Cabot Top Ten Trader Issue: October 2, 2023

Rates Up, Stocks Down

The market looked ugly early last week before finding some support, but we’re going to need to see more before changing our stance—interest rates continue their fierce uptrend (rate-sensitive stocks are coming unglued), and the intermediate-term trend of most stocks, sectors and indexes remains down. We will say that, with September in the rearview mirror, there are many studies that point to a year-end rally, there are many near-term oversold-type measures that suggest the market may be able to build off last week’s low and we continue to see a decent number of potential growth-y leaders that aren’t far from overcoming some technical hurdles (like 50-day lines, etc.). In other words, now’s not the time to stick your head in the sand, but as always, we want to see it first (some decisive buying) before taking much action given the weakness seen in most everything out there. We’ll leave our Market Monitor at a level 5.

This week’s has a broad array of resilient stocks, though there are fewer zingers and more steady Eddie’s. Our Top Pick is Nutanix (NTNX), which is in pole position to be one of the top growth stocks—if and when the market gets going.

Stock 1

Atlassian (TEAM)

Why the Strength
Atlassian focuses on business software that allows teams to work together more efficiently, improving the productivity of project planning, management and workflow applications. The company is already well-established in corporate IT departments, with more than 260,000 clients globally. The move to cloud environments is providing tailwinds for Atlassian, even amid the uncertainty inflation has wrought on corporate budgets over the past year. In its latest fiscal year, ended June, Atlassian overcame investor fears of a slowdown, beating expectations with $3.5 billion in revenue and earnings per share of $1.92 (up 28% on the year), with cloud migration by clients and the German and Singapore markets being highlights for the company. Management entered the new year bullish despite continuing headwinds from inflation and other tech budget-related uncertainty. Migration to cloud services is expected to grow at a double-digit pace, with traditional server solutions seen slowing slightly. The real challenge for Atlassian of late is converting businesses using free introductory apps into paid clients. That challenge is expected to continue which has management preaching patience. While they wait, the company is shifting more salespeople to hand-holding high-value customers to generate incremental revenue. All in all, though, the stock is strong now because big investors are thinking the macro picture will soon stop being a headwind, that results can continue to blow past estimates (June quarter revenues of $939 million topped by $33 million) and that cloud-based revenue will drive the big picture (initial forecast 25% to 30% cloud growth for this fiscal year, likely conservative). Atlassian is a great long-term growth story that has come through some tough times and should prosper going ahead.

Technical Analysis
TEAM had a huge run in the last bull market, which meant it had a massive decline (483 to 114!) during the bear. And the recovery took a while, too, with shares only rallying above their 40-week line in June of this year. But despite the market being in a tough correction for most of the time since then, TEAM has been grinding higher, reacting well to earnings in August and respecting its 50-day line for the past three months. We’ll set our buy range up from here, looking for big-volume strength off support.

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Stock 2

Frontline (FRO)

Why the Strength
Frontline is a good-sized oil tanker firm, a sector that’s as cyclical as they come but is thriving today for a few reasons: Demand in Asia is up huge from a year ago, with much of that being transported by tankers; global oil demand, in general, is expected to be up nicely in the second half of the year; less Middle East output is increasing demand for larger vessels; and increased refinery activity in the second half (and longer-term) is another demand boost. That’s all to the good, but the exciting part here is that, because of so many ups and downs in recent years, few are really investing in the sector, which is keeping supply low: Orderbooks for new vessels in most sizes are near 25 year lows (as a percent of the current fleet), and there are tons of 20-years-or-older vessels that could be scrapped during the next few years that could further crimp the worldwide fleet. That means charter rates are elevated (albeit very volatile), and with Frontline’s very low breakeven costs (under $23,000 per day per ship, including drydocking expenses), cash flow and earnings are enormous, likely coming in around $2.75 per share in 2023. And while analysts see that figure slipping next year, management sees enormous cash flow potential if the market remains tight, possibly into the $4-plus per share range. Just as important is that the top brass is handing over most of the cash flow in the form of a variable dividend—the past two quarters saw 70 cents and 80 cents per share payouts, respectively, and while the Q3 figure will likely be lower, you’re still looking at a potentially huge yield for a long time to come. Oil tankers aren’t usually long-term investments, but near term, Frontline looks enticing.

