October 21, 2022

This week, Dow (DOW) and Nokia (NOK) reported earnings. The deluge for our companies starts next week with twelve companies reporting.

Next week, we will publish the November edition of the Cabot Turnaround Letter on Wednesday and our proprietary Catalyst Report on Friday.

Earnings Reports

Dow (DOW) – As the world’s largest producer of ethylene and polyethylene, the most common plastics, as well as selected specialty products, Dow is a cyclical company whose shares have tumbled on fears of a recession. However, the company is well-managed, has a very strong balance sheet, generates sizeable profits and free cash flow, and pays a readily-sustainable dividend that yields over 6%. Dow is likely to remain profitable and healthy in economic conditions other than a deep and prolonged recession. At our recommendation date, the shares traded for an overly-discounted 4.8x EV/EBITDA on recession-minded 2023 earnings estimates.

Dow reported a reasonable quarter that showed the effects of modestly weaker demand combined with higher raw material and energy costs compared to a year ago and to the prior sequential quarter (Q2). The company’s European operations were hit particularly hard, as weaker demand combined with sharply higher natural gas input prices. The company provided fourth-quarter sales guidance that was about 5% below the current consensus and pointed to continued weak markets. It will provide its 2023 outlook with fourth-quarter results.

Some useful nuggets: Dow said that it has $1 billion of new cost-cutting initiatives (about 2% of full-year revenues) on tap to help buttress profits in the weakening environment. Also, the company is cutting global polyethylene production by 15% and is actively adjusting to the difficult natural gas market in Europe and elsewhere. Dow trimmed its full-year 2022 capital spending guidance by about 10%. Nearly all of its debt is fixed-rate, so the impact of higher interest rates won’t directly weigh on its profits. The company is likely to halt its share repurchases to build up its cash balances in advance of further weak end-markets.

In the quarter, sales fell 5% but were 8% above the consensus estimate. Excluding the effect of the strong dollar, sales would have declined by only 1%. Operating earnings of $1.11/share fell 60% from a year ago but beat the consensus estimate by 3%.

Our view on Dow is that, while the peak of the highly profitable commodity cycle is clearly in the past, the shares have overshot on the downside and now discount a dark but highly unlikely future for Dow.

In the quarter, local prices increased 3% from a year ago, although on a sequential basis local prices fell 6%. Volumes fell 4% from a year ago and 3% sequentially. North America and Asia Pacific showed growth, while Europe/Middle East/India fell as perhaps expected due to the immense economic difficulties in Europe.

Free cash flow was a robust $1.5 billion, although this declined by 35% from a year ago. This remains 3x the quarterly dividend payout. Dow repurchased $800 million of its shares in the quarter – a smart buy at discounted prices. The balance sheet remains robust.

Nokia (NOK) - Initially recommended in 2015, Nokia has struggled for years to regain its competitiveness. It appears that the new CEO, Pekka Lundmark (March 2020), is capable of finally getting the company back into the game, particularly with the critical change-over to 5G over the next few years.

Nokia reported a reasonably good quarter, but the shares fell as investors had perhaps expected an earnings “beat” and worried about slowing demand and weaker margins. The market overall seems to be missing the underlying fundamental strength of Nokia.

Revenues rose 6% (adjusted for currency changes) to €6.2 billion and were about 3% above the consensus estimate. Earnings of €0.10/share rose 25% from a year ago and were in line with the consensus estimate.

Operating profits of €658 million rose 4% but the operating margin compressed to 10.5% from 11.7% a year ago. This produced angst among traders as it suggests that Nokia’s margin expansion story is being derailed. But the decline was driven by weaker Technologies profits, which were weaker apparently due to timing issues on patent contract signings, not weakness in the core segments. The company maintained its full-year revenue and margin guidance, although it said that the margin will likely be toward the low end of its guidance range, presumably due to this quarter’s weakness in the Technologies results, incremental expense pressures and some currency hedging losses.

Other nuggets: Being based in Europe, sales and operating profits benefitted immensely from the strong dollar, but the profit effect was more than offset by hedging losses in what in hindsight was a misplaced strategy. The company said that the supply chain issues appear to be easing, although salary inflation, spending on research and development and other overhead costs are limiting their ability to restrain expenses. Nokia still has about €100 million of recurring cost cuts scheduled for next year to help offset higher new spending.

Also: The weakening macro environment and increasingly complicated Chinese market will likely slow Nokia’s growth rate next year. However, India is poised to start its 5G rollout and Nokia is well positioned to benefit in this enormous market.

The two core segments (Mobile Networks and Network Infrastructure, which account for over 80% of revenues and 77% of operating profits) showed healthy revenue growth profit margin expansions.

In Cloud and Network Services segment, a recent carve-out to address Nokia’s lagging cloud effort, had a 3% decline in constant-currency sales and a 50% decline in profits, but this segment isn’t important to the company’s future or to our thesis in any meaningful way. Sales in the Nokia Technologies segment, which houses the company’s patents and other intellectual property, fell 19% (constant currency) but the company said this was more of a timing issue than a structural issue. Given its 70% profit margin, Nokia Technologies produces 30% of operating profits, so it is an important driver of overall Nokia results. Losses in the Group Common segment (which houses centralized research and various overhead costs as well as venture capital and other specialty operations) increased to €(70) million from €(38) million.

Free cash flow was €266 million, produced mostly from profits, and the net cash balance increased to €4.7 billion. Nokia continues to repurchase its shares and is about 40% through its €600 million repurchase program.

Friday, October 21, 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 14 minutes and covers:

• Earnings updates:
  
  • Dow (DOW) and Nokia (NOK).
• Comments on other recommended companies:
  
  • ESAB (ESAB) – made a reasonable acquisition.
  • Western Union (WU) – new CEO unveiled a reasonable turnaround plan.
  • Holcim (HCMLY) – pleaded guilty and paid a $780 million fine related to ISIS bribes in 2012-2014.
  • TreeHouse Foods (THS) – activist shareholder highlights reasons for share price upside.
  • General Electric (GE) – will be winding down its Boston presence.
  • Walgreens (WBA) – State of New Mexico presses for an opioid settlement.
  • Kaman (KAMN) – receives an order for the K-Max helicopter.
• Elsewhere in the markets:
  
  • Ten-year Treasury yields approach 5%... on their way to 6% or 7%?
  • “Newsflow” and Verizon shares
• Final note:
  
  • Elon Musk may have found a new way to get out of the Twitter deal.
    

To listen to the podcast…______________

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