Cabot Turnaround Letter Issue: June 28, 2023

Focusing on Small Cap Turnarounds

While much of our emphasis is on mid-cap and large-cap turnarounds, there are often attractive turnarounds in the small-cap segment of the market. Companies in this group, with market values generally below $1 billion, tend to be more different from their larger peers than commonly perceived yet also offer worthwhile investment opportunities.

A major difference is their elevated operating risk relative to larger companies. They usually occupy a narrow market niche, often with limited pricing power, have fewer customers and may not have much product or geographic diversification. Management quality is critical. Weak management can destroy a small company, whereas large companies have a more embedded culture and a customer franchise that can often withstand leadership problems. Importantly, small companies have fewer financing options than larger companies. Capital markets tend to have little interest in small debt and equity issues, leaving small companies to deal with more expensive commercial banking or niche funding sources. Also, small companies have limited negotiating power relative to their mid-cap and large-cap peers.

And, many small-cap shares have thin trading liquidity with wide price spreads and other elevated transaction costs. Prices can be more vulnerable to the ebbs and flows of investor sentiment. Many have minimal if any broker coverage. Given these traits, investors generally work into their positions with care and tend to use limit orders.

However, greater risk can sometimes bring greater rewards. Small-cap turnaround stocks typically sell at discounted valuations. New leadership and the right conditions can propel them sharply upwards. Our research has uncovered several interesting small-cap turnarounds this year, including Ammo, Inc (POWW), Chico’s FAS (CHS), Heidrick & Struggles (HSII), Garrett Motion (GTX), Steelcase (SCS), Bread Financial Holdings (BFH), Vera Bradley (VRA) and several small-cap restaurants including Carrols Restaurant Group (TAST), Dave & Buster’s Entertainment (PLAY), El Pollo Loco Holdings (LOCO), Fiesta Restaurant Group (FRGI), Potbelly Corporation (PBPB) and Red Robin Gourmet Burger (RRBG). Several of these companies have market caps significantly below our traditional $400-million floor.

This month, we are focusing our research entirely on small-cap turnarounds. Discussed below are eight that have worthwhile appeal. Our feature recommendation this month, L.B. Foster (FSTR), is an attractive small-cap turnaround.

Closing prices on June 23, 2023.

* Enterprise value/Earnings before interest, taxes, depreciation and amortization. EBITDA is a measure of cash operating earnings. For Hawthorn Bancshares, valuation is P/TBV, or price/tangible book value.

Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Emergent BioSolutions (EBS) – Emergent is a pharmaceuticals company that focuses on vaccines for rare but pandemic-scale illnesses like anthrax and smallpox, with sales primarily to the U.S. government. Its monopoly on the only FDA-approved anthrax vaccine helped drive its growth and profits for years. The company also sells a nasal spray version of prescription Narcan, the emergency treatment for opioid overdoses. Emergent also operates a small contract manufacturing business (about 10% of sales).

The company’s shares appreciated steadily for years, culminating in a pandemic-driven surge driven by its contract to manufacture Covid vaccines for Johnson & Johnson and AstraZeneca. However, its Bayview Covid-vaccine facility suffered from major quality problems, resulting in significant financial and reputational damage. Further weighing on its prospects, the U.S. government reduced its purchases of Emergent’s vaccines. The company’s profits turned to losses while debt (boosted from acquisitions and operating losses) remains elevated at $1.4 billion. Emergent’s shares have collapsed 93% from their peak and trade near all-time lows.

Not all is lost, however. Revenues appear to be stabilizing while management works to cut its expenses. Proceeds of $270 million from the divestiture of its travel vaccines business and an updated credit agreement buys Emergent about 18 months before lenders can take more aggressive action including forcing a bankruptcy. A game-changer could come from the recent FDA approval of an over-the-counter version of Narcan, which may sharply boost Emergent’s prospects. Risks in Emergent shares are high, and near-term results will likely be uninspiring and could pull the shares down further. The valuation at 15x depressed EBITDA is not particularly meaningful. Yet, if the company’s turnaround efforts plus uncontrollables like OTC Narcan work in Emergent’s favor, the return potential is high (a double or more).

