Cabot Turnaround Letter Issue: August 3, 2022

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When considering turnaround situations, our most-preferred catalyst is a chief executive officer change. When a business is sliding backwards, this could be exactly the change needed to restore its prosperity. For frustrated shareholders, the change can bring immense potential. We discuss six new CEO situations that look appealing.
Long ago, astute investors noticed that the stocks with the highest dividend yields in the Dow Jones Industrial Average tended to become the index’ best performers in future years. Following the recent market sell-off, we re-visited this group to look for interesting opportunities. We review six of the highest dividend yielding Dow stocks, and leave out three that have immense strategic and profit pressures.
Our feature recommendation this month is Volkswagen AG (VWAGY). The shares have plummeted after our timely sale last year for a 182% total return and we take this opportunity to repurchase them at the current low price. The financially sturdy company has a new CEO and another possible catalyst from a Porsche initial public offering.

We note our recent ratings change of Credit Suisse (CS) from Buy to a Sell.

Cabot Turnaround Letter Issue: August 3, 2022

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Six Out-of-Favor Companies with New CEOs
When considering turnaround situations, our most preferred catalyst is a chief executive officer change. The CEO determines and drives a company’s strategy and capital allocation, selects and monitors the other senior executives who run the operations and financials, and sets the tone that reverberates throughout the entire organization. When the CEO is changed, it can portend major changes in all aspects of a company. When a business is sliding backwards, this could be exactly the change needed to restore its prosperity. For frustrated shareholders, the change can bring immense potential.

In recent months, we’ve seen a surge in CEO change-outs. Some of the turnover is likely due to executive burnout: running a company during a global pandemic, followed by labor shortages, cost inflation, supply chain disruptions and a now-volatile stock market is exhausting. Yet, boards of directors may feel pressure to make a change if these problems aren’t adequately being alleviated regardless of the reason, if competition has accelerated or shifted or if a company’s strategy no longer works in the post-pandemic world. Weak operating performance combined with a low share valuation is an invitation to activist investors – guests that few boards want to entertain.

Discussed below are six out-of-favor companies with recent changes in their top executive. This month’s feature recommendation, Volkswagen AG, fits this profile.

Biogen (BIIB) – Following the FDA’s approval of Biogen’s controversial Alzheimer’s treatment (named “aducanumab”) in June 2021, the company’s future looked exceptionally bright. The market potential was enormous, Biogen would have had a monopoly and the treatment would have rescued the company from its fading multiple sclerosis franchise. However, aducanumab’s revenues proved to be so unimpressive that Biogen recently gave up on the treatment. Investors seem to have given up as well, with the shares plummeting over 50% from their peak and now trading near their 19-year low. However, the dour investor expectations plus a CEO change make Biogen shares appealing again. In May, the company announced that its somewhat-discredited CEO will step down once a successor is brought on. We believe this will improve the company’s strategic direction and tactical execution. While not assured, the as-yet-unnamed CEO will hopefully look to other higher-probability categories to restore the company’s fortunes. Near-term fundamentals will likely remain uninspiring, with moderately declining revenues and profits. Yet, Biogen’s balance sheet is strong, with its reasonable $6.3 billion in debt mostly offset by $4.9 billion in cash and supported by healthy free cash flow. Biogen’s shares trade at an unchallenging 8.5x EBITDA and 12.6x estimated per-share earnings.

Pinterest (PINS) – Pinterest is a highly popular image sharing and social media service company with over 430 million monthly active users. Many investors lump this company into the same category as highly unprofitable, hyper-growth tech companies, illustrated by its share price which has fallen 80% from its pandemic-driven peak. Helping turn off momentum-focused investors are the company’s user statistics, revenue growth rate and profit margins – these are incrementally slipping as consumer behavior normalizes. But Pinterest has important differences that make it worth a look. First, the company has a sturdy balance sheet, with $2.6 billion in cash/marketable securities ($4/share) and zero debt. Second, unlike most of its hyper-growth peers, Pinterest is profitable on a GAAP basis. The company’s capital spending is minimal, and its profits allow it to generate sizeable free cash flow. One concern about Pinterest’s cash flow is its heavy use of stock-based compensation. No doubt the company may need to convert some of this non-cash expense to either cash expenses or dilutive new stock options, but we view these effects as acceptable given the balance sheet strength and GAAP profits. The shares trade at a very reasonable 17.4x EV/EBITDA (based on our pricing date information). Two catalysts make this stock even more interesting. First, the co-founder recently stepped aside as CEO (a rare yet smart move) and is being replaced by highly regarded former Google President of Commerce, Bill Ready. And, activist investor Elliott Management has taken a 9% stake in the company, indicating that perhaps more aggressive shareholder-friendly changes are ahead. Interestingly, Pinterest’s $13 billion market cap is small enough that a major tech or media company might be interested in acquiring it.