Technical Analysis
FRO has actually been in a (very, very) choppy uptrend since the start of 2022, rallying above 19 by early March of this year. But instead of a quick air pocket, shares began working on what’s turned out to be a very nice-looking base—FRO tightened up near the 40-week line for many weeks, rallied back toward its high in August and, after a quick shakeout with the market has month, has powered right back to the 19 area on a string of good-volume days. We’re OK nibbling here with a stop near the recent low.

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Stock 3

Guidewire Software (GWRE)

Why the Strength
California-based Guidewire provides a cloud-based property and casualty (P&C) insurance platform that supports the entire insurance lifecycle (including filing claims and managing policies and billing) for leading insurers, helping them to accelerate their digital transformation. Its offerings include InsuranceNow, an out-of-the box solution with workflows and functionality to help clients go live and personally engage customers, and Analytics, a comprehensive data set to facilitate better underwriting outcomes and claims management processing, as well as cyber-risk control. Last month, Guidewire released fiscal Q4 (ended July 31) results that saw revenue of $270 million that jumped 10% from a year ago, plus earnings of 74 cents that blew past the consensus by 37 cents (the reason for the stock price strength). The company closed 17 cloud deals in the quarter, including 11 with Tier-1 insurers (among which were giants Progressive Insurance and Allstate Canada, plus a major commitment from leading Australian insurer IAG), all of which resulted in estimate-beating annual recurring revenue (ARR) and fully ramped ARR (the full annual price outlined in customer contracts) that grew 15% and 17%, respectively. Meanwhile, total cloud ARR (which includes all customers that have contracted to move to the cloud) grew 28% and comprised 60% of total ARR. Cloud strength was underlined by a 25% rise in subscription and support revenue, continuing a five-year, double-digit growth trend in this metric. The company emphasized it finished the fiscal year with a positive operating margin, “significantly ahead of our plan,” thanks to “growing acceptance” of its cloud solution in the P&C industry. It’s not a rapid growth story, but Guidewire looks like a good bet to deliver 10%-ish top-line and faster cash flow growth for many quarters to come.

Technical Analysis
GWRE hit a major multi-year low last fall but almost immediately started clawing its way out of last year’s bear market. It pierced the 40-week line in February and rallied to around 83 in March before starting a choppy five-month period of no net progress. But after a 50-day line test in August, GWRE rallied nicely and then gapped on earnings, and while it’s pulled back since, the chart is still in good shape. A lot will depend on the market, but we’re OK with a nibble around here and a tight stop in the low 80s.

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Stock 4

Nutanix (NTNX) ★ Top Pick ★

Why the Strength
Nutanix’s various offerings and the sector itself (hyperconverged infrastructure) can give you the proverbial ice cream headache, as most sound like they’ve been named by engineers. But the underlying story is easier to understand and has big potential: The firm has a platform that powers all of a client’s IT equipment and can power just about any type of deployment, including all apps, workloads, databases and programs (AI, machine learning, etc.)—and, importantly, it allows them to run and move between all of the different cloud environments out there, so everything can run where it operates best and at a much lower cost. (Nutanix estimates total costs are 40% less over five years than the standard way of doing things.) All of that bodes well for the underlying business, and thanks to the firm’s transition to a subscription business model—which has taken a few years—costs are falling (especially for renewal efforts), retention rates are elevated (north of 90%) and recurring revenue (up 30% in the latest quarter) are surging. And that means free cash flow is set to pick up in a big way: For fiscal 2024 (which just started in August), Nutanix sees about $1 per share of free cash flow, and last week, management released some long-term projections, with recurring revenue expected to double in the next five years while free cash flow grows four-fold. It’s worth noting that the top brass’ big-picture projections from two years ago were easily topped, which is a good sign even these projections could be low. Overall, Nutanix looks to be in the right place (a key tech and AI infrastructure player) at the right time (when its business model transition is bearing fruit).

