Cabot Turnaround Letter Issue: September 28, 2022

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As stock prices tumble under the twin pressures of rising interest rates and the likely arrival of an economic downturn, just about every new stock pick is destined to be a disappointment. How does one select stocks in such an environment? While most fresh ideas will be near-term duds, there is an important purpose to picking new ideas. And, one doesn’t need to buy full positions right away. We screen for low P/E stocks on depressed 2023 earnings, with estimates for those earnings that are increasing. These make good stocks in which to take starter positions.

We also sorted through stocks with high dividend yields and highlight two picks and two pans (with enticing yields yet have serious dividend risks).

Our feature recommendation this month is Dow (DOW). Its shares have been sold by fearful investors, but the company’s low valuation doesn’t recognize the improvements in its financial strength and cost structure since the dark days of early 2020, nor the attractive yet sustainable dividend yield.

Cabot Turnaround Letter Issue: September 28, 2022

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Stocks with Low P/E ratios and Rising Earnings Estimates
As stock prices tumble under the twin pressures of rising interest rates and the likely arrival of an economic downturn, just about every new stock pick is destined to be a disappointment. How does one select stocks in such an environment? How much confidence can there be in any stock pick regardless of the methodology? Why even bother?

True, most fresh ideas will be near-term duds, including the ones in this article. Few stocks can buck a relentless bear market. But, part of the purpose of sorting through stocks and picking new ones is to maintain awareness of what individual stock prices and fundamentals are doing, and what opportunities are being produced. Only by this process can investors hope to find names that will later produce rewarding returns.

When buying these names, one need not buy full-sized new positions, especially as they could shrivel in value in mere weeks, leaving the investor with only frustration and a motivation to “sell everything.”

Instead, the investor can buy small, starter positions, even if only a quarter or an eighth of a normal position – just enough to get involved with a stock but not be too heavily damaged if the market continues to slide. And, as the valuation becomes excessively pessimistic relative to the company’s fundamental outlook, the investor can add more at lower prices. This is how some investors generate returns vastly better than the overall market.

To find worthwhile ideas in this market, we screened for stocks with low price/earnings multiples –

those below 5.5x. This low multiple leaves little room for further compression. Given the likelihood that earnings for most companies will be weaker in 2023, we used estimates for that year in our valuation screen.

Also, we wanted to have some confidence that those 2023 earnings will actually materialize. To help in this effort, we screened for companies with 2023 estimates that were increasing, on the assumption that it is unlikely (but certainly not impossible) that rising estimates will suddenly convert into falling estimates. As value investors know, the definition of a value trap is a stock that keeps its low valuation multiple but collapses anyways as the earnings collapse. No one wants to own those kinds of stocks.

In our screen, very few companies (only 62 out of a universe of over 2,700) met our valuation and estimate revision criteria. Most companies had either higher P/E multiples or negative earnings in 2023 (nearly a quarter of our universe).

Our list below includes the few stocks that look worthwhile. Many cyclical companies showed up, including several homebuilders, but we currently recommend M/I Homes (MHO) so we don’t include others here other than to mention that Pulte Homes (PHM), Century Communities (CCS) and Taylor Morrison Homes (TMHC) met the criteria. Also, currently recommended Goodyear Tire & Rubber (GT) met the criteria. Several oil and gas stocks were screened in, as these often trade at low multiples yet are seeing estimates increase as analysts appear to be underestimating the favorable impact of high energy commodity prices. We include Chord Energy (CHRD) as the most worthwhile representative of the group.

Closing prices on September 23, 2022.
* Valuations based on fiscal years ending in 2023. For Jackson Financial, the multiple shown is price/free cash flow.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Chord Energy Corporation (CHRD) – Chord Energy is an independent oil and gas producer focused exclusively on the Williston Basin in the Dakotas, Montana and lower Canada. Like many of its peers, Chord Energy has a colorful history. It previously was named Oasis Petroleum, which filed for Chapter 11 bankruptcy in late 2020. Oasis made a quick exit, then combined with Whiting Petroleum in July 2022, creating the current Chord Energy. The shares have generated strong gains since then, but the valuation is still inexpensive. Yet, even as oil prices slide, estimates are rising as analysts underestimate the profits that Chord will generate. And, if oil prices reverse and head back up, its profits and shares should rebound sharply. We’ll leave the commodity price outlook to traders, but we like the company’s strong free cash flow, its commitment to returning at least 75% of that free cash flow to investors, its net-cash balance sheet position, and its recently raised dividend that yields nearly 4%. At a near-20% free cash flow yield and low valuation, Chord Energy shares strike the right tone.

