Cabot Turnaround Letter Issue: August 30, 2023

Four Interesting Large-Cap and Mid-Cap Turnarounds…

The attention of most investors, commentators and analysts has been on the winners, notably the Magnificent Seven, driving this year’s stock market rally. But, of course, there are 493 other stocks in the S&P 500 and hundreds of other large-cap and mid-cap stocks not in this famous index, many of which have had miserable years.

As contrarians, we are fine with letting a few overpriced trendy stocks capture the spotlight. Sooner or later, most of these glamour stocks will fade, or worse. One place that draws our attention is the other end of the spectrum – those with the worst performance. Most of the companies behind these rejected stocks fully deserve the market’s dour judgment. Some, however, have changes underway that could restore their prosperity and return their shares to investors’ favor.

Below, we look into four large-cap and mid-cap stocks that fit this latter description. Investing in these shares requires a balancing of the currently favorable setup (overly discounted valuation and significant prospects for fundamental improvements) with the often slow and unpredictable pace and timing of the changes. Turnarounds can produce unappealing near-term headlines, sending the shares lower, even as the foundations for a brighter future are being laid.

And, with year-end approaching, major institutional investors become risk-averse. They readily offload losers regardless of price, sending shares of out-of-favor stocks lower, often on no news whatsoever.

As it is impossible to perfectly time these stocks – buying a full position exactly at the bottom – as a prospective investor you will want to pace your purchases. One approach is to open a starter position now. This might be as small as a token number of shares, but enough to get involved in more closely following the company and its share price. Then, as your familiarity and understanding of the story increases, you can add more, particularly at the time when it is clear that the turnaround will work yet the valuation doesn’t reflect it. And, if the shares slide sharply on bad but temporary headlines, but the long-term story remains intact, you can add at lower prices, thus improving your overall likely return if the turnaround is successful. Of course, if the turnaround proves unsuccessful, having only a starter position, rather than a full position, greatly reduces your risks.

Hawaiian Electric Industries (HE) – Hawaiian Electric comprises three different companies under one corporate umbrella. The namesake business, a regulated utility, is the island state’s primary electricity provider, serving 95% of its residents. Wholly owned American Savings Bank is the state’s third largest bank with about $10 billion in assets. The Pacific Current subsidiary invests in local zero-carbon infrastructure projects. While previously a relatively dull company, Hawaiian Electric has become exceptionally volatile and risky due to its possible liability for the tragic Maui wildfires. In a worst-case scenario, the utility business is found liable for an amount in excess of what it could pay, leading to its bankruptcy. Due to this risk, the share price has tumbled 75% to nearly a 40-year low.

What makes the shares interesting are two traits. First, the shares may already fully discount the downside loss in a bankruptcy, as the value of American Savings Bank is reasonably estimated at about $8/share, roughly the current share price. If the electric utility subsidiary files for bankruptcy, rather than the parent company, shareholders would theoretically retain rights to the full value of the bank (we are conservatively assuming that Pacific Current has no value). Creditors would attempt to grab the value of the bank, potentially leaving shareholders with a total loss, but there is a reasonable chance that the bankruptcy court would prevent this.

The second trait is the upside potential if Hawaiian Electric is found completely not liable. Even allowing for some discount for future wildfire liabilities, the shares would likely surge to perhaps $30 – a triple from the current price. At present, there is no realistic way to accurately measure the company’s current or future wildfire liabilities. But, the upside/downside trade-off is fascinating.

California-based Pacific Gas & Electric (PGE) faced a similar situation. Its shares tumbled surrounding its wildfire liabilities and subsequent bankruptcy, but shareholders were not wiped out. The company’s shares have roughly tripled from their lows. While the fatalities, property damages, state regulations, legal precedents and other considerations are different in the two cases, the Pacific Gas outcome is useful to inform how Hawaiian Electric shares might fare.

It is very early days for the Hawaiian Electric situation. The ultimate outcome is unknowable and could take years to fully play out. But, the risk/return is setting up to be worth watching closely. Aggressive investors may want to take a starter position, perhaps backed by hedges to buffer a worst-case outcome.