Red Robin Gourmet Burgers (RRGB) – Red Robin is a major quick-service restaurant company with over 520 stores in the United States and Canada. The company completed its IPO in 2002 at $12/share. Since then, the shares have followed a roller-coaster path, surging twice to above $60 and tumbling three times to below the IPO price where they rest today. Red Robin has struggled with execution in a competitive environment, as well as turnover in its executive suite. While revenues are recovering from the pandemic, profits remain elusive, most recently due to elevated food, labor and marketing costs. The shares are speculative given these losses, the company’s $194 million (about 2.2x EBITDA) in debt, and its marginally positive free cash flow. However, the three-year pre-defined term of the CEO, who joined for that period to stabilize the business, is expiring, with a permanent CEO starting in September. With a new, dedicated CEO who brings a fresh perspective, as well as the company’s depressed 3.5x EV/EBITDA share valuation, this company offers an appetizing opportunity.

Under Armour (UAA) – This widely recognized brand captured the sports apparel industry’s imagination with its high-impact “We Must Protect This House” advertising slogan in the early years of this millennium. The 3.25 split-adjusted IPO price in late 2005 was a bargain as the shares surged to over 54 a decade later. Today, the shares trade at their pandemic low and are unchanged from their 2007 price. The company has clearly not protected its house, as weak management and board oversight led to an aggressive expansion strategy that diluted its valuable brand. The “Under Armour” label now moves the merchandise largely because of the discounted pricing. Worse, the product line-up is uninspiring, and operational missteps along with supply chain constraints and elevated materials and shipping costs continue to plague the company. In terms of numbers, revenue growth and margins are subpar. On most fronts, the company is more like “Under Achieving” than “Under Armour”. However, important changes may be coming to this beleaguered company. The board has ousted the CEO and is actively searching for a replacement. The company needs a fresh outsider’s perspective to completely re-think its strategy and improve its operations and merchandising. Providing a solid foundation is the company’s balance sheet, where its $1 billion in cash more than fully offsets its $672 million in debt. And, the valuation at 6.2x EV/EBITDA leaves plenty of margin for safety, particularly when compared to Nike’s lofty but well-earned 21x multiple. With better governance and leadership, Under Armour may yet provide a solid home for investors. Investors may want to opt for the Class A shares (UAA), which carry one vote, rather than the Class C shares (UA) which have no voting rights. Founder Kevin Plank controls the company through his 10 votes per share Class B shares.

Vera Bradley (VRA) – Based in rural Indiana, this company has carved out a valuable niche for quilted bags that have a highly loyal following among women and girls. Sales are generated through 145 full-line and factory outlet stores across most of the United States, as well as through its on-line store and a selection of third-party retailers. In 2019, Vera Bradley acquired for $75 million a controlling interest in Pura Vida, a California-based bracelets and accessories brand. While Pura Vida sales and profits look promising, the core Vera Bradley revenues continue their slow but steady decay while corporate costs continue to rise. These issues have helped drive the shares down 92% from their 2011 peak to near all-time lows. Recently, however, the long-time CEO, who ran the company since 2013, is stepping down. A national search that includes insiders and outsiders is underway. The balance sheet carries $64 million in cash and zero debt, and Vera Bradley generates reasonable profits and free cash flow. The shares trade at a highly discounted 2.3x EV/EBITDA. With its strong financial foundation and low share valuation, along with the right CEO choice, Vera Bradley could see an impressive turnaround.

Weber (WEBR) – Weber produces the iconic cooking grills and related accessories. Sales have grown steadily over the past 40 years and surged during the pandemic when consumers spent more time in their back yards. During this brief golden era, the company went public via a SPAC deal, with early trading at around 18/share. However, that era is unwinding, and Weber is suffering from weak sales and sliding margins as rising materials, freight and other costs overwhelm its ability to raise prices. Changing consumer preferences, toward travel and away-from-home experiences, are also eroding Weber’s near-term prospects. We hold the company in high regard, partly due to its impressive brand and global operations, but also due to the presence of Byron Trott (the only investment banker approved by Warren Buffett) as the controlling shareholder. Trott was likely a driving force behind the company’s recent announcement that its CEO is departing, with a search underway for an outsider replacement. The shares have plummeted and may linger, or worse, as the company sorts out its leadership and as investors worry about its elevated debt (at 5.2x EBITDA) and still-pricey 12x EV/EBITDA valuation. But this is a name to watch. If anyone knows how to create shareholder value from a problem company, it is Buffett protégé Trott.

