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Turnaround Letter
Out-of-Favor Stocks with Real Value

August 13, 2021

Today’s note includes ratings changes, earnings updates on six companies and the podcast.

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Today’s note includes ratings changes, earnings updates on six companies and the podcast.

Ratings Changes:
We made two ratings changes this past week.

First, we moved Albertsons (ACI) from BUY to SELL, after its sharp price gain to well above our price target and to a valuation that prices in an optimistic future. ACI shares produced a 94% profit from our recommendation only 13 months ago.

And we moved Berkshire Hathaway (BRK/B) from BUY to HOLD. The shares are too expensive to justify additional buying (Warren Buffett seems to agree on this) yet we can’t reasonably justify selling the shares, either.

Please note that General Electric’s (GE) price target is now 160, to reflect the recent 1:8 reverse split.

Earnings updates:
Most of our companies have reported. Only three remain (all retail), including Macy’s (M) on August 19, and Signet Jewelers (SIG) and Duluth Holdings (DLTH) on September 2.

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 that revenues grew 22% compared to a year ago. Operating profits of $6.7 billion increased 21% from a year ago.

The company’s diverse range of industrial businesses showed strong improvement across the board compared to the pandemic-weakened period a year ago. The insurance segment results were weaker, primarily due to a 70% decline in profits at GEICO, partly offset by sharply lower losses in the re-insurance segment. GEICO profits suffered as more drivers used their cars, resulting in more accidents and more damage per accident. The improved reinsurance profits largely came from a favorable comparison to weak year-ago results in its property and casualty operations.

The company repurchased $6 billion in shares in the quarter, essentially at the same quarterly pace as in the first quarter. Net float (a proxy for excess cash) was $142 billion, up about 2% from year-end.

Berkshire shares are trading above our 285 price target, and are valued at about 1.4x the book value per share of $206. Given the company’s exceptional leadership and business array, as well as the likely higher break-up value, we can’t reasonably justify moving the shares to a Sell. However, it would similarly seem unreasonable to raise our price target, thus justify buying more shares, when Warren Buffett himself seems increasingly reluctant to buy shares. As such, we are moving the shares to a HOLD.

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.

The Elanco investment is back to Square One. The company reported reasonably good results, but guidance was light and the company said it received a subpoena from the SEC regarding channel inventory and sales practices prior to mid-2020. Investors sold the shares, driving the price down 17% on the day. The price is now 6% above the 29.58 price at our initial recommendation. We remain steadfast in our Buy recommendation even if other investors have lost confidence in the company.

Elanco’s fundamentals generally are improving, but there is a lot of work yet to do, including de-levering the balance sheet and addressing the SEC investigation. The activist investors will likely continue to exert more pressure on the company’s leadership – a positive in our view. We remain patient.

Earnings of $0.28/share were sharply higher than $0.09 a year ago and were about 8% above the consensus estimate. Revenues of $1.3 billion, which weren’t comparable to year-ago numbers which didn’t include the Bayer division that Elanco recently acquired, were about 3% above the consensus estimate. Adjusted EBITDA of $291 million was about 8% above the consensus estimate. All in, the quarter was better than guidance and estimates.

However, the company trimmed its full-year adjusted EBITDA and EPS guidance. While not debilitating, investors had apparently expected a guidance raise. In the current market, where many companies report results well ahead of estimates, this guide down (however small) was in the wrong direction, and thus penalized.

While any subpoena from the SEC is serious and often can rightfully spook investors, this one appears to be of only modest concern. It appears to be somewhat technical and apparently relates to an issue that was cleaned up a year ago. A restatement of current and trailing 12-month results seems unlikely. The company could get a fine, but that is unlikely to be meaningful in size.

Meredith Corporation (MDP) Meredith has two businesses. Its National Media Group is the nation’s leading print magazine publisher, and its Local Media Group owns 17 television stations. Its magazine portfolio is high-quality and is transitioning to a digital world as it faces the secular headwinds in print publications. The shares were initially recommended in January 2020, and have fully recovered from their sharp pandemic-related decline yet remain undervalued as Meredith continues to benefit from its digital transition and the strengthening economy.

Meredith reported healthy results as we wait for completion of their TV station sale for $2.8 billion in cash, which is on track for a fourth quarter closing.

Revenues of $718 million rose 17% from a year ago and were about 4% above the consensus estimate. In the National Media Group (the magazine segment, or NMG), which will be the remainder business after the sale of the TV station business, revenues grew 16%. Digital advertising surged by 80% and now represents about 25% of NMG revenues, nearly matching print magazine revenues. Digital consumer and licensing, while small at about 11% of NMG revenues, grew 19%. Overall, Meredith’s portfolio of branded magazine properties is successfully recovering from the pandemic downturn in advertising while also successfully transitioning to the digital world.

Adjusted earnings of $1.11/share compared to a $(0.14) loss a year ago and was more than double the $0.52/share consensus estimate. NMG earnings, as measured by EBITDA, doubled to $93.1 million.

The company generated decent free cash flow and repaid some of its debt. Following the split from the TV station group, Meredith will further pay down its debt.

Organon & Co (OGN) – Recently spun-off from Merck, Organon specializes in patented women’s healthcare products and biosimilars. It also has a portfolio of mostly off-patent treatments. Investors have ignored the company, but we believe that Organon will produce at least stable and large free cash flows with a reasonable potential for growth. At our initial recommendation, the stock traded at a highly attractive 4x earnings.

In its first quarter as an independent company, Organon reported encouraging results, reaffirmed their full-year guidance and initiated a $0.28/share quarterly dividend which would produce a 3.7% yield.

