Earnings season is in full gear this week, with 13 companies reporting. We review Borg Warner (BWA), Credit Suisse (CS), DuPont (DD), General Electric (GE), Kraft Heinz (KHC), Mohawk Industries (MHK), Molson Coors (TAP), Newell Brands (NWL), Nokia (NOK), Royal Dutch Shell (RDS/B), Volkswagen (VWAGY), Western Digital (WDC) and Weyerhaeuser (WY).
There were no ratings changes this week.
As today is the first Friday after the monthly Cabot Turnaround Letter, we are including the Catalyst Report. We hope you find the combined format more convenient. Please let me know what you think and how this works for you.
Friday, October 30, 2020 Subscribers-Only Podcast
Covering recent news and analysis for our portfolio companies and other topics relevant to value investors.
Today’s podcast is about 16 minutes and covers:
- Brief updates on:
- Earnings from the 13 companies reporting earnings
- Wells Fargo (WFC) – plans to sell its $570 billion (assets) investment management business.
- Oaktree Specialty Lending (OCSL) – combining with sister-company Oaktree Strategic Income (OCSI) in a non-dilutive and sensible merger.
- Elsewhere in the market:
- Mega-cap tech stocks finally rediscovering gravity?
- Final note
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.
Earnings reports by Cabot Turnaround Letter recommended companies:
BorgWarner (BWA) – BorgWarner produces turbocharger and drivetrain components for cars and trucks. It recently acquired Delphi Technologies, so it will have cost-cutting opportunities as well as integration risks. The company is fairly well-positioned for the transition to electric vehicles.
In the quarter, results were ahead of estimates. Sales rose 2% from a year ago and were about 6% above consensus estimates. The Delphi deal closed on October 2, so none of its revenues were included in the report. Per share earnings of $.88 were about 8% below a year ago but 11% ahead of consensus estimates. The company raised its full-year 2020 guidance, however, the new estimate range was still below consensus estimates (perhaps due to some conservatism on management’s part with so many unknowns including the Delphi integration), so the shares fell on the day.
Strength in China and North America were partly offset by weak European operations, particularly with slowing demand for diesel engines. However, the company continues to gain traction in the emerging EV market, winning two major hybrid-vehicle contacts in Europe.
Credit Suisse (CS) – This Swiss bank is shifting its strategy to more stable Switzerland banking and global investment management and away from weak/volatile trading and investment banking, to help it fully recover from the decade-ago financial crisis. The bank is making progress but not fast enough, in our view.
In the quarter, revenues of CHF 5.2 billion, which excludes gains and the effects from divestitures, rose 4% from a year ago, while adjusted pre-tax income rose 29% to CHF 1.1 billion. Earnings fell short of consensus estimates, leading the shares to fall 5% on the day. For reference, $U.S. 1.00 = CHF 0.90.
Inflows of investment assets was a positive in the period. The bank said that since its capital position is now sturdy enough, with CET1 capital at 13.0%, it will pay its previously-deferred 2019 half-year dividend of CHF 0.1388, accrue a 2020 dividend at a 5% higher rate, and begin share repurchases next year of at least CHF 1.0 billion.
CS shares trade at about 51% of their CHF 16.89 tangible book value per share.
DuPont (DD) – Following its complicated and planned merger/reorganization/split-up with Dow Chemical, DuPont is working to boost its revenue growth, reduce unnecessary costs and narrow its focus (through divestitures) under talented CEO Ed Breen. Also, it is whittling down its pandemic-elevated debt.
The third quarter showed good progress. Sales fell 6%, but rebounded from the pandemic-weakened second quarter and were a tad higher than estimates. Sales of its vast array of proprietary products helped bolster revenues, including its semiconductor and smartphone materials. Automobile materials sales were weaker than a year ago but are showing renewed strength. Non-core sales were $331 million, down 23%, reflecting its planned divestiture program.
Adjusted per share earnings of $0.88 fell 8% from a year ago but were about 17% higher than estimates. Adjusted EBITDA of $1.3 billion fell about 7% from a year ago but was about 10% above estimates. The company raised its full-year earnings guidance to a mid-point of $3.19/share, about 5% above the current $3.03/share consensus.