THE NEW “DOGS OF THE DOW”
Long ago, astute investors noticed that the stocks with the highest dividend yields in the Dow Jones Industrial Average tended to become the index’ best performers in future years. This intuitively makes sense – the 30 members of the index are high-quality and resilient companies, and so when they are out of favor they usually rebound when economic cycles and market sentiment invariably turn. Further, their high dividend yields provide a solid cash return to pay investors while waiting.

Following the recent market sell-off this year, we revisited this group to look for interesting opportunities. Reviewed below are six of the highest dividend yield Dow stocks that have considerable appeal. Noticeably absent from this list are IBM (IBM), Intel (INTC) and 3M (MMM). Due to the pace of technology changes, companies like IBM and Intel have fallen behind and face immense strategic and profit pressures, as well as the risk of dividend cuts, that suggest they aren’t resilient enough to bounce back. 3M is splitting off several operations but is facing potentially enormous environmental liabilities. Share valuations of these stocks don’t yet fully reflect the risks.

Cisco Systems (CSCO) – This company has been a longstanding provider of technology hardware that connects data and communications networks. Cisco rose to prominence in the late 1990s tech and dot-com boom as its gear was in the sweet-spot of that era. While the company will never return to the same degree of prosperity, it has been successful in developing software and services to help maintain its relevance. Today, the company is facing new challenges as customers migrate to the cloud and thus need less of Cisco’s equipment and one-stop-shop services. Cisco’s prospects are starting to improve under a relatively new CEO, who is shifting Cisco toward a software and subscription model and is rolling out new products, helped by its strong reputation and entrenched position within its customers’ infrastructure. The company is highly profitable, generates vast free cash flow (which it returns to shareholders through dividends and buybacks) and its sturdy balance sheet carries $20 billion in cash that more than offsets its $9.4 billion in debt. The shares trade at a modest 9.2x EV/EBITDA. The stock is a current Buy recommendation in our sister publication, the Cabot Undervalued Stocks Advisor.

Chevron (CVX) – Energy giant Chevron is well positioned for the elevated oil and natural gas price environment, with its strong global resource base, sizeable refining operations, disciplined investment policy and high-quality management. The company has improved its efficiency so that it can maintain its dividend and capital spending even if oil slides to $50/barrel. Chevron recently demonstrated its strength with its impressive second quarter results. This year, the company is on-track to generate over $30 billion in free cash flow – nearly 10% of its market value – much of which will be returned to shareholders through dividends and share buybacks. Chevron’s balance sheet carries $30 billion in debt, but this is less than half its EBITDA and is partly offset by $11 billion in cash. The shares still look appealing after the recent jump in their price.

Dow Inc. (DOW) – In 2017, Dow Chemical merged with DuPont to create DowDuPont, then split into three companies in 2019 based on product type. The new Dow is the world’s largest producer of ethylene and polyethylene, the most widely used plastics. Investors have largely abandoned Dow shares due to concerns that U.S. and global economic growth will stall, and that, combined with the risk of new supply, the immense pricing power that has driven the company’s currently wide profit margins will evaporate. Another worry is that Dow might squander its prosperity on aggressive capital spending. Yet, pricing power is likely to remain sturdy due to sustained high prices for oil and natural gas, constrained supply additions and Dow’s favorable low-cost position. Dow has capably used its cash flow to cut its debt (to a modest 1x EBITDA), reduce its pension liabilities, streamline its operations, and return cash to shareholders (the plan for this year is to reduce the share count by nearly 6%). The stock trades at a low 4.4x EV/EBITDA. Dow’s shares are current Buy recommendation in our sister publication, the Cabot Undervalued Stocks Advisor.

JPMorgan Chase & Co (JPM) – JPMorgan, the nation’s largest bank, is well known for its top-quality management team, highly profitable operations and strong risk controls. The bank was one of the few that sailed through the global financial crisis over a decade ago, and today it holds solid franchises in nearly all segments of the financial system. Its shares, however, have slipped as investors worry about narrowing profit margins from lending, weakening trading and investment banking profits and rising loan losses as the economy slows. JPMorgan will also need to boost its capital base by terminating its share buybacks and dividend increases to meet regulatory stress test requirements. But given all of its strengths, the company is in no danger of becoming a basket case. Its shares, however, seem to price in these fears, as seen in their 33% slide since last November back to their early 2018 level, and in their low 10.4x price/earnings multiple and 1.7x price/tangible book value multiple.

