Today’s note includes earnings updates on 11 companies and the podcast. On Thursday, we moved shares of Oaktree Specialty Lending Corporation (OCSL) from Buy to Sell.
Tomorrow, Berkshire Hathaway (BRK.B) reports earnings, and next week six companies report, including Viatris (VTRS), Elanco Animal Health (ELAN), Meredith Corporation (MDP), Organon & Co. (OGN), Toshiba (TOSYY) and Macy’s (M).
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 turnaround so far.
The company reported a disappointing quarter as it struggles with widespread production slowdowns at major customers (mostly related to the chip shortage) and rising commodity costs. Adient said that these problems would extend into the rest of the year and possibly into early 2022. Despite already dipping 25% from their mid-year high, the shares fell about 7% on Thursday. We look through the near-term issues and remain committed to the shares as the company’s turnaround and its post-chip/commodity cycle positioning continue to look strong.
Revenues of $3.2 billion were double the pandemic-affected year-ago revenues but fell slightly short of the consensus estimate. The adjusted loss of $(0.53)/share compared to the ($2.78) loss a year ago, while adjusted EBITDA of $118 million compared to a $(122) loss a year ago. Earnings comparisons with year-ago results are largely meaningless due to the heavy impact of the pandemic.
Despite the disruptions, Adient produced $162 million of free cash flow – this is highly encouraging as it suggests that the company’s ability to navigate remarkably complicated conditions is much-improved since the new CEO took the helm. Also critical: Adient’s product quality and customer service seems to have been restored to high levels, solidifying its franchise as a premier seat-maker.
The balance sheet carries $2.8 billion in debt net of cash. This is a manageable level, yet the company seems highly attuned to the size and continues to whittle it lower. Adient will receive about $1.4 billion in cash when its China exit/restructuring is completed later this year, much of which will be applied to debt paydowns.
Full-year revenue guidance was trimmed by about 3% while adjusted EBITDA guidance was trimmed by about 10%. For the full year, Adient said its adjusted EBITDA would be about $380 million lower due to the disruptions – a negative 35% incremental margin. The company cited Ford, Daimler, Stellantis, Renault and VW as being “severely” impacted by the chip shortage. Once these headwinds are mitigated, Adient’s profitability should jump.
Commodity costs, particularly steel and chemicals, continue to surge (steel is 3x its year-ago price). Fortunately, many/most of Adient’s contracts include either price lags or pass-through provisions of between 60-100%, such that about 70% of higher costs through the cycle are recovered.
Conduent (CNDT) – Conduent was spun off from Xerox in 2017. After a promising start, the company’s revenues fell sharply due to management problems, leading to a collapse in its share price. In late 2019, the company replaced the CEO, who began a major overhaul that is starting to show progress. Activist investor Carl Icahn owns 18% of Conduent’s shares, while Darwin Deason (who sold his business to Xerox which later was spun off as Conduent) holds a 3.3% stake.
Conduent reported an encouraging quarter, as it generated improved profits and higher new contract signings. Improved profits come from running its business better and higher new contract signings means that its services and pricing are gaining traction in the marketplace – both are critical to the Conduent turnaround. While the year/year comparisons were helped by the year-ago pandemic, the absolute results were confidence-building. Conduent also incrementally raised their full-year revenue and Adjusted EBITDA margin guidance.
Revenues rose 1% from a year ago and were fractionally higher than the consensus estimate. Adjusted earnings of $0.20/share rose 68% from a year ago and were sharply higher than the $0.14 consensus estimate. Adjusted EBITDA of $128 million increased 16% from a year ago and was about 13% higher than the consensus estimate, which anticipated minimal improvement.
The Adjusted EBITDA margin of 12.5% is approaching our 13.0% targeted margin. This is encouraging as it offers the potential for margins to exceed our target, although we anticipate that the company will prefer to win new orders rather than let its margins expand “too much.”
Conduent signed $775 million in new contracts, largely bolstered by add-on government healthcare deals and a large $178 million contract with Highways England that significantly expanded Conduent’s role in automated highway toll-collecting there.
