Cabot Top Ten Trader Issue: October 23, 2023

Trend Still Down, but Emotions Running High

The market has continued to unravel, and there’s no need to review all the gory details from the prior few days—suffice it to say that the trend of interest rates remains up, the trend of most indexes, stocks and sectors remains down, with hundreds of stocks hitting new lows and hardly any at new highs. Now, it’s also true that emotions are starting to run high, with a few signs of panic out there as investors throw most everything overboard, bringing lots of stuff down to key levels. Because of that, we remain on the lookout for some sort of market turn—today was a good start, but we’re taking it on a day-to-day basis: If and when the market turns up, and should earnings season go well, there will be plenty of ideas to snatch up, but until then, we advise holding plenty of cash and keeping any new positions on the small side as we wait for the sellers to run out of ammo. We’ll respect the latest leg lower and drop our Market Monitor to a level 4.

This week’s list is a great place to start building your watch list if you haven’t already, with many names that are clearly resisting the market’s pull. Our Top Pick is Elastic (ESTC), a tech name that looks to have the right mix of steady growth, big earnings expansion and huge AI potential—as well as a resilient stock.

Stock 1

Adobe (ADBE)

Why the Strength
Tech giant and PDF pioneer Adobe has long been on the cutting edge of graphic design, editing and file-sharing software. Last week, Adobe told its followers on the “X” (formerly Twitter) social media platform to expect some “jaw-dropping innovations” in the coming weeks which involve artificial intelligence (AI) projects that promise a “new era of creativity.” On that score, Adobe just unveiled Project Fast Fill (powered by Firefly, a standalone web tool from the firm), which is being widely touted as a revolutionary development within the graphics design industry. The new product integrates generative AI technology into video editing applications and allows users to modify and create new images, transform text and accelerate color variation in videos as if they were still photos by using only text prompts. The new product was revealed at a recent company event, where Adobe said 11 additional new technologies based on generative AI will likely become generally available in the next six to 12 months. It was also a big reason for the stock’s strength and prompted several major Wall Street institutions to upgrade shares based on the company’s “greater pace of innovation” in the words of one investment bank, while another one pointed out that 90% of current Firefly web app users (which is free to the public in limited form) aren’t current Adobe subscribers, so the growth runway should be huge as the generative AI model expands. Numbers-wise, Adobe continues its solid top- and bottom-line growth, and remaining performance obligations (RPO, a key metric) lifted 11% in. the latest quarter. Analysts see those trends continuing, but it’s clear the AI releases have many big investors thinking growth could accelerate down the road.

Technical Analysis
Given the destruction in tech (and most other) stocks, ADBE’s relative strength sticks out like a sore thumb. Following a big kickoff in May and June, shares rallied into the 550 zone in July and even scored a new high in early September. The pullback after that was sharp but found support near 500 and immediately shot back toward the old highs. ADBE certainly looks like it wants to move higher if the market allows it—we’ll set our buy range up from here, thinking another rebound would lead to good things.

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Stock 2

American Eagle Outfitters (AEO)

Why the Strength
In what can only be described as a challenging environment for U.S. clothing retailers—characterized by a rash of smash-and-grab thefts in retail stores nationwide—American Eagle has managed to maintain growth while boosting profit margins as consumers gravitate toward higher-end apparel offerings. The company offers on-trend clothing, accessories and personal care products under the American Eagle (specializing in denimwear) and Aerie (lingerie and activewear) brands through nearly 900 store locations worldwide. The firm’s latest quarterly report in early September had more than a few encouraging nuggets. Although total Q2 revenue of $1.2 billion was essentially flat from a year ago, it improved 11% from the prior quarter and set an all-time high for the second quarter, with store revenue rising 4%. American Eagle said it’s seeing “positive momentum” and an ongoing sequential revenue improvement trend supported by several new marketing campaigns and on-trend collections that are “resonating well” with customers. By segment, Aerie sales of $380 million increased 2% while American Eagle sales of $767 million were up 1%. But the main reason for the strength isn’t an out-and-out growth story but a return to normalcy when it comes to earnings, thanks to cost controls, inventory management and a normalization of supply chain shenanigans from the past few years—despite so-so revenue tallies, per-share earnings of 25 cents in Q2 improved an eye-opening 21 cents from a year ago while beating estimates by 60%. The company touted its continued focus on maintaining inventory discipline, posting a 7% total inventory decline with units down 11%, and management said the profit improvement focus is expected to yield even more positive results over the next 12 to 24 months. Looking ahead, expect modest sales improvement and, while earnings 2024 earnings estimates are mundane, many are likely looking for more bottom-line beats, which makes the already-modest valuation even more appealing.