Technical Analysis
When we wrote up NTNX a month ago, the stock had just broken out from a nine-month rest period, including some very tight action the prior 12 weeks. Since then, the stock has done nothing—which we view as very encouraging given the market environment. Indeed, NTNX has chopped around with some big daily swings around its recent Investor Day, but has held its 25-day line. A nibble here with a stop near the 50-day line is a solid risk/reward situation.

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Stock 5

Ollie’s Bargain Outlet (OLLI)

Why the Strength
Most discount retail stocks are in tatters, with inflation crimping consumer budgets and also boosting costs. But Ollie’s Bargain Outlet remains a port in the storm, offering investors a solid turnaround situation and may actually be benefiting from some tough times in the retail sector. The story here is simple: Ollie’s is the leading closeout retailer (it just opened its 500^th location), with a top-notch buying team and deep retail relationships that allow it to get Good Stuff Cheap (the firm’s motto) in a variety of product lines and pass much of those savings onto consumers, generally 40% to 70% below normal prices. Buyers like it for cheap stuff, of course, but retail partners rely on Ollie’s to help manage their excess inventories and closeout merchandise, giving the firm better access to deals. (Indeed, reduced inventory levels in general in the retail sector are leading to a very strong deal environment for Ollie’s.) Throw in the fact that the company itself just starting to get over a couple of tough years (pandemic-induced supply chain issues, though Ollie’s also had some company-specific issues that cut earnings in half the past two years), and growth is getting back on track and big investors are re-focusing on the long-term outlook here: In the July quarter, sales (up 14%), EBITDA (up 147%) and earnings (up 205%) all topped expectations while same-store sales were up 7.9%, and Ollie’s eventually sees more than 1,050 locations (opening 45 this year), driving double-digit sales and EBITDA growth for many years to come. To be fair, the valuation is up there for a 15%-ish grower, but given the earnings beats of late, investors are thinking the 2024 estimates could prove too low.

Technical Analysis
OLLI began in July 2022 etching what turned out to be a very long, very tedious basing effort, but the stock changed character in July of this year, with a straight-up move to new highs. The stock tightened up beautifully after that and has shown solid relative strength—there have been plenty of ups and downs, but OLLI has held its 50-day line during the past two months, including a successful test last Thursday. If you’re game, we’ll set our buy range up from here, as a push higher from here would mark a solid breakout.

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Stock 6

Ryder System (R)

Why the Strength
Florida-based Ryder is a top provider of fleet management solutions, as well as supply chain management and logistics for businesses of all sizes. Despite a freight cycle downturn, Ryder expects to generate “meaningfully higher” earnings and returns this year compared to the previous freight cycle peak in 2018, thanks to growth in its contractual supply chain and lease business. Additionally, Ryder enjoys an advantage over its competitors in border-related North American trade activity, thanks to extensive relationships with large-order clients (which include automaker and agribusiness partners that do business outside the U.S.). To be fair, after a moonshot last year, business is pulling back some this year—in Q2, revenue of $2.9 billion was 5% lower from a year ago, reflecting weaker market conditions in used vehicle sales and rentals. However, the firm’s Supply Chain Solutions (SCS, 55% of revenue) and Dedicated Transportation Solutions (DTS, 15% of sales) segments both outperformed and improved by single digits from a year ago. Earnings of $3.61 a share were also lower but beat estimates by an eye-catching 72 cents (the reason for the stock’s strength). The top brass touted Ryder’s balance sheet strength and “solid” investment-grade credit rating, which it said allows the firm to continue pursuing targeted acquisitions, as well as shareholder returns, including a 2.7% dividend yield and the purchase of over a million shares in the quarter (share count down 15% since 2021). Analysts see sales meandering sideways in the next two quarters, then turning higher for most of next year as the full effects of the company’s recent shift to growing the asset-light supply chain segment (and exiting the sub-performing U.K. and lease liability insurance businesses) kick in. Analysts see earnings remaining elevated, and even those estimates are likely conservative.

Technical Analysis
R hit a post-pandemic-crash high near 90 a couple of times in 2021, dipped to a low of 62 in April 2022, then actually pushed out to new highs near 100 in February of this year before entering a fresh, proper base-building effort. That process has taken a while, but seems to be bearing fruit now—R returned to its highs following earnings in late July, held firm even as the market has slid and pushed to new highs last week. We like the action, but we’ll set our buy range down a bit given the environment.

