Cabot Turnaround Letter Issue: October 26, 2022

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At its most basic level, investing is a mental game supplemented by a calculator. The calculator helps us understand the valuation of a company as it sits today and in a possible post-recovery future as well as assess its fundamental strengths and weaknesses. This is generally a straightforward, tangible exercise although it requires invoking some analytical creativity regarding assets, strategy and management.

The mental game is intangible and complex. Objectively assessing one’s tolerance for buying while being uncomfortable, or evaluating whether a situation is beyond one’s field of competency, or determining the right amount of patience needed to avoid joining the bandwagon during sharp rallies – these can’t be readily or clearly measured. We have to use subjective guesses. And these guesses can be captive to our very human traits of greed and fear. Except for a rare few, we become more greedy when stocks are going up and more fearful when stocks are going down.

Over the years, we’ve found that relying on our calculator tends to make for better investing. Stocks that are inexpensive in reasonable current and future scenarios, and have adequate strategic, managerial and financial endurance, like last month’s recommendation of Dow, probably will be successful long-term holdings. The calculator helps us muster the courage to buy when stocks are going down.

Our first article this month focuses on these kinds of companies. A few have an abundance of endurance, others have sizeable near-term issues yet also have a path to recovery along with valuations that more than compensate for the risks. They readily lend themselves to analysis with a calculator.

Our other articles discuss companies with deeper issues but whose shares have been so heavily sold that their risk/return trade-offs are highly attractive, even if their theses rely less on a calculator and more on pure contrarian instincts.

Enduring Companies with Out-of-Favor Stocks

AMC Networks (AMCX) - Not to be confused with the completely unrelated movie theater operator AMC Entertainment, AMC Networks is a cable network company that owns the AMC Channel, AMC+ streaming service, Sundance, WE tv, IFC and several other channels. Spun off from Cablevision in 2011, its audiences reach nearly 80 million cable households. AMC’s programming library owns valuable content including The Walking Dead, Breaking Bad and Better Call Saul franchises, and it launched the highly acclaimed Mad Men series in 2007. However, with its marquee programs either in the past or currently in wind-down mode, investors worry about what comes next to retain the vast audience of viewers and the advertising and affiliate fees that follow them. AMC also faces issues common to all cable networks including the slow secular decline in cable subscriptions, a weakening advertising market, intensified streaming competition and rising programming costs. As such, shares of AMC Networks have collapsed by 70%, back to their all-time lows.

To help restore its fortunes, AMC has replaced its CEO with Christina Spade, an industry veteran whose was previously CFO of ViacomCBS and its CBS predecessor as well as a senior executive who helped build out Showtime. With AMC’s sizeable library of other programs and its ongoing rights to its marquee programs, its core audiences and revenues won’t evaporate overnight, providing time for its promising new content and its international and streaming initiatives to build upon their early and encouraging results. AMC will continue to generate positive profits and free cash flow, and its elevated debt appears readily serviceable. For better or worse, the Dolan family holds a controlling stake which provides an incentive to build the company’s value through either internal initiatives or a sale. In a sale, its tiny $3.4 billion enterprise value would be an easy bite for one of the media giants. Trading at only 5x EBITDA, its shares appear to be a bargain for investors of all sizes.

Closing prices on October 21, 2022.* EV/EBITDA is Enterprise value to Earnings before interest, taxes, depreciation and amortization. EBITDA is a proxy for cash operating earnings. Valuations based on calendar years ending in December 2023. Valuation for AGNC is price/current tangible book value.

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

Comcast Corporation (CMCSA) – With $120 billion in revenues, Comcast is one of the world’s largest media and entertainment companies. Its properties include Comcast cable television (with 34 million cable, video and voice subscribers), Universal movie studios and theme parks, NBC and Telemundo television networks, Peacock TV, and the Sky media company in Europe. Comcast also owns the Philadelphia Flyers professional hockey team. Comcast shares have tumbled 50% from their late 2021 peak and now trade in-line with their mid-2015 price. Investors worry about cyclical and secular declines in advertising and a secular decline in cable subscriptions as consumers shift toward streaming services, as well as rising programming costs and incremental pressure as phone companies upgrade their fiber networks. But, competition has been intense for decades yet Comcast always seems to maintain its revenues and profits. In the second quarter, the company produced 5% revenue growth and 10% profit growth – hardly the markings of a company on the brink. Comcast supports its dividend (recently raised 8%) and reasonable debt load with immense free cash flow. It is also using some of its cash to buy back another $11 billion in shares (part of a $20 billion program) by the end of the year. The stock trades at a discounted 6.1x EBITDA and 7.9x earnings and offers a 3.6% dividend yield. The Roberts family holds a near-controlling 33% stake but have been good stewards of the firm’s resources.

