March 3, 2023

This week, we comment on earnings from Bayer AG (BAYRY), Berkshire Hathaway (BRK/B), Dril-Quip (DRQ), Holcim (HCMLY), Kohl’s Corporation (KSS), Macy’s (M), Six Flags Entertainment (SIX), Viatris (VTRS), Volkswagen AG (VWAGY) and ZimVie Holdings (ZIMV).

Next week, we provide an update on earnings from ESAB (ESAB) and Duluth Holdings (DLTH), which should wrap up this earnings season.

We apologize, but there won’t be a podcast today. Your chief analyst has contracted the six-week cough virus (not Covid) that has rendered it impossible to complete the podcast. We’re about three weeks into this – hopefully next week will be more workable.

We are moving our rating on ZimVie (ZIMV) from Buy to Hold.

Earnings updates:

Bayer AG (BAYRY) – Bayer is a Germany-based crop science, pharmaceutical and consumer health products conglomerate with $60 billion in revenues. The company has had remarkably poor operational and strategic leadership, clearly illustrated by its $63 billion deal for Monsanto in 2018 that almost immediately brought major liabilities amid allegations that glyphosate, the active chemical in Roundup, causes cancer. Other worries include litigation risk from PCBs, glyphosate pricing pressure, and upcoming patent expirations on Xarelto and Eylea, its two largest pharmaceuticals. The shares remain just above their 15-year low. While the surface-level prognosis for Bayer seems dour, deeper analysis suggests a significantly undervalued company, with sizeable and stable profits and cash flow. A new CEO from outside the company, who starts in June, is likely to bring much better operational execution and may make major strategic changes (break-up). The balance sheet carries a reasonable debt burden. The shares appear to sharply over-discount the glyphosate and other risks. (€1 = $1.06).

Bayer’s third-quarter results and outlook were mixed but relatively stable to positive. The arrival in June of the new CEO should significantly improve Bayer’s execution, especially in the pharmaceutical segment, as well as possibly lead to a major strategic change (divestiture). Bayer carries reasonable debt and generates strong free cash flow, although part of this cash flow is being diverted toward legal costs relating to its glyphosate, PCB and other legal issues.

The company raised its annual dividend 20%, to €2.40/share, which we believe is readily sustainable.

No change to our BUY rating.

Guidance for 2-3% organic sales growth was reasonable, while guidance for adjusted EBITDA of between €12.5 billion and €13.0 billion was light compared to consensus of about €13.1 billion and our estimate of closer to €13.3 billion. The implied EBITDA margin of 24.8% would be lower than last year’s 26.6%. Free cash flow was guided to roughly a repeat of last year’s €3.0 billion.

In the quarter, revenues of €12.0 billion rose 8% (4% ex-currency and net acquisitions). Pricing rose 5% while volumes fell 1%. Revenues were in line with the consensus estimate. Adjusted earnings of €1.35/share rose 7% and were 6% above estimates. Adjusted EBITDA of €2.5 billion rose 3% but the margin slipped by a percentage point to 20.5%.

Sales in the Crop Science segment rose 11% (organic) while Adjusted EBITDA rose 8%. Pharmaceutical sales fell 3% (organic) while Adjusted EBITDA fell 5%. Consumer Health sales rose 6% (organic) and Adjusted EBITDA was flat.

Total debt ticked up 2% during the year, but higher cash/equivalents pulled net debt down by 4%, or €1.4 billion. Bayer includes leases in its debt and certain receivables in its cash, so the comparison to American calculations isn’t precise, but close enough.

Berkshire Hathaway (BRK/B) – Recommended at the end of March 2020 in the depths of the market’s pandemic-driven sell-down, Berkshire Hathaway is an exceptionally well-managed financial and industrial conglomerate.

