April 25, 2023

Everything Everywhere All at Once, Part II

It was only a month ago when we wrote about how the seemingly out-of-the-blue turmoil in the banking sector, driven by the sharp increase in interest rates, could lead to a major financial accident that traumatizes the world’s capital markets. Part II recognizes an ever-expanding roster to include additional percolating problems.

The current earnings season is showing that, so far, the market has discounted the generally lackluster results. Unfortunately, the outlook for future earnings offers little inspiration. For 2023, the S&P 500 earnings growth is projected to be only +0.8%. This would not only be the weakest pace since 2016 (excluding the pandemic slide) but also reflects a sharp let-down from the originally expected +15% growth rate.

The current growth rate for 2024 earnings is a more encouraging +11%. But, just like estimates for 2023, estimates for 2024 have slid sharply and are now below the original estimates for 2023. The continuing erosion of the earnings outlook isn’t exactly a cause for optimism.

For now, the economy remains healthy. The industrial side hasn’t slowed much yet, nor has consumer spending, but looming problems including the burn-off of excess savings, the ending of the student loan repayment freeze, higher interest rates, the lack of federal spending stimulus and other factors are suggesting an economic stall-out later this year.

Geopolitical tensions between the West and Russia/China seem intractable and are worsening every week. Comments by the Chinese ambassador to France that former Soviet states, implying Ukraine, have no sovereignty (despite a quick back-peddling on these comments on Monday) could be seen as a clear sign that China remains highly focused on capturing Taiwan – an initiative that could plunge the world into a deep military, economic and technology crisis that would dwarf the current fall-out from Russia’s invasion.

The U.S. federal government is running out of money which would, without an expansion of its borrowing limit, produce a clear default on perhaps the most reliable benchmark of risk-free assets: U.S. Treasury obligations. Investors are starting to price in a default, as seen by the nearly 2 percentage points higher yield on 3-month T-bills compared to 1-month T-bills. The more esoteric credit default swaps on Treasuries are also surging. The 1-month T-bill is viewed as maturing before any likely chance of default, thus the lower yield. A widely held view (which we share) is that a default will be averted, but that the brinksmanship could delay a deal until the last second. But, like others, we are thinking about failure: how long a default situation might last before it is cured by a Congressional agreement, and how significant the fall-out might be across capital markets. We believe that the federal government will eventually make good on all of its obligations. Nevertheless, this problem offers little in the way of encouragement.

In 18 months, voters will select the next president of the country. The outcome is impossible to predict this far in advance (it might be impossible to predict even on election night). However, the election tensions will ratchet higher, as candidates posture and parry and as the outcome could portend more policy shifts both domestically and internationally.

Inflation and interest rates, along with Fed policy, look poised to remain higher for longer. With the S&P 500 trading at nearly 17x next year’s decaying earnings estimate, the upside from higher valuations when risk-free interest rates are at 5% isn’t obvious. Investors could be facing a demoralizing bear market in which share prices grind lower and show little improvement for years.

There of course are other risks and issues that weigh on the stock market – these are only a few of the majors.

So, what does one do in this environment? Buy stocks, of course. We are adding NOV, Inc. (NOV) to our buy list. This high-quality company appears to be in front of an upshift in demand for drilling equipment even as its shares trade at a modest valuation. See our note below for more.

Share prices in the table and discussed below reflect Monday, April 24 closing prices.

Note to new subscribers: You can find additional color on past earnings reports and other news on recommended companies in prior editions and weekly updates of the Cabot Undervalued Stocks Advisor on the Cabot website.

Send questions and comments to Bruce@CabotWealth.com.

Today’s Portfolio Changes
NOV, Inc. (NOV) – New Buy

Last Week’s Portfolio Changes
None.

Upcoming Earnings Reports

Tuesday, April 25: Sensata Technologies (ST)

Thursday, April 27: Allison Transmission (ALSN), Comcast (CMCSA), NOV (NOV)

Tuesday, May 2: Molson Coors Beverage Company (TAP)

Wednesday, May 3: Barrick Gold (GOLD)

Thursday, May 4: Gates Industrial (GTES)

GROWTH/INCOME PORTFOLIO

Cisco Systems (CSCO) is facing revenue pressure as customers migrate to the cloud and thus need less of Cisco’s equipment and one-stop-shop services. Cisco’s prospects are starting to improve under a relatively new CEO, who is shifting Cisco toward a software and subscription model and is rolling out new products, helped by its strong reputation and entrenched position within its customers’ infrastructure. The company is highly profitable, generates vast cash flow (which it returns to shareholders through dividends and buybacks) and has a very strong balance sheet.