Group 1 Automotive (GPI) – This company is the nation’s fourth largest publicly traded car dealership company. It owns 149 dealerships across 17 states, with its home state of Texas producing over 35% of its unit sales. Group 1 also owns 55 dealers in the United Kingdom, mostly around London. The company’s dealers emphasize sales of new cars rather than previously owned cars. Its operations also include 47 collision repair centers. Group 1’s shares have slipped 30% from their recent high, although they remain well above their pre-pandemic level. Most investors assume that that dealership companies have highly cyclical business models and are prone to fade with the arrival of electric vehicles and direct selling that bypasses dealers. But these companies are resilient: major market share gains by EVs are a decade or more away, and direct selling is unlikely to gain share for new vehicles due to local laws and industry logistics. And, for Group 1 specifically, over 35% of its profits are generated from parts and service – which are enduring due to the increased complexity of car repairs and dealers’ greater ability to retain labor relative to independents. While 2023’s results will lag those of 2022, profits will likely remain quite strong. Group 1 will likely continue to generate sizeable free cash flow, which it uses to fund its disciplined acquisition program as well as generous dividends and share buybacks. The company’s corporate debt, which excludes borrowing to fund its car inventory, remains low. While investors may want to be patient buyers during the current market meltdown, GPI shares offer considerable fundamental and valuation appeal. We note the recent announcement that the CEO is retiring (the internally promoted new CEO will likely bring a continuation of the same good quality of leadership) and that the company raised its dividend.

Jackson Financial (JXN) – Jackson is a leading provider of variable annuity insurance products. Founded in 1961 and acquired by the U.K. company Prudential plc in 1986, Jackson Financial regained its independence with its spin-off in October 2021. The company is well run, well regarded in the industry and has a high-quality distribution network that is ranked #1 in the independent broker-dealer, bank and wirehouse channels. Favorably, it has little presence in the career agent or direct sales channels. After a brief run-up, the shares have nearly returned to their spin-date price as investors worry about the impact that the collapsing stock market will have on its annuity business and the supporting capital base. While the stock market could continue to slide, Jackson has a relatively new book of business (very little written on the unfavorable terms that were common prior to the 2008 financial crisis) and thus has lower risks than many others in the industry, although the company may need to taper its share buyback to preserve its strong capital position. The generous dividend looks readily sustainable. We value the company on free cash flow, which is a useful proxy for cash earnings given the numerous accounting charges that populate its income statement, like most insurance companies.

Sylvamo Corporaton (SLVM) – Spun off from International Paper in October 2021, Sylvamo is one of the world’s largest producers of uncoated freesheet, or UCF, paper (primarily printer and copier paper). As UCF is somewhat of a commodity product, low cost is critical: as 70% of its capacity is in the lowest global and regional cost quartiles, Sylvamo’s mills have a cost edge over most competitors. Nearly 68% of its profits are generated in Europe and Latin America, which have favorable structural conditions, with the balance from North America. Also, the company produces the valuable Hammermill and HP (Hewlett-Packard) brands and provides the paper for the Staples office supply brand, all of which help preserve its margins. Other advantages include its mill locations near tree supplies and its heavy use of biomass to provide most of its energy. We consider the company to be well run and operated with an intent to maintain its operational quality and efficiency. The balance sheet carries a reasonable debt burden, which is well supported by generous annual free cash flow of around $450 million. While paper usage is in mild secular decline, Sylvamo is able to pass through higher pricing that more than offsets the lower volume as well as rising costs. Unlike many industrial firms, the company’s inventory is on the low end of normal. The shares have slid 33% from their high and trade only moderately above their initial post-spin price. The company looks like a long-term survivor in most economic conditions.

High Dividend Yield Stocks: Picks and Pans
Stocks with high dividend yields can seem so appealing: a dividend yield of, say, 6% can provide an 18% hard-cash return to an investor over a three-year period regardless of what the underlying stock price does. And, yield support from a generous and sturdy dividend can put a floor on a stock price, even when other shares across the market are tumbling. During an economic downturn, dividends can pay investors generously to hold onto a stock – in essence, paying them to wait – until an economic rebound helps drive the share price back upward.

We agree with all that – as long as the dividend is readily sustainable.