Overall, DuPont’s recovery from the pandemic low point is encouraging, as are its cost-cutting programs (added another $100 million to its 2020 target) and divestiture efforts. The Nutrition & Biosciences divestiture is on track for closing in the first quarter of 2021. Cash flow is strong, which will help reduce its debt, particularly as it is expecting upwards of $7.3 billion in proceeds from the Nutrition & Biosciences sale.
General Electric (GE) – GE’s exceptionally complicated and difficult turnaround made progress in the third quarter. Revenues excluding the impact from the divested Biopharma unit fell only 12%, roughly in line with estimates. Per-share earnings, adjusted for a range of write-offs, asset sales and other charges which appear reasonable to us, were a positive $0.06, down 60% from a year ago but sharply ahead of estimates that projected a $(0.03) loss. GE’s Industrial profits, adjusted for the charges, was a positive $1 billion, with improvement across most of its segments producing results that were across-the-board better than investors had expected. GE is making considerable progress with its cost-cutting and adding higher-margin revenues. Industrial free cash flow was a surprisingly strong positive $514 million and the company said that fourth quarter Industrial free cash flow would be a huge $2.5 billion, while also projecting positive free cash flow for all of 2021.
It appears that GE has sold about 30 million shares of Cabot Turnaround Letter recommended Baker Hughes (BKR), or about 8% of its total holdings.
Its risk position is improving as well: Total debt fell by $12 billion year-to-date, its annual insurance premium deficiency test had no effect on earnings, and other claims/liabilities appear to be contained.
GE clearly has a long way to go with stabilizing its revenues and long-term profit outlook, particularly with the weight of the pandemic and secular issues. However, the quarter’s strength was encouraging.
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.
In the quarter, Kraft Heinz’s net sales of $6.4 billion rose 6% from a year ago, slightly ahead of estimates. On average, prices increased 3.7% and volumes increased 2.6% – both were healthy positives. In the United States, sales increased 7.4%, with strong pricing and volumes. Lower promotions drove higher pricing, while the growth of at-home consumption drove volumes. Emerging markets, a source of strong revenue growth in the quarter, will receive new emphasis at Kraft Heinz.
Adjusted per-share earnings of $0.70 were one cent higher than a year ago and eight cents ahead of estimates. The company incrementally raised its revenue and earnings guidance for full-year revenue and Adjusted EBITDA. In the quarter, Adjusted EBITDA of $1.5 billion rose 13.5%, as stronger United States profits were weighed down by corporate expenses that rose 32%.
Kraft’s total debt is too high, at $28.4 billion, but net of cash balances it has declined by $1.3 billion so far this year. This is moving in the right direction and we want to see continued steady progress with debt-reduction. Free cash flow was strong at $970 million in the quarter. Year-to-date free cash flow of $2.9 billion was more than double that of a year ago.
The turnaround is going reasonably well, but is early. CEO Patricio noted that consumers are shifting down in their price points, which may weigh on future results but is incorporated into their guidance. While the duration of the pandemic tailwind is hard to project, it appears likely to remain plenty strong.
Mohawk Industries (MHK) – We initiated a Buy on Mohawk shares in March 2019, when the shares had fallen heavily out of favor due to several sizeable earnings “misses.” The shares fell sharply during the March 2020 sell-off and after a brief bounce dropped to near their March lows on allegations of fraud. We think the fraud charges ultimately will not having a meaningful impact on the company and that Mohawk will continue to execute and improve its balance sheet.
Mohawk reported a highly encouraging third quarter. Revenues of $2.6 billion were about 2% above the year-ago results and slightly ahead of estimates. Adjusted per-share earnings of $3.26 were 19% higher than a year ago and 50% higher than estimates.
The company is seeing strong demand for its residential flooring products, particularly in northern Europe, more than offsetting weaker commercial demand. Overall pricing is sturdy, and various restructuring efforts are helping improve its operating efficiency. Mohawk’s rising confidence about the fourth quarter prompted it to raise its full-year earnings guidance to about 32% above current consensus estimates.
The company generated significant free cash flow of $530 million (about 85% more than a year ago) partly as it worked down inventories, although we anticipate some inventory re-build next quarter. Net debt of $1.45 billion was down sharply from $2.6 billion a year ago and $1.97 billion at the end of the second quarter.
Mohawk said it had concluded a thorough internal investigation of the fraud changes, with the assistance of outside counsel, and concluded that the charges were without merit. It also said that it is cooperating fully with the government investigation.