Verizon (VZ) – In its recent second-quarter earnings report, telecom giant Verizon said it was facing slowing new subscriber growth, rising costs and higher promotional spending. Competitor AT&T is becoming more price-aggressive and T-Mobile seems to now have a better 5G network, leaving Verizon in a difficult competitive and strategic position. The company trimmed its full-year 2022 guidance to reflect these challenges as well as the likely small but inevitable market share erosion. In response, its shares have tumbled to prices not seen since 2017 and now trade only fractionally above their 2007 price. Yet, the $0.64/share quarterly dividend, which is producing the highest yield at 5.5% among the Dow stocks, is well covered by profits and free cash flow. While Verizon’s total debt balance may seem high, it is properly sized. Given the strong asset base and solid management team, the company is likely to fix its recent shortcomings and lift its shares from their out-of-favor status.

Walgreens Boots Alliance (WBA) – Once a retail pharmacy powerhouse, Walgreens faces hefty secular challenges from an overbuilt and mature store base, with customers who have plenty of alternatives to visiting its often poorly run and expensively priced stores. And pricing pressure from private and government payors is squeezing its prescription profit margins. Yet, led by the much-needed fresh perspective from a new CEO, Walgreens is re-focusing its efforts on the United States market where it is developing its stores into a healthcare network. Despite a recent failed effort to divest its Boots U.K. pharmacy unit due to weak market conditions, Walgreens will likely have an opportunity to complete this sale in the next year or so on reasonably favorable terms. Earnings growth will be uninspiring as the company builds out its new strategy but they are likely to be resilient. The company’s shares are bargain-priced even as Walgreen’s is in solid financial condition and produces large and stable profits and cash flow.

RecommendationS

Purchase Recommendation: Volkswagen AG (VWAGY)

Volkswagen AG (VWAGY) Investor Relations Letterbox 1849 38436 Wolfsburg, Germany www.volkswagenag.com

Symbol: VWAGY Market Cap: $86.7 billion Category: Large Cap Business: Vehicle Production Revenues (2022e): $280 Billion Earnings (2022e): $17.6 Billion 4/29/22 Price: 19.76 52-Week Range: 16.79-36.74 Dividend Yield: 5.5% Price target: 29

Background
Volkswagen is one of the world’s largest car makers, selling over 8.6 million cars and trucks last year. Based in Germany, the company owns the mass market Volkswagen, Skoda and SEAT brands, as well as the higher end Audi, Porsche, Bentley and Lamborghini brands. It also produces commercial trucks under the MAN, Navistar and other brands. Volkswagen’s financial services unit holds over $100 billion in loans and leases that currently finance about a third of the company’s vehicle sales. Geographically, China is Volkswagen’s largest market (38% of vehicle unit sales), followed by Western Europe (32%) and North America (10%).

Investors generally view Volkswagen as a sprawling car-making giant with heavy exposure to China, with a large but unsettled bet on electric vehicles and a complicated governance structure. The Chinese market carries two risks – one from slower demand due to the Covid lockdowns and one from potential geopolitical issues. Volkswagen’s electric vehicle prospects haven’t been helped by chronic problems with its internally-developed software. And, like most others in the industry, Volkswagen has struggled with semiconductor shortages, rising costs, and supply chain constraints. Concerns about a slowing global economy and rising interest rates further weigh on VW’s shares.

With little optimism about the company’s prospects, investors have sold the shares down to their pre-pandemic January 2020 price level.

Analysis
Volkswagen was a previous Cabot Turnaround Letter recommendation which produced a 182% total return when we sold the shares in April 2021 at 42.33. We are taking advantage of this opportunity to repurchase the shares at a much lower price. We acknowledge the numerous headwinds, yet the market is over-discounting these while ignoring the company’s strengths. Also, several important catalysts look primed to unlock value within the company.

Recent second quarter results were impressive, suggesting that VW is navigating chip shortages, rising costs and supply chain constraints relatively well. Covid-related weakness in China continues but is showing signs of easing. The geopolitical risks related to China will likely not be resolved during our investment horizon, but we believe the likelihood of a major negative issue is low.

VW’s huge electric vehicle program is based on creating a common platform for EVs throughout the company’s core brands. If successful, this platform would produce remarkable economies of scale and provide VW with a significant competitive edge. Little optimism is built into the share price regarding this platform, but the company’s improving EV results provide encouragement.

