May 6, 2022

This week’s Friday Update includes a summary of the recent Cabot Turnaround Letter, and comments on earnings from 12 companies including Adient (ADNT), Berkshire Hathaway (BRK/B), Conduent (CNDT), Gannett (GCI), Goodyear Tire & Rubber (GT), Ironwood Pharmaceuticals (IRWD), Kaman (KAMN), Marathon Oil (MRO), Molson Coors Beverage Company (TAP), Organon (OGN), Shell plc (SHEL) and ZimVie (ZIMV). We also summarize the podcast and include The Catalyst Report.

We encourage you to look through The Catalyst Report. It includes a listing of all companies that have reported a catalyst in the past month, including 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.

Having returned to the United States in the wee hours on Tuesday morning (London time), and focusing on publishing our monthly edition of Cabot Turnaround Letter, our earnings summaries may be abbreviated to just the key takeaways unless a company requires extra attention. In the following days, we will dig in further to get caught up and update you if any companies need further commentary.

On Wednesday, we published the May edition of the Cabot Turnaround Letter. In the issue, we share some thoughts on the market’s focus on momentum and narratives even as it dismisses out-of-hand the merits of valuation. If this month’s letter has a theme, it would be to highlight overly-discounted stocks of companies with enduring value.

We first look at shares of homebuilders. Investors see plenty of negative momentum in light of a dour narrative, but this has pushed the valuations into discounted territory even as that narrative may not be valid. We discuss four stocks that look particularly appealing.

We also discuss seven worthy companies whose shares trade at or below 5x EV/EBITDA, as their price momentum and narratives have led to these deeply discounted valuations.

Our feature recommendation is homebuilder M/I Homes (MHO). This company has a diversified menu of home offerings across 15 states, is fully participating in the booming housing industry and has a solid balance sheet. Its share valuation, however, implies a dismal future which seems unlikely to arrive anytime soon.

The letter also includes our previously distributed change in our rating of Vistra Energy (VST) from Buy to Sell.

Earnings updates:
Adient (ADNT) – Adient, one of the world’s largest automobile seat makers, struggled due to weak leadership after its 2016 spin-off from Johnson Controls. We became interested in late 2018, after the shares fell sharply, due to the arrival of Doug Del Grosso as CEO. While we were a bit early on this name, Del Grosso’s highly-capable leadership has produced an impressive turnaround so far, although the company continues to run into numerous headwinds.

Adient reported an adjusted loss of $(0.13)/share, compared to a profit of $1.15/share a year ago and the consensus estimate of $(0.04)/share. Revenues fell 8% and were about 1% above estimates. Demand for its products is healthy but Adient continues to struggle with supply chain disruptions, high input, labor and freight costs, labor availability and other production problems, which is leading to small losses instead of sizeable profits. The company guided down its full-year 2022 profits outlook due to the headwinds, even as it continues to chip away at its debt.

Adient has transitioned into a well-managed company, so we will look through the frustrating near-term profit picture to wait for the sizeable upshift in profitability that seems inevitable. No change to our price target or ratings.

Sales fell as vehicle production remains subdued. The company’s prior full-year sales guide pointed to 12% year over year growth, but its updated guidance is now for about 6% growth and we wouldn’t be surprised if it ends up being flat. Weakish demand in Europe and China are the primary drags to vehicle output growth.

The company said that the Adjusted EBITDA of $159 million would have been twice that but for ongoing challenges in its manufacturing operations, especially in Europe where profits fell $130 million. As a supplier to car and truck makers, Adient is rocked by disruptions in the industry’s entire vertical stack: its order flow is disrupted by customers who are scrambling to produce in chaotic conditions, which adds to its already-challenged ability to find labor, schedule its production, procure adequate supplies and ship its goods, all while costs are surging for everything. Eventually, Adient and the industry will return to a more steady state, but we (and the company) can’t know yet what the profit margins will be in those conditions. The company outlined many of the steps it is taking to mitigate current and future disruptions – encouraging as an indicator that management is on top of the situation as much as possible.

We see Adient as a solidly profitable franchise but must wait to see what the end game looks like in terms of profits. The balance sheet continues to improve as Adient paid down over $700 million in debt in the quarter. Debt net of cash is down 16% over the past two quarters.