The company generated $62 million in free cash flow, part of which was used to trim debt. Positive free cash flow for a narrow-margin company like Conduent is encouraging. Conduent has about $600 million in debt due next year (December 2022), so better financial results reduce the costs of a refinancing.
Gannett (GCI) – Gannett, publisher of the USA Today and many local newspapers, is racing to replace its declining print circulation and ad revenues with digital revenues. It also is aggressively cutting costs to maintain its profits and help cut its expensive and elevated debt. The biggest challenge for Gannett is to overcome investors’ perception that the company is not viable.
Second-quarter results were highly encouraging, as the business showed revenue growth (albeit compared against a remarkably weak period a year ago) and improved profits, and as Gannett continued to whittle away at its cumbersome debt burden. The results add to the evidence that the company is viable.
Revenues of $804 million rose 5% from a year ago and were about 2% higher than the consensus estimate. Adjusted EBITDA of $116 million was about 50% above year-ago results and 11% above the consensus estimate. Adjusted earnings of $0.20/share were sharply higher than the $0.01 estimate. The four analysts that cover Gannett had a dim view of Gannett’s earning power – this quarter’s healthy results may help improve that view although it will take more than a single quarter against an easy comparison to accomplish this.
The revenue picture is improving. Digital revenues are now 32% of total revenues and appear to be at worst stabilizing compared to the trend for the past five quarters. Much of the prior declines seem to be more related to the industry-wide decline in ad spending rather than a Gannett-specific debilitation. The company still has work to do to show it can produce enduring digital revenue growth.
Two statistics are highly encouraging for attracting digital advertisers. First, digital-only subscriptions grew 13% from the first quarter and 41% from a year ago. The multi-quarter trend shows no sign of slowing. And, second, the digital platform client count is ticking upward, suggesting that more advertisers are finding Gannett’s offerings to be valuable. Gannett’s efforts to improve its relevance are starting to work.
We like the agreement with Tipico, which brings Gannett into the sports betting world. While the actual value is hard to gauge, the option value is high.
Traditional newspaper same-store circulation revenues fell 9%, continuing the secular trend. We see the slow-ish 10% decline as acceptable and manageable.
Gannett generated $23 million of free cash flow. Critically, the total debt balance, now at $1.5 billion, was trimmed by $46 million from the first quarter. Another $60 million or so of asset sale proceeds this year, plus more free cash flow, should trim this debt further. Debt paydown is critical to convincing investors that the company is viable. We are not fans of the highly unfavorable debt terms that management agreed to, but if the refinancing reduces its interest costs and generally helps Gannett turn the debt-overhang corner, the valuation multiple expansion should more than pay for it. The company has $159 million of balance sheet cash, more than adequate as long as free cash flow remains positive.
GCP Applied Technologies (GCP) – After an initially strong start following its spin-off from WR Grace in 2016, the company’s weak leadership led to a steady stream of disappointing results. Activist investor Starboard Value (with an 8.9% stake) successfully replaced most of the board and the CEO in 2020 as the opening round of its turnaround. The company’s turnaround includes improving its revenue growth, margins and cash production.
GCP reported an encouraging second quarter but the company still has a way to go with its turnaround. So far, it has not been a pandemic beneficiary, unlike other construction companies, as its commercial construction revenues remain subdued even as it struggles with rising costs. Net, the pandemic has delayed the company’s turnaround but not prevented it.
Revenues of $253 million rose 25% from a year ago (net of currency effects) and were modestly higher than the consensus estimate. Adjusted earnings of $0.22/share were nearly double the pandemic-affected year-ago results and a cent above the consensus estimate. The adjusted EBITDA of $38 million was about $12 million higher than a year ago and slightly ahead of estimates.
We like the revenue growth. But the company’s gross margin fell nearly three percentage points, as higher raw material, packaging and transportation costs were only partly offset by higher pricing and better efficiency. Overhead costs fell from a year ago so they appear to be in good shape. But for the weaker gross margin, GCP would be close to hitting our 18.5% EBITDA margin target. And, its cash flow production would also be approaching our target. The company said that cost and margin pressures will continue into the third and fourth quarters, and that it hopes to get ahead of these by further raising its prices, which currently lag the cost increases.
