Cabot Top Ten Trader Issue: October 9, 2023

Some Leaders Popping; Market Still Iffy

Friday was an encouraging day, not just because the indexes were up—for the first time in a while, we finally saw a few stocks that were holding up well really pop higher, with a few actually moving to new high ground and holding up well today. And when you combine all of that with horrid sentiment and some recent oversold readings, our antennae are up for a real market turn. However, does that change what we’re thinking? Not yet—from a top-down perspective, the intermediate-term trend remains for the indexes and the vast majority of individual stocks. The way we’d think about it is that what we’re seeing out there is a good first step, but the market will have to show more to gain enough momentum for a sustained advance. We’ll leave our Market Monitor at a level 5 for now and keep an eye on how things react to the new war in the Middle East.

This week’s list targets many of the stocks that are perched near (or are already hitting) new high ground. Our Top Pick is CrowdStrike (CRWD), which seems to be leading a possible new group move in cybersecurity stocks—you can start small here, though we prefer to look for pullbacks as selling on strength is still the norm in the market.

Stock 1

Arista Networks (ANET)

Why the Strength
AI is the killer app for highly sophisticated networking equipment like switches, routers and relays that Arista Networks makes. The reason is that the vast amount of data that AI absorbs and generates have provided a reason for customers to buy terabyte switches, giving Arista a roadmap to continued growth. There’s always been some risk that Arista is too concentrated in a handful of clients–Microsoft and Meta provide 26% and 16% of revenue, respectively. But those companies aren’t going anywhere and have been picking up their buying to upgrade everything in recent quarters—and now they need to spend heavily to get their systems up to speed to handle all the emerging AI services they plan on offering. That has sales orders coming in faster than expected since springtime: Arista’s Q2, reported at the end of July, blew away expectations after a just-ok Q1, raising hopes for the rest of 2023 and beyond. Management has said full year revenue will crest $5.47 billion, but Wall Street expects even more, with consensus estimates looking for $5.75 billion, meaning Q3 adn Q4 quarter should produce about $1.47 billion sales each, putting the last six months of 2023 up 20% from last year. Net income is seen burgeoning too, with analysts seeing $6.17 for the year, a 35% hike and well above estimates from earlier this year. The real sales gains from AI should be in late 2024 and in 2025 as the AI-optimized networks Arista is currently testing hit the market. The runway for selling AI network gear should be long, with management seeing AI deployment fueling sales for the next decade as smaller companies follow Microsoft and Meta’s push. Management is heavily investing in developing routing architectures that optimize how to utilize computing power and transmit information for AI. Eventually, its “AI Spine” will run on something like Ethernet, which Arista prefers today, and would displace a chunk of the market dedicated to a different architecture called InfiniBand, which was developed in the 1990s and is seen as more deficient when handling AI loads. Next year’s estimates (earnings up just 10%) are mundane, but big investors clearly think those are too low.

Technical Analysis
ANET etched a big base during the bear market and broke out to new highs in March of this year, but the path since then has been very choppy as the environment never truly turned supportive—shares have seen higher highs and lows, but with tons of volatility including two big shakeouts in May and July. However, after approaching the 200 level in September, ANET’s latest pullback was more controlled, finding support at the 50-day line—and now shares are bouncing. We’re OK starting a position here with a tight stop and adding more if the stock and overall market kick into gear.

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Stock 2

CrowdStrike (CRWD) ★ Top Pick ★

Why the Strength
CrowdStrike is positioned to be one of the market leaders of any sustained rally that develops for many reasons: The firm was one of the first to take cybersecurity out of the old days, with old school firewalls and the like becoming outdated thanks to mobile work and the cloud movement, and with CrowdStrike (as its name suggests) being among the first to integrate data from all its clients (trillions of data points a week!) into its platform to improve results (and share those updates across the entire user base). As we wrote a month ago, the firm started and still dominates the endpoint security market, but it’s moved into a bunch of a newer, higher-growth areas, all of which are selling well, with a lot of cross-selling opportunities (63% of clients now take at least five modules, while 24% take at least seven) and producing the terrific top- and bottom-line growth seen in the table below. (Free cash flow is larger than earnings here, too, likely totaling $3.75 per share or so this year.) All of that is key, but a big reason why the stock actually tagged new high ground last week was because of some bullish longer-term tidbits offered by management three weeks ago: The firm hiked various longer-term profit margin targets, including a nine percentage point hike in operating margin target (to 30%, up from 21% in the most recent quarter) and a five percentage point lift in free cash flow targets (to a whopping 36%, up from 29% in the first half of this year), achievable within three to five years—all while management talked about (not official guidance) annualized recurring revenue continuing to crank ahead at 20%-plus clips. Translation: Rapid, reliable growth looks like a good bet for a long time to come, which is like catnip for institutional investors. We like it.

