Cabot Turnaround Letter Issue: December 28, 2022

Top Five Stocks for 2023

At the end of each year, the Cabot Turnaround Letter looks through its portfolio of recommended stocks to select the “Top Five” for the coming year. We are reluctant to select only five, as we like all of our 39 current recommendations (otherwise they wouldn’t be on the roster). However, these five stocks have what we believe are the most favorable combinations of risk/reward and timeliness. As always, we encourage investors to hold a diversified portfolio of turnaround stocks, as individual names can carry high risk.

In previous years, our picks have often produced strong returns. For 2021, the average return was 115%. This year, the average return was more modest but nevertheless positive, at +4%, in a year when the S&P 500 posted a 19% loss.¹ Our selection of Credit Suisse (CS) produced a 47% loss, but our sale at $5.11 avoided the subsequent 39% decline. The only other loss was in Nokia (NOK), which fell 25%. The remaining three stocks produced strong results, led by the 39% gain in Dril-Quip (DRQ), followed by LambWeston Holdings (LW) which rose 31%, and a 21% increase in TreeHouse Foods (THS).

This year’s Top Five list emphasizes shares that have been heavily beaten down in the current bear market. The fundamental situations among the companies are different, but they all have a very favorable risk/return trade-off, even if their individual riskiness is somewhat elevated compared to our typical Top Five selections of prior years. We anticipate that our list will receive media coverage in the near future, as it usually does. However, as a loyal subscriber, it is only fair that you see the list first.

Duluth Holdings (DLTH) – After struggling with a disjointed and overly aggressive store expansion strategy and then the pandemic, this retailer of rugged workwear and outdoor gear is slowly but surely turning around its operations. A new CEO is limiting new store openings while emphasizing infrastructure upgrades and the introduction of new and promising apparel lines. Like many retailers, Duluth is working to offload excess inventory. Worries about the margin-shrinking effects of discounting and higher advertising expenses have driven the shares down to near their pandemic lows. Also, the new CEO needs to set achievable guidance and then meet or exceed it to show that he is on top of the situation. Duluth has a valuable niche and a loyal following and is likely to extract itself from the inventory glut while also making headway with new customers. The balance sheet is in good shape, providing a solid foundation while the turnaround continues. With a valuation at 4.7x EV/EBITDA on depressed estimates, expectations are low, so it wouldn’t take much good news for the shares to surge from here.

Goodyear Tire & Rubber (GT) – The Goodyear stock price has slid about 36% since our initial recommendation at $16/share in March 2022. Investors worry that the arrival of a recession would exacerbate the company’s already-difficult inventory and cost outlook. However, the decline in the shares makes our thesis more interesting. We recommended Goodyear as an opportunistic purchase of an average company whose shares had fallen sharply out of favor for what look like short-term reasons. These reasons are taking a while to be resolved, but we believe they will be, and the entry price is now much lower. Goodyear is seeing daylight in its fight against inflation, as third-quarter pricing overtook higher input costs. And, helping its efforts: the cost of petroleum, a major ingredient, peaked earlier this year and has fallen about 12% in the fourth quarter compared to the third quarter. Also, transportation and energy costs have likely flattened or declined – easing the company’s cost pressures. Goodyear continues to realize cost-savings from the Cooper acquisition, a deal that removed a competitor from its markets. Despite the pressure that elevated inventory is exerting on the balance sheet, Goodyear’s finances look sound. Trading at 5.2x depressed earnings, Goodyear shares look ready for a good ride.

Closing prices on December 23, 2022.
* Enterprise value/earnings before interest, taxes, depreciation and amortization. Based on consensus estimates for calendar years ending in 2023.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.
Disclosure: The chief analyst personally owns shares of all Cabot Turnaround Letter recommended stocks, including the stocks mentioned in this article.