Berkshire reported a respectable quarter. Operating earnings fell 8% from a year ago, but all segments were profitable. Float increased to $164 billion, partly due to the Allegheny acquisition. Berkshire remains an impressively solid company from both financial and operating perspectives. With Warren Buffett now 92 years old, we see incremental succession risk – not from who will be next, but from the fact that no one can truly replace the one-of-a-kind Warren Buffett. Our rating remains HOLD, but we are looking for an opportunity to raise this to BUY.

Buffett’s letter to shareholders was insightful but brief. We fully agree with his views on share repurchases.

In the quarter, the decline in operating earnings was driven mostly by the $(1.5) billion loss in “Other” which includes the effects of changes in the value of the dollar. Insurance investment income rose 64% and was partly offset by a 12% decline in Railroad profits. All segments showed profits, although the Insurance Underwriting profits remain weak at $244 million. The company repurchased $2.6 billion of its shares in the quarter. The full-year total repurchase was $7.9 billion, roughly 1% of the company’s current market value.

Your chief analyst will be attending the 2023 Berkshire Hathaway annual meeting in May to provide an on-the-ground perspective.

Dril-Quip (DRQ) – A major supplier of subsea equipment, Dril-Quip is working through the downturn in offshore oil and natural gas drilling. It generates positive free cash flow and has a sizeable cash balance yet no debt, all of which should allow it to endure until industry conditions improve.

Dril-Quip reported a highly encouraging quarter, with revenues and profits jumping sharply from a year ago. Net bookings, a strong indicator of future revenues, rose to $94 million (up 18% vs year ago) to the highest pace since 2019. The offshore drilling market is now entering the long-awaited upturn. Gross margins are expanding, while overhead costs are falling due to the winding down of several one-off legal/administrative costs and research and development costs for strategic projects that are now finished.

The company’s guidance for 2023 is for 10% revenue growth and 50% incremental EBITDA margins. From this, we derive about $400 million in revenues and $50 million in EBITDA, which would produce a nearly 67% increase in profits compared to 2022.

The Dril-Quip story remains on track.

In the quarter, revenues rose 24% from a year ago and were about 9% above estimates. Adjusted EBITDA of $10 million improved essentially from break-even a year ago and was 60% above estimates. Adjusted earnings were $0.06/share compared to a loss of $(0.46) a year ago and were sharply higher than the consensus estimate for a $(0.05) loss.

Free cash flow was sharply negative, which we believe is due to a sizeable inventory build-up related to the strong order growth.

Holcim (HCMLY) – This Swiss company is the world’s largest producer of cement and related products. After its troubled 2015 merger and a payments scandal, Holcim hired Jan Jenisch, a highly capable leader whose turnaround efforts are showing solid results, particularly by expanding the company’s profit margins and cash flow. A possible overhang on the shares is the carbon intensity of cement production, but the company’s efforts in reducing its carbon footprint are impressive. (CHF is Swiss francs, CHF1.00 = US$1.07).

Holcim reported a strong quarter with revenues and profits reaching records, with the profit margin expanding incrementally. The company is successfully improving its core operations while moving with impressive results into faster-growth but related businesses, all while substantially reducing its debt through sizeable divestitures. Guidance for 2023 calls for 3-5% (like-for-like) revenue growth and incremental margin expansion, with free cash flow of CHF 3 billion.

The architect of this five-year turnaround, CEO Jan Jenisch, will be moving to the board chair, leaving the company well-positioned for an as-yet-unnamed new CEO to continue the strategy. Holcim is now underleveraged, with net debt at only 0.8x EBITDA, compared to its targeted limit of 2.0x. This gap would allow for perhaps CHF9 billion in new deals (given that the divestiture program is mostly finished) – enough to continue the company’s transformation. Jenisch implied that major acquisitions aren’t likely, so the incoming CEO will likely make incremental deals. For reference, revenue in the Solutions & Products segment, which is doing all the acquiring, is targeted for 30% of company sales by 2025 compared to the current 19%.

