While it may seem that all the stocks in the Dow Jones Industrial Average may move together, there are always those laggards that can’t catch up. This creates opportunity for the turnaround investor.
In this issue, we provide our thoughts on the laggards, highlighting those with promising appeal as well as some that might best be left alone for now.
Cabot Turnaround Letter 419
IN THIS ISSUE
Dow Picks and Pans
Tainted Stocks Upcoming Surge in IPOs
RECOMMENDATIONS
Buy: GameStop
Sell: Wabtec
News Notes
Change to Terminology Performance
Picks and Pans Among The Dow’s Laggards
[vc_row][vc_column][vc_column_text]With ETFs and other passive strategies capturing more investor dollars, it is easy to forget that each index is comprised of individual stocks. And, when the media discusses the Dow Jones Industrial Average, the most widely recognized stock market indicator, it may seem that all 30 member stocks generally move together. While this may be true on any given day, over time their performances can diverge significantly. In the brief period since year-end, the strongest Dow Jones stock (IBM) gained 22%, while the weakest (Walgreens Boots Alliance) fell 10%. Over longer periods, since year-end 2014, for example, the differences are stark. While the Dow gained about 45%, the three strongest stocks, United Healthcare (+144%), Microsoft (+153%) and Boeing (+185%), rose a lot more.
The weakest stocks did poorly, as ExxonMobil fell 14%, IBM declined 13%, and Goldman Sachs lost 3%. This reminds us of the joke about the economist who put one hand in boiling water and one hand in freezing water and said “on average, my hands feel fine.” If one separates the thirty Dow names into three groups of ten each, over the same 4½-year period the spread is similar: the best 10 stocks appreciated 108% on average while the worst 10 gained only 2% on average.
Boiling and freezing, indeed. What drives this gaping divergence? Behind the tickers are real companies, in different industries, led by executives with varying degrees of motivations, experiences and capabilities. Similarly, each comes with a different valuation and set of investor expectations.
While all 30 Dow Jones names are heavily researched by Wall Street, set of share price moves seem anything but efficient. We outline below our thoughts on the laggards, highlighting those with promising appeal as well as some that might best be left alone for now.[/vc_column_text][/vc_column][/vc_row][vc_row][vc_column][vc_single_image image="4995" img_size="full”][/vc_column][/vc_row][vc_row][vc_column][vc_column_text]
PICKS
DowDuPont (DWDP) –This conglomerate was formed by the 2017 merger of Dow Chemical and DuPont with one goal in mind: the combination and spin-off of their overlapping business. The first spin-off, set for April 1st, will be “new” Dow, the world’s largest producer of commodity ethylene and related industrial plastics. Next, by mid-year, the “new” DuPont, maker of specialty chemicals and overseen by highly regarded Ed Breen, will go its own way. Remaining will be agricultural seed and herbicide business Corteva. Each company has different growth, strategic priorities and risks. For now, we don’t see the combined company as a stand-out bargain even as the shares are down nearly 20% since the merger. But once the splits occur, we expect to see some opportunities. Investors will want to watch this process closely.
ExxonMobil (XOM) – Led by new chairman and CEO Darren Woods, this energy giant is moving boldly after years of stagnant production growth. ExxonMobil forecasts strong global oil demand, with existing supply being pressured by steadily tapering output from existing wells. At its recent Analysts Day, the company outlined its ramp-up in capital spending and its expectations for generating $90 billion in free cash flow after dividends over the next six years (the company assumes only a moderate increase in oil prices to about $70). This strategy is the opposite of many other oil companies, which are emphasizing restrained spending. Investors are being paid an attractive 4% dividend, and, should the strategy work, will participate in a potential gusher of free cash flow.
Goldman Sachs (GS) – As the new CEO, David Solomon looks to utilize his wide- ranging skills (he is a part-time DJ with the moniker “D-Sol”) and highly-regarded perspective to rejuvenate Goldman Sachs. His plans include breaking apart the company’s inefficient fiefdoms and emphasizing fee-based revenues at the expense of fading businesses like commodities trading. Also ahead is more focus on technology and consumers, including its emerging Marcus retail branding segment and the credit card joint venture with Apple. Goldman shares remain vulnerable to the global economy, and the Malaysian scandal could result in fines of as much as $8 billion. Yet, the shares are appealing, as they remain somewhat out of favor despite Goldman’s impressive talent pool and new leadership. GS shares trade at a sub-par 0.9x book value and 7.9x earnings. Recurring fees are less exciting than volatile trading profits but deserve a higher multiple, potentially leading to a higher share price.
