November 12, 2021

This week’s Friday Update includes our comments on earnings from eight companies. Also, Toshiba (TOSYY) reported earnings this morning, along with its plan to split into three companies. We believe the split-up plan is a clear positive even though it could take 2-3 years, and that the earnings were good enough on a first-impression basis. We will have a more complete update next week.

We moved Signet Jewelers (SIG) from BUY to SELL earlier this week.

Next week, Vodafone (VOD) and Macy’s (M) are scheduled to report earnings.

Ratings changes:
This past Monday, we moved Signet Jewelers (SIG) from BUY to SELL. With the shares trading just over 104, above our many-times-raised price target currently at 94, our willingness to raise our target again is limited, given the risk/return trade-off. Signet’s turnaround has been one of the most impressive in the market in the past five years. Since our initial recommendation in September 2019, the company has completely overhauled its previously-broken operations and is now in the vanguard of jewelry retailing, backed by a fortress balance sheet and solid cash flows.

If its fundamental strength continues, Signet could see its shares continue to surge. As such, shareholders may want to consider keeping a stub position that could participate in any further price gains. Yet, we also acknowledge the downside. If results flatten out, or decline, or repeatedly miss ever-rising investor expectations, the shares could tumble. Overall, the risk/return trade-off has moved to unfavorable.

The Signet investment produced a 505% profit in about 26 months.

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.

Adient reported weak fiscal fourth-quarter results due to the slowdown in global vehicle production as well as higher costs. The company also provided general guidance that EBITDA will be about flat next year, which would be noticeably below consensus estimates. We view the company as having a solid operating and financial foundation that will produce strong profits and cash flow down the road. As previously announced, the strategically important Chinese transactions have closed, which brought in $695 million in net proceeds in the quarter and will bring in another $625 million in the next quarter and $125 million in the following quarter. We remain positive on ADNT shares.

In the quarter, revenue fell 23% from a year ago and was about 10% below the consensus estimate. The $(0.24)/share adjusted loss compared unfavorably to a $1.15 profit a year ago, but this was sharply better than the consensus $(0.61)/share loss. The adjusted EBITDA of $118 million fell 59% from a year ago and was in line with estimates.

The Chinese transactions improved Adient’s direct control over its operations and cash flow there, as well as generated immense cash to help slash its debt. With as much as 35% of its revenues coming from China, this control is valuable.

For Fiscal Year 2022, Adient expects sales of close to $15 billion, better than FY 2021 revenues of about $14 million. This is encouraging, particularly as Adient said it expects global vehicle production to be flat, with the company growing as much as 4 percentage points faster. The company continues to win new and replacement contracts in gas-powered and EV vehicles. Adient expects FY 2022 adjusted EBITDA to be modestly lower than in FY 2021 due to continued elevated costs.

Despite the setbacks, the turnaround is making clear progress. The current management team has rescued Adient from what could easily have been bankruptcy during the industry’s downturn had it been led by the prior management team.

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 good results, with operating earnings of $6.4 billion rising 18% from a year ago. Combined with a 5% reduction in shares, operating earnings per share, rose 25%. Revenues rose 12%. Tangible book value rose 12%, to $213.38/Class B equivalent share, from a year ago, such that the shares currently trade at about 134% of book value.

Berkshire repurchased about $7.6 billion of its shares in the quarter, bringing the year-to-date total to about $20 billion. Over the past two years, Berkshire has reduced its share count by about 13% – quite a change for a company that previously eschewed any buybacks.

We are retaining our HOLD rating for now given the valuation relative to book value. This is a “true” HOLD in that we see no reason to sell Berkshire shares, yet no compelling reason at the moment to add to positions to the extent that investors have a full position.

However, Buffett sees some value in Berkshire shares, as he continues to nibble away at the share count. Perhaps this is partly motivated by his seeing a lack of value elsewhere in the market, combined with perhaps some wariness about accumulating too much cash.

In the quarter, the insurance underwriting segment produced a $(784) million loss due to Hurricane Ida and a surge in automobile claims at GEICO. The other segments, including Railroad, Utilities and Energy, showed healthy profit growth from a year ago. Overall, Berkshire continues to build profits and value for its shareholders.

Elanco Animal Health (ELAN) – Elanco is one of the world’s largest providers of pet and farm animal health products, ranging from flea and tick collars, prescription treatments and farm animal nutritional supplements. Following its September 2018 IPO at $24 as part of its spin-off from pharmaceutical giant Eli Lilly, Elanco shares have been lackluster, due to weak revenue growth, high expenses and an uninspiring new product pipeline, combined with elevated debt. Veteran activist investor Sachem Head recently gained a board seat, likely leading to an upturn in the company’s execution and driving its undervalued shares higher. The August 2020 acquisition of Bayer Animal Health offers additional opportunities for improved results.

Elanco reported a reasonable quarter, showing revenue and profit growth compared to a year ago, although much/most was driven by their Bayer Animal Health acquisition. Revenues and earnings were above consensus estimates, and management raised their revenue guidance for the full year. The company needs to continue to deliver on its growth program, as activist investors Sachem Head and Starboard Value remain significant shareholders.

