May 4, 2022

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

One of the enduring features of the stock market is that near-term share prices are driven by momentum and narratives. While this may yield huge money-making stocks on the way up, losses can be devastating on the way down. Fortunately for value investors, downturns driven by negative momentum and unfavorable narratives can create impressively attractive opportunities.

We discuss two groups of stocks that fit this bill: homebuilders and stocks with valuations below 5x EV/EBITDA. Our featured recommendation this month is homebuilder M/I Homes (MHO), which trades at a large discount to its liquidation value despite what may be a reasonably steady industry over the next several years.

We note our recent move of Vistra Energy (VST) from a Buy to a Sell.

Attractive Turnaround Stocks

Momentum, Narratives and Valuation
One of the enduring features of the stock market is that near-term share prices are driven by momentum and narratives. Momentum is simply the price trend: investors prefer to buy stocks that are going up and sell stocks that are going down. This can become self-reinforcing – the more a stock goes up, the more desirable it becomes, and vice versa. A narrative is the current story that accompanies a stock. Perhaps a company is “rapidly growing” or is a “market leader” or is “the next Apple” (or, perhaps it actually is Apple). Stocks that show both strong upward price momentum and have a positive narrative can be huge money-makers on the way up.

However, as the current market is displaying, these forces work in both directions. The reversal (or, even just a weakening) of a positive narrative can convert upward price momentum into a collapsing stock. The pandemic moonshots of Netflix (NFLX), which has plummeted 72% from its peak to return to its 2017 price level, Okta (OKTA), down 60%, and Peloton (PTON), down 90%, are only three examples among literally hundreds of former momentum-narrative stocks that have lost 60% or more of their value since peaking after the pandemic, even as the S&P 500 has slipped only 14% from its peak. Traders may generate vast profits on the way up, but losses can be devastating on the way down. And, almost by definition, many momentum investors arrive late to the party, only to see their small paper profits reverse into deep and permanent losses.

While caught in the short-term throes of momentum and narratives, most investors dismiss out of hand the merits of focusing on valuation. Legendary investor Warren Buffett, who focuses heavily on buying undervalued companies, lamented this past weekend at the Berkshire Hathaway annual shareholder meeting that the speculative frenzy of momentum and narratives has turned the stock market into a “gambling parlor.” Fortunately for value investors, downturns driven by negative momentum and unfavorable narratives can create impressively attractive opportunities.

If this month’s letter has a theme, it would be to highlight overly discounted stocks of companies with enduring value. One of our favorite Buffett quotes is, “in the short run, the stock market is a voting mechanism and in the long run it is a weighing mechanism.” Our scales are working overtime.

Time to Get Constructive on Homebuilder Shares
In keeping with our view that investors are selling stocks based on negative price momentum and popular narratives rather than valuations, we are finding some unusual bargains in the homebuilding industry.

The narrative says that the U.S. economy is slowing and that rising interest rates will sharply crimp demand for new housing, and thus investors should avoid homebuilder stocks. We readily admit that this story has some merit. Homebuilders’ profits are cyclical and highly sensitive to economic activity. News that first-quarter GDP fell 1.4%, much slower than an expected increase of 1%, supports the narrative. Further evidence of a slowdown includes the 9% decline in new home sales in March.

Mortgage interest rates have surged, reaching 5.1% last week, up from less than 3% in the past two years. This threatens the affordability of new houses, as does rising home prices which have jumped 15% on average over the past year. Combined, a slowing economy and weakening affordability threaten to derail what has been a surprisingly robust post-pandemic demand surge.

Similarly, rising lumber, plastics and labor costs threaten to squeeze homebuilder profits, as do constraints on procuring adequate construction supplies and labor, adding more pressure on the shares.

Supported by these dour narratives, perhaps it isn’t surprising that homebuilder shares have fallen sharply from their peaks last year. Yet, share prices can follow negative narratives only so far, until the valuation becomes compelling. This looks like the situation today.

