October 27, 2023

This week’s note includes our comments on earnings from 10 of our companies. The deluge continues next week.

The note also includes the monthly Catalyst Report and a summary of the November edition of the Cabot Turnaround Letter, which was published on Wednesday. We encourage you to look through the Catalyst Report. This report is a listing of all of the companies that have reported a catalyst in the past month. These catalysts include new CEOs, activist activity, spin-offs and other possible game-changers. We source many of our feature recommendations from this list. You will find it nowhere else on Wall Street.

In this month’s Cabot Turnaround Letter: We discuss five homegrown turnarounds in Massachusetts, including Azenta, Inc. (AZTA), EverSource Energy (ES), Mercury Systems (MRCY), State Street Corporation (STT) and TripAdvisor (TRIP). Gold stocks have disconnected from gold prices, leaving some bargains. We review two gold stocks, including Barrick Gold (GOLD) and Newmont (NEM).

Our Buy recommendation this month is Agnico Eagle Mines (AEM), the third largest gold miner in the world. Its shares have fallen out of favor and offer an attractive value to contrarian investors.

Agnico concentrates exclusively on quality mines in the legally safe countries of Canada, Mexico, Australia and Finland. After several large acquisitions in recent years, the company will focus on fully integrating and improving these operations and growing production in its existing mines.

As the owner of some of the industry’s highest quality mines, Agnico’s production volumes look steady for years to come. The company is an efficient operator with below-average costs and flattish capital spending in the coming years. Management quality is high. Agnico generates net income of over $1 billion, with EBITDA (cash operating profits) of about $3.3 billion. Free cash flow this year will likely match net income, but will surge if gold prices remain elevated. The balance sheet is robust, with net debt of only about 0.5x EBITDA. Agnico’s shares trade at a 25% valuation discount, with an understated earnings power, and offer an attractive 3.2% dividend yield.

Comments on Earnings

Agnico Eagle Mines (AEM) – Agnico is the third largest gold miner in the world. It is arguably the highest quality miner as it focuses exclusively on strong mines in the legally safe countries of Canada, Mexico, Australia and Finland. After several large acquisitions in recent years, the company is emphasizing integrating and improving these operations and growing production in its existing mines. Management is similarly high-quality. Agnico shares have fallen out of favor and offer an attractive value to contrarian investors.

The company reported a good quarter, with production growth (+4%) and costs (+9%) coming in as expected. Management said that fourth-quarter results would be similarly encouraging.

In the quarter, revenues rose 13% and were in-line with estimates. Adjusted earnings of $0.44/share fell 10% but were 5% above estimates.

The 13% increase in revenues was comprised of 4% higher production and 13% higher gold prices (average $1,928/ounce). Profits slipped as minesite costs and related royalties increased 15%. The balance sheet remains sturdy, with debt increasing incrementally during the quarter. Free cash flow was strong at $669 million. Year-to-date, free cash flow is $1.97 billion, up 20% from a year ago.

Capital One Financial (COF) – Capital One is one of the nation’s largest banks, with over $440 billion in assets and 775 branches. A major difference from other banks is its focus on credit card lending, which comprise 40% of total loans. It is the third largest issuer of Visa and Mastercard credit cards. Auto loans (27%) and commercial loans (32%) comprise the balance. Its shares are depressed from worries about a possible recession and, like all banks, its ability to retain deposits at costs that don’t erode its net interest margin. However, the bank is well-managed, has robust capital and credit reserves and strong underlying profitability. For patient investors, Capital One shares look like a true contrarian bargain.

Capital One reported a strong quarter as profits increased 6% whereas the consensus estimate was looking for a 22% decline. Decent revenue growth (+6%) and incrementally lower operating expenses fully offset a 37% increase in credit costs. The bank is navigating the rising interest rate environment reasonably well – while the net interest margin slipped to 6.69% from 6.80% a year ago, it was higher than the second quarter’s margin of 6.48%.

Bad loan charge-offs more than doubled from a year ago, but fell compared to the second quarter. The bank continued to add to its loan loss reserves but at a tempered pace, indicating that it feels confident in its outlook for future losses. Capital remains strong at a 13% CET1 capital ratio.