Technical Analysis
After basing out for about three months, CRWD’s earnings-induced move to new highs in September looked promising and was an early sign of potential leadership. Shares were yanked lower by the market from there, but they held their 50-day line (unlike nearly 90% of stocks) and, as soon as the pressure came off the market last Friday, CRWD exploded higher on big volume. We’re OK with a small position here or (preferably) on dips, with a stop near the 50-day line.

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Stock 3

Ionis Pharmaceuticals (IONS)

Why the Strength
Ionis develops RNA-targeted therapeutics for some of the most difficult-to-treat diseases with a focus on neurology and cardiometabolic diseases. The basis of Ionis’ drug discovery platform is a proprietary antisense technology that targets RNA, the molecule that conveys genetic information from a gene to the protein synthesis machinery in the cell. By targeting RNA, the company’s antisense technology can be used to dramatically decrease the production of specific disease-causing proteins; antisense therapies can also treat diseases caused by too little protein by increasing its production, thereby restoring protein amounts to normal levels. Ionis’ offerings include four commercially approved drugs for treating various diseases, and its pipeline boasts 29 drug candidates in various stages of development—including 15 in Phase II and nine in Phase III, with Eplontersen (for treating hereditary ATTR polyneuropathy) currently in the registration phase for approval. Ionis just released late-stage data on its candidate olezarsen for a rare genetic disorder that met a primary endpoint. The trial indicated a 100% reduction in acute pancreatitis events compared to placebo, prompting a major Wall Street institution to upgrade the stock (a reason for the strength). Ionis’ lead drug is Spinraza, which is licensed to Biogen and is the global leader for treating all types of spinal muscular atrophy (SMA), with $880 million in global product sales year-to-date; that gives the company a good revenue base, though the overall top line is fairly stagnant on a year-over-year basis (up 6% this year and 4% next according to estimates). But management believes it’s on track to secure up to 10 new FDA approvals by 2027, which is the real draw, with olezarsen also likely to be submitted for approval early next year.

Technical Analysis
IONS character started to change character in May after years of lackluster action—shares bottomed near 33 in March but showed good-volume buying in May as the market improved. And while the stock didn’t really follow through from there, it tightened up for months in the 39 to 43 area, and now we’re seeing signs of the buyers taking control: IONS surged on the recent trial results, and while it ran into profit taking with the market, the stock immediately snapped back last week. It’s obviously volatile, but if you’re game, a small buy on dips of is fine by us.

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Stock 4

Meta Platforms (META)

Why the Strength
After a tough 2022 which saw the stock plunge over 70%, Meta Platforms has roared back to life thanks to a series of cost-cutting initiatives (including huge layoffs), but also to a renewed focus on its ad business, especially in some of its newer platforms. Indeed, the ad sales ramp is largely due to more advertising on its popular Facebook Reels, which is Meta’s answer to TikTok; Reels is a short-form video platform that allows users to add music, plus audio and visual effects to video clips up to 60 seconds long. Collectively, these measures are part of what Meta has dubbed as a “Year of Efficiency” as the company puts more emphasis on profitability. To further that goal, Meta is also investing more in products and will release a new version of its own smart glasses series next week in partnership with Ray-Ban, which include improved audio and better cameras in the glasses themselves—there’s even a new artificial intelligence (AI) assistant that can live stream what the user sees directly to Facebook and Instagram (which Meta owns), and it will also have the ability to translate foreign languages. Meta also recently unveiled the latest version of its best-selling Quest, a mixed-reality headset that allows users to “alternate realities without the need for an external computer or console.” And on the AI front, Meta has released Meta AI, a chatbot that can provide text-based responses along with photo-realistic images as envisioned by the user. Along with its core ad business, the combined measures prompted a major investment bank last week to declare that Meta is near a “tipping point” relating to AI that could increase the firm’s core ad revenue in a big way. In Q2, Meta’s total sales of $32 billion increased 11% year-on-year, continuing an accelerating trend of late, while EPS of $3.23 jumped 31% from a year ago in a sign the profitability focus is working. Q3 earnings are due October 25, and analysts see low double-digit sales and 20%-plus earnings growth ahead.