There was no significant company-specific news in the past week. Tech distributor CDW Corp (CDW), considered a benchmark indicator of demand for tech gear, provided a disappointing revenue outlook. The news led to a sell-off in tech equipment companies like Cisco.

CSCO shares fell 6% this past week and have 40% upside to our 66 price target. The valuation is attractive at 8.9x EV/EBITDA and 12.6x earnings per share. The 3.3% dividend yield adds to the appeal of this stock. BUY

Comcast Corporation (CMCSA) – With $120 billion in revenues, Comcast is one of the world’s largest media and entertainment companies. Its properties include Comcast cable television, NBCUniversal (movie studios, theme parks, NBC, Telemundo and Peacock), and Sky media. The Roberts family holds a near-controlling stake in Comcast. Comcast shares have tumbled due to worries about cyclical and secular declines in advertising revenues and a secular decline in cable subscriptions as consumers shift toward streaming services, as well as rising programming costs and incremental competitive pressure as phone companies upgrade their fiber networks.

However, Comcast is a well-run, solidly profitable and stable company that will likely continue to successfully fend off intense competition while increasing its revenues and profits, as it has for decades. The company generates immense free cash flow which is more than enough to support its reasonable debt level, generous dividend and sizeable share buybacks.

The head of NBCUniversal, Jeff Shell, is departing immediately after he admitted to an inappropriate relationship with a woman who is an employee of the company. While disruptive in the near term, we see little obvious long-term impact from the departure given Comcast’s deep management bench. However, the loss of Shell’s apparently energetic approach may eventually bring changes to Comcast’s strategy in streaming and other product groups. We expect some limited comments when Comcast reports earnings on Thursday, April 27, with the consensus earnings estimate of $0.82/share.

Comcast shares fell 1% in the past week and have 12% upside to our 42 price target. The shares offer an attractive 3.1% dividend yield. BUY

BUY LOW OPPORTUNITIES PORTFOLIO

New Buy: NOV, Inc (NOV) – This high-quality mid-cap company ($7.3 billion market cap) appears to be in front of an upshift in demand for drilling equipment even as its shares trade at a modest valuation.

Formerly named National Oilwell Varco, NOV is a major global supplier of oil and gas drilling equipment, with revenues of $8.5 billion. Based in Houston, Texas, NOV has its roots in the late 1800s, with the current company being the result of both organic growth and numerous mergers. The company is organized into three divisions. Wellbore Technologies (37% of sales) produces equipment to improve drilling results and efficiencies. Completion and Production (35%) focuses on well completion and production equipment. Rig Technologies (28% of sales) makes land and offshore drilling rigs and related equipment as well as gear related to wind towers. All three segments also produce aftermarket parts and provide related services. About 64% of NOV’s revenues are generated outside of the United States, with a customer base that includes independent, major and national oil companies, as well as service providers, with operations in every oil-producing region in the world.

NOV’s emphasis on proprietary technologies makes it a leader in both hardware, software and digital innovations, which boosts its relevance to customers and helps maintain its profit margins. Strong economies of scale in manufacturing and distribution as well as research and development further boost its competitive edge. The company’s large installed base helps stabilize its revenues through recurring sales of replacement parts and related services.

Well aware of the emerging transition to alternative energy sources, NOV has become a leading designer and producer of equipment for offshore wind turbine installation vessels and onshore wind tower construction equipment. Its drilling expertise is also well-placed to meet the growing demand for carbon sequestration and geothermal wells.

A recovery in demand for drilling equipment appears to be underway, stimulated by the recovery and apparent stability of oil prices. Oil prices are being supported by relatively tight supply, bolstered by OPEC+ production discipline and slowing production growth by publicly traded majors under pressure to return more cash to shareholders. Further constraining oil production is nearly a decade of underinvestment by oil producers.

Resilient demand for oil is also supporting the commodity’s price. Demand remains robust at around 100 million barrels/day and is likely to continue to increase by about 1 million barrels a day every year into the foreseeable future, following the growth of the global economy.

NOV is a direct beneficiary of rising demand for oil drilling equipment. Oil at roughly $80/barrel is high enough to encourage producers to drill both onshore and offshore. Demand in the offshore market, usually the last to show growth yet which is NOV’s specialty, is gradually recovering, reflected in an increasingly tight market for drillships.