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 essentially flat operating earnings compared to a year ago, as insurance underwriting profits fell sharply, offset by a 16% increase in earnings in the manufacturing, service and retail business operations. Auto insurance profits remain somewhat elusive as the re-opening is leading to higher claims. The manufacturing, service and retail segments are seeing strong revenue and profit improvements as the economy remains robust. Such are the benefits of Berkshire’s diversified operations. Berkshire repurchased $3.2 billion of its shares in the quarter, a bit less than in recent periods reflecting the higher share price. All-in, a reasonable quarter. We have no change to our HOLD rating.

Conduent (CNDT) – Conduent was spun off from Xerox in 2017. After a promising start, the company’s revenues fell sharply due to management problems, leading to a collapse in its share price. In late 2019, the company replaced the CEO, who began a major overhaul that is starting to show progress. Activist investor Carl Icahn owns 18% of Conduent’s shares, while Darwin Deason (who sold his business to Xerox which later was spun-off as Conduent) holds a 3.3% stake.

The company reported a reasonable quarter, with adjusted earnings of $0.10/share slipping by 33% from a year ago but beating the consensus estimate by 66%. Revenues fell 5% but were in line with estimates. Earnings were lifted by a one-time recovery, so the true results weren’t as strong and were further weakened by the roll-off of the pandemic stimulus program. Adjusted EBITDA fell 11% compared to a year ago when factoring in the one-time recovery. But, overall, the results were good enough to suggest that the company is making progress.

Management reiterated their full-year guidance, but Conduent may struggle to achieve this due to the aggressive improvements needed later this year. Understandably, investors are losing patience with the company as its turnaround always seems to be a year away. We remain patient given the low valuation and positive (if grindingly slow) progress. Carl Icahn continues to hold 18% of the shares, and late last year the CEO raised his stake by 45% to about 1.5% of the company.

Commercial segment revenues were flat this past quarter and appear likely to turn positive later in the year as new contracts come online. Government and Transportation segments showed sizeable revenue declines (9% and 12%), partly from the end of temporary programs like the government stimulus check processing program but they are also losing business. These latter two segments are by no means lost causes, but for the Conduent story to work, the company needs to return to positive growth – even if only slightly positive. This remains a challenge.

The planned spin-off of the Transportation business may be a positive, but we wonder why they are choosing to spin rather than sell. There appear to be some tax benefits to a spin, but it seems just as likely that Conduent didn’t receive any worthwhile offers. It would seem that a private equity firm would find this annuity-like business attractive, but perhaps the spread between what the company wanted and what PE would pay was too wide. Perhaps management is still talking with potential buyers behind the scenes.

Looking ahead, the key sales metrics are moving in the right direction, highlighted by first-quarter new business signings that were the strongest since Conduent was spun off. But these gains aren’t large enough to make the company’s full year guidance an easy hurdle. And, cost-cutting along with more-profitable contracts may not be enough to offset sloppy revenue progress this year.

The balance sheet holds $588 million in cash and only minimal amounts of debt mature until 2026 so the company has plenty of time to fix its core operations.

Gannett (GCI) – Gannett, publisher of the USA Today and many local newspapers, is racing to replace its declining print circulation and ad revenues with digital revenues. It also is aggressively cutting costs to maintain its profits and help cut its expensive and elevated debt. The biggest challenge for Gannett is to overcome investors’ perception that the company is not viable.

Gannett reported Adjusted EBITDA of $64 million, down 36% from a year ago and 4% below the consensus estimate. For now, our focus is on EBITDA and free cash flow, as opposed to earnings (which was a loss of $3 million) as we want to see the underlying profit improve along with paydown of debt from free cash flow. The company reiterated its revenue, earnings, free cash flow and other full-year guidance.

While total sales fell 4%, same store sales (which excludes divestitures) fell 2.5%, suggesting some stability in post-pandemic revenues. Circulation revenues, about 40% of total revenues, continues to slide, down 11% in the quarter. While digital-only revenues grew 30% and are showing immense promise, the dollar increase was only $7 million due to its small revenue base. Print circulation revenues fell $42 million (-14%), overwhelming the digital-only gains. This is the key challenge for Gannett: boosting its digital and other revenues fast enough to offset the secular burndown in print circulation revenues. We see little chance for improvement in the print circulation decay: prices for paper subscriptions are already absurdly high and increasingly are a discretionary item that can readily be replaced with better/cheaper news sources.