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Stock 7

Synopsis (SNPS)

Why the Strength
Moore’s Law states that computing speed typically doubles every year and a half, thanks to advances in semiconductors. But this exponential performance is getting harder to maintain as the industry runs up against the limitations of shrinking chip dimensions to the atomic level. However, it looks like the use of artificial intelligence (AI) in chip production will help to keep Moore’s Law alive, and leading this charge is Synopsis, a leading provider of semiconductor engineering design automation (EDA) software and simulation tools that allow chipmakers to design and test their silicon chips before commercializing them. Synopsis offers not only the design tools critical for chip manufacturers but also provides simulators that assist in the design of the logic for chips and computer systems, as well as the industry’s first (and fastest) unified hardware for prototyping, the ZeBu EP1, which accelerates the verification process for system-on-a-chip (SoC) designs. Importantly, the company recently has assumed the mantle of the industry’s leading EDA provider for AI chip designers, thanks to its generative AI-infused Synopsis.ai software, which helps engineers quickly isolate and fix problems related to the AI chip design process; it already accounts for 10%-ish of revenue and is driving margins higher, too. The track record of growth here is fantastic and shows no sign of slowing: In fiscal Q3 (ended July 31), Synopsis reported record quarterly revenue of nearly $1.5 billion that increased 19% year-on-year, driven largely by AI-related demand, plus EPS of $2.88 that beat estimates by 5%, and analysts see 20%-plus earnings growth this year and next. It’s a solid story.

Technical Analysis
SNPS actually held up pretty well for a chip stock during the bear market, and then traded extremely tightly into May before blasting off on the AI-induced buying wave. Interestingly, the stock hasn’t done much of anything since then, and has now spent a few months again tightening up—and, more importantly, resisting the market’s selling pressure of the past two months and actually attacking new high ground last Friday. We’ll set our buy range up from here, thinking a breakout would lead to good things.

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Stock 8

Watsco (WSO)

Why the Strength
Extreme heat in July and August set all-time records in several regions around the world, including in many U.S. states, which was good news for the HVAC (heating, ventilation and air conditioning) industry. Around 90% of homes in the U.S. currently use air conditioning, with two-thirds of that comprised of central air or heat pumps, and the overall North American HVAC industry is expected to grow at a slow, steady pace for the next few years. Watsco is the nation’s largest distributor of HVAC equipment and supplies (including refrigeration), with around 700 locations nationwide. Watsco saw a 6% year-on-year drop in revenue during Q2, along with a 51-cent miss on earnings of $4.42 a share, which disappointed Wall Street. The lower results were mainly due to supply chain backups and lower residential sales, but were partly offset by double-digit growth in the commercial segment. Below-normal temperatures across much of the nation in late spring also contributed to the weakness. Yet after taking a minor post-earnings hit in August, the stock has strengthened on expectations that business will improve in the second half of 2023, thanks in part to market share gains and a positive trend on the regulatory front—namely an upcoming rebate for up to $8,000 for buyers of heat pumps as part the U.S. green energy bill, plus higher temperatures (and AC demand) during the summer months. Consequently, analysts expect the firm will see increasing gains in the coming quarters from a steady shift toward higher efficiency HVAC products. Watsco also just acquired South Carolina-based Gateway Supply Co. in a deal that adds 16 locations and $180 million in sales, which should further boost growth. This obviously isn’t a true growth story, but it’s a very solid business and there should be some catalysts (with subsidies especially) going ahead.

Technical Analysis
WSO was mired in the typical bear market haze through 2022 but came to life to start the year and has been stair-stepping higher since then, with higher highs set in February, April and again in June. That last peak gave way to a three-month rest period with support in the 340 area—and last week’s strong-volume pop was a good sign the next major move is up. If you want in, we’re OK with a small position here and a stop around 340.