Our primary valuation tool for homebuilders is price/tangible book value, or P/TBV. As homebuilder profits historically are highly cyclical, earnings-based valuations are less reliable. The P/TBV metric takes advantage of the clarity provided by homebuilder balance sheets. Most of the assets are cash, homes inventory (homes under construction) and land inventory (for future homebuilding). These are recorded at cost, and given the relatively rapid turnover, are closely linked to market values. We ignore intangible assets as these can have murkier value. Netting out the liabilities, this tangible book value approximates liquidation value and provides a useful gauge of a company’s underlying value. We would consider a price/tangible book value of less than 1.0x to be a discounted valuation. With many homebuilders trading below 1.0x tangible book value, investors seem to be assuming that this cycle is over and that homebuilding activity, and thus profits, will slide downward.

However, investors are giving homebuilder shares no credit for the strength of current housing market conditions. Orders for new homes in terms of units, a measure of the number of buyers purchasing homes, remains steady. Orders in terms of dollars are rising 15-20%, suggesting that higher prices aren’t yet deterring buyers. From a historical perspective, demand for new housing is roughly in line with its long-term average and well below the housing bubble levels of 14 years ago. Meanwhile, the inventory of unsold existing homes, a measure of supply, is at only one month, the lowest level in over 20 years. And, many parts of the country suffer from severe housing shortages.

Other indicators of secular growth include an elevated median age of the housing stock, now at 40 years from 25 years in 1989 (suggesting an elevated replacement cycle ahead), and the permanence of remote work, which features more interest in new housing away from urban centers. Other sources of demand: institutional investors that buy large volumes of houses to rent and consumers who want the inflation-hedging benefits of home ownership. Supporting the strong demand is the low unemployment rate and strong wage growth. All-in, it seems unlikely that new housing demand will suddenly plummet. For homebuilders, even flat unit demand is adequate to lift their shares significantly.

Also, investors seem to be ignoring the favorable effects of higher profits and inflation on tangible book values. As companies sell their houses, the house and land inventory convert to cash profits, which accretes directly to tangible book value. It seems likely that most companies will see a 20% increase in tangible book value by this coming year’s end, making the shares even cheaper.

Our positive view on homebuilders may be early. But contrarian investors will want to take note of these out-of-favor stocks. Our feature recommendation this month is homebuilder M/I Homes (MHO) and below we list four additional homebuilders that also have strong current and forward-looking fundamentals and low valuations. For the group, estimated 2022 earnings are double or triple their pre-pandemic 2019 levels, with current-year estimates that generally continue to increase. Also, most of these companies are small, making them potential acquisition targets for the larger, more highly valued homebuilders.

KB Homes (KBH) – KB Homes focuses primarily on first-time home buyers, which represent 55% of its units sold. Another 21% of its units are built for move-up buyers. The company operates in the attractive west coast, southeast and southwest parts of the country. In general, KB takes a lower-risk approach to its business, emphasizing build-to-order rather than speculative-build. This approach dampens upside margin opportunity, reflected in its slightly below-average 22% construction margin, but also dampens downside profit risk. Its backlog remains strong, up 29% in units compared to a year ago and up 55% in dollar value. KB’s balance sheet is more highly levered than most of its peers, but the debt maturities are spread out over the next nine years such that they should be readily serviceable. Its land inventory should meet its needs for the next two years, but the company is spending aggressively to add sites for 2024 and beyond.

Meritage Homes (MTH) – Meritage operates in ten states, primarily in the southeast and southwest. Over 80% of its homes are entry-level, a segment that it has strongly emphasized in the past year. The company is taking an aggressive approach to capitalize on the strong housing market. Moreso than most of its peers, Meritage is focusing on spec-homes (not pre-sold), with nearly 80% of its sales coming from these projects. Combined with the generally higher margins of entry-level homes, this spec-build strategy is boosting the company’s construction margins to a remarkable 30%, compared to mid-20% margins for its peers. Interestingly, to help preserve affordability to new buyers, Meritage has purchased retroactive interest rate locks on all eligible floating-rate loans for homes in its backlog that are scheduled to close in the second half of 2022. Recent unit sales fell 1% but the dollar value rose 17%, while its order book rose 46% in value, reflecting heathy demand and sharply higher average prices. Meritage has a solid balance sheet and plenty of land inventory (nearly two-thirds of which is owned) for future construction.

