Cabot Turnaround Letter Issue: May 3, 2023

Three Small-Cap Stocks with More Cash Than Debt

Capital market conditions have tightened in the past year, as interest rates have jumped sharply and as private equity, lending and other sources of funding have become more selective. This makes companies that hold excess cash more valuable and less reliant on fickle external financing.

Our search for companies with more cash than debt produced a long list of candidates. Most of these, however, were cash-burning pharmaceutical, alternative energy and technology businesses, meaning that their surplus cash isn’t likely to last, much less be returned to shareholders.

We focused on cash-rich companies that have real products and services with proven and enduring demand whose shares are out of favor. Read our discussions, below, on three small-cap stocks that meet these criteria and offer worthwhile upside potential. Our feature recommendation this month, Frontier Group Holdings (ULCC), fits this criteria. Several currently recommended Cabot Turnaround Letter names, including Janus Henderson Group (JHG), Dril-Quip (DRQ), Xerox Holdings (XRX), Nokia (NOK), Duluth Holdings (DLTH) and Ironwood Pharmaceuticals (IRWD), would also make this list.

Closing prices on April 28, 2023.
* EV/EBITDA is Enterprise value to Earnings before interest, taxes, depreciation and amortization. EBITDA is a proxy for cash operating earnings. Valuations based on fiscal years ending in December 2023.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Ammo, Inc (POWW) – This Scottsdale, Arizona company ($200 million revenues) produces ammunition for law enforcement, military, sport and other rifles and pistols. It also owns gunbroker.com, the world’s largest online marketplace for firearms and accessories, which uses only federally licensed dealers as transfer agents. Setting aside the controversial and potentially legal liability-rich nature of its operations, the company is intriguing from a turnaround perspective. The shares have slid 80% from their 2021 high and trade below their public debut price (via SPAC in 2017). Strong profits last year will likely turn negative this year due to lower revenues and rising raw materials costs. The story, however, is intriguing. Ammo was founded in 2016 by a now 81-year-old entrepreneur, Fred Wagenhals. This old-school “American success story” previously built from scratch an industry-leading maker of NASCAR toys, which became an NYSE-listed company that he sold for over $245 million in 2005. He also has earned several high-reputation academic and professional accolades.

To drive a turnaround, Ammo has hired an impressive new president who previously was a senior executive with the American business of venerable Italian ammunition giant Fiocchi Munizioni. The new strategy is to shift away from commodity ammunition toward premium, specialized ammunitions that offer significantly higher margins. One additional opportunity: In a new world where the Ukraine war has created a global shortage of basic ammunition, this company could benefit from a ramp-up in friendly-government ammunition purchases. Ammo’s balance sheet holds $27 million in cash compared to $12 million in debt, providing considerable financial flexibility as it works through its turnaround. Also, the gunbroker.com business is growing rapidly and could be worth more by itself than the market value of the entire company. Potential investors should be aware of the long list of risks that this company faces. Yet, with risk, there may be considerable return.

Chico’s FAS (CHS) – This retailer ($2.1 billion revenues) specializes in high quality lifestyle brands including Chico’s, White House Black Market and Soma that target fashion-savvy women with moderate-to-high incomes. The company has 1,269 stores in 46 states and franchised locations in 58 other countries along with several websites and a call center. Chico’s shares were on a steady downward trajectory from 2013 through 2019 due to ineffective company management and changing customer shopping habits. The company recognized these problems in late 2019, when it hired Molly Langenstein away from her successful career at Macy’s. Under the new leadership, Chico’s successfully navigated the pandemic and is now generating solid profits and free cash flow. In 2022, revenues grew 18%, the gross margin returned to an impressive 39%, and operating profits of $142 million were more than double that of the prior year. Free cash flow was $120 million, equal to nearly 20% of the company’s current market value. The company appears to be executing well on its sensible strategic, operational and financial goals. Guidance for 2023 is for incremental improvement, suggesting that profits and cash flow are at least steady. The balance sheet carries $178 million in cash, only partly offset by $49 million in debt. Given these favorable traits, Chico’s is probably worth a lot more than its current $5.04 share price implies, especially with a valuation of only 2.6x EBITDA, 6x earnings (only 4.4x after adjusting for the net cash) and a 20% free cash flow yield.

