April 28, 2023

This week, seven companies reported earnings, including Capital One Financial (COF), General Electric (GE), Mattel (MAT), M/I Homes (MHO), Newell Brands (NWL), Polaris (PII) and Xerox Holdings (XRX). Newell reported this morning, so our comments are brief.

Next week, Goodyear Tire & Rubber (GT), ESAB (ESAB), Molson Coors (TAP), Western Union (WU), Volkswagen (VWAGY), Janus Henderson Group (JHG), Kaman (KAMN), Warner Bros Discovery (WBD), Gannett (GCI) and Ironwood Pharmaceuticals (IRWD) are scheduled to report earnings.

Shares of M/I Homes have reached our 67 price target. But, with its strong results and still-modest valuation, we are raising our target to 71.

The monthly edition of the Cabot Turnaround Letter will be published next Wednesday, May 3, one week later than usual as previously noted. The Catalyst Report will be published on Friday, May 5.

Earnings Updates:

Capital One Financial (COF) - Capital One is one of the nation’s largest banks, with over $440 billion in assets and 775 branches. Reflecting its roots, Capital One’s loan book is about 40% credit card loans, as it is the third largest issuer of Visa and Mastercard credit cards. The balance of its loans comprises auto loans (27%) and commercial loans (32%). The bank exited the single-family mortgage business in 2017. As investors worry that a recession would sharply increase the bank’s credit losses and have other negative effects on profits, its shares have slid sharply and now trade at a price unchanged from five years ago. While a recession would weigh on Capital One’s near-term outlook, the bank’s robust capital position, large credit reserves and strong underlying profitability will allow it to endure to a prosperous post-recession future. For patient investors willing to look across the valley of a recession, Capital One shares look like a true contrarian bargain.

The bank reported an OK quarter in which its financial performance excluding credit costs appears to have stabilized at a near-record plateau. However, higher charge-offs of credit cards and higher reserves for future losses weighed on results. Charge-offs in all other major segments were unchanged or smaller than in the fourth quarter, and the bank appears to have been incrementally aggressive in charging off credit card loans. We see charge-offs and reserves rising until losses peak and/or these levels reach at least pre-pandemic levels. This “valley of a recession” was anticipated as part of our thesis – but we still need to go through it.

Loan mix is shifting toward credit cards, as these volumes ticked up 3% from fourth-quarter levels while other loans (auto, consumer, commercial) declined. Credit card interest rates reprice faster than the other loan types, which will help margins.

Capital One is shepherding its capital (although it repurchased $150 million of its shares) and is aggressively building liquidity, recognizing the risk of a possible credit card and commercial loan downcycle ahead even as preparation for this is pressuring near-term earnings. Commercial real estate loans comprise only 1.2% of total loans. Deposits grew, credit reserves remain healthy, capital remains strong (at 12.5% CET1) and expenses are under control. About 78% of deposits are FDIC-insured, supporting a low risk for a run on its deposits. Capital One classifies all of its securities as available for sale, so the market values of its fixed-income securities are fully reflected in the capital ratio.

In the quarter, revenues of $8.9 billion rose 9% from a year ago but were about 2% below estimates. Earnings of $2.31/share fell 59% from a year ago and were 41% below estimates. Deposits grew 12% from a year ago and 5% from the fourth quarter. Loans grew 12% from a year ago and were flat compared to the fourth quarter. The net interest margin of 6.60% was higher than the year-ago margin of 6.49% due to higher profits on non-interest-bearing deposits.

The shares trade at about 102% of tangible book value of $90.86/share. No change to our rating on this quality bank.

General Electric (GE) – Led by impressive new CEO Lawrence Culp, GE finally appears to be righting its previously severely damaged businesses. Key priorities include much better execution and a strategic emphasis on cash flow and debt reduction. Following the spin-off of 80% of GE Healthcare (GEHC) in January 2023, General Electric now comprises GE Aerospace (commercial and military jet engines) and GE Vernova, which includes the Renewables segment (on-shore and offshore wind power) and the Power segment (gas turbines, coal, nuclear). GE Aerospace and GE Vernova will separate in 2024.

GE reported a good quarter, with strong growth in revenues, profits and new orders across nearly all segments. Profit margins expanded meaningfully. Free cash flow turned positive (first time in a decade that a 1Q period had positive free cash flow). GE continues to simplify its businesses in advance of the final split-up next year: sold its remaining stake in Baker Hughes, redeemed $3 billion of Series D preferred shares, implemented new accounting rules for its insurance contracts. Full-year earnings and free cash flow guidance were raised incrementally. Despite the favorable news, the shares fell on the day – due in our view to the weak overall stock market and perhaps some disappointment that free cash flow guidance wasn’t raised enough.

