Cabot Turnaround Letter Issue: May 31, 2023

Four Solid Technology Companies with Out-of-Favor Shares

It’s no secret that a fresh fascination with artificial intelligence has ignited shares of companies like Alphabet (GOOG), Microsoft (MSFT) and Nvidia (NVDA), while “safety stocks” like Apple (AAPL) have rebounded on recession fears. However, shares of more prosaic technology companies have had lackluster returns, as demand for equipment, software and services has entered a cyclical slowdown following the pandemic boost.

Some of these “boring” companies nevertheless offer highly relevant albeit slow-growth products and services, making their businesses highly resilient. They are often well supported by durable balance sheets and capable management. And, of great interest to value investors, their shares currently carry modest valuations. Eventually, the technology spending cycle will recover, providing both a profit boost and a valuation boost to their share prices. Our selection below includes four such companies.

To this group, we would add current Cabot Turnaround Letter recommended Xerox (XRX) and Western Union (WU), as well as Intel Corp (INTC), which we’ve written about in recent letters but won’t repeat here. Dell Technologies (DELL), mentioned in our March 2023 letter prior to its 14% jump, would also fit this category on any meaningful weakness in its price.

Cisco Systems Inc. (CSCO) is a technology giant that generates over $50 billion in revenues. Its routers, switches and other gear connect and manage enterprise-scale data and telecom networks. These products, supplemented by a broad range of related software and services, create a capable one-stop shop for customers. In the dot-com era of the late 1990s, Cisco’s shares surged to 80 but subsequently collapsed due to extreme overvaluation and stagnating revenue growth. Even now, they remain 36% below their dot-com peak. Today, Cisco’s primary strategic challenge is that customers need less of Cisco’s one-stop offerings as they migrate to the cloud. But, favorably, given its strong reputation and entrenched position within its customers’ infrastructure, Cisco only needs to stay “close enough” to competitors’ offerings. And its prospects have improved under a relatively new CEO and a highly regarded CFO, who are shifting the company toward a software and subscription model.

Financially, Cisco is strong. It is highly profitable, with a wide 65% gross margin and an impressive 27% net profit margin. Free cash flow typically runs at nearly 25% of revenues – a rare feat for any company. Cisco is returning much of this cash to shareholders in dividends and share buybacks. The fortress balance sheet holds nearly $15 billion more cash than debt. Investors worry about a cyclical downturn in tech spending, which is fair, but Cisco is a solid company with a resilience that investors continue to underestimate. The share trade at an unchallenging 9.2x cash operating profits and 13.1x earnings per share based on recession-minded fiscal 2023 estimates. The 3.2% dividend yield, which is readily sustainable, adds to the shares’ appeal. Cisco is currently a Buy recommended stock in the Cabot Value Investor, with a 66 price target.

Closing prices on May 26, 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.

F5 (FFIV) – Based in Seattle, this company pioneered the load-balancing technology that distributes internet traffic evenly across multiple servers. Rapid expansion of its market drove a 6x increase in its share price from early 2009 to early 2011. But, as F5’s growth rate faded, investors lost interest in its shares, which now are unchanged from their 2011 price. However, revenues continue to increase, even if at a modest 3% pace, supported by enduring relevance, an expanded offering and incremental acquisitions. Gross margins, an indicator of its competitive edge, remain high at 80%. Management is implementing a sizeable efficiency program to further boost profits.

The company generates considerable free cash flow and has committed to at least half being used for share repurchases starting this year. The balance sheet is debt-free. F5 shares trade at a discounted 9.1x EV/EBITDA and 13.4x per-share earnings. If demand rebounds as management expects, this left-behind tech stock could rebound sharply.

Hewlett Packard Enterprise Company (HPE) – This company was split off from the original Hewlett-Packard in 2015 as part of a multi-year shareholder value initiative. HP Enterprise focuses on gear and related software and services that help enterprises capture, store, move and use data. The “other half” of the original H-P is now primarily a printer and PC company. Since the split, HP Enterprise has divested several major operations and made numerous acquisitions including supercomputer maker Cray in 2019.

However, the shuffling has done nothing for the share price – it remains essentially unchanged since the 2015 split-up. Much of what makes the shares of this sluggish but resilient company attractive is the lack of investor interest – and the overly discounted valuation at 3.5x EV/EBITDA and 7.4x per-share earnings. HP Enterprise’s efforts to upgrade to higher-margin and faster-growth markets, including its emerging GreenLake technology that helps companies migrate to the cloud, are boosting its already-respectable profits. The company also has a disciplined cost mentality. Its likely $2 billion in free cash flow this year produces a free cash flow yield of 11%. HP Enterprise will likely return more than half of this to shareholders through dividends and share buybacks.