We are puzzled by the still-low valuation for Holcim’s shares, currently at about 5.7x estimated 2023 EBITDA. Peer CRH (in Ireland) is arguably a stronger company with incrementally faster growth, but we wonder if Holcim’s sizeable discount to CRH’s 7.5x multiple is warranted. Heidelberg (in Germany) trades at 5.4x but is arguably a lesser company. Both have equal or greater leverage and lower margins than Holcim. Some discount may be due to worries about a recession, but that shouldn’t much affect the relative share valuations.

So, for now, we will remain patient with the Holcim story. Continued strong execution, ongoing resilience in the global economy, favorable news on the new CEO and perhaps some sizeable new share buybacks will improve investor recognition of Holcim’s value.

In the quarter, revenues rose 10% like-for-like (the European term for ex-currency and acquisitions/divestitures) while recurring operating profits also rose 10%. Sales were about 1% below estimates.

Kohl’s Corporation (KSS) – Kohl’s Corporation operates over 1,100 department stores in 49 states and the kohls.com e-commerce business. Investors see the retailer as a broken company left behind by time, trends and technology, with unsettled leadership, further pressured by bloated inventory, a possible recession, and rising labor and goods costs. An aggressive activist campaign led to changes on Kohl’s board, a major share repurchase, a sizeable dividend and a new CEO (Tom Kingsbury) in February 2023. Kingsbury is a proven operator whose mandate and expertise is to restore and upgrade rigor and discipline in the company’s operational performance, including inventory management. The company’s profits and free cash flow, while weakened, are resilient. The debt burden is reasonable but is being trimmed further. While the turnaround carries risks, the deeply undervalued shares provide a margin for safety.

The company reported a remarkably weak quarter, but with stale inventories cleared out and capable new leadership starting to make critical improvements to basic store operations, the Kohl’s story remains intact.

In the quarter, the traditionally highly profitable period was transformed into essentially breakeven as Kohl’s slashed prices on its merchandise to move it out of inventory. Clearance markdowns reduced the gross margin by 7.5 percentage points – the equivalent of $280 million of foregone profits (which would have tripled the roughly $100 million in EBITDA). Free cash flow was a thin $591 million in the quarter and a negative ($639) million for the year.

While disastrous at first glance, the quarter set the table for a brighter future. Kohl’s has a decent-enough balance sheet that it could readily withstand the flushing out of unwanted merchandise, leaving inventories in reasonable shape (up only 4% from a year ago) for better profits in 2023. Another measure of the size of the inventory flush: inventories fell 35% from the third quarter, whereas a year ago fourth-quarter inventories fell only 16% from the prior quarter.

Under new CEO Tom Kingsbury, the company outlined its full-year 2023 guidance: sales down 2-4% from last year, operating margin of 4% and earnings of $2.10-$2.70/share. We would call this guidance a reasonable single-point outlook but one that has a wider range of possible outcomes than it implies.

The company’s priorities reflect the new leadership’s skillset and what Kohl’s needs: improving merchandising and pricing, more inventory and cost/capital spending discipline, and paying down debt. The Sephora store-within-a-store concept continues to produce favorable results and remains a top priority. Kohl’s reiterated its commitment to the $2.00/share dividend and its long-term financial goals of a 7-8% operating margin, low single-digit sales growth and a strong balance sheet.

In the quarter, total and same-store sales fell 7% from a year ago. Compared to estimates, revenues were 4% light. The loss of $(2.49)/share compared to a $2.20 profit a year ago and estimates for a profit of $0.97. Adjusted EBITDA of $102 million fell 84% from a year ago and was 75% below estimates.

Macy’s (M) – With a capable new CEO since February 2018, Macy’s is aggressively overhauling its store base, cost structure and e-commerce strategy to adapt to the secular shift away from mall-based stores. Macy’s acceleration of its overhaul shows considerable promise.