GCP’s balance sheet remains sturdy with its $138 million net cash position. The company has a $100 million share buyback program in place, but seems more likely to use its balance sheet to make selective acquisitions.
In our view, we would rather the company be a seller than a buyer. Acquisition prices are high, which would produce a large premium for GCP shares if the company was acquired. This would be much more preferable than GCP paying a high multiple to buy companies.
The shares are a bit more than halfway to our $28 price target. With a few more quarters of revenue growth – which could come from the ongoing residential strength, a commercial construction upturn and some strength in overseas markets, although these are mixed due to new Covid concerns – and some relenting on the gross margin pressure, the turnaround will be completed.
General Motors (GM) – GM is making immense progress with its years-long turnaround from a poorly-managed post-bankruptcy car maker to a highly profitable gas and electric vehicle producer. We would say it is perhaps 90% of the way through its gas-powered vehicle turnaround, and is well-positioned but in the early stages of its EV development. GM Financial will likely continue to be a sizeable profit generator.
GM’s second-quarter earnings report complicates our investment decision-making, but we are retaining our Buy rating for now. The company reported very strong results, which would have been even higher but for the chip shortage and a large $1.3 billion warranty expense. These are probably temporary issues that we can mostly look through. However, it appears that the company’s ability to generate ever-higher profits is maxxed out after adjusting for these items, leading to our question about the future decay rate from this peak. Also, as we learn more about the electric vehicle business, we wonder (doubt?) what the eventual profitability of these cars will be, and hence what kind of return the company will earn on its immense capital outlays.
From a valuation perspective, the shares are priced to reflect conservative but reasonably strong profits (with the recognition that this is a cyclical industry) backed by a sturdy balance sheet, but have zero value assigned to the EV business.
We see GM producing strong gas-powered vehicle profits and cash flow for at least another year or two, although at a tapered downward trajectory. The chip shortage (and perhaps the rising input costs) will eventually ease, and the warranty costs will likely return to normal although the Chevy Bolt warranty issue may be a chronic one for the EV business (but that is outside of the value of the gas-powered car business).
It seems unreasonable that the EV business actually has zero value, given the investments made by highly credible partners like Honda, but it still is speculative. Investors have returned to their senses, at least partly, by assigning a near-zero value to independent EV makers but GM has the technical and financial firepower to be an end-game survivor.
Tesla is generating remarkably high manufacturing profits, but is helped by having zero legacy vehicle costs, zero dealer network costs and zero advertising costs. Once their new factories are filled, they may be more likely to cut prices to expand their sales volumes rather than further boost their margins, potentially shrinking the profit pool for GM and other EV producers. We also wonder whether GM’s high EV investment is more defensive (zero or negative rate of return) rather than offensive (decently positive rate of return).
We’re keeping GM a Buy for now, but need to think more about this stock. The valuation is too low to warrant a sale, and the fundamentals are by no means deteriorating. Yet, the upside is now murkier for the gas-powered business and especially the EV business. We don’t see a future “blow-up” and the most likely course for the fundamentals and shares is a grinding upward move. The long-term risk/return balance isn’t as favorable as we would like, but for now, we’re staying with our Buy rating.
It seems that investors had hoped for a huge “beat-n-raise” but were caught off guard by the warranty expense and effects of the chip shortage on future production, pushing the share price down sharply on the earnings date. This seems more like an emotional reaction by short-term traders than a fully rational analysis by long-term investors.
In terms of the numbers, GM reported adjusted earnings of $1.97/share compared to a $(0.50)/share loss a year ago and the $2.25/share consensus. The company raised its full-year EBIT guidance by a generous 19%, and raised their EPS guidance by 21% to $5.90 (midpoint). The cash flow guidance was unchanged due to unpredictability of working capital and chip arrivals. Most analysts had higher estimates for the full year, so these estimates now will be coming down.
Automotive profits were a record-high $2.9 billion, even as volumes were restrained due to the chip shortage and the company had a huge $1.3 billion unexpected warranty expense. GM lost market share in most categories except North American trucks, which smartly became a production priority, where it gained share.