Revenues of $1.6 billion rose 5% from a year ago and were about 4% above the consensus estimate. Revenues fell 1% net of currency changes. Excluding currency changes, sales rose 16% in the Women’s Health segment and 35% in the Biosimilars segment but fell 10% in the Established Brands segment. Sales grew or were flat, ex-currency, in every geography except Asia-Pacific/Japan, where sales fell 29% due to patent expirations of Zetia in Japan. The company reaffirmed their outlook for $6.1 billion -$6.4 billion in full-year revenues, helping to build our confidence in its stability. While the headwinds we highlighted in our initiation report remain in place, Organon highlighted on the conference call a wide range of initiatives and end-market trends that provide support for its positive outlook.

Adjusted earnings of $1.72 per share fell 32% from a year ago but the comparison included unusual costs due to the mid-quarter split from Merck. Earnings were about 20% above the consensus estimate. Adjusted EBITDA of $627 million was about 12% above the consensus estimate. The 40.1% EBITDA margin was encouraging as the company has guided for only a 36%-38% full-year margin.

Management said that the dividend is their top capital allocation priority, after which is organic growth investments, then debt paydown/external growth opportunities. The company wants to maintain their investment grade rating and bring their net debt/EBITDA ratio down to 3.5x from the current 4x.

All-in, a strong start for Organon.

Toshiba (TOSYY) – This Japanese industrial conglomerate is recovering from its nuclear power plant construction business (Westinghouse Electric) debacle, which forced it to sell a majority stake in its Kioxia memory chip production operations. We are looking for a divestiture of its minority Kioxia stake, with proceeds paid out to shareholders, as well as operational improvement and better governance. Note: ¥100 = $0.91

Toshiba reported a reasonable quarter. Revenues of $6.6 billion grew 21% from the pandemic-weakened year-ago period and were about 3% above the consensus estimate. Operating profit of $130 million compared to a $(113) million loss a year ago and was slightly below the consensus estimate. Revenues for their hard disk drives and semiconductor segment rebounded with 60% sales growth, while its Retail & Printing Solutions group (printers and retail checkout equipment) rose a strong 29%. Nearly all segments rebounded with positive profits compared to losses a year ago, except for the Energy Systems & Solutions segment (large-scale nuclear, thermal and renewable power generation systems).

The shares have been weak recently, along with most other semiconductor companies’ shares, as investors worry about chip prices.

The bigger story at Toshiba is governance, as the company is in the midst of a major overhaul to its leadership following scandals and weak performance. Two tangible signs of progress: the company’s recent $400 million share repurchase (on its way to meeting its $1 billion year-end target) and its recent $1/share special dividend. The board is making progress with its strategic review, finding a new CEO, improving its auditing controls, and changing its compensation structure to create a “ownership culture.” In October, the company will share more about its Mid-Term Plan, further outlining strategic and profit goals for each segment.

Integral to the traditional corporate culture in Japan is maintenance of the status quo and lack of transparency. We believe that the Toshiba leadership (board and senior executives) have been sufficiently rattled by powerful outside shareholders to start making significant improvements, ultimately driving the value of the firm higher. However, most of the current action is behind the scenes with little (understandably) to share with investors until the various committee work and plans are completed. Our preference would be for a break-up/divestiture of Toshiba’s disparate operations, at a minimum. Its old-school conglomerate structure, long-discredited in the United States and elsewhere, clearly doesn’t work. There is real value hidden within its walls – we would like to see that value unlocked. We will wait patiently (for now).

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 see Viatris as an undervalued stream of reasonably stable free cash flow. As evidence of this stability is produced, along with better capital allocation, governance and transparency, we see strong potential for a higher share price.

Viatris reported encouraging second-quarter results that provided more evidence that the company’s strong free cash flow production is (at a minimum) steady, backed by stable/growing revenues and stable/expanding margins. Viatris shares remain attractively priced.

Revenues of $4.6 billion were unchanged from pro forma results a year ago excluding currency changes – indicating stability despite all the controversies regarding patents, pricing and other headwinds. Actual revenues were 4% above the consensus estimate. Dissecting the results more finely: gross revenue lost was about 9% due to patents, rebates and base business erosion. However, net revenue lost was only 4%, on the strength of new products.

Management said that new products should contribute about $700 million in new revenues this year and provided encouraging transparency on their pipeline. The company fractionally (about 1%) raised its full-year revenue guidance. This is a positive, as it shrinks the likelihood of revenue declines.

Adjusted earnings of $0.98/share fell 10% from a year ago but this comparison is not particularly valid due to the merger. Profits were about 11% higher than the consensus estimate. On an adjusted EBITDA basis, earnings grew 91% from a year ago, as lower costs helped boost the margin to 36.6% from 32.2% a year ago.

The company spoke about $6.2 billion of EBITDA being a “true floor” for this year and beyond – if this pans out, it would be a strong positive for the underlying value of the company.

Viatris raised its full-year free cash flow guidance by 7%, adding support to our view. The company reduced its total debt by $1.3 billion in the quarter and is on-track to repay a total of $6.5 billion by 2023.

Overall, the turnaround remains on track.

Friday, August 13th, 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 13½ minutes and covers:

  • Brief updates on:
    • Ratings Changes
    • Earnings reports

  • Comments on other recommended stocks:
    • Pre-market prices down 20%?
    • Wells Fargo (WFC) – new board chairman is a positive.
    • Albertsons (ACI) – stand by our recent Sell rating, but fundamentals may continue to improve and drive the stock even higher. Not all buy/sell decisions are black and white.
    • General Motors (GM) – restarting all of its full-sized truck production.

  • Elsewhere in the market:
    • SEC considering new emission disclosure mandate – we have mixed views.
    • Gold prices, interest rates and inflation

  • Final Note

Our 9th Annual Smarter Investing, Greater Profits Conference, is next week, on August 17-19, that’s Tuesday – Thursday. Be sure to sign up to 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.