Technical Analysis
AEO topped out in June 2021 and slid almost continuously until last October, surrendering about 75% along the way. There was a solid rally after that, but shares petered out in February and ended up retesting the low near 10 in May. Since then, though, it’s been all good—AEO shot back to slightly higher highs in September, and perhaps more encouragingly, it’s dip that month led to a strong bounce to higher highs despite the market. Everything is a toss-up in this environment, but if you want in, you could nibble here with a stop a few dimes under the 50-day line.

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Stock 3

Autoliv (ALV)

Why the Strength
Autoliv is the global market leader in automobile safety products, such as airbags, seatbelts, inflators and dozens more active and passive systems. On Friday, the company reported third-quarter results that showed the supply crunch that has held back much of the world’s auto industry was easing. The Swedish company reported $2.6 billion in sales, up 13%, with a 35% gain in earnings per share, to $1.66. In addition to the supply chain for critical components (like semiconductors) flowing again, Autoliv is also positioned well to sidestep many of the recent problems facing car makers. While Autoliv has a dominant share in its markets, Detroit’s big three contribute just 13% of revenue, and Autoliv’s U.S. workers aren’t union members, meaning the UAW strike isn’t a major concern; the largest customers are the Nissan-Renault-Mitsubishi alliance at 11% of sales, followed by Stellantis near 11%, Volkswagen at 10% and Toyota at 9%. Autoliv also has an opportunity to gain customers given the U.S. Transportation Department’s large recall of airbags due to faulty inflators. Nearly all the recalls are for those produced by competitor ARC, with just a small portion covering legacy parts Autoliv is responsible for from a business it bought in 2009. The macro trend benefits Autoliv as well, with light vehicle production rising nearly 8% globally in 2023, with increasing requirements for safety products. Such requirements are more profitable in North America, where the average car has $360 worth of related safety components, compared to $220 for faster-growing China and $90 for India. Still, management sees cost controls and a good balance sheet as a sturdy foundation for growth. This year, Autoliv projects organic sales growth of 17%, and analysts see the bottom line soaring into 2024. A decent dividend (2.7% yield) and share buyback program (share count off 2.5% in Q3) also help the cause.

Technical Analysis
ALV looked like it was getting going in July when it ran up before and after earnings to reach its highest levels since early 2022, but the buyers moved on and the market turned weak, dragging the stock lower. The decline hasn’t been very sharp, and in fact, ALV has twice found support at its rising 40-week line of late—and last Friday’s earnings pop was a good sign. The market is obviously a wild card, but we’re not opposed to a small buy here with a stop just under last week’s low of around 90.

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Stock 4

Chord Energy (CHRD)

Why the Strength
There’s a lot of hubbub in the oil patch about the Permian Basin these days due to Exxon’s big buyout of Pioneer Natural of late, and today’s purchase of Hess by Chevron is another eyebrow-raiser for the sector. Chord Energy is a name in the group that’s easy to love as it continues to make hay in the Williston Basin in North Dakota and Montana—it has the largest acreage position in that area, and it might have the very best economic setup among all oil explorers: The firm has 10 years of low-cost inventory (1,085 drilling sites that provide at least a 20% return at $60 oil or less), a near-perfect balance sheet ($185 million of net debt, or just 0.1x cash flow) and its cash flow is huge even at modest energy prices—for 2023, given first half results and assuming $70 oil and $2.75 natural gas for the second half, free cash flow here would likely total $18 per share (!), and given the low leverage, three-quarters of that will be returned. Indeed, in the first half of the year, Chord paid out $4.58 per share in dividends and bought back a tiny amount of shares, and with energy prices up of late despite skyrocketing interest rates and economic fears, the thought is those payouts could easily increase in the quarters ahead. (The Q3 report will be released November 1.) At this point, there’s not a ton of M&A activity happening (or rumors of it happening) in the Williston, but with a modest market cap of $7 billion or so and with big players looking to buy quality acreage (as opposed to spend a ton on new exploration), it wouldn’t be surprising if someone started to hunt around given the buoyant free cash flow yields here. All told, Chord is a well-run outfit and could be one of the biggest beneficiaries of resilient energy prices going ahead, and if the group has entered an M&A phase, there’s no reason it couldn’t be a target.