GM Financial continued to generate large profits, earning $1.6 billion, compared to $226 million a year ago and $1.2 billion in the first quarter of this year. For the trailing four quarters, GM Financial has produced a remarkably high 35.5% return on tangible equity.
The company continued to invest heavily in EVs and AVs, as it wants the #1 market share in North America. Management anticipates profit margins will be similar to or higher than on gasoline engines. Anytime GM, or any capital-intensive cyclical company, aims for the #1 market share, we almost instinctively add “… at the expense of profits.”
GM is hosting an October 6-7 investor update which should feature more color on their gas-powered and EV profit outlook.
Holcim (HCMLY) – This Swiss company is the world’s largest producer of cement and related products. After its troubled 2015 merger and a payments scandal, Holcim hired Jan Janisch, a highly capable leader whose turnaround efforts are showing solid results, particularly by expanding the company’s profit margins and cash flow. A possible overhang on the shares is the carbon intensity of cement production, but the company’s efforts in reducing its carbon footprint are impressive. (CHF is Swiss francs, CHF1.00 = US$1.10).
Holcim reported decent first half 2021 results. Earnings of CHF1.43, about 78% above the year-ago results which were weakened by the pandemic and missed the consensus estimate for CHF1.81. Revenues on a like-for-like basis (which is the same as “organic” in the United States) rose 17% and were fractionally higher than the consensus estimate. Recurring EBITDA of CHF3.1 billion was 33% higher than a year ago and about 11% above the consensus estimate. Holcim raised its full-year recurring EBIT growth rate to “at least 18%” (on a like-for-like basis) from “at least 10%.”
While sales in North America lagged, at +1%, other areas around the world showed impressive strength, including Latin America (+49%) and Asia Pacific (+26%), as Holcim has a large presence in emerging markets. Some of the growth variation is due to the differing depths and pace of rebound from the pandemic. Volume increases provided most of the growth, while pricing was a positive contributor.
One indication of the company’s progress: its 1H21 recurring EBIT margin of 15.8% is considerably higher than its 12.8% recurring EBIT margin in 1H19, before the pandemic, even though its revenues now are almost 20% lower. The new management has done an exceptional job of garnering better pricing, cutting costs and shedding low-margin operations.
Overall, the company continues with its turnaround. Capital spending remains subdued, helping boost its free cash flow and lift its return on investing capital to above 8%.
Ironwood Pharmaceuticals (IRWD) – After years of weak leadership, Ironwood has one remaining product, Linzess, so investors view the company as a failed business. However, Linzess is a steady revenue producer with growing volumes that offset its slow per-unit price decline. As cash accumulates on the balance sheet and now exceeds its debt, Ironwood is repurchasing its shares. Respected activist investor Alex Denner, who now holds a board seat, is exerting his influence, including ousting the CEO and slashing spending. Ironwood’s shares trade at a highly discounted valuation.
Second-quarter results were strong. Adjusted net income of $0.34/share more than doubled from $0.16 a year ago and was sharply higher than the $0.22 consensus estimate. Revenues of $104 million rose 17% from a year ago and were about 12% above the consensus estimate. The company raised its full-year 2021 revenue guidance by 3 percentage points (to +6% to +8%) and raised its adjusted EBITDA guidance by about 10%.
Revenue growth is a key to the Ironwood story (THE key is at least stability). Higher revenues indicate ongoing demand for Linzess and a foundation for higher profits. The demand for Linzess remains healthy, more than offsetting mild price erosion. The consensus view continues to hold that Linzess has a grim future and will have little if any value after its patent expires in 2029.
As the company continues to whittle away at its previously bloated and unnecessary expense base, profits and cash flow increase. Cash continues to pile up on the balance sheet, reaching nearly $500 million compared to $438 million only 90 days ago, and more than offsetting the $442 million in debt.
Kraft Heinz Company (KHC) – Following a disastrous cost-cutting strategy that left the company with diminishing relevance to consumers, Kraft Heinz is rebuilding its brands and products, led by new CEO Miguel Patricio (July 2019). The pandemic is providing a much-needed tailwind, particularly as Kraft Heinz is carrying a sizeable debt burden.