Nokia Corporation (NOK) – Nokia is one of the world’s primary providers of telecom equipment, along with Ericsson, Samsung and China-based Huawei. Based in Finland, the company has long struggled with disappointing new product initiatives (including mobile phones), the lack of a major telecom upgrade cycle, a wrong-way bet on semiconductor technology, and weak executive leadership. Its €15.6 billion acquisition of Alcatel-Lucent in 2016 has been a disappointment as well. Current worries include the intensely competitive environment, particularly in radio access networks, a core component in telecom systems. Nokia shares have gone nowhere in the past 10 years.

Today, new leadership is refocusing and rebuilding Nokia. Pekka Lundmark helped develop Nokia’s business in the 1990s, then gained valuable business and leadership experience from impressive roles at other major companies until rejoining Nokia as CEO in late 2020. Under Lundmark, the company has corrected its semiconductor mistake, reinvigorated its sales efforts, streamlined its profit structure and is investing heavily in new product development that is lifting its market share trajectory.

These improvements are showing up in the company’s financial results. Sales growth hit 6% ex-currency and earnings per share rose 25% in the most recent quarter. The operating profit margin dipped, but this was due to a timing issue with high-margin patent contracts. Nokia remains on track to maintain and build upon its already-improved margins, even as it ramps up its technology spending.

Global telecom service providers continue to ramp their spending for the rollout of 5G technology. India has been widely cited as a large and upcoming new market. Due to security concerns, China’s Huawei is being sidelined, leaving more market share opportunities for western companies like Nokia. While the industry is highly competitive, Nokia is increasingly capable of maintaining its position, at a minimum.

Free cash flow is strong, allowing the company to now hold €4.7 billion in cash above its debt balance. With its new financial flexibility, Nokia has restored its dividend and is about halfway through its €600 million share repurchase program.

The share valuation at 4.8x estimated 2023 EBITDA, is unchallenging. All-in, this under-appreciated company offers an attractive turnaround opportunity for 2023.

Vodafone Group (VOD) – This U.K.-based company is a major telecom and cable television service provider. While its core markets include the United Kingdom, Germany, Spain and Italy, it operates in thirteen other markets around the world ranging from Australia to Turkey. It also has a sizeable business in Africa through its Vodacom segment. Its M-Pesa in Africa is one of the continent’s largest and fastest-growing digital payments services. With Vodafone shares trading at 20-year lows, the board finally fired its CEO, Nick Read, after he presided over a disastrous four years for the company. Change was needed when he took the helm in October 2018, but that change came too slowly and was too small and included the bungled integration of the huge Liberty Global acquisition as well as many missed opportunities to either offload or consolidate its operations in problematic markets like the U.K., Italy and Spain.

The recent departure of highly regarded activist shareholder Cevian, the arrival of billionaire Xavier Niel who recently took a 2.5% stake and telecom operator Emirates Telecom which now has a 10% stake, likely shocked the board into action. The company clearly needs an outsider CEO with a fresh perspective and full mandate from the board. We believe that there are plenty of changes needed, including refocusing on the core businesses with full exits from tangential but valuable operations like the Africa Vodacom business and Vodafone Towers, along with exits or shut-downs of smaller market operations and side businesses. We believe the dividend will be cut by at least 50% to help Vodafone trim its unwieldy debt burden.

Vodafone was on our short list for a Sell recommendation, but, with the shares completely washed out and new leadership on the way, there is a fascinating possible opportunity for a major turnaround here.

ZimVie Holdings (ZIMV) – ZimVie is a $900 million (revenues) medical technology company that produces spinal and dental implants. Sales are roughly evenly split between the two segments, and about 30% of revenues are generated outside of the United States. The company was spun off from Zimmer Biomet in February 2022. The former parent still holds a 19.7% stake.