Macy’s fourth quarter showed weaker results compared to a year ago but was better than somewhat dour expectations. The company is showing what capable leadership can accomplish even in disruptive times. Macy’s provided encouraging 2023 guidance for a small decline in sales and a roughly 13% decline in earnings which nevertheless would be above the current consensus estimate. From here, Macy’s needs to keep executing well against tough competition and a strong but weakening consumer. One headwind is student loan debt: repayments are starting and the Supreme Court is weighing the legality of debt forgiveness. Overall, an encouraging quarter, but we are retaining our 25 price target and Buy rating.

The company has shown impressive all-around skill in navigating the immensely disruptive pandemic and post-pandemic periods. Fourth-quarter sales returned to their pre-pandemic level and are 3% higher on a same-store basis. Per-share earnings are only 11% lower despite wage and other cost inflation, intensified competition and other headwinds. The full-year numbers are more impressive: unchanged revenues with same-store sales up 4% while per-share earnings are 53% higher. Macy’s transition to online sales has fully made up for lower sales in its physical stores, illustrating both skilled execution on Macy’s part and some enduring loyalty/preference on customers’ part.

Macy’s focus on merchandising and inventory management is paying off: fourth-quarter inventories fell 3% from a year ago and 18% from 2019, driven by better data analytics, improved supply chain management and tighter discipline. This effort helped preserve Macy’s full-year gross margin, which has slipped only 1.5 percentage points from the highly profitable 2021. The fourth quarter gross margin fell 2.4 percentage points.

Fourth-quarter and full-year revenues from credit cards were steady/higher compared to a year ago. Macy’s credit card revenues are a sharing of profits with the underwriter – Macy’s does not carry direct credit risk, but rather participates in the fee and interest rate profits less charge-offs.

The balance sheet carries $2.1 billion in net debt, or about 0.8x EBITDA, a level that we believe is about right. On the more complex measure of EBITDAR/adjusted debt, which includes lease and pension liabilities, the company has a 2.0x leverage ratio, in line with its target. The first meaningful debt maturity is in 2027.

In the quarter, sales fell 5% from a year ago, while same-store sales fell 3%. Sales were in line with estimates. Adjusted net income of $1.88/share fell 23% but was 18% above estimates. Adjusted EBITDA fell 27% but was 4% above estimates.

Six Flags Entertainment (SIX) – This company is one of the world’s largest theme park operators. Since mid-2018, the shares have collapsed due to stalled revenue growth, over-expansion and the pandemic. This has led to a complete changeover in the board of directors and senior leadership. Six Flags is implementing a new strategy focused on raising prices while significantly improving the guest experience to attract more families. Investors worry that this strategy will not be successful. We see an asymmetric payoff: the shares assume a dour future, but a reasonable turnaround could produce sharp gains. Six Flags generates considerable free cash flow that will help reduce the company’s elevated debt. A long-time 20% shareholder provides valuable shareholder-oriented oversight to keep management properly focused.

Six Flags reported a decent quarter, with adjusted EBITDA reaching a fourth-quarter record. The new leadership is making worthy improvements to its operations, not just in higher ticket pricing but with new initiatives like better/more relevant in-park merchandise sales and new seasonal events that boost same-day ticket sales. So far, the company’s new strategy appears to be working, but the upcoming summer season will be a much more important test period. On the conference call, management outlined in reasonable detail its plan to boost revenues and profits. The strategy and approach make immense sense to us: make the parks more valuable to customers and they will come and pay more. The key is in execution (did they do it right?) and outcome (did it actually work?). No change to our rating or price target.

In the quarter, revenues fell 12% from a year ago and were in line with estimates. Adjusted earnings of $0.33/share compared to a loss of $(0.02) a year ago and were nearly double the consensus estimate. Adjusted EBITDA of $99 million rose 5% and was about 1% above estimates.

While attendance fell 30%, average spending per guest rose 23%. Park operating costs and overhead expenses fell 20%, helping drive profits higher. Net debt remains elevated but unchanged over the past year, even as the share count has declined 4%. Free cash flow for the full year was robust at about $152 million but slipped from $213 million a year ago. Six Flags plans to use much of its future free cash flow to chip away at its elevated debt balance.