In the quarter, revenues increased 14% (+17% organically) and were about 8% above estimates. Adjusted earnings of $0.27/share improved from a $(0.36) loss and were nearly double the $0.14 estimate. New orders increased 26%. Aerospace growth is riding a “pronounced ramp” in commercial engine demand, Renewable Energy is seeing sharply higher demand for grid-related and offshore wind equipment, and Power is benefitting from increased heavy-duty turbine demand. The adjusted operating profit margin of 6.9% increased 3.3 percentage points after removing the effects of acquisitions and divestitures.

Mattel (MAT) – At our initial recommendation in 2015, Mattel was struggling with its failure to adjust to the realities of how young children spent their playtime. This failure had produced years of revenue decay. In addition, its cost structure became bloated, and its debt levels increased. However, led by its new CEO, Mattel now appears to be finding its way.

Mattel reported a much weaker quarter than a year ago, but this was largely expected following a glut of inventory at retailers which is now being worked off. End-market demand remained positive. The company reiterated its full-year guidance, which calls for a repeat of 2022 but with $400 million in free cash flow this year compared to $256 million last year. Mattel has resumed repurchasing shares, indicating confidence in its outlook. So, we mark time until we can gauge the results from Mattel’s new initiatives and the aftermath of the inventory cycle. No change to our Buy rating.

In the quarter, revenues fell 21% in constant currency and were 10% above estimates. The adjusted loss of $(0.24)/share compared to $0.08 a year ago and was much weaker than the $(0.16) estimate. Gross billings fell 23%. Nearly all product category revenues were weak except for Hot Wheels. With the revenue decline, the gross margin fell. This, plus higher operating and marketing expenses, pressed the operating margin into negative territory (-10.6%).

M/I Homes (MHO) – M/I Homes is one of the country’s largest homebuilders, with 175 communities under development across 15 states. Its shares have tumbled sharply from their 52-week high and now trade at their pre-pandemic price as investors worry about a possible recession, the effects of rising mortgage interest rates and higher labor and raw materials costs. While we appreciate the headwinds facing M/I Homes and its industry, we see a diversified, highly profitable, financially solid and well-managed company whose shares trade at a sizeable discount to their liquidation value.

The company reported a strong quarter, with strong revenue and profit growth. Trends in backlogs and new contracts are flattening after falling sharply in recent quarters, suggesting that the company’s fundamentals aren’t likely to freefall. Management seems to be pulling in the reins a tad, which shows a reasonably conservative approach to growth vs. risk control. The shares have reached our 67 price target, but with fundamentals remaining healthy and the stock trading at 87% of the $77.13/share in book value, and 88% of the $76.55/share in tangible book value, the stock remains reasonably valued. We are raising our price target to 71.

In the quarter, revenues rose 16% and were 27% above estimates. Adjusted earnings of $3.64/share rose 12% to a first-quarter record and were 54% above estimates.

While down 40% from a year ago, the backlog of $1.7 billion is unchanged from the fourth quarter, suggesting that the revenues weren’t generated simply from completing already-ordered homes. New contract volumes fell 14% year over year, but this is a flattening from the 44% decline experienced in the fourth quarter.

The company generated over $250 million in cash from operations and seems content with letting much of this cash accumulate on the balance sheet. Compared to year-end, the cash balance increased by $231 million. The land position declined from a year ago and the fourth quarter as land and lot purchases were half the year-ago pace. M/I Homes’ balance sheet remains solid with only $151 million of homebuilding debt (which excludes debt related to its short-term funding of mortgages for resale).

Newell Brands (NWL) – The company has struggled, literally for decades, with weak strategic direction and expense control, epitomized by its over-reaching $16 billion acquisition of Jarden in 2016. Pressured by activist investors last year, and now led by a capable new CEO, Newell appears to be finally fixing its problems, yet the shares remain significantly undervalued relative to their post-turnaround potential.

Expectations for Newell are very low, as its shares are trading near their 20-year lows. First-quarter results fully justified these expectations as the company produced a loss and trimmed its already dour full-year guidance. Favorably, free cash flow improved as Newell is working down excess inventory.

The future of Newell, now a fully mediocre company with too much debt, rests with its incoming CEO Chris Peterson. He brings considerable respect and a more aggressive approach to cutting overhead costs and generally streamlining the still-bloated Newell operations. Not yet in the CEO seat, Peterson’s new Project Phoenix has already cut $18 million and is on its way toward cuts of up to $160 million this year alone. No change to our rating or price target but we are well aware of the value trap risk in Newell shares.