There are few if any free lunches in the stock market. High dividend yields usually exist because the underlying company has limited if any credible growth prospects, or because its fundamental prospects are dimming, which pushes down the share price and drives up the yield. It’s been said that only three things can happen to a high dividend yield stock, two of them bad: the dividend is cut, the share price slides more than is offset by the extra yield, or the stock recovers which adds attractive share price gains to the generous dividend.

Many, if not most, high dividend yield stocks, therefore, are not worthwhile, even to value investors. However, occasionally some have strong enough business models, capable leadership and sturdy enough free cash flow to provide a high confidence level that the dividend will be sustained through nearly any reasonable economic downturn. These stocks can provide the hoped-for benefits outlined above: a solid cash return combined with profits from the eventual rebound in the share price.

Listed below are two stocks that look appealing. They both have real businesses that generate significant free cash flow in excess of their dividends and are backed by capable managements and reasonably solid balance sheets. To this list we would also add current Cabot Turnaround Letter stocks like Newell Brands (NWL), Xerox (XRX), JanusHenderson Group (JHG), Walgreens Boots Alliance, Western Union (WU) and this month’s feature recommendation, Dow (DOW). While no dividend is ever guaranteed, these all look highly sustainable.

Our discussion below also includes two popular companies with high dividend yields that do not look sustainable. These companies have fundamental issues that could readily force them, sooner or later, to cut or eliminate their dividends. Many investors use prior dividend payment track records as an assurance of future dividends, but future dividends are paid with cash on hand, not with prior track records. As the economy is showing considerable volatility, investors want to look closely at the company behind any generous dividend yield.

Closing prices on September 23, 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 fiscal years ending in December 2023. Valuation for KeyCorp is P/E multiple.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

KeyCorp (KEY) – Based in Cleveland, Ohio, KeyCorp is a super-regional bank with over $187 billion in assets. It provides a range of traditional banking, investment management and investment banking services to business and personal customers through its network of over 1,000 branches across 15 states. KeyCorp has improved its operating results and upgraded its technological capabilities while also exercising considerable expense control, helping it to generate returns on tangible equity of over 20%. Its capital remains robust with a CET1 ratio of 9.2%, within its targeted range of 9.0%-9.5%. While this ratio is lower than most mega-banks, it reflects Key’s lower risk profile. Credit losses, at 0.16%, are impressively low. The bank should benefit from a rising interest rate environment as its asset yields rise faster than its funding costs. Key is shareholder-friendly, returning close to 75% of its profits to shareholders as dividends or share buybacks. The bank trades at an overly discounted 6.9x estimated 2023 earnings. The generous dividend is readily supported by profits and the bank’s strong showing in the Fed stress tests.

Weyerhaeuser Company (WY) – This real estate investment trust (REIT) is an integrated forest products company. Its operations span from growing trees with proprietary seedlings on its own land (it is one of the world’s largest private timberland owners) to harvesting timber to producing lumber, panels and engineered wood. This vertical integration provides Weyerhaeuser with considerable control over its costs and valuable tactical flexibility in capturing market opportunities. It also bolsters the company’s financial flexibility, as it can sell assets or excess wood to help provide liquidity as needed. Weyerhaeuser is benefiting from robust pricing and volumes, but even if the housing market slows, the company is likely to earn more than before the pandemic. One interesting source of value is its carbon capture service, which the company believes could generate an incremental $100 million in profits (adding as much as 30% to total profits) in a few years. A source of cost protection is derived from its own biomass, which meets 70% of the company’s energy needs. As a REIT, the company pays out most of its profits to shareholders, reducing the risk of empire-building or other distractive uses for its cash. The debt burden is readily manageable. Weyerhaeuser is a former Cabot Turnaround Letter recommendation (+70% return).

Two high yielding stocks whose dividends are at risk:

Altria Group (MO) – Previously a Cabot Turnaround Letter recommended stock (produced a 27% total return), Altria has a dominant position in the United States cigarette market, led by its Marlboro brand. While this franchise generates immense free cash flow, nearly all of it is consumed by its $6.8 billion in annual dividends. And, this free cash flow is jeopardized by the 7%+ decline rate in cigarette unit volumes due to the secular decline in the number of smokers, and the cyclical pressure from high gasoline prices and weak economy that motivate consumers to trade down to discount brands. Altria’s oral tobacco products are also seeing lower volumes and profits, further weighing on free cash flow. The company’s JUUL and other alternative tobacco products have little chance of becoming anything more than cash drains, especially if the pending Philip Morris International/Swedish Match merger is completed. Altria’s dividend yield is exceptionally high for a good reason – investors have little confidence in its sustainability.