Fortunately, advertising revenue has remained remarkably stable. Advertisers are shifting to Gannett’s digital properties from its newspapers.

The decline in EBITDA reflects the revenue challenge. Gannett has held its costs relatively flat (they need to decline, in our view) so any decline in revenues leads to a corresponding decline in profits. In the first quarter, revenues fell $29 million and profits fell $36 million.

Gannett’s guidance calls for roughly flat full-year revenues, stability in its same-store revenues, $390 million in EBITDA and $170 million in free cash flow. The profit and free cash flow guides would represent significant increases compared to the prior year. If it can hit this guidance, the story would clearly remain on track. We have reasonable confidence that the company can get “close enough” to this guidance given the overly discounted shares to remain interested in the stock.

Goodyear Tire & Rubber Company (GT) – An investment in Goodyear is an opportunistic purchase of an average company whose shares have fallen sharply out-of-favor for what look like short-term reasons. Investors aggressively sold the shares following the company’s disappointing outlook provided during its fourth quarter earnings call. However, demand and pricing will likely remain robust, more than enough to offset rising input costs. And, the benefits from Goodyear’s acquisition of Cooper Tire provide additional value. The company’s balance sheet is sturdy.

This morning, the company reported earnings of $0.37/share, down 14% from a year ago but sharply higher than the $0.21 consensus estimate. Sales rose 20% excluding the contribution from the Cooper Tire merger and currency changes, and were about 5% higher than estimates. All-in, an encouraging report. However, the shares are off 9% in late-Friday trading, leading us to believe that the management said something less encouraging on the conference call. We will review the call transcript to find out.

In the quarter, revenue was helped by stronger pricing and higher-value mix, which exceeded the drag from higher input prices by $130 million. The pricing/mix strength relative to costs, as well as strong volume growth, are key components of our thesis. Nevertheless, Goodyear continues to struggle with production inefficiencies due to labor availability, disrupted vehicle producer schedules and Chinese market demand, as well as chronically higher wage, energy and transportation costs.

Operating cash flow was a negative-$(711) million due to a massive $1 billion increase in inventories and receivables. The balance sheet remains relatively sturdy.

Ironwood Pharmaceuticals (IRWD) – After years of weak leadership, Ironwood has one remaining product, Linzess, so investors view the company as a failed business. However, Linzess is a steady revenue producer with growing volumes that offset its slow per-unit price decline. As cash accumulates on the balance sheet and now exceeds its debt, Ironwood is repurchasing its shares. Respected activist investor Alex Denner, who now holds a board seat, is exerting his influence, including ousting the CEO and slashing spending. Ironwood’s shares trade at a highly discounted valuation.

The company reported first-quarter earnings of $0.21/share, down 13% from a year ago and about 19% below the consensus estimate. Revenues rose 10% from a year ago and were in line with the consensus. Linzess revenues grew 8% – growth of this franchise continues to be much more resilient than investors are paying for. Expenses were lower, adjusted EBITDA rose 26%, and cash flow was healthy. The company is buying back its shares at a respectable clip. Management reiterated their full-year revenue and profit guidance.

The decline in per-share earnings was almost entirely due to the dilution in share count caused by new accounting treatment of Ironwood’s convertible notes. The economics haven’t changed, only the disclosure. Still, the optics may weigh on the shares.

The two new treatments, which we see as distractions to the free cash flow story, remain low-value options with limited visibility into their potential. However, one of the biggest risks to our thesis is that Ironwood splurges on new treatments or on acquisitions.

No change to our rating or price target.

Kaman Corporation (KAMN) – Based in Connecticut, Kaman is a high-quality defense and aerospace company. A reconfigured board along with a new CEO and several other new senior executives are prioritizing Kaman’s high-value precision engineering operations and emphasizing higher margins and shareholder returns while exiting/de-emphasizing the company’s lower value businesses. The company is profitable and its sturdy balance sheet provides a solid foundation.

Kaman reported first-quarter adjusted earnings of $0.15/share, down 48% from a year ago and sharply below the $0.35 consensus estimate. Revenues of $158 million fell 8% from a year ago and were about 20% below the consensus estimate. While the Engineered Products segment (the gem) saw higher year-over-year sales and profit growth, the Precision Products and Structures segments had lower revenues and profits, dragging down the company totals. The JPF weapon fuses operations within Precisions Products offset by itself strength elsewhere.