UBS (UBS) – At the start of this year, UBS was a healthy and stable Swiss bank. However, its emergency rescue deal of Credit Suisse in March, engineered by the Swiss government, added both tremendous risk and sizeable opportunity to the story. Terms of the acquisition included a CHF 3 billion all-share acquisition price (roughly 7% of Credit Suisse’s tangible book value), the assumption of Credit Suisse’s murky liabilities and CHF 25 billion in various safety nets, along with about CHF 100 billion of government-provided liquidity. The new UBS now holds an impressive position as the largest (by far) Swiss bank. The end game is for UBS to keep the valuable wealth management and banking businesses while jettisoning about 50% of Credit Suisse’s cost structure, slashing the securities book and other risks, and creating a unified, singular and productive culture. UBS is taking an aggressive approach to making this deal work, starting with replacing its CEO with the bank’s former chief, Sergio Ermotti. Ermotti oversaw the bank’s emergence from the global financial crisis and transformed it into a healthy, well-capitalized operation, then retired in 2020. While this integration is immensely complicated with many moving parts, conservative estimates put the new UBS’ earning power at over CHF3/share in a few years. Capital remains robust at well above 13% CET1, providing flexibility to write off unwanted assets. UBS shares have surged above $24 on growing optimism, so investors may want to take only a starter position now in advance of the August 31 earnings report. The integration process will likely have hiccups, allowing nimble investors to accumulate more shares on any future weakness.

The Walt Disney Company (DIS) – The Disney name is one of the world’s most valuable brands. In addition to the immense value the name brings to its theme parks and the movie studio, the company also owns a vast library of content as well as other high-profile brands including ESPN, Pixar Studios, Marvel, Lucas Film, 20th Century Studios and the ABC TV network. Yet, despite this arsenal, the company is struggling to adapt to change, as consumers shift from linear cable TV to streaming. A major problem with undertaking the massive transition to digital is that streaming may be structurally less profitable than linear TV, due to near-zero ad revenues, cable carriage fees and other revenues, while all-in costs to produce viewable content may not be any lower and the broadcasting rights prices for the sports that ESPN carries continue to increase. Adding to worries is the recent decline in the number of Disney+ streaming subscribers. While management reiterated their guidance for healthy full-year 2023 revenues and profits, future growth is by no means guaranteed anymore. Perhaps it is not a surprise that Disney shares have slid 60% from their peak and now trade at their 2014 price level.

To accelerate the transition, former CEO Bob Iger has returned to the seat for an extended role. He is increasingly taking a “no limits” approach, such that former core operations like the ABC TV network and other linear TV operations may be jettisoned, ESPN will likely introduce a streaming platform alongside new partnerships with Penn Entertainment and possibly the NFL and others (an Amazon partnership has been rumored), and the remaining stake in Hulu appears likely to be acquired from Comcast. The Disney+ streaming service continues to devour money but at a slowing pace as monthly fee increases and aggressive cost-cutting, along with the side-benefit of the Hollywood strike, bolster its prospects. Iger is targeting Disney+ to breakeven by year-end 2024. An overall $5.5 billion cost-efficiency program should help Disney’s total profit outlook.

The outcome of this transition is unknown and will take years. Other media companies struggle as well, and there is no clear-cut example of success. Disney has a reasonably sturdy A-rated balance sheet, with net debt of only 2.3x EBITDA, and is generating positive free cash flow. But, a possible $15 billion cash purchase of Comcast’s Hulu stake, ongoing capital spending, the likelihood of a new dividend and other cash demands could squeeze Disney. The share valuation, at 11x EBITDA and 17x per share earnings based on 2024 estimates, partly reflects these issues. If the company can figure out how to more fully and sustainably monetize its immensely valuable brands, the current share price will have been a bargain.

Closing prices on August 25, 2023.
* P/E based on calendar year 2023 estimates, except DIS which is Sept 30. For UBS, multiple shown is Price/tangible book value based on first quarter 2023 actuals.
** Current Cabot Turnaround Letter recommendations.
Sources: Company releases, Sentieo, S&P Capital IQ, Nasdaq and Cabot Turnaround Letter analysis.