Technical Analysis
After last year’s debacle, META turned the corner in early November and spent the next few weeks tightening up ahead of its early 2023 take-off. There was a strong earnings reaction in February that invigorated the stock even more and helped established a multi-month rising trend with the 50-day line serving as support. META took a well-earned breather in August and fell (briefly) under the trend line for the first time this year—but, impressively, the stock has held up very well and even traded tightly while the market has hit the skids. The environment remains a headwind, but if you’re game, you could nibble here with a tight stop.

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Stock 5

Nvidia (NVDA)

Why the Strength
AI has jumped in to replace the evaporating demand from the faltering cryptocurrency space and NVIDIA’s historical video game-related offerings look to shake off a multi-quarter malaise. NVIDIA’s GPU cluster architecture is well-suited to the computing demands of AI, so much so that its GPUs are considered as the top of the rung for optimizing very expensive AI back office systems in the AI ecosystem, like networking customer Arista. Fiscal 2023 has been great so far: NVIDIA shattered expectations in its second quarter, following a gravity defying Q1. In Q2, reported in August, revenue came in more than $2 billion higher than consensus, at $13.5 billion, with net income vaulting consensus by $1.6 billion, to $6.74 billion, or $2.70 a share—both representing massive, massive acceleration from the prior few quarters. And in the current period, analysts predict sales of $15.9 billion – an eyepopping $10 billion more than last year – with a similar, $10 billion-plus jump predicted for Q4 as demand goes bananas. Data center and gaming remain important sectors for NVIDIA, with the latter showing double digit growth again after being flat. They’re especially important as exports to China (still about 25% of sales) are being curtailed by U.S. national security rules. But the main story now is all about AI. NVIDIA is heavily developing industry-specific flavors of its Jetson Orin, a system that comes with all the pieces (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. The thinking is that the software creates an extra advantage for NVIDIA, which believes that if new AI products are built on its packages, it creates more opportunities for its premium priced hardware. After tripling this year, analysts see the bottom line up another 59% next, and most think those estimates will prove very conservative.

Technical Analysis
After a huge gap higher in May on Q1 results, NVDA has continued higher, though it finally did have a decent correction into August and, after a brief snap back to new highs, another good-sized drop (18% in six weeks) in September. The low, though, was back on September 21, and NVDA has marched higher since then and is now toying with its 50-day line. It’s not free and clear, of course, but we think starting a small position on further strength if you’re not yet in makes sense.

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Stock 6

PDD Holdings (PDD)

Why the Strength
PDD Holdings (covered in the September 5 issue) is China’s second-largest e-commerce platform, boasting around 900 million active buyers. There’s still growth potential in its home country with some new angles (see below), but there is a limit to the number of customers it can get, so the firm is also looking overseas for upside. PDD rolled out a new e-commerce site last year called Temu, which offers a wide selection of heavily discounted goods that are shipped to customers directly from China. More importantly, Temu connects Chinese merchants to foreign customers while allowing them to gain access to the lucrative U.S. market. Management has been giving more of its attention to the Temu platform of late with a focus on enhancing customer satisfaction; already the site has experienced what one analyst described as “spectacular” growth, gaining over 100 million active users in just the last year while rapidly extending its reach. Indeed, Temu is now available in nearly 40 markets and just made a foray into the coveted Philippine market (which is dominated by Sea Limited’s Shopee). On the homefront, PDD is focused on growing sales by leveraging artificial intelligence (AI) to disrupt China’s trillion-dollar farm economy. To accomplish this, PDD uses data-driven insights, including advanced precision farming, along with 40 “cutting-edge” systems that help farmers boost crop yields by up to 30% while reducing costs. The end result of these efforts is increasing modernization for China’s ag sector, as well as “optimization” in the matching of supply and demand for both growers and customers—and better sales for PDD. On the back of these initiatives, Wall Street expects steady 20%-ish earnings growth, though after Q2’s big beat (earnings of $1.44 topped by nearly 40 cents), most think that’s too conservative. A reasonable valuation (22x trailing earnings) also helps.

