Cabot Undervalued Stocks Advisor Issue: November 2, 2022

Not the End of Days, but a Return to Normal

One by one, the pandemic bubble stocks are popping. In the past week or so, we’ve seen sharp declines in the price of Amazon and Meta shares, as notable examples of the bear market. Dozens of stocks, along with Amazon and Meta, currently trade below their pre-pandemic prices, including Netflix, Intel, PayPal, Zoom, Uber, Lyft, Micron Technologies, Shopify, DocuSign, Okta, Zoom Video, Square/Block, Peloton and Wayfair.

Does this herald the apocalyptic “end of days?” Will rising interest rates render the U.S. and global economy into tatters and a deep recession even as inflation may not be tamed to the 2% Federal Reserve target rate?

Our view is that, no, it is not the End of Days, but rather a return to a more normal world. The fall-off in stock and bond prices is an unwinding of vast excesses driven by unusually low interest rates. Near-zero interest rates for over a decade are hardly the stuff of normalcy. Hyper-growth companies chasing ephemeral tech fads yet having zero prospects for ever earning a profit is not normal. Economic growth may be stagnant for several quarters or perhaps lift to 2-3% real growth as in the third quarter, but a 9% fall-off followed by a 12% surge in GDP, like in the 2020-2021 period, isn’t normal.

The economy and stock market probably won’t ever get to a fully “normal” state because it never does, but interest rates around 5% and stock market multiples around 15-16x feel a lot closer to normal than we’ve been at any time in the past decade or so.

Share prices in the table reflect Tuesday (November 1) closing prices. Please note that prices in the discussion below are based on mid-day November 1 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

None

Portfolio Changes Since Last Month

Comcast Corporation (CMCSA) – New Buy
Merck (MRK) – Moving from Hold to Sell

Earnings Reports

Barrick Gold (GOLD) – Thursday, November 3Organon & Company (OGN) – Thursday, November 3Gates Industrial Corp (GTES) – Friday, November 4Aviva plc (AVVIY) – Wednesday, November 9Arcos Dorados (ARCO) – Wednesday, November 16Cisco Systems (CSCO) – Wednesday, November 16Big Lots (BIG) – Thursday, December 1

Growth & Income Portfolio

Growth & Income Portfolio stocks are generally higher-quality, larger-cap companies that have fallen out of favor. They usually have some combination of attractive earnings growth and an above-average dividend yield. Risk levels tend to be relatively moderate, with reasonable debt levels and modest share valuations.

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.

CSCO shares have rebounded with the market but remain below what we believe to be their intrinsic value. Cisco holds a key role in the basic plumbing of technology systems. Near-term revenues and profits may be sloppy, but on a secular basis, the company’s positioning seems, at worst, stable. Given its ability to adapt, it will likely return to revenue and earnings growth albeit not at the rocket-like pace of newer tech companies riding some emerging trend. Cisco is essentially a dull company that grinds forward.

The shares rose 2% in the past week and have 46% upside to our 66 price target. The valuation is attractive at 9.1x EV/EBITDA and 12.8x earnings. The 3.4% 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 (about 55% of revenues), NBCUniversal (32% of revenues), which includes the Universal movie studios and theme parks, NBC and Telemundo television networks and the Peacock TV streaming service, and Sky media company in Europe (13% of revenues). Comcast also owns the Philadelphia Flyers professional hockey team and a 33% stake in the Hulu streaming service. The Roberts family holds a near-controlling stake in Comcast yet has been a good steward of the firm’s resources.

Comcast shares have tumbled 50% from their late 2021 peak and now trade in line with their mid-2015 price. Investors worry 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 company that for decades has successfully fended off intense competition while increasing its revenues and profits. Its operational breadth and depth, as well as management’s patience and discipline, have allowed it to understand and adapt to changes in technology and customer preferences. In the recently completed third quarter, revenues rose 5% excluding the one-off boost from the year-ago Tokyo Olympics. And, profits rose 6% even when including the effects of higher Olympics profits a year ago. Compared to the pre-pandemic third quarter of 2019, recent revenues and profits were 11% higher. These are hardly the markings of a company on the brink.

The company’s diversified operations have helped provide it with valuable stability. Its slow-and-steady cable business is highly profitable even as it invests in technology upgrades to maintain its edge over competitors. Incremental losses in the number of total customer relationships are being offset by higher pricing and new services. Comcast is expanding its small but promising wireless phone service, supported by attractive pricing, quality performance and (surprisingly) generally well-regarded Xfinity customer service reputation. While losses in the emerging Peacock streaming service remain elevated, the company will likely use its disciplined capital allocation mindset to reshape this unit to at least break even over the next few years.

NBCUniversal continues to recover from the pandemic. The Universal theme parks recently recorded record-high U.S. profits, while summer hits like Jurassic World: Dominion and Minions: The Rise of Gru have boosted year-to-date Studio profits to above comparable 2019 results.

The company is not without its challenges, of course. The Sky operations remain uninspiring with flat revenues excluding the effects of the weak British pound, but this segment continues to generate respectable profits. Advertising revenues across all of Comcast fell 26% in the third quarter but these comprise about a tenth of the company’s total revenues and are likely to rebound with the eventual cyclical upturn.

A major appeal of Comcast is that it generates immense free cash flow – a strength that is likely to endure. Cash flow from operations looks resilient and the company is able to maintain its competitive edge while restraining its capital spending to about 11-12% of revenues. This free cash flow is not only plenty to support its reasonable debt level (which carries a low and fixed rate of interest), but also supports a generous dividend (recently raised 8%) and sizeable share buybacks. Comcast has repurchased 6% of its shares in the past five quarters. In September, the company doubled its buyback program to $20 billion, strongly suggesting buybacks will continue.

Despite its strengths and quality, Comcast shares trade at an overly discounted 6.1x cash operating profits (EBITDA) and 7.9x earnings, and offer a 3.6% dividend yield. Investors searching for solid and enduring value at a very fair price need look no further than Comcast.

Comcast was selected for the Cabot Stock of the Week this week, with the full text included in the above description.

On Thursday, October 27, Comcast reported a decent quarter that was consistent with our thesis. Revenues slipped 2%, but this was entirely due to the one-time boost last year from the NBC coverage of the Tokyo Olympics. Even so, profits expanded by 6%, which included record-high profits at the cable segment and the U.S. operations of Universal theme parks. Small losses in the number of cable subscribers were nearly offset by an increase in wireless subscribers. Comcast repurchased $3.5 billion of shares in the quarter. Overall, Comcast is making incremental progress with its incremental initiatives to defend its franchises and is returning sizeable amounts of cash to shareholders.

Revenues fell 2% from a year ago but were in line with estimates. Adjusted earnings of $0.96/share rose 10% and were 7% above estimates. Adjusted EBITDA of $9.5 billion rose 6% and were 3% above estimates.

Total revenues fell about $450 million. Advertising revenues fell $1.2 billion (-26%), contributing more than all of the revenue decline. However, ad revenues from a year ago were boosted by $1.8 billion from the NBC coverage of the Tokyo Olympics – excluding this boost, total revenues would have increased by 5%. Cable operations revenues rose a dull but solid 3%, while within NBCUniversal, revenues from theme parks, content licensing and theatrical all rebounded sharply from pandemic-weakened results a year ago. