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Turnaround Letter
Out-of-Favor Stocks with Real Value

May 2, 2020

In a very busy earnings week, 16 companies reported results. We retain our Buy ratings and price targets on all names, except for BP, CNSL and JHG which had price target reductions, as noted below:

Berkshire Hathaway (BRK/B) - Revenues of $61.3 billion were fractionally higher compared to a year ago. Pre-tax income, excluding the effect of the decline in the value of Berkshire’s investment portfolio, was $7.2 billion, about 1% below a year ago.

In the quarter, the sharp decline in the stock market, which reached its low about a week prior to quarter-end, reduced the value of Berkshire’s traded securities by $70.3 billion. Actual reported net income, which includes this decline as well as taxes, was a loss of ($49.7 billion). Berkshire repurchased $1.7 billion in its shares in the quarter.

Book value per Class B share fell to $154, higher than our estimate of $149. Berkshire has about $137 billion in cash, and used very little to buy stocks in the quarter.

The Covid-19 pandemic had a moderate effect on Berkshire’s overall quarterly results, but will have a much more significant impact on the second quarter. Many of its products and shops are consumer-facing, which will be severely affected.

Berkshire is a very solid company with a strong group of operating businesses and a true “fortress” balance sheet led by some of the most capable managers in industry. Our recommendation took advantage of the market’s downturn and Berkshire’s lower share price.

The company’s Annual Meeting starts today at 4pm EDT.

BP (BP) - The company reported Underlying Replacement Cost profit of $791 million, down 66% from a year ago. Production of oil and gas was 0.7% higher, adjusted for acquisitions/divestitures and profit sharing volumes.

A brief primer on BP’s terminology: “Underlying” is comparable to “Adjusted” results used by US-based companies to remove non-recurring items. “Replacement Cost” removes the effect of rapidly changing commodity costs on the company’s profits. Profit accounting assumes that the company’s cost of goods sold is based on historical prices (FIFO, or first-in, first-out), whereas replacement cost assumes that the cost of goods is based on current market prices. In BP’s quarter, current prices (hence, costs) were much lower than historical costs, so “replacement cost” profits were much higher than reported profits. However, this treatment ignores the very real reduction ($3.8 billion) in the value of BP’s oil inventories. Using historical costs, BP lost $4.4 billion.

To adjust to the low oil price environment, BP is slashing costs (by $2.5 billion) and capital spending (by 25%, or $4 billion), raising cash from $7 billion in new bonds and $10 billion in new revolving credit borrowing and continuing its divestiture program. Its leverage (or “gearing”, a measure of net debt/equity) was 36.2%, above its 20%-30% target. BP announced its regular quarterly dividend.

The company will be pressed to maintain both its dividend and its capital spending program, as well as keeping debt from getting too high. BP estimates cash break-even at about $35 Brent, which compares to the current $26/barrel price. We believe the dividend, totalling over $8 billion/year, is likely to be cut or suspended unless oil prices surge to well over $35 in the near-term. We will continue with our Buy rating, although we are reducing our price target to $40 to reflect the new environment.

Consolidated Communications (CNSL) - Revenues fell 4% while Adjusted EBITDA increased 1% compared to a year ago. Both were in-line to slightly ahead of estimates. The company continues to do a reasonable job of defending its revenues (including re-investing in its network) while cutting costs to generate stable/higher free cash flow. It has seen higher network traffic, and no weakening in collecting receivables from its customers, reflecting the critical nature of telecom services. The company withdrew its 2020 guidance due to the economic uncertainty.

The pace of this quarter’s revenue decline was slightly more favorable compared to its trendline. Lower cash operating costs helped boost Adjusted EBITDA. Lower capital expenditures and having no dividend (eliminated last year) helped boost free cash flow to a positive $45 million, which the company used to reduce its $2.3 billion in debt (equates to roughly an 8% annual rate of reduction).

At its current pace, the company will reach its 4x debt/Adjusted EBITDA target for restoring its dividend in about 3 quarters, or year-end 2020. We estimate that it will restore the dividend around 2Q-2021. All-in, Consolidated Communications’ progress should help the stock grind higher. We are reducing our price target to $12 (from $22) to better reflect the company’s position and condition.

General Electric (GE) - Revenues of $20.5 billion fell 8% compared to a year ago, while Industrial organic revenues fell 5% to $18.9 billion. Adjusted earnings of $0.05/share were 62% lower than a year ago. Revenues were in-line with consensus estimates while per-share earnings fell 38% short of the $0.08 estimate.