Kaman maintained its full year outlook. The company is in the early stages of its operational turnaround and any positives are still overwhelmed by the negatives. No turnaround happens overnight and this one is no different. However, it appears to be on track. No changes to our rating or price target.

Marathon Oil Company (MRO) – This oil and gas exploration and production company is fundamentally strong, with a high-quality resource base that generates remarkably generous free cash flow and is backed by a low-leverage balance sheet. A major appeal that we can buy shares of this company at a highly discounted 4.1x EV/EBITDAX valuation. We acknowledge the risks that commodity prices might fall, that management may choose to overly invest in production growth rather than returning most of its free cash flow to investors, and that regulations change.

Marathon reported adjusted earnings of $1.02/share, nearly 5x the $0.21/share of a year ago and about 4% above the consensus estimate. The company generated $940 million of free cash flow, more than double the year-ago results. Marathon raised its full-year free cash flow expectations by nearly 50%, to $4.7 billion. It remains committed to restraining its capital spending to essentially maintain its output (although investors chaffed at the 8% spending increase necessary to maintain output stability as costs have increased) while returning 50% or more of free cash flow to shareholders. Since October, Marathon has reduced its share count by 11% and recently raised its quarterly dividend by 15%. All-in, the company is doing what an oil company should be doing: generating immense amounts of cash and returning it to shareholders. If conditions remain unchanged, MRO shares could deliver cash back to investors of between 14% and 24% of the company’s current market value, this year.

No change in our rating or price target, but we continue to evaluate that price target as, at some point, the shares will no longer represent a good investment.

Molson Coors Beverage Company (TAP) – Molson Coors is struggling with weak growth, yet is working under a new CEO to more aggressively develop specialty/higher-end beverages and reduce its reliance on mainstream and value offerings. Also, the company is increasingly focusing on its cost structure. Molson Coors continues to trade at a discount to its peers and its fundamental prospects.

Molson Coors reported first-quarter adjusted earnings of $0.29/share, which compared to $0.01/share a year ago and the consensus estimate of $0.19. Year-ago results were depressed from pandemic pub closures, which made for easy comparisons. Nevertheless, results were solid. Sales grew 17% and were about 3% higher than estimates. Driving the strong results were healthy volumes (+5%) and pricing (+10%). Strategically, Molson continues to make good progress with its cost and product rationalization and new product initiatives. While the results were impressively strong, the company’s second-quarter earnings guidance was surprisingly weak (even though management reaffirmed their full-year guidance), leading to a 3% dip in the stock price.

Second-quarter earnings were guided to a decline of 20-30% compared to a year ago. The company is aggressively stepping up its marketing spending as it launches new products. While this spending is critical to strong launches, it is higher than we expected and than implied by the company’s prior commentary. Also, an ongoing strike at its Canadian facilities will weigh on second quarter volumes and profits. Another drag is higher inventory at wholesalers compared to a year ago, so shipments to the wholesale channel will be weaker.

As the company maintained its full year guidance, the weak second quarter implies a strong third and fourth quarter – achievable for sure but now not quite as likely. The company’s ability to maintain its pricing spread relative to inflation and its ability to maintain volume growth even as Americas volumes are underwhelming will be critical to achieving its guidance – we are not entirely convinced but the shares’ discount provides a margin for safety.

All-in, the Molson story remains on track but the full recovery to the assumptions in our price target may take a bit longer.

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.

Organon reported adjusted earnings of $1.65/share, down 7% compared to the pre-spin year-ago period and about 27% above the consensus estimate. Revenues rose 4% and were about 3% above estimates. Adjusted EBITDA rose 14% and was 26% above estimates. We take the earnings comparisons vs. a year ago with a grain of sale as the company was still part of Merck and as such its true costs can only be estimated. Still, the report was encouraging, the company maintained its full-year revenue and profit guidance, and the shares rose 5% on a day when the stock market slid over 3%.

The solid results were driven by relatively steady sales of the Nexplanon contraceptive (-7%), as well as growth in the Biosimilars (+22%) and Established Brands (+10%) segment. There was no effect from China’s volume-based procurement program which had previously been a drag on sales. All-in, Organon’s revenue stability helps establish a floor to profits, which if sustained would lead to a higher valuation for the company’s shares.

Organon’s balance sheet has improved from the spin-off date but was essentially unchanged in the quarter.

