February 3, 2023

This week, we comment on earnings from Janus Henderson Group (JHG), Meta Platforms (META), M/I Homes (MHO), Polaris Industries (PII), Vodafone (VOD) and Western Digital (WDC).

Next week brings earnings from Western Union (WU), Mattel (MAT), Brookfield Re (BANR), Goodyear Tire (GT) and Newell Brands (NWL).

We are moving shares of Meta Platforms (META) from BUY to SELL following their surge above our 180 price target. We are not raising our price target, as the company’s valuation and fundamentals don’t justify new money, and we generally avoid HOLD ratings. One way to think about the Meta investment is that it isn’t quite a cigar butt in the Ben Graham/Warren Buffett sense, but not a long-term growth company in the Charlie Munger sense. Based on yesterday’s closing price of 188.77, the shares would produce a 60% gain since our late December 2022 recommendation at 118.04.

Earnings updates:

Janus Henderson Group (JHG) – Janus Henderson Group is a global investment management company focusing on publicly-traded equities and bonds. The 2017 merger of Denver-based Janus Capital Group and London-based Henderson Group was to produce faster growth and a more valuable firm, it has proven unsuccessful on most counts. However, the company’s low valuation and chronic problems led activist Trian Partners becoming the firm’s largest shareholder with a 19% stake. Trian is actively driving change by replacing the CEO, taking two board seats and pressing for an overhaul. Janus is highly profitable, has a fortress balance sheet and pays a generous dividend.

Janus reported a good quarter that was well above estimates, driving the shares sharply higher. No change to our Buy rating.

Revenues fell 26% but were about 9% above estimates. Revenues are tied to assets under management (AUM), which fell 34% but were partly offset by stronger performance fees. Of the $145 billion decline in AUM from a year ago, more than half (about $80 billion) came from the sharp fall-off in stock and bond markets, although client withdrawals ($37 billion) and product closures ($28 billion) were significant.

Adjusted earnings of $0.61/share fell 42% but were nearly 50% above estimates.

The company continues to struggle with asset outflows as the investment performance of its products is weak. Fourth-quarter outflows of $11.0 billion were worse than any of the prior nine quarters – we anticipate further sizeable outflows this year. We believe that the new CEO and leadership team, overseen by activist investor Trian Partners, are making the necessary structural and cultural changes to boost investment performance and thus stabilize asset outflows.

Janus’ dividend remains well covered and the balance sheet remains robust.

Meta Platforms (META) – Meta Platforms, formerly named Facebook, is the world’s largest social media company. The shares are among the most disliked in the market, due to the company’s immense spending on a metaverse and Apple’s new private restrictions which are weighing on advertising revenues. Also, Meta faces regulatory issues, a slowing ad spend environment and governance problems. However, its core business franchise continues to grow and produce immense profits and cash flow, backed by a fortress balance sheet. Any significant relenting of its problems should drive the remarkably cheap shares significantly higher.

Meta reported a strong quarter, tempered its plans for 2023 spending and announced a $40 billion increase in its share repurchase program. Also, the U.S. government lost its anti-trust case, allowing Meta to acquire Within, a company that will help Meta with its metaverse build-out. The change in management’s mindset from all-out growth to “the Year of Efficiency” helped drive the shares above our 180 price target.

As mentioned earlier, we are moving the shares to a Sell.

In the quarter, revenues fell 4% but were about 2% above estimates. All active user metrics were positive in the +2% to +5% range. Ad impressions rose 23% but were offset by the 22% decline in ad prices. The resilience in revenues was highly encouraging as it illustrated the durability of Facebook and other apps. Costs and expenses rose only 2%. This led to adjusted earnings of $3.00/share that fell 18% from a year ago but were 35% above estimates.

First-quarter revenue and expense guidance were better than expected. Full-year expense guidance was reduced to $89-$95 billion from $94-$100 billion, while capital spending guidance was reduced to $30-33 billion from $34-37 billion.

M/I Homes (MHO) – M/I Homes is one of the country’s largest homebuilders, with 175 communities under development across 15 states. Its shares have tumbled sharply from their 52-week high and now trade at their pre-pandemic price as investors worry about a possible recession, the effects of rising mortgage interest rates and higher labor and raw materials costs. While we appreciate the headwinds facing M/I Homes and its industry, we see a diversified, highly profitable, financially solid and well-managed company whose shares trade at a sizeable discount to their liquidation value.

