July 29, 2022

This note includes our review of earnings from Dril-Quip (DRQ), General Electric (GE), Holcim (HCMLY), Janus Henderson Group (JHG), Kraft Heinz Company (KHC), Lamb Weston Holdings (LW), M/I Homes (MHO), Newell Brands (NWL), Polaris (PII), Shell plc (SHEL) and Xerox Holdings (XRX).

There were no ratings or price target changes this week.

This week’s Friday Update includes The Catalyst Report. We encourage you to look through this listing of all of the companies that have reported a catalyst in the past month. These catalysts include new CEOs, activist activity, spin-offs and other possible game-changers. We source many of our feature recommendations from this list. You will find it nowhere else on Wall Street.

As a reminder, we will be publishing the August edition of the Cabot Turnaround Letter next Wednesday.

Earnings Update

Dril-Quip (DRQ) – A major supplier of subsea equipment, Dril-Quip is struggling with the downturn in offshore oil and natural gas drilling. It generates positive free cash flow and has a sizeable cash balance, yet no debt, all of which should allow it to endure until industry conditions improve.

The company reported an encouraging quarter. Revenues rose 16% and were 7% above estimates. Adjusted earnings of $(0.10)/share improved from $(0.53) a year ago although it fell short of the $(0.06) estimate. Adjusted EBITDA of $9.3 million increased from $2.5 million a year ago and was 30% above estimates.

Sustained elevated oil and natural gas prices are leading to increased offshore drilling activity. This is driving higher demand for “short-cycle” downhole products and services as energy companies can readily justify quick-return projects and early work on re-starting other projects. Demand for newer and larger projects remains uncertain. Dril-Quip’s revenues are directly affected by these trends. And, new orders of $50 million indicate improvement in customer confidence.

Impressively, Dril-Quip kept its operating expenses under control. Overhead expenses were essentially flat excluding the favorable effect of lower legal expenses this year following the successful litigation in 2021. Flat expenses allowed much of the incremental gross profits to flow to EBITDA.

The company repurchased $3.8 million in shares, a pittance in our view. Their timing has been impeccable, however, with their year-to-date average cost of about $23.35/share. Had they deployed, say, $100 million, they could have repurchased perhaps four million shares, or more than 10% of the total shares outstanding. The balance sheet, currently with $321 million in cash and zero debt, could easily have funded such a purchase.

General Electric (GE) – Led by impressive new CEO Lawrence Culp, GE finally appears to be righting its previously severely damaged business. Key priorities include a primary focus on the Industrial businesses (and an exit from the Financial businesses), much better execution and a strategic emphasis on cash flow and debt reduction. To help achieve its goals, GE is decentralizing its operations and pushing more responsibility and accountability down to each business line.

GE reported a reasonably good quarter. Revenues on an organic basis rose 5% and were 4% above estimates. Adjusted earnings of $0.78/share rebounded from $0.22 a year ago and were 86% above estimates. The company said it continued to trend toward the low end of its full year guidance ranges on all metrics except free cash flow, which will be below its guidance range. Second quarter free cash flow was a dismal $162 million, which rose incrementally from a year ago (net of the appalling practice, now discontinued, of factoring its receivables).

GE Aerospace rebounded with revenues up 27%, orders up by 26% and profit margins expanding sharply to 18.7% from only 3.6% a year ago. The other three segments produced lower revenues and profits in aggregate. Overall, GE is becoming a more profitable company, reflected in the increase in its adjusted operating profit margin to 9.3% from 8.9% a year ago. However, the turnaround has a long way to go. The three-way split-up, on track to start next year, will be the largest catalyst that could boost shareholder value (excluding the arrival of CEO Larry Culp) since the departure of former CEO Jeffrey Immelt in 2017.

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$1.04).

Holcim reported encouraging first half results. Revenues rose 13% on a like-for-like basis and were about 4% above estimates. Earnings before impairments and divestments were CHF2.14/share, up 50% from a year ago, and were sharply higher than the consensus estimate. Management increased its full year 2022 outlook. Overall, the story remains on track.