The company’s financial results fell sharply in recent years but are showing signs of recovery. Revenues in 2021 fell to $5.5 billion, down 35% from 2019, while EBITDA of $229 million fell nearly 75% from the 2019 level. However, last year, NOV saw revenues improve to $7.3 billion and EBITDA improve to $679 million. NOV’s backlog continues to tick up and was 8% above year-ago results in the most recent quarter. We see the company generating over $9 billion in revenues and $1.3 billion in EBITDA in three years as oil drilling more fully recovers.

NOV is well-managed by a respected team of company and industry veterans. Its financial strategy is conservative, reflected in its cash-heavy ($1.1 billion) and low-debt ($1.7 billion, or 1.7x EBITDA) balance sheet. Nearly all of its debt matures in 2029 or later and carries a fixed rate of interest of 3.90% or lower. The company is profitable and generates positive free cash flow. Over time, we anticipate that the company will deploy some of its excess cash into acquisitions and share buybacks.

Primary risks include the possibility of a sharp and/or prolonged decline in oil and natural gas prices, easing/termination of war-related Russia sanctions and elevated commodity and labor costs. Supply chain issues and weaker onshore gas drilling activity, as well as sizeable inventory increases in advance of expected demand, may impede near-term results.

At about 18.50, NOV shares trade at the low end of their 20-year range of 10-85 due to investor expectations for an uninspiring future. We see this consensus view as overly pessimistic, given the company’s strong position in an industry with improving conditions, backed by capable company leadership and a conservative balance sheet. NOV shares provide a reasonable 1.1% dividend yield. Our price target for NOV shares is 25, based on a 7.5x EBITDA multiple on our 2025 estimates.

Prospective investors should know that the company reports first-quarter earnings on Thursday, April 27, pre-market open. The consensus earnings estimate is $0.22/share.
BUY

Allison Transmission Holdings, Inc. (ALSN) – Allison Transmission is a midcap manufacturer of vehicle transmissions. While many investors view this company as a low-margin producer of car and light truck transmissions that is destined for obscurity in an electric vehicle world, Allison actually produces no car or light truck transmissions. Rather, it focuses on the school bus and Class 6-8 heavy-duty truck categories, where it holds an 80% market share. Its EBITDA margin is sharply higher than its competitors and on par with many specialty manufacturers. And, it is a leading producer and innovator in electric axles which all electric trucks will require. The company generates considerable free cash flow and has a low-debt balance sheet. Its capable leadership team keeps its shareholders in mind, as the company has reduced its share count by 38% in the past five years.

The company is scheduled to report earnings on Thursday, April 27, with the consensus earnings estimate of $1.53/share.

ALSN shares rose 1% in the past week, have 15% upside to our 54 price target and offer a 2.0% dividend yield. BUY

Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc, hired as CEO in July 2020, is revitalizing Aviva’s core U.K., Ireland and Canada operations following her divestiture of other global businesses. The company now has excess capital which it is returning to shareholders as likely hefty dividends following a sizeable share repurchase program. We expect that activist investor Cevian Capital, which holds a 5.2% stake, will keep pressuring the company to maintain shareholder-friendly actions.

There was no significant company-specific news in the past week.

Aviva shares rose 1% this past week and have 33% upside to our 14 price target. Based on management’s guidance for the 2023 dividend, the shares offer a generous 7.7% yield. On a combined basis, the dividend and buyback provide more than a 10% return to shareholders. BUY

Barrick Gold (GOLD), based in Toronto, is one of the world’s largest and highest-quality gold mining companies. About 50% of its production comes from North America, with the balance from Africa/Middle East (32%) and Latin America/Asia Pacific (18%). Barrick will continue to improve its operating performance (led by its highly capable CEO), generate strong free cash flow at current gold prices, and return much of that free cash flow to investors while making minor but sensible acquisitions. Also, Barrick shares offer optionality – if the unusual economic and fiscal conditions drive up the price of gold, Barrick’s shares will rise with it. Given their attractive valuation, the shares don’t need this second (optionality) point to work – it offers extra upside. Barrick’s balance sheet has nearly zero debt net of cash. Major risks include the possibility of a decline in gold prices, production problems at its mines, a major acquisition and/or an expropriation of one or more of its mines.

There was no significant company-specific news in the past week.

Over the past week, commodity gold fell 1.5% to $1,986/ounce. Gold prices can be impressively volatile and have risen 22% since troughing late last year at $1,630. The recent surge is likely due to a growing popularity of the view that the Fed’s rate hike campaign is approaching its limit even as inflation remains well above the 2% Fed target.

This past week, the 10-year Treasury yield was essentially unchanged at 3.53%. The U.S. Dollar Index (the dollar and gold usually move in opposite directions) was also essentially unchanged at 101.60.