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Stock 9

XPO (XPO)

Why the Strength
The recent bankruptcy of America’s third-largest less-than-truckload (LTL) carrier, Yellow, has removed an estimated 10% of capacity from the domestic market, paving the way for its chief competitors to increase market share and raise prices. XPO is one of North America’s largest LTL transportation providers, with coverage spanning the U.S., Canada, Mexico and the Caribbean, and with a fleet of more than 38,000 semi-trailer trucks. It’s the result of a 2021 spinoff of GXO Logistics, its former contract logistics arm, and RXO, its former truck brokerage division, and now serves as the sole LTL provider for the company formerly known as XPO Logistics. Indeed, the latest data from July shows that XPO is already benefiting from Yellow’s bankruptcy, as tonnage per day for July and August increased 4% and 3% (respectively) from the prior year, while shipments per day jumped 9% and 8%. The stock’s recent strength is also due to a sanguine industry outlook, as management indicated that demand hit a trough in March and has recovered in recent months, signaling an “improved freight demand environment.” Although revenue of $1.9 billion fell 6% in Q2 (mainly due to lower fuel surcharges), shipments per day increased in the quarter, and while the adjusted operating ratio (a key metric) deteriorated 4%, it improved on a sequential basis, and the firm said it’s on track to deliver a significant improvement in this metric for many years to come. Other key metrics—including claims and damage ratios and on-time performance—all showed improvement as well in Q2, as purchased transportation costs dropped by a stunning 35% (XPO plans to achieve a 50% reduction in this metric as a percent of revenue by 2027). Wall Street expects sales to dip slightly into Q4, then rebound strongly through next year while earnings rebound.

Technical Analysis
After rounding out a bottom in the second half of 2022, XPO changed character in April and began what ended up being a persistent, explosive advance all the way to 77 or so in August after a positive earnings reaction. It’s now been nine weeks since that peak, during a time when the market has corrected, but XPO has stood firm, trading mostly sideways—and, last week, finding good-volume buying that brought shares back near their highs (and pushed the relative performance line, not shown here, to new highs). We’re not ruling out more short-term wobbles, so we’re OK with a small buy here, albeit with a tight stop in case the sellers dig in.

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Stock 10

Zscaler (ZS)

Why the Strength
Zscaler is a network security provider for large organizations, specializing in security of cloud environments and situations where employees are working remotely. The company sells its “Zero Trust Exchange” as a way to prevent hacks and limit unneeded access among authorized users by essentially separating security from the network—meaning users can access certain apps they’re supposed, but not the overall network itself, which keeps them seeing only what they’re permitted to. Zscaler also denies proxies and other architectures that often hide data threats and uses tech sleight of hand to hide client apps so hackers can’t easily find them. With generative AI exploding, Zscaler prevents employees from pasting any language or data into AI prompts, preventing potential data leakage. Business is growing fast and the market is huge, with Zscaler saying in peak periods it processes 250 billion interactions a day, nearly double two years ago and more than 20 times the number of transactions Google handles. The overall offering works and has gained lots of traction: Clients include 12 of the 15 cabinet-level federal agencies as well as two Fortune 50 companies that recently bought licenses for more than 150,000 users each after testing Zscaler for as briefly as one quarter. In the fiscal year ended July 31, the company grew revenue 48% to $1.6 billion with earnings per share of $1.79 on gross margins over 80%. In the current quarter, management sees sales rising 33% to $473 million with about $0.49 EPS. The full year is expected to produce $2.06 billion revenue, up 27%. It’s quite possible that could be larger, with Zscaler saying demand, especially around AI security, is booming and it expects to aggressively spend to capture market share. All told, it’s possible the firm will be able to crank out 30%-ish earnings growth this year and next.

Technical Analysis
ZS broke an 18-month slump this spring as sales momentum drew buyers back in; the earnings gap in May changed the stock’s character overnight. Since mid-June, though, shares have effectively been in a choppy, lateral range—which isn’t bad action given the implosion in many growth stocks. More recently, ZS rallied back to its old high after earnings in early September, with the backing-off period finding support near the 50-day line. We’ll set our buy range up above 165, as a move north of there would eclipse multi-month resistance.

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Previously Recommended Stocks

The next Cabot Top Ten Trader issue will be published on October 9, 2023.