After an initial surge of enthusiasm, investors have lost faith in the company’s prospects, sending its shares down 80%. The primary concerns focus on ZimVie’s small scale relative to competitors, its struggling dental products segment, and elevated debt which requires relatively high annual interest and principal payments. Regarding its size, the company holds the #5 market share in dental implants and #6 market share in spinal implants. The smaller scale limits ZimVie’s ability to spend on new product innovations and to attract the highest-producing sales representatives that are vital to long-term growth. While the dental segment is operating relatively well, the spinal segment is in turnaround mode as it struggles with weak product differentiation. ZimVie’s debt at 4.4x EBITDA is floating rate and carries a 5% annual debt repayment requirement – the combination consumes much of the company’s free cash flow. Adding further pressure to investor sentiment is the limited public company experience of ZimVie’s leadership team.

However, ZimVie shares look appealing on several measures. First, at 5.1x estimated 2023 EV/EBITDA and 6.5x estimated 2023 earnings per share, the shares are remarkably inexpensive. And, while earnings estimates for many companies are sliding, estimates for ZimVie remain essentially unchanged from over a year ago. The drop in the share price isn’t because earnings are collapsing, it is because the multiple has collapsed. Expectations are dour, offering a valuable margin of safety should the company fail to deliver on its promises, while offering considerable upside potential if it is successful.

Second, ZimVie’s dental business has a solid franchise that likely can produce 4-6% annual revenue growth. This provides a solid base while the management turns around the Spinal segment. The Spinal segment strategy is to stabilize its market share and profits by pruning low-profit products, exiting unprofitable geographies and introducing new higher-margin products. Also, ZimVie is working to re-energize its commercial sales organization – previously neglected under its former corporate parent. Importantly, new leadership in this segment is bringing a much-needed fresh perspective.

While the company’s debt service is elevated, it generates more than enough free cash flow to cover the costs. As its operating profits improve, its ability to service this debt increases. ZimVie currently holds $116 million in cash, providing a valuable financial cushion. And, we see the debt constraint as a positive – it focuses management on its existing operations rather than relying on acquisitions.

The company’s management appears capable. Vafa Jamali, who joined Zimmer in 2021 to become ZimVie’s CEO, brings considerable medical technology senior leadership experience at both smaller companies and major firms including Medtronic and Covidien.

With low investor expectations, a strong dental segment and a pending turnaround in its Spine segment, ZimVie shares have strong upside potential with relatively limited downside.

1. Returns include only price changes and are based on the period from our December 23, 2021, article to December 23, 2022, the date of this year’s article.

Market Review and 2023 Outlook

The investing world has certainly changed from a year ago. In late 2021, asset prices were surging to all-time highs as investors were optimistic that prosperous conditions would continue indefinitely. Today, asset prices across the board are sharply lower as investors worry about inflation, recessions and war.

This year, the S&P 500 returned a negative 18.0%, with the tech-heavy Nasdaq Composite producing a negative 33.0% return. Surprisingly, the relatively bland Dow Jones Industrial Average total return index fell only 6.7%, suggesting that much of the sell-down was focused on fast-growing but over-hyped and earnings-resistant concept stocks. While the front end of hype cycles can produce exhilarating profits and new billionaires (and help fund awe-inspiring innovations – think “Internet 2022” vs “Internet 1999”), the back end of the cycle can quickly unravel the fortunes of the new billionaires and regular folks alike. Investors with losses can take solace in the knowledge that no matter how bad their losses were, their year was vastly better than the wealth implosions experienced by Sam Bankman-Fried (lost all of his $26 billion fortune) and Elon Musk (lost $110 billion).

And, despite the weak returns this year, the S&P has generated an annualized 7.8% return over the past three years and an impressive 12.6% rate of return over the past 10 years.

Within the S&P500, the four largest stocks (AMZN, MSFT, AAPL, GOOG) fell an average of 35.5%, while the next four (BRK.A, UNH, JNJ, XOM) rose 22%, helped by the +78% return of XOM. The equal-weighted S&P 500 Index returned a negative 11.4%. Growth stocks slid sharply, down 28.9% year to date, while Value stocks were more resilient, losing only 7.7%. However, large-cap growth stocks continue to have an annualized four percentage point lead over value stocks over the past 10 years, reflecting the immense gains in large-cap tech and other stocks. This edge completely disappears in the small-cap indices.