United Technologies (UTX) – This industrial conglomerate will be separating into three market-leading companies: Otis Elevator, Carrier air conditioning and the new United Technologies (Pratt & Whitney jet engines and Collins Aerospace). Each company will have a more suitable capital structure and stand-alone strategy to improve shareholder value. Over the past few years, heavy investments have dampened UTX’s margins, similarly dampening investor interest. But as these costs are winding down, revenues and profits are accelerating. Its products have strong secular demand with high barriers to entry, although they also are cyclical with considerable exposure to Chinese customers. The shares offer a 2.4% yield and trade at a reasonable 10.9x EV/EBITDA.
Walgreens Boots Alliance (WBA) – Since replacing General Electric in June 2018, Walgreens shares have fallen 8%, the third-worst in the Dow. As the largest retail pharmacy in North America and Europe, with 18,500 stores, it is an intermediary between manufacturers and consumers. With consumers increasingly shopping on-line while drug pricing undergoes heightened scrutiny, Walgreens is being squeezed in the middle. In response, Walgreens is expanding its reach with new initiatives including a promising health clinic joint venture with Humana and a test of Walgreens stores within Kroger grocery stores. These augment larger deals like its purchases of over 1,900 RiteAid stores and a 26% stake in Amerisource Bergen. While its challenges are large, so are its resources and resolve. At only 8.1x EV/EBITDA, and sporting a 2.8% yield, Walgreens offers some appealing turnaround potential.
PANS
The Coca-Cola Company (KO) – Consumers continue to migrate away from Coca-Cola’s soft drinks toward healthier beverages. While organic revenues (which exclude currency and acquisitions) rose 5% last year, organic profits increased only 7%, with only a tepid outlook for 2019. New CEO James Quincey is focusing on acquisitions, highlighted by his recent $5.1 billion purchase of Costa Coffee, a British company with 3,900 coffee shops in 32 countries. Coke recently raised its dividend for the 57th consecutive year to an above-market 3.5% yield. We think the company is doing many of the right things, and it remains highly profitable and likely to weather a recession relatively unscathed. Despite these positives, we see little appeal given the stock’s expensive valuation. Better to pause for a more refreshing opportunity.
IBM (IBM) – IBM’s years-long battle against declining revenues and uninspiring earnings was interrupted by better earnings and cash flow in the recent 4th quarter results. Its shares have rebounded nearly 30% from its decade-low $108. Its “Strategic Imperatives” category, home to promising services like Watson, artificial intelligence and the cloud, grew more than 9% last year and now comprises more than half of IBM’s total revenues. While these could become long-term revenue drivers, we think investors should wait before buying IBM shares. Achieving sustained growth will be difficult for IBM, particularly with its hobbled balance sheet after paying $34 billion for cloud computing firm RedHat. Although the 4.5% yield is attractive, IBM’s valuation is not a particular bargain.
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BUYING STOCKS TAINTED BY PRODUCT PROBLEMS
It can be an investor’s worst nightmare. Your seemingly well-managed and successful company is producing steadily rising revenues and profits, propelling its share price nicely up-ward. Then, you hear unnerving news implying that the company’s products are not safe. Your (and everyone else’s) first thoughts are “how bad is it going to get,” quickly followed by “sell now before it gets any worse.”
In this “shoot first and ask questions later” situation, the share price plummets. Few investors have any interest in stepping in front of the next piece of stock-rattling bad news. And, who wants to own shares of a company that sells dangerous products? But is waiting for an all-clear signal always the right approach? In some cases, being patient is a good idea. Credit data firm Equifax’s shares still remain 20% below their highs of 2017 before an embarrassing data breach exposed personal financial information on 143 million Americans. Facebook’s ubiquitous social media platform is losing its cache, partly due to growing concerns over its inherent lack of privacy protection. However, in other cases, with the news at its worst, that is a good time to buy.