Levi Strauss & Co. (LEVI) – Shares of this iconic maker of blue jeans have slid nearly 50% from their late 2021 peak and now trade 15% below their March 2021 IPO price of $17. At a modest 6.9x estimated EBITDA and 9.8x earnings per share, the stock looks like a bargain. A few appealing fundamental traits stand out. First, the company’s widely recognized and enduring brand provides immense value as a go-to source for jeans. Related to this, the company’s revenues and profits are generally quite stable – this may mean slow growth in a strong economy but also limited downside in a weak economy. The company guided for full-year revenues to increase about 6% and net income to increase about 1%, and pointed to incrementally better growth in fiscal 2023. Supporting its operations are healthy free cash flows and a sturdy balance sheet that carries minimal debt of about 1.2x EBITDA. Management is capable with a strong track record. The long-term plans to expand its brands and retail and international operations may be a bit aggressive, but the share price is already assuming that the company won’t meet its targets. Overall, shares of this high quality, enduring company are priced for the bargain basement.

Six Flags Entertainment (SIX) – This company is one of the world’s largest theme park operators, with 27 parks across the United States, Mexico and Canada. Impressive revenue and earnings growth drove a 600% gain in the shares in the decade following its 2010 initial public offering. But, since mid-2018, the shares have collapsed 70% as growth stalled and several overseas initiatives failed. Frustration with the results has led to a near-complete changeover in the board of directors and senior leadership. The new CEO, Selim Bassoul, joined in November 2021 after previously leading Middleby Corporation during an 18-year stretch which produced an 80-fold increase in that company’s shares. His strategy is to raise prices to drive away youths who pay little while crowding the park, and then make Six Flags more attractive to families and others willing to pay higher prices for a better experience and who might buy more in-park food and trinkets. This strategy makes a lot of sense but requires complicated pricing changes as well as elevated capital spending for non-ride improvements. Early results show that this strategy is producing mixed results: in-park spending is rising but attendance is falling, and the lower revenues are not being offset by cost cutting. Labor costs and availability are additional challenges for this turnaround, as is the elevated debt burden at 4.5x EBITDA. However, the company generates plenty of free cash flow, has capable new leadership and is being monitored by long-time shareholder H Partners which holds a 13% stake. At the low valuation of 9.1x EBITDA, expectations are low, so a successful turnaround could produce a very rewarding ride for shareholders.

Rowe Price Group (TROW) – This company is one of the industry’s largest fund managers, with $1.2 trillion in assets under management. Its high-quality management, strong brand name recognition, wide breadth of products, and deep penetration of nearly all distribution channels provide it with an enduring franchise. However, its near-term outlook has darkened, as the sliding stock market is crimping its asset-based fees. Further hurting its revenues is the growth-stock tilt of many of its mutual funds – as this category of stocks has been hit the hardest, clients are pulling money out of T. Rowe’s products due to weak relative performance. Earnings for this year will likely drop by 40% from a year ago. Yet the company continues to expand its horizons and growth potential. Its recent acquisition of Oak Hill Advisors expands its offerings into private credit, while other initiatives should build its international capabilities. Also part of its strategy is to deepen its penetration into the vast United States market. The company remains highly profitable and is backed by $2.1 billion in cash, nearly 10% of its market value. Its generous dividend, which currently offers a 4.7% yield, is solidly backed by free cash flow and is augmented by regular share buybacks. With the shares down 53% from their peak and currently unchanged from early 2018, long-term investors have an outstanding entry point.

Good Assets But A Bad Balance Sheet

Scotts Miracle Gro (SMG) – As one of the largest marketers of branded consumer lawn and garden products, Scotts has long been a beneficiary of expanding suburbs. During the pandemic, the company thrived as home-bound consumers upgraded their properties, which helped drive Scott’s shares to more than double from early 2020. However, the company is now struggling and faces a liquidity crisis that threatens bankruptcy, with investors sending the shares to lows not seen in a decade. The major problem is that Scotts over-estimated the durability of the pandemic demand surge. Over-production drove its inventory up $500 million, or nearly 50%, above a year ago, while sales have plummeted 26%. The resulting cash drain, exacerbated by ill-timed actions like a recent $213 million acquisition, a $150 million investment in a cannabis investment firm and a $150 million-plus share repurchase, has left Scotts with debt at an unwieldy 6x EBITDA that has strained its relations with creditors. Adding to its problems is that demand for cannabis supplies has slipped sharply, risking the viability of its huge investment in its Hawthorne hydroponics operations. If the company fails to engineer a recovery, it will likely be forced into bankruptcy, sending the shares to near zero.