3M Corporation (MMM) – Historically, this diversified and well-managed manufacturer of consumer and industrial products has paid a remarkably reliable dividend, with over 64 consecutive years of annual increases. Its free cash flow is robust, and the current balance sheet carries modest debt at only about 2x EBITDA (cash operating profits). However, the company is under pressure from two potentially debilitating legal problems. First, it faces liabilities that could total $10 billion to $20 billion or more for its role in using toxic PFAS chemicals. At best, litigation would drag on for years, carrying with it the expense and attention burden along with a dark cloud of uncertainty. Second, the emerging liability from its Combat Arms military hearing protectors puts another $10 billion or more at risk. 3M now faces over 235,000 lawsuits claiming that the devices sold between 2008 and 2015 failed to protect soldiers’ hearing. The company’s efforts to isolate this liability by sending the business into bankruptcy was rejected by a court, thus allowing the claims to proceed against all of 3M. Like the PFAS liability, the hearing protector overhang won’t likely be resolved for years. 3M is proceeding with a spin-off its Healthcare division, but this will only serve to reduce the cash available to parent 3M to support future expenses, payouts and debt. 3M’s dividend could be at risk for the first time in decades.

RecommendationS

Purchase Recommendation: Dow, Inc. (DOW)

Dow, Inc. (DOW) 2211 H.H. Dow Way Midland, MI 48674 (989) 636-1000 www.dow.com

Symbol: DOW Market Cap: $32 billion Category: Large Cap Business: Chemicals Revenues (2022e): $57.6 Billion Earnings (2022e): $10.5 Billion 4/29/22 Price: 43.90 52-Week Range: 43.04-71.86 Dividend Yield: 6.3% Price target: $60

Dow is one of the world’s largest chemical producers. Founded in 1897 by Herbert H. Dow in Midland, Michigan, the company expanded into chemicals and plastics, and rode to global prominence in the post-war economic expansion. In 2017, Dow Chemical merged with DuPont in an all-stock transaction to create DowDuPont, with the intent of splitting apart into three companies based on product lines. The combination of product lines provided improved scale economies while reducing competitive pressures. In 2019, Dow was spun off, with an opening-day trading price of $53.50/share.

Today, Dow is the world’s largest producer of ethylene and polyethylene, the most widely used plastics, as well as other more specialized products. Its basic strategy is to leverage its massive global scale and innovate as much as possible to expand its profit margins, while continuously reducing its costs and debt to provide long-term financial strength and flexibility.

The company operates in three segments. Packaging and Specialty Plastics (50% of sales) converts raw materials like natural gas into commodity and related plastics, with arguably the world’s largest and most geographically diverse reach in the industry. The Industrial Intermediates and Infrastructure segment (30%) produces a broad range of chemicals including solvents and lubricants used across the industrial economy. Products from the Performance Materials and Coatings (20%) segment are used by its commercial customers to improve their paints, coatings, adhesives, consumer products and other goods. All of these products are key ingredients in the global economy – they cannot be replaced or substituted. Dow is a global company, with nearly two-thirds of its sales produced outside the United States and Canada.

Dow shares have tumbled 37% from their post-spin peak and now trade below their first-day price. Investors are abandoning the shares on worries that rising interest rates will drive the global economy into a downturn, leading to lower demand for Dow’s products. A major related worry is that global supply won’t decline much, leading to lower prices. Combined, these could sharply weaken Dow’s profits and potentially threaten its generous dividend.

Analysis
While we acknowledge the worries about weaker volumes and pricing, Dow shares already discount a dour scenario. Such a scenario looked highly likely in early 2020 amid the depths of the pandemic. At that time, Wall Street analysts estimated that, in 2020, Dow would generate about $5.3 billion of EBITDA on about $38 billion in revenues. These estimates assumed that global lockdowns would lead to a depressed 2020 economy. Yet, even on these grim estimates, and assuming that this condition was the new normal, Dow shares would have been worth about $29/share, only about 34% below the current price.

Since 2020, Dow has become a much better and more valuable company, even excluding today’s more favorable economic conditions. First, its capital structure is stronger. Debt of $18.2 billion in March 2020 has been whittled down to $13.7 billion today, a reduction of 25% and equivalent to $6/share in value transferred to equity holders from bond holders. And, due to savvy financial management, less than $1 billion in debt matures within the next four years, offering Dow considerable financial flexibility to weather any downturn. In terms of leverage, even if the company reverted to its 2020 pandemic-weakened earnings level, leverage would only be about 2.6x EBITDA – a readily manageable and still modest amount of debt. On current recession-minded 2023 estimates, debt is only about 1.5x EBITDA.

