February 23, 2022

Thank you for subscribing to the Cabot Turnaround Letter. We hope you enjoy reading the March 2022 issue.

In what could be a low-return market over the coming decade, stocks of relatively boring companies have a better chance to shine. We highlight five companies with grind-it-out growth, low share valuations and often-generous dividends that could produce significant market-beating returns.

We also discuss six appealing stocks we found by trolling through the 13F/D filings of like-minded institutional investors.

Our featured recommendation this month is Goodyear Tire & Rubber Company (GT). An investment in Goodyear is an opportunistic purchase of an average company whose shares have fallen sharply out of favor for what look like short-term reasons.

We note our recent price target increases for Wells Fargo (WFC), Marathon Oil (MRO) and Shell plc (SHEL).

Attractive Turnaround Stocks

Like Watching Paint Dry?
There is no doubting the immense strength of the U.S. stock market over the past decade. Since early 2012, the S&P 500 has surged at an annualized pace of over 12%, with dividends adding to those gains. This is much faster than the average 10-year rate of 9.2% over the past century and a half. Propelling these gains have been a robust economy, exceptionally low interest rates, generous monetary stimulus and lavish fiscal spending, all of which have contributed to strong corporate earnings growth and elevated valuations.

Yet, it seems unlikely that returns can maintain this tempo over the next decade. Even if earnings continue to grow at an above-trend 8% rate, the stock market would need to trade at a lofty 29x earnings multiple in 2032 for the S&P 500 to match the prior decade’s performance. A repeat would be highly challenging, particularly with the loss of bountiful fiscal and monetary stimulus, the fading of easy global trade, and the addition of possible secular headwinds like inflation and geopolitical conflict. For those that look askance at the chances of an uninspiring decade ahead, one only needs to note the zero change in the S&P 500 over the dozen-plus years from 2000 to 2013.

In a lower-return environment, stocks of relatively boring companies have a better chance to shine. Their gains may come more slowly, and with less pizazz, than those of hot IPOs, speculative biotech and emerging tech companies of the now-past era, but their grind-it-out growth from selling tangible, everyday products, combined with low current share valuations and often-generous dividend yields, could produce significant market-beating returns over time. Sometimes boring is better.

Discussed below are five companies that fit this description, whose stocks may be as dull as watching paint dry, but may also provide the confidence that, yes, eventually paint does dry.

Allison Transmission Holdings (ALSN) – Many investors reflexively dismiss this company, viewing it as a low-margin producer of car and light truck transmissions that is destined for obscurity in an electric vehicle world. However, this view would be incorrect. Allison produces no car and light truck transmissions, instead it focuses on the school bus and Class 6-8 heavy-duty truck categories, where it holds an 80% market share. Its 35% EBITDA margin is sharply higher than its competitors and on-par with many specialty manufacturers. And, it is a leading producer and innovator in electric axles which all electric trucks will require. Another indicator of its advanced capabilities: Allison was selected to help design the U.S. Army’s next-generation electric-powered vehicle. The company generates considerable free cash flow, which has helped it maintain a low-debt balance sheet. Its capable leadership team keeps its shareholders in mind, as the company has reduced its share count by 38% in the past five years. While ALSN qualifies for a “like watching paint dry” stock, it also fits our 13F criteria, as noted value investment firm Polaris Capital Management recently took a sizeable position (1.5% stake) in the company.

Bristol-Myers Squibb (BMY) – Investors have dismissed shares of pharmaceutical maker Bristol-Myers, as several of its key products, including Revlimid (starting this year) and Opdivo and Eliquis (starting in 2026) will face patent expirations. These three products comprise nearly two-thirds of the company’s current revenues. Bristol is working to replace the eventual revenue losses by developing its robust product pipeline while also acquiring new treatments (notably with its acquisitions of Celgene and MyoKardia), and by signing agreements with generics competitors to forestall their competitive entry. Its efforts are led by a shareholder-aware management team that is backed by a solid, investment-grade balance sheet and as much as $15 billion a year in free cash flow.

As outlined in our Buy-recommendation thesis for BMY in the Cabot Undervalued Stocks Advisor, we think the likely worst-case scenario is flat revenues over the next 3-5 years. Once the company’s revenue and profits are proven sustainable, investors should be well-rewarded for their patience, but this might take a while. During the wait, shareholders will receive an easily supported 3.6% dividend yield.