Investors and commentators offer a wide range of outlooks for the economy, interest rates and inflation. We have our views but hold these as more of a general framework than a high-conviction posture. Investing in gold-related equities is a long-term decision – investors shouldn’t allow near-term weakness to deter their resolve.

Barrick shares fell 2% in the past week and have 43% upside to our 27 price target. BUY

Big Lots (BIG) – Big Lots is a discount general merchandise retailer based in Columbus, Ohio, with 1,431 stores across 47 states. Its stores offer an assortment of furniture, hard and soft home goods, apparel, electronics, food and consumables as well as seasonal merchandise. Our initial case for Big Lots rested with its loyal and growing base of 22 million rewards members, its appeal to bargain-seeking customers, the relatively stable (albeit low) cash operating profit margin, its positive free cash flow, debt-free balance sheet and low share valuation. Our thesis was deeply rattled by the company’s surprisingly large inventory glut, now resolved, but which leaves the company with a hefty and permanent $300 million debt burden.

Big Lots shares remain high-risk due to the new debt balance, weak fundamentals and the possibility of a suspension or reduction of the dividend. Sentiment in the shares is very weak – investors unwilling or unable to sustain further losses in the shares should sell now, as sentiment could weaken further and drive the shares lower.

Regarding the dividend, Big Lots now has every incentive to eliminate it. Investors clearly are not convinced that it will be maintained, given the company’s likely weak profits for at least the current fiscal year. And, eliminating the $35 million in cash payouts would help the company retire its $300 million debt as well as ease future seasonal borrowings.

Big Lots shares were recently downgraded by brokerage firm Piper Sandler, which drove shares sharply lower to below their pandemic lows. The analyst said that weaker near-term demand will pressure sales and that this would threaten the dividend (risks that we already know).

Big Lots shares tumbled 14% this past week and have over 100% upside to our revised 25 price target. The shares offer a 13.6% dividend yield, although, as noted, investors should not rely on this dividend being sustained. We continue to hold onto Big Lots’ shares as we believe the company will ultimately rebuild about half of its prior earnings base. The shares’ highly discounted valuation provides a reasonable valuation cushion, even as investor sentiment continues to push the shares lower. HOLD

Citigroup (C) – Citi is one of the world’s largest banks, with over $2.4 trillion in assets. The bank’s weak compliance and risk-management culture led to Citi’s disastrous and humiliating experience in the 2009 global financial crisis, which required an enormous government bailout. The successor CEO, Michael Corbat, navigated the bank through the post-crisis period to a position of reasonable stability. Unfinished, though, is the project to restore Citi to a highly profitable banking company, which is the task of new CEO Jane Fraser.

On April 14, Citigroup reported a good first quarter, with adjusted earnings of $1.86/share falling 1% from a year ago but 11% above the $1.67 consensus estimate. Return on assets of 0.76% improved incrementally from 0.74% a year ago. Return on equity of 9.5% also improved incrementally from 9.0% a year ago. These return metrics are improving but still well below the 1.0% ROA and 12% ROE that we would consider reasonable targets. Guidance for 2023 was unchanged.

Revenues rose 12% due to higher interest rates, as fee income slipped 3%. The net interest margin of 2.41% improved from 2.05% a year ago and 2.39% in the prior quarter. Citi is having to boost the interest rate it pays on deposits to retain this funding source. The average rate paid in the first quarter was 2.72%, up from 0.33% a year ago. In the year-ago period, the 0.33% rate was about 50 basis points below the 90-day T-bill rate, while today the deposit interest rate is about 233 basis points below the T-bill rate. This incremental spread, plus the higher spread on non-interest-bearing checking deposits, is helping boost Citi’s net interest margin despite the inverted yield curve.

Non-interest expenses rose only 1% and remained controlled, particularly for a bank undergoing an aggressive overhaul. Citi’s efficiency ratio (operating expenses as a percent of total revenues) improved to 62% from 69% a year ago. Credit losses increased incrementally from the prior quarter but remained low. The bank boosted its reserves for losses to a hefty 2.65% of total loans, and the bank appears to be satisfied with this size.

Capital strength increased, with the CET1 ratio rising to 13.4% compared to 11.4% a year ago and 13.0% in the prior quarter. The bank did not repurchase any shares during the quarter. Data on the securities portfolio were not reported – we will get this from the 10Q which has yet to be filed. Deposits fell only 3% from the prior quarter and were unchanged from a year ago.

There was no significant company-specific news in the past week.

Citi shares remain attractive as they trade at 58% of tangible book value of $84.21 and offer a sustainable 4.2% dividend yield.