Returns among the sectors were similarly skewed. Major sectors holding high-growth tech stocks, which included the Technology (down 28%), Communications Services (-38%) and Consumer Discretionary (-36%) sectors, fell sharply. In recent years, the S&P500 Index overseers have re-assigned many tech stocks to these sectors to prevent the traditional Technology sector from dominating the market. Names like Amazon and Netflix (in Consumer Cyclical) and Alphabet and Meta Platforms (in Communications Services) are no longer included in the Technology sector even though they clearly are tech-driven companies. The sharp fall-off in their shares this year helped pull down the returns of their new sectors.

The strongest sector by far was the Energy sector (+63%), driven by surging oil prices and low beginning-of-the-year share prices. Utilities (+2%), Consumer Staples (+0%) and Healthcare (-2%) provided some stability, although the latter was weighed down by the collapse of speculative biotech stocks (-28%).

Outside of the United States, returns were generally in line with the S&P 500. The MSCI EAFE index of developed country markets lost 9.1% (local returns), buoyed by 3.3% gain in the United Kingdom and a modest 6% loss in Japan but weighed down by sharp losses in Germany (-19.3%) and Switzerland (-18.1%). Due to the imposing strength of the U.S. dollar, the EAFE index fell 16.7% in U.S. dollar terms.

Emerging market returns were dismal once again, falling 18.0% in local terms after sliding 3% last year in a raging bull market year. Returns in China (-23.2%) had an outsized negative effect as that country comprises nearly a third of the total index weight. Taiwan (-23.8%) and Korea (-23.5%), also with sizeable index weights, fell sharply as well. Returns in India (-0.6%) and Brazil (-3.5%) provided relative stability. In U.S. dollar terms, the EM Index fell 22.5%.

Fixed income returns were disappointing, as rising interest rates depressed the value of these securities. Investment-grade corporate bonds produced a 15.2% loss – one of the worst losses on record and a shock to the 60/40 allocation that was supposed to provide diversification against market downturns. High-yield bond returns were better, down 10.4%, as their higher coupons helped offset their falling prices. The relatively sturdy economy helped restrain credit risks, which helped support high-yield returns. Commodity prices were mixed. After considerable volatility, the price of gold ended unchanged from year-end, while the price of oil rose only 5.5%. Copper prices fell 15% while wheat and corn finished the year relatively close to where they started.

As we do every year-end, and keeping in mind our favorite quote about forecasts, spoken by the linguistically creative baseball legend Yogi Berra, “predictions are difficult, especially about the future,” let’s review our 2022 outlook that we published a year ago, and then turn to our outlook for 2023.

The weak stock market in 2022 fell well short of our 5% total return forecast. We will score this as a “wide miss.” As we anticipated, Value stocks performed much better than Growth stocks, but still posted a loss so we’ll score this as a “narrow win.” Other wins included our expectation that the Fed would reverse its easy monetary policy, that inflation would remain well above the 2% target rate, and that bonds would have a difficult year. We were only half-right about earnings growth: we expected 10% growth in S&P 500 earnings, while the actual growth rate will be about 5%.

From a strategic picture, our multi-year view that markets would be increasingly influenced by “The Two Easts” – Washington D.C. (in the eastern U.S.) and China (the Far East) continued to work. The Fed, weaker fiscal stimulus and more changes to China’s economic and political climate were “wins.” However, we completely missed the possibility (and reality) of Russia’s invasion of Ukraine, which in many ways overpowered the influence of the Two Easts. This was a “large loss,” and highlights the folly of long-term predictions, vindicating Yogi Berra.