The surprise replacement of the CEO brings both concerns and opportunities. Two concerns are that the incoming CEO, Oliver Blume, could bring yet another strategy change and more governance questions as he will be the CEO of both VW and its Porsche AG operations. Yet he is also more likely to bring a fresh perspective to resolving the electric vehicle software problems and other operational difficulties that the company faces.

Another potential catalyst is an IPO of the Porsche business. The company announced an assessment of this potential transaction on the same day that Russia invaded Ukraine, and investors continue to speculate on the odds of an actual offering. Little to no value uplift from an IPO is priced into VW shares. Yet the unlocked value could be substantial as Porsche could be worth as much as €60 billion, compared to VW’s total market value of about €85 billion. While unlikely near-term, the company could also unlock further value by offloading its ownership in truck-maker Traton or ultra-luxury car makers Bentley or Lamborghini.

Volkswagen is profitable and generating positive free cash flow. Its balance sheet is robust, with over €15 billion of cash in excess of its automotive segment debt. The financial services business is solidly profitable and well-capitalized. These strengths provide Volkswagen with plenty of runway to execute its plans. While the precise valuation is murky, given the company’s complicated balance sheet, the shares appear to be remarkably undervalued and pay an attractive and sustainable dividend.

We recommend the purchase of Volkswagen AG (VWAGY) shares with a 29 price target.

Ratings Changes
On Thursday, July 14, we moved shares of Credit Suisse (CS) from Buy to Sell.

As we have spoken about in recent weeks, our patience with the pace and likelihood of positive changes in the bank’s leadership, risk management, tactical execution and strategic direction have been wearing thin. On July 14, our patience expired. The slim chance of a turnaround and recovery is more than offset by the risk of an implosion which could drive the shares toward zero.

Our view crossed into “time to sell” due to the accelerating pace of changes in securities prices across the board – stocks, bonds, currencies, commodities and private/alternative assets. Inflation has moved from mild to high and persistent with remarkable speed. This rapid acceleration is forcing the Fed and many other central banks into faster and bigger interest rate increases. In turn, this is creating exceptionally large price and direction divergences across capital markets, and rapidly changing economic conditions, in ways that greatly increase the risks to banks like Credit Suisse.

Some banks, like JPMorgan, are exceptionally well managed, technologically advanced, tightly risk-controlled and have solid balance sheets, and will readily survive. Yet even JPMorgan is starting to feel the capital markets’ stresses and is preparing for more stresses. A chronically mismanaged, technologically lagging, uncontrolled-risk bank like Credit Suisse, whose balance sheet may well contain sizeable old and new losses would seem to have little chance of recovery, let alone prosperity.

We regret having to take the approximate 58% loss on this investment, but Credit Suisse has a real chance of completely imploding. The slim chance for a turnaround from here, and the potential upside should this happen, is not worth the risk of an implosion.

Note: Subsequent to our Sell decision, the company finally replaced its CEO and appears ready to accelerate its transition away from risky and volatile trading and capital markets operations. The new leader is the former head of Credit Suisse’s asset management business who brings experience from a previous role at competitor UBS. Our hope had been for a strong outsider to take the helm, and we are moderately unimpressed with the company’s choice. But, we may have missed a major turnaround if the new CEO proves to be capable.

Disclosure: The chief analyst of the Cabot Turnaround Letter personally holds shares of every company on the Current Recommendations List. 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 currently hold and may purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time.

Performance

The following tables show the performance of all our currently active recommendations and recently closed out recommendations.

Large Cap¹ (over $10 billion) Current Recommendations

Mid Cap1 ($1 billion – $10 billion) Current Recommendations

Small Cap¹ (under $1 billion) Current Recommendations

Most Recent Closed-Out Recommendations

Notes to ratings:

1. Based on market capitalization on the Recommendation date.
2. Price target in parentheses.
3. Total return includes price changes and dividends, with adjustments as necessary for stock splits and mergers.
4. SP - Given the unusually high risk, we consider these shares to be speculative.
5. *Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.

The next Cabot Turnaround Letter will be published on August 31, 2022.

About the Analyst

Bruce Kaser has more than 25 years of value investing experience in managing institutional portfolios, mutual funds and private client accounts. He has led two successful investment platform turnarounds, co-founded an investment management firm, and was principal of a $3 billion (AUM) employee-owned investment management company.

Previously, he led the event-driven small/midcap strategy for Ironwood Investment Management and was Senior Portfolio Manager with RBC Global Asset Management where he co-managed the $1 billion value/core equity platform for over a decade. He earned his MBA degree in finance and international business from the University of Chicago and earned a Bachelor of Science in finance, with honors, from Miami University (Ohio).