However, Scotts is a good company with a bad balance sheet. Its Scotts, Miracle-Gro, Ortho, Round-Up and Home-bound brands are widely recognized and have considerable value. It has raised its prices to combat commodity inflation and slashed costs, production and capital spending. Scotts recently replaced its CFO with its former CFO who appears to have come out of semi-retirement and is considered exceptionally capable. Scotts amended its credit facility to allow its elevated leverage for another seven quarters – a showing of remarkable restraint by creditors which points to their confidence in the turnaround. We think that the dividend will be eliminated next, saving $150 million a year in much-needed cash. At worst, the working capital squeeze should be resolved by the next growing season. This would then allow Scotts to gradually work down its debt balance.

While this turnaround is complicated and risky, if Scott’s balance sheet and profits are restored to health, the returns could be generous. The shares trade at about 6.5x a post-recovery EV/EBITDA multiple, compared to a more typical 11x or so.

An “Extreme Yield” Situation Worth A Leap of Faith

Beyond the reasonably calculable risks of high yield securities is the speculative realm of extreme yield. These securities offer dividend yields above 15%. Shares of normal companies simply don’t offer yields this high, so clearly there are unusually high risks that are not readily calculable and could lead to a complete loss of one’s investment. Yet, they also offer the possibility of a very generous quarterly payment and gains of well over 100% if things turn out right.

Such an investment can be found in mortgage-backed real estate investment trusts like AGNC Investment Corporation (AGNC). At its most basic level, AGNC is an investment company that holds government-backed mortgage securities. It earns a yield on these bonds that is higher than its cost of funds, such that the spread generates a profit. As a real estate investment trust, or REIT, the company pays out nearly all of its annual profits to shareholders as dividends and thus avoids federal corporate income tax.

AGNC, however, is more complicated than this basic level, which adds risk and potential return. The company uses leverage, currently about 8x its capital base, to magnify its spread profits. It also uses a highly complex set of hedges and other transactions in an effort to tamp down its risks from changes in the yield curve, changes in spreads between different maturities, changes in mortgage prepayments, and many other risk-producing factors. While the company provides considerable disclosures, the internal hedging program is essentially a black box to outsiders including most experts.

Shares of AGNC, and nearly all mortgage REITs, are under intense pressure. Sharply rising interest rates squeeze its profit spread while its hedges struggle to handle the abrupt decline in mortgage prepayments and other risks. AGNC holds credit risk transfer securities which can quickly lose value when home mortgage defaults increase. The hedging program has worked reasonably well in most market conditions, but the current conditions fall outside of past norms and no one can know for sure whether AGNC will survive. In a worst case scenario, AGNC shareholders could be wiped out.

Despite all of these risks, and the essentially unanalyzable “trust management” nature of its hedge book, AGNC shares have some legitimate appeal. First, the shares have fallen sharply and trade at all-time lows, indicating that investors have abandoned them. Second, the 18.4% dividend yield, if preserved, provides investors with a remarkably high cash return. And, if the company is able to survive and return to prosperity, which it could once changes in interest rates stabilize, the shares could readily double or more. Management has proven themselves capable and honest stewards, so they have earned the necessary “trust” component of a buy thesis.

As it is beyond the effective analytical range of a calculator, an investment in AGNC shares requires the use of the “leap of faith” approach. But, there is also enduring value, as mortgage-backed securities will be around for the foreseeable future, as will their yield premium over AGNC’s funding costs. And, at a time when almost no other investors are willing to take the leap of faith, AGNC offers a high risk but appealing contrarian opportunity. In terms of valuation, a reasonably decent but by no means perfect metric is price/tangible book value. The current multiple of 0.68x is well below the typical valuation at 1.05x.

AGNC reports third-quarter profits on Tuesday, October 25, past this letter’s publication deadline, so investors will want to assess the results prior to investing.

Airline Merger Arbitrage: Worth a Flier?

While we focus on out-of-favor companies with real value, usually undergoing strategic and operational turnarounds, we also have an eye for situations where the risk-return profile seems inordinately skewed in our favor. Such a situation can be found in the shares of Spirit Airlines (SAVE), the seller in the pending JetBlue-Spirit Airlines merger. JetBlue has an agreement to acquire Spirit for at least $33.50/share in cash, potentially increasing to as much as $34.15/share. With Spirit shares trading at $20.30, this would produce at a minimum a 68% return if held to the closing date.

Why the wide spread? First, there is no certainty that regulators would approve the deal. A combination would be viewed as limiting competition, given the considerable overlap at major airports and the elimination of a highly competitive discount airlines. Also, the current regulatory environment is skeptical at best toward industry consolidation. Second, the $3.8 billion cash price is considerably more than JetBlue’s market cap of $2.3 billion, so its ability to finance this transaction could be limited. And, few investors have the patience to wait for what will likely be 2023 for any indication of the regulators’ attitudes, and perhaps as long as early 2024 for the transaction’s closing.