Kraft’s second-quarter report was mixed. Revenues and margins are making progress, but that progress seems slow and it is unclear how much will be sustained after the pandemic tailwind subsides. Rising costs aren’t a problem yet but their long-term ability to pass them through isn’t known yet. The near-term earnings outlook seems weak. We’re still on board with the Kraft turnaround.
Adjusted earnings of $0.78/share fell 3% from a year ago but was about 8% higher than the consensus estimate. Revenues, adjusted for currency and acquisitions/divestitures (or, “organic”), fell 2% from a year ago but was fractionally higher than the consensus estimate. Adjusted EBITDA fell 5% from a year ago.
The company said their full-year EBITDA will be higher than in 2019, despite the exit of the nuts and McCafe businesses.
Compared to the pre-pandemic 2019 period, organic revenues were 5% higher. We had expected that more of the pandemic volume and mix tailwind would stick, and it appears that promotional activity is returning to a more normal level (higher than during the pandemic). Adjusted EBITDA was about 6% above the 2019 level, or about 9% excluding the impact of divestitures. This is helpful, but here again we wonder how much will stick. Nevertheless, the company generated $100 million more in EBITDA than two years ago, even with the McCafe and Canada Natural Cheese divestitures, and the 25.8% margin was higher than the 25.0% margin two years ago.
The company remains on track for its $2 billion, 5-year efficiency initiative. For perspective, $2 billion is about 8% of revenues. If all of this dropped to the bottom line, Kraft would be immensely profitable, but we anticipate only about an eighth will become pure profits, with the balance being reinvested either in new products or in marketing/price cuts. We’re fine with this in general as it releases otherwise wasted dollars to produce a more competitive company.
Kraft is experiencing inflation, like everyone else, but is confident in their ability to mitigate its effects partly by passing along the higher costs to customers. The company is raising its capital spending by 30%. We have mixed views on this as we appreciate the need to spend, but are wary of any boosts by a growth-oriented management team in a highly competitive industry. Similarly, we’re wary of the company’s renewed interest in acquisitions.
Oaktree Specialty Lending (OCSL) – In 2017, highly regarded investment manager Oaktree Capital was voted in by shareholders as the new outside manager to turn around this company.
Yesterday, we moved shares of Oaktree Specialty Lending Corporation from BUY to SELL.
Oaktree reported a reasonably strong quarter, with net investment income (adjusted for the merger with Oaktree Strategic Income) of $0.19/share, sharply higher than $0.12 a year ago and the consensus estimate for $0.14. Net asset value, or NAV, increased 2% from the prior quarter and 19% from a year ago (despite paying out roughly 8% of its NAV in dividends during this period).
Interestingly, the company raised its quarterly dividend by 12%, for its fifth consecutive quarter. This is paired with a sharp decrease in new investment commitments in the second quarter, although commitments picked up in July. We are getting a sense, both from the numbers and the company’s commentary, that the market for their type of investments has become exceptionally frothy (and thus unattractive to the highly disciplined management team).
The company’s turnaround is complete, both fundamentally and as its shares have reached our 7.00 price target. Its portfolio has been fully restructured and now features higher-quality companies and much more favorable lending terms (to Oaktree), and its balance sheet is conservatively financed and low-cost. Oaktree’s leadership is solid.
As such, we are moving OCSL shares to a Sell. Despite the appealing 8.3% dividend yield (on the new dividend), we now find the risk/return moving into unfavorable territory. If the shares were to fall sharply, our interest would quickly rekindle.
OCSL shares produced a 69% total return since our July 2018 recommendation.
Vistra Corporation (VST) – spun off from then-bankrupt Energy Future Holdings in 2016, Vistra is the nation’s largest independent electricity producer. The merchant electricity business can be highly risky, but Vistra is led by a solid management team, has strong internal risk controls in place, has a sturdy-enough balance sheet and produces generous free cash flow. Vistra’s long-term strategy is appealing: it is migrating to a vertically integrated business model that provides it with end-customers who consume the energy that it produces. This greatly reduces its overall risk while maintaining its attractive profit margins. The shares trade at a discounted valuation and offers an attractive dividend yield.