Technical Analysis
CHRD has quietly been one of the leading oil plays out there for a long time, and that continues to this day. After hitting new (dividend-adjusted) highs a year ago, the stock did pull in from about 155 to 115, but it bottomed during the banking crisis in March and has actually been in a relatively smooth uptrend since then, for the most part riding its 10-week line higher. Most recently, the early-October shakeout was met with a quick rebound to new highs—we’ll set our entry range down a bit given the market, with a stop in the vicinity of this week’s lows.

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Stock 5

Dell Technologies (DELL)

Why the Strength
Dell (covered in the September 18 issue) has lately captured analysts’ attention with a strong showing in the storage market since the introduction of PowerFlex, its proprietary software-defined storage offering. The product is enjoying wide use due to its ability to autonomously adjust both compute and storage power while meeting the needs of high-demand applications, and it has shown growth for the last eight quarters, with demand in Q2 more than doubling from a year ago. But where the company is really making waves is in artificial intelligence (AI): At a recent investor conference, the company said generative AI (GenAI) “will be a force multiplier to digital transformations around the world” and that AI’s total addressable market will likely grow at an 18% annual clip, hitting $124 billion by 2027. Dell also thinks GenAI could represent up to a 30% productivity and efficiency improvement opportunity for several sectors of the economy, with 75% of all businesses surveyed increasing their AI investments. Key to capturing some of that demand is the recent introduction of Dell’s PowerEdge XE9680 server designed for high-performance applications targeting the AI field; importantly, that product also boasts a $2 billion-plus order backlog and is the “fastest ramping new solution” in Dell’s history and is a big part of the “significant strength in AI-enabled servers” the company is seeing. (Management also noted that AI now represents 20% of the firm’s total server revenue.) That’s the main reason for the stock’s resilience, but Dell hasn’t forgotten its core PC business and plans a renewed focus on this going forward, where it sees up to a 4% annualized growth opportunity between now and 2026. Growth here won’t be amazing, but earnings numbers have been crushing estimates of late (2024 earnings estimates were “only” $6.13 per share two months ago) and the cheap valuation (9x trailing earnings) means future earnings beats aren’t necessarily baked into the cake.

Technical Analysis
After a steady advance between March and August which saw shares reach 58, DELL pulled back to its 50-day line immediately before the Q2 report was released in early September. Shares found support above the trend line and exploded higher on massive volume on earnings, hitting a record high at 73 a few days later. The stock has been chopping sideways-to-lower for the past few weeks with the market, with a test of the 50-day line today. We’ll set our buy range up from here, looking for a strong rebound to tell us the sellers are out of ammo.

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Stock 6

Elastic (ESTC) ★ Top Pick ★

Why the Strength
Elastic is effectively a Big Data company—for years, it’s made hay with its Search offerings, allowing employees and customers of mostly giant outfits to ingest and seach more efficiently though the reams of data they now collect. And, importantly, this isn’t just searching text or numbers, but also unstructured and even geospacial data, as well as for the huge and growing observability (how all a firm’s IT and other assets are working) and security markets. As the top brass said, Elastic is becoming the data analytics platform of choice for addressing real-time corporate search. Business has been solid for a while, with the firm’s impressive customer base (Adobe, Cisco, Workday, Uber, Barclays, Microsoft, T-Mobile, Pfizer, Comcast, Booking.com, Home Depot, etc.) contributing to solid and steady revenue growth (up 17% last quarter), with its cloud offerings (up 24% and now 41% of revenue) expanding faster, while solid cost controls result in powerful earnings growth and expanding margins. All that is great—but the real excitement here is Elastic’s potential to effectively be a key cog in the new AI world, as its platform is perfectly suited to take a firm’s own or third-party machine language models, store data on massive scale, search in real-time across various types of data and enforce data privacy, all of which will allow clients to boost productivity and create new customer experiences. Basically, Elastic has an up-and-running offering that should see greater adoption as AI takes hold. All told, it’s a solid current growth story, and the AI kicker looks real and could be massive.