Technical Analysis
After topping around 105 in January, PDD slid 44% before finding support at 60 in May. The earnings report later that month kick-started a fresh rally, with the next earnings release in August providing an even bigger boost to the stock, enabling it to climb back to the prior peak. Since our write-up a month ago, PDD mostly consolidated normally even as the market caved in, and last Friday’s big bump was certainly a positive. Given the still-tricky environment, we’ll set our buy range down a bit.

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Stock 7

Range Resources (RRC)

Why the Strength
After trading south of $3 for nearly all of 2023, natural gas inventories are rising less than expected and demand remains steady, which has led to the commodity perking up to its highest level since January in the $3.35 area, which is still relatively “low” compared to the past few years. That bump is a good thing for Range Resources, which looks like the top natural gas play out there: It’s a top 10 gas and natural gas liquids producer thanks to more than half a million acres in Pennsylvania, and because it has mostly contiguous locations (leading to lower CapEx compared to its peers) and buoyant wells, as well as having diverse end markets (a quarter goes to LNG, another quarter to the Gulf Coast, 30% to Midwest, etc.) it’s costs are amazingly low, with about 2,000 undeveloped drilling locations that have a breakeven natural gas price below $2, with an overall current breakeven near $1.25! Indeed, at $2.50 natural gas, Range estimates free cash flow would be be positive (a bit less than $1 per share), while at $4, that figure would balloon to $3.50 per share or more. To this point, shareholder returns have been modest, with that free cash flow going toward debt reduction (down to $1.6 billion of net debt now vs. $2.7 billion at the end of 2021), but now that debt is close to its goal of $1.5 billion, buybacks (share count is off 3% from a year ago) and dividends (1.0% yield) could pick up in a big way if natural gas prices really move. All told, Range Resources looks like a solid high-reward, reasonable-risk play, with a lot of upside if the recent upmove in gas continues.

Technical Analysis
RRC peaked in mid 2022 with most energy stocks and slipped for many months, finally bottoming out in February and March of this year. The action after that didn’t offer any obvious change in character, but a gradual strengthening despite rock bottom natural gas prices. The August peak of 34 led to a more modest dip (14%), but shares saw growing-volume support near 30 two straight weeks and have quickly surged back to their highs. We’ll set our buy range down from here, thinking a near-term exhale is likely and should provide an opportunity to get in.

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Stock 8

Regeneron Pharm (REGN)

Why the Strength
Regeneron is a leading biotech player that’s focused on neurotrophic factors—proteins that support the growth of neurons and their regenerative capabilities (hence the company’s name). It uses the insights gained from this to develop medicines that help patients with eye diseases, allergic and inflammatory diseases, cardiovascular and metabolic diseases, cancer and more. The company’s blockbuster eye medicine Eylea, which treats wet age-related macular degeneration (AMD), had U.S. net sales of nearly $6 billion last year and accounted for nearly 60% of total revenue in Q2. And, after a hiccup in June (related to issues with the company’s contract manufacturer), Regeneron received U.S. regulatory approval for a high-dose version of Eylea in August, which allows patients to receive treatments less frequently, resulting in several Wall Street institutions upgrading the stock (one reason for the recent strength). The new version of the drug is expected to invigorate sales for the company, with one analyst suggesting it could push Regeneron into the top position in the huge AMD treatment space. Additionally, Regeneron gained recent approval for pozelimab, which treats the rare immune ailment CHAPLE disease (the drug is also under investigation in combination with another drug for treating other rare disorders). More recently, the company was awarded an FDA priority review for odronextamab, a late-line treatment for adult lymphoma, while its treatments for allergic diseases, Dupixent, was just granted breakthrough designation for patients with a certain type of the lung disease COPD (the top brass said it sees a “tremendous unmet need” for this drug). The decline in Covid treatments has pulled down earnings in recent quarters, but the numbers here are still big, with Q2 sales of over $3 billion (up 11%), while earnings of $10.25 a share beat estimates by 34 cents and profit margins are excellent (37%). Looking ahead, Regeneron should offer steady, 10%-ish growth with upside once new treatments hit the market.

