August 23, 2024

In today’s note, we discuss the recent earnings report from Advance Auto Parts (AAP). We also discuss two new additions to the portfolio in the form of YETI Holdings (YETI) and Alibaba Group Holding (BABA).

I’ve also decided to recommend taking a 50% profit in our sizable gain in Foot Locker (FL) ahead of next week’s earnings. In doing so, I’m re-introducing the portfolio management technique of taking partial profits (namely quarter-, half- and three-quarter profits) in the Turnaround Letter, which I think will improve the overall results of the portfolio over time.

The importance of various liquidity measures is also discussed in this week’s podcast, along with its impact on the current market environment.

We also take look at potential early-stage turnarounds in three major players in the consumer staples sector: Hershey (HSY), General Mills (GIS) and Hormel Foods (HRL). Plus, there are LOTS of ratings changes this week.

Comments on Earnings

With that, let’s turn our attention to the latest earnings among our Cabot Turnaround Letter portfolio stocks.

The only one of our holdings reporting earnings this week was Advance Auto Parts (AAP), which announced flat revenue of $2.7 billion for Q2, with earnings of 75 cents a share missing estimates by 16 cents. The downbeat results and even more downbeat fiscal 2024 guidance caused shares to lose 18% on Thursday.

The company’s turnaround story was largely predicated on its ability to increase profit margins to levels closer to its industry peers, yet it hasn’t been able to achieve this goal. Gross profit margin and operating income margin were both lower year-on-year in the latest quarter, and management just reduced its operating margin guidance for 2024 from 3.4% at the midpoint in Q1 to just 2.3% now.

I had hoped the stock would react more favorably to earnings, but that wasn’t the case, and given the technical damage inflicted by Thursday’s action, I’m moving Advance Auto to a sell. Now I know what you might be thinking: “Clif, isn’t it possible Advance has hit rock bottom, both in terms of valuation as well as from a price perspective?”

While this could certainly be the case, a glance at the chart tells me that the amount of technical damage the stock has sustained will make a recovery to my predecessor’s upside target a long, grueling prospect. I’d rather cut the dead weight and free up capital to deploy in more productive ways, hence my decision to cut AAP.

For those of you who may want to maintain a holding in Advance, my advice would be to watch the 50 a share level very closely, which has long-term significance as a technical support. If this level is decisively broken on a weekly closing basis, I suspect it could trigger algorithm-based selling pressure and would suggest a major loss of institutional support. But for the purposes for the Cabot Turnaround Letter portfolio, I’m moving the stock to a SELL.

RATING CHANGES: Advance Auto Parts (AAP) has been moved from BUY to SELL.

Barnes Group (B) has been moved from BUY to SELL. We’ll book a minor profit (+4%) on this stock, which has essentially been treading water in the months since its initial recommendation after backing off from an unsuccessful charge at long-term resistance last month.

Fidelity National Information Services (FIS) has been moved from BUY to HOLD.

General Electric (GE) has been moved from BUY to HOLD. The stock has had a stellar run since 2020, gaining nearly 500% in that time, but with potentially strong overhead supply beginning around 180 and the momentum dissipating, it’s time to get defensive.

Nokia (NOK) has been moved from BUY to HOLD.

Six Flags Entertainment (FUN) has been moved from BUY to HOLD.

Tyson Foods (TSN) has been moved from BUY to HOLD.

Earlier this week, we moved United States Steel (X) from a BUY to a SELL. The position was up 3%, but an industry-wide weakening of the global steel outlook prompted the decision to exit.

Western Digital (WDC) has been moved from HOLD to SELL. The stock has given us a 66% gain since the initial buy recommendation in October 2020, but recent price action suggests institutional sentiment has turned negative on WDC.

Western Union (WU) has been moved from BUY to SELL. Unacceptably large 3-year and 5-year losses, plus accelerating competition from upstart money transfer services, makes the initial turnaround thesis untenable at this time.

I’m also recommending that we sell half our position in Foot Locker (FL), which has gained 24% since my predecessor initially recommended it last month. Accordingly, I’m changing the rating to SELL A HALF.

NEW POSITION: On Wednesday, we placed Alibaba Group Holding (BABA), the China-based online shopping juggernaut, on a buy. The company generates most of its revenue from multiple e-commerce businesses, but it also has a booming cloud business, which saw AI-related product revenue post triple-digit growth year-over-year during the most recent quarter.

Although Alibaba is an e-commerce leader in China, it’s relatively unknown to casual shoppers in the United Stated and Europe. And on that front, the company is actively trying to expand its footprint internationally, especially through its retail platform AliExpress, which sells directly to consumers worldwide. Meanwhile, Alibaba Cloud, its cloud computing arm, has been growing its data centers and services outside of China, particularly in Asia, Europe, the Middle East and North America.

Meanwhile, Alibaba’s financial arm, Ant Group, has been increasing its digital payment services internationally through partnerships and acquisitions, while its digital wallet, Alipay, is being introduced in several new foreign markets. I see the push toward international expansion as a big part of the turnaround story here.