Interestingly, it is divesting its 49% stake in the H3C China joint venture due to geopolitical and other reasons. The exit’s valuation is attractive at 15x earnings, especially when HPE’s shares trade at less than half that multiple. And, HP Enterprise could receive at least $3 billion in net proceeds, enough to repurchase 16% of its share count.

Seagate Technology Holdings PLC (STX) – Seagate is strikingly similar to its peer (and Cabot Turnaround Letter-recommended) Western Digital Corp. Both companies are major makers of the hard disk drives (HDD) used to store data in the cloud and on servers, PCs and other devices. Shares of both have tumbled sharply since early 2022. Both have a market cap of about $12.5 billion, similar-sized hard disk drive revenues (about $1.5 billion in the most recent quarter), comparable HDD gross margins (around 20%) and carry elevated net debt of about $5 billion.

The major difference is that Seagate does not have a flash memory business. This has allowed it to avoid the losses plaguing Western Digital (negative 5% gross margins in flash memory), which has helped it pay a sustainable dividend that currently yields 4.7% and repurchase its shares. As a positive cash flow company, Seagate can wait out the industry downcycle with much less pain than can Western Digital. Partly offsetting this advantage is that Seagate’s debt maturity calendar is more front-end loaded, with 30% maturing before 2026, compared to only 20% for Western. Seagate also doesn’t have a catalyst like Western’s likely sale of its flash memory business. But, all-in, both companies have heavy exposure to a rebound in HDDs, which is likely inevitable as the volume of data stored everywhere continues to increase exponentially.

Attractive Financial Stocks From 13F Filings

With all of the bank turmoil, we dedicated our April edition of the Cabot Turnaround Letter to researching and discussing the industry. While the urgency seems to have faded after the demise of several large banks, there is no full resolution to the problems of underwater Treasuries, commercial real estate credit losses and possible runs on deposits. In the April issue, we listed several well-known bank stocks with contrarian appeal – some with modest risk and others with extreme risk but extreme upside potential.

Since then, we’ve had more time to find additional interesting financial stocks. A good source of ideas are the 13F filings that institutional investors overseeing at least $100 million in assets must file with the SEC. These quarterly public filings provide a window into who holds what stocks. By looking at portfolios of like-minded value investors, we can find potential new ideas and benefit from the deep research that these firms undertake.

As a side note, the 13F filing was created in 1975 when Congress amended the 1934 Securities Exchange Act with the new Section 13(f). We wonder what Warren Buffett thought of this new law – did he see it as a positive tool that allowed him to see what others were buying, or a negative because it required him to reveal his positions to others, thus risking a free-rider problem?

In the most recent batch of filings, we found that several highly regarded value shops bought or raised their positions in some of our Cabot Turnaround Letter names. Berkshire Hathaway bought a $950 million stake in Capital One Financial (COF), and Oakmark raised its already-large stakes in Wells Fargo & Company (WFC) and Warner Bros Discovery (WBD). Beleaguered Elanco Animal Health (ELAN) got an endorsement as Black Creek Investment Management purchased a 2.1% stake, while Dodge & Cox retained its 17.2% stake.

Listed below are three financial stocks that saw sizeable new purchases or meaningful additions to already-sizeable holdings by well-respected value managers.

Closing prices on May 26, 2023.
* P/TBV is price/tangible book value. Valuations based on most recent calendar quarter data. For FIS, multiple indicated is P/E multiple based on estimated 2023 earnings per share.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Bread Financial Holdings (BFH) – Shares of the formerly named Alliance Data Systems recently completed an impressive triple round-trip to 30: first from 2004-2009 (peaking at 80), then from 2009 to 2020 (peaking at 300) and again from 2020 to today (peaking at 120). As the internet drew revenues away from specialty retailers, department stores and other clients, Alliance Data’s proprietary products lost most of their relevance. However, starting in 2018, Alliance overhauled its entire business model to become a straightforward credit card company similar to Capital One Financial. The changes were significant: it sold its Epsilon marketing business (in 2019), spun off most of its LoyaltyOne business (now worthless) in 2021 and relocated from Texas to Columbus, Ohio. Cosmetically, but important nonetheless, it changed its name to Bread Financial in 2022. A smaller and revamped board oversees the company, while new executive leadership, including CEO Ralph Andretta, who previously ran Citi’s U.S. Cards business, along with a new CFO and new chief commercial officer (both with executive experience at major banks) are implementing the plans.

During the transition, the company boosted its CET1 capital ratio to 20% and its loss reserves to 12%, providing a solid capital base. It also sharply cut its parent company debt, raised its retail deposit base to 28% of total funding, and is upgrading its technology and operations. Most of its retail deposits are FDIC-insured and it has no held-to-maturity securities, so it is unlikely to experience a deposit run. While Bread is showing impressive wins of marquee card portfolios including Michaels Stores and the New York Yankees, it still may lose major card portfolios like its 2022 loss of the BJ Wholesale account. Another key risk is credit losses, which are rising toward 8%, given Bread’s elevated exposure to subprime customers. While Bread’s wide net interest margin (19%) and low expense ratio will cushion elevated write-offs, investors will likely not give the shares much credit until losses start ticking down.

