November 10, 2023

This week’s note includes our comments on earnings from Adient (ADNT), Ammo, Inc (POWW), Bayer AG (BAYRY), Berkshire Hathaway (BRK/B), Brookfield Re (BNRE), Elanco Animal Health (ELAN), Goodyear Tire & Rubber (GT), L.B. Foster (FSTR), TreeHouse Foods (THS) and Warner Bros Discovery (WBD). The earnings deluge continues next week.

Comments on Earnings

Adient (ADNT) – Adient, one of the world’s largest automobile seat makers, struggled due to weak leadership after its 2016 spin-off from Johnson Controls. We became interested in late 2018, after the shares fell sharply, due to the arrival of Doug Del Grosso as CEO. While we were a bit early on this name, Del Grosso’s highly capable leadership has produced an impressive turnaround so far.

Adient reported mildly disappointing fiscal fourth-quarter results that fell short of estimates. Initial fiscal 2024 revenue and earnings guidance were also light of estimates mostly due to pressures from the auto workers strike.

From our perspective, the announced retirement of CEO Doug Del Grosso is a negative turn. His leadership and skills restored the company’s competitiveness, profitability and financial strength despite immense internal and external challenges. We attribute much of the share sell-off to his departure. Replacing him, starting on January 1, will be the current CFO, who also previously headed the company’s Americas business. We have little insight into his capabilities, but have some confidence that the board and Del Grosso would not leave Adient with a low-quality leader. For now, we will retain our Buy rating.

In the quarter, revenues rose 2% but were 2% below estimates. Adjusted earnings of $0.52/share fell 4% and were 16% below estimates. Adjusted EBITDA of $235 million rose 4% and was 5% above estimates. Free cash flow was $219 million, up 22% from a year ago. For the year, free cash flow was a strong $415 million, particularly compared to only $47 million in fiscal 2022.

Net debt of $1.4 billion puts Adient’s balance sheet squarely into the “healthy” category, as net debt/EBITDA is only 1.5x and at the low end of the company’s leverage target.

Ammo, Inc (POWW) – Ammo produces rifle and pistol ammunition for sport, law enforcement and military uses and owns Gunbroker.com. The 82-year-old founder, an old-school “American success story,” has handed the reins to a capable industry veteran who is bringing on-line a much more efficient production facility, shifting the company to higher-margin segments and installing a professional organizational structure. Ammo’s balance sheet is solid with more cash than debt and is profitable. The valuation overly discounts the improving fundamentals and the Gunbroker.com marketplace. Risks are high, however, given the company’s small-/micro-cap business and the controversial and potentially legal liability-intensive nature of producing ammunition and selling guns.

Ammo reported a sloppy quarter, with problems not unexpected for a small company undergoing major changes. We remain patient with this turnaround.

Revenues fell 29% as the company phases out its low-margin products and as ammunition sales were weak across the industry. Ammo has run into difficulties getting its new factory running properly, including that one of its rifle casing presses went down. Unlike a major company with many products and production facilities, a small company like Ammo is vulnerable to a single outage. The problems, along with weaker revenues and less-profitable sales mix, pulled the gross margin down to 24.1% from 26.6% a year ago.

Gunbroker.com sales fell 14%, reflecting weaker industry conditions. The site added 26,000 new users per month and the take-rate improved to 6.0%, indicating ongoing strength in the site’s relevance. The new, centralized payment processing gateway launch is underway – this could provide a significant boost to sales and profits.

Despite overall company revenues declining by $14 million, adjusted EBITDA fell only $4.5 million, suggesting that the underlying profitability is being reasonably protected. Adjusted net income per share was breakeven.

Legal costs related to a lawsuit by the former owner of Gunbroker.com weighed on results. Ammo said that the trial is set for January and that they are confident of victory. This legal issue is a clear overhang: a loss could result in shareholder dilution or crippling costs, but a victory would lift a sizeable cloud and likely the shares. While we are not legal experts, our view is that the company will prevail.

Bayer AG (BAYRY) – Bayer is a major German crop science, pharmaceutical and consumer health products conglomerate. Weak leadership led to underperforming operations and the disastrous $63 billion deal for Monsanto in 2018 which 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. However, the company is significantly undervalued, despite the legal issues, with sizeable and stable profits and cash flow. The new outsider CEO should bring stronger operational execution and perhaps major strategic changes (break-up). The balance sheet carries a reasonable debt burden.

The company reported weak results but these were somewhat built into the share price and management’s incrementally positive view on the fourth quarter helped steady the shares although official guidance was unchanged.