Molson Coors Beverage Company (TAP) – Molson Coors is struggling with weak revenue and profit growth, yet is working under a new CEO to more aggressively improve its strategic positioning toward more specialty/higher-end beverages so that it relies less on mainstream and value offerings. Also, the company is increasingly focusing on its cost structure. TAP shares continue to trade at a large discount compared to its peers and its fundamental prospects.
In the quarter, the results showed that the company is making progress with its turnaround and that investors underestimate this progress. Net revenues of $2.75 billion fell 3.1% from a year ago, but about 4% better than consensus estimates. Adjusted per share earnings of $1.62 were nearly 60% better than estimates. Underlying EBITDA of $713 million was 1% higher than a year ago and 26% higher than estimates.
Pandemic-related closures/limitations at restaurants, sports arenas and other venues continues to weigh on net sales, particularly in Europe where revenues fell 12%. Overall pricing remains positive but mix was a slight headwind. Currency changes provided a modest tailwind as foreign-currency-denominated revenues translated into more dollars.
Operating efficiency efforts provided a modest lift as overhead costs fell 8%, some of which was due to avoiding marketing spending at now-closed sporting and live entertainment events.
The company produced $433 million in cash from operations and reduced its net debt by $266 million. In many ways, these are the most two important statistics for the Molson Coors story – if cash flows and debt repayment remain healthy, eventually the company’s underlying value will become obvious to the market, as will its ability to pay a respectable dividend.
Newell Brands (NWL) – The company has struggled for literally decades with weak strategic direction and expense control, epitomized by its over-reaching $16 billion acquisition of Jarden in 2016. Pressured by activist investors last year, and now led by a capable new CEO, Newell appears to be finally fixing its problems, yet the shares remain significantly undervalued relative to their post-turnaround potential.
The company reported a highly-encouraging third quarter. Revenues of $2.7 billion increased 5% from a year ago and were about 9% of estimates. Adjusted per-share earnings of $0.84 increased 15% from a year ago and were almost double the $0.44 estimate.
Core sales, which excludes divestitures and the effect of currencies, rose 7.2%. Sales growth was strongly positive in three of its four segments, with only the Learning & Development segment showing a decline (-10%) due to weak back-to-school sales. All geographies showed positive growth.
Normalized operating margins, which adjusts for acquisition amortization and other charges, rose to 14.9% from 12.7% a year ago. Slightly weaker gross margins (due to the mix of business) were more than offset by overhead expenses that fell by $55 million as Newell’s efforts to cut expenses and reduce its overly-complex operations started to have a meaningful impact.
The company reinstituted 2020 guidance, projecting full-year normalized earnings of between $1.63 and $1.69, nearly 30% higher than the $1.29 consensus.
Cash flow from operations of $688 million was impressively strong compared to $433 million a year ago. Free cash flow, which we define as cash flow from operations less capital spending, was $624 million, 76% above a year ago. The balance sheet improved as well, with debt net of cash down by $531 million compared to the second quarter. Year-to-date, the company has reduced its net debt by $341 million. Debt reduction is a key performance metric for our Newell thesis, and the company is making good progress on this. It has been a bit of a rough ride for our Newell recommendation, but it looks like the story is coming together.
Nokia (NOK) – Initially recommended in 2015, Nokia has struggled for years to regain its competitiveness. Despite the long period of lackluster progress, it appears that the new CEO, Peter Lundmark (March 2020), is capable of finally getting the company back into the telecom game, particularly with the critical change-over to 5G over the next few years. Lundmark has re-segmented the company into four divisions, each with its own profit responsibility and plan for restoring its growth and competitiveness. This makes a lot of sense to us. Also, he announced plans to launch a cloud-based services segment – they are probably too late to this game but the effort is worth making as not having one may leave them at a disadvantage in the future.
Nokia’s shares fell sharply on the news, reversing most of the post-March bounce. The current quarter’s results were disappointing, as sales of €5.3 billion were 7% lower than a year ago. Adjusted operating profits rose 2% as cost-cutting helped alleviate some revenue-loss pressure. Both revenues and income were about 5% below estimates. Generally speaking, Nokia is at risk of losing its product competitiveness even as it cuts excess costs. Fortunately, the company continues to produce sizeable free cash flow (€319 million in the quarter) and has €7.6 billion in cash balances. Its cash exceeds its total debt by €1.9 billion. Lundmark said they will invest “whatever it takes to win in 5G,” so they will lean on this cash in their rebuilding efforts.
