November 19, 2021

This week’s Friday Update includes our comments on earnings from Macy’s (M), Toshiba (TOSYY), and Vodafone (VOD). In the podcast, we discuss other recommended companies, compare shares of Rivian Automotive (RIVN) and Lucid Motors (LCID) to cans of sardines, and share some thoughts on the Ohio State Buckeyes football team.

The last company to report is Duluth Holdings (DLTH), scheduled for December 2.

Note: Due to the upcoming Thanksgiving holiday in the United States, next week’s Friday note will be published on Wednesday, November 24, and the December edition of the Cabot Turnaround Letter will be published on Wednesday, December 1.

Ratings changes:
No ratings changes this past week.

Earnings updates:
Macy’s (M) – With a capable new CEO since February 2018, Macy’s is aggressively overhauling its store base, cost structure and ecommerce strategy to adapt to the secular shift away from mall-based stores. Its sizeable debt is not crippling the company but remains an overhang. Macy’s was hit hard by the pandemic, setting back its turnaround from a financial perspective, but the company’s acceleration of its overhaul shows considerable promise.

Macy’s reported a strong third quarter, raised its revenue and profit guidance, announced an expansion of its e-commerce platform to include third-party merchants, and said it was exploring a possible separation of its e-commerce business. With its solid fundamentals and the e-commerce news, Macy’s shares surged 21% on the news.

Macy’s provided comparisons with their third-quarter results – a useful metric given the pandemic distortions of a year ago.

In the quarter, results were consistently and impressively strong compared to a year ago, two years ago and to consensus estimates. Revenue of $5.4 billion rose 36% from a year ago and was 4% above consensus estimates. On a same-store basis, sales grew 37% compared to a year ago and 9% compared to two years ago. The company’s efforts to boost its relevance and accessibility to customers are driving much of the increase, along with strong general retail demand across the economy. Inventories and merchandising seem well-positioned for the upcoming holiday season.

Adjusted earnings of $1.23/share compared to a $(0.19) loss a year ago and a $0.07/share profit in 3Q 2019, and was nearly 3x the consensus estimate. Adjusted EBITDA of $765 million compared to $159 million a year ago and was more than double the $325 million of two years ago. Adjusted EBITDA was almost 2x the consensus estimate.

Better merchandising and pricing pushed up gross margins, even when compared to 2019, as did lower overhead costs. Interestingly, the labor shortage actually helped profits – the company seemed to move its merchandise just fine even as it spent less on labor costs. Strong sales in its e-commerce segment (now 33% of company sales) dragged on margins, though, due to delivery costs, which we expect is a permanent feature of Macy’s cost structure.

Retailers like Macy’s typically have modest/break-even third-quarter profits and consume immense amounts of cash as they build inventories for the holiday rush. Yet, Macy’s produced a large profit and consumed only $124 million in cash despite a massive $670 million cash flow drag from inventories and other working capital uses. Given this, its sizeable cash balance, and management’s rising confidence in the fourth quarter, Macy’s repaid $1.6 billion in debt, paid $46 million in dividends and repurchased $300 million in shares (more than 4% of total shares outstanding) this quarter. For a company that many had given up for dead, Macy’s is becoming a low-debt cash machine.

One negative is that Macy’s is returning to a hefty capital spending program of $1 billion/year for the next several years, compared to a pandemic-reduced $650 million this year. This spending is probably critical to maintaining its physical and digital competitiveness, but it is a sizeable drain of cash.

Macy’s also announced plans to launch a “curated digital marketplace” in the second half of 2022. At its most basic, this will allow a selected group of other merchants to sell their products on Macy’s and Bloomingdales’ websites. But, this is a potentially huge step in a new direction that leverages Macy’s position as one of the top e-commerce sites in the country. We think of it in this way: at its maximum ideal outcome, this would turn Macy’s into a higher-class and more specialized Amazon. While this outcome is exceptionally unlikely, we think it illustrates the direction that Macy’s is headed. Adding immense credibility to the effort, Macy’s has outsourced this initiative to an impressive tech specialist, Mirakl. This private company looks like a solid partner.

Further, the company said it has hired Alix Partners, a highly credible advisory firm, to review its business structure. This is a nod in the direction suggested by activist investor Jana Partners that owns a roughly 1% stake in Macy’s. This news likely contributed at least a dollar or two to the $6.50 increase in the share price on Thursday.

We rate Macy’s shares as HOLD, but this is not a soft version of “sell.” It reflects a balance between our value-oriented turnaround mindset and the immense opportunity that Macy’s seems to be creating for itself.

Toshiba (TOSYY) – This Japanese industrial conglomerate is recovering from its nuclear power plant construction business (Westinghouse Electric) debacle, which forced it to sell a majority stake in its Kioxia memory chip production operations. We are looking for a divestiture of its minority Kioxia stake, with proceeds paid out to shareholders, as well as operational improvement and better governance. Note: ¥100 = $0.88.

Toshiba reported incrementally improved fiscal second-quarter results. Revenues rose 6% from a year ago to ¥818 billion (about $7.3 billion). Overall pre-tax profits of ¥52.9 billion more than doubled as overhead costs remained flat. No usable consensus estimates were available for this period. Segment operating income, which excludes interest, taxes and other costs, rose 93%, driven by sharp improvement in the Electronic Devices & Storage (mostly semiconductors) segment and the Energy Systems & Solutions segment. Rising component costs weighed incrementally on profits. Overall, business is improving, with new orders rising 19% from a year ago and order backlog rising 6%.