Closing prices on April 29, 2022.
* Price/tangible book value for most recently reported period.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Taylor Morrison Home Corporation (TMHC) – Originally part of the U.K.’s Taylor Wimpey company, Taylor Morrison was acquired by a private equity group (which included former Cabot Turnaround Letter-recommended Oaktree Capital) in 2011, then completed its IPO in 2013. Based in Scottsdale, Arizona, Taylor Morrison is focused on the first-time and move-up segments. The 25% share price slide from the peak last year has brought the price back to its 2014 level, despite considerable interim volatility. The company is fundamentally strong and has a valuable property base as reflected in its ranking as #3 in the “Submarket Desirability Index” just behind Toll Brothers and M/I Homes. Looking to capture value from the home rental trend, Taylor Morrison entered the “build-to-rent” market in 2019 and will sell its first major development soon, once rents reach a stabilized level. In the most recent quarter, backlog slipped 7% in units but rose 16% in dollar value, reflecting a sharp average price increase. Construction margins are healthy at over 24%. The balance sheet is reasonably sturdy, and the company continues to whittle down its debt. Taylor is spending more on property acquisitions, which increases its risk, yet it also has rewarded shareholders by repurchasing nearly 10% of its shares in the past year.

Toll Brothers (TOL) – Toll Brothers is the nation’s fifth-largest homebuilder. It has a strong emphasis on the luxury segment (nearly half of its revenues), such that its average home price is nearly twice the industry average. It also has a growing “affordable luxury” segment, along with offerings in the empty-nester and apartment segments. Toll operates in 24 states, with the heaviest presence on the east and west coasts. In the most recent quarter, its order backlog rose 27% in units and 45% in dollars, suggesting that demand continues to be robust. The company has several valuable but intangible assets: it owns several valuable brands, has a strong reputation (ranked as the #1 Most Admired Homebuilder by Fortune magazine for 2022) and owns property in some of the country’s most tightly controlled land approval markets which provide it with considerable barriers to entry. Other differentiators include its sizeable factory that produces wood panels and trusses, and its growing use of steel framing to help avoid the high cost of lumber. In recent years, Toll has emphasized gaining control of land through options rather than outright purchases, helping it to control its risks while redirecting its freed-up capital to dividends and share buybacks (the company has repurchased 36% of its share count in recent years). The balance sheet is investment grade and management owns 9% of the company.

Worthy Companies Selling Below 5x EV/EBITDA
In addition to homebuilder stocks, the shares of a wide range of other companies have been discarded by investors. To identify these, we looked for stocks trading at EV/EBITDA multiples below 5x. This compares quite favorably to the broad stock market which trades at about 12x.
Many companies in this cheap group have high-risk, quirky business models or may well be on their way to oblivion. Our focus, however, is on conventional companies, with legitimate business models and enduring products, reasonable balance sheets and capable management teams. Listed below are seven companies that fit the bill.

Several of these stocks are former Cabot Turnaround Letter winners. One important rule of turnaround investing is to avoid falling in love with owned stocks. We use a disciplined price target approach to help us adhere to this rule. The other important rule is to never fall in hate with your stocks – rather, be willing to repurchase the shares if they get cheap again. One side-benefit is that you already know the company well and can move quickly when the opportunity presents itself.