Bread shares trade at a very low 3x earnings and .77x TBVPS of $38.44. The likely sustainable dividend provides a 2.9% yield. Highly regarded Turtle Creek Asset Management (Toronto, Canada), with about $3.2 billion in assets, recently raised its position to become the second largest shareholder with an 11.3% stake.

East West Bancorp (EWBC) – Himalaya Capital Management is a concentrated $14 billion (assets) Seattle-based fund run by Li Lu. Charlie Munger calls Lu the “Warren Buffett of China,” and Lu is the only outside manager Munger has ever hired. So, when the manager’s recent 13F filing included a new 1% position in East West Bank, it caught our attention. East West is a $60 billion (assets) bank in Pasadena, California that is heavily focused on Asian Americans. It has 120 branch locations, with several in China and a new location in Singapore that build cross-border relationships. East West is highly profitable: its wide 4.0% net interest margin and low 31% expense ratio help it generate a 2.0% return on assets and a 23% return on tangible equity. Most of its loans are floating-rate, which supports its profits as interest rates increase. The bank is well capitalized with an 11.3% CET1 ratio after adjusting for lower securities values. East West is well-managed and an active repurchaser of its shares.

While its commercial real estate (CRE) portfolio, at 40% of loans, is a risk, its CRE loan book is diversified across industries and customer types with low loan-to-value ratios and strong personal guarantees. The deposit base generally comprises small and loyal depositors, and about 56% of deposits are FDIC-insured, so the run-off risk appears modest. The shares have tumbled about 35% since the start of the banking turmoil. Trading at 1.2x the $41.33 TBV, 5.7x earnings and providing a 3.8% yield, these shares look like a low-risk way to benefit from a banking recovery.

Fidelity National Information Services (FIS) – We wrote about this company in our February edition of the Cabot Turnaround Letter, noting that it had attractive turnaround potential. We liked its strategic re-focus on its core business, its likely divestitures and streamlining, and its plans to pay down its elevated debt. The change in leadership added considerable appeal, as did the strong and reasonably stable free cash flow. But, we were hesitant, due partly to the daunting task of turning around a complicated company in a dynamic and highly competitive industry, and partly due to the not-quite-cheap-enough share valuation. With the shares having tumbled about 25% since our article, and the valuation dipping to about 8.0x EV/EBITDA and 9.2 per-share earnings, FIS shares now look more interesting.

Lending further appeal is that several noted value investment firms have recently raised their positions: Baupost Group more than doubled its stake, Dodge & Cox incrementally added to its position as the fourth largest shareholder, and Barrow Hanley boosted its holdings by 34%. Fundamentally, Fidelity may be stabilizing as it reported a relatively healthy first quarter, with revenues increasing 3% while per-share earnings fell a reasonable 12%. Management incrementally raised its full-year guidance. The company is making progress with its cost-cutting, pending spin-off of WorldPay and improvements to its compensation structure. This turnaround continues to carry considerable risk, but the lower share price and encouraging fundamentals make it much more attractive.

RECOMMENDATIONS

Purchase Recommendation: Tyson Foods, Inc (TSN)

Tyson Foods, Inc (TSN) 2200 West Don Tyson Parkway, Springdale, Arkansas 72762 www.tysonfoods.com

Symbol TSN Market Cap $18.4 billion Category Large Cap Business Food production Revenues (FY2023e) $54 Billion Earnings (FY2023e) $577 Million 5/26/23 Price $52.01 52-Week Range: 47.11-92.32 Dividend Yield: 3.70% Price target: $78

Background: Tyson Foods is a major producer of protein foods. Founded in 1935 by John W. Tyson in Springdale, Arkansas as a live chicken delivery service, the company gradually expanded into chicken raising and production. The company completed its IPO in 1963. Its acquisition of IBP in 2001 for $3.2 billion made Tyson the world’s largest producer of chicken, beef and pork. The 2014 purchase of Hillshire Brands for $8.6 billion added several iconic processed foods brands like Hillshire Farms and Jimmy Dean to the portfolio. Today, beef products generate about 37% of sales, with chicken (32%), pork (12%) and Prepared Foods (18%) providing the balance. Tyson’s chicken operations are vertically integrated, while its beef and pork operations source their live produce from independent farmers. The company sells its products in fresh, value-added, frozen and refrigerated formats to a wide range of outlets. Sales to customers in 140 countries outside of the United States comprise about 15% of total revenues.