Strategically, Toshiba announced a three-way split of its businesses. This is a huge and positive step in the right direction, if for no other reason than it indicates that the leadership is acknowledging investors’ concerns about Toshiba’s valuation and strategic direction. The plan is to spin off its infrastructure businesses (~66% of total Toshiba sales ex-Kioxia) and its Device businesses (~33% of total Toshiba sales ex-Kioxia) by the end of fiscal 2023, which ends in March 2024. The stub would be Kioxia and the Toshiba Tec stake, with the Kioxia stake to be liquidated with the cash returned promptly to shareholders.

The segments make reasonable sense, with long-cycle, big-project-oriented infrastructure in one group and short-cycle, technology-oriented gear like specialized semiconductors and disk drives in another. Completing the exit from Kioxia also makes sense.

However, we are left with questions rather than answers. Why wait nearly 2½ years to complete the split… is this just a stall tactic against the activist investors? Why not simply sell some or all of the businesses for cash, and start that process now? Will the two split-off businesses be better-managed or just smaller? The plan resulted from the five-month review, but there appear to have been other, perhaps higher-value, alternatives that weren’t fully considered. News reports suggest that several large activist investors will vote against the plan at the upcoming shareholders meeting in March 2022.

So, we sit tight on this fascinating and slowly improving turnaround with significant upside if the activists keep the pressure on.

Vodafone (VOD) – Vodafone is a major European wireless telecom, broadband and cable TV service provider. The relatively new CEO Nick Read (October 2018) is focused on increasing the company’s return on capital by strengthening its telecom “connectivity” platform, improving its operating efficiency and spending its capital more efficiently. In 2019, Vodafone acquired Liberty Global’s German and Eastern European assets, and will soon spin off its European cell tower business (named Vantage Towers). Vodafone has a few obscure assets: it is the leading provider of mobile data and payments services in Africa and has a vast network of high-capacity data pipelines that may increase in value as 5G rolls out.

Vodafone reported decent first-half fiscal 2022 results that showed incremental progress with its strategic and operational initiatives. The company also incrementally raised its full-year revenue, profit and free cash flow guidance.

Revenue of €22.5 billion rose 5% from a year ago and was fractionally ahead of the consensus estimate. Adjusted earnings of 4.90 eurocents/share rose about 24% from a year ago and adjusted EBITDA of €7.6 billion rose 6.5% on an organic basis from a year ago. Both earnings numbers were in line with estimates.

Service revenues, which are the core of Vodafone’s business, rose 2.8% from a year ago (after adjustments for acquisitions, divestitures and currencies). Any growth here is a positive, with 2.8% being reasonably strong. Italy and Spain continue to show modest declines, but the pace of declines seems to be improving. Growth was healthy in Germany (about 31% of total service revenues) as well as in Africa and the rest of the company’s markets. Vodafone continues to build its relevancy, including upgrading its network to 5G and switching off 3G in more markets, as well as expanding its digital services offerings. Subscriber and customer numbers in general are stable or improving – about as good as can be hoped for in Vodafone’s highly competitive business.

EBITDAaL, a complicated term Vodafone uses for Adjusted EBITDA, rose 6.5% from a year ago to €7.6 billion. The profit margin expanded by 0.7 percentage points to 33.6%.

Vodafone said it has completed the first phase of its turnaround. Among various operational improvements, the company boosted its return on capital employed (ROCE) to a still-weak 6.3%. We would like to see this upshift to at least 8-10%. In the next phase, Vodafone will boost this return through better revenue growth and improving its capital and operational efficiencies. Growth will be driven by pressing harder on its growth initiatives as well as selected in-market acquisitions. Efficiencies will come from cutting its shared costs along with selected divestitures and other initiatives.

Interestingly, Vodafone Egypt is being moved to the Vodacom segment, putting essentially all of Vodafone’s African operations under one umbrella. This not only should simplify and reduce the cost structure, but also provide a more strategically unified business that could perhaps be fully divested someday. Vantage Towers, already partly spun off with Vodafone holding an 82% stake, will step up its acquisition program to gain more European market share. Vodafone is also making its towers business more financially and strategically independent, in advance of what we see as a potential full divestiture several years down the road.

Vodafone’s net debt jumped almost €4 billion, or 10%, in the period, due in large part to a huge €3.2 billion build in working capital that seems poised to fully reverse in the second half. Also, the company repurchased €1.1 billion of shares to offset convertible bond dilution. The company incrementally raised its full-year free cash flow guidance to “at least €5.3 billion” – a number that our math shows is achievable assuming a large reversal in working capital.

Overall, the Vodafone story is improving (although at a snail’s pace) both operationally and strategically. As Vodacom and Vantage Towers increasingly become valued independently, the sizeable residual value of Vodafone’s core should become more apparent. The shares provide a high and stable dividend yield of about 6.5%, paying investors to wait.

Friday, November 19, 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 17 minutes and covers:

• Brief updates on:
  
  • Companies reporting earnings

• Comments on other recommended companies:
  
  • Kraft Heinz (KHC) – 3G Capital offloads $1.1 billion of its stake.
  • General Motors (GM) – becoming more involved in chipmaking.
  • Baker Hughes (BKR) – rig count continues to tick upwards.
  • Organon (OGN) – post-earnings sell-off leaves shares remarkably undervalued.

• Elsewhere in the markets:
  
  • Speculating vs. investing in EV car stocks and sardines.

• Final note:
  
  • College football entering critical last two weeks, with Ohio State-Michigan State game this weekend.

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.