To adjust, the company will take over $2 billion in costs out of its operations and undertake more than $3 billion in ‘cash preservation activities’. Helping its condition are the $20 billion in cash proceeds from the March 31st sale of BioPharma. Cash on hand now totals $47.3 billion, even after reducing Industrial debt by $7 billion and reducing GE Capital deby by $4 billion. While difficult to gauge with much accuracy, GE does appear to be approaching the limit of how much additional debt it can raise.

Profits in GE’s Aviation segment fell 39% to $1.0 billion while Healthcare profits increased 15% to $896 million, excluding BioPharma. GE Power swung to a $129 million loss and GE Capital swung to a $164 million loss.

Looking ahead, GE’s already-challenging turnaround is now more difficult. Although flush with cash, it will likely need to burn through some of that to fund cash outflows in a very difficult second quarter and probably third quarter as well. The Aviation segment will likely struggle for at least a year, until commercial air traffic recovers and demand for new jets re-emerges.

Overall, GE’s long-term outlook remains reasonably bright (although dimmer than before due to the effects of the downturn), particularly with its highly capable CEO Larry Culp who is aggressively re-shaping the company’s cost structure and competitiveness. However, GE needs to squeeze through a narrower near-term window to get to the prosperous “other side”.

We continue to rate GE shares a Buy.

Gilead Sciences (GILD) - Revenues increased 5%, although only 1% when excluding higher orders by customers to stock up on treatments. Net income, adjusted for changes in the value of equity securities, was unchanged from a year ago. Revenues were about 2% above consensus estimates while adjusted net income per share was about 8% ahead of estimates. Strong continued growth in its HIV treatments (+14%) offset weaker hepatitis-C and other treatments. The company still faces considerable risk from generic competition later this year.

The Gilead thesis remained on-track in the quarter, led by new CEO Daniel O’Day. The company generated $1.4 billion in operating cash flow, and, combined with using some of its $26 billion in cash, repaid $500 million in debt, paid $874 million in dividends and repurchased $1.3 billion in stock. After quarter-end, Gilead paid $4.9 billion to complete its acquisition of Forty Seven, an early-stage company with promising cancer treatments and a capable immuno-oncology research team.

The much-publicized studies of remdesivir have shown a positive clinical effect in reducing the duration of the Covid-19 illness in severely afflicted patients. Gilead is expanding its production capabilities and may spend up to $1 billion to complete the tests, get FDA approval, and manufacture and distribute the treatment. While the medical benefits may be critically important, the financial benefit to Gilead is likely to be limited.

Other effects of Covid-19: clinical trials of other Gilead treatments may be delayed and some current Gilead treatments may see modestly weaker revenues as patients delay visits to physicians.Janus Henderson Group (JHG) - Adjusted per-share earnings of $0.60 was 7% higher than a year ago and about 9% above consensus estimates. Adjustments primarily included a $487 million write-down of goodwill and contracts due to the market’s decline.

At period-end (March 31), assets under management were down 21% from December 31st and down 17% from a year ago. However, average assets, which includes the stronger January and February markets, declined only 3% from last year’s fourth quarter and were 1% higher than last year’s first quarter. As revenues are driven by average assets, and partly by the mix of products (favorable in this quarter), the company’s revenues net of pass-through fees to third parties was actually up 6% compared to a year ago.

As expenses were up only slightly, the company’s operating profits rose 15%, indicating that it is managing its business fairly well. Balance sheet cash totalled $802 million, which excludes a wide range of other cash held in various entities controlled by Janus. Debt totalled $316 million, although that excludes $83 million of debt in various entities controlled by Janus. The company’s capital position remains sturdy.

In the quarter, Janus retained its $0.36/share cash dividend and purchased $31 million in shares, indicating some confidence in its future.

Janus’ investments products continue to have mixed performance. However, the company saw its strongest increase in asset inflows since the merger. This is an encouraging sign, although the stronger inflows were offset by higher outflows. Our outlook for Janus remains positive, but we are reducing our price target to $29 (from $44.50) to reflect the company’s position in the weaker stock market.

Jeld-Wen Holding (JELD) - The company provided preliminary results, with full results to be reported on May 5. First quarter revenues of $979 million fell 3% from a year ago. Core revenues fell 3%, while a 2% decline from the effects of weaker foreign currencies was offset by their acquisition of VPI Quality Windows last year. Pricing strengthened 2% but was more than offset by 5% weaker volume/mix, primarily in Europe and Australasia. Compared to estimates, revenues were essentially in-line.

