November 11, 2022

This week’s update includes commentary on earnings from Adient (ADNT), Berkshire Hathaway (BRK/B), Brookfield Reinsurance (BAMR), Elanco Animal Health (ELAN), TreeHouse Foods (THS), Viatris (VTRS) and ZimVie (ZIMV).

Our recommended list has become too large, at 39 names. Our approach is to focus on the most promising turnarounds – those with our highest conviction – based on valuation and fundamentals. Turnarounds change and evolve as time passes. So, over the coming months, we plan to whittle our roster down to fewer than 30 names. Stocks that don’t make this cut will be weeded out. From a portfolio management perspective, proceeds from these sales can be reinvested back into the remaining names.

It is possible, even likely, that many of the stocks will be sold for losses at prices well below our price targets, so we will provide color on our thinking behind each removal. We aren’t changing any ratings yet because we don’t know which names we will be cutting.

Earnings Updates

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 operational turnaround so far, although the company (and shares) have struggled with issues common to the vehicle industry.

Adient reported a reasonable fiscal fourth quarter, provided an encouraging outlook for fiscal 2023 and announced a $600 million share buyback program (about 18% of its total share count). The company continues to chip away at its now-reasonable debt load (net debt is down 25%), helping reduce its risk while also providing considerable financial flexibility. Adient continues to improve its operational efficiency and productivity even in a challenging macro environment, reflecting its skilled and capable leadership team.

Revenues of $3.7 billion rose 32% from a year ago and were about 4% above estimates. Adjusted earnings of $0.53/share compared to a loss a year ago and were a cent above the consensus estimate. Adjusted EBITDA of $227 million rose 92% from depressed results a year ago and was about 15% above the consensus estimate. Adient’s fourth-quarter results continued to reflect low vehicle production and rising costs, although the company is seeing improvements.

Guidance for FY 2023 was slightly lower than the consensus outlook but demonstrated across-the-board improvements (sales, EBITDA, free cash flow) compared to a weak FY 2022, whichwas encouraging in that it validated the consensus as something of a floor against investors who anticipated a worse year ahead.

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 good quarter, with operating earnings (ex-currency) of $6.9 billion that rose 10% from a year ago and were about 12% above the consensus estimate. The insurance segment continues to struggle with elevated Geico underwriting losses. Weaker railroad profits also weighed on results. The energy, manufacturing and other businesses generally were strong. Helped by higher interest rates, the insurance investment income jumped 21% from a year ago. The company repurchased only $1.1 billion in shares during the quarter, a surprising slowdown given the lower stock price.

Overall, Berkshire’s legendary performance and favorable long-term outlook remain unchanged. Berkshire Hathaway shares trade at about 136% of the current $211/share tangible book value.

Brookfield Reinsurance Ltd (BAMR) – 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 accumulate considerable value for shareholders.

Along with a shortened and improved new name, Brookfield Reinsurance Ltd reported an encouraging third quarter as distributable earnings rose to reflect the company’s development toward a larger business. Its acquisition of American National insurance is going well and Brookfield continues to add new premiums and assets by closing several risk transfer deals and other acquisitions in the quarter. The upcoming transaction by parent Brookfield Asset Management to spin-out a 25% stake in its asset management business is on track.

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, prescription treatments and farm animal nutritional supplements. Following its September 2018 IPO at $24 as part of its spin-off from pharmaceutical giant Eli Lilly, Elanco shares have been lackluster, due to weak revenue growth, high expenses and an uninspiring new product pipeline. Veteran activist investor Sachem Head recently gained a board seat, likely leading to an upturn in the company’s execution and driving its undervalued shares higher. The August 2020 acquisition of Bayer Animal Health offers additional opportunities for improved results.

Elanco reported a respectable quarter, as its profit margin expanded noticeably due to lower costs even as sales fell 11%, which was in-line with estimates. Adjusted earnings of $0.20/share rose 5% and were 25% above estimates. Adjusted EBITDA of $205 million fell 3% but was about 1% above estimates. Full-year guidance was reduced incrementally due to resilient currency pressures and weaker economic conditions. New product development seems to be making progress.

Excluding currency effects, sales fell only 4%, with Farm Animal sales flat while Pet Health sales fell 7%. Volumes fell 7% while pricing rose 3%. The company attributed the weak Pet Health results to difficult economic conditions. The gross profit margin narrowed due to elevated costs and lower-priced mix of products but was nearly fully offset by impressively lower operating expenses. The EBITDA margin of 19.9% improved from 18.7% a year ago.

Cash flow excluding a one-time benefit from a swap settlement rose to $116 million from $89 million a year ago. The balance sheet remains excessively leveraged but only minimal debt matures until 2027. Most of the debt is fixed-rate and Elanco is well within its debt covenants.

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 9.2% stake and is likely to pressure this undervalued company to either sell or change its strategy and leadership.

TreeHouse reported a sloppy quarter with excessive adjustments complicated by a divestiture. Fourth-quarter revenue guidance was encouraging as it pointed toward sales growth of 22-24% and adjusted EBITDA margin expanding to 10.5% -12.0%. We remain engaged with the TreeHouse turnaround.

After quarter end, TreeHouse completed its sale of a significant portion of the Meal Prep business ($950 million total price), allowing TreeHouse to reduce debt by $500 million. TreeHouse is receiving a $420 million note that pays interest at 10% or more, yielding $42 million in income per year, which is an attractive return on capital (arguably better than TreeHouse’s core business).