The share drop was driven by the weak results and the new/lower guidance for the fourth quarter and full-year 2021, as well as the lingering concerns about its competitiveness. The most significant is that operating margins will be lower, with FY2021 margins likely being 7-10% rather than close to the 11% that investors were expecting. Much of the shortfall is likely due to the higher research and development expenses, with part also due to market share losses and pricing pressure in North America, particularly at Verizon.
The sharp drop in the share price is painful but the stock now discounts a dour future. The company is investing aggressively in better products to catch up after years of neglect. From here, the recovery will take time and faces clear challenges, but we believe it will ultimately succeed.
Royal Dutch Shell (RDS.B) – Shell has been on the recommended list for a long time (January 2015), so we are circumspect about its continued presence there. The company is well-managed and has navigated the weak oil/natural gas environment better than its peers, but its upside (and downside) is tied to unpredictable energy prices. The 4.5% dividend yield now appears secure but is uninspiring by itself given the company’s commodity exposure.
In the quarter, Shell produced adjusted earnings of $955 million and organic free cash flow of $6.7 billion. Weak results in its Integrated Gas/New Energies segment and its Upstream segment was partly backstopped by decent (down/flat) results in its Oil Products and Chemicals segments.
Compared to a year ago, the reduction in cash flow from operations, excluding working capital, was mostly offset by capital spending reductions. The company paid down its debt by $4.4 billion.
Shell announced an impressive capital allocation plan to reduce its net debt by $8.5 billion (about 12%), after which it will distribute to shareholders 20-30% of its cash flow from operations. The remaining cash flow would be allocated to “disciplined and measured” capital spending and debt reduction to maintain a AA credit rating. As a starter, Shell raised their quarterly dividend by about 4% (although they had sharply cut it earlier this year).
Oil prices need to remain reasonably buoyant for Shell to have the cash to fund its capital allocation program. Demand for its to-be-divested assets also needs to be healthy as Shell is relying on $4 billion/year in divestment proceeds. Helping our thesis on Cabot Turnaround Letter recommended Valero Energy, Shell will close or sell 8 of its 14 refineries by 2025.
Volkswagen AG (VWAGY) – Following the emissions scandal and VW’s sharp share price decline, we recommended its shares for their deep undervaluation and likely improvement in earnings power. Since then, the company has also starting making a sizeable bet on electric vehicles (EVs), looking to become a major producer. VW continues to make progress on all fronts. For reference, the current exchange rate is $1.00 = €0.86.
Third-quarter sales fell only 3.4% from a year ago, with vehicle deliveries declining 2.6%. However, operating profits adjusted for special charges fell 30%, but importantly was a positive number (€3.2 billion) after a difficult period earlier in the pandemic. China volumes recovered but results there were hurt by foreign currency translation back into euros. Helping profits was lower marketing spending – once volumes recover the company will likely spend more but that spending is essentially paid for by profits on the higher volumes. VW also held back research and development expenses, which we anticipate will also rebound.
Overall, VW’s brand volumes and profits were all reasonably healthy. A piece of trivia: We saw that eight Bentleys (average price $200,000) were sold this quarter compared to seven in 3Q19.
As previously announced, VW’s TRATON unit agreed to buy the 83.3% of American truck maker Navistar it currently doesn’t own.
VW produced a huge €6.2 billion of free cash flow, helped by its higher profits, cash released from working capital and lower capital spending. The balance sheet remains sturdy with plenty of cash and other sources of liquidity. The company continues to press forward with EVs. With the stock’s recent fall-off to lows excluding the March bear market, investors are giving the company little credit for its improvements.
Weyerhaeuser (WY) – Initially recommended in April 2012, Weyerhaeuser is recovering from weak results in its core markets. Given its return to stability and its reliance on perhaps highly cyclical timber prices with little improvement elsewhere, we are evaluating our rating on WY shares.