When food from the Chipotle restaurant chain began making its customers sick in 2015, CMG shares fell nearly 65%. But, with aggressive leader-ship and strategy changes, the shares have now rebounded 170%. Recently, Johnson & Johnson, Boeing and Bayer have made headlines as the safety of their core products is being questioned. Johnson & Johnson faces a $4.7 billion verdict after a jury found that its iconic baby powder causes cancer. Two fatal Boeing 737 jet crashes, which appear related to flight software, have led to order cancellations and the grounding of the jets in many countries.
Germany-based Bayer recently acquired Monsanto, whose product Roundup, the world’s most widely used weed-killer, has twice been found in jury trials to cause cancer. Currently, it makes sense to be patient before investing in these stocks. What distinguishes a good contrarian investment from a downward spiral? We look for three traits in particular. The first is evaluating the extent to which the product is inherently unsafe, unfixable and produces company-threating downside risk. Chipotle’s food wasn’t inherently unsafe yet required major changes to food procurement and handling practices. These costs, while high, were fairly quantifiable and contained. But Roundup is a toxin that may cause cancer in humans, potentially requiring its removal from the market and possibly leaving the company vulnerable to severe financial penalties Further, it could also threaten its valuable Roundup-ready seed business.
Bayer thus has a hard-to-quantify risk of a long, downward spiral. Second is to consider the company’s responsiveness. Customers generally are forgiving the faster and more sincere the apology and the more effective the actions taken to eliminate the problem, the sooner these customers will return and the sooner the stock will recover. While Turnaround Letter Buy-rated SeaWorld was somewhat slow to address the inhumane treatment of its highly popular orcas, exposed by the 2013 movie Blackfish, it has since made bold changes to its practices and marketing, resulting in much-improved stock performance. Third, the company’s shares need to sell at an attractive valuation. Boeing and Johnson & Johnson shares still trade at high valuations.
But, after its emissions cheating scandal in 2015, Volkswagen, saw its share price plunge by 40%. Demand for its cars remained healthy, and the aftermath led to a reawakening at the company, providing a highly-discounted entry point. Volkswagen is currently a Turnaround Letter Buy-rated stock. With research and selectivity, investing in the stocks of tainted companies can turn someone else’s nightmare into your sweet dream.
BRIEF THOUGHTS ON THE UPCOMING SURGE IN IPOS
The initial public offering (IPO) tide is surging. After a relatively quiet start to the year, 2019 looks to be the fourth consecutive year of rising IPO proceeds. Last week, shares of iconic jeans maker Levi Strauss (LEVI) jumped 32% on its first trading day.
The first of a wave of high-profile technology companies, ride-sharing company Lyft, will start trading on March 29. The deal is rumored to be heavily oversubscribed even with the recent 9% increase in expected pricing. Lyft produced a net loss of $911 million last year, an increase of 32% from the prior year, despite revenues doubling. Coming up soon are other tech companies including Uber, Airbnb, Slack and Palantir, which also have generated losses but are expected to be highly-popular IPOs. These will test disciplined investors’ resolve, just as previous hot IPO markets reminded investors that IPO also stands for “It’s Probably Overpriced”
Purchase Recommendation: GameStop Corporation
Background: GameStop is a global retailer of video games, collectibles and consumer electronics, with over 5,800 stores in the United States, Canada, Europe and Australia. With its roots in Babbage’s, a software retailer that opened in 1984, GameStop completed its initial public offering in 2002 and is currently a Fortune 500 company with nearly $9 billion in revenues.
GameStop thrived in the era when gamers bought the latest video game consoles, cartridges and discs at its stores. Customers frequently would re-sell these back to the company as pre-owned, as well as buy other pre-owned items at sizeable discounts to new ones . Not only were the pre-owned products a high-margin business, but they drove a tremendous amount of traffic to the stores, which provided plenty of opportunities to sell other high-margin accessories.
Today, however, physical game cartridges and discs are being replaced by direct downloading. And, more-powerful PCs and mobile devices, along with the trend toward cloud-based games, are reducing the need for dedicated game consoles. Few items sold at GameStop are unavailable from competitors. The common narrative on GameStop’s niche: it’s really “GameOver”, with the company on the same path as Blockbuster Video.