Vistra reported a mixed quarter, as Winter Storm Uri continues to weigh on results, including billing credits, fuel-cost adjustments and costs to mitigate future problems, yet the company maintained their full-year profits and cash flow guidance. Management said that the quarter’s results were generally in line with their expectations, and that the company would be on track to exceed its guidance if Uri hadn’t happened. We’ll take this statement at face value for now.
Vistra said that overall power market margins are healthy and likely to stay that way, particularly as natural gas prices remain elevated. Also, the fallout from Uri may benefit Vistra as it provides a source of backup energy.
The management said they have begun a review of the company’s strategic direction and how they allocate capital. One priority is that the company wants to achieve an investment-grade credit rating sooner than the Uri-delayed 2022 or 2023 window. Another priority is to find ways to increase the market’s recognition of the company’s value (in essence, the stock price), as the management believes the stock is significantly undervalued. A third priority is to expand their renewables/batteries businesses with a partner. One option is major share repurchases. Vistra will provide more color on this review by the third-quarter earnings report.
Next year, the company said they have the ability to produce $3.4 billion in EBITDA, excluding any Uri billing credits, and convert as much as 70% of that to free cash flow before capital spending for growth initiatives. This massive free cash flow, equal to about a quarter of the company’s market capitalization, highlights management’s interest in making some strategic changes.
In terms of results, Adjusted EBITDA of $825 million fell 11% from a year ago and was about 5% below the consensus estimate. Excluding the Uri results, adjusted EBITDA would have been about $909 million. Strong 27% growth in retail segment profits was more than offset by weaker profits in the power generation segment.
A major source of volatility in reported earnings is the accounting treatment of the company’s vast array of hedges. To limit the economic effects of changes in input and output prices across its geographies, across time and across many commodities and electricity prices, Vistra manages a complex hedge book. Accountants generally mark all of these to their market values but this hides the other side of the transaction – the effect these have on stabilizing the company’s revenues and profits.
Western Digital (WDC) – Western’s new and highly capable CEO, David Goeckeler, who previously ran Cisco’s Networking & Security segment, is making aggressive changes to improve the company’s competitiveness in disk drives and other storage devices, as well as bolster its financial strength. The company generates free cash flow and holds plenty of cash to buy time for the turnaround and to help pay down its elevated debt.
Western reported a strong fiscal fourth quarter and raised its full-year 2022 revenue and earnings guidance, indicating that the turnaround is on track. Revenues grew 15% and were 8% higher than the consensus estimate. Adjusted earnings of $2.16/share more than doubled from $1.12 a year ago and were 44% higher than the consensus estimate.
Revenue growth was strong across all three segments – Client Devices, Data Center and Client Solutions. The company set an internal record by shipping over 104 exabytes of capacity enterprise hard drives, while demand for computers, gaming devices and flash-based products was robust. Their updated 18-terabyte hard drive is seeing a very strong reception in the market. Margins expanded from the year-ago quarter and the sequential third quarter from both higher volumes and (impressively) higher pricing.
The balance sheet continues to improve. Compared to a year ago, net debt has declined by 18% to a more manageable $5.4 billion. Strong free cash flow in the fourth quarter, nearly $800 million, brought more financial flexibility and boosted our confidence in the turnaround. Western Digital’s net debt is within its targeted 1.0-3.5x leverage range, suggesting that further improvement could lead to share repurchases or a resumption of its dividend.
Ratings changes:
Moved Oaktree Specialty Lending Corporation (OCSL) to a Sell.
Friday, August 6, 2021 Subscribers-Only Podcast
Covering recent news and analysis for our portfolio companies and other topics relevant to value investors.
Today’s podcast is about 14 minutes and covers:
- Brief updates on:
- Earnings reports
- Vodafone (VOD) – hinted that they may spin off their M-Pesa business
- General Electric (GE) – reminder of their 1:8 reverse split
Please join us for the 9th Annual Smarter Investing, Greater Profits Conference, held online again this year, on August 17-19, that’s Tuesday – Thursday. You can see presentations by all of our analysts, which will include updates on their areas of expertise and discussions of their best picks.
Please feel free to share your ideas and suggestions for the podcast 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 limit we may not be able to cover every topic each week, but we will work to cover as much as possible or respond by email.