Cabot Turnaround Letter Issue: May 25, 2022

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While the stock market has surged since its pandemic low, shares of many companies have sold off sharply and now trade below their March 23, 2020 level. We touch on several different types of situations behind these sell-offs and highlight five stocks backed by reasonably healthy companies yet trade at attractive valuations. We also mention one additional stock that has significant potential but not under the current value-destroying management.

We delve into the investment management industry and highlight four stocks of companies that look appealing but are not generally on investors’ radar screens. Our featured recommendation this month is investment firm Janus Henderson Group (JHG). The company produces strong free cash flow, has a fortress balance sheet, offers an attractive 5.7% dividend yield and is under pressure from activist investor Trian Partners to improve its results.

We note our recent ratings change of Altria Group (MO) from Buy to a Sell.

Cabot Turnaround Letter Issue: May 25, 2022

Companies with Shares Below their 2020 Pandemic Low
While the stock market has been on a wild ride over the past 2½ years, most stocks remain above their prices of March 23, 2020, when the S&P 500 hit its pandemic low. The index has surged (up 74%) since then, but shares of many companies have sold off sharply and now trade below their March 23, 2020 level.

This group of laggards spans many different situations. Several durable companies like Clorox (CLX) and WD-40 Company (WDFC), are losing their pandemic momentum yet remain too expensive for our value-oriented approach. Others, like Netflix (NFLX) and Okta (OKTA), have headwinds or profit issues that currently knock them out of our interest zone but have legitimate businesses. Some companies, like Peloton (PTON), Zoom Video Communications (ZM) and DocuSign (DOCU), may endure but only as shadows of their former potential. And more than a few, on the other hand, like Smile Direct Club (SDC), Teladoc Health (TDOC) and a large selection of biotech companies, never had legitimate business prospects so their shares are tumbling as investors increasingly recognize this.

Our focus is on reasonably healthy companies whose shares have been discarded by investors, perhaps on recession or other concerns, and whose shares are attractively valued. Listed below are six stocks that meet these criteria. The list includes Hyster-Yale (HY), as investors have rightfully given up on its prospects yet it is worth watching for catalysts or other reasons.

Easterly Government Properties (DEA) – Based in Washington, D.C., Easterly is a real estate investment trust (REIT). It concentrates on Class A commercial properties that are leased to U.S. Government agencies, including the Veterans Administration, FBI, and U.S. Citizenship and Immigration Services, that provide essential services. Its properties are diversified across a long list of agencies, geographies and lease maturities, providing limited risk from any single property or agency. And its sole customer seems highly unlikely to miss any payments. The company is solidly profitable and generates healthy free cash flow. A key component of Easterly’s strategy is adding new properties, which is boosting its growth rate yet also boosting its debt load, which may be off-putting to investors. Yet, helping ease the debt burden is the low 3.5% average interest rate and the mostly fixed-rate nature of Easterly’s debt. The shares trade at a discounted valuation and pay a sustainable 5.6% dividend yield.

Heartland Express (HTLD) – Iowa-based Heartland Express is one of the nation’s largest and most highly regarded trucking companies. It focuses on short- to medium-haul loads (less than 500 miles) in the United States, often considered a sweet spot in terms of fleet profitability and efficiency. The company also operates 24 terminal facilities to help boost its productivity. Heartland is a regular winner of numerous industry awards that reflect its high-quality operations, including the FedEx Express 2021 National Carrier of the Year Award (11^th consecutive year) and the FedEx Express Platinum Service Level Award for its 99.99% on-time delivery record. It hires only experienced drivers and maintains a young fleet of tractors and trailers that average less than 3.7 years of age. Other than Walmart (10% of revenues), Heartland’s revenues are spread across a large number of customers. Investors have discarded its shares, which currently trade unchanged from their 2005 price level, over fears of a recession, high fuel costs and a fall-off of spot shipping prices. These are serious problems if they fully materialize, but much has already been factored into HTLD shares, and company management has indicated that it continues to see strong revenue and profits for at least this full year. Heartland has a sturdy balance sheet with $187 million of cash and no debt, generates strong free cash flow and is repurchasing its shares. Last August, the company rewarded shareholders with a $0.50/share special dividend. Shares of this company would likely surge in a no-recession or mild-recession scenario.