Weyerhaeuser reported good results, with revenues rising 26% from a year ago. Adjusted per share profits of $0.52 rose sharply from $0.08 a year ago and were about 13% ahead of estimates. Essentially all of the improvements came from rising prices for its lumber and oriented strand board (OSB), as volumes and other product prices were unchanged or generally weaker than a year ago and over a multi-year period.
Weyerhaeuser’s balance sheet improved, as it repaid nearly $350 million in debt and added about $200 million in cash, as cash flow from operations was a sturdy $608 million. It also is redeeming a $500 million bond in the fourth quarter. The company re-started its previously suspended quarterly dividend, but at only $0.17/share, half the previous rate. However, it said it would dedicate a fixed amount of its “funds available for distribution” to a supplemental annual dividend. However, based on current results, this supplement would be only about $0.26/share. In total, this would produce perhaps a $1/share annual total dividend stream, or about a 3.7% yield based on the current price.
Western Digital (WDC) – This new recommendation (October) has a new CEO who is focused on improving its efficiency and effectiveness, particularly as the 2016 SanDisk acquisition was never properly integrated, re-invigorating the company’s uninspired culture and reducing its debt.
In the quarter, the company made noticeable progress, although it offered subdued forward guidance. Revenues of $3.9 billion fell 3% from a year ago but slightly ahead of consensus estimates. Adjusted per share earnings of $0.65 were 91% higher than a year ago and about 18% higher than consensus estimates. The period had one fewer week than the year-ago period, so results on a true like-for-like basis were probably better.
Guidance was for the next-quarter earnings of between $0.40-$0.60/share, below the $0.62 consensus. While revenue headwinds remain, the revenue guide was in line with expectations.
In the quarter, the Client Devices segment, which houses solid state drives for notebooks, desktops, gaming and mobile phones, jumped 20%, while Data Center Devices & Solutions revenues fell by 26%. Gross margins improved to 26.3% from 24.8%, and operating expenses fell 8%, which combined to increase adjusted operating profits by 37%. The company is re-organizing its operations into two divisions: Flash (NAND memory) and HDD (hard disk drives), each with a dedicated leader, to boost results and accountability.
Western’s balance sheet improved with a $213 million debt paydown, while ending the quarter with a sturdy $3.0 billion in cash. Free cash flow (before debt paydown) was $196 million.
Next week’s earnings reports (12 companies) include: LaFargeHolcim (HCMLY), Mosaic (MOS), Gannett (GCI), Jeld-Wen (JELD), Peabody Energy (BTU), General Motors (GM), Barrick Gold (GOLD), Meredith (MDP), ViacomCBS (VIAC), GCP Applied Technologies (GCP), Conduent (CNDT) and Berkshire Hathaway (BRK.B)
Catalyst Report
This month saw 14 new CEOs and a smattering of activists and spin-offs. Also, several large acquisitions were announced, creating larger companies with cost-cutting opportunities (Intel’s deal was a major divestiture).
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 a much-needed positive change to out-of-favor companies.
One highly-effective way to use this tool is to is to pair the names with weak stocks. Combining these two traints 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.
You can also access our entire Catalyst Report archive in sortable spreadsheet format here.
Tapestry (TPR) $5.9 billion market cap – This apparel company owns the Coach, Kate Spade and Stuart Weitzman brands, and is struggling with changes in fashion as well as pandemic-driven weakness in sales. Recent turmoil in the executive suite may be eased with this month’s appointment of Joanne Crevoiserat – a retail veteran who appears up to the turnaround task.
AIG (AIG) $26.0 billion market cap – AIG continues to rebuild and refocus from the financial crisis over a decade ago. The outgoing CEO made vast improvements, many of which were led by current president Peter Zaffino who will become CEO soon. Also, AIG announced that it will be divesting its life and retirement products group – itself a legitimate catalyst.
ON Semiconductor (ON) $10.9 billion market cap – Mentioned in our recent monthly letter, ON has a subpar operating margin partly driven by its reliance on expensive in-house manufacturing. Recent comments by a respected activist investor may prompt a strategic re-think when the company replaces its retiring CEO.
Elanco (ELAN) $15.9 billion market cap – Activist Sachem Head recently took a 9.1% stake in this animal health company, looking to pressure the company to accelerate its revenue growth and boost its profit margin margins. The company is often compared (unfavorably) to peer Zoetis. Elanco was spun off from biopharma giant Eli Lilly in 2018.