In the quarter, core revenues fell 18% but were fractionally above estimates. The adjusted loss of $(0.06)/share compared to a profit of $0.35 a year ago and was worse than the $(0.03) consensus estimate.

Polaris (PII) – Shares of this high-quality and market-leading manufacturer of powersports equipment like off-road vehicles, snowmobiles, motorcycles and boats, have fallen out of favor with investors. Major concerns include the risk of a post-stimulus falloff in demand as well as supply chain disruptions that are weighing on margins by 3-4 percentage points. We believe the company’s long-term prospects remain intact. Polaris produces strong profits and free cash flow, has a solid balance sheet, and a strong, shareholder-friendly management team.

Polaris reported a healthy quarter, with strong sales and earnings compared to a year ago and to estimates. The company gained meaningful market share, but the overall demand picture is mixed. The adjusted EBITDA margin expanded due to higher sales, better pricing and more sales of higher-margin products. Some production inefficiencies remain, so over time Polaris has the potential to further expand its margins. Guidance for the full year was unchanged. After the severe pandemic-related shortage, dealer inventories are nearly back to normal. The Polaris thesis remains on track although we may need to wait longer for the cycle to more fully play out. PII shares continue to be undervalued. No change to our rating.

In the quarter, revenues rose 22% and were about 11% above estimates. Adjusted earnings of $2.05/share rose 55% from depressed results a year ago and were 20% above estimates. The Adjusted EBITDA margin of 10.9% increased from 9.2%. Free cash flow was positive, and the balance sheet remains strong.

Xerox Holdings (XRX) – While the near-term outlook remains clouded, as office workers remain in partial work-from-home mode, we believe the company’s revenue and cash flow will recover. Investors underestimate Xerox’s value due to its zero-growth prospects, but the company’s hefty free cash flow has considerable value. The balance sheet is strong, new and capable leadership is working to drive shareholder value higher, and its generous dividend looks reliable.

Xerox reported a highly encouraging quarter, with sales and profits increasing, demand trends improving and the balance sheet strengthening. Xerox continues its strategic shift toward simplifying its business and increasing its transparency. Even though the shares jumped on the report, they remain significantly undervalued on very reasonable assumptions.

In the quarter, revenues rose 3% from a year ago (6% ex-currency) and were essentially in line with estimates. Adjusted earnings of $0.49/share improved from a $(0.38) loss a year ago and were sharply higher than the $0.17 consensus estimate.

Equipment sales rose 25%, some of which were sales from a high backlog due to improved product availability. The strength is encouraging, as equipment sales are a leading indicator of the enduring stream of profitable aftermarket sales. Post-sale revenues were essentially flat, driven by sluggish equipment sales during the pandemic.

Profits jumped partly due to higher prices and more sales of high-margin gear, and partly due to lower costs from cost-cutting efforts and easing supply-chain costs. A small release of financing credit reserves, reflecting better credit conditions, helped profits. The equipment gross margin jumped to 36.5% from 20.4% a year ago, while the adjusted operating profit margin increased to 6.9% from a loss a year ago.

Xerox donated the Palo Alto Research Center (PARC) to SRI International, a non-profit research center in Menlo Park, California. We see this as a favorable company simplifier even as Xerox will apparently retain strong access to PARC’s research.

Corporate debt, which excludes debt directly associated with its lease financing arm, fell to $449 million and is now more than offset by the $591 million cash balance. Related, its efforts to create a stand-alone leasing business continue to advance toward what we believe will be a sale.

Friday, April 28, 2023, Subscribers-Only Podcast:

Covering recent news and analysis for our portfolio companies and other topics relevant to value/contrarian investors.

Today’s podcast is about 12 minutes and covers:

• Comments on other recommended companies
  
  • TreeHouse Foods (THS) – Interim CFO moves to permanent CFO.
• Final note
  
  • Next weekend – off to the Berkshire Hathaway annual shareholder meeting.

Disclosure: The chief analyst of the Cabot Turnaround Letter personally holds shares of every Rated recommendation. The chief analyst may purchase securities discussed in the “Purchase Recommendation” section or sell securities discussed in the “Sell Recommendation” section but not before the fourth day after the recommendation has been emailed to subscribers. However, the chief analyst may purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time.Please feel free to share your ideas and suggestions for the podcast and the letter with an email to either me at bruce@cabotwealth.com or to our friendly customer support team at support@cabotwealth.com. Due to the time and space limits we may not be able to cover every topic, but we will work to cover as much as possible or respond by email.