Today, we see 2022 as a bridge year, in which capital markets and the economy crossed over from an overstimulated pandemic era to a more normal post-pandemic era. Inflation forced the Fed to shift from free and unlimited money to higher-priced and tighter money. The federal government stimulus splurge has ended, leaving consumers to draw upon their regular incomes and savings to fund their spending. This era-crossing might take a second year, as companies, capital markets and the economy likely need more time to fully adjust and as the knock-on effects make the task more complicated.

The year also was a crossing from a relatively peaceful era to a war era. Russia’s invasion of Ukraine brought outright war to Europe. Finland and Sweden are joining NATO, while developed nations around the globe are re-arming over worries about potential new aggressions. Countries in the Asian Pacific region are particularly concerned about a possible Chinese attack against Taiwan. In the long sweep of history, unfortunately, war and aggression, not peace, have been the norm.

Our outlook for the S&P500 for 2023 is for a flat year. We see only modest, if any, earnings growth and limited change to the current 16.6x earnings multiple. The economy, in our view, will remain healthy enough to grow 2-3%, but elevated wages, interest expenses and other costs will likely crimp profit margins. We see market interest rates in general remaining about where they are, with the Fed raising rates perhaps by another 50-75 basis points but not cutting rates during 2023. As such, bond performance will likely be better than in 2022, with perhaps a single-digit positive return.

We see no (good) end to the Ukraine war and worry that China, Iran, Russia, North Korea and other autocracies will continue to be disruptive forces, mostly in negative ways. But, the possibility exists for a radical positive change in any of these countries. Our “Two Easts” stratagem should remain in full effect, although our definition of “east” may need to be expanded to include eastern Europe.

All-in, we see a year with many changes but also year in which consumers, companies and countries – amazing sources of ingenuity and resolve – work their magic to adapt to whatever curve balls are thrown at them. Our optimism is undaunted.

Bankruptcies and High-Yield Bonds: Getting More Interesting

Public company bankruptcies remained modest in 2022 despite the harsher economic and capital market conditions. Thirty-four companies filed for bankruptcy, an uptick from the 22 filings last year, while the aggregate asset total remained unchanged. This year, we excluded from our roster the Chapter 15 filings of companies with insignificant U.S. operations. More foreign companies are taking advantage of the U.S. bankruptcy system, as noted by the eleven companies with assets totaling $24 billion that we excluded from our official 2022 tally.

The largest bankruptcy was filed by Talen Energy Supply, an independent producer of electricity based in Houston. Several widely known companies that failed include biopharma company Endo International (one of eleven in the industry to collapse), cosmetics company Revlon, movie theatre company Cineworld which owns Regal cinemas in the United States, and home/office floor tile specialist Armstrong Flooring. TPC Group, another large filer, is a chemicals company based in Houston that faced daunting legal claims following an explosion at its Port Neches, Texas refinery. Core Scientific and Voyageur Digital are among the first of likely many public cryptocurrency companies to evaporate (FTX and Alameda Research are private companies).

The ongoing dearth of failures is being driven by two forces. First, economic activity remains robust. Third-quarter inflation-adjusted GDP was faster than a year ago, and nominal economic activity grew at a 7.7% pace, almost as fast as the 8.1% rate a year ago. Since companies service their debts in nominal (actual) dollars, healthy nominal activity supports their debt service capabilities. Looked at a different way, inflation is a tailwind for debtors. The Atlanta Federal Reserve Bank’s GDPNow forecast is pointing toward a healthy 3.7% inflation-adjusted GDP growth rate in the fourth quarter, which implies a nominal growth rate of perhaps 8%.

1. Aggregate of total pre-filing assets of all publicly-traded companies filing for Chapter 11, 7, or 15 (excluding financial companies). Starting in 2022, also excludes Chapter 15 filings of companies with insignificant U.S. operations.
2. Through 12/21/22.
Source: BankruptcyData.com

Second, it takes time for struggling companies to succumb to higher interest rates and tighter capital market conditions. The difficult environment only started about a year ago. For now, many creditors are in the “amend and pretend” stage – amending their agreements to allow for easier credit terms while pretending that the company’s profits will improve.