Wolverine Worldwide (WWW) – This company is a major producer of widely recognized shoes, boots and related apparel including Merrell, Saucony, Wolverine, Bates, Sperry and Sweaty Betty. After riding the pandemic surge in outdoor gear, Wolverine’s revenues and profits are sliding. Lower wholesaler and consumer demand, along with higher discounting (to remove an inventory glut) and elevated input costs are pressuring the company’s prospects. The $417 million all-cash acquisition of Sweaty Betty in 2021 added new weight to the over-leveraged balance sheet. In response, investors have unloaded the company’s shares, which have tumbled 80% from an all-time high to near their global financial crisis low.

To help right the ship, earlier this month Wolverine abruptly replaced its CEO with its well-regarded president and head of the Active (sports) segment. In addition, the board has been refreshing its board, replacing the leadership of several segments, and narrowing its product focus while raising cash. Wolverine is offloading many of its iconic leisure brands (including Sperry and Keds) as well as unnecessary real estate to concentrate on its core Work and Active boots and shoes, along with Sweaty Betty. New guidance for full-year 2023, calling for a 10% revenue decline and a modest 5% operating margin (compared to 8.5% last year), appears reasonably conservative. The new leadership is targeting a 12% margin for next year, which may be achievable given the turnaround program and the elimination of several non-repeat headwinds.

While the balance sheet is levered at 3x year-end estimated EBITDA, most of the debt is at fixed interest rates and the nearest major maturity is in 2026, providing some financial flexibility for the turnaround. Wolverine generates positive free cash flow. The shares trade at a reasonable 7.0x estimated 2024 EBITDA and a modest 5.3x per-share earnings. While a successful march to a more prosperous Wolverine isn’t guaranteed, the shares of this shoe and boot maker may be a good fit. Investors may want to open a starter position to get involved with the stock and then add if the shares tumble further.

…and One to Avoid for Now

Not all beaten-down stocks recover, even those with positive catalysts. Still-high valuation, intractable problems, ineffective leadership (even if new), overbearing debt and other major headwinds can weigh on a stock indefinitely. Usually, it is best to let these stories unwind further, either until the valuation is embarrassingly low or the fundamentals start to flatten or improve. Discussed below is one such stock.

International Flavors & Fragrances (IFF) – This company, often called “IFF,” produces ingredients, enzymes, fragrances and inactive substances that enhance foods, beverages, consumer products and pharmaceutical products. While the company was immensely successful in the past, reflected in the strong outperformance of its shares between 2009 and 2019, IFF has fallen on difficult times, which have unwound most of the gains. Revenue growth has turned negative (likely down 8% this year), profits are headed for a 20% decline and cash flow is tight. The $23 billion acquisition in 2021 of DuPont’s Nutrition & Biosciences operations heavily diluted shareholders, while the $7 billion cash and share purchase in 2018 of Frutarom Industries added new debt, and both added considerable complexity to IFF while tainting the company’s otherwise high reputation among investors.

A new CEO (since February 2022), along with a refreshed executive suite and several new board members, is implementing an aggressive operating improvement plan. This includes an overhaul focused on the Functional Ingredients segment (25% of revenues) to improve sales execution, boost efficiency, invest in higher-margin products and discontinue lower-margin products. But the company has repeatedly reduced its guidance, leaving investors wondering whether this team is up to the task.

Further, IFF is facing hefty headwinds. The fading popularity of “fake meat” along with a grinding de-stocking at customers means lower demand for longer for IFF’s compounds. Also, IFF has relied on higher prices to drive sales and profits, but this game is winding down as competition from low-cost competitors is rising while customers are pushing back on price increases. Management’s target for 2024 sales growth of 4% and EBITDA growth of 15% seem out of range.