Revenues of $1.1 billion rose 27% from a year ago and was about 4% higher than estimates. However, assuming that the acquired Bayer Animal Health operations were at Elanco for both quarters, revenues grew 6%. Legacy Elanco, which excludes the acquired businesses, grew at a meager 2%. Clearly, the Bayer operations are boosting the company’s revenue growth, but it is encouraging that the legacy businesses are also growing, even if modestly.

Adjusted earnings of $0.19/share rose 46% from a year ago and were about 12% above the consensus estimate. Adjusted EBITDA of $211 million rose 42% from a year ago, mostly due to the acquisition, and was fractionally above the consensus estimate. The EBITDA margin increased to 18.7% from 16.6% a year ago, again largely due to the higher margin of the acquired businesses. The balance sheet remains over-levered with $5.9 billion of debt, up slightly from $5.6 billion at the prior year-end.

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 barely viable.

Gannett reported a decent quarter even though earnings were about 20% below the consensus estimate. The company has growthy characteristics tucked beneath a stagnant revenue base, but as much as analysts want this company to produce growth, it is primarily a free cash flow story. In this regard, it was another confirming quarter as free cash flow was $29 million.

Revenues dipped a modest 2% from a year ago and were 2% below consensus estimates that expected flat revenues. Same-store sales, which excludes divestitures, rose about 1% from a year ago. Year-ago revenues fell sharply during the pandemic, so stability here isn’t thrilling but it nevertheless is encouraging in that it provides a steadier base that can produce steady free cash flow. Weak print advertising and circulation revenues, still about 60% of total revenues, were supported by stronger digital advertising and marketing sales.

Gannett’s interest costs continue to tumble, at $35 million this quarter compared to $58 million a year ago. Debt repayments plus refinancings at lower rates are helping. After the quarter, Gannett refinanced its huge $900 million 5-year note, further cutting its interest rate by over 2 percentage points which could save $18 million a year in interest payments. We anticipate further debt reductions in every quarter from here funded by free cash flow and asset sales.

Overall, Gannett continues to grind forward, perhaps not at the pace that investors want to see but forward nonetheless. We note the new presence of Bill Miller (former Legg Mason legend and now head of Miller Value Partners) as a personal shareholder with a 4.9% stake in Gannett. This is an encouraging endorsement.

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.

The company reported a mixed quarter, as revenues and profits were higher than consensus estimates. Sales in its core Women’s Healthcare segment fell 10%; while management’s explanation – that year-ago volumes were artificially elevated and made for a difficult comparison, and that physician visits this past quarter were suppressed by Covid – made some sense, we need to see solid strength going forward. Management said that the key Nexaplanon treatment (sales fell 8%) should see double-digit sales growth in the fourth quarter.

Established Brands sales (about two-thirds of total revenues) fell 8%. This segment includes a range of products that are approaching or already past their patent expirations, so the decay rate is important. Here, management expects erosion to taper to perhaps 2% – acceptable to us but we need to see it.

Management re-affirmed its full year 2021 revenue and earnings guidance, but said that the EBITDA margin will be lower in the future due to rising research costs.

Organon shares have been weak following the report. We believe most of the weakness is related to concerns about revenues in the Established Brands and Nexaplanon, and the lower profit margin guidance. The announcement that Organon is acquiring Forendo Pharmaceuticals seems like a modest positive given its promising treatments and success-based purchase price. We remain steady in our conviction on OGN shares, especially given the low valuation.

In the quarter, revenue of $1.6 billion fell 3% (excluding currency benefit) from a year ago and was in line with the consensus estimate. Adjusted earnings of $1.67/share fell 30% from a year ago but was about 16% above the consensus estimate. Adjusted EBITDA of $636 million fell 15% from a year ago but was 11% higher than estimates.

Biosimilar segment sales rose a strong 39% ex-currency. Sales in Established Brands slipped 8% but excluding known patent losses fell only 4%. While Organon’s overall EBITDA margin of 39.8% fell from a year ago, the company is laden with spin-off costs that are already known to investors. Free cash flow remains healthy at $332 million. Net debt remains modestly elevated at 3.6x EBITDA.

TreeHouse Foods (THS) – As a major contract producer of private label foods, TreeHouse has struggled with poor execution and elevated debt resulting from its acquisition-driven strategy even as the private label food industry remains healthy. The company remains profitable and generates reasonable free cash flow. Respected activist investor JANA Partners has a large 9.2% stake and is likely to pressure this undervalued company to either sell or change its strategy and leadership.

Treehouse reported dreary third-quarter results. Core volumes slipped 1%, but revenue grew 5% due to a rescue by its 3% price increase and an acquisition. The highly-scrubbed $0.46/share in adjusted earnings fell 35% from a year ago and was 8% below the consensus estimate. Higher commodity, freight, labor and other costs dragged down profit margins, with the adjusted EBITDA margin of 9.9% falling from 13.1% a year ago. Fortunately, the company generated $75 million in free cash flow, which buys it time. Management slashed their fourth-quarter guidance to $0.00 to $0.20/share in profits due to higher costs.