Harte Hanks (HHS) – This tiny company, based near Boston, bears little resemblance to its original operations as a major newspaper and television station business. These segments were sold off years ago. Perhaps not surprising, Harte Hanks was plagued by strategic mistakes and high management turnover as it struggled to build a new core business of providing digital marketing services.

However, a diligent turnaround effort that started in 2019 refocused Harte Hanks into a smaller but more profitable company. Under a new turnaround-specialist leader, revenues are growing (+6% last year) and operating profits nearly doubled in 2022 to produce a 7% profit margin. First-quarter 2023 results were weaker due to anticipated and generally one-time events and the company said it is cautious about its near-term prospects given the “currently challenging environment,” but Harte Hanks appears to be more resilient than its cautious stance implies.

Its customer base includes a wide range of premier companies like Bank of America, GlaxoSmithKline and Unilever. The company has cleaned up its balance sheet by repaying all of its outstanding debt, repurchasing the remaining preferred shares from Wipro, sharply reducing its pension liabilities and completing new credit agreements with lenders. Harte Hanks now has $13 million in cash (nearly a third of its market cap) and zero debt. The company’s financial strength has improved enough that the board recently authorized the repurchase of up to 10% of the share count.

With its life-saving turnaround efforts now complete, the company is moving to a growth posture. A major game-changer in this direction is the recent hiring of an industry veteran, Kirk Davis, as CEO. He is charged with leading Harte Hanks’ efforts to boost its revenues, profits and operating strength. Davis brings decades of industry experience, most recently as CEO of Metro Corp and, previously, head of GateHouse Media. The company’s shares currently trade nearly 70% from their 2022 peak and remain depressed. The valuation, at 3.0x EBITDA and 6.4x earnings, gives almost no credit to the changes underway at Harte Hanks. While the risks are high, so is the potential return.

Haverty Furniture Companies (HVT) – This small-cap company, based in Atlanta, is a full-service home furnishings retailer with over 100 stores in the Southern and Midwestern states. Investors worry that the secular shift toward online retailing will grind away at brick-and-mortar companies like Haverty. But these investors overlook several key traits. First, the company isn’t struggling against online retailers, rather, it is getting stronger. For major products like furniture, consumers want to gauge the quality and comfort in person rather than guessing online. The tattered reputation of online-only retailers like Wayfair (W), which ironically is now discovering the benefits of brick-and-mortar stores, illustrates this point clearly. Haverty’s sales reached a record high in 2022, and its gross margin – a key indicator of its pricing power and franchise quality – was a healthy 57.7%, higher than the 54.0% margin in 2016 just prior to the surge in online competition. Also, Haverty’s overall profits continue to climb. Per-share earnings last year were $5.24, four times higher than the $1.30/share it earned in 2016. The outlook for 2023 earnings is for a decline to $3.88, still a strong showing compared to its history. Management has guided gross margins to be above 58%.

Haverty is skillfully and conservatively managed. It carries zero debt and maintains a healthy amount of inventory. Its shareholder-friendly management continues to return much of its generous free cash flow to shareholders. The dividend, which yields 4.2%, is well-covered by earnings, was recently raised, and has been a regular feature since 1935. In each of the past three years, the company paid an additional special dividend of $1.00/share or more. While these discretionary payouts won’t likely occur in 2023 due to the company’s purchase of its Florida distribution center, future special dividends would be an added bonus for investors. And, finally, value investors will like the low valuation. The shares, which trade at 7.3x estimated 2023 per-share earnings, already discount an uninspiring future. There are plenty of attractive stocks that the growth crowd is missing. Haverty Furniture looks like one of them.

Hawthorn Bancshares (HWBK) – Based in Jefferson City, Missouri, Hawthorn is a $1.9 billion (assets) community bank with 22 branch offices. Founded in 1932, the bank offers a standard range of traditional banking and trust services, including residential, commercial and personal loans, various checking and savings accounts as well as trust and safe box services. Hawthorn also owns a small captive insurance company. The bank is regulated by the FDIC and Missouri banking regulators, its deposits are insured up to the standard $250,000 FDIC limit, and the holding company is subject to supervision and examination by the Federal Reserve Bank.