Energizer Holdings (ENR) – Spun off from Edgewell Personal Care in 2015, Energizer is a major producer of disposable batteries (including Energizer and Eveready), portable lighting and various car care products. With its 2019 deal with Spectrum Brands, Energizer added the Rayovac battery brand as well as auto care products like ArmorAll and STP to its portfolio. Now in a duopoly with Duracell, the company should be able to gradually raise prices for its batteries, helping to preserve its margins as the industry resumes slow but steady growth after the pandemic. Its car care segment generates healthy growth but seems less appealing given its lower barriers to entry, so perhaps its deal-oriented CEO (a lawyer by training) will divest this business after a few years.

Like many companies, Energizer is struggling with limited prospects for near-term growth due to tough comparisons from a strong 2021, as well as elevated cost pressures and a debt overhang that the company is paring down, so there is little to charge up the shares near term. But for patient investors, the shares pay an attractive 3.5% dividend while they wait for more electric returns in a year or so.

Intel Corporation (INTC) – After losing its lead in the never-ending battle for semiconductor supremacy, Intel is aggressively working to catch up. Under its new CEO, Pat Gelsinger, a former company executive and then CEO of VMWare who rejoined Intel a year ago, the company plans to spend as much as $30 billion a year to upgrade and expand its manufacturing capabilities, as well as invest billions more to accelerate its development of new chips. Even with likely federal government support and a healthy semiconductor end-market, these programs, along with its generous dividend, will consume essentially all of Intel’s cash flow for years to come. Intel’s $28 billion cash hoard, almost fully offsetting its modest (about 1.2x EBITDA) debt balance, provides valuable stability. But, as the eventual outcome of this bold yet risky strategy is very murky, the shares could meander for years. However, expectations are low, so once the company emerges (successfully, we believe), long-term investors could be well rewarded.

Unilever plc (UL) – London-based consumer giant Unilever, with nearly $60 billion in revenue, has a roster that ranges from laundry detergents and hand soaps to nutritional care and ice cream. This sprawl has led to chronic underperformance: its shares remain essentially unchanged since mid-2014. Overseeing the company is a relatively new CEO, Alan Jope (since January 2019), but he is a 37-year company veteran with essentially no experience outside of Unilever. His turnaround strategy, which has included efficiency measures, the divestiture of the iconic but slow-growth Lipton tea business and consolidation of its headquarters in London, hasn’t produced much improvement in operating results nor gained any traction with investors. Its attempt to buy GlaxoSmithKline’s consumer goods business was rejected as inadequately priced.

If the turnaround is successful, it will be slow-moving, given the company’s heft and sluggish pace. Even with the new presence of activists like Trian Partners, who catalyzed change at Procter & Gamble, investors might need exceptional patience. However, the 3.9% dividend yield combined with the unusually low valuation may make this stock well worth the wait.

Using 13F/D Filings to Find New Ideas
Among our tools for finding interesting new ideas are regulatory filings at the Securities and Exchange Commission (SEC). All institutional managers of $100 million or more are required to file 13F reports within 45 days of the end of every calendar quarter. These investors want to keep their best ideas secret, but the 13F discloses their holdings, allowing everyone to see them. The most recent filings were due on February 15.

The Form 13D is another useful regulatory filing. Any investor accumulating a beneficial ownership of 5% or more of any voting class of a company’s SEC-registered equity securities must report their position within 10 days of reaching the threshold. This filing can tip off the market that an activist is preparing a campaign against a company. In many cases, activist investors buy just under 5% to avoid this report, or may rush to accumulate larger positions within the 10-day window before revealing their stake. In some cases, if an investor declares that they have no intent of influencing control and own less than 20% of the voting shares, they may file a 13G instead, which has easier reporting requirements. When a 13G investor switches to becoming a 13D investor, it can signal the onset of an activist campaign.

Our 13F/D idea sourcing process concentrates on the filings of an evolving roster of over 50 value-oriented managers. We look for either top holdings which have been added to or major new holdings, as these indicate a higher degree of confidence and favorable timing. We then cull the list to more precisely fit our criteria. As long-term investors, we have an advantage – longer holding periods for turnaround stocks means that the regulatory filings remain relevant for longer. It doesn’t make much sense to see what a momentum investor was holding on December 31st if their high-turnover strategy means they probably have sold the position by February 15th.