Technical Analysis
REGN rallied above round number resistance of 800 in March and April before giving up the ghost as biotech stocks faded, with a big drop in June when the FDA initially rejected the high-dose Eyela treatment. But that was the low, REGN snapped back nicely in August, and after a few weeks of shaking and baking (including some weakness on news of higher R&D), the stock has bounced back toward its highs. We’re OK starting small here with a very tight percentage stop and adding if the market and stock can get going.

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Stock 9

Spotify (SPOT)

Why the Strength
Spotify is a classic special situation—it’s a big player in a big industry that’s always done good business, and with some activists involved, institutional investors are thinking costs will be reeled in, new offerings will help business and cash flow has a lot of upside ahead. The firm’s music and podcast products are hugely popular, with 220 million paying subscribers (up 17% from a year ago) and 343 million free subs (that hear ads—up 34%) that drove a 14% hike in local-currency revenue in Q2. And those users are relatively sticky despite plenty of competition, thanks to the breadth of its offerings and some new ventures (audiobooks in the U.K. and Australia are helping, with 70% of the New York Times bestseller list available to paying subs; should be coming to the U.S. soon). In fact, Spotify is going ahead with price hikes after a decade of none, lifting them to $11 per month in the U.S. Meanwhile, costs are finally starting to be contained (OpEx is up 13% from a year ago, compared to a 30% to 60% ramp in 2022!), which is allowing margins to pick up a bit; management forecasts gross margin of 26% this year, up from the mid 24% range for the latter part of 2022. The idea here is that the land grab phase of new subscribers is slowing down somewhat, with more emphasis on cost controls (including shutting down some less-listened-to podcasts) and profitability—and given Spotify’s huge user base, there should be a ton of value to tap into. Analysts see revenue growth actually picking up some going forward (likely in part due to the price hike), while earnings turn positive in 2024 and free cash flow accelerates. Earnings are due October 24.

Technical Analysis
SPOT had a big ramp as soon as the year began and then entered steady, persistent advance into the market peak in July. The correction after that was very sharp (29% in just over five weeks), but it held the 40-week line, SPOT bounced back nicely during the brief late-August rally and, impressively, has traded tightly since. Like some other names, we’ll set our buy range above here, looking for a decisive push higher to kick off a real advance.

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Stock 10

Western Digital (WDC)

Why the Strength
The storage industry has faced serious headwinds in the wake of the pandemic-era consumer electronics boom, thanks to a semiconductor supply glut. Indeed, the industry has contracted for the last several quarters, but now there’s finally light at the end of the tunnel. Western Digital is a top provider of hard disk drives (HDD) and digital storage solutions, including NAND flash memory. A major bank has reiterated an overweight rating on the stock while upping the price target (the reason for the strength), noting that demand for NAND storage remains “strong” and that, while there is still an oversupply of storage chips, there have lately been NAND flash price increases of up to 20% in both the consumer and enterprise markets—a massive improvement from levels seen earlier this year. Last week, another major institution noted that there are signs the HDD and flash markets are indeed stabilizing, and that the strategic review process that Western started last year to evaluate a separation of its flash and HDD businesses may be nearing a conclusion. Additionally, Western is working on a potential tax-free merger of its flash business with Japanese memory manufacturer Kioxia Holdings, which would allow Western to share expenses while offloading some of its excess NAND supply. Moreover, the company is expected to benefit from higher HDD demand from data centers, thanks to the increased storage demands related to the artificial intelligence (AI) revolution that enterprise customers are embracing. (One recent industry study estimated that generative AI could contribute nearly 10% to total memory sales by 2025.) Analysts see revenues bottoming out in fiscal 2024 (ending July 31), then exploding higher in the next couple of years as the memory chip cycle strengthens.

Technical Analysis
WDC has outperformed most of its storage space peers in recent months—as well as showing relative strength against the weak backdrop of the broad market—a good indication the stock is in strong hands. The stock changed character in May, beginning a two-steps-forward, one-step-back type of advance. A late-August surge to higher highs was intriguing, and the latest weakness still has WDC near its 25-day line. If you want in, we’re OK grabbing a stake around here.

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Previously Recommended Stocks

The next Cabot Top Ten Trader issue will be published on October 16, 2023.