The real story for Bayer is the new CEO, Bill Anderson, and his as-yet undefined plans for a complete overhaul of the company. Anderson is reviewing a sequential three-way break-up of the company (similar to GE’s break-up) and a complete change in how the company operates. He commented that “there are 12 layers between me and our customers” and that “50 billion euros in revenues but zero free cash flow is simply not acceptable.” Part of the plan is to simplify and push decision-making down to teams closer to customers and speed up overall company decisions and actions. We see this as exactly the right approach for a sclerotic company like Bayer.

Early next year will bring more details on Anderson’s targets and some early evidence on the effectiveness of the turnaround program. We see this turnaround as just starting, with depressed shares assuming little success.

In the quarter, sales were down 8% but flat excluding currency changes. Sales were about 1% below estimates. Core earnings of €0.38/share fell 66% and were half the consensus estimate.

Crop Science slipped to an EBITDA loss as pricing for glyphosate continued to slide, although volumes were strong. Pharmaceutical EBITDA fell 9% (mostly due to weaker currency) but the margin remained healthy at 32%. Consumer health EBITDA fell 8% (mostly due to weaker currency) but the margin expanded incrementally. Free cash flow slipped 6% but was still sizeable. The debt load was reduced by €900 million, or 4%, in the quarter. While the debt isn’t too elevated, we would like to see this chipped lower as interest costs are surging.

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 impressive growth in operating earnings, which rose 41% to $10.8 billion. A sharp turnaround in insurance underwriting profits, to a $2.4 billion profit from a $(1.1) billion loss a year ago, was a major driver of the improvement. Also, higher interest rates led to a $1 billion increase in investment income. The combined results of all of the other segments declined compared to a year ago.

The company’s share count is down 1.4% from a year ago due to share buybacks. Berkshire’s float, representing assets held for future payouts (which matches net liabilities assumed under its insurance contracts) was a record $167 billion. Its equity portfolio remains highly concentrated, with 78% of its $319 billion equity portfolio comprised of only five stocks, including Apple ($157 billion), Bank of America ($28 billion), American Express ($23 billion), The Coca-Cola Company ($22 billion) and Chevron ($19 billion).

Overall, Berkshire continues to move forward with its strategy and results.

Brookfield Reinsurance Ltd (BNRE) – Recently spun out of highly-regarded Canadian investment management firm Brookfield Asset Management, BAM Re is a new investment company that acquires the assets of and future contributions to pension plans and life insurance books. It invests these assets with the expectation that the returns will be significantly greater than the build-up in the related payout obligations. Over time, excess returns can build up considerable value for shareholders.

Brookfield reported reasonable third-quarter results and more progress with its build-out strategy. Total assets rose 25% through both acquired growth and organic expansion. The deals to acquire Argo Group and American Equity Life are likely to close in the next few quarters, bringing assets to over $100 billion.

Revenues rose 5% while distributable operating earnings rose 14%. There are no analysts that currently provide estimates for Brookfield Re separately from Brookfield Corp.

Elanco Animal Health (ELAN) – Elanco is one of the world’s largest providers of pet and farm animal health products, ranging from flea and tick collars to prescriptions and farm animal nutritional supplements. Its share price has tumbled since our initial recommendation, weighed down by concerns over its Seresto flea and tick collar, lackluster new product roster and elevated debt. The shares have admittedly been a value trap – a falling share price but no change in valuation as earnings have tumbled. However, the company may finally be getting its act together: it has now fully integrated its Bayer Animal Health acquisition, has a promising new product pipeline and is seeing stabilization in its revenues, helped by price increases.

The company reported results above estimates and provided in-line/fractionally higher fourth-quarter guidance. Management committed to incremental sales growth, but not profit growth, in 2024. Investor expectations were justifiably low, so the favorable news sent the shares sharply higher. The turnaround is grinding forward, with the largest step-up in its prospects needing to come from successful new products. While early, there is some indication that the pipeline will convert into decent sales and profits.

Elanco showed incremental revenue and profit growth, with a better gross margin that helped incrementally expand the EBITDA margin. Higher prices were the primary driver behind the higher revenues and wider margin. Operating expenses rose 6% as the company hires new salespeople and lifts marketing spending in advance of its product launches. While price increases can’t provide a sustainable push, the increase shows that Elanco retains some ability to press for higher pricing and suggests that its products aren’t losing relevance.

The company is generating positive cash flow, helped by better inventory management. Net debt remains way too high at 5.7x EBITDA, but Elanco knows this and is slowly chipping away at it. The first major maturity is in 2027, and most of the interest rates are fixed through next year. Elevated debt and debt service costs (interest) remain a major risk for Elanco.

In the quarter, revenues increased 5% ex-currency and were 2% above estimates. Adjusted net income rose 6% and was 50% above estimates. Adjusted EBITDA of $214 million rose 5% and was 14% above estimates.