Hawthorn’s appeal is two-fold. First, it is reasonably profitable, with a 3.2% net interest margin, a 0.7% return on assets and a 10.2% return on equity. It also is decently capitalized with a 9.8% CET1 capital ratio and sizeable loan reserves. Its deposit base seems secure, as 83% of its deposits are insured. Second, it recently hired a capable new outsider CEO – unusual for a community bank, which typically promote internal candidates. Brent Giles, the new leader, previously led a Kansas City bank through an IPO, oversaw new growth and strong operating performance, then sold the highly regarded bank to a major competitor in 2019. Hawthorn’s outgoing CEO, 66, has led the company since 2011 and will remain chairman. The motivation for bringing in a proven outsider seems clear: while Hawthorn is healthy, it could use tighter operating efficiency and stronger credit management. The shares currently trade at a low 97% of book value and 7.4x trailing per-share earnings (no analysts cover the stock). Insider ownership is high at nearly 13%, suggesting that the leadership is aligned with public shareholders. The dividend provides a respectable 3.6% yield.

Oil States International (OIS) – This global company manufactures highly engineered equipment used in oil and natural gas well drilling, construction and production. It also produces supplies and provides related services. With moderating energy prices and an enduring depression in new drilling activity, Oil States’ revenues and profits have been uninspiring in recent years. Nevertheless, the company remains well-managed, well-capitalized and consistently produces positive free cash flow. Its order book and revenues are turning up even as oil prices remain in the low $70 range. It is on track to generate about $30 million of free cash flow this year and close to $50 million next year, providing some flexibility for share repurchases. The balance sheet carries about $140 million in debt, relatively modest compared to the company’s $100 million in EBITDA even as Oil States continues to whittle this debt lower. Its leadership team includes industry and company veterans with a focus on profits and competitiveness, while its board of directors looks impressive for a company of Oil States’ size. Investors in Oil States get a solid company trading at a modest 6.1x depressed EBITDA with the potential for a much higher price in a more accommodative drilling environment.

Shoe Carnival (SCVL) – This company is one of the nation’s largest footwear retailers, with sales of over $1.2 billion. It operates 398 stores across 35 states and Puerto Rico that cater to families using a highly promotional store environment and competitive pricing for its name-brand and private-label merchandise. Its shares have fully unwound their pandemic-driven run-up even as the company is arguably stronger. Compared to 2019, operating profits are 170% higher, even as the balance sheet remains free of debt and over 40% of its store base has been refreshed (with the remaining stores to be completed over the next few years). Its customer base of 32 million members, as measured by its Shoe Perks loyalty program, is 34% larger than in 2019.

Investors worry that a possible recession would drag down the company profits. Not helping sentiment, management had to trim its 2023 full-year earnings guidance, which now calls for a 6% decline compared to earlier guidance for a 3% increase. Another worry is that Shoe Carnival’s elevated inventories may portend additional problems.

However, Shoe Carnival’s customer franchise is sturdy and its bargain-priced emphasis provides a measure of defensiveness should the much-forecasted recession ever arrive. Also, many key national brands, including Nike, are rediscovering the merits of selling through third-party retailers like Shoe Carnival (reversing the prior trend away from these outlets), which could help results as soon as the upcoming back-to-school season. Shoe Carnival’s inventories are already near normal and on track to be below year-ago levels. Free cash flow is strong, the company continues to pay its well-covered dividend and management looks fully capable of continuing to maintain the company’s health and modest growth path. Trading at reasonable multiples of 6.0x per-share earnings and 6.4x EBITDA, the out-of-favor shares look like bargains.

Vista Outdoor (VSTO) – Vista is a company with a complicated history. It was assembled through acquisitions by Vista’s former parent company Alliant Techsystems in the early 2000s, then spun off in 2015 in connection with Alliant’s combination with rocket engine maker Orbital Sciences. Vista then included two business lines: guns and ammunition, and non-gun outdoor products like sunglasses. Under pressure due to a sharp increase in national gun violence, Vista sold its gun manufacturing operations in 2019. Today, its Sporting segment is the largest maker of commercial and U.S. law enforcement ammunition. Its Outdoor segment owns Camelbak, Bell Helmets, Fox Racing and other popular brands.

