September 1, 2023

This week, we comment on results from Duluth Holdings (DLTH), the last of our companies to report this earnings season.

We also include the Catalyst Report and a summary of the September 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: The attention of most investors, commentators and analysts has been on the winners, notably the Magnificent Seven, driving this year’s stock market rally. As contrarians, we are fine with letting a few overpriced trendy stocks capture the spotlight. One place that draws our attention is the other end of the spectrum – those with the worst performance. While most of these stocks fully deserve the market’s dour judgment, some have favorable changes underway. We look into four large and midcap stocks that fit this description, including Hawaiian Electric Industries (HE), UBS (UBS), The Walt Disney Company (DIS) and Wolverine World Wide (WWW), and one that does not, International Flavors & Fragrances (IFF). We also discuss a tactic to help improve one’s success when investing in out-of-favor stocks.

Our Buy recommendation this month is Advance Auto Parts (AAP), one of the four major auto parts retailers, with nearly 5,000 locations, primarily in the United States. Advance Auto’s aggressive acquisition spree overstretched the company, and its former CEO was not up to the task of rationalizing the sprawl. Sharply falling profits, an inventory glut and too much debt have led to an 83% dividend cut and an erasure of management’s remaining credibility with investors. It’s not surprising that the shares have collapsed 73% from their 2022 peak and now trade at 12-year lows.

However, a comprehensive overhaul is now underway, starting at the top. The failed CEO is being replaced with a capable outsider, Shane O’Kelly. O’Kelly previously was head of HD Supply, a subsidiary of Home Depot, and has considerable CEO and distribution industry experience. He also was a captain in the U.S. Army and holds an MBA from Harvard. In addition, the CFO has departed, allowing O’Kelly to select his own finance lieutenant. The board is being refreshed and is now led at least on an interim basis by highly regarded Gene Lee. These changes should bring tighter oversight of the executive suite’s strategy and execution. We anticipate that the new leadership’s plans will be announced in early 2024 and include both operational and strategic changes.

While Advance’s debt burden is too high, it is manageable, with nearly all the debt carrying fixed interest rates at a relatively modest 4.50% average rate. The nearest major maturity is in March 2026. Even with its tight financial position this year, free cash flow should be at least $150 million.

The valuation is at a depressed multiple of depressed earnings. We have a $98 price target, up about 50% from the current price. Advance Auto is a repeat – our October 2018 recommendation produced an 80% return in about 14 months. We have no illusions about the difficulty of the current turnaround but would be pleased to have a similarly successful repeat performance.

Prospective investors will want to be aware that this turnaround will likely take time to play out, and interim bad news could readily drag the shares lower in the near term. From a tactical perspective, investors may want to take a starter position now, then add on any meaningful weakness at lower prices. Despite its current wheel-spinning, this company has all of the components of a successful turnaround, which would drive the shares meaningfully higher.

Earnings Updates:

Duluth Holdings (DLTH) – This retailer of rugged workwear and outdoor gear struggled with a disjointed and overly aggressive store expansion strategy. Duluth ousted the CEO in September 2019, terminated the failed strategy, and hired a new, permanent CEO in May 2021. The founder continues to be a major shareholder. Duluth has immense opportunities – its challenge is to strike a successful balance between pursuit and execution.

Duluth reported another disappointing quarter with lackluster sales and profits. The company also reduced its full-year Adjusted EBITDA guidance by 15% and said its CFO is leaving for a job at another company. The company’s operating cash flow is much improved from a year ago (favorably) but this cash is being washed away by the elevated capital spending program.

From a strategic perspective, Duluth appears to be transitioning away from its roots as a retailer of seriously durable clothing for the working man and toward a retailer of clothing with lighter but trendier qualities that appeals to a broad audience. CEO Sam Sato’s comments about the “apparel collection” and “new colors and fits” help reveal this transition, as does its evolving product and label array and the “Secret Sauce” page in the slide deck. The North Face was successful with this approach, but others have not been. Duluth’s softer/trendier lines are growing reasonably rapidly but the “working man” customer seems to have moved elsewhere.

Our view is that Duluth is now a zombie company. Its operations are improving but awful customer reviews point to a need to get a lot better. The financial condition is clearly getting better. But, the core of its business – selling clothes that people actually want to buy, and buy at respectable prices – is struggling. New products seem to be moving, illustrated by the 30% growth of the AKHG Women segment, but these are still too small (despite that 30% growth, overall women’s sales grew only 3%) as total sales fell 2%.

Until we see more durable traction in total sales and better in-store traffic flows, we won’t have much confidence in any growth of its core merchandising business regardless of the improvements in peripherals like operations and finance.

Revenues continue to be pressured by moderating customer demand seen around the industry. And, profits slipped due to weaker gross margins, which fell 2 percentage points due to discounting. Operating costs actually increased – due to the new distribution facility and new hiring which probably makes sense – but we’re not seeing the benefits yet. As Duluth hasn’t been an icon of cost control in its past, we believe the company will be plagued by elevated expenses regardless of its weak-ish revenues.

Duluth shares remain a very timid Buy, but a Buy nonetheless, given its improved operational and financial foundation and the potential for better merchandising results down the road. The share valuation is an unchallenging 5.8x EBITDA even though the EBITDA seems a bit loose.

In the quarter, revenues fell 2% but were in line with estimates. The $(0.06)/share loss compared to a $0.07 profit a year ago and was below estimates for a $0.02 profit. Adjusted EBITDA of $8.6 million fell 35% and was about 30% below estimates.

Full-year revenue guidance was unchanged but EBITDA guidance was reduced 15% to about $42 million. The company said it would post negative earnings per share for the year compared to its former guidance for profits.

Friday, Sept 1, 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 9 minutes and covers:

• Summary of monthly Cabot Turnaround Letter
• Comments on earnings
• Comments on other recommended companies
  
  • LB Foster Company (FSTR) – Discontinuing a product line but reaffirming guidance.
  • Walgreens Boots Alliance (WBA) – CEO Roz Brewer is out.
• Elsewhere in the market
  
  • Upcoming institutional investor conferences can provide private investors with useful color on their companies.

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.

The Catalyst Report

August was a busy month with 53 reported catalysts. Deal activity heated up, including Campbell Soup’s (CPB) high-profile deal for Sovos Brands (SOVO) and Cleveland Cliff’s (CLF) bid for U.S. Steel (X). Our most recent Buy recommendation, Advance Auto Parts (AAP), was driven by a CEO replacement.

With rising interest rates and tighter capital markets, we’re seeing more Chapter 11 bankruptcy filings, including four this month, led by the inevitable filing by Rite-Aid (RAD).

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:

US Cellular (USM) $3.9 billion market cap – This wireless telecom service provider spent decades battling to remain independent. But, in this industry, scale matters, leading to the inevitable decision to finally sell out. The range of values attainable for US Cellular are wide but likely higher than the current price. And, 82% owner Telephone & Data Systems (TDS) would ride along with any sale. An additional possibility: TDS sells its other operations which could propel its shares still higher.

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Hanes Brands (HBI) $1.8 billion market cap – This poorly run and over-leveraged company is facing significant competition. But, aggressive activist investor Barrington Capital has taken a stake and wants new leadership that is focused on cost-cutting, inventory and debt reduction and wider gross margins. Hanes’ shares are severely out of favor so any fundamental improvement would likely drive the share price higher.

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Wolverine World Wide (WWW) $637 million market cap – As described in our recent Turnaround Letter, this company is struggling with elevated debt and weak operating results. An abrupt change-out in CEOs is bringing the potential for better operating results as well as divestitures.

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.