January 26, 2022

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

The market seems to be ignoring small- cap stocks. We highlight four high-quality small- cap companies with beaten down share prices. And, amidst the rubble of initial public offerings, we found three worthwhile companies whose shares trade below their IPO price. We also briefly comment on the market’s recent sell-down, and provide an update on the performance of our group of recommended stocks, which have held their value so far this year.

Our featured recommendation this month is Polaris (PII), the leading North American manufacturer of powersports equipment including off-road vehicles, snowmobiles, motorcycles and boats. Investors are overly -discounting near-term issues, leaving the shares significantly undervalued.

We note our recent price target increase for Baker Hughes Company (BKR), from 26 to 31.

Attractive Turnaround Stocks

Four High-Quality but Beaten Down Small-Cap Stocks
While investors focus on the mega-cap stocks like Apple, Amazon, Microsoft and Nvidia, as well as hyper-growth tech stocks in general, small-cap stocks remain neglected. Interestingly, since year-end 2019, performance of the major market indices has correlated strongly with their market caps – mega-caps have had the best returns, with large caps next, and so on to the bottom drawer of small-cap stocks.

Some of this bias is justified. The small-cap realm is heavily populated with mediocre companies that couldn’t graduate to the major leagues, as well as a large representation of previously -promising biotech and other fast-growers that faded, only to drag down the performance of the entire small cap group.

Yet within the small- cap space, there clearly must be some hidden value – high-quality companies with solid business models that have had their share prices beaten down for temporary reasons. Listed below are four companies that fit the bill. Each trade on a major exchange and haves plenty of liquidity.

CIRCOR International (CIR) – Based in Massachusetts, CIRCOR is a leading producer of severe service flow control equipment and other highly engineered products for industrial, aerospace, and defense companies around the world. Investors have steadily lost confidence in the company over the past eight years due to its former high exposure to the energy sector, along with unfulfilled growth promises. Not only have the shares failed to recover to their year-end 2019 level, they remain 67% below their 2014 peak that coincided with the prior top in oil prices. Although CIRCOR has diversified its revenues away from the energy industry, frustration with the pace of CIRCOR’s progress led the board to fire its CEO (eight-year tenure) last week. This exit followed last month’s departure of the CFO, adding to a series of short-tenured CFOs. The turnover could indicate internal accounting issues, or that major and favorable changes may be coming to the company. CIRCOR has stable revenues, generates profits and free cash flow, and is emphasizing reducing its elevated debt burden. Trading at 9x EBITDA, the shares appear to discount what could be a much brighter future.

DistributionNOW (DNOW) – Spun -off from drilling rig outfitter National Oilwell Varco at the top of the last energy market peak in 2014, DistributionNOW is one of the largest distributors of energy industry parts and supplies. Its global inventory of 300,000+ stock-keeping units, its e-commerce platform, and its operations in over 20 countries all provide it with a key role in the global energy industry supply chain. The company’s shares have fallen 75% from their 2014 high, and remain 20% below their 2019 price. Yet, the company is now generating profits and positive free cash flow even at the bottom of the cycle.

Surging oil and natural gas prices should lead to more drilling activity, which would directly benefit DistributionNOW. The company has a debt-free balance sheet and holds $312 million in cash (about $3/share). Trading at 9.0x depressed 2022 estimated EBITDA, the shares look primed for a rebound.

Closing prices on January 21, 2022.
* Enterprise value/earnings before interest, taxes, depreciation and amortization. Based on consensus estimates for calendar years ending in 2022. Credit Suisse multiple is price/tangible book value.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.
Disclosure: The chief analyst personally owns shares of all Cabot Turnaround Letter recommended stocks, including the stocks mentioned in this article.

Marcus Corporation (MCS) – Wisconsin-based Marcus owns the nation’s fourth-largest movie theater chain. It also owns eight hotels and operates ten others for third parties. The sharp decline in the shares, including the recent sell-off, reflects the pandemic’s effects on revenues and profits at both businesses. Yet, the 5.5x EBITDA multiple seems to overly -discount the recovery now underway as well as the company’s high quality. Earnings this year will likely be about three-quarters of their pre-pandemic level and should fully recover by next year. Audiences are starting to return to theaters, and this year’s movie slate looks strong, including Top Gun: Maverick, Doctor Strange, and Mission Impossible 7. We believe the shorter theatrical exclusivity window (45 days down from 75) will have only a minimal effect on attendance. Marcus’ theaters historically draw above-average attendance, reflecting the quality locations and management. The hotel segment, with generally higher-end rooms, tilts toward business travel which remains subdued, but Marcus is succeeding in boosting leisure accommodations. The balance sheet has modest debt and the company is currently cash flow positive. The founding Marcus family, who holds a controlling 70% of the shares, remains highly -attentive to the business. A hidden asset is its vast land-holdings beneath the majority of its theaters.