Heidrick & Struggles International (HSII) – This company is a top-tier executive search firm. It generates nearly $1 billion in revenues, led by its strong reputation and global presence and supported by emerging consulting and interim management operations. Following a surge during the pandemic, results have weakened: sales declined 16% and operating profits fell 23% in the most recent quarter. Concerns over an economic and hiring slowdown have driven its shares down 50% from their peak to a level essentially unchanged from the 2015 price. Heidrick, however, is well managed and well diversified across industries, and is fully aware of the cyclicality of its industry. One indicator: While first-quarter revenues fell, the profit margin remains relatively high at 11.5%. Margins would have been even higher except for its investments in the promising consulting and interim management businesses. First-quarter profits were noticeably better than estimates, and management’s confidence is leading analysts to incrementally raise full-year 2023 estimates. With long-term demand in its industry likely to remain robust, Heidrick is well positioned to continue to prosper. Its balance sheet carries $205 million in cash (following its traditional year-end bonus payouts) and zero debt. The shares trade at a modest 3.6x EV/EBITDA and the likely sustainable dividend generates a 2.4% yield.

Turnarounds Worthy Of A Close Look

Our research process involves looking at a large number of possible turnaround ideas. As investing legend Peter Lynch once said, “The person that turns over the most rocks wins the game.” Digging up large volumes of rocks greatly increases the chances of finding hidden gems.

Many of the ideas we come across are discarded as not the gems we are looking for: They are not turnarounds, or are unlikely long shots, or are too far outside of our skill set (even though we keep pushing the boundaries of this skill set). Other names are placed in the “not yet” pile, which means the story has potential but usually requires waiting for a sharply lower share price.

A smaller number of ideas have both promising turnarounds ahead yet also have discounted share prices. These stocks undergo a more thorough analysis, from which an even smaller number earn a passing grade. Listed below are six such stocks.

Closing prices on April 28, 2023.
* EV/EBITDA is Enterprise value to Earnings before interest, taxes, depreciation and amortization. EBITDA is a proxy for cash operating earnings. Valuations based on fiscal years ending in December 2023.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Garrett Motion (GTX) – Garrett is a $3.6 billion (sales) producer of turbochargers for light vehicle manufacturers and aftermarket customers. The company was spun off from Honeywell in 2018 and filed for bankruptcy in 2020 due to a controversial payment dispute with its former parent and to pandemic-related issues. Garrett emerged in 2021 with a lighter debt burden. Operationally, the company is recovering, with sales, profits and cash flow improving in the first quarter. Also, guidance was raised for the full year. Importantly, Garrett is cleaning up its complex post-bankruptcy balance sheet, as its two tranches of preferred stock have been an overhang on the common stock. The Series B preferreds have been fully redeemed, and the company recently reached an agreement to repurchase $570 million of expensive (11% coupon) Series A preferreds, with the balance being converted into common stock. The agreement also relieves Garrett of burdensome performance milestones, and reduces financing costs by nearly $100 million. Following the transaction, the company will generate considerable free cash flow to help trim its modestly elevated (3x EBITDA) debt that nevertheless has no maturities until 2028. Garrett shares trade at about 6.0x pro forma EV/EBITDA and a 13.5% free cash flow yield.

Seven & I Holdings (SVNDY) – This $81 billion (revenues) Japanese conglomerate is the owner of the 7-Eleven convenience store chain which operates over 83,000 stores around the world. Seven & I also owns the Ito-Yokado, Sogo & Seibu, York and other retailers, various financial services businesses and several media and other operations. Overall, the company is profitable, carries considerable cash, and its debt is a very reasonable 1.5x EBITDA. However, while the 7-Eleven chain has considerable value and generates over 90% of total operating profits, it is being obscured by the company’s conglomerate structure in which the other businesses drain cash and value. Also, the management has a reputation for not looking after shareholder interests.