Hyster-Yale Materials Handling (HY) – We’re watching with intrigue as this iconic maker of industrial forklifts continues to destroy shareholder value by investing heavily in fuel cell technology. While we may ultimately be proven wrong, the burden of proof is on the management to justify the nearly $200 million in losses at its Nuvera fuel cell segment over the past five years. The rationale that investors should consider this business a venture capital endeavor, and valued accordingly (i.e., at stratospheric levels) rings hollow, as Hyster-Yale would be an unlikely home, to say the least, of a fuel cell breakthrough. And it appears that this program is drawing away management’s attention from the core forklift segment which has produced lackluster results while the overall industry has boomed. Debt is elevated at nearly 4x an optimistic 2023 EBITDA consensus estimate and we wonder if the dividend is on the chopping block. Why mention Hyster shares in this note? The depressed share price (trading essentially at an all-time low) and clear sources of value destruction would appear to be a prime recipe for a shareholder revolt, even as the CEO’s family recently doubled its stake to 17%. This stock is highly speculative but worth watching if solely for the educational and entertainment value.

Closing prices on May 20, 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 2022. Hyster-Yale is projected to post an EBITDA loss.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Intel Corporation (INTC) – Shares of Intel continue to unravel, down 40% from their high and back near their five-year low. Intel’s new and capable CEO is spending aggressively to upgrade and expand the company’s semiconductor production capabilities, but the increasing likelihood of a global recession, along with the stock market’s recent sell-off, leaves investors unwilling to wait for the long-term turnaround to arrive. If Intel’s profits slip much further, the company will need to cut or eliminate its dividend to continue to fund its aggressive plans. We believe management would readily sacrifice the dividend, as it would halt the outflow of as much as $6 billion in much-needed cash. The share valuation based on current estimates, which could decline, is an unchallenging 5.8x EV/EBITDA. For value/contrarian investors, Intel’s stock is worth watching and perhaps merits a token position to keep this name top of mind should its price slide further.

Reynolds Consumer Products (REYN) – While Reynolds’ share price trades slightly above its own Covid low, it remains below its March 23, 2020 price (where the S&P 500 index bottomed) so it is included in this article. Originally part of aluminum company Reynolds Metals, this business was acquired in 2008 by New Zealand’s Rank Group, which is controlled by billionaire Graeme Hart. In February 2020, Reynolds completed its IPO at 26 a share. Hart continues to own a 74% stake. Today, Reynolds is comprised of two powerhouse brands: the iconic Reynolds brand of aluminum wrap, parchment paper, plastic wrap and other products, and the widely recognized Hefty plastic bags business. The company holds a #1 market share in nearly all of its product categories – a testament to its solid franchise and stability. Recent results were strong, but like many other consumer products companies Reynolds provided weak second-quarter guidance and tilted its full-year earnings guidance toward the low end of its guidance range due to higher costs. Yet the company is the low-cost producer, has been raising its prices, and the fact that 40% of its revenues that are sold as private label store brands helps provide market share and pricing defenses. Also, Reynolds should benefit if a recession drives consumers away from restaurants toward eating at home. The balance sheet carries a reasonable debt load, the share valuation is discounted and below peers, and the shares offer an attractive 3.4% dividend yield.

Verizon Communications (VZ) – Highly recognizable Verizon is among the very few mega-cap companies whose shares trade below their pandemic low. Part of this story is that the company’s membership in the responsibly competitive wireless oligopoly helped limit its declines two years ago. The company’s #1 position in wireless service (44% share) and broadband service (49% share), combined with the slow but steady secular growth in demand along with high barriers to entry, will likely provide it with healthy profits and cash flows for years to come. Recently, the shares slipped 13% as weak first-quarter new subscriber additions (possibly due to slowing economic growth or incremental market share losses) and rising costs led the company to trim its full-year revenue and earnings guidance. But the change in revenue guidance was tiny – from +1.5% growth to flat – and the earnings guide was merely toward the low end of its already-provided range. And AT&T announced that it is raising its prices, which will provide support to overall industry profits. Management is alert and capable and the balance sheet carries a reasonable debt load. The shares have begun to recover, yet still provide a worthwhile entry point for investors. The 5.2% dividend yield offers a secure and hefty cash return in a market where little else can be counted on.