M/I Homes reported a healthy quarter that was well ahead of the consensus estimate, but the boom times of sharply increasing units and pricing have ended. While the shares have surged, they remain about 9% below our price target. The valuation at 0.9x liquidation value per share remains low enough, and the fundamentals remain strong enough, that we will hold out longer in anticipation of the shares reaching our price target.

In the quarter, revenues rose 14%, comprised of a 3% increase in home deliveries and an 11% increase in average price. Revenues were 18% above estimates. Adjusted earnings of $5.15/share rose 35% from a year ago and were 24% above estimates.

Future demand is falling from peak levels. New contracts fell 44% and backlog (homes under contract but not yet delivered) fell 28% from a year ago in dollar value. The contract cancellation rate was a high 30% compared to 10% a year ago. We see further weakness but not a collapse in demand – while the low interest rates and demand surge following the pandemic have passed, underlying secular demand is at worst steady due to household formation. M/I Homes is well run, is highly profitable, has a solid balance sheet and operates in high-demand local and regional markets.

Polaris (PII) – Shares of this high-quality and market leading manufacturer of powersports equipment like off-road vehicles, snowmobiles, motorcycles and boats, have fallen out of favor with investors. Major concerns include the risk of a post-stimulus falloff in demand as well as supply chain disruptions that are weighing on margins by 3-4 percentage points. We believe the company’s long-term prospects remain intact. Polaris produces strong profits and free cash flow, has a solid balance sheet, and a strong, shareholder-friendly management team.

Polaris reported a strong quarter. Revenues rose 21% although this was in-line with estimates. Adjusted earnings of $3.46/share were 57% above year-ago results and were 6% above estimates. Adjusted EBITDA rose 50%, producing a 14.0% margin compared to 11.3% a year ago. Strength across all three drivers (pricing, volume and mix, with pricing being the primary driver) propelled the results, which more than offset headwinds from currency, higher warranty costs and weaker off-road volumes. Stronger gross margins were partly offset by higher promotional, research and overhead costs.

Later in the week, Polaris announced a 1 cent per quarter increase in its dividend, to $0.65/share.

The company provided 2023 guidance for flat to +5% revenue growth and +/- 3% change in per share earnings from continuing operations. Both guides are above consensus estimates that look for revenues and earnings to decline 4%. EBITDA margin guidance calls for an increase to as high as 13%, which is our target margin. Investors continue to underestimate the durability of the Polaris franchise.

The outlook for demand, reflected in the guidance, is mixed – customer trends remain healthy but not as robust as in 2022. Recreation demand is currently soft. Dealer inventories are approaching normal, so Polaris’ sales will more closely match end-customer purchases and normal seasonality.

During the full year, Polaris generated $800 million in cash profits and increased its net debt by $450 million. The resulting $1,250 million in cash went to: $300 million in working capital, $300 million in capital spending, $500 million in share repurchases and $150 million in dividends.

Debt isn’t a worry (at 1.9x EBITDA) and we are somewhat impressed at the company’s willingness to basically borrow to buy at low share prices (about $114/share, on average). The current share count is 6% below the year-ago count.

The large cash drain from working capital is easing – in 2021 it was a $540 million drain and in 2022 it was a $300 million drain. We anticipate that in 2023 the drain will approach zero. This should free up another $300 million in cash to pay down some of Polaris’ debt and fund the $400 million in planned capital spending (up from $307 million in 2022).

At 7.1x estimated 2023 EV/EBITDA, the shares continue to trade at a sizeable discount to fair value. We recognize the potential cyclicality in the earnings stream over the next year or two, but investors are overly discounting this issue.

Vodafone (VOD) – Vodafone is a major European wireless telecom, broadband and cable TV service provider. This company has produced dismal operating results since our recommendation, so we were on the edge of exiting the position in late 2022. However, following the forced departure of the CEO along with heightened activist pressure and the sharp undervaluation of the shares, we are now much more optimistic about this stock. From here, we want to see a skilled and motivated outsider CEO take the helm with a strong turnaround plan that can be implemented successfully. A sharp dividend cut could readily be part of this plan, with the released funds at least partly dedicated to cutting Vodafone’s elevated debt. Vodafone has a few and valuable obscure assets: it is the leading provider of mobile data and payments services in Africa and has a vast network of high-capacity data pipelines that may increase in value as 5G rolls out.

Our comments will be brief as we await news (likely in Q2) of the selection of a new CEO and as the third-quarter report included only revenue-related results. Second half profits will be reported on May 16. The company said it continues to target full-year 2023 adjusted EBITDAaL of €15.0-15.2 billion and adjusted free cash flow of €5.1 billion. At the helm is Interim CEO Margherita Della Valle.