Seven & I is in an increasingly public and vitriolic battle with respected activist investor ValueAct Capital, which has a 4.4% stake. To defend itself, Seven & I has refreshed the board with six independent directors, of which three were chosen with input from ValueAct. Also, the company has divested a few operations, will restructure its financial services operations, said it will take the giant Ito-Yokado superstore public in three years and has committed to specific return and payout targets. While all this sounds impressive, the pace and scale of the changes is too slow, certainly for ValueAct, and management’s low credibility leaves considerable doubt as to whether its commitments can be relied upon. The upcoming Annual General Meeting, on May 25, will offer clues regarding the pace of the company’s simplification. Trading at a low 7.5x EV/EBITDA, Seven & I shares appear primed to lift if the company moves faster.

On a side note, activists are seeing more opportunity in Japan in general. Funds like Elliott Management are boosting their Japan teams, and the head of Oasis Management (a respected $500 million activist fund) recently said, “The value trap that was Japan is no longer.” Helping drive the change, the Tokyo Stock Exchange is imposing a new rule this spring requesting that companies with shares trading below book value develop a plan to improve their results. As many as half of TSE Prime Market Index stocks and a third of the blue chip TOPIX 100 stocks currently trade below book value. While Seven & I trades at about 1.6x book value, more attention will likely bring higher pressure on its management to improve its shareholder value.

Stanley Black & Decker (SWK) – This $14 billion (revenues) maker of tools, with iconic brand names like Black & Decker, Stanley, Dewalt, Craftsman and Cub Cadet, has seen its fortunes unravel. Pandemic-driven demand drove a surge in revenues, which were expected to produce large profits. Management provided guidance in early 2022 for full-year profits to reach $12-$12.50/share, with nearly $2.0 billion of free cash flow. However, end-demand slowed, leaving distributors with a glut of inventory, while input cost inflation and supply chain disruptions more than offset higher pricing. Earnings for 2022 landed at $4.62/share while free cash flow came in at negative $2 billion. Guidance for 2023 isn’t much better: earnings between zero and $2.00/share, with free cash flow of no more than $1 billion. Not surprisingly, its shares have tumbled 61% from their peak and now trade at their pandemic low (and unchanged from mid-2013).

Yet, Stanley’s fortunes may be turning up. The company divested three sizeable but ancillary operations which generated over $4 billion in proceeds. It is overhauling its global supply chain and inventory processes, implementing a $2 billion cost-cutting program and aiming for a return to its former 35% adjusted gross margin (last earned in 2018) from the 20% gross margin in the most recent quarter. As much as $1 billion in excess inventory is likely to be converted into cash this year alone. The former CFO has been promoted to CEO to boost the chances that the financial and operational targets are reached. The turnaround won’t happen overnight, and the upcoming May 4 pre-market earnings report could be a disappointment that sends the shares even lower. But, all-in, this out-of-favor stock, which trades at a reasonable 10x EV/EBITDA on depressed 2023 estimates, is worthy of at least a starter position. The shares pay a worthwhile 3.9% dividend yield which looks readily sustainable.

Steelcase (SCS) – Steelcase may be one of America’s most respected operating companies, but shares of the office furniture maker have lost investors’ respect. The stock has tumbled to 10-year lows and remains 40% below its 2003 price even as the S&P 500 has tripled. Plaguing the shares is the lack of meaningful fundamental progress in two decades: Revenues and profits are essentially unchanged, while a 25% lower share count has been offset by a doubling of net debt. Contrarian investors see opportunity from a few perspectives. First, the low 5.9x EBITDA valuation provides downside protection. Second, the earnings base appears to have troughed and is improving following a pandemic-related downturn. While work-from-home trends created a permanent one-time stepdown in demand, growth will likely resume as updated office configurations become necessary to accommodate new work habits. The new CEO is pressing for additional growth in adjacent markets like education while also improving capital allocation. The May 4 Investor Day will provide more color on these initiatives. A major strategic change (not yet contemplated) would be for Steelcase to exit its overseas (EMEA) operations – these have produced a cumulative loss over the past six years. Additional operations comprising nearly 9% of sales, classified as “Other,” have break-even profitability, so they are ripe for an exit, as well. Unlikely to ever generate meaningful profits, these segments drag down overall company performance and value. An activist investor would likely highlight these easy fixes. Steelcase shares offer an appealing 5.1% dividend yield which is probably sustainable. Respected value investor Pzena Investment Management has a 9.3% stake in this company, adding credibility to the story.