Preliminary Adjusted EBITDA was between $73 million and $76 million, producing a 7.6% margin compared to 8.8% a year ago. Compared to estimates, the results were essentially in-line.

The pre-release was in conjunction with a $250 million senior notes offering at a 6.25% interest rate. Jeld-Wen’s new debt raises its total to about $2 billion, partly offset by $300 million-$500 million in cash. Moody’s rated the new debt at Ba2 (below investment grade) and changed its outlook to negative. Despite the new debt, which helps bolster Jeld-Wen’s liquidity, we remain optimistic on the company’s long-term recovery. Jeld-Wen’s shares trade at less than half their 2020 high.

Kraft Heinz (KHC) - The company reported an encouraging quarter. Revenues increased 3.3%, but excluding the effects of currencies and divestitures, revenues grew a strong 6.2%. While the company attributed all of the 6.2% increase to consumers stocking up, the net effect of otherwise flattish revenues is encouraging given Kraft’s secularly challenged product array and the weakness in food-service revenues that comprise about 15% of total revenues. Higher pricing of 1.6% in the United States and other countries, excluding Canada, helped boost revenues, while a 4.6% increase in volumes provided most of the lift.

Adjusted EBITDA fell 1%, but included a 1.8% decline due to divestitures and about a 1% from weaker currencies, translating into an “organic” growth of about 1.8%. Adjusted EBITDA in the United States, which comprises about 85% of total Adjusted EBITDA, increased 6.2%. Higher corporate expenses were disappointing.

Kraft Heinz’ balance sheet, carrying nearly $33 billion in debt, remains elevated.

The company appears to be executing well under the new leadership, as management commented about its efficiency and effectiveness in keeping its grocery and other customers well-supplied. While we have no way to independently corroborate management’s comments, there don’t appear to have been many glitches which is a positive in today’s highly unusual business climate. One tangible indicator is that the company provided reasonably specific guidance for the second quarter - for organic revenues to be up low-mid single digits and Adjusted EBITDA to be up mid-single digits compared to a year ago.

This growth is despite what will likely be very weak results in its food-service business during the stay-at-home environment. In the upcoming third and fourth quarters, the pantry-stocking may reverse while food-service slowly recovers, so the company isn’t likely to see these strong trends continue indefinitely. However, we like the good start to the year.

We would like to see more of the profits converted into free cash flow. So far, this conversion has been weak although Kraft has plenty of liquidity to continue to pay its dividend. Ultimately, this is how the company can reduce its huge debt burden. This quarter’s results and second quarter outlook provided some encouragement that the turnaround is on track.

MolsonCoors (TAP) - Restaurant and bar closures around the world drove MolsonCoors’ revenues down 8.7% and Adjusted EBITDA down 16.6% compared to a year ago. Revenues were about 5% below estimates while Adjusted EBITDA was about 3% below estimates. Adjusted EPS of $0.35 was 6% higher than estimates.

About 23% of the company’s revenues are from on-premise consumption, which effectively produced zero revenues. Higher sales from off-premise purchases only partly offset that weakness. The bulk of overall volume weakness (-8.3%) came from lower production of beer that MolsonCoors brews for third parties and from lower channel inventories. Shipments of its proprietary brands fell only 1.8%. The company received modestly higher prices on a per-product basis, but this was more than offset by higher sales of lower-priced brands, the loss of on-premise sales particularly in the U.K. and from losses on returns and reimbursements from stale on-premise inventories.

In one way, MolsonCoors is benefitting from the recession, as consumers are shifting to lower-priced beers - where the company is well-positioned. This is a reversal of the previous trend in which these beers were losing share to higher priced craft beers and specialty alcoholic beverages.

The decline in profits was driven by a lower gross margin, partly offset by lower marketing/general/admin costs.

MolsonCoors was not optimistic about the rest of the year: volumes will remain weak, so it is preserving its cash by cutting capital spending and operating/marketing expenses, drawing on its line of credit and evaluating whether to cut/suspend its dividend. The company is fairly adamant about preserving its investment grade credit rating and staying within its leverage covenants. We think the quarterly dividend will be suspended, but partially reinstated in early 2021. However, we retain our $82 price target, even as we think the shares will take longer to reach it.