Investment Management Stocks: Beaten Down Enough?
With the stock market sliding sharply this year, investors instinctively are exiting stocks of investment management companies. These companies manage the mutual funds, index funds, private equity funds and other investments on behalf of their customers, which range from everyday consumers (retail) to major pension plans. Some firms, like Blackrock (BLK), oversee a broad range of strategies that includes nearly every asset class from S&P 500 index funds to privately-owned wind farms, while others concentrate exclusively on a few closely related products.

Most companies generate revenues by charging fees based on the dollar amount of assets under management (AUM). As such, their revenues are heavily influenced by the rise and fall of the capital markets. Some companies charge performance fees – a bonus for outperforming portfolio benchmarks in exchange for lower base fees – which can be less sensitive to capital markets.

A standard strategy of all firms is to increase AUM and thus revenue growth regardless of market conditions. This may be accomplished by bringing in net new funds (inflows less outflows) from existing and new customers, which usually requires strong performance by their portfolios relative to their benchmarks. Consistently beating a benchmark is exceptionally challenging, making this source of AUM growth somewhat unreliable, made more difficult by the secular shift by customers to index strategies (particularly those indexed to the S&P 500). Companies therefore often turn to other strategies to generate growth, including launching new products and acquiring other investment companies. Incremental growth can also be produced through a shift toward higher-fee products.

As costs tend to be relatively fixed (it takes the same amount of effort to manage a $1 billion portfolio as it does a $100 million portfolio), profits are leveraged to AUM. In the short run, this makes investment management stocks high-beta versions of the stock market. Over the long run, the success of the company’s strategy and execution has a major effect on its share price.

All-in, it is no surprise that shares of these companies have fallen sharply this year, but it appears that investors have overly punished the group. And, in any major market rally, these shares would likely bounce hard. We note the discounted shares of several major firms, including T. Rowe Price (TROW), Franklin Resources (BEN), and Invesco (IVZ), but our focus in this article is the less followed companies that offer more interesting company-specific prospects. We discuss four attractive stocks below, and highlight this month’s feature recommendation, Janus Henderson Group (JHG).

AllianceBernstein (AB) – Formed by the 2000 merger of Alliance and Bernstein (two highly regarded investment firms, and includes Bernstein Research), this $685 billion AUM company seems to have finally resolved its lingering cultural, leadership and strategic issues. On the back of solid investment performance, as noted by its #2 ranking in Barron’s 2021 Best Fund Families analysis, AllianceBernstein recently produced its 20th consecutive quarter of net inflows, with $11 billion coming in during the first quarter. Overall revenue and profits are showing notable strength, as well. Its private wealth business generates a third of total fees, and this segment provides valuable stability along with a sizeable opportunity for new growth. Sensing the possibilities, the company aspires to double its total revenues over the next eight years. While much of the growth will come from organic sources, some will almost certainly come from acquisitions. AllianceBernstein recently bought private credit investor CarVal Investors for $750 million, and other deals seem to be in the pipeline. One question in investors’ minds is the resilience of AB’s fund performance, given that many of its funds featured heavy growth-tech exposure. Also, its limited partnership structure (owners receive K-1 statements) may reduce its appeal to some investors. AllianceBernstein pays a generous but variable dividend, and the overhang from further selling by former parent company Equitable Holdings has faded as Equitable now holds only 4% of the shares. Investors in AB could get a combination of high dividends and growth – rare in the investment management industry.

Pzena Investment Management (PZN) – This $50 billion AUM company is led by founder Richard Pzena, a former head of U.S. Equity Investments at highly regarded value manager Sanford C. Bernstein. Unlike diversified investment firms with many different strategies, Pzena Investment Management’s funds follow only one: an “unwavering focus on classic value investing.” While the company struggled during the booming growth stock era, the sharp turn in the markets toward value investing could bring a tide of new money into Pzena’s products. The company is well managed and has a very favorable reputation in the industry. One concern is its complicated capital structure that features several classes of shares, each with different and changing claims on the underlying company’s profits. Also, its average fee rate is below industry averages as it manages, on a sub-advised basis, investment products for other investment firms. All-in, however, it looks like the stars may finally be aligning for this firm.