Closing prices on April 29, 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 the current fiscal year.
** We include MHK as its valuation was around 5x prior to its strong earnings report last Friday.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Big Lots (BIG) – Big Lots is a discount general merchandise retailer based in Columbus, Ohio, serving bargain-oriented and budget-minded consumers with an evolving selection of highly discounted close-out merchandise and recurring yet discounted convenience goods. Its 1,431 stores across 47 states generate about $6.1 billion in annual revenues. Big Lots’ product categories include furniture, hard and soft home goods, apparel, electronics, food and consumables as well as seasonal merchandise. The shares have fallen by nearly 60% from their all-time high reached mid-2021 and currently trade in line with their price of 15 years ago. The company’s fundamentals are relatively stable year after year. As inflation and a slowing economy increasingly pressure consumers’ budgets, Big Lots is likely to benefit. Helping draw in customers is Big Lots’ large and loyal customer base of 22 million Rewards program members. The management is “good enough,” helped by buybacks over the past three years that total nearly 30% of its shares. The balance sheet is essentially debt-free, while cash flow is plenty healthy to sustain the $0.30/share quarterly dividend. Activist investor Mill Road Capital (5.1% stake) recently highlighted the company’s deeply discounted shares. Last month, we put a Buy rating on Big Lots in the Cabot Undervalued Stocks Advisory, and this week it was selected as the Cabot Stock of the Week.

BorgWarner Automotive (BWA) – This company is a major supplier of turbochargers and other critical components to Ford, GM and other car makers. BorgWarner shares were previously recommended by this advisory (+70% gain) yet have fallen by a third since reaching the price peak last year and now trade in line with their 2011 level. Our sale was based on full valuation and the likelihood that the company will spend its free cash flow on acquisitions to facilitate its transition to electric vehicles. This is still the case, but the company is worth more today even as the shares trade at a lower price and valuation. As such, the stock is worth a fresh look. Turbochargers (20% of sales) remain in strong demand as they allow car makers to shrink engine sizes (to boost fuel economy) without sacrificing power. As long as there are gas-powered cars, there will be turbochargers, and any slowing in the adoption of electric vehicles would be a positive for BorgWarner. Favorably, its transition to the EV world is making good progress. Borg has relatively modest debt and generates considerable profits and free cash flow. The market is giving the company little credit for its reasonably bright future.

Dell Technologies (DELL) – Although it has been a public company since 2019, Dell Technologies is essentially a new company following the spin-off of its massive VMWare stake and its sale of Boomi. The company now focuses on selling PCs, servers and data storage equipment to businesses and consumers. Since the spin-off peak, Dell shares have fallen 23% on concerns about an economic and tech industry slowdown, particularly for PC sales, as well as generally intense competition. Yet Dell holds a strong market position, is well-managed and is likely to outrun the currently difficult supply chain conditions. Dell is highly profitable, generates immense free cash flow, and carries a modest amount of debt even as it wants to reduce this further. The generous dividend looks readily sustainable, and the company is likely to chip away at its share count with buybacks.

Kyndryl Holdings (KD) – Spun off from IBM last year, Kyndryl is the world’s largest IT infrastructure provider. The company designs, builds, manages and upgrades complex, mission-critical information systems – admittedly a difficult and highly competitive business. Yet Kyndryl has some advantages. In addition to its scale, its new-found independence expands its market to include companies that previously were competitors to IBM, and it is now unshackled from a bias toward IBM products. The low valuation reflects real challenges: revenues will likely be weak as it loses ties to IBM’s sales force, its margins will slip toward break-even, partly due to onerous make-whole requirements to dismissed employees, and its free cash flow will be weak as it needs to boost its capital spending. Fortunately, Kyndryl’s sturdy, investment-grade balance sheet provides it with enough runway to right its profit structure. And, the low expectations built into the share price offers considerable upside potential if the future is better than expected. Potential investors should note that the unusually low 1.4x EBITDA multiple is partly distorted by company-specific accounting treatments.

