction that followed was a doozy—it started with a poor earnings reaction in August and eventually saw the stock fall 34% from its July peak, slipping below its 40-week line in the process. That said, like many names of late, we’re putting weight on the latest move: DDOG gapped up on earnings on its second heaviest weekly volume ever (biggest was May 2020), and its held the move thus far. There is resistance above here, but a small buy near 100 with the idea of adding on further strength makes sense.

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Stock 3

Duolingo (DUOL)

Why the Strength
Duolingo has a great, unique growth story that is only getting bigger, and the consistent string of better-than-expected results has the stock hitting all-time highs. To review, Duolingo is far and away the top grossing education app out there, with a fun, game-like system that has goals and rewards along the way, resulting in a product that works and is very enagaging, too. (One of our favorite metrics is that there are more people learning certain languages on the app, in fact, then there are native speakers of those languages.) The firm also uses a freemium model, with many using the app for free (it has a total of 83.1 million monthly active users, up 47% from a year ago), with ads bringing in some revenue for the firm. However, the driver here is subscriptions, with more and more choosing to pay up for added features—paid subscribers (5.8 million total, up 60% from a year ago) are growing nicely, with subscription revenue up 47% from the year before. The firm also does a small business in selling virtual goods on the app, as well as providing an English Learning Test for many institutions and academies. Growth here has been both rapid and consistent, and with so many free users on the platform, converting a few percent of them will keep the arrow pointed up for a long time to come. That’s the main story ... but we think a big part of the excitement last week came from Duolingo’s launch of music and math courses on its app, which obviously opens up entire new revenue opportunities. To be clear, management doesn’t expect material contributions from those areas for a while as it tests what works, but given the success it’s proven to have in languages, Wall Street is discounting the company succeeding in those (and maybe other) new areas down the road. Analysts see growth plowing ahead for many quarters to come.

Technical Analysis
DUOL blasted off in March but, while it did make progress, it was nearly impossible to hold on to—starting in late March, the stock had dips of 20%, 27% and, most recently, 22%, all while the stock made no net progress for seven months. But like many leaders, DUOL’s kiss of its 40-week line led to a bounce—and the post-earnings strength has been decisive (biggest weekly volume ever), bringing the stock above even its post-IPO high from late 2021. Given the volatility, we’ll set our buy range down from here, thinking we can snag shares on a dip.

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Stock 4

GoDaddy (GDDY)

Why the Strength
From a growth perspective, no one’s heart is thumping because of GoDaddy’s organic, single-digit growth, but the stock is strong today because the firm has a borderline ridiculous cash flow story and the top line should pick up speed into 2024, too. The company itself has a few moving parts but the overall story is very straightforward: GoDaddy is one of the leading ways for entrepreneurs or very small businesses (it has 21 million customers that pay an average of $200 annually; 85% customer retention rate, which is great given the small-fry client base) to get up and running online, offering domains, Microsoft 365 email, various website building offerings (including online stores or those with faster loading speeds), hosting, payments, security and marketing. (Its AI offering has generated some hubbub, too, giving clients more and easier access to ideas for branding, social media marketing and more.) The core business (domains and the like) isn’t growing but is highly profitable, but the applications and commerce offerings, while just one-third of revenue, is growing double digits, and more important are the margins—the overall EBITDA margin in Q3 was 28% (up from 25% a year ago), and with the company’s product development investments in the past (spending on that should decline next year), margins should grow further (it’s targeting 31% EBITDA margin in 2024 with upside the following two years) and free cash flow should remain very attractive. Indeed, free cash flow has been strong and growing steadily for a while, which led the top brass to buy back a ton of shares during the past two years (20% share count reduction!) This year, free cash flow will be north of $1 billion or $7.25 per share, with Q3 alone bringing in $280 million. It’s not changing the world, but GoDaddy is a well-managed outfit that should see a slight acceleration in growth and huge and growing profitability for at least the next couple of years.