These reports also allow us to see who the major holders of Cabot Turnaround Letter candidate stocks are – valuable input into the mosaic of information about the consensus view. Is it a “hedge fund hotel” (mostly held by hedge funds, which have notoriously fickle attention spans), or index funds, or savvy long-term value investors? We also monitor major holders of our recommended stocks.

Listed below are six stocks that have favorable changes to their ownership base that also meet many of our turnaround candidate criteria.

Encompass Health Corp. (EHC) – This company, formerly named HealthSouth, is the nation’s largest owner and operator of inpatient rehabilitation facilities and a leading provider of skilled home-based health and hospice services. Encompass has a strong in-hospital franchise that allows it to provide high-quality treatments to high-acuity patients at lower cost, while its home/hospice care segment is well-positioned for the growing elderly demographic. After a strategic review last year, Encompass will spin off its home/hospice segment sometime before June. This smaller segment has struggled with labor and other issues that have been heightened by the pandemic. Once independent, both companies could receive higher valuations than the current 9.6x EBITDA multiple.

However, respected activist investor Jana Partners owns about 3% of the shares and is pressuring the company to sell its home/hospice business to a private equity buyer which could generate higher value to shareholders. Jana may nominate a highly regarded turnaround executive to the company’s board to advance its ideas. Well-regarded Wellington Management recently raised its position and is the #2 shareholder at 11%.

Koninklijke Philips NV (PHG) – Former conglomerate and Netherlands-based Philips, which was founded in 1891, now focuses on health technology products including diagnostic imaging equipment, respiratory care, electric toothbrushes and others. The shares have slipped by over 40% since mid-2021 and remain unchanged since nearly 20 years ago. Plaguing the company is a steady headwind of pricing pressure due to tighter spending controls at hospitals as well as rising competition in many of its categories that offset Philips’ impressive technological prowess and entrenched position at many of its customers. Given its chronically weak share performance, its overly-broad array of products, underleveraged balance sheet and low valuation at 9.4x EBITDA, Philips looks primed for activist pressure. Investment firm Harris Associates, home of the highly regarded and value-oriented Oakmark fund family, recently raised its stake to just over 4%, suggesting that the shares offer appealing turnaround potential.

Meta Platforms (FB) – One might think that FB is about the last stock that a value/contrarian investor would consider. Meta, of course, is the new name for Facebook, perhaps the most iconic social media platform of its time. Nearly a third of the world’s population, or 2.9 billion people, use the Facebook app on a regular basis. But, Facebook’s era is fading as younger users move on to other trendier services while fewer new users join. Dozens of acquisitions since 2005, including Instagram and WhatsApp, were completed with hopes of extending the franchise’s reach and duration, but this strategy has produced mixed results.

Reflecting the fading growth, as well as Apple’s new privacy rules that threaten to shrink Facebook’s ad revenues, Meta shares have fallen 44% from their high and now trade in line with their mid-2018 price. What is the appeal now? One is its discounted valuation, at only 8.4x EV/EBITDA. Others: despite the headwinds, Meta continues to generate healthy 20% revenue growth, wide operating margins of 37%, immense free cash flow (estimated at $45 billion this year), is repurchasing its shares (3% in the fourth quarter), and has a fortress balance sheet with $48 billion in cash and zero debt. Even if earnings growth slows to 5% (about a third of current growth estimates), Meta shares look cheap. We put little credibility on its metaverse aspirations, but its Oculus franchise means that whatever the metaverse ends up becoming, Meta will likely have a presence there. Noted value investor Dodge & Cox, as well as respected hedge fund Marshall Wace, recently took sizeable stakes in Meta. Perhaps the most contrarian investment is the one that is in plain sight.

Norwegian Cruise Lines Holdings (NCLH) – Bill Miller, who left Legg Mason over 20 years ago to launch Miller Value Partners, is widely recognized for thinking differently about stocks. His selection of Norwegian Cruise Lines certainly requires this trait, as the company continues to struggle with high costs and low passenger counts resulting from the lingering effects of the pandemic. Fourth-quarter cash operating losses are expected to be $(320) million – deeply negative compared to the $383 million profit in the fourth quarter of 2019.