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. Demand should remain relatively stable and pricing will likely remain robust, more than enough to offset rising input costs. The benefits from Goodyear’s acquisition of Cooper Tire provide additional value. The recent 10% stake by activist Elliott Management adds pressure for the company to revitalize itself.

Goodyear reported an incrementally encouraging quarter. Sales slipped 3% as tire volumes fell 3% but per-tire prices rose 2%. Segment-level profits fell 10%. Adjusted earnings per share were double the consensus estimate. A notable positive is that raw materials costs are falling, although these are still being offset by inflation elsewhere as well as weaker chemical business results and one-offs like storm and fire damage at two factories.

Management’s fourth quarter outlook was for incremental sales weakness but better raw material costs, resulting in a downtick in analyst estimates. The turnaround will take longer than analysts expect, but pressure from activist Elliott Management will likely keep it moving forward.

The company said it will announce the results of its strategic and operational update on November 15. We’re looking for meaningful changes in how Goodyear runs its business.

Goodyear’s debt remained elevated, but free cash flow is turning in the right direction and the company has no major maturities until 2026.

In the quarter, sales fell 3% and were 3% below estimates which called for flat revenues. Adjusted earnings of $0.36/share fell 10% but were almost double the consensus estimate.

L.B. Foster (FSTR) – After years of weak share price performance, this small cap manufacturing and distribution company, with a focus on railroad industry products and precast concrete structures, is undergoing a strategic overhaul. A new leadership team, refreshed board and a halt to its previously steady stream of acquisitions and divestitures is allowing the company to emphasize improving its operating efficiency and trimming its unwieldy debt burden. This slow-moving turnaround seems to be on the right track but the stock market hasn’t recognized this yet.

The company reported a reasonable quarter and maintained their full-year revenue and profit guidance. However, investor expectations for improvements were ahead of reality, new orders were weak-ish and the U.K. end-market is struggling, all of which pushed the shares lower on the day following a sharp run-up over the past few months. The LB Foster turnaround remains on-track.

New orders fell about 12% excluding divestitures. Backlog increased excluding divestitures and product line exits. While not terribly worrisome, the new order backlog will probably need to turn back upward for the company to get full credit for its revenue increases.

The gross margin and EBITDA margin expanded as the company controlled its expenses. Cash flow was strong at $19 million. Foster repaid $17 million in debt, pulling their net debt down to $69 million, or about 2.3x EBITDA. For perspective, the $17 million paydown accreted $1.53/share to shareholders, or about 7% of the current share price.

In the quarter, revenues excluding one-offs rose 10% (or 13% on an organic basis). Revenues were 4% above estimates. Earnings of $0.05/share compared to a $(0.20) loss a year ago but were sharply below the $0.26 estimate. Adjusted EBITDA of $9.7 million was 8% above estimates.

TreeHouse Foods (THS) – As a major contract producer of private label foods, TreeHouse has struggled with poor execution and elevated debt resulting from its acquisition-driven strategy even as the private label food industry remains healthy. The company remains profitable and generates reasonable free cash flow. Respected activist investor JANA Partners has a large stake and is pressuring this undervalued company to get its act together.

TreeHouse reported a disappointing quarter as sales slipped from weaker demand and some one-off product problems. Favorably, profits improved but the actual progress was clouded by questionable adjustments. Fourth quarter revenue guidance was modestly disappointing but profit guidance remained unchanged. The TreeHouse story continues to move forward despite management’s sloppy execution and a tapering of favorable end-demand. The essence of the turnaround is for modest revenue growth but stronger earnings and cash flow growth as TreeHouse becomes more efficient.

With the huge $428 million cash proceeds that came in October, TreeHouse now has a respectable balance sheet that could either be used for share buybacks (good) or acquisitions (bad). We lean on the boardroom presence of high-quality activist investor Jana Partners (8.7% stake) to keep management focused on shareholders. No change to our Buy rating.

Revenues were 5% below management’s prior guidance from only three months ago. Unit case volume rose 1% but weakening in its end-markets weighed on revenues more than management anticipated. Also, a product recall and a supply chain problem erased some sales. While theoretically one-time problems, they illustrate some fragility in TreeHouse’s business model. Revenues were helped by a 3% price boost but this pace is slower than in prior quarters and appears to be fading as customers push back more. Demand for private label goods remains healthy.

Adjusted profits improved from various efficiency programs and a one-off benefit from a cost-sharing agreement. The company continues to remove expenses like “Growth, reinvestment, restructuring programs and other” from its adjusted net income and EBITDA results. While the purpose could be to display the underlying earnings power, these adjustments are real costs and are recurring, as all businesses must spend on growth, reinvestment and efficiency improvements. The concept of adjusted earnings is loose enough already – we don’t need the company to aggressively push it even further.