Newell Brands (NWL) - Revenues of $1.9 billion fell 8% from a year ago, while normalized (adjusted) net income of $0.09/share was 25% below $0.12/share a year ago. Revenues were in-line with consensus estimates but per share net income was 80% better than the $0.05/share consensus. Cost-savings under the new leadership is helping improve operating efficiency, particularly at the gross margin line.

However, the shares were weak as the company said that second quarter results would be hit hard. Newell said that April revenues were down 25%, indicating the depth of the likely second quarter problems. While many of its products are sold through Walmart, Target and other major retailers that have remained open, the closure of many smaller-scale retailers are weighing heavily on sales. The company’s Yankee Candle stores remain closed. Some of its production facilities also remain closed due to government restrictions, and supply disruptions are affecting sales.

In the quarter, Newell generated $41 million in cash from working capital, compared to a use of $118 million a year ago, as it works to improve its capital efficiency. Overall operating cash flow was a positive $23 million - quite respectable given the difficult quarter. We believe the company will consume rather than generate cash in the stronger second quarter. Newell had $476 million in cash on hand and $6.0 billion in debt, so liquidity appears adequate although leverage remains elevated.

Newell’s turnaround is making progress but this is obscured by the pandemic. At $12.28/share, the stock appears valued for a somewhat dour future that is actually brighter.

Nokia (NOK) - Revenues of €4.9 billion fell 2% from a year ago, while adjusted per-share earning were €0.01 compared to a (€0.02) loss a year ago. Adjusted operating profits turned positive at €116 million, compared to a (€59 million) loss a year ago. At current exchange rates, €1=$1.10.

The company said that the pandemic pulled down revenues by about €200 million, partly due to supply disruptions in China, and expects to recoup most of the lost sales later this year. Nokia said that the largest pandemic impact would come in the second quarter.

Nokia modestly reduced its full-year earnings guidance. Longer-term, the new CEO appears to be positioning the company for a higher revenue, higher margin future. The company is targeting operating margins in the 12-14% range, compared to about 9% for this year. The company’s cash balance of €6.3 billion and net cash (cash reduced by debt) of €1.3 billion offers considerable financial flexibility. The company plans to reinstate its dividend when the net cash balance improves to over €2 billion.

Peabody Energy (BTU) - Revenues of $846 million were 32% below a year ago, while Adjusted EBITDA of $36.8 million fell 86% from a year ago. Net income was a loss of ($130) million, or ($1.31)/share compared to a $124 million profit, or $1.15/share, a year ago. Revenues were in-line with consensus while Adjusted EBITDA was 31% below consensus and per-share earnings were 8% worse than estimates. Weaker volumes and weaker pricing weighed on revenues and profits.

Given the very difficult environment (Covid-19, Australia floods and fires, record low natural gas prices that compete with coal, falling global steel production, etc), surprisingly Peabody burned only $42 million in cash, all-in. At this pace, the company could last for years as it has $683 million in cash on hand. However, it is very sensitive to price and volume changes - so a weaker environment combined with the eventual roll-off of its fixed price/volume contracts poses a meaningful threat.

Peabody is aggressively slashing costs across all of its operations, as well as finding cash from working capital and other sources. It is working on selling its now-shuttered (following the fire there) North Goonyella met coal facility.

The company rightfully took some flak on the call for not repurchasing some of its $459 million in bonds due 2022, which are selling at only 76 cents on the dollar. They could repurchase the entire series for $350 million, even if they have to borrow on their line of credit. This would buy them three more years, as the next maturity is in 2025. We think there may be some explicit or implicit covenants with the credit line lenders or with 30% owner Elliott Management that is restraining them. Peabody currently has $683 million in cash on hand.

Peabody is contesting the FTC decision to challenge the proposed combination of Peabody’s and Arch Coal’s Wyoming operations. We think the FTC’s decision is poorly and narrowly conceived but doubt that Peabody will be successful in their efforts.

While recognizing the significant risks and long-ish odds in the Peabody story, we are retaining our Buy rating and $15 price target.

Royal Dutch Shell (RDS/B) - A large one-time liquidation of inventories ($7.5 billion) helped produce $12.1 billion in free cash flow, but weak earnings (actually a loss of $24 million) and a difficult oil and gas price outlook forced the company to cut its dividend by 66%, its first reduction in 75 years. While its shares fell about 19% in the following two trading days, the shares fell less than we would have expected. The stock, now at $29.83, remains 52% higher than its low of March 18 and yields about 4.3%.