Closing prices on May 20, 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 2022. For AllianceBernstein and Pzena, due to the companies’ organizational structure, EV/EBITDA is not meaningful, so the multiple shown is price/earnings.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Victory Capital Holdings (VCTR) – Victory is a multi-boutique company, as it owns 12 separate investment companies with their own unique strategies. This structure gives the investment managers plenty of autonomy to maintain their culture and produce strong returns, while it also improves the effectiveness and efficiency of the marketing and administrative functions by centralizing them. Victory is a relatively new firm, created by a buyout of KeyBank’s investment management firm in 2013 with the help of Crestview Partners which still retains a 41% stake. Since then, the firm has grown from $18 billion in AUM to the current $166 billion. Helping drive the growth was the transformative purchase of USAA’s mutual fund, ETF and 529 college savings plan business in 2019. This deal more than doubled Victory’s asset base, expanded its range of offerings and provided a valuable stamp of approval as USAA likely wanted a high quality and reliable buyer for its branded fund business. Acquisitions are a central component of Victory’s strategy, so its ability to find and complete sensible deals at sensible prices is critical. So far, the evidence is quite favorable. The strategy has led to an elevated debt burden (at 2.8x adjusted EBITDA), but the company appears to be taking a sound approach to managing its debts, bolstered by strong free cash flow generation. We like its recent shareholder friendly steps of repurchasing shares while also eliminating its dual class stock structure. Favorable investment performance and its sensibly innovative distribution platform are helping bring in a steady flow of new assets. Overall, this interesting young firm has attracted our attention and looks worthy of a starter position.

Westwood Holdings Group (WHG) – Dallas-based Westwood was founded by Susan Byrne in 1983, who still serves as Vice Chairman and remains a 3% shareholder. The company is a boutique investment firm with $14 billion in AUM, of which about 58% is in value-oriented, high-conviction equity strategies. The shares started on a downward slide in mid-2018 as Westwood struggled with sizeable asset outflows, due partly to weak fund performance and other issues, which led to problem issues and a slashed dividend. However, Westwood took meaningful steps to right its ship by overhauling its investment and operating teams, which appears to have worked. While net fund flows were modestly negative in the most recent quarter, its products continue to outperform their benchmarks. The balance sheet is sturdy with $74 million in cash and no debt. Most employees own shares in the company and the employees and directors own 22% of the total share base – fostering an entrepreneurial, resilient and independent attitude which helped it fend off an unsolicited and undervalued takeover offer last year. Two knocks on the firm are that its CEO pay is elevated for a firm of its size and that management hasn’t driven more growth in the company’s asset base. These could lead to more pressure from activist investor JCP which continues to hold a 10.5% stake in Westwood.

RecommendationS

Purchase Recommendation: Janus Henderson Group plc (JHG)

Janus Henderson Group plc (JHG) 201 Bishopsgate London, United Kingdom EC2M3AE +44 (0) 20 7818 1818 www.janushenderson.com

Symbol: JHG Market Cap: $4.5 billion Category: Mid Cap Business: Investment Management Revenues (2022e): $2.4 Billion Earnings (2022e): $490 Million 4/29/22 Price: 27.17 52-Week Range: 25.76-48.55 Dividend Yield: 5.7% Price target: 41

Background
Janus Henderson Group is a global investment management company with $361 billion in assets under management (AUM). The company offers a range of equity (about 57% of total AUM), fixed income (18%), multi-asset (14%), quantitative (9%) and alternative (2%) strategies to its clients, which include retail, advisor and institutional investors. About half of its assets are sourced from outside of North America.

The company was created by the 2017 merger of Denver-based Janus Capital Group and London-based Henderson Group. At the time, the combination brought hopes that its larger scale, stronger distribution and market position, and complementary investment capabilities would produce faster growth and a more valuable firm. Some important measures have improved: operating profits are 33% higher on wider margins, its share count has fallen by 18% and the dividend is 22% higher.

However, the strategic rationale has not been achieved. Revenues are unchanged despite the hopes for new growth, and AUM remains essentially unchanged. A chronic problem is net asset outflows – clients are pulling their funds out of the company’s products faster than new money is coming in. Underlying this issue is that Janus Henderson’s products are underperforming their benchmarks. In the most recent quarter, only 62% of its AUM were in products that outperformed their 3-year benchmarks. This is dismal, and well below the 77% rate shortly after the merger. And the secular trend toward index products, particularly those tied to the S&P 500, only raises the penalty for underperformance.

Janus Henderson shares have fallen over 40% from their November 2021 all-time high and remain about 10% below their 2017 post-merger price. In addition to worries about continued asset outflows, investors worry about the effects of further declines in the stock market. Both of these would weigh on the company’s value, as Janus Henderson’s revenues and hence profits are directly linked to AUM. An additional headwind is that many of the company’s investment strategies have a strong growth orientation, which have fallen sharply out of favor this year. A smaller but notable issue is the strength of the U.S. dollar, as a significant portion of the company’s revenues are generated outside of the country.