In the quarter, revenues adjusted for the Snack Bar divestiture rose 4% but were 5% below estimates. Adjusted net income from continuing operations was $0.57/share, up 58% but was 4% below estimates. Adjusted EBITDA of $90 million rose 13% and was 7% above estimates.

Viatris (VTRS) – Viatris was formed in November 2020 through the merger of pharmaceutical generics producer Mylan, N.V. and Pfizer’s Upjohn division. Declining revenues, limited drug pipeline visibility, elevated debt, and a confusing change in strategy have continued to drag the shares lower since our initial recommendation. However, a new CEO along with increased visibility into its new strategy and post-divestiture business model, as well as better operational execution offer the potential for a fundamental turnaround and a higher share price.

The company reported a reasonable quarter with little new information. Earnings fell but were incrementally above estimates. Fourth-quarter guidance was in-line with estimates. Revenue growth was flattish as growth from new products offset decay from older products. Costs remain a problem but will likely be more assertively addressed in 2024. Viatris is generating decent free cash flow and chipping away at its debt. The share valuation remains low as long as Viatris’ fundamentals show no further decay.

The relatively new CEO seems to be considerably better than the former at steering the company toward profitable stability. Viatris said it remains committed to the generous dividend. One risk is that the company re-starts its acquisition program to build upon its current in-house pipeline, but we see their ability to acquire as being somewhat constrained by their self-imposed debt limit. All in, we are remaining patient with the shares.

In the quarter, revenues fell 3% but when adjusted for divestitures and currency rose 1%. Revenues were 1% shy of estimates. Adjusted earnings of $0.79/share fell 9% but were 7% above estimates. Adjusted EBITDA of $1.4 billion fell 9% but was 5% above estimates.

Warner Bros. Discovery (WBD) – Warner Brothers Discovery is a global media company with a vast portfolio of properties including the Warner Brothers film studio, HBO, the Discovery Channel, The Learning Channel and CNN. Investors worry about the integration risks and enormous debt burden that accompanied its acquisition of the Warner Media operations from AT&T. Other concerns include Discovery’s streaming challenges and the secular erosion in its network segment. Acknowledging these issues, we see an investment primarily as a turnaround of the Warner Media assets within a stable and profitable Discovery business, led by an aggressive, determined and highly focused CEO. Legacy Warner Brothers is healthy and profitable and produces a large and growing stream of cash flow, buying it time for a turnaround while capably servicing its elevated debt.

While Warner Bros reported a reasonable quarter, the message that the de-leveraging will be delayed, along with a 1% downtick in the number of streaming subscribers, sent the shares sliding nearly 20%.

The de-leveraging strategy is critical to Warner Bros given its hefty debt burden. Due to the weaker advertising market and some effects of the Hollywood strikes, however, the pace won’t be as fast as management promised earlier this year. The goal of net debt/EBITDA of less than 3x by the end of 2024 won’t happen without a crisp improvement in ad spending.

However, we see the de-leveraging as only delayed, not derailed. The company is making impressive progress (has paid off 20% of its debt so far) and continues to generate impressive free cash flow that it will use to further slash its debt. Net debt will be at less than 4x by the end of the current year, a notable feat given the 5x level at the start of the year.

For the Warner Bros thesis to work, revenues need to remain stable while aggressive expense cuts help produce generous free cash flow. This is happening. In the third quarter, revenues rose 1% (2% including a favorable currency effect) and expenses fell 5%. Free cash flow of $2.1 billion compared to negative $(192) million a year ago. Year-to-date, free cash flow of $2.9 billion compared to $835 million a year ago. Management said the company is on track for another $2.1 billion in free cash flow in the fourth quarter. The company is aggressively paying down debt: year to date, net debt is down 6%, or nearly $3 billion. We anticipate total 2023 debt paydown of about $4 billion. For perspective, this is nearly $2/share in accretion to shareholders from free cash flow alone. This is more than 20% of the current share price.

In the quarter, revenues rose 1% excluding currency changes and were in-line with estimates. Adjusted EBITDA of $3.0 billion increased 22% from a year ago and was 3% above estimates.

Friday, November 10, 2023 Subscribers-Only Podcast:

Covering recent news and analysis for our portfolio companies and other topics relevant to value/contrarian investors.

Today’s podcast is about 14 minutes and covers:

• Summary of comments on earnings reports
• Other comments on recommended companies
  
  • Vodafone (VOD) – announces deal to sell Vodafone Spain.
• Elsewhere in the market
  
  • Dealing with the upside-down physics of the stock market.

Please know that I personally own shares of all Cabot Turnaround Letter recommended stocks, including the stocks mentioned in this note.

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.