Technical Analysis
GDDY was basically the opposite of a Top Ten stock for years, with shares completely waterlogged as they went nearly straight sideways. But we’re thinking the huge earnings move and solid follow-through seen the past two weeks is a major change in character—the stock has quickly moved to 18-month highs, and this comes after many months of tightening action (trading between 70 and 77), too. It’s not going to double in a month, but we’re OK buying some here or on dips.

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Stock 5

Lennox (LII)

Why the Strength
Energy transition initiatives in nations around the world are resulting in boom times for the heating, ventilation and air conditioning (HVAC) industry even as higher energy costs are resulting in greater demand for money-saving products. Texas-based Lennox is a leading global provider of climate control solutions, as well as a top player in the refrigeration market, and it’s benefiting from both trends. Higher-efficiency product demand helped drive residential sales growth of 7% year-on-year in Q3, to nearly $900 million, resulting in “continued momentum” and driving top-line growth while expanding margins. Record revenue of $1.4 billion increased 10% and earnings of $5.37 improved 30% (and beat by 60 cents!) from the year-ago quarter, prompting the company to raise full-year earnings estimates as well as sales and free cash flow guidance (reasons for the stock’s strength). The company’s commercial segment achieved “remarkable” profit growth in the quarter, mainly through pricing and a better energy-efficiency product mix. Lennox noted that increased factory productivity offset inflation’s impact and touted “significant” progress on new factory construction, which it sees as a strategic energy transition-related investment and supporting continued growth and productivity. It also announced the bolt-on acquisition of Architectural Engineering Services, which management said would further accelerate growth and enhance its service offerings. Looking ahead, Lennox sees free cash flow doubling this year, while Wall Street sees double-digit growth in 2024 and beyond, and even that should prove conservative given recent beats.

Technical Analysis
LII shot up like a weed from April until September, thanks in part to higher warm-season HVAC demand. But the fall quarter saw shares cool off somewhat, with the late-October 15% dip shaking out more than a few investors. However, no sooner than they were gone, the Q3 report ushered in a new wave of strong-volume buying interest and pushed LII to a yearly high. (Volume three weeks ago was LII’s largest in years.) There is resistance up here, so we’ll set our entry range down a bit and use a tight (percentage) stop.

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Stock 6

Light & Wonder (LNW)

Why the Strength
Las Vegas-based Light & Wonder (L&W, covered in the August 28 report) is the leading cross-platform global gaming provider, with offerings including casino slot machines, tabletop games, lottery systems and digital gaming solutions. It operates gaming offerings for both brick-and mortar and online gambling outfits through three segments, including land-based Gaming (new and used gaming machines and parts), SciPlay (mobile gaming) and iGaming (online betting). While the Gaming segment accounts for the bulk of revenues (64%), analysts anticipate the iGaming and SciPlay segments will grow substantially in the coming years due to the explosive increase in mobile and online gaming globally. Last week’s Q3 report highlighted this trend, as revenue of $731 million increased for the tenth consecutive quarter (up 13% from a year ago), per-share earnings of $1.08 more than doubled estimates and free cash flow of $123 million (about $1.30 per share) reversed the year-ago loss (all reasons for the stock’s strength). Gaming segment revenue increased 11%, led by “continued momentum” in gaming machine sales (up 23%), while SciPlay saw another quarter of record revenue—up 15% and driven by the core social casino business and outpacing the market (the company further just acquired the remaining 17% equity interest in SciPlay not already owned by L&W). iGaming record sales of $70 million, meanwhile, increased 21% and was driven by growth in both the U.S. and international markets. Also noteworthy is the firm’s new partnership with Netflix to launch the latter’s first casino industry deal, with the Squid Game slot machine due to be released next year. It’s not as dynamic as some pure plays, but Wall Street expects sales growth to approach 10% in 2024 and 2025 while the bottom line surges on the back of the online gaming boom.

Technical Analysis
After a 20% correction early this year, LNW established support and spent a few months consolidating above the 200-day line before turning the corner in Q2. The stock ran all the way to 78 in September before stumbling with the market (down 14% in just a couple of weeks), but it found support in early October and began to rebound. The bobbing and weaving of the last few weeks set the stage for last week’s earnings-related breakout to a 24-month high. We suggest aiming for dips if you want in.