Unifi (UFI) – This old-school maker (founded in 1969) of polyester yarns and fabrics remains highly relevant in the global apparel, automotive, home furnishings and industrial markets. Its proprietary Repreve® fiber, an innovative product that uses recycled plastics, continues to gain market share and now comprises 37% of Unifi’s revenues. More customers are finding that Repreve helps them meet their sustainability goals – which are increasingly noticed by today’s consumers. Unifi’s sales are recovering sharply and are trending above their pre-pandemic level. Gross margins have expanded to 13.3% from about 10% pre-pandemic – suggesting that the company is successfully navigating the complicated cost and supply chain issues. The balance sheet carries modest debt, of which more than half is offset by cash. We note that Home Depot founder Ken Langone, and highly regarded activist firm Inclusive Capital, led by former ValueAct head Jeff Ubben, hold a combined 15% of the shares, suggesting there is more to this company and its management than its mere fiber-spinner narrative, and 6.5x EBITDA multiple, would suggest.

Three Worthwhile IPOs Amidst the Rubble
After two years of exuberance, it appears that the initial public offering party is rapidly winding down. It was quite a blowout. A typical year might see 160 IPOs which raise about $40 billion. But, in 2020, investors welcomed 221 new companies to the market, raising $78 billion, only to be topped by 2021 which featured 399 IPOs (a post-2000 record) that raised $142 billion (an all-time record). These 2021 totals exclude SPACs – including these nearly doubled the merriment: last year saw 613 SPACs make their debut, collectively raising $145 billion. It was a party for the ages.

Value investors, however, were mostly left out in the cold. Few deals combined worthy companies and attractive valuations. The Cabot Turnaround Letter captured the Albertsons (ACI) IPO, producing a 94% gain, but we missed Eastern Bankshares (EBC). Most offerings failed on one or both of these traits, as they were either purely speculative SPACs and biotechs, extremely expensive and loss-producing hyper-growth concepts, dubious China-based companies, or had tenuous business models – of which do-it-yourself orthodontics company Smile Direct Club (SDC) is a superb example (down 92% from the IPO price).

We estimate that at least 78% of all IPOs from 2020-2021 now trade below their IPO price. Losses from the all-too-common post-IPO price spike are much larger. Shares of highly -touted Robinhood (HOOD), for example, have fallen 66% from their IPO price but 85% from their all-time high. This type of performance is why many value investors rephrase the IPO acronym to mean, “It’s Probably Overpriced.”

Yet, the closing of the IPO window means the opening of opportunity for valuation-sensitive investors. Lower share prices bring valuations of worthy companies into an attractive range. And, if companies decide to go public in a weak market, buyers have the upper hand in deal pricing.

Listed below are three worthy companies with shares that have declined from their IPO price. All of the companies offer recognizable products and services, have sound business models executed by capable managements, are solidly profitable and are backed by reasonable balance sheets. We may be early on these names, as investor sentiment could continue to drive down their share prices. And, sometimes it takes a few quarters or more for companies to adapt to life in the public markets, which can bring temporary sell-offs. Potential investors may want to nibble on these, then become more aggressive on any meaningful weakness.

Other IPO companies, including Arhaus (ARHS), Enact Holdings (ACT) and Sun Country Airlines Holdings (SNCY), were close to making our list but fell short on valuation or pricing relative to their IPO price. These also are worth watching closely.

Krispy Kreme (DNUT) – While its founding in 1937 suggests longevity and stability, Krispy Kreme’s reality has been the opposite. Its acquisition by food conglomerate Beatrice Foods in the 1970s went so poorly that a group of frustrated franchisees acquired it. Renewed popularity in the 1990s led to a highly -enthusiastic reception to its 2001 IPO. But, mismanagement, over-zealous growth, accounting fraud and the low-carb trend nearly led to its collapse by 2005. The company gradually cleaned up its operations and was acquired by JAB Holdings, a well-run German firm that also holds minority stakes in firms like Coty and Peet’s Coffee and made successful investments in Keurig Dr Pepper and Panera Bread. Now under capable and credible leadership, Krispy Kreme continues to overhaul its business model to emphasize quality, freshness, and efficiency, while shifting away from a franchise approach toward company-owned stores to help ensure consistency and execution. Also, management is leveraging Krispy Kreme’s immensely valuable global brand to expand distribution and boost pricing. The company generates healthy profits and cash flow, and is reducing its modestly elevated debt. JAB retains a 45% stake, and BDT Capital (see Weber, below) holds an 8.5% stake, helping ensure that the company’s turnaround stays on track.