Two other problems are IFF’s unwieldy debt burden (5.3x EBITDA) and thin free cash flow. Planned divestitures will help a bit, but free cash flow isn’t covering the $0.81/share quarterly dividend, so it is likely to be trimmed or eliminated. Freed-up cash would be at least partly allocated to debt reduction.

The shares aren’t cheap, either. Based on optimistic 2024 estimates, IFF shares trade at 12x EBITDA and 14.7x per share earnings. IFF’s glory days are in the past, so the elevated multiples from 2016 to 2022 aren’t relevant anymore. We see little potential for a sustained drive upward in IFF’s shares.

RECOMMENDATIONS

Purchase Recommendation: Advance Auto Parts (AAP)

Advance Auto Parts 4200 Six Forks Road Raleigh, North Carolina 27609 www.ir.advanceautoparts.com

Symbol AAP Market Cap $3.8 billion Category Mid Cap Business Auto Parts Retailer Revenues (2023e) $11.3 Billion Earnings (2023e) $275 Million 8/25/23 Price $64.08 52-Week Range: 63.09-194.35 Dividend Yield: 1.50% Price target: $98

Background:
Advance Auto Parts is one of the four major auto parts retailers in the United States. Founded in 1932 through the purchase of three Virginia stores from Pep Auto Supply, the company expanded mostly organically until its 1998 purchase of Western Auto Supply from Sears. Advance became a publicly traded company in 2001 through its acquisition of Discount Auto Parts. The deal increased its store base by 35% to nearly 2,500 locations. Additional deal-driven growth included the $2 billion purchase of General Parts in 2013, which added Carquest and Worldpac brands and made Advance Auto the largest auto aftermarket supplier in the country. Today, Advance Auto has 4,790 stores, primarily in the United States, and serves an additional 1,300 independently owned CarQuest stores. A typical store carries 23,000 SKUs, with another 260,000 available in its complete offering. The company serves professional installers and do-it-yourself (“DIY”) customers.

Advance Auto’s reputation has fallen sharply from 2005 when it was named “Best Managed Company in America” in the retail sector by Forbes magazine. Its aggressive acquisition spree overstretched its ability to efficiently operate its vast network, while its former CEO, appointed in 2016 following activist pressure, was not up to the task. Sales growth has stagnated, while profits have been cut in half from only two years ago. An inventory glut has further siphoned off cash flow. This cash flow deterioration, combined with the somewhat elevated debt (at 2.4x EBITDA) led to the sensible but surprising 83% slashing of its inappropriately large quarterly dividend to $0.25/share. Per-share earnings estimates have slid 70% from only a year ago, wiping away any remaining credibility held by the former management team. It’s not surprising that the shares have collapsed 73% from their 2022 peak and now trade at 12-year lows.

Analysis:
Advance Auto clearly has financial, operating and leadership problems. Yet, the board is taking aggressive action to rebuild the company. A critical first step is the leadership overhaul, starting with the replacement of the failed CEO with a capable outsider, Shane O’Kelly. O’Kelly previously was head of HD Supply, a subsidiary of Home Depot, and has considerable CEO and distribution industry experience. He also was a captain in the U.S. Army and an MBA from Harvard (we’ll call that a positive here). O’Kelly starts in mid-September. In addition, the CFO has departed, allowing O’Kelly to select his own financial lieutenant with full alignment to the new task.

The board of directors has been refreshed, as well. Gene Lee, a highly regarded executive, is the new interim board chair. Five other members of the nine-person board, including the CEO spot, will have been changed out since August 2020. These changes should bring tighter oversight of the executive suite’s strategy and execution.

Advance Auto will undertake a comprehensive operational and strategic review. We anticipate hearing significant details by early 2024, recognizing that the leadership needs at least the standard 90 days to develop a meaningful plan. Some early indications of tactical improvements include addressing high employee turnover (likely related to below-market wages), clunky infrastructure and generally weak productivity – all of which will require higher expenses and capital outlays which will depress margins temporarily. Much of the new CEO’s job is to reverse the poor policies and priorities of the former CEO. We anticipate store closures, possible exits from low-margin geographies and other strategic changes.