Citi shares ticked down 1% in the past week and have 73% upside to our 85 price target.

When comparing Citi shares with a U.S. 10-year Treasury bond, Citi offers a higher yield and considerably more upside potential (about 73% according to our work vs. 0% for the Treasury bond). Clearly, the Citi share price and dividend payout carry considerably more risk than the Treasury bond, but at the current valuation, Citi shares would seem to have a remarkably better risk/return trade-off. BUY

Gates Industrial Corp, plc (GTES) – Gates is a specialized producer of industrial drive belts and tubing. While this niche might sound unimpressive, Gates has become a leading global manufacturer by producing premium and innovative products. Its customers depend on heavy-duty vehicles, robots, production and warehouse machines and other equipment to operate without fail, so the belts and hydraulic tubing that power these must be exceptionally reliable. Few buyers would balk at a reasonable price premium on a small-priced part from Gates if it means their million-dollar equipment keeps running. Even in automobiles, which comprise roughly 43% of its revenues, Gates’ belts are nearly industry-standard for their reliability and value. Helping provide revenue stability, over 60% of its sales are for replacements. Gates is well-positioned to prosper in an electric vehicle world, as its average content per EV, which require water pumps and other thermal management components for the battery and inverters, is likely to be considerably higher than its average content per gas-powered vehicle.

The company produces wide EBITDA margins, has a reasonable debt balance and generates considerable free cash flow. The management is high-quality. In 2014, private equity firm Blackstone acquired Gates and significantly improved its product line-up and quality, operating efficiency, culture and financial performance. Gates completed its IPO in 2018, with Blackstone retaining a 63% stake today.

There was no significant company-specific news in the past week.

GTES shares fell 1% in the past week and have 20% upside to our 16 price target. BUY

Molson Coors Beverage Company (TAP) is one of the world’s largest beverage companies, producing the highly recognized Coors, Molson, Miller and Blue Moon brands as well as numerous local, craft and specialty beers. About two-thirds of its revenues come from the United States, where it holds a 24% market share. Investors worry about Molson Coors’ lack of revenue growth due to its relatively limited offerings of fast-growing hard seltzers and other trendier beverages. Our thesis for this company is straightforward – a reasonably stable company whose shares sell at an overly discounted price. Its revenues are resilient, it produces generous cash flow and is reducing its debt. A new CEO is helping improve its operating efficiency and expand carefully into more growthier products. The company recently reinstated its dividend.

There was no significant company-specific news in the past week.

TAP shares rose 4% in the past week and have 17% upside to our 69 price target. The stock remains cheap, particularly on an EV/EBITDA basis, or enterprise value/cash operating profits, where it trades at 9.2x estimated 2023 results, still among the lowest valuations in the consumer staples group and below other brewing companies. BUY

Sensata Technologies (ST) is a $3.8 billion (revenues) producer of nearly 47,000 highly engineered sensors used by automotive (60% of revenues), heavy vehicle, industrial and aerospace customers. About two-thirds of its revenues are generated outside of the United States, with China producing about 21%. Investors undervalue Sensata’s durable franchise. Its sensors are typically critical components that generally produce high profit margins. As the sensors’ reliability is vital to safety and performance, customers are reluctant to switch to another supplier that may have lower prices but also lower or unproven quality. Sensata has an arguably under-leveraged balance sheet and generates healthy free cash flow. The relatively new CEO will likely continue to expand the company’s growth potential through acquisitions. Electric vehicles are an opportunity as they expand Sensata’s reachable market.

Sensata reports earnings on Tuesday, April 25, with a consensus earnings estimate of $0.87/share.

ST shares rose 1% in the past week and have 57% upside to our 75 price target. Our price target looks optimistic in light of the broad market sell-off and worries over a possible recession (which would slow demand in its automotive and other end-markets), but we will keep it for now, even as it may take longer for the shares to reach it. BUY

Strong Buy – This stock offers an unusually favorable risk/reward trade-off, often one that has been rated as a Buy yet the market has sold aggressively for temporary reasons. We recommend adding to existing positions.
Buy – This stock is worth buying.
Hold – The shares are worth keeping but the risk/return trade-off is not favorable enough for more buying nor unfavorable enough to warrant selling.
Sell – This stock is approaching or has reached our price target, its value has become permanently impaired or changes in its risk or other traits warrant a sale.

Note for stock table: For stocks rated Sell, the current price is the sell date price.

Current price is yesterday’s mid-day price.
CSCO: Estimates are for fiscal years ending in July of 2023 and 2024