In the quarter, revenues rose 6% and were 2% above estimates. Earnings of $4.45/share rose 6% and were 37% above estimates.

Dril-Quip (DRQ) – A major supplier of subsea equipment, Dril-Quip is struggling with 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 mixed quarter that showed improvement in revenues and adjusted EBITDA compared to a year ago. Revenues included noise from the recent acquisition and adjusted earnings included noise from gains, acquisition costs, currency losses and other one-offs that unfortunately seem to be somewhat recurring. Still, beneath it all, Dril-Quip’s fundamentals appear to be improving.

Free cash flow is noticeably positive although this was boosted by working capital and a tax refund. The company’s efficiency programs are making progress.

In the quarter, revenues rose 33% and were 4% above estimates. The adjusted loss of $(0.15)/share compared to a $0.04 profit a year ago and was well below estimates for a $0.13 profit. Adjusted EBITDA of $12 million improved from $7 million a year ago and was 20% below estimates.

Frontier Group Holdings (ULCC) – Frontier is an ultra-low-cost airline focused on leisure travel. Our initial Recommendation looked like an opportunistic purchase of a financially strong airline that was trading near an all-time low and 50% below its IPO price. However, in hindsight this was ill-timed as weak demand has pressured the company’s ability to fill its increasing capacity. The company’s balance sheet carries more cash than debt. Management is capable and entrepreneurial.

Frontier reported a weak third quarter that nevertheless was better than estimates, with reasonable fourth-quarter guidance, so the shares rose in a sloppy day in the market. Profits were pressured by a lower load factor (capacity utilization) and lower revenues per passenger, along with higher wages and station fees (on-ground costs incurred at airports). Another way to look at this: Frontier’s capacity increased a huge 21% as it added more planes, so its total operating costs increased, but at the same time it had to cut its fares in a weak market to fill those planes. Frontier’s financial condition isn’t threatened but its turnround is in a holding pattern for now.

In the quarter, revenues fell 3% and were in-line with estimates. The adjusted loss of $(0.14)/share compared to a $0.15 profit a year ago but was better than estimates for a $(0.17) loss.

The company reported that its CASM ex-fuel (cost per available seat mile, excluding fuel costs) fell 1%. While interesting, the improvement is a statistical quirk. CASM is calculated as Operating expenses ÷ Available Seat miles (ASM is number of available seats x number of miles flown). Operating expenses ex-fuel rose 19%, but ASM rose 21% as the airline added a lot of capacity. Frontier needs to fill its planes to better cover its costs.

General Electric (GE) – Led by impressive new CEO Lawrence Culp, GE finally appears to be righting its previously severely damaged businesses. Key priorities include much better execution and a strategic emphasis on cash flow and debt reduction. Following the spin-off of 80% of GE Healthcare (GEHC) in January 2023, General Electric is now comprised of GE Aerospace (commercial and military jet engines) and GE Vernova, which includes the Renewables segment (on-shore and offshore wind power) and the Power segment (gas turbines, coal, nuclear). GE Aerospace and GE Vernova will separate in 2024.

GE reported strong revenues (+18% organic), earnings (compared to a loss) and free cash flow (of $1.7 billion). Revenues were 11% above estimates, while adjusted earnings per share were 47% above estimates. The company raised its full year guidance for revenues by about 1 percentage point (to “low teens” growth), for per-share earnings by 18% and full-year free cash flow by 13% – although much of these increases were due to strong third-quarter results.

Organic orders rose 18%. GE repurchased the remaining $2.8 billion in preferred stock and repurchased $300 million of common stock. The company is well-positioned for the separation of GE Aerospace and GE Vernova, which will occur at the beginning of the second quarter of 2024. GE will file its registration documents and host investor days in advance of the separation.

GE’s turnaround is a textbook example of how a capable and experienced CEO can turn a broken company into a prosperous one. We have little doubt that GE would have gone bankrupt without Culp at the helm. No change to our Buy rating.

GE Aerospace has clearly revived and is producing strong results. Revenues rose 25% while operating profits increased 33% as higher volumes and pricing more than offset higher costs and new investments. Orders jumped 34%. For the year, guidance for segment revenues were for low 20% growth and $6 billion in profits, with free cash flow increasing compared to a year ago.