Technical Analysis
ESTC topped with the market in late 2021 around 190 before crashing and burning to 51 in May of last year, and then it spent more than a a year testing and retesting that area; as of two months ago, it was still languishing near 60 and wasn’t showing anything special on the chart. But the September 1 report, outlook and AI-related tidings caused a big earnings gap that’s changed the stock’s character, with a quick, powerful move to the 80 area—and the fact that ESTC is still hanging around that level after the market’s maelstrom is impressive. If you want to nibble, you could do so here with a stop under the 50-day line.

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Stock 7

Light & Wonder (LNW)

Why the Strength
Video gambling machines (poker, keno, bingo and the like) are hot commodities in the U.S., with industry revenues growing 14% year over year to a record $60 billion in 2022, and given that a number of states and cities are still moving to legalize video and online gaming, that trend is likely to continue. Light & Wonder (covered in the August 28 issue) is the leading cross-platform global gaming provider known for its immersive casino, online and mobile games. Among its offerings are casino slot machines, tabletop games, lottery systems and digital gaming solutions, as well as perpetual licenses to gaming operators. Earlier this month, Light & Wonder was singled out by a major Wall Street institution at a global gaming conference in Las Vegas as being a standout in the sector (a reason for the stock’s latest show of strength). During the expo, the company also emphasized its commitment to generate $1.4 billion in EBITDA by 2025 (this year’s figure is on track for $1.1 billion or so; free cash flow has been just over $1 per share in the first half of the year), noting that its cross-selling capabilities across its land-based, Social, and iGaming segments will help contribute to reaching this goal. Light & Wonder also said it’s developing a direct-to-consumer platform for its mobile gaming-based SciPlay division, which will allow it to lower platform fees from 30% to 10%. The firm also used the expo to showcase its latest offerings, including a large-screen Horizon cabinet, which it called “the next evolution of the highly successful Jumbo cabinet” and which features a 75-inch screen, integrated lighting and dual play buttons for “an immersive and seamless player experience.” Earnings are due out November 9, and analysts expect revenue to jump 10% for Q3, with faster EBITDA growth ahead.

Technical Analysis
We’re taking another swing at LNW after last month’s market-led correction tripped our stop. That dip was a doozy, seeing the stock fall 14% in just three weeks and easily crack its 50-day line—but that came after a persistent advance (a sign big investors were accumulating shares), and the strong show of support despite the market’s continued weakness bodes well for when the market turns healthy. If you want in, you can consider nibbling here with a stop near the recent lows, or just keep LNW on your watch list.

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Stock 8

New Oriental Education (EDU)

Why the Strength
New Oriental is an educational services company in China. The business was rocked in 2021 when the central government ruled that all K-6 academic tutoring in the country had to be nonprofit, a segment that accounted for 60% of New Oriental’s business. Mitigating the loss of the K-6 market is the fact the new rules also restrict how much time Chinese grade school students can spend on academic tutoring, leaving the large market with newly found free time. Parents began filling it with non-academic tutoring New Oriental offers, such as music lessons and sports coaching, as well as study abroad tours to broaden student horizons. Overall, New Oriental is a diversified business within the education arena, with a strong presence in foreign language courses for students and adults and a solid footprint in centers administering standardized tests, which management is aggressively expanding this year. Additional segments include its own private schools in some major mainland cities, online education services, school content production like textbooks, and foreign school placement consulting. The outlook is that Chinese government regulations won’t crimp these services, which is a plus since every business line is profitable, allowing New Oriental to weather the reboot. The loss of K-6 tutoring sliced revenue from a peak of $4.28 billion in 2021 to $3 billion in fiscal 2023, ended May, with earnings tanking as well. But the rebound is underway and growth is there to be had: The ability of Chinese to travel abroad after COVID is powering strong growth in cultural tours and study abroad, which has investors projecting $3.8 billion in revenue this year, a 25% gain, with EPS seen jumping well over $2. The next big event is earnings, which are due Wednesday morning.

Technical Analysis
EDU had a big comeback from its mid-year 2022 lows through January of this year, leading to a sideways rest as the 40-week line caught up. Once it did, the stock turned higher again, with shares ripping to the upper 50s in July before and after earnings—and impressively, the stock has actually moved higher since then, holding the 50-day despite the market’s cave-in. If you’re super aggressive, you could nibble around here ahead of earnings, though there’s nothing wrong with waiting to see the reaction given the iffy environment.