Mohawk Industries (MHK) – Previously a Cabot Turnaround Letter recommendation (+51% gain), Mohawk shares have lost nearly half their value in the past year and now trade unchanged from their 2013 price level. We include it in this article as its EV/EBITDA multiple was around 5x prior to its 8% stock price lift following a strong quarterly report. The company, a major producer of carpets, floor tiles and vinyl flooring, continues to produce impressive earnings, but investors are assuming that these are not sustainable as the housing market appears to be softening. Worries also include Mohawk’s pullback from Russia (5% of sales), the likely write-off of its five Russian production facilities and the company’s 25% of revenues that are generated in Europe. Also, rising input costs and tight labor supply could dampen near-term profit margins. However, about a third of Mohawk’s sales are from remodels and replacements, and another 13% is from commercial projects, both of which are more resilient than new housing construction, even as homebuilding demand is likely to be more enduring than investors currently believe. Also, the company’s price increases should eventually offset its rising costs. A favorable long-term outlook combined with the low share valuation offers meaningful long-term profit potential. Mohawk has a solid balance sheet, generates considerable free cash flow, and has repurchased 12% of its shares outstanding since early 2020. The chairman owns 15% of the shares.

Penn National Gaming (PENN) – This company operates 44 land-based gaming properties in 20 states, as well as numerous online sports betting websites. Investors have offloaded its shares, which now sell 75% below their pandemic- and meme-driven peak reached in early 2021. At least partly driving the weak sentiment is disappointing results following the ending of stimulus checks, its acquisition of theScore, and the still-on purchase of the remaining 64% of Barstool that it doesn’t own despite operating losses and the sometimes-sketchy behavior of Barstool founder Dave Portnoy. However, the company’s land-based casinos have considerable value, and investors are getting the online sports betting businesses nearly for free even though they offer the potential for a large future profits. Penn’s debt load is reasonable and its free cash flow is healthy, providing the company with plenty of time to improve its results. A large $750 million share buyback initiative should provide some support to the shares.

Thor Industries (THO) – This company is the world’s largest manufacturer of recreational motorized and towable vehicles. Also a prior Cabot Turnaround Letter recommendation (+64% gain), Thor Industries’ shares have slid nearly 50% from their peak on concerns that the pandemic pulled demand forward, that the economic slowdown will further dampen demand and that sales in Europe will fade. Also, Thor’s recent $300 million acquisition of luxury RV maker Tiffin Motorhomes, and $750 million purchase of components supplier Airxcel, heighten concerns that the company is expanding too aggressively in front of a slowdown. Yet, these acquisitions strengthen Thor’s position in a market with relatively high barriers to entry and help it better control its supply chain. End-demand remains relatively healthy, and the order backlog is large. Thor generates strong free cash flow, has a reasonable balance sheet, steadily increases its dividend and is repurchasing its shares.

New Recommendations, Updates and Performance

RecommendationS

Purchase Recommendation: M/I Homes, Inc (MHO)

M/I Homes, Inc (MHO) 4131 Worth Avenue, Suite 500 Columbus, Ohio 43219 (614) 418-8000 www.mihomes.com

Symbol: MHO Market Cap: $1.3 billion Category: Mid Cap Business: Homebuilder Revenues (2022e): $4.3 Billion Earnings (2022e): $455 Million 4/29/22 Price: 44.28 52-Week Range: 40.30-74.85 Dividend Yield: 0% Price target: 67

Background
M/I Homes is one of the country’s largest homebuilders. Founded in 1976, the company builds houses for the first-time, move-up, luxury and empty-nest customers. M/I currently has 175 communities under development across 15 states, primarily in the central and southeastern regions of the country. The shares have twice been previously recommended by this advisory (+92% and +75% gains).
The company’s shares have tumbled 41% from their 52-week high and now trade at their pre-pandemic price. Investors worry that the economy will continue to slow and possibly slide into a recession, which could reduce demand for new houses. Rising mortgage interest rates, now at 5.1%, as well as sharply higher home prices, up 20% or more in the past year, threatens to further dampen demand as affordability becomes another deterrent to new homebuying. See more on our industry outlook in the article above, “Time to Get Constructive on Homebuilder Shares.”