Demand remains impressively resilient, particularly in North America, and is being supported by faster organic growth in the emerging Solutions and Products segment. Acquisitions are adding further growth. Profit growth lagged revenue growth as price increases weren’t enough to offset higher costs, particularly in Asia Pacific. Free cash flow was weak due to a temporary drag from working capital. The balance sheet remains sturdy but net debt increased 7% from a year ago due to higher acquisition spending and dividend payouts.

Janus Henderson Group (JHG) – Janus Henderson Group is a global investment management company focusing on publicly-traded equities and bonds. The 2017 merger of Denver-based Janus Capital Group and London-based Henderson Group was to produce faster growth and a more valuable firm, but it has proven unsuccessful on most counts. The recent market sell-off has further weighed on its shares. However, the company’s low valuation and chronic problems led activist Trian Partners to become the firm’s largest shareholder with a 19% stake. Trian is actively driving change by replacing the CEO, taking two board seats and pressing for an overhaul. Janus is highly profitable, has a fortress balance sheet and pays a generous dividend.

Revenues fell 29% but were in-line with estimates. Adjusted earnings of $0.63/share fell 46% from a year ago and were 3% below estimates. All-in, a reasonable quarter.

Revenues are driven by assets under management (AUM) and the average fee rate. AUM fell 30% due partly to the sell-off in the stock and bond markets, but also due to the closure of the quantitative strategies and sizeable redemptions by clients. The average fee rate fell from 50.5 basis points (100 basis points = 1 percentage point) to 49.2. Also weighing on revenues was the $80 million swing to a small negative in its performance fees, as its products’ performance continues to be lackluster. Better investment performance is a top priority for the new leadership team.

Expenses fell by 17% as compensation declined. Janus’ challenge on expenses is to restrain them without hurting the company’s ability to execute. We think the management team will address this in its turnaround plan.

The balance sheet remains solid with $930 million in cash in excess of its debt. Janus continues to generate considerable free cash flow, but we are aware that its dividend payout ratio (dividends per share as a percent of earnings per share) is at 70% – fine for now but we don’t want to see much more erosion.

The Janus-Henderson merger was unsuccessful in generating any shareholder value, and competitors have gained considerable ground while the industry has clearly evolved in the five years since the combination. The challenge for the new leadership team is to either blend together the two companies in a way that makes the overall entity stronger and more valuable, or split them up/sell them off. We are optimistic and encouraged by management’s clear and determined commentary. We think the best way to boost shareholder value is to split the company and sell the two parts separately.

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.

The company reported a strong quarter and provided mostly encouraging guidance, but its comments about its ability to keep raising prices (which is delicately phrased as “elasticity impacts from pricing actions”) and plans to boost promotions spooked investors and the shares fell 6% on the news. Overall, the Kraft turnaround remains on track although we will watch its ability to raise prices closely.

Revenues fell 1% but were 3% above estimates. Adjusted earnings of $0.70/share fell 11% from a year ago but were also 3% above estimates. Adjusted EBITDA fell 11% and was about 1% above estimates. Kraft raised its full year revenue guidance by about 3 percentage points but kept its Adjusted EBITDA – heightening investor concerns about margin pressure.

Kraft raised its prices by 12% during the quarter, more than offsetting a 2% volume decline, such that organic revenues rose 10%. Pricing and efficiency gains, however, were more than offset by steadily rising commodity, logistics and manufacturing costs. The company said that its adjustments in response to the cost pressures should help margins in future quarters, but its guidance was not entirely convincing on this.

Cash flow lagged as inventories are elevated and as the company has slowed the collection of its receivables while paying off a divestiture-related tax liability. The balance sheet remains sturdy but we would like to see inventories and receivables worked lower.