Further bolstering its balance sheet: the prior pension liability of $9.8 billion will likely fall away entirely due to several cash infusions combined with the favorable effect of rising interest rates on the present value of future pension obligations. This is an underappreciated source of value improvement, worth an incremental $13/share, although we do not explicitly factor it into our valuation model. Partly offsetting this, the company holds about $1.3 billion less cash today, for a reduction in value of about $2/share.

Due to the benefits from the merger/split-up and management’s subsequent efficiency programs, Dow today has a much-reduced cost structure. We estimate that the company’s underlying cost structure is $800 million lower that it was in early 2020. Capitalized on an after-tax basis, this increase would be worth about $5/share.

Adding up all of these improvements, with only half-credit to the pension liability reduction, would produce an additional $16/share in incremental value relative to the $29/share valuation (described earlier) if the economy stayed in the darkened world envisioned at the bottom of the pandemic in 2020. And, even if this projected future unfolded again, Dow would likely continue to pay its $2.80/share annual dividend – in its worst quarter in 2020 the company generated $840 million of free cash flow, or an annualized $4.59/share.

Fortunately, the world will likely not return to such a dour environment. Global economic growth will likely be 10% higher in 2023 than pre-pandemic 2019, suggesting that even in a weak economy, demand for Dow’s products will remain reasonably healthy. The company said it will be trimming its production volume rather than risk saturating the market, thus protecting its margin but weighing on profits the rest of this year. As oil prices have a notable impact on plastics pricing, their slippage will weigh on Dow’s profits, but as oil prices are nearly double their 2020 average, plastics pricing should remain considerably above the 2020 level. In Europe, plastics prices, natural gas availability and competitive supply volatility will affect profits there, and conditions in the rest of the world clearly won’t return to the impressive 2021 strength. Yet, all-in, given the changes to demand, supply and cost structure, the consensus estimate for 2023 is for $8.8 billion in EBITDA on $53.5 billion in revenues. This is well ahead of the outlook as of early 2020.

Even with the weak 2023 estimated results, Dow will likely continue to generate immense free cash flow of about $5.0 billion. This free cash flow is still considerably above the $2.0 billion in dividend payments. We have little doubt that with Dow’s commitment to its shareholders, it would taper its cash outflows to sustain its dividend.

Dow’s management has proven itself to be a capable steward of shareholder value. Led by CEO Jim Fitterling, the company is performing better in nearly all metrics compared to its position at its 2019 spin-off. The board of directors includes Richard Davis (a highly disciplined and no-nonsense banking executive) and other executives with strong oversight experience. In addition to its commitment to the dividend, Dow is a sensible repurchaser of its shares. The company has repurchased $2.2 billion in shares year to date. All-in, the company targets returning to shareholders about 65-70% of net income.

At 4.8x EBITDA, the shares are trading well below their normal multiple of around 6.0x. And, this low multiple is based on a recession-minded 2023 EBITDA estimate of $8.8 billion, almost 25% below the profits of the past 12 months. Also, the shares offer a highly attractive 6.3% dividend yield. We believe this dividend is readily sustainable in all but a deep and enduring global recession and offers an additional and rare source of value to investors.

The shares, of course, are not risk-free. Major risks include a collapse of oil prices, a deep and enduring global recession and excessive capacity increases by competitors. But we see these risks as unlikely to become reality. And, Dow’s leadership appears fully capable of successfully navigating the company through these conditions if they occur. For patient investors, Dow’s shares look like a legitimate bargain.

We recommend the purchase of Dow (DOW) shares with a $60 price target.

Disclosure: The chief analyst owns shares of Dow (DOW).

Ratings Changes
None this week.

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 October 26, 2022.

About the Analyst

Bruce Kaser has more than 25 years of value investing experience in managing institutional portfolios, mutual funds and private client accounts. He has led two successful investment platform turnarounds, co-founded an investment management firm, and was principal of a $3 billion (AUM) employee-owned investment management company.

Previously, he led the event-driven small/midcap strategy for Ironwood Investment Management and was Senior Portfolio Manager with RBC Global Asset Management where he co-managed the $1 billion value/core equity platform for over a decade. He earned his MBA degree in finance and international business from the University of Chicago and earned a Bachelor of Science in finance, with honors, from Miami University (Ohio).