Along with concerns over possibly stalling or declining revenues and the higher costs of lumber, plastics and labor, investors fear that difficulties in procuring supplies and labor could dampen the company’s construction pace, weighing further on M/I Homes’ shares. Investors are assuming that the dour outlook will become reality.

Analysis
While we appreciate the headwinds facing M/I Homes and its industry, we see a diversified, financially solid and well-managed company whose shares trade at a sizeable discount to their liquidation value.

M/I Homes’ operations are spread across 15 states and serve customers in all four primary home-type categories. Its diverse geographic markets reduce risks from regional slowdowns. The company’s properties are in valuable local communities, reflected in its #2 ranking in the highly regarded John Burns Submarket Desirability Index. While M/I Homes’ lower-priced offerings (about 42% of sales) expose it to price-sensitive buyers, about 58% of its sales are in less-price-sensitive categories in which buyers typically benefit from appreciation in their current homes when trading up. Also, the company is more constrained by its ability to deliver homes than by any lack of demand.

Fundamentally, M/I is performing well. First-quarter revenue, profits and backlog set new record highs. The construction gross margin (the spread between sales price and construction and related costs) improved to an impressive 24.8%, comparable to its peers, while its overhead expenses were flat, helping boost profits by 8% compared to a year ago. The company continues to successfully pass along higher costs by raising prices. Return on equity was a healthy 22.6%. Backlog units rose 1% while backlog dollars rose 17%.

Industry forecasts range from “strong growth for a decade” to “sharp decline as the economy enters a recession.” We view these forecasts with skepticism – the future is unknown. Our valuation thesis is based on a conservative outlook that includes a slowdown in industry demand and M/I Homes’ profits over the next few years. Our price target is based on only an incremental increase in the company’s P/TBV multiple to about .85x. We consider a multiple below 1x to be a discount. Historically, MHO shares rarely trade below .80x and the current 0.68x multiple was reached only once in the past decade – at the depths of the 2020 pandemic selloff. The combination of healthy earnings and the modest boost in valuation drive the upside potential. Given the company’s low valuation, the current share price provides a considerable margin of safety if our thesis is wrong.

Supporting the company is its strong balance sheet. Its $700 million in corporate debt bears interest at a very reasonable 4.5% average rate and doesn’t mature until at least 2028. Partly offsetting this debt is over $200 million in cash. M/I also originates mortgages for its customers, and the company maintains credit lines to finance these, but the mortgages are almost immediately resold and present essentially no risk to the company.

As a homebuilder, M/I Homes needs to acquire properties for future development. In this regard, the company is well-positioned, owning 2.8 years of land inventory and controlling another 2.3 years through options. One side benefit: the company should benefit from rising inflation as these properties appreciate in value.

We consider the company well-managed, based on its track record and strategy. We like that the current chairman and CEO, Robert Schottenstein, 69, is a member of the founding family and owns 2.4% of the shares. While the burn rate (stocks awarded to management as a percent of shares outstanding) is too high at 1.8% – we would consider 1% to be enough – we believe this rate will continue to taper, and our concerns are further assuaged by the recent step-up in share repurchases at below book value.

With low investor expectations, strong current fundamentals and a reasonable likelihood for at least stable industry conditions over the next few years, M/I Homes shares have strong upside potential with relatively limited downside.

We recommend the purchase of M/I Homes (MHO) shares with a $67 price target.

Ratings and Price Target Changes
On April 22, we moved shares of Vistra Energy (VST) from Buy to Sell, as the shares crossed our 25 price target. While natural gas prices have surged, which benefits Vistra, energy markets have become exceptionally volatile, adding to the fundamental risks within the company. The risk/return trade-off is no longer favorable. The shares generated a +56% total return since our initial recommendation about ten months ago.

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 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 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 June 29, 2022.