Lamb Weston Holdings (LW) – As the largest producer of frozen potato products (mainly French fries) in North America, Lamb-Weston’s revenues fell sharply when restaurants closed during the pandemic and continues to feel the effects from supply chain issues. We believe “Lamb” is a sturdy company, conservatively financed, with a strong market position among fast food restaurants (McDonald’s is a 10% customer, for example) and other food service venues. LW shares trade at an oversized discount to their underlying value.

Lamb reported an encouraging fiscal fourth quarter. Revenues rose 14% from a year ago and were about 7% above estimates. Adjusted earnings of $0.65/share rose 48% and were 27% above estimates. Pricing rose 15%, which drove the revenue increase as volumes fell 1%. Most of the volume weakness was due to a lack of overseas shipping capacity. The higher prices also drove the higher operating profit margin.

The company provided its 2023 guidance, calling for 16% revenue growth and 27% adjusted earnings per share growth. Compared to the pre-pandemic year 2019, this guidance points to a 27% increase in revenues, 17% lower adjusted per-share earnings and 3% lower adjusted EBITDA. The company is approaching its pre-pandemic profits even though the margins will be a bit weaker due to higher input, transportation and potato prices, partly offset by better pricing and efficiency improvements.

Lamb’s balance sheet remains robust, as does its free cash flow. The shares have rebounded 58% from their 2022 low and trade about 7% below our $85 price target.

M/I Homes (MHO) – M/I Homes is one of the country’s largest homebuilders, with 175 communities under development across 15 states. Its shares have tumbled sharply from their 52-week high and now trade at their pre-pandemic price as investors worry about a possible recession, the effects of rising mortgage interest rates and higher labor and raw materials costs. While we appreciate the headwinds facing M/I Homes and its industry, we see a diversified, highly-profitable, financially solid and well-managed company whose shares trade at a sizeable discount to their liquidation value.

The company reported a strong quarter. Revenues rose 8% to a second-quarter record, and were in-line with the consensus estimate. Earnings of $4.79/share (also a record) rose 27% and were 27% above estimates which called for flat earnings. All-in, the fundamentals were remarkably strong but will weaken incrementally as the housing market loses its near-hyper demand surge. We see little chance of a sharp housing market downturn, and remain optimistic about the M/I story.

Revenue growth came from a combination of a 6% decline in units paired with a 16% increase in the average price of a delivered home. Higher prices helped drive gross margins to 27.3%, compared to 25.1% a year ago – reflecting the strong pricing in excess of rising materials and labor costs. Historically, margins anywhere near 27% are exceptionally high, with normal at perhaps 18% to 20%. Sharply lower timber prices will help the company maintain its near-term margins, but as pricing slips so too will margins. Financial services revenues slipped 32%. The company’s cycle time, which indicates how long it takes to build a home, was unchanged, suggesting that M/I isn’t struggling much with labor or materials availability.

While the quarter proved to be remarkably strong, demand is clearly slowing. New contracts fell 20%, and backlog units fell 5% as the company is delivering faster than new orders are arriving. But demand likely won’t fall sharply indefinitely and could readily stabilize at a healthy level once homebuyers adjust to higher mortgage rates.

The balance sheet remains solid, largely unchanged from the prior quarter as excess cash was used to increase its land development and to repurchase shares. Tangible book value per share, our preferred valuation base, rose 30% from the year-ago quarter and 7% from the first quarter. This accretion of value is impressive. The shares trade at about 73% of the current $63.02/share of tangible book value – a substantial discount when the company’s fundamental outlook is at worst moderately weak.

Newell Brands (NWL) – The company has struggled, literally for 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.

Newell reported a reasonable quarter, maintained its full-year guidance excluding the effects of the strong dollar, but guided for weaker third quarter results. Our review here will be brief due to the timing of Newell’s report, with more color later if necessary.