Petco Health and Wellness Company (WOOF) – From its roots in a 1965 San Diego veterinary supplies company, Petco has grown to over 1,500 locations across the United States, Mexico and Puerto Rico. The company has been public and taken private several times, most recently with its 2016 acquisition by a well-regarded private equity firm, followed by its January 2021 IPO at $18. Led by a highly capable management team, Petco is producing impressive results. In their October quarter, same store sales grew 32% from their pre-pandemic level while the EBITDA margin expanded. Investors worry about a post-stimulus demand slowdown, and higher supply chain and labor costs. Yet, the industry has a healthy secular tailwind, and Petco is increasing its physical and online market shares while restraining costs even as it invests in new technology and growth initiatives. Cash flow is strong, which the company is using to reduce its already-modest debt and may soon initiate dividends and share buybacks.

Weber (WEBR) – Founded nearly 70 years ago, Weber makes the iconic outdoor cooking grills. The company has an impressive global presence, with half of its revenues produced from over 70 countries outside the United States. It holds the global industry’s #1 market share (at 24%). Weber’s shares jumped immediately following the August 2021 IPO at $14, but have now slipped 26% to a much more reasonable valuation. The company’s revenue outlook remains healthy, but investors are concerned about a post-pandemic revenue slump and near-term gross margin pressure from rising input and freight costs. However, long-term demand looks healthy. And, Weber is using its brand and distribution strength to raise prices while also reducing its costs through initiatives that include a new plant in Poland. The company generates strong profits and cash flow, backed by a solid balance sheet. Management and board quality is high, stacked with capable executives with proven experience in closely related industries. BDT Capital Partners, led by Byron Trott (Warren Buffett calls Mr. Trott the only investment banker that he trusts), holds a majority stake, indicating a strong, reliable and honest backer that looks after shareholders’ long-term interests.

On a side note to Weber, we also briefly looked at competitor Traeger (COOK), the Utah-based maker of trendy wood pellet-fired outdoor grills. The company has a loyal following but currently holds a tiny 3% U.S. market share, and sells only the higher-priced specialized grills. While the concept has grown quickly, it faces refreshed competition from Weber, which is upgrading its pellet-fired lineup after an initial misstep. Traeger completed its IPO in July 2021 at $18, just before Weber, and the shares have fallen about 50% to $9.53. The valuation at 11.4x estimated EBITDA is elevated but this company is worth watching.

Comments on Performance During the Current Market Sell-down
The current market sell-down appears to be a straightforward asset repricing, driven by the strong likelihood of rising interest rates to help address the elevated inflation rate. Interest rates affect the value of all investments – and those whose valuations are the most speculative are of course the most sensitive.

Seth Klarman, a highly successful contrarian investor who founded and oversees the respected Baupost Group ($32 billion in assets), recently wrote in his annual letter to investors, “it is said that bull markets always climb a ‘wall of worry’ as the cautious are left behind while the intrepid get ahead and the reckless lead the pack. But the opposite may also be true – bear markets must inevitably descend a mountain of overconfidence and hubris.”

The Cabot Turnaround Letter focuses on out-of-favor stocks with real value, ideally with catalysts that help the company realize that value. We emphatically avoid chasing fads. We were fortunate to generate strong above-market returns in 2021 by owning neglected stocks. This approach has continued to show its merits: through this edition’s pricing date (Friday, January 21, 2022), our average stock has gained 0.6% while the S&P500 has declined 8.0%. Past performance is no guarantee of future returns, and as we write this note the market continues to slide, but we are encouraged that the approach continues to provide value to our readers.