Self-inflicted problems also plague Gamestop. Efforts to diversify, including their AT&T reseller and Cricket Wireless forays, have distracted them from improving their core gaming relevance. Leadership churn, having just announced its fifth CEO change in two years, has left the company in strategic and operational disarray. Its board appears ineffective and likely botched an attempted sale of the company.
Analysis: Despite all of these negatives, GameStop shares have two-fold appeal. First, while clearly the company is facing secular headwinds, its demise is greatly exaggerated. GameStop’s revenues have been surprisingly stable, falling only about 4% over the past four years. Comparable store sales have remained similarly stable, actually increasing 2.1% in the third quarter and 1.5% over the holiday period, although fourth quarter results could be weaker. While online games continue to improve, helped by streaming services like Steam and higher-powered phones and tablets, sales of physical consoles remain strong and provide a highly sought-after gaming experience. Even with the lack of leadership, GameStop continues to attract customers to its stores and highly developed online platform.
Further indicators of GameStop’s relevance: its PowerUp Rewards program has 55 million members worldwide, while its Game Informer magazine is the largest digital publication in the world and the 4th largest consumer print publication in the United States.
The second appeal of GME shares is financial. We estimate that at its fiscal year-end (to be released in early April), the company will have $1.1 billion in cash, only partly offset by $820 million in debt (or, excess cash of $2.75/share). The company should continue to generate plenty of free cash flow even after funding its capital spending and a generous dividend (15% yield). Under stronger leadership, GameStop could probably further boost its cash flow through better cost-controls and other operational improvements. The simple accumulation of cash in a better-managed GameStop would provide strong value to shareholders.
Despite these financial traits, GameStop shares trade at a 1.7x EV/EBITDA multiple, perhaps the lowest multiple of any credible and sizeable company listed on the NYSE or Nasdaq. This outlier valuation appears to also obscure the potential value of its Game Informer media franchise.
Change may be coming to GameStop. Two activist investors are pushing for more shareholder-friendly actions by the board, beyond the $300 million share repurchase (about 27% of its market cap) and $350 million debt paydown already promised, and are threatening a proxy fight to replace the entire board at the upcoming annual meeting (likely in June). Given investor frustration with the company’s oversight, we anticipate additional support. We are encouraged (reluctantly, given the high CEO churn) that the company has just appointed a new and respected outsider as CEO, George Sherman. He could prove to be a positive surprise for shareholders.
GameStop shares carry considerable risk. In addition to the effect of the secular challenges, the company could fend off the activist involvement, eliminate the dividend and spend its cash on unprofitable projects. The company will report its 4th quarter results on April 2, potentially leaving new investors with a quick and sharp loss if the report is disappointing.
Despite the obvious secular challenges, the company’s demise is not set in stone. For patient, risk-tolerant investors, the shares’ extreme discount, with potential value unlocked by several catalysts, offers the opportunity for outsized returns.
We recommend the PURCHASE of shares of GameStop Corporation (GME) with a $16 price target.
Sale Recommendation: Wabtec
GE shareholders received stock in Wabtec (WAB) as part of the sale/spin-off of GE Transportation. We see uninspiring upside and recommend holders sell their WAB shares.
NEWS NOTES:
On March 19th, we changed NII Holdings (NIHD) to a HOLD on our website following the disappointingly low divestiture price for its Nextel Brazil operations. As it is possible that another bidder emerges or that the deal is rejected by shareholders, and with the all-cash deal with a credible buyer likely limiting the downside from here, we have not yet moved it to a Sell.
With Oaktree Capital’s (OAK) deal to be acquired by Brookfield at a 12% premium, we moved OAK shares to a SELL on March 14th.
CHANGE TO OUR “BUY LIMIT” TERMINOLOGY
In response to subscriber comments, we are replacing the term “Buy Limit” with “Price Target.” The numbers themselves won’t change. The Price Target is what we believe the stock is worth once the turnaround is complete. With this terminology change, readers can more clearly see what the remaining potential upside is for our Buy-rated stocks.
PERFORMANCE
The tables below and on the next page show the performance of all of our currently active recommendations, plus recently closed out recommendations.