Tyson Foods (TSN) – Tyson is a major food company ($53 billion in sales) focused on the three primary proteins of beef (37% of sales), chicken (32%) and pork (12%). The Prepared Foods segment (18%) includes highly recognized brands like Hillshire Farms and Jimmy Dean. Its chicken operations are vertically integrated, while its beef and pork operations source their live produce from independent farmers. Tyson processes and sells these proteins as fresh, value-added, frozen and refrigerated products to a wide range of outlets.

Tyson’s shares are down 35% from their 2022 peak and now trade at 8-year lows due to an uncommon simultaneous downcycle in all three protein groups. Reflecting this, the 3.4% operating profit margin in the most recent quarter was sharply lower than the 11.1% margin a year ago. Also, guidance for 2023 was reduced as the downturn is likely to linger. Further, Tyson is facing reputational issues as the CFO, 31, the son of a board member and a great-grandson of the founder, recently settled charges of public intoxication and criminal trespassing.

However, the company’s difficulties are likely at their nadir, even if a recovery may take a while. Chicken prices are improving although elevated feed costs may continue to weigh on profits. Tight conditions in live beef and hog markets may continue but should gradually ease starting later this year. Processed Foods should remain a high-margin source of profit stability and is likely undervalued by investors. Helping support profits this year is a $300 million-plus cost-cutting initiative. Prior operational issues seem to be mostly resolved, as well. The shares trade at 8.4x depressed EBITDA and offer a 3.1% dividend yield.

United Therapeutics (UTHR) – This $2 billion (sales) pharmaceutical company sells treatments for pulmonary arterial hypertension (PAH) and other life-threatening diseases. It also markets an oncology treatment and is engaged in early research on manufacturing organs for transplants. The company is the first biotech or pharmaceutical company to take the form of a public benefit corporation, or PBC. As such, they work to balance societal benefits with shareholder value. One other major overhang: At least two of its five core products are facing patent expiry-related competition. Usually, a company description like this makes for an instant turn-off by value investors.

United Therapeutics, however, may break this mold. First, as a Delaware PBC, they remain subject to significant litigation and reputational risk if their public benefit purpose has a negative impact on shareholder interests, thus assuaging concerns that they might pursue wasteful activities. Second, the company has solid financials: relatively steady revenue growth, wide 54% EBITDA margins that help it generate generous free cash flow, with a balance sheet that holds $4.2 billion in cash, well in excess of its $800 million debt. Net cash is equal to 32% of United’s market value. The shares trade at a low 6.0x EV/EBITDA and 11.6x earnings per share.

Critically, investor concerns over the patent expiry seem overdone. United’s Tyvaso and Orenitram products (a combined 65% of total sales) have no competition until at least 2026 due to an agreement with generics makers. Tyvaso (nearly half of total sales) is growing at a 40%+ pace, while Orenitram is growing at around 5%, so these two treatments will continue to help United generate large profits for a few more years. Most promising is a new product extension, which has no competition, that allows Tyvaso to treat a variant of PAH for which there is no competition. Revenues from this use could nearly replace future expiry-related revenue losses. Helping support the appeal of these shares is the presence of savvy value-oriented investors like Wellington Management (doubled their stake to 5.5%) and Polaris Capital.

RECOMMENDATIONS

Purchase Recommendation: First Horizon Corporation (FHN)

Frontier Group Holdings (ULCC) 4545 Airport Way Denver, Colorado 80239 www.flyfrontier.com

Symbol ULCC Market Cap $2.0 billion Category Mid Cap Business Airlines Revenues (2023e) $4.0 Billion Earnings (2023e) $250 Million 4/28/23 Price 9.49 52-Week Range: 8.19-15.25 Dividend Yield: 0% Price target: $15

Background: Frontier Group Holdings is a major ultra-low-cost airline focused on leisure travel. Based in Denver, the company has a colorful history. While the original Frontier Airlines folded in 1986, the current Frontier was founded in 1993. It went bankrupt in 2008, was acquired in bankruptcy by Republic Airways, then sold to a private equity firm in 2013 followed by a strategic shift to its current discount carrier strategy. Frontier went public via IPO in April 2021 at $19/share. An agreement to merge with Spirit last year was terminated, as Spirit accepted a deal to be acquired by JetBlue Airways.