However, the company has begun a phased relaunch of its cruise ships, with 70% of its berth capacity currently operating with guests on board and the full fleet operating by April or so. Pent-up demand for cruises appears robust, as bookings for the second half of 2022 are already in line with the comparable period in 2019, while pricing exceeds the two-year-ago level. Cash-rich customers might readily splurge on high-margin on-board extras, further bolstering Norwegian’s profits. After years of cash burn, the company said that it should generate positive operating cash flow in the upcoming second quarter. A recent restructuring raised cash, reduced its share count and pushed out its debt maturities, such that new equity issuances are likely off the table.

While Norwegian faces ongoing Covid risks, elevated capital spending, rising fuel costs and a possible carbon emission tax, it’s easy to see why Bill Miller finds these highly out-of-favor shares attractive.

PVH Corp (PVH) – This company, one of the largest apparel companies in the world, owns the Tommy Hilfiger and Calvin Klein brands. PVH shares remain 40% below the high set in mid-2018, partly due to concerns about the future of branded apparel, and more recently due to an otherwise encouraging third-quarter report that showed disappointing revenue growth. Yet, PVH is undertaking strategic improvements, driven by the capable and relatively new leadership (since 2021) of chair and CEO Stefan Larsson. Its recent sale of its Heritage Brands segment which included Izod, Van Heusen and other trademarks is improving its focus on its two primary brands, leading to better execution and eventually higher margins. Sale proceeds, along with tighter financial management, has reduced PVH’s debt to a modest 2.1x EBITDA. And, high marks for sustainability are boosting its brands’ appeal to its customer base which is increasingly attuned to these traits.

Near term, the company should benefit from the post-Omicron reopening, particularly as it produces two-thirds of its revenues outside of the United States. The shares trade at a discounted 6.6x EBITDA, which has increased their appeal to deep-value investor Pzena Investment Management, PVH’s second-largest shareholder, which recently raised its stake to 11%

Motorcar Parts of America (MPAA) – This small-cap company is one of the nation’s largest producers of remanufactured and new automotive after-market parts. MPAA shares have fallen 60% from their all-time high of $40 in 2015 and are down a third from their mid-year price last year, leaving the valuation at a discounted 4.5x EBITDA. Yet, investor worries about Motorcar Parts’ future appear to be misplaced. The company’s focus on non-discretionary parts, including brakes, alternators, starters and wheel bearings, where it has a strong and growing market share, provide it with a solid franchise. Industry demand will likely remain robust both near term (as workers become commuters again) and long term (due to an aging fleet of vehicles). Recently reported third-quarter results, in which sales grew 32%, buttress this view.

Like at many companies, normally healthy profits have been crimped by supply chain issues, but Motorcar Parts looks likely to recover. The company is expanding its electric car diagnostic and control capabilities – and won an important contract with NASA for its Mars mission – highlighting its initiatives to bridge this eventual shift. The balance sheet carries modest debt. Small-cap specialist Rutabaga Capital as well as earlier-noted Pzena Investment Management, hold sizeable stakes in the company.

New Recommendations, Updates and Performance

RecommendationS

Purchase Recommendation: Goodyear Tire & Rubber Co. (GT)

Goodyear Tire & Rubber Co. (GT) 200 Innovation Way Akron, Ohio 44316 (330) 796-2121 Corporate.goodyear.com

Symbol: GT Market Cap: $4.5 Billion Category: Mid Cap Business: Tire Mfg. Revenues (2021e): $20.6 Billion Earnings (2021e): $657 Million 2/18/22 Price: 16.01 52-Week Range: 13.45-24.89 Dividend Yield: 0% Price target: 24.50

Background
Goodyear is the largest tire manufacturer in the United States and third-largest in the world. Founded in 1898 in Akron, Ohio by descendants of Charles Goodyear, who developed the vulcanization process that properly cured rubber, the company pioneered the automobile tire industry. An independent public company since 1927, nearly all of Goodyear’s growth has been from organic expansion, other than its $3.3 billion acquisition of Cooper Tire in 2021. Today, Goodyear sells a full range of tires for passenger, heavy trucks and specialty vehicles around the world. About 80% of its volume is for replacements, with the balance sold to vehicle manufacturers.