New Recommendations, Updates and Performance

RecommendationS

Purchase Recommendation: Polaris, Inc. (PII)

Polaris, Inc. (PII) 2100 Highway 55 Medina MN 55340 763-542-0500 polaris.com

Symbol: PII Market Cap: $6.6 Billion Category: Mid Cap Business: Power Sports Revenues (2021e): $8.1 Billion Earnings (2021e): $560 Million 1/21/22 Price: 105.78 52-Week Range: 100.52-147.73 Dividend Yield: 2.4% Price target: 160

Background
Polaris is the leading North American manufacturer of powersport equipment including off-road vehicles, snowmobiles, motorcycles, boats and a variety of specialized vehicles for commercial and defense customers. Launched in 1954 with the industry’s first snowmobile, Minnesota-based Polaris was acquired by Textron in 1968, then purchased by the management group in 1981.

While growth has generally been produced by internally developed products, the acquisitions of Indian Motorcycle, Boat Holdings, Aixam-Mega and other companies have expanded its portfolio. Polaris sells its products through an extensive network of independent distributors and dealers. About 82% of total sales are generated in the United States and Canada, with the balance from over 100 additional countries. Polaris offers financing to dealers and customer through third parties that accept the related credit risks.

After some post-pandemic enthusiasm, investors have soured on Polaris’ shares. The stock has declined 28% from last April and more than a third from the high reached in 2015. Investors worry that with the end of generous stimulus checks and a return to work for potential buyers, demand will fall off sharply. Even though Polaris reported flat year-over-year third-quarter sales, the end-market as represented by North American retail sales declined 24%.

Furthermore, Polaris is battling significant supply chain headwinds which are leading to bloated inventory and, when combined with higher costs, compressed profits. The surprise departure of long-time CEO Scott Wine in late 2020 may continue to weigh on sentiment. All this leaves Polaris’ shares out of favor.

Analysis
Investor concerns appear to overly discount the bright future for Polaris. The valuation at only 7.3x estimated 2022 EBITDA is low in absolute terms and relative to the company’s typical 9x or 10x multiple. And, this valuation assumes minimal profit growth or free cash flow production – an outcome that seems too pessimistic.

The overall industry should continue its moderate but steady secular growth trend. Polaris seems poised to gain more incremental market share, given its strong brand value and reputation for quality and innovation.

Much of the current end-market weakness is driven by a severe lack of product availability at dealers and distributors, whose inventories are estimated to be 75% below pre-pandemic levels. For most of this year, Polaris has faced significant delays in procuring critical components due to supply chain issues, leaving a bulge of partially completed vehicles on the company’s factory floor rather than ready-to-sell vehicles in retailers’ showrooms.

Including the related production inefficiencies, expedited shipping costs, and higher commodity and labor costs, Polaris estimated that its supply chain issues will weigh on this year’s profits by as much as $300 million, or more than 3.5% of revenues. Even with this burden, the company will likely still produce an EBITDA margin of about 12%.

Encouragingly, consumer demand continues to be robust, supported by a very strong pre-order book, suggesting that once the production issues are resolved, Polaris’ revenues and margins could improve significantly. While its vertically integrated manufacturing approach is leading to sizeable temporary problems, it helps the company generate high profits and maintain a cost advantage over its competitors in the long run.

Concerns about the former CEO Scott Wine’s departure seem unwarranted. Wine left Polaris for the right reason – to accept the CEO position at a much larger company (CNH Industrial, with $32 billion in revenues, or 4x Polaris’ revenues). His replacement, Michael Speetzen, is a capable and experienced seven-year Polaris veteran who is backed by a solid group of senior executives. Competition in the industry is robust, but we anticipate that this team can, at a minimum, maintain Polaris’ competitive edge.

The company generates strong profits and free cash flow, which it returns to shareholders after reinvesting in its business. Polaris has repurchased $411 million of its shares year to date, even as it reduced its already-low debt balance by 18%. The $150 million in annual dividend payouts, or $2.52/share, offer an attractive 2.4% yield.

Our practice is to generally avoid recommending companies just before they report earnings. However, this can be problematic during earnings season. Readers should know that Polaris reports on January 25 pre-market-open, after our editorial and stock pricing deadline. We have no insight into the earnings report. The shares may react sharply in either direction: if they stumble from a weak report, investors should take advantage of the lower price. And, a strong report might suggest the turnaround is already underway and thus reduces the risk of the story.

We recommend the purchase of Polaris, Inc (PII) shares with a 160 price target.

Price Target Change

On January 21, following a strong earnings update from Baker Hughes (BKR), we raised our price target from $26 to $31. Baker is seeing strong growth in new orders, particularly in its Turbomachinery & Process Solutions segment which produces nearly half of the company’s profits. Cash flow production is robust, and the share valuation remains attractive.

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 February 23, 2022.