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

The company reported adjusted earnings of $1.20/share, up 45% from a year ago and higher than most estimates we could find. Shell continues to benefit immensely from high oil and natural gas prices. EBITDA was $19 billion (compared to $12 billion a year ago) and free cash flow was nearly $11 billion (compared to about $8 billion a year ago). About $2.2 billion of the higher profits was due to inventory profits, which are produced when the value of Shell’s oil and gas inventories increase along with the commodity prices. This is fine, as it is eventually converted into cash profits, although this effect reverses when commodity prices decline.

The company is keeping its operating expenses and capital spending reined in, even as profits surge, which is an encouraging indicator of its newfound discipline. However, Shell promised to spend as much as $30 billion over the next decade on renewables – even for Shell, this is a huge amount of money and we hope that it is spent on projects that provide an attractive return.

Shell distributed $5.4 billion to shareholders through dividends (the quarterly dividend was raised 4%) and buybacks. About half of its $8.5 billion buyback program was completed in the first quarter, with the balance to be completed by roughly mid-July. Shell said in the second half of 2022 it would continue this pace of about 30% of operating cash flow being paid to shareholders. Shell trimmed its debt by another $4.1 billion, or about 8%, in the quarter, to a level that is appropriate for its operations.

Profits will likely be even higher in the second quarter, as current commodity prices are 10% or more higher than first quarter prices. Most of this incremental price increase will flow directly to the bottom line.

ZimVie (ZIMV) – Recently spun off from Zimmer Biomet Holdings, ZimVie specializes in dental and spinal implant products. Like with many new spin-offs, investors sold ZIMV shares for technical reasons, as well as due to concerns about the ability of the new company to fix its struggling spinal products division. The shares are attractive given their unusually low valuation, the company’s durable dental franchise and reasonable potential for a turnaround in its spinal products segment. ZimVie should generate considerable free cash flow, providing financial flexibility as its works down its modestly elevated debt burden.

The company reported adjusted earnings of $0.50/share, down 37% compared to the pre-spin results a year ago yet were 32% ahead of the consensus estimate. Adjusted EBITDA of $34 million fell 15% from a year ago but was 13% above estimates. Revenue fell 5% (about half the decline was due to currency changes) but was 4% above estimates. Dental segment revenue rose 6% while Spine segment revenues fell 14%. The company does not break out profits by segment.

The results had some spin-off related costs so they weren’t entirely clean. ZimVie reiterated its full-year revenue and profit guidance. Overall, an encouraging first quarter as a public company.

Friday, May 6, 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 17½ minutes and covers:

• Earnings:
  
  • Comments on the 12 companies reporting earnings.

• Comments on other recommended companies:
  
  • Western Digital (WDC) – receives letter and offer of $1 billion from activist Elliott to help with a spin-off of its flash memory segment.
  • Walgreens Boots Alliance (WBA) – reached a $683 million opioid settlement with Florida.

• Elsewhere in the market:
  
  • Cabot Turnaround Letter names on average have held their value in a difficult market, returning -2% YTD on average, compared to the -13% return for the S&P 500.
  • Advice from The Gartman Letter about generals leaving the battlefield
  • The peak uselessness of the “peak hawkishness” concept
  • Calling out Morningstar for sloppy math on its market view.

The Catalyst Report
April was a reasonably active month for catalysts, led by 13 CEO changes, several activist campaigns and more than a few acquisitions.

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 jumpstart 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:

Orange SA (ORAN) $32.5 billion market cap – Formerly named France Telecom, this company is a major wireline and wireless telecom services provider that has struggled for years, and the shares reflect this. Yet, with the new CEO, an impressive woman from outside the company who appears to bring a much-needed fresh perspective, Orange could be on a path to a turnaround.

Dave & Buster’s Entertainment (PLAY) $2.1 billion market cap – Shares of this entertainment company have rebounded from their pandemic low, but continue to have an uninspiring valuation. Yet, the company has the backing of KKR and activist investor Hill Path. It will be acquiring privately-held Main Event, and bringing that company’s CEO over to lead the combined company. There may be more opportunity here than meets the eye.

Warner Brothers Discovery (WBD) $52.2 billion market cap – After its complicated transaction with AT&T, shares of this company have slid backwards. But, with an unchallenging valuation and plenty of opportunity, this discarded stock may be worth a closer look.

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