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Stock 7

Nvidia (NVDA)

Why the Strength
NVIDIA’s chipsets were developed to provide the computing horsepower to run video games and now appear well-suited to the potentially much larger AI market. The company has rolled out a product called TAO, an open-sourced AI development tool used on other NVIDIA software and chipsets to train AI models on visual images. The initial target market is smart machines in industrial settings, to be able to identify humans and non-human objects like forklifts, scooters, pallets and the like; it sounds simple, but every new class of object requires a lot of computing power and AI training. NVIDIA is also developing industry-specific versions of its Jetson Orin, an all-in-one box (GPU, CPU and accelerators) for corporations to build AI systems as well as a library of tools for IT folks to write software to speed along development. Management believes the more AI gets built on its hardware, the more demand it sows down the line. If NVIDIA can get its chips into machines beyond PCs and servers, it will add increased momentum to what is looking like an excellent fundamental run for the company that’s just kicking off. NVIDIA’s chipsets are considered best-in-class for optimizing very expensive AI back-office systems by others in the AI ecosystem, like networking customer Arista, creating huge demand that more than offsets weakness in its previously robust cryptocurrency and mainland China markets. This year has already been great, with the company shattering expectations in both Q1 and Q2. For Q3, to be reported after the market close Tuesday Nov. 21, analysts see sales touching $15.9 billion, fully $10 billion more than 2022’s Q3—with a similar, $10 billion-plus jump predicted for Q4, while next year should be another barnburner, with early estimates calling for 60%-ish earnings growth.

Technical Analysis
NVDA has been the #1 AI (and, really, growth stock in general) this year, but even it took many months off of late—net-net, shares made no net progress from the start of June through late October thanks to some choppiness early in the summer and a 22% correction in the fall. But, while volume has been light, the price action of late has been like smoke up a chimney as NVDA has rallied persistently, overcoming some resistance near 476 and taking aim at the prior highs (and round number resistance) around 500. Earnings are a risk, of course, but we’re OK starting small here on on dips and seeing what the report brings.

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Stock 8

ServiceNow (NOW) ★ Top Pick ★

Why the Strength
Recent breakthroughs in artificial intelligence (AI) are set to result in huge productivity gains across every segment of the economy, commanding headlines at every turn. Yet lost in all the excitement is how AI is revolutionizing the public sector. Indeed, a rapid simplification and standardization process is underway to transform the complexity of government processes onto a single platform to “speed things up.” Leading this transformation is ServiceNow (covered in the September 18 issue), which provides a software-based platform for businesses to digitize workflows and enhance productivity. The company just released head-turning Q3 results that showcased growth (and in many cases, accelerating growth) across most key metrics (a reason for the stock’s strength), led by a 27% year-on-year increase in subscription revenue of $2.2 billion and earnings of $2.92 a share that jumped 49%. But what really captured attention was the astonishing growth of ServiceNow’s federal segment, which had its best quarter ever with 75% sales growth. While the company closed 83 total deals in Q3 with a net new annual contract value (ACV) above $1 million (up 20%), 19 of those big-money deals were with government agencies, with three of them raking in $10 million apiece. Notable wins included the U.S. Air Force, which the firm said was its third-largest deal ever, along with contracts from the Defense Department and the state of California. Management explained the deals reflect government’s ongoing multi-year journey to simplify procedures, with ServiceNow’s new generative AI capabilities able to be used to “enhance and aid.” The sanguine outlook prompted several investment banks to raise their target prices, with most analysts expecting low 20%-ish sales and earnings growth annually for the next two or three years.

Technical Analysis
NOW exited the 2022 bear market by initiating a new bull run once the calendar flipped, which has been composed of a series of base-on-base formations. The last extended rally petered out in July, with shares marking time by forming a lateral base (just 14% deep over 15 weeks) ahead of the Q3 report. Earnings got the stock moving and kicked off a string of 10 days up in a row, with Friday’s move setting a 22-month price high. While near-term dips are possible, we’re not expecting a major retreat; we’re OK buying some here or on minor weakness.