GE Vernova is recovering but still unprofitable. Revenues rose 14% while operating profits improved from a $(793) million loss to a $(79) million loss. Orders increased 3%. Full-year guidance is for high-single-digit (we’d call it 8-9%) revenue growth and a $(200) million operating loss, with only incremental improvements to free cash flow.

Mattel (MAT) – At our initial recommendation in 2015, Mattel was struggling with its failure to adjust to the realities of how young children spent their playtime. This failure had produced years of revenue decay. In addition, its cost structure became bloated and its debt levels increased. However, led by its new CEO, Mattel now appears to be finding its way.

Mattel reported a strong quarter compared to a year ago and to estimates. However, fourth-quarter earnings guidance for about $0.26/share was 33% below the consensus, leading to a sell-off in the shares. Fundamentally, the company continues with its prolonged but now-impressive turnaround. We remain patient with the shares.

In the quarter, revenues rose 9% (7% ex-currency) and were 7% above estimates. Adjusted earnings of $1.08/share rose 32% and were 26% above estimates. Adjusted EBITDA of $580 million increased 22% and was 20% above estimates.

Mattel’s margins expanded (gross margin by 2.7 percentage points, operating margin by 3.7 percentage points) indicating that pricing and cost efficiency remains solid. The balance sheet improved as the company used some of its stronger free cash flow to trim its debt. Inventories at Mattel and its customers (retail stores like Walmart and others) look lean.

Demand remains strong for most of Mattel’s products but not quite as high as analysts anticipated. And overall full-year 2023 results will likely match, but not significantly exceed, full-year 2022 results. Mattel will need another year of strong results to convince the market that it is worth something closer to our admittedly aggressive $38 price target.

Polaris (PII) – Shares of this high-quality manufacturer of powersports equipment like off-road vehicles, snowmobiles, motorcycles and boats fell out-of-favor due to concerns over a post-stimulus falloff in demand as well as supply chain disruptions. We believe the company’s long-term prospects remain intact. Polaris produces strong profits and free cash flow, has a solid balance sheet, and a strong, shareholder-friendly management team.

Polaris reported a modestly disappointing quarter. The company fractionally trimmed its full year revenue guidance and cut its earnings guidance by about 4% (to down 4%). End-market demand for the core Off-Road gear is positive, especially in North America, but overall demand for the company’s products is softening. We don’t see a collapse in demand but enduring weakness will keep Polaris shares tamped down until the next upcycle. The company continues to generate healthy profits and free cash flow and has a sturdy balance sheet. No change to our Buy rating.

In the quarter, revenues fell 4% and were 1% below estimates. Adjusted earnings of $2.62/share fell 17% from a year ago and 4% below estimates. Narrower gross margins (down about 1.3 percentage points), due to higher manufacturing costs and financing costs as well as unfavorable product mix, pressured profits. Sales and marketing expenses increased 3%. Adjusted EBITDA fell 11%.

The Off-Road segment (about 80% of total sales) remains healthy with 6% revenue growth, although the gross margin slipped over 2 percentage points due to more sales of lower-margin products as well as elevated manufacturing and financing costs. End-market demand continues to tick higher. Polaris has several interesting new products hitting the markets soon.

On-Road segment sales fell 19% on weaker demand. The gross margin improved due to more sales of higher-margin products. End-market demand is flat/weak.

Marine segment sales fell 48% as demand is slumping with little prospect for an immediate rebound. The gross margin fell about 3.4 percentage points.

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 financial services unit. China is Volkswagen’s largest market, (38% of vehicle unit sales), followed by Western Europe (32%) and North America (10%). Investors worry about the sizeable China exposure, large but unsettled bet on electric vehicles, complicated governance structure, issues with its in-car software, and the likely effects of a recession. We acknowledge the numerous headwinds, yet believe the market is over-discounting these while over-looking the company’s strengths, including its sturdy balance sheet and sizeable profits and free cash flow, which give it plenty of time to execute its plans. Several important catalysts, including the Porsche IPO and new leadership, should help unlock value within the shares.