Analysis
The company’s low valuation and chronic problems have attracted the attention of noted activist investor Trian Partners, led by Nelson Peltz. Trian took an initial 9.9% stake in Janus Henderson in October 2020 and recently raised its holdings to 19%, making it the firm’s largest shareholder. Along with its larger ownership stake, the activist has implemented major leadership changes including replacing the CEO (effective June 2022) and taking two board seats (Peltz and noted turnaround manager Edward Garden, both of Trian).

The new CEO, Ali Dibadj, brings an impressive set of capabilities. He joins Janus Henderson from AllianceBernstein, where he has been the CFO, head of strategy and a top-ranked research analyst. Previously he was a McKinsey consultant and has degrees in engineering and law. Last month, the chief investment officer departed in what likely will be the first among many staffing changes. Also, Janus Henderson announced the sale of its Intech quantitative strategy operation, which has an abysmal performance record and drives much of the entire company’s outflows of assets.

Trian will likely take a wait-and-see, behind-the-scenes approach with the expectation that the new CEO will make meaningful changes to turn around the marketing and investment performance. Part of the firm’s problems likely stem from the culture clash of combining a firm based at the foot of the Rocky Mountains with a firm ensconced in London. Trian and Dibadj may ultimately determine that the two firms make an unwieldy combination and thus decide to split up the company or sell it entirely. Rumors of a sale to Invesco (IVZ), where Trian holds a 12% stake, have been floated, but we view this as an unlikely outcome. All-in, Trian’s highly visible involvement gives them a strong incentive to make this turnaround successful.

Janus remains highly profitable and should continue to generate as much as $450 million of free cash flow a year, equal to nearly 14% of the company’s enterprise value. The balance sheet is fortress-like, with over $500 million of cash net of debt. The firm has started a share buyback program and recently raised its dividend, which now produces a 5.7% dividend yield. At 5.2x estimated 2022 EBITDA, the shares are trading at a discounted valuation. The 8% loss from our previous Cabot Turnaround Letter recommendation of JHG shares reflects the difficulties of investing in this company, but the current setup looks favorable, particularly with Trian’s involvement.

We recommend the purchase of Janus Henderson Group (JHG) shares with a $41 price target.

Ratings and Price Target Changes
On May 19, we moved shares of Altria Group (MO) from Buy to Sell. While the shares were 23% below our 66 price target, the risk/return trade-off has become unfavorable. The primary increase in risk comes from Philip Morris International’s likely acquisition of Swedish Match. PMI has made an all-cash offer and we believe a definitive deal is likely, as the Swedish Match board has agreed to the transaction. With the combination, Philip Morris would re-enter the United States market and pose a new and more aggressive competitive threat to Altria in the critical smokeless tobacco products segment.

Philip Morris was spun off from Altria in 2008 and sells Marlboro and a range of other tobacco products globally with the exception of the United States, whereas Altria has the U.S. market for these products. Philip Morris would gain access to Swedish Match’s U.S. smokeless and non-tobacco products, including oral nicotine pouches where it would have a powerful 64% market share compared to Altria’s 18%. Further, PMI could drive its vaping and other non-smokable tobacco products through the newly acquired manufacturing and distribution channels in a direct threat to Altria’s market share.

This adds to our concerns about Altria’s future, where tobacco industry unit volumes have resumed their 5%+ decline, where consumers are reining in spending due to inflation (hindering Altria’s ability to continue to raise prices) and a slowing economy, and where there’s potential risk from a government ban on menthol cigarettes, which generate an estimated 20% of Altria’s profits.

Altria has little financial room for profit weakness. It currently pays out close to 90% of its free cash flow as dividends – any further threat to the dividend (especially as its 7% yield is helping support its share price) would lead to share price pressure. Similarly, the business value has downside if the otherwise stable earnings and cash flow start to weaken.

The MO recommendation generated an approximate 27% total return since our initial recommendation at 43.80 in our March 2021 edition of the Cabot Turnaround Letter.

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. Price target in parentheses.
3. Total return includes price changes and dividends, with adjustments as necessary for stock splits and mergers.
4. SP - Given the unusually high risk, we consider these shares to be speculative.
5. *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 June 29, 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).