Tyson’s shares have fallen nearly 50% from their 2022 peak and now trade unchanged from their late-2015 price. Weighing on the shares is an unusual simultaneous downcycle in all three protein groups. Operating margin this year will likely be about 2.0% compared to its historical average of about 7.5% and last year’s margin of 8.3%.

Chicken profits are being pressured by weak retail prices, partly due to a domestic glut as the Avian flu outbreak has halted exports. Also hurting profits are higher feed costs. Profits in the beef segment are being squeezed by higher prices for live cattle that Tyson must pay for its beef inputs. Due to drought conditions, farmers previously sold unusually high numbers of their cattle, leaving fewer available for the current market. Weaker beef pricing and volumes add to the profit problems. Pork profits have slid due to weak global demand and pricing, even as rising costs trim margins.

Tyson continues to trim its FY2023 guidance and offer vague estimates of when a recovery may happen, adding to investor pessimism. Weak cash flow combined with a multi-year boost in capital spending is leading to elevated debt.

Analysis: Tyson is admittedly an average company in a commodity industry. The primary appeal is that its shares discount dim earnings prospects, leaving considerable upside potential following a cyclical recovery. The hardest time to invest in a cyclical company is at the bottom of the cycle, when it appears that there is little chance of a recovery.

Conditions are no doubt weak. The chicken and pork segments generated operating losses in the second quarter, while the beef segment produced a minuscule profit. For the year, all three segments will likely produce only break-even margins.

But, as a commodity industry, the solution to low prices is low prices. Weak conditions will eventually reduce market supply and thus improve retail prices. More rain in the Midwest would help reduce grain prices and restore herds. If the swine flu continues its resurgence in Asia, local demand for hogs will likely tighten prices globally for all proteins. While the exact catalyst and timing of a recovery are difficult to pinpoint, we believe that a recovery is inevitable.

Favorably, the Prepared Foods segment remains solidly profitable, backed by a high-quality franchise, likely producing a 9.5% operating margin for the foreseeable future.

While Tyson waits for the recovery, it is implementing several self-help initiatives, including completing the remaining $300 million in cost cuts, closing two chicken processing plants, shifting two other plants to higher-margin boneless chicken products, and investing in automation gear to reduce its labor costs.

Due to the weak profits and its elevated capital spending program dedicated to capacity increases, upgrades and efficiency investments, the balance sheet carries more than normal debt. At the end of this year, net debt could reach 3.5x EBITDA. The company has plenty of liquidity and could cut its capital spending to help keep its promise to maintain its investment-grade credit rating.

Like all turnarounds, Tyson’s carries risks: the downturn may prove to be deeper and/or last longer than we anticipate, and the company may have operational and leadership problems that have not been made public. Reputational issues plague the company, from its price-fixing settlements (albeit tiny) and from its CFO (the son of a board member and a great-grandson of the founder), who recently settled charges of public intoxication and criminal trespassing.

Also unknown is the extent to which Tyson is creating its own cyclical problems by emphasizing growth. This would be a negative as the added supply depresses prices but could be a long-term positive if it eliminates weaker competitors.

The shares trade at 11.8x depressed estimated FY2023 EBITDA. Management speaks with pride about its commitment to the dividend, which currently provides a 3.7% yield. Investors may want to nibble on Tyson shares at the current price, then buy more aggressively if the shares slide on further bad news. The long-term outlook is healthy, and the lower the entry price, the better for investors.

We recommend the purchase of Tyson Foods (TNS) shares with a 78 price target.

Ratings Changes

On May 18, we moved shares of M/I Homes (MHO) from Buy to Sell, as they reached our recently raised 71 price target. The shares benefitted from being significantly undervalued at our recommendation date along with having strong earnings backed by resilient housing demand. The shares now trade at about 1.0x tangible book value, compared to 0.68x at our recommendation date. Industry conditions remain favorable, but the risk/reward has moved to neutral at best due to the valuation.

The shares have generated a 66% total return, compared to a roughly zero total return for the S&P 500, since our initial recommendation in late April 2022, at 44.28.

On May 24, we moved shares of Ironwood Pharmaceuticals (IRWD) from Buy to Sell. The company is acquiring Switzerland-based Vectiv Bio Holding AG (VECT) for about $1.0 billion, net of its cash on hand, in an all-cash transaction. Vectiv Bio is a clinical-stage company (no revenues, only products under development). The deal makes sense for Ironwood from a strategic perspective: it provides new growth opportunities in a field very closely related to its eventually expiring Linzess franchise, it can readily afford the cash outlays given its large $740 million in cash on hand, and it is backed by the interim stability of the Linzess cash flows. But, the deal sharply violates our thesis that Ironwood is a cash flow machine that could return its vast cash hoard and cash flows to shareholders. Rather, Ironwood is now a speculative (albeit well-funded) biotech company. Ironwood shares have generated an approximately 10% loss since our initial recommendation in late December 2020 at 12.02.

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 June 28, 2023.