VW reported a reasonable quarter and said that its full-year outlook is on track to deliver 8-15% more vehicles, roughly comparable profits and sharply higher free cash flow. The results weren’t strong enough to offset investor worries about China, rising costs and a slowing global economy, so the shares continued their slide.

Revenues rose 12% and were 4% above estimates. Net income of €7.76/share nearly doubled and was 19% above estimates. Operating profits of €4.9 billion increased 15% but fell short of estimates by 14%. The wide difference between operating profits and net income was due to sharply higher interest rates even as VW’s automotive segment balance sheet remains cash-heavy (net cash of €38 billion).

Global vehicle deliveries rose 7% in the quarter and 11% YTD. Electric vehicle deliveries rose 9% in the quarter and are on-track to comprise about 10% of total company sales for the year.

The Western Union Company (WU) – This widely-recognized money transfer company is facing secular headwinds from the transition to digital money. Prior efforts to diversify away from the core retail business using the company’s sizeable cash flows were unsuccessful, but a new CEO with impressive fintech experience brings the real possibility of a meaningful improvement in both execution and strategy as it makes its transition to the digital world. Investors have aggressively sold WU shares, ignoring the company’s relatively stable revenues, sizeable free cash flow and valuable intangible assets as well as its generous dividend yield.

Western Union reported a good enough quarter with higher revenues and profits which came in above estimates. However, management’s fourth-quarter guidance for earnings of about $0.35/share is about 7% below estimates, hence the sell-down of the shares. Investors want to view Western Union as a growth company of sorts, and want the turnaround to be linear. However, Western’s turnaround is complicated and subject to wide quarterly variability, given their focus on “serving the aspiring populations around the world.”

Also, Western is a cash flow story rather than a growth story. All we need to see is stable/incremental growth in the already robust free cash flow – eventually the financial strength will be recognized by the market. YTD free cash flow was $528 million, up about 29%. For reference, on an annualized basis, this produces a free cash flow yield of about 14% (free cash flow ÷ market cap). Western Union is returning much of this cash flow to investors, given its 7.3% dividend yield and incremental share repurchases. The company is also paying down its debt.

A key metric that we are watching is the EBITDA margin. This metric ticked down to 23.3% from 24.9% a year ago, partly due to technology spending related to its turnaround and partly due to rising variable costs. Two other key metrics are the number of transactions and dollar volume of transactions. The transaction count showed continued strength in the quarter (+5%) after bottoming at a decline of 5% in mid-2022. Dollar volume was fractionally negative (-0.1%) but continues to improve.

All-in, we remain patient with this edgy, grind-forward turnaround.

Revenues rose 4% after scrubbing out currency changes and the benefits of Argentina inflation, and were about 5% above estimates. Adjusted earnings of $0.43/share increased 2% and were 18% above estimates. Adjusted EBITDA of $262 million rose fractionally and was 6% above estimates.

Xerox Holdings (XRX) – While the near-term outlook remains clouded, as office workers remain in partial work-from-home mode, we believe the company’s revenue and cash flow will recover. Investors underestimate Xerox’s value due to its zero-growth prospects, but the company’s hefty free cash flow has considerable value. The balance sheet is strong, new and capable leadership is working to drive shareholder value higher, and its generous dividend looks reliable.

Xerox reported a reasonable quarter with revenues falling slightly short of expectations but earnings handily beating estimates. The company maintained its full year guidance. However, management said that revenues will be at the lower end of its guidance range as sluggish trends will continue into the fourth quarter and as demand in Europe softens. Cost-cutting and the termination of low-margin products will help maintain the profit margin. No change to our Buy rating.

Investors continue to want Xerox to be a “growth” company. We can see this in the sharp early sell-off on Tuesday when the company suggested that revenue growth will be subdued. However, Xerox will never be a growth company. It is in an industry that at best is in secular stagnation and competition is aggressive. We see Xerox as a cash flow company, so our primary focus is that revenues remain reasonably stable and that cash flow stays robust. There is immense post-pandemic and work-from-home noise in Xerox’ year-over-year comparisons, but looking through to longer-term trends we continue to see a flat/stable revenue company.