Today, the company remains fully independent and serves 100 airports with primarily nonstop service in the United States and the Americas. Its business model is structured for low costs. Its fleet of 120 Airbus planes, with an average age of four years, is one of the youngest in the industry. This approach fosters lower operating and maintenance costs along with industry-leading fuel efficiency while offering customers an incrementally upscale flight. The company leases all of its aircraft, further reducing costs while providing financial flexibility. Non-core functions are outsourced and its tickets are sold through low-cost channels including its website, mobile app and call centers. Frontier’s unit cost advantage, at $140/round trip lower than the industry average, provides a competitive and profit edge. Its operational flexibility allows it to readily adjust to seasonal and regional changes in demand.

Investors have soured on Frontier, and all airline stocks, due to revenue concerns about an economic slowdown, an end to the post-pandemic travel surge and price wars. Also, worries over rising fuel and labor costs have contributed to the share weakness. Frontier’s stock has fallen 50% from its IPO price and trades just above its lows of March 2022.

Analysis: While we appreciate the risks that demand will taper, there is no sign of this happening yet. Demand for flights is strong as consumers want to travel. As noted in recent earnings updates by other airlines, as well as TSA checkpoint data, demand has fully recovered to 2019 levels, yet continues to increase. In addition, the U.S. economy remains strong as indicated by final demand in the most recent GDP release. Robust employment and wage strength further supports the ability for customers to pay for vacation travel.

A price war is unlikely as the current supply of seating capacity is constrained and potentially getting tighter. During the pandemic, many older planes were retired, but new plane production by Airbus and Boeing continues to lag. Also, a shortage of pilots and flight crews will linger, as it takes considerable time to recruit and train new talent. Tight supply is supporting elevated ticket prices, and consumers seem willing to pay up. We anticipate strong demand and high fares across the industry will endure for some time. With its low-cost approach, Frontier is well positioned to benefit from these conditions.

An additional revenue and profit booster is Frontier’s skills at earning ancillary fees. These non-airfare fees for baggage check, advanced seat selection, stretch seats, cancellations and other items reached $82 per passenger in the fourth quarter, up 41% from 2019’s fourth quarter and higher than the $51 average ticket price. These are very high margin revenues which consumers seem more than willing to pay. While this willingness may not last forever, other airlines’ discounted fares also emphasis non-fare revenue such that they are becoming standard in the industry.

On the cost issues, while fuel and labor costs have increased, these are unlikely to continue to rise at their prior pace and are increasingly factored into earnings estimates. Frontier’s pilot contract is due for negotiation in 2024, which will boost wages, but the increase is unlikely to meaningfully impact profits, particularly as Frontier offers many perks that other airlines are generally unable to match, including faster promotions and same-day base returns. Further helping the company, its recruiting efforts have led to a small surplus of in-house pilots, an unusual condition in the industry which should ease the pressure on Frontier significantly raised wages. All-in, we see enduring revenue and profit strength for the airline industry in general and Frontier in particular.

Frontier is financially healthy. Its profits have recovered and it generates positive free cash flow. The balance sheet carries $761 million in cash compared to $429 million in debt. The management is capable and entrepreneurial, helping the company capture opportunities while remaining adaptable to changing conditions. At the modest valuation of 4.7x EBITDA (or, 4.5x using EBITDAR) on depressed earnings, the shares look ready for take-off.

We recommend the purchase of Frontier Group Holdings (ULCC) shares with a $15 price target.

Ratings Changes

On Friday, April 28, shares of M/I Homes (MHO) reached our 67 price target. The company reported strong first-quarter results, its balance sheet is robust and the outlook is encouraging yet the shares continue to trade at only 88% of tangible book value. We incrementally raised our price target to 71.

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 May 31, 2023.