Core revenues rose 2% and were in-line with estimates. Normalized earnings of $0.57/share rose 2% from a year ago and were 21% above estimates. The company maintained its constant-currency revenue and profit guidance, but on an actual-currency basis the guidance was reduced due to the strong dollar. Third quarter guidance for $0.50-$0.54 in normalized earnings fell short of the current $0.57 consensus estimate. The shares are slipping about 2% in early trading.

Polaris (PII) – Shares of this high-quality and market leading manufacturer of powersports equipment like off-road vehicles, snowmobiles, motorcycles and boats, have fallen out-of-favor with investors. Major concerns include the risk of a post-stimulus falloff in demand as well as supply chain disruptions that are weighing on margins by 3-4 percentage points. We believe the company’s long-term prospects remain intact. Polaris produces strong profits and free cash flow, has a solid balance sheet, and a strong, shareholder-friendly management team.

Polaris reported a reasonable quarter. Sales rose 8% from a year ago but were about 5% below estimates. Adjusted earnings of $2.42/share were about 14% above estimates. Adjusted EBITDA of $255 million fell 6% but was 6% above estimates. Polaris raised its full year 2022 revenue guidance to a 13-16% increase compared to its prior guidance for a 11-14% increase. Guidance for full year adjusted operating earnings per share was essentially unchanged (high-end of range was reduced by 10 cents). Overall, the turnaround remains on track.

Polaris sells to dealers, so it provides a “retail sales” number to indicate end-customer demand. In the quarter, retail sales fell 23% compared to a year ago, suggesting that low dealer inventories continue to plague sales volumes. Difficulties procuring components are slowing production, yet these are starting to ease. Polaris anticipates a strong tailwind next year as it refills historically low dealer inventories. The primary unknown is whether end customer demand stays healthy, as this would affect 2023 orders to Polaris.

In the quarter, margins slipped on higher production costs, but Polaris is implementing price increases to bolster its profits. Operating costs actually fell compared to a year ago. The balance sheet remains strong although inventory is high – likely due to unfinished machines waiting on components.

Shell (SHEL) – 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 recently-raised dividend now appears secure, to the extent that commodity prices remain stable, under its new policy.

Shell reported immense profits and an overall encouraging quarter. Adjusted profits of $1.54/share increased 117% and were about 5% above estimates. Adjusted EBITDA of $23.2 billion rose 70% from a year ago. Free cash flow of $12 billion increased 29%. Profit metrics improved noticeably from the first quarter – itself a strong period for Shell. The company was exceptionally well-positioned to benefit from rising oil and natural gas prices as well as wider refining margins.

Shell deployed its growing cash hoard of $39 billion by distributing $7.4 billion to shareholders, cutting its net debt balance by $2.1 billion to the lowest level since the BG acquisition in 2016, and buying the outstanding common units of its Shell Midstream Partners LP. Capital spending rose 39% but the company is staying within its budget. All of this is good for shareholders.

Shell’s shares continue to trade at a low valuation while paying an appealing 2.9% dividend yield.

Xerox Holdings (XRX) – While the near-term outlook is clouded, as office workers remain in partial work-from-home mode, we believe the company’s revenue and cash flow will recover. Investors underestimate Xerox’s value due to its zero-growth prospects, but the company’s hefty free cash flow has considerable value. The balance sheet is strong and its generous dividend looks reliable.

Xerox reported a modestly disappointing quarter, but the shares already discount considerable bad news. The company reiterated its full year revenue and free cash flow guidance. The return to office trend continues to advance, although at a slower-than-anticipated pace.

Revenues rose 1% excluding currency effects and were 7% above estimates. Adjusted earnings of $0.13/share fell 72% from a year ago and were 19% below estimates.

Revenues were stable but profits fell sharply as supply chain disruptions, elevated costs and more investment in its new businesses pressured the company’s margins. Free cash flow was modestly negative in the quarter. Xerox expects these pressures to ease in the second half of the year, with further help coming from raising its own prices. Corporate debt fell, funded by cash on the balance sheet, with the overall debt position remaining readily manageable. The company’s turnaround is delayed following the surprise death of the CEO. An interim leader is working to keep the company moving forward during the search for a permanent CEO.