Viatris (VTRS) – Viatris was formed in November 2020 through the merger of pharmaceutical generics producer Mylan, N.V. and Pfizer’s Upjohn division. Investors worry about its declining revenues, limited drug pipeline visibility, elevated debt, loss of exclusivity for Lyrica and Celebrex in Japan, and reforms to China’s volume-based procurement programs. We see Viatris as an undervalued stream of reasonably stable free cash flow. As evidence of this stability is produced, along with better capital allocation, governance and transparency, we see strong potential for a higher share price.

Viatris reported an unimpressive quarter that missed estimates. Full-year results saw revenues and EBITDA profits decline, while the 2023 guide calls for more of the same. Full-year free cash flow remained steady at about $2.5 billion and was guided for the same in 2023. So, we have a stagnant company that holds a stake of unknown value in India-based biotech company Biocon Biologics (acquired as an outcome of its biosimilars sale), but one that is generating enough free cash flow to continue to repay its moderately elevated debt while also stepping up its share repurchases, and soon to be led by a new and capable CEO who might lead them to enough new prosperity to offset the slow but steady decline in its aging off-patent product line. We worry, still, that it will make acquisitions that in effect buy free cash flow to offset the decay in the core business.

While frustrated with the loss in our position (down about 32%), we are keeping Viatris for now. The arrival of better leadership, combined with the apparent stability, size of its free cash flow and the shares’ continued low valuation at about 6x EBITDA, are enough. The company’s challenges are sizeable so we’re not ready to back up the truck. Our current 26 price target is probably too high, but we will leave it there for now as the Viatris story has yet to fully play out.

In the quarter, revenues fell 11% from a year ago but fell only 2% excluding currency changes. Revenues came in about 3% below estimates. Adjusted earnings of $0.67/share fell 11% from a year ago and were about 7% below estimates. Adjusted EBITDA fell 10% and was 6% below estimates. For the year, new products contributed about 3% of revenues – tiny, but an incrementally growing source of sales, and roughly enough to offset the decline in the base business. Viatris expects new products to contribute about $500 million in 2023. The emerging Eye Care segment offers some interesting potential, with its lead-off product Tyrvaya and others expected to generate $1 billion in sales by 2028.

In November, the company completed the sale of its biosimilars business to Biocon Biologics for $3 billion: $2 billion in cash and a 12.9% equity stake (with attributed value of $1 billion) in Biocon Biologics. Viatris will receive $335 million in additional cash in 2024 related to the deal. Biocon Biologics is a private company that is controlled by Biocon, India’s largest pharmaceutical company (market value of about $3 billion).

More divestitures are ahead but have yet to be specified. The CEO change was unexpected. Viatris’ new CEO, Scott Smith, joined the Viatris board last December. He looks highly qualified as he was president and chief operating officer for biotech Celgene (which was acquired by Bristol-Myers) and has deep experience with developing and commercializing successful new treatments.

Guidance for 2023, excluding the effect of the divestiture, calls for revenues to decline about 3% and for adjusted EBITDA to decline by about 10%.

Volkswagen AG (VWAGY) – Volkswagen is one of the world’s largest car makers, with a portfolio of brands including Volkswagen, Audi, Porsche and Lamborghini, as well as commercial trucks and a major financial services unit. Investors worry about the sizeable China exposure, large but unsettled bet on electric vehicles and complicated governance structure, as well as the likely effects of a recession. Our view is that the market is over-discounting these risks while overlooking the company’s strengths including its sizeable profits and free cash flow and sturdy balance sheet that give it plenty of time to execute its plans. Several important catalysts look primed to unlock value within the company, including the Porsche IPO and new leadership.

The company reported this morning, sooner than had been specified. In brief, sales and earnings were healthy, and the company provided an encouraging outlook for 2023. We will have a more thorough review next week.