Eventually, however, higher interest expenses will begin to overwhelm unprofitable companies and creditors will grow weary of the amend and pretend game, leading to a higher number of bankruptcies. Also, the previously voracious appetite among institutional and retail investors for income-producing assets has faded – the 10-year Treasury now offers a risk-free 3.75% rate of return – which will increasingly weigh on lenders’ capacity to refinance unserviceable debts.

A year ago, high-yield bond market conditions were exceptionally favorable and high-yield bond prices were exceptionally high. At the time, we believed that both were unsustainable and wrote that “high-yield bonds look poised to enter the unfavorable part of the credit cycle (and have) very limited current appeal.” This outlook proved accurate. High-yield bonds have returned -10.4% this year.

Today, market conditions are roughly neutral (neither favorable nor unfavorable). High-yield bond prices have slipped enough that the average bond now sports a yield of 8.7%, sharply higher than the paltry 4.4% yield a year ago. The yield spread over Treasuries has widened, as well, to 4.6 percentage points compared to 3.0 points a year ago, providing an additional margin for safety. Spreads could certainly expand from here: several times this century the spread reached 7.5 points, with the peak spread hitting a massive 20 points in the depths of the global financial crisis.

1. Through 12/21/22.
2. Assets at period-end prior to filing. Excludes financial companies. Starting in 2022, also excludes Chapter 15 filings of companies with insignificant U.S. operations.
Source: BankruptcyData.com

We anticipate that the default rate will rise to perhaps 3-5% in the coming cycle. But the elevated bond yields are high enough to absorb most of these higher credit losses and still provide for a respectable edge over risk-free securities. And, loss rates may be lower than those of prior cycles as today’s crop of publicly traded high-yield bonds has, in aggregate, higher credit quality. Many of the edgiest credits are now housed inside leveraged loan funds and private credit funds (a close relative of private equity funds).

All-in, we see high-yield bonds having more appeal than a year ago. And, if the Fed relents on its rate hike program or if the economy remains resilient, these securities could produce very respectable returns. Dedicated high-yield investors may want to nibble on selected credits, particularly those with BB credit ratings (the upper tier of junk bonds) while avoiding the growing number of zombie companies. Generalist investors may want to nibble on high-yield ETFs which, although they tend to carry higher fees, allow access to high-yield bonds with the benefits of diversification.

RECOMMENDATIONS

Purchase Recommendation: Meta Platforms, Inc. (META)

Meta Platforms, Inc. (META) 1601 Willow Road Menlo Park, California 94025 (650) 543-4800 https://about.meta.com/

Symbol: META Market Cap: $309 billion Category: Large Cap Business: Social Media Revenues (2022e): $116 Billion Earnings (2022e): $23.8 Billion 12/23/22 Price: 118.04 52-Week Range: 88.09-352.71 Dividend Yield: 0% Price target: $180

Background: Meta Platforms is the world’s largest social media company, with over 3.7 billion unique users per month (nearly half the world’s population). Formerly named Facebook, the company was launched in 2004 by Harvard University sophomore Mark Zuckerberg and several other Harvard students. It was initially limited to other students at the school, but its popularity allowed rapid expansion to nearly everyone. By 2005 it had over six million users. Facebook completed its initial public offering in 2012 at $38/share. While most of the company’s growth was organic, its acquisitions of Instagram in 2012 (for $1 billion), WhatsApp in 2014 (for $19 billion) and OculusVR in 2014 (for $2 billion) expanded its product offering and user base. The company changed its name to Meta Platforms in October 2021, reflecting its increased focus on building a metaverse. Essentially all of Meta’s revenues are produced by advertising.