These two segments (ammo and non-ammo) never belonged together and are finally being separated later this year. The CEO who oversaw the company’s acquisition spree has been removed, allowing for a clean restart. The Sporting Products (ammo) business is impressive, with a wide 27% EBITDA margin, although sales can be volatile. Outdoor Products (everything else) has a lower 13% margin and has struggled with weaker results following a pandemic surge but probably has faster growth potential as a separate company with better leadership. More details on the leadership teams and separate company financials are yet to be released. Nevertheless, it appears that investors have, at best, taken a wait-and-see approach, as Vista shares are trading at about half their late-2021 price, with a modest valuation at 5.1x EBITDA and 6.0x per-share earnings. The still-together company has modest 2x debt leverage. Last year its free cash flow of nearly $500 million was a third of its current market value (no repeat performance this year, though). We believe there is a reasonable chance that both segments eventually end up in private or strategic owners’ hands. For investors willing to suffer through more uncertainty and gyrations, the eventual split-up could be quite rewarding.

Vitesse (VTS) – Vitesse is an oil and natural gas company that emphasizes owning partial stakes, or working interests, in other energy companies’ wells. It holds working interests, averaging 2.7%, in over 6,400 producing wells, almost exclusively in the Bakken region. Created over a decade ago, the company was recently spun off from Jefferies Financial Group (JEF) as part of that company’s strategic refocus on its financial services business. Vitesse shares are interesting for several reasons. First, it is at its essence a dividend production company. The leadership is heavily committed to paying its $0.50/share quarterly dividend, as this has been and remains a foundational principle for the company’s existence. As such, the $0.50/share quarterly dividend holds the first claim on free cash flow. Management provides good evidence that this dividend is fully supportable by the company’s free cash flow at oil prices of $65/barrel or higher.

Second, the company is highly selective with its capital spending. As a non-operator, it can pick and choose which specific wells and projects it will participate in, allowing it to skip those that have unfavorable risk/return traits. Importantly, its well partners are generally large, highly reputable companies and its wells are high quality such that they require only minimal capital spending to replace their annual production. With the management’s deep expertise in the industry, as well as innovative software and other technology tools, Vitesse is well-positioned to continue to pay and potentially increase its dividend. Nearly 30% of the company is owned by management and Jefferies executives, so they not only think like owners, but they actually are. The shares are not risk-free, given the dependence on oil prices, and the company may make a large acquisition. But investors can take solace in management’s commitment to a deal price and economics that must be exceptionally favorable and also increase the dividend-per-share paying power. The shares have moved up since the spin-off but offer an attractive 9.5% dividend yield and remain undervalued, especially if oil prices lift from the current $70 range.

RECOMMENDATIONS

Purchase Recommendation: L.B. Foster Company (FSTR)

L.B. Foster Company (FSTR) 15 Holiday Drive, Suite 100 Pittsburgh, Pennsylvania 15220 www.lbfoster.com

Symbol FSTR Market Cap $151 million Category Small Cap Business Industrial Mfg Revenues (2023e) $524 million Earnings (FY2023e) $6 Million 6/23/23 Price $13.60 52-Week Range: 9.00-15.96 Dividend Yield: 0% Price target: $23

Background: L.B. Foster is a small-cap manufacturing and distribution company with operations in the United States and Canada (combined 84% of sales), the United Kingdom (9%) and other countries. About 60% of its revenues are produced from railroad industry products ranging from rails to friction management to monitoring technologies. Foster is also a leading high-end supplier of precast concrete products (21% of sales), with the balance of its revenues produced from customized steel fabrication, coatings and measurement products and services. Based in Pittsburgh, the company was founded in 1902 by then-20-year-old Lee B. Foster to resell used rails to the booming oil industry. It expanded over the subsequent decades into a range of other steel-related businesses. In 1977, it was acquired by private equity firm Kohlberg Kravis & Roberts (KKR) in one of its earliest leveraged buyouts, then returned to public ownership in 1981. Much of its subsequent growth has come from numerous acquisitions.