In terms of the key financial metrics, Alibaba’s free cash flow dropped in fiscal Q1, which was released last week. The company attributed this to a “significant increase in expenditure on the AI infrastructure investments,” but it expressed confidence that it would return to double-digit growth in the second half of the fiscal year with gradual acceleration thereafter as it begins to execute on its integrated cloud and AI development strategy.

More recently, a major Wall Street bank just released a list of the 50 stocks that most frequently appear among the top 10 holdings of “fundamentally-driven investors from quantitative funds or funds that mirror private equity investments,” which is another bullish factor going forward. Admittedly, however, our position in Alibaba is not without above-average risk due to the weak economic backdrop for China, and for that reason, I’ll be keeping this stock on a tighter leash than I normally allow our other portfolio holdings. BUY

Friday, August 23, 2024 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 15 minutes and covers:

• Discussion of the two biggest takeaways from the early-August market correction
• Why the market’s strong liquidity profile supports the turnaround stock outlook
• Comment on potential turnarounds in consumer staples
• Comment on earnings
• Elsewhere in the markets
  
  • A review of this week’s lone earnings report in our holdings, Advance Auto Parts (AAP).
• Final note
  
  • Comments on our latest portfolio additions, YETI Holdings (YETI) and Alibaba Group Holding (BABA), plus a brief overview of upcoming earnings announcements.

Turnaround Watch List

America’s love affair with chocolate is so well established that demand for Hershey (HSY) products is entrenched even in economic downturns or times of uncertainty. That’s just one reason why the company is positioned to outperform in the coming months. Soaring sugar and cocoa prices over the last couple of years put pressure on Hershey’s margins, but with the prices for both commodities cooling off, value-oriented institutional investors are taking a closer look at the stock.

Moreover, the recent Kellanova-Mars mega-merger in the sector has many analysts looking at Hershey as a player in the M&A hunt for companies with exposure to the salty snacks business. (On that score, Hershey recently announced plans to “aggressively scale” its salty snack business). A steady dividend over the last century (currently at a healthy 2.8% yield) serves as an added enticement, and management expressed its belief in the company’s turnaround potential by raising the dividend by 15% at the end of Q1.

For food producers like Hershey, the ability to capitalize on falling input costs is of paramount concern in the drive to improve gross margins. Another company falling under this category is consumer foods giant General Mills (GIS), which needs no introduction. The company should also benefit from lower input costs going forward, and its dividend is regarded by analysts as being both recession- and inflation-proof, with 124 years of uninterrupted payouts. Moreover, a recent tracking poll by Nielsen found that General Mills was among a handful of standout brands that saw its retail food sales over a four-week period ended August 10 improve sequentially during the tracking period. Wall Street sees revenue steadily improving from here over the next few years, as well.

Also, among the major consumer brands, Hormel Foods (HRL), well known for its canned meat products including Spam, is trying to establish a bottom and is close to doing so, although the bottom hasn’t yet been confirmed.

The company’s second fiscal quarter represented the fourth consecutive quarter it achieved volume growth, with the Foodservice segment delivering profit growth for nine out of the last 10 quarters. Hormel also described the performance of its International segment as “very encouraging” given the challenging conditions it faced last year, with International growing segment profit by 30% year-on-year in the first half of 2024.

Management guided for the second half of this year to see accelerating strength across most of its segments as its three-year turnaround strategy—which includes growing operating income by $250 million by 2026—gains traction. Fiscal Q3 earnings for Hormel are due out September 4.

Elsewhere in the consumer retail product space, we initiated a long position in YETI Holdings (YETI) last week, as mentioned in the previous update. Known for its trendy, high-end food and beverage coolers and line of insulated stainless-steel mugs, the outdoor and recreational products maker is working to expand its reach, with a growing number of nationwide retail outlets carrying the most popular YETI products.

New product innovation is a key component of YETI’s growth strategy, and it’s battling inflationary headwinds by selling its newer offerings at lower price points. It also continues to expand its footprint by collaborating with established brands, including a recent partnership with the NFL, which includes a broad licensing agreement to sell branded products for all 32 football teams, along with a more extensive deal with the Dallas Cowboys.

In Q2, strong demand for YETI’s coolers and equipment drove a 15% revenue increase, giving the company a profit of 70 cents a share—up from the year-ago 57 cents a share, while adjusted operating margin improved to 17%. Going forward, the firm expects adjusted sales to increase by around 10% for the full year, and it just raised its net income outlook for 2024 above prior guidance. Analysts see the bottom line rebounding this year and accelerating in the next few years, which should help drive the turnaround.

Please know that while I don’t yet personally own shares of all Cabot Turnaround Letter recommended stocks, this will materially change in the coming weeks as I become fully integrated as your new chief analyst.

Please feel free to share your ideas and suggestions for the podcast and the letter with an email to either me at cdroke@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.

Portfolio

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