ZimVie (ZIMV) – Recently spun off from Zimmer Biomet Holdings, ZimVie specializes in dental and spinal implant products. Our thesis is broken: the company inherited a severely damaged spine business as well as burdensome floating rate debt and an unwieldy tax situation.

ZimVie reported a weak quarter, as the 15% (organic) decline in Spine segment sales overshadowed the reasonably stable (-3% organic) results in the Dental segment. It is clear now that Zimmer Biomet wanted to offload its severely troubled Spine segment but needed to pair it with Dental to make it palatable to investors. Also, the former parent seemed to have been in a hurry to offload these operations as there appears to have been very little operational prep, yet it was happy to dump $500 million of debt into the new business. This deal is why spin-offs get a bad reputation – a major company with a huge information advantage pawns off not-seaworthy businesses yet promotes them with glowing words. Our view of the ethics of Zimmer Biomet is deeply tarnished by this episode.

The outlook for 2023 is disappointing but marginally acceptable on the revenue line, calling for an 8% sales decline. Given all the disruptions in its sales and distribution efforts, the pricing issues in China (which are so bad that the company is exiting its China spine operations) and other transition problems, we are actually impressed that the management can maintain or possibly improve on their adjusted EBITDA margins, with guidance for 13.5-14.0% margins.

Management has done yeoman’s work to fix this boat: completed numerous ERP conversions, updated its core IT systems, exited/restructured much of its global footprint facilities, cut excess inventory and exited troubled geographies like China (Spine operations).

What led to the 50% drop in the shares (intra-day) on Thursday was that higher interest expenses and higher taxes built into the 2023 EPS guidance are permanent features, not temporary one-offs. Thus, the new earnings base is roughly $0.40/share, about $0.80/share lower than what investors (and us) had expected. The damage is essentially a permanent impairment of value.

Higher interest expenses come from the company’s floating-rate debt. We had anticipated that the company would have refinanced its debt at a fixed rate, or at least hedged it via swaps. This was not the case. On taxes, the company will not have much in the way of usable tax loss carryforwards, so its go-forward tax rate now hits pre-tax income at full tilt. Both of these problems are vestiges of the spin-off: a thoughtful parent would have encouraged/forced its spin-off to have fixed-rate debt and would have helped engineer a more sophisticated tax management program. Perhaps the current management carries some blame, but we will assign 99% of it to the former parent. Shame on them. We wish the current management team good luck.

Given the broken ship and permanent impairment of capital, we are ready to abandon ZimVie shares. The sharp sell-off on Thursday may lead to a bounce, and we will use such a bounce to time our exit. As such, we are moving our rating from BUY to HOLD.

In the quarter, sales fell 12% from a year ago (-9% organic) and were 4% below estimates. Adjusted earnings of $0.16/share compared to a loss of $(0.36)/share a year ago and 24% below estimates. Adjusted EBITDA of $28 million fell 7% from a year ago and was 3% below estimates.

Comments on other Recommended stocks:

Nokia unveiled a new corporate logo and said it is shifting its strategy more toward enterprise (business) customers, with less emphasis on telecom service customers, over the next decade. This makes sense to us, given the strong growth potential in the enterprise segment, but also concerns us in that it is a tacit admission that the 5G transition may have peaked.

Viatris said that it would stop selling essential drugs in the U.K. without changes to the drug pricing agreement. The U.K. agreement helps keep essential drugs affordable but is now threatening drug makers with the possibility of selling treatments at a loss.

Disclosure: The chief analyst of the Cabot Turnaround Letter personally holds shares of every Rated recommendation. 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.Please feel free to share your ideas and suggestions for the podcast and the letter with an email to either me at bruce@cabotwealth.com or to our friendly customer support team at support@cabotwealth.com. Due to the time and space limits we may not be able to cover every topic, but we will work to cover as much as possible or respond by email.