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Stock 9

Uber (UBER)

Why the Strength
Uber is effectively an emerging blue chip, with its two core businesses—ride sharing and delivery—continuing to grow, which, combined with solid cost controls, has revealed huge operating leverage (read: increased profits) in the business. In Q3, trip growth accelerated to 25% from a year ago, with the top brass saying Asia and Latin America have really picked up and with total drivers (which is really the key to ride sharing growth—more drivers means lower costs and more convenience for users) rising north of 30%. (The momentum continued in October, with the month setting another new high in trips.) Meanwhile, in the delivery business, revenues grew 18%, and probably most important for investors, EBITDA for both continue to boom—while accounting earnings are relatively tiny, Uber’s EBITDA totaled $1.09 billion in the quarter, up 19% from the prior quarter and up 112% from a year ago, while free cash flow came in at $905 million (around 44 cents per share); over the past four quarters, free cash flow has been $2.1 billion (more than $1 per share). Even better, the best is almost surely yet to come: Management has repeatedly sounded a confident tone concerning both growth and an expanding bottom line, as it’s in the very early innings in some international markets, has a ton of newer ride sharing offerings that are growing rapidly not to mention some entirely new avenues (the app itself should see $1 billion in ad revenues next year) that have big potential. The bottom line is that sales, EBITDA and free cash flow should continue their rapid ascent for many quarters to come, which should keep big investors involved.

Technical Analysis
UBER began to bottom out in May/June of 2022, had a couple of false starts with the market in the months after and then finally got going after earnings in early May of this year. The run to round number resistance at 50 was solid, but the market’s retreat in the summer and fall dragged the stock lower—though the damage wasn’t too bad, with shares falling “only” 19% from high to low. And UBER’s action since tagging its 40-week line has been gorgeous, with a straight-up move pre- and post-earnings. Yes, there could be some near-term wobbles, but we’re OK grabbing some here or (preferably) on a dip of a point or two.

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Stock 10

WW Grainger (GWW)

Why the Strength
Illinois-based Grainger is a top provider of maintenance, repair and operating products, which it sells in retail outlets across the U.S., as well as in Canada, Japan and the U.K. A stellar Q3 earnings report is the reason for the stock’s latest strength; revenue of $4.2 billion expanded 7% from a year ago while EPS of $9.43 beat estimates by 50 cents, driven by positive performance in both the High-Touch Solutions (North American customers with complex buying needs) and Endless Assortment (online-only business which includes Zoro.com and Japan based MonotaRo.com) segments. High-Touch daily sales increased 9% as volumes accelerated sequentially for the first time in five quarters, with “solid” volume growth across all geographies. Endless Assortment daily sales rose 6%, driven by a 15% jump in new customer acquisition across the segment, as well as enterprise customer growth at MonotaRo and 600,000 new product additions for Zoro. Details aside, a big part of the story is simply that the firm’s bottom line went bananas a few years ago and, instead of coming back down to Earth, continues to levitate: Grainger produced $523 million in operating cash flow (up 38%) and nearly $400 million in free cash flow, of which $287 million was returned to shareholders through dividends (0.9% yield) and share repurchases. The company also just increased its dividend for the 52^nd consecutive year, placing it on the exclusive list of “dividend kings.” Elsewhere, improved product mix and availability were tailwinds and drove freight and supply chain efficiencies in the quarter. Going forward, the top brass is focused on acquiring new customers and improving repeat purchase rates across the Endless Assortment segment, which it says will drive long-term profit growth. Wall Street estimates 6%-ish earnings growth next year, but that’s almost surely conservative.

Technical Analysis
GWW broke out of a narrow multi-month holding pattern in June and eventually rallied up to 800 in July. The correction that followed ultimately shaved 17% off the stock, but after a one-day shakeout below it, the 40-week line came to the rescue, with earnings prompting buyers to re-enter the picture en masse. Since then, GWW has been super impressive, staging a persistent (and usually big-volume) run as shares take aim at their prior high. Of course, $800 stocks aren’t our favorite, but we think grabbing a few shares on dips will work.

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Previously Recommended Stocks

The next Cabot Top Ten Trader issue will be published on November 20, 2023.