Meta shares have fallen sharply out of favor. After peaking at $380 (10x its IPO price) in late 2021, the stock has tumbled nearly 70%. While the company has had its share of regulatory and other controversies, which along with the broad market sell-off has weighed on its stock price, the primary drivers of the collapse are the stalling of its revenue growth and the company’s aggressive efforts to create a metaverse. In the second quarter of 2022, Meta posted its first year-over-year revenue decline (-0.9%), followed by a larger (-4.5%) decline in the third quarter. Fourth-quarter estimates point to a steeper (-6%) decline.

Meta’s appeal to advertisers is Facebook’s ability to deliver customized advertising to each of its users. The foundation for this customization is the Identifiers for Advertising (IDFA), a random identifier assigned by Apple to each user’s device. The IDFA can track smartphone activity (with some limits on personally identifiable information), thus helping advertisers target the most relevant potential customers. Advertisers pay premium rates for this high level of accuracy. However, Apple tightened its privacy policy in 2021 with its App Tracking Transparency (ATT) service, which sharply curtailed this tracking. Facebook and advertisers are struggling to adjust to this shift. Additionally, ad revenue is likely being siphoned off by the rise of short-form video service TikTok and other competitors. The slowdown in industry-wide advertising is moderately exacerbating these problems.

To help regain control of its ability to monetize its user data and also to create its next major growth vehicle, Meta is developing a metaverse. We take the view that these alternative worlds that reside in the digital realm (the movie “Ready Player One” illustrates an example) will eventually become as popular as video games are today. Also, metaverses will provide highly valuable real-world benefits including training and other yet-unidentified applications. But this future is likely decades away and requires fully functioning 5G or 6G telecom capabilities and other technologies that don’t yet exist. Furthermore, essentially every new consumer technology spawned from a twenty-something entrepreneur with a captivating new idea – not from an established technology giant like Meta. Ironically, Facebook itself is a prime example of this phenomenon.

So, like most investors, we view Meta’s doubling of capital spending, from about $15 billion in 2019 to over $30 billion in 2022 and beyond, as a remarkably expensive “moonshot” project. While the spending will build Meta’s computing power, which has some value, we view at least $10 billion of the incremental $15 billion of capital spending, along with what could be another $7 billion in elevated operating expenses dedicated to this cause, as a complete waste. This spending is draining Meta’s free cash flow and repelling investors.

If a company with a broad and diverse shareholder base had these problems, its leadership would almost certainly be challenged. At least one investor has attempted this: Meta shareholder and activist investor Altimeter Capital Management recently wrote an open letter to the company with specific recommendations to fix its problems. But Meta is controlled by founder Mark Zuckerberg, who holds 59% of the voting power of the outstanding shares, primarily through his 95% ownership of the super-voting Class B shares. This control essentially neutralizes any direct challenge to Zuckerberg’s decisions.

Further worrying investors is growing regulatory pressure from the European Union and elsewhere. Perhaps the largest and most immediate risk is that Meta is potentially facing EU fines and penalties for privacy and other violations of up to €3 billion as well as limits on its ability to collect user data in EU countries.

With no shortage of problems at Meta, it is no surprise that its share performance has suffered so dramatically. It is one of the most disliked large-cap stocks in the market.

Analysis: Given all of the company’s serious problems, what is the appeal of an investment in Meta? The most basic appeal is foundational: Meta’s products remain exceptionally relevant and popular, and the company is highly profitable with a fortress balance sheet. In a reasonable bear scenario, the stock is likely to have limited downside, and its favorable foundational traits likely provide investors with plenty of time to wait. However, if the leadership relents on its aggressive metaverse strategy, and other headwinds ease even moderately, the shares likely have significant upside potential. It is this favorable risk/return trade-off that has drawn our attention.