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Stock 9

Petrobras (PBR)

Why the Strength
A bigger-than-anticipated drawdown in U.S. oil storage, plus a call by Iran for an oil embargo against Israel in the wake of the Middle East conflict, have revitalized crude oil prices. To keep oil supplies flowing, Brazil (a major producer) has stepped up production and recently hit a single-month record. Brazilian state-run energy giant Petrobras is one of the world’s largest oil/gas producers and exporters, with expertise in deep and ultradeep water exploration and production. With global energy demand on the rise, the company just released Q3 output figures that showed crude and natural gas production from its various projects increased 8% year-on-year, which it attributed to ramp-up of two offshore platforms in South America’s energy-rich Santos and Campos Basins. What’s more, Petrobras said its nine refineries collectively achieved a 97% utilization rate in September for the second straight month—the highest in almost a decade. Earlier this month, the firm was granted a permit from Brazil’s environmental agency to drill in the Potiguar Basin, which is considered one of Brazil’s last promising oil exploration opportunities (a reason for the stock’s strength). Also boosting the stock was news that two big Texas-based energy firms just signed long-term contracts with Petrobras to provide storage, regasification and drilling support. Financial results from the past couple of quarters were lackluster, with fading sales and earnings on lower oil prices and a sharp drop in crack spreads for diesel. However, profits here are still in the stratosphere, with operating cash flow of $9.6 billion in Q2 alone, and with oil prices up since then, most expect the bottom line to remain healthy. The dividend has been irregular, but it’s paying out a 23-cent per share dividend near the end of November, with much bigger payments likely if energy prices remain resilient.

Technical Analysis
PBR repeatedly banged its head on the 16 to 17 area in 2022 before finally giving up the ghost about a year ago, dipping under 9 before the end of 2022. This year, the stock spent months building a bottom and stretched its legs in June, returning to the 15 range. Instead of backing away, though, PBR held firm for three months, and after a shakeout to start October, it moved back to new recent highs before today’s dip. If you want in, we’ll set our entry range up from here, as a rebound would make today look like a bullish shakeout.

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Stock 10

Scorpio Tankers (STNG)

Why the Strength
Scorpio Tankers is the world’s largest product tanker owner, shipping refined petroleum products around the globe, with 112 total vessels (many of them younger and more efficient), which is 31 more than the nearest competitor. As with many commodity-related sectors, shipping rates went wild in 2022 after the pandemic-related bust, which led to humongous earnings and cash flow—and now, as we’ve seen in many other instances, it’s looking like some company moves plus continued tightness in supply (newbuild pricing is at its highest level since 2008; the industry’s orderbook is just above 23-year lows; seaborne shipping volumes continue to plow ahead) is going to keep earnings elevated for a long time to come. Scorpio has spent the boom times of the past year getting its house in order, cutting debt by about one-third since the end of 2021 and repurchasing a bunch of vessels that are on lease. More important, it’s also been super aggressive with share buybacks, with the Q2 share count down 14.3% from the year before, and even though shipping rates are softening a bit, it’s still hammering away at the tally, with another 980,000 bought as of August 15. (It also pays a modest 1.8% dividend, too.) The upside here will come if the market re-strengthens, as Scorpio has a massive amount of leverage to higher day rates—even if dayrates increase just a few percent from where they were in early Q3, Scorpio sees $9.80 of annual cash flow per share after debt repayments, which lines up with analyst estimates for this year and next. To be fair, things can change rapidly in the shipping sector, but the fundamental resilience in the sector given all of the world’s worries is a positive sign.

Technical Analysis
STNG had a giant, giant run during the worst of the market in 2022 and early 2023 before finally topping out in February at 63. The decline from there was sharp, dipping to 40 in July, but now the stock has put together a few months of repair work—while there’s still overhead resistance, STNG has been up 10 of the past 13 weeks, including a push to six-month highs early last week. It’s aggressive, but we’re OK nibbling on a bit more weakness with a stop just below round-number resistance near 50.

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Previously Recommended Stocks

The next Cabot Top Ten Trader issue will be published on October 30, 2023.