Goodyear has struggled for decades due to steady competition and high fixed costs, combined with the ironic trait that the industry’s efforts to create higher-quality, longer-lasting tires reduce the demand for replacements. The company’s shares have gone nowhere in 20 years.

The acquisition of Cooper Tire removed a competitor and offers the potential for sizeable cost synergies, along with $450 million of value from tax savings. Investors bid up GT shares by 20% on the news, suggestive of the merits of the combination. While fourth-quarter results, reported on February 11, were encouragingly strong, the company warned that profits in 2022 would be sub-par and free cash flow would be zero instead of the hoped-for $500 million or so, due to higher working capital and a bump-up in capital spending. Disappointed investors aggressively sold the shares, which fell 27% on the news. The shares now trade only modestly higher than just before the Cooper merger announcement.

Analysis
An investment in Goodyear is an opportunistic purchase of an average company whose shares have fallen sharply out of favor for what look like short-term reasons.

Goodyear’s business value is driven by the long-term enduring demand for its products. Regardless of the eventual transition to electric vehicles, which may require higher-technology tires that could actually create a profit tailwind for the industry, tire demand is not going away anytime in the foreseeable future. Volumes look poised to recover from the pandemic weakness as workers return to the roads. A further volume boost comes from vehicle manufacturers, which are ramping up production as the semiconductor shortage fades. Demand for heavy-duty truck tires and other specialized and high-margin tires continues to rebuild. Goodyear is well-positioned to gain market share as it improves its distribution and tire offerings, including EV-fitted tires.

Rising costs threaten Goodyear’s margins, and this is perhaps investors’ biggest worry. Yet, consumers are showing no resistance to the company price increases, which should continue to more than offset Goodyear’s higher raw materials costs as well as much of its elevated labor, transportation, energy and other costs. Its prices for automakers and specialized customers are generally indexed to raw material inflation, helping the company bypass a potential source of incremental margin pressure. Competing tire makers face similar input cost pressures, thus curtailing price competition. And, constraints on imports from lower-priced Asian tire makers are helping further reduce pricing risks.

All-in, recovering volumes plus pricing strength should provide a stable revenue and core profits stream for Goodyear.

In addition, sensible savings from removing duplicative production, overhead and distribution costs through the Cooper acquisition are already adding incremental profits. Over the next two years, total savings of $250 million, up from initial guidance of $165 million, remain on track. Healthy core profits combined with the cost savings should help Goodyear return to an 8% profit margin, and possibly higher, by 2024.

Investor disappointment with Goodyear’s free cash flow outlook for 2022 seems overdone. The company sensibly wants to rebuild its inventory, draining $300 million of cash flow this year, but this won’t recur next year. Its capital spending, elevated for the next year or two by as much as $300 million, is being invested in highly valuable projects that should boost future profits. While the loss of free cash flow this year means limited or no paydown of Goodyear’s modestly elevated debt from the Cooper acquisition, the company has over $1 billion of cash and no maturities until 2025, providing it with plenty of financial flexibility.

While the risks with a Goodyear investment aren’t modest, the returns look attractive for patient investors, helped in no small part by the depressed $16 share price and low valuation at 4.5x EBITDA.

We recommend the purchase of Goodyear Tire & Rubber (GT) shares with a 24.50 price target.

Price Target Change
On February 11, we raised our price target on Wells Fargo (WFC) from 55 to 64. Rising interest rates are boosting the bank’s underlying profitability, while Wells is also making progress with its regulatory relief initiatives. The shares trade at 1.6x tangible book value, which is too much of a discount to its healthier peers that trade around 2.4x.

Also, we raised our price targets on Marathon Oil (MRO) from 18 to 24 and on Shell plc (SHEL) – formerly named Royal Dutch Shell (RDS/B) – from 55 to 60 as these shares remain inexpensive relative to oil prices in the $90-100/barrel range. However, if we lose confidence that oil prices will remain in this range, we could exit some or all of these shares before they reach our new price targets.

You can find more details by visiting our website at cabotwealth.com.

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 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, plus recently closed out recommendations. For additional details, please visit cabotwealth.com.

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 higher 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 March 30, 2022.