In the quarter, revenues rose 17% to $875 million. Adjusted net income of $0.30/share fell 29% but was sharply above the consensus estimate. Adjusted EBITDA of $77 million fell 11% from a year ago and was 8% below estimates. Due to the divestiture, it is not entirely clear what was included in the consensus estimates so we will take them with a grain of salt. And the adjusted numbers have so many adjustments, some of which are clearly unwarranted, that we look at all of the adjusted numbers with a handful of salt, such that they are almost unusable. Why, for example, does the company adjust out $2.5 million for Covid-19 costs in late 2022?

Pricing (up 21%) drove the revenue gains, as volumes slipped 4%. However, the gross margin fell nearly 2 percentage points, to 14.8%, as labor, supply chain and other costs rose faster than pricing. Operating costs rose 19% as the company raised its wages to reduce attrition and labor shortages. Higher costs pressured the EBITDA margin, which fell to 8.8% from 11.4% a year ago. Free cash flow was negative as working capital absorbed considerable cash.

Inflation and weak economic conditions are driving consumers to lower-priced food and beverages which clearly helps TreeHouse. The company said it sees EBITDA earning power of $400 million, up from guidance for $280 million in 2022, once the commodity inflation and other costs are fully offset.

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 initially viewed Viatris as an undervalued stream of reasonably stable free cash flow, but due to the radical changes underway we are re-evaluating this view.

The company reported an encouraging quarter and provided an update on its aggressive divestiture strategy. Viatris reaffirmed its full-year revenues, adjusted EBITDA (with results toward the lower end) and free cash flow guidance, and is on track to realize $1 billion of cost savings by the end of 2023. The company has nearly ended the services sharing with Pfizer, an important hurdle that severs the umbilical cord to allow Viatris to stand on its own.

Revenues fell 10% and were 1% below the consensus estimate. Adjusted earnings of $0.87/share fell 13% from a year ago but were about 4% above estimates. Adjusted EBITDA of $1.5 billion fell 12% but beat the consensus estimate by 5%.

Nearly all of the revenue decline was due to currency changes, as ex-currency revenues fell 1%. About half of the profit decline was similarly due to currency changes. Improved expense control helped lift profits. The company’s core business continues to erode even if slowly. New product introductions are behind target although this probably was inevitable as drug launches are complex and full of uncertainty. Free cash flow similarly is slipping, down 21% in the third quarter (largely due to a one-time $259 million Epi Pen settlement) although up 14% YTD. These trends aren’t particularly relevant given the company’s transformative restructuring scheduled for completion by the end of 2023.

Viatris paid down about $614 million in debt in the quarter, putting its YTD total paydown at about $2.1 billion. Debt remains elevated at about 3.3x guided 2022 EBITDA. The company pays out about $580 million/year in dividends, at the $0.12/quarter rate.

The company’s divestiture strategy includes nearly $9 billion (pre-tax proceeds) in assets, including the Biocon deal for its biosimilars business announced earlier this year, which will boil down to around $5 billion in net proceeds. Viatris plans to slash its debt by $6.5 billion to maintain its investment grade credit rating, return about half of its free cash flow to shareholders and apply half to acquisitions. Related to this, the company announced a deal to acquire two ophthalmology biotech companies for a combined total of between $700 million and $750 million.

ZimVie (ZIMV) – Recently spun off from Zimmer Biomet Holdings, Zimvie specializes in dental and spinal implant products. Like with many new spin-offs, investors sold ZIMV shares for technical reasons, as well as due to concerns about the ability of the new company to fix its struggling spinal products division. The shares are attractive given their unusually low valuation, the company’s durable dental franchise and reasonable potential for a turnaround in its spinal products segment. ZimVie should generate considerable free cash flow, providing financial flexibility as its works down its modestly elevated debt burden.

ZimVie reported a reasonable quarter and re-affirmed its full-year 2022 guidance. Expectations embedded in the estimates and the share price were so pessimistic that these results were enough to drive the shares sharply higher.

We are encouraged by pace of ZimVie’s operational and financial improvements following its spin-off. The management seems motivated and enthusiastic about making the company more competitive and more profitable (committing to expanding its EBITDA margin to 17% from 13% over the next three years), and the fixes seem reasonably achievable. Quarterly results will likely include several one-off positives and negatives until reaching a post-spin-off steady state in the next few quarters. Overall, we continue to like the prospects of this small but spunky company.

Revenues fell 11% but were down 7% excluding the effects of the strong U.S. dollar and were in-line with the consensus estimate. Adjusted earnings of $0.49/share rose 75% from a year ago and were 81% above estimates. Adjusted EBITDA of $29 million rose 25% from a year ago and was 17% above estimates.

The Dental segment continues to perform well, with sales rising 2% excluding currency changes. This segment doesn’t need a turnaround but could use some incremental improvements in execution and cost efficiency which we believe are underway.

Spinal segment revenues continue to struggle, falling 14% ex-currency. This segment clearly needs a turnaround and management is working to make this happen. Part of the sale declines are a positive as they are due to exits from unprofitable markets and products – when accounting for these changes the sales decline was 8% ex-currency.

We would like to see profitability broken out by segment but the company does not disclose this. Overall profitability as measured by the EBITDA margin expanded to 13.8% of sales from 9.9% a year ago.

Management is freeing up cash that currently is tied up in inventory and tightening its capital spending on spinal segment instruments. We like the fast improvements in ZimVie’s capital allocation and their motivation to cut the elevated debt (4.5x EBITDA) down to size.

Friday, November 11, 2022 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 17 minutes and covers:

• Earnings updates
• Comments on other recommended companies:
  
  • Walgreens Boots Alliance (WBA) – major deal to accelerate entry into healthcare services.
• Elsewhere in the markets
  
  • Inflation may not be broken but it appears wounded
  • Inevitable crypto collapse continues with unraveling of FTX
• Final note
  
  • Congratulations to the Houston Astros
  • Veterans Day
    

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.

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.