Following a surge through mid-2014, the company’s shares have struggled, falling 75% to a price unchanged since 2005. Frustration with its share price and weak operating performance, and pressure from activist investors including 22NW (12% stake) and Gabelli Asset Management (9%), led the company to undertake a strategic overhaul in 2021. While early results are promising, investors remain skeptical that Foster can meaningfully improve its business, particularly as recession worries cloud the company’s near-term outlook.

Analysis: Foster has taken its turnaround seriously. Like nearly all turnarounds, replacing ineffective leadership is a key early step. The senior leadership team, including the CEO, CFO and key division heads, have been replaced. Critically, the board has been refreshed and is now chaired by Raymond Betler, who previously led Wabtec Corp. (Westinghouse Air Brake) and brings deep leadership and rail industry experience.

Another valuable step for Foster was to end, at least temporarily, its otherwise steady stream of acquisitions and divestitures. These deals had led to unwieldy debt and overly complex operations. Several businesses have recently been offloaded as part of the turnaround plan, which has allowed the company to trim its debt burden, yet Foster does not anticipate any significant acquisitions in the foreseeable future. Further, the company is implementing an SAP tech system that will produce better insights into its many remaining businesses and generate higher efficiencies across its operations.

Successful turnarounds often include ambitious but attainable long-term goals. As such, Foster has set a goal of reaching $600 million in sales and $50 in adjusted EBITDA by 2025 (an 8.3% margin), compared to current estimates for $530 million in sales and $31 million in adjusted EBITDA (a 5.8% margin) in 2023.

Changes can take time to show up in financial results. Yet, Foster’s new approach appears to be working. Organic growth is improving, up 11.5% in the first quarter, with the gross margin improving to 20.2% from 16.6% a year ago. Adjusted EBITDA rose sharply, to $4.5 million, for a 3.9% margin compared to a 1.7% margin a year ago. New orders and backlog continue to move upward. Management reiterated its full-year profit guidance while trimming its revenue guidance due to the divestiture of a marginally profitable business. It remains confident in meeting its 2025 revenue and profit goals.

The improved profits, as well as modest capital spending (about 2% of sales), are helping the company generate free cash flow. First-quarter surplus cash went toward reducing its debt, which now totals $80 million, down from over $90 million at year-end. The debt leverage ratio is a reasonable 2.4x, and management is targeting an even lower 2.0x ratio over the next year or so. Confidence in its cash production led the board to announce a $15 million (about 10% of Foster’s market cap) share buyback program.

Like all turnarounds, Foster’s carries risks. Slowing economic growth, particularly in the United Kingdom, as well as contract/execution problems, product quality issues and tighter government spending could derail its outlook. Nevertheless, the company has a strong likelihood of being successful, both from internal changes and an external tailwind from increased infrastructure spending across the country.

Investor skepticism offers patient turnaround investors an opportunity to buy shares at a reasonable 7.7x estimated 2023 EBITDA, and at a highly discounted 4.6x EBITDA if it hits its 2025 targets. Our conservative price target assumes only a 6.0x multiple if it reaches its 2025 targets. Adding further valuation support are the $100 million in net operating loss carryforwards, worth an estimated $15 million in present value.

We recommend the purchase of L.B. Foster (FSTR) shares with a $23 price target.

Ratings Changes

On June 9, we moved shares of Molson Coors Beverage Company (TAP) from Buy to Sell. The shares were approaching our $69 price target, with only about 4% upside remaining. This is close enough, given that much of the run-up is being driven by Budweiser’s Bud Light marketing blunder in the United States. Sales of Bud Light have slumped as much as 25%, while sales of Coors, Miller and others have jumped. It’s not clear how long this phenomenon will last, but the share valuation is becoming relatively full. We are reluctant to raise our price target from here. Shares of Molson Coors produced a 30% total return since our initial recommendation.

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 July 26, 2023.