Friday, July 29, 2022 Subscribers-Only Podcast:
Covering recent news and analysis for our portfolio companies and other topics relevant to value/contrarian investors.

Today’s podcast is about 18 minutes and covers:

• Earnings
  
  • Comments on recommended companies reporting earnings.

• Elsewhere in the market:
  
  • Maybe interest rates and inflation will converge at 4%?

• Final note:
  
  • Perhaps some encouraging news for parents whose sons drop out of college to become bearded ski bums.

The Catalyst Report
July was another active month for catalysts, led by 18 CEO changes that continues a trend that we have seen for the past several months. See the upcoming August edition of the Cabot Turnaround Letter for our top New CEO picks.

Previously recommended Credit Suisse, which we de-rated to a Sell earlier this month, finally replaced its CEO. But we see the company’s problems as deep-rooted and seriously problematic in the currently difficult capital markets.

The Catalyst Report is a proprietary monthly report that is unique on Wall Street. It is an extensive listing of companies that have experienced a recent strategic event, such as new leadership, a spin-off transaction, interest from an activist investor, emergence from bankruptcy and others. An effective catalyst can jump-start a struggling company toward a more prosperous future.

This list is intended to be comprehensive. While not all catalysts are meaningful, some can bring much-needed positive changes to out-of-favor companies.

One highly effective way to use this tool is to pair the names with weak stocks. Combining these two traits can generate a short list of high-potential turnaround investment candidates. The spreadsheet indicates these companies with an asterisk (*), some of which are highlighted below. Market caps reflect current market prices.

You can access our Catalyst Report

.

The following catalyst-driven stocks look interesting:

Jefferies Financial Group (JEF) $7.5 billion market cap – This company is a diversified financial services firm with an overly-complicated and confusing two-company structure and various orphan operations. However, the company announced that it is jettisoning many of its non-core units and combining Jefferies Financial Group and Jefferies Group. These transactions make immense sense for this under-respected company.

3M Corporation (MMM) $79.1 billion market cap – This diversified company is spinning out its health care operations, selling its food safety business to Neogen, and having its ear plug unit file for bankruptcy in the wake of rising claims. The company still faces potentially large liabilities for toxic PFAS contamination. If its skillful lawyers can put those behind it, too, the shares will surge. The stock has been cut nearly in half from their early 2018 peak and now trades at a modest 13.5x earnings with a 4.9% dividend yield.

Prudential plc (PUK) $32.8 billion market cap – Shares of this dull company have been remarkably volatile and now trade near their 20-year low. Among investor worries is the company’s exposure to China and Hong Kong, but these markets will likely improve, and Prudential’s operations elsewhere in Asia remain strong. A new CEO takes the reins next February, which brings both opportunity and uncertainty. The shares reflect little of the company’s likely healthy earnings growth in coming years. Prudential plc is unrelated to the American company with the same name.

Please feel free to share your ideas and suggestions for the podcast and the letter with an email to either me at bruce@cabotwealth.com or to our friendly customer support team at support@cabotwealth.com. Due to the time and space limits we may not be able to cover every topic, but we will work to cover as much as possible or respond by email.

Please know that I personally own shares of all Cabot Turnaround Letter recommended stocks, including the stocks mentioned in this note.

Disclosure: The chief analyst of the Cabot Turnaround Letter personally holds shares of every Rated recommendation. The chief analyst may purchase securities discussed in the “Purchase Recommendation” section or sell securities discussed in the “Sell Recommendation” section but not before the fourth day after the recommendation has been emailed to subscribers. However, the chief analyst may purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time.Please feel free to share your ideas and suggestions for the podcast and the letter with an email to either me at bruce@cabotwealth.com or to our friendly customer support team at support@cabotwealth.com. Due to the time and space limits we may not be able to cover every topic, but we will work to cover as much as possible or respond by email.