However, despite the low odds, JetBlue makes a reasonable case that it would be successful in the regulatory battle. And, Spirit shares price in a near-zero chance of success, limiting the potential downside. Plus, shareholders would receive just over $1/share in cash (about 5% of the stock price) from JetBlue as a break-up fee. Helpfully, airline industry earnings look healthy so far this quarter, suggesting that travelers aren’t cutting back on flights even in the face of a weakening economy. And, in the event of an anti-trust rejection, perhaps a bid from Frontier Group re-emerges: the shares currently trade very near their spurned bid price.

While speculative, a flier in Spirit Airlines shares could prove rewarding.

RECOMMENDATIONS

Purchase Recommendation: Capital One Financial Corp. (COF)

Capital One Financial Corp. (COF) 1680 Capital One Drive McLean, Virginia 22102 (703) 720-1000 www.capitalone.com

Symbol: COF Market Cap: $37 billion Category: Large Cap Business: Banking Revenues (2022e): $33.7 Billion Earnings (2022e): $7.6 Billion 4/29/22 Price: 96.25 52-Week Range: 90.27-170.00 Dividend Yield: 2.5% Price target: $135

Background
Originally a credit card company spun out of Signet Bank in 1995, Capital One is now one of the nation’s largest banks, with over $440 billion in assets and 775 branches and cafes. Its evolution into a regular bank accelerated over a decade ago through its acquisitions of Hibernia Bank and North Fork Bank. A major difference from most other banks is that Capital One’s loan book is about 40% credit card loans, as it is the third largest issuer of Visa and Mastercard credit cards. The balance of its loans is comprised of auto loans (27%) and commercial loans (32%). The bank exited the single family mortgage business in 2017.

Investors worry about the effects that a recession could have on Capital One’s auto and other loans, as many of the bank’s customers are in the sub-prime category, which historically are more vulnerable to the effects of a weak economy. Also, rising interest rates could trim the bank’s net interest income as customers demand higher rates on their deposit accounts. Weighed down by these and other concerns, shares of Capital One have slid nearly 50% from their high and now trade at a price unchanged from five years ago.

Analysis
A recession would no doubt weigh on Capital One’s near-term outlook, but our interest is in looking past this to the bank’s bright long-term future.

Near-term, in a recession, Capital One’s loan charge-offs could surge to close to 2.75% of loans, compared to the 1.18% pace in the most recent quarter. Rising interest rates could raise the cost of the bank’s low-yield deposits, compressing its net interest margin from the current 6.54% to perhaps 6.40%. Also, it might need to spend more on marketing to continue to gather deposits and loans. Yet, most of these negative effects are already captured in the consensus estimates for 2023 and 2024, so they shouldn’t be a surprise to investors if they materialize.

And, not all of the potentially depressing effects on near-term earnings are assured. Strong employment numbers could readily restrain loan losses, while rising interest rates are more likely to raise the bank’s net interest margin as it would boost earnings on its assets faster than it would lift the cost of its funding.

The bank’s robust capital position provides it with plenty of strength to weather a downturn. Its capital level as measured by the CET1 ratio is at 12.1%, among the highest in the industry. Its loan loss reserves, at 3.9% of loans (6.9% in its credit card segment), provides an additional large buffer against future lending losses. Arguably, the bank is actually over-capitalized, as it felt confident enough about its future to repurchase 13% of its shares in the past year.

Helping to maintain its capital strength are Capital One’s highly profitable operations that currently generate a return on equity of 15%. Its net interest margin is about 3 times that of most other banks, much due to its credit card portfolio, while its expense ratio is lower. The management team and board are high quality and have proven their integrity and capabilities in complicated conditions. Importantly, Capital One is a financial technology leader which boosts its efficiency while restraining its credit losses.

Following a downturn, Capital One’s earnings will likely recover to $23/share or more. Using a conservative 6.5x target multiple, the shares could be worth $150, which we are using as our price target.

Currently, the shares trade at a low 5.5x multiple on the recession-minded consensus 2023 earnings estimate of about $17.40/share (down 12% from the $19.81 consensus for 2022 earnings) and only 110% of tangible book value. These compare to their more typical 10x earnings and 130% of tangible book value multiples. For patient investors willing to look across the valley of a recession, Capital One shares look like a true contrarian bargain. And, its well-supported dividend offers a respectable 2.5% yield while investors bide their time.

Potential investors will want to note that Capital One reports earnings after the market closes this Thursday, October 27.

We recommend the purchase of Capital One Financial (COF) shares with a $150 price target.

Ratings Changes
On October 11, we raised our rating on shares of Macy’s (M) from Hold to Buy, with a 20 price target. Investor worries about higher interest rates and a slowing economy are pushing the shares down past what we would see as a reasonable adjustment to the new reality. Macy’s is arguably a better company today than it was in July 2021 when we downgraded it.

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 and 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.
3. SP – Given the unusually high risk, we consider these shares to be speculative.
4. * Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.

The next Cabot Turnaround Letter will be published on November 30, 2022.