The company’s debt burden, while too high, is manageable. Essentially all of the debt is fixed rate with an average interest rate of about 4.50%. The nearest major maturity is in March 2026, allowing plenty of time for better financial results to ease the issuance of replacement debt. Even with its tight financial position this year, free cash flow should be at least $150 million.

With the stock’s washout, the valuation is at a depressed multiple of depressed earnings. For our $98 price target, we estimate that EBITDA will recover about 33% to $1 billion (on par with historical results but with a margin that remains less than half its peer average) while we leave the valuation multiple unchanged at 7.1x, below its longtime average of around 8.3x.

Advance Auto is a repeat recommendation from the Cabot Turnaround Letter. Our October 2018 recommendation produced an 80% return in about 14 months. We have no illusions about the difficulty of the current turnaround but would be pleased to have a similarly successful repeat performance.

The Advance Auto turnaround will likely take time to play out. Investors have lost faith in the company, so its shares won’t receive much credit for fundamental improvements until they happen. Industry competition is fierce and the internal and external challenges are significant. More bad news is likely, which could readily push the shares lower in the short term. From a tactical perspective, investors may want to take a starter position now, then add on meaningful weakness at lower prices. Despite its current wheel-spinning, this company has all of the ingredients for a successful turnaround, which would drive the shares meaningfully higher.

We recommend the purchase of Advance Auto Parts (AAP) shares with a 98 price target.

Sell Recommendations

On August 18, we moved shares of four companies, Toshiba (TOSYY), Holcim AG (HCMLY), First Horizon (FHN) and ESAB Corporation (ESAB), from BUY to SELL.

With its go-private tender offer now underway, we see essentially zero chance of an overbid by another party for Toshiba (TOSYY). The company’s shabby governance, in which board members repeatedly looked out for their own personal interests rather than the shareholders to which they presumably have a fiduciary duty, is a dark blotch on the entire country’s public markets. Fortunately, this episode is helping catalyze a sharp improvement in corporate governance, led ironically by the government, across Japan’s business realm. We exit our Toshiba position with an approximate 24% total return.

Holcim AG (HCMLY) reported strong first-half results, with organic revenues increasing 7% and organic profits increasing 13%. The company is firing on all cylinders except for its Solutions & Products segment where temporary problems are now reversing. Holcim’s turnaround is complete, and the CEO and CFO who led the turnaround are transitioning out. The company is producing strong revenue growth and wide profit margins, generating impressive free cash flow and has a solid balance sheet. The top-down strategy is sound and well-executed. All of this seems to be fully recognized by the stock market. While the shares haven’t quite reached our 16 price target, they are close enough, and we won’t quibble about being about a ½ turn too aggressive on our 7.0x EBITDA multiple target. We exit the Holcim position with a total return of approximately 49%.

Following the collapse of its deal to sell to TD Bank, First Horizon (FHN) would have remained a Buy. But, it is now being caught in the secular problems of rising deposit costs and the declining value of its loan book – both driven by higher interest rates. First Horizon’s capital base is reasonably strong but if rates continue to rise and new government regulations become law, the bank’s underlying profitability and value will likely be squeezed. We are disappointed with the roughly 23% loss on the position, but it is time to exit.

ESAB Corporation (ESAB) moved above our 68 price target. We see only limited potential for the stock to move significantly higher as the fundamentals are increasingly being priced into the shares. The position generated a 55% profit.

Other Ratings Changes

On August 24, due to circumstances beyond our control, we suspended our rating on Kopin Corporation (KOPN). For clarity, the shares are not rated Buy, Sell, Hold or any other rating. They are in essence unrated. We apologize for the unavoidable murkiness involved with this change.

You can find more details by visiting our website at cabotwealth.com.

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, plus 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. Total return includes price changes and dividends, with adjustments as necessary for stock splits and mergers.
* Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.
** BNRE return includes spin-off value of BAM shares.
*** GE total return includes spin-off value of GEHC shares at January 6, 2023 closing price to reflect our sale.

The next Cabot Turnaround Letter will be published on September 27, 2023.