Some favorable news: Demand for the company’s products is ahead of its ability to supply it, and consumers are shifting incrementally back to the lower-priced store brands that TreeHouse produces. Also, pricing is likely to catch up to cost pressures next year, resulting in a more normal rate of profits, although not likely the full $300 million of operating profits generated in prior periods.

The company announced that it has hired advisors to help it explore strategic alternatives, including either a complete sale or a divestiture of most/all of its meal prep operations. We believe that this decision is entirely the result of pressure from Jana Partners, and is clearly good news. This exit is why we own the shares and we remain patient with TreeHouse.

Viatris (VTRS) – Viatris was formed in November 2020 through the merger of pharmaceutical generics producer Mylan, N.V. and Pfizer’s Upjohn division. Investors worry about its declining revenues, limited drug pipeline visibility, elevated debt, loss of exclusivity for Lyrica and Celebrex in Japan, and reforms to China’s volume-based procurement programs. We see Viatris as an undervalued stream of reasonably stable free cash flow. As evidence of this stability is produced, along with better capital allocation, governance and transparency, we see strong potential for a higher share price.

Viatris reported a decent quarter, with revenues and earnings beating the consensus estimates. Revenues slipped about 4% but only about 1% when adjusted to reflect known losses due to patent expirations – a modestly encouraging sign that the business is stabilizing. Profits and free cash flow were reasonably strong. Management fractionally raised their full-year revenue and profit guidance and spoke optimistically about their strategy which they will expand upon at an investor day on January 7, 2022. The company paid down $750 million in debt, chipping away at its elevated balance. Importantly, management said that they consider $6.2 billion in annual EBITDA to be the “true” floor, which if they prove this over time it will provide a clear basis for the shares to move upward. Overall, the story remains on track.

In the quarter, revenues of $4.5 billion were 3% above estimates, adjusted earnings of $0.99/share were 12% above estimates and adjusted EBITDA of $1.7 billion was about 9% above estimates. Direct comparisons to a year ago aren’t meaningful as year-ago results include only the Mylan side due to merger accounting rules. The first clean quarter will be the first quarter of 2022. Viatris’ adjustments to its earnings are generous, almost to the extent that a clear comparison isn’t possible. We hope that future quarters provide fewer adjustments.

Branded treatment revenues grew 1% excluding known patent losses, providing some encouragement that this segment will stabilize. While China remains a risk as that country executes its plan to reduce drug prices, Viatris has so far navigated this region reasonably well. There will likely be more China revenue pressure ahead, so we will continue to watch for more stability or deterioration. Viatris continues to develop new treatments, which produced $158 million in revenues in the quarter and are on track to hit the $690 million target for 2022.

Vistra Corporation (VST) – Spun off from then-bankrupt Energy Future Holdings in 2016, Vistra is the nation’s largest independent electricity producer. The merchant electricity business can be highly-risky, but Vistra is led by a solid management team, has strong internal risk controls in place, has a sturdy-enough balance sheet and produces generous free cash flow. Vistra’s long-term strategy is appealing: it is migrating to a vertically-integrated business model that provides it with end-customers who consume the energy that it produces. This greatly reduces its overall risk while maintaining its attractive profit margins. The shares trade at a discounted valuation and offers an attractive dividend yield.

Vistra reported a good quarter, showing that it remains a highly profitable company despite some temporary issues earlier in the year. Management raised and narrowed their full-year adjusted EBITDA guidance range, although they effectively reduced their outlook for Ongoing Operations Adjusted Free Cash Flow before Growth. This overly wordy term can be translated as free cash flow before spending on growth initiatives (it includes maintenance spending, however).

Importantly, the company announced a plan to repurchase $2 billion of shares by the end of 2022, and return at least $7.5 billion to shareholders through share buybacks and dividends through 2026. These are enormous commitments given Vistra’s $9.5 billion market cap. The company also committed to reducing its debt by $1.5 billion by the end of next year.

If Vistra can continue to generate solid free cash flow, as we expect, it will have little trouble keeping its commitments.

In the quarter, revenues of $3.0 billion fell 16% from a year ago and was about 39% below the consensus estimate. Adjusted EBITDA of $1.2 billion slipped 1% from a year ago but was about 4% above the consensus estimate. Revenues can fluctuate widely, and for Vistra, EBITDA is the key metric, along with free cash flow.

Friday, November 12, 2021 Subscribers-Only Podcast
Covering recent news and analysis for our portfolio companies and other topics relevant to value investors.

Today’s podcast is about 17½ minutes and covers:

• Brief updates on:
  
  • Companies reporting earnings

• Comments on other recommended companies:
  
  • General Electric (GE) – Three-way split announced.
  • Macy’s (M) – Shares surge and earnings coming up next week.
  • Toshiba (TOSYY) – Three-way split announced.

• Elsewhere in the markets:
  
  • Breakfast Cereal Theory of Corporate Diversification

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.

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.