The fiscal third quarter showed weak and deteriorating revenue trends. Organic service revenues (excluding hyper-inflationary Turkey) rose 0.5%, yet another quarter of declining growth. Growth throughout its European operations deteriorated, turning more negative in Germany (at -1.8%) and Spain (-8.7%) and remaining weak in Italy (-3.3%). Growth in the U.K. decelerated to +5.3%. Germany generated 30% of total Vodafone service fee revenue – weakness here weighs significantly on total company results. Its Vodacom revenues (Africa) remained healthy.

We see little inspiration in the results as we wait for new leadership.

Western Digital (WDC) – Western’s new and highly capable CEO, David Goeckeler, who previously ran Cisco’s Networking & Security segment, is making aggressive changes to improve the company’s competitiveness in disk drives and other storage devices, as well as bolster its financial strength. The company generates free cash flow and holds plenty of cash to buy time for the turnaround and to help pay down its elevated debt.

Western Digital reported a rough fiscal second quarter but continues to cut operating and capital spending as well as boost its liquidity to endure through the current cyclical downturn in tech memory and storage gear. Its guidance for the fiscal third quarter is for even weaker results. The company is well run and should emerge stronger in the inevitable upcycle (although this may be a year away). No change to our rating.

In the quarter, revenues fell 36% from a year ago, with comparable declines in all three of its segments (cloud, client and consumer). Revenues were about 5% above estimates but given the size of this downturn the revenue estimates were mostly guesses. The adjusted loss was $(0.42)/share, compared to a year-ago profit of $2.30 and estimates for a $(0.13) loss.

For the fiscal third quarter, the company guided revenues to a midpoint of $2.7 billion (down 39% from a year ago) and about 11% below the consensus estimate. While weaker, the guide suggests that the pace of declines isn’t getting much worse and that for this cycle annual revenues may bottom at around $10 billion (down 45% or so from the prosperous 2022 level). Third-quarter profits were guided to a loss of roughly $(1.58)/share. At this level, Western would generate negative free cash flow of about $300 million or so per quarter, depending on working capital changes. To adjust, the company is further cutting its cash outflow from expenses and capital spending – adding to cuts made already. It started a 30% reduction in flash production in January.

We don’t see Western Digital as facing bankruptcy or secular decay. Demand for disk drives and memory chips isn’t going away – the secular demand trends remain remarkably strong. However, near-term demand is weakening due to slowing end-markets, including in China, and a glut of drives/chips following what likely was over-aggressive ordering in response to the pandemic-era shortages. This downcycle will be the worst for the industry in probably 20-30 years. But, Western produces a critical product (hard disk drives) with only two meaningful competitors (Seagate and Toshiba) and is one of only four meaningful producers of NAND flash memory chips. While competition is fierce, producers aren’t irrational and Western Digital is more than holding its own on product relevance.

Western has $1.9 billion in cash and another $2.3 billion in untapped credit lines. While the company’s leverage is elevated at 3.2x EBITDA, we see little chance of a credit issue. Its first major maturity is a year away, its next meaningful maturity is in 2026 and most of its debt is fixed at low interest rates.

The shares trade at the trough prices of each of the past three major cycles since 2012 and are valued at about 7.3x EV/EBITDA based on a partial recovery in 2024.

Friday, February 3, 2023 Subscribers-Only Podcast:

Covering recent news and analysis for our portfolio companies and other topics relevant to value/contrarian investors.

Today’s podcast is about 16 minutes and covers:

• Earnings
  
  • Janus Henderson Group (JHG), Meta Platforms (META), M/I Homes (MHO), Polaris Industries (PII), Vodafone (VOD) and Western Digital (WDC).
• Ratings changes
  
  • Moving shares of Meta Platforms (META) from BUY to SELL
• Comments on other recommended companies:
  
  • Goodyear Tire & Rubber (GT) – weak overseas demand will weaken 4Q results, to be reported next week.
  • Six Flags Entertainment (SIX) – adds new board member.
  • Gannett (GCI) – anticipates paying down $120 million in debt this year.
• Elsewhere in the markets
  
  • Meltdown of the Adani share price in India

Disclosure: The chief analyst of the Cabot Turnaround Letter personally holds shares of every Rated recommendation. 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 purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time.Please feel free to share your ideas and suggestions for the podcast and the letter with an email to either me at bruce@cabotwealth.com or to our friendly customer support team at support@cabotwealth.com. Due to the time and space limits we may not be able to cover every topic, but we will work to cover as much as possible or respond by email.