The new CEO announced a strategic cost-cutting program that he said would return its operating margins to at least 10%. Xerox should always have some efficiency program underway given its highly competitive industry. If the company can get anywhere near this 10% target, the shares are remarkably undervalued. However, this margin target is for fiscal 2026, three years away, so all we can hope for in the meantime is healthy indications that the company is on track to meet this goal.

We were disappointed to learn that the financing segment won’t be sold (which would simplify the Xerox story and remove a credit risk from the balance sheet), but rather will focus only on Xerox customer financing. However, we are partly assuaged by the planned slashing of the portfolio to about $1 billion from the current $2.6 billion.

In the quarter, revenues slipped 6%, or 7% excluding currency changes and were 4% below estimates. Adjusted earnings of $0.46/share increased from $0.27/share and were 18% above estimates.

Equipment sales fell 2%. These sales are generally a leading indicator of future demand for post-sale products and services. Entry-level machine sales fell 25% as work-from-home demand appears to be fading, while mid-range and high-end machines (about 84% of total equipment sales) are growing (at a 3-6% pace) reflecting a healthy economy. Post-sale revenues comprise about three-quarters of Xerox’ revenues, and these sales fell 9%.

Xerox’ balance sheet, excluding the finance subsidiary, strengthened and now has more cash than debt. After the quarter ended, Xerox repurchased all of Carl Icahn’s shares, which reduces the share count by 22%. The company is financing the purchase with debt.

Friday, Oct 27, 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 12 minutes and covers:

• Summary of monthly Cabot Turnaround Letter
• Comments on recommended companies
  
  • Walgreens Boots Alliance (WBA) – Pharmacists walk out.
  • Western Digital Corp (WDC) – Hits a snag in its potential deal for Kioxia.

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

The Catalyst Report

October was a relatively busy month for catalysts. Deal activity, especially for large deals like ExxonMobil’s (XOM) deal for Pioneer Natural Resources (PXD) and Chevron’s (CVX) purchase of Hess (HES), was up. Several spin-offs either were announced or completed. We are seeing more companies file for bankruptcy – not surprising given the tighter credit markets and slowing economy.

The Catalyst Report is a proprietary monthly report that is unique on Wall Street. It is an extensive listing of companies that have experienced a recent strategic event, such as new leadership, a spin-off transaction, interest from an activist investor, emergence from bankruptcy, and others. An effective catalyst can jump-start a struggling company toward a more prosperous future.

This list is intended to be comprehensive. While not all catalysts are meaningful, some can bring much-needed positive changes to out-of-favor companies.

One highly effective way to use this tool is to pair the names with weak stocks. Combining these two traits can generate a short list of high-potential turnaround investment candidates. The spreadsheet indicates these companies with an asterisk (*), some of which are highlighted below. Market caps reflect current market prices.

The following catalyst-driven stocks look interesting:

VF Corp (VFC) $7.0 billion market cap – This company rode the business casual wave a decade or two ago, but its concentration in semi-mature The North Face and past-its-prime Vans, along with generally poor execution, has produced a dismal fundamental outlook and a staggering debt load. VFC shares have collapsed. Activist Engaged Capital wants a complete re-boot, which is clearly needed.

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Goldman Sachs (GS) $98.6 billion market cap – Shareholders and employees are getting restless as Goldman’s CEO unwinds his disastrous (financially and culturally) shift into consumer finance. The $1.2 billion loss (~70%) in GreenSky after only a year exemplifies the problem. The shares are cheap at about 1x book value. Continued sloppiness in capital markets could pull the shares lower. Eventually, CEO Soloman will likely be ousted, an event that could readily drive the shares higher both immediately and longer-term.

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Frontier Communications (FYBR) $4.2 billion market cap – Investors have almost no interest in owning a debt-burdened, capital-intensive and unprofitable company like Frontier. But, there must be some value: Activist Jana Partners has taken a stake in the company and is pressing it to sell to either a strategic or financial buyer. Ares Capital, no amateur when it comes to undervalued assets, has a 16% stake in Frontier. And peer company Consolidated Communications (CNSL) was recently taken private.

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.