Oil and gas production fell 1% compared to a year ago. On a constant-cost-of-supply (CCS) basis, which is comparable to “replacement cost,” Royal Dutch earned $2.8 billion, down 48% from a year ago. Lower profits from energy production as well as refining and marketing pressured profits. Like all oil companies, Royal Dutch is slashing costs (by $3-4 billion) and capital spending (to below $20 billion from a prior plan of $25 billion), and looking for cash from all sources. Net debt (“gearing”) was 28.9%,

We are retaining our Buy rating. With all the disruption in nearly all facets of the global economy, and possibly in governments, we see a very wide range of future oil prices. With its aggressive cost-cutting and potential to participate in higher oil prices, and the low share price, we believe there is adequate justification for our rating.

Trinity Industries (TRN) - Earnings of $0.11/share was 54% below results from a year ago and about 25% below the consensus estimate.

The pandemic did not significantly affect its operations during the quarter, nor has it experienced any significant increases in lease payment delinquencies. Trinity anticipates that its railcar production will slow as customers defer their purchases. The company will utilize the tax-loss carryback provision of the CARES Act to receive a $300 million tax refund - a welcome windfall.

Railcar leasing/management operating profits of $236 million increased by 18% from a year ago as the lease fleet was larger, rent expense was lower, and profits from selling unneeded railcars from the fleet were higher. Also, depreciation expense was lower due to their revisions in the estimated lives of their railcars - we see this as an unfortunate step that has a generally bad reputation. The lease fleet was 95.4% utilized, down from 98.4% a year ago.

Railcar Products (manufacturing of railcars) revenues fell 19% to $509 million and operating profits fell 47% to $25 million. The railcar industry was weakening prior to the current recession and this trend is continuing. New orders fell 34% from a year ago, and the backlog is 15% lower at 12,810 railcars, partly hurt by cancellations of 540 railcar orders.

The company moved various operations from the All Other Group into its railcar results such that this group now includes only the highway products business. This group produced $9 million in profits this past quarter. We anticipate that Trinity will sell this business.

Trinity’s balance sheet and liquidity appear sturdy enough to withstand the ongoing weaker railcar sales and lower fleet utilization as the economy goes into recession. Overall, we believe the Trinity story remains on-track.

Weyerhaeuser Company (WY) - Revenues increased 5% from a year ago while adjusted net income of $0.18/share was 64% higher than a year ago. Adjusted EBITDA of $413 million was 13% higher than a year ago. Revenues and Adjusted EBITDA were modestly ahead of consensus estimates while per-share earnings were 38% higher than estimates. WY shares fell 18% as the company temporarily suspended its dividend and said that the second quarter results would be significantly weaker. Partly driving down the shares was market sentiment that punished cyclical companies including Weyerhaeuser.

Most of the first quarter increase in profits came from its Wood Products division, helped by strong housing construction at the start of the year. However, with the recession, lumber prices and volumes have fallen and will continue to be meaningfully weaker in the second quarter. Weyerhaeuser is reducing capacity and cutting costs to adjust.

The Timberlands and Real Estate/Energy/Natural Resources divisions as well as Corporate are reducing their activity and cost levels to adjust to slower demand. Overall capital spending will be reduced by 25% .

Weyerhaeuser drew $550 million from its credit line and raised $750 million in 4% notes. Proceeds will retire its 2020 and 2021 bond maturities. Excluding the bond proceeds, the company has about $700 million in cash along with another $950 million in remaining revolver capacity. We have few concerns over the company’s ability to weather this storm.

Volkswagen AG (VWAGY) - The company reported €55.1 billion in revenues, down 8.3% from a year ago, and €904 million in adjusted operating profit (1.6% margin), down 81% from a year ago. Deliveries of 2.0 million vehicles was down 23% from a year ago. Automobile Division net cash flow was an outflow of €2.5 billion. Overall, VW has about €18 billion of net liquidity, adequate for all but a deep recession. While the first quarter was weak, VW has re-started production in Europe and said that Chinese sales showed signs of recovery. Still, the company and the industry face what could be a prolonged period of weak revenues, with the second quarter being particularly rough. Over time, however, VW is running its business much better than a few years ago and is reasonably well-positioned from both a financial and strategic perspective to see better days ahead.

Disclosure Note: One or more employees of the Publisher own shares of all Turnaround Letter recommended stocks, including the stocks mentioned in this note.