Meta’s primary metrics of customer relevancy, which drive its advertising engine, remain strong and growing. All four of the company’s user engagement metrics – Family¹ daily/monthly active people and Facebook daily/monthly active users – grew 2-4% in the third quarter and were 8-16% higher than two years ago. Customer engagement remains high and impressively steady at 66% for Facebook and 79% for Meta’s family of products. We see these favorable trends continuing.

Meta at its core continues to be a highly profitable business. In 2021, the company’s gross margin of 81% and EBITDA margin of 54% illustrate its impressive underlying profitability. While results for 2022 will likely see EBITDA decline by about 20%, to $51 billion, this will still exceed 2020 EBITDA by 9%. And, of the expected $13 billion decline in EBITDA, we estimate that $10 billion is likely due to increased research and development spending. We accept that perhaps $3 billion of the elevated expenses are critical to its efforts to negate the Apple privacy changes, address threats from TikTok and other competitors, and maintain its customer relevance. But that implies that as much as $7 billion is wasted on its metaverse buildout (excluding the costs allocated to capital spending).

We are encouraged that the leadership is acknowledging, albeit slowly, investor concerns about surging expenses. Recently, Meta announced a headcount reduction of about 13% of its workforce. We would like to see vastly deeper cuts.

Meta historically has generated immense free cash flow. Free cash flow in 2020 was $28 billion, followed by $38 billion in 2021. This year, free cash flow will likely be only $16 billion, but much of the decline is due to the $15 billion increase in capital spending on top of the $10 billion increase in R&D spending. The outlook for 2023 is essentially a repeat of 2022 results. However, when looked at in a different light, Meta can afford to spend immense sums on the metaverse without dipping into negative free cash flow territory – an impressive feat even if the spending is a complete waste.

The company is backed by a fortress balance sheet, with $42 billion of cash and only $10 billion of debt. We believe the company will protect this strong net cash balance, although it will likely undertake some share repurchases and small acquisitions, rather than spend it on large acquisitions or even more aggressive funding of its metaverse ambitions.

A major appeal of Meta Platform shares is their highly discounted valuation. Based on estimated 2023 results, Meta shares trade at only 5.7x EBITDA. These valuations might be more appropriate for a broken company with limited prospects.

All-in, Meta shares represent a fascinating turnaround investment opportunity.

We recommend the purchase of Meta Platform (META) shares with a $180 price target.
1. Unique users across all of Meta’s family of products.

Ratings Changes

On December 12, the parent company of Brookfield Reinsurance (BNRE) completed its partial spin-off of its asset management business. Holders of Brookfield Re received 1 share of Brookfield Asset Management (BAM), for every four shares held of Brookfield Re. Please note that the new ticker symbol for Brookfield Re is BNRE. Our Brookfield Re price and total return in the Performance table below includes the value of the BAM shares received.

Brookfield Asset Management is a high-quality company so new owners might want to keep the shares. However, as the company is not in a turnaround situation, we will be removing BAM shares from our recommended list on any reasonable strength in their price.

On December 20, we moved the shares of The Kraft Heinz Company (KHC) from Buy to Sell. As the shares were approaching our price target and as part of our effort to reduce the number of names on our recommended list to focus only on the most attractive turnarounds, the shares no longer belong in the turnaround portfolio.

Kraft has capable leadership that has allowed the company to prosper during the pandemic and in the post-pandemic inflationary period. The turnaround in the company’s strategy (essentially a complete reversal) and in its fundamental execution has been impressive. Our Sell decision is not based on weakening fundamentals or a threatening risk. The dividend yield, at 4.0%, is attractive. However, the shares’ risk/return trade-off is not favorable enough to justify holding in a turnaround portfolio.

Since our initial recommendation in June 2019, KHC shares have generated a 60% total return.

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.
SP Given the unusually high risk, we consider these shares to be speculative.
* Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.
** BNRE return includes BNRE shares plus spin-off value of BAM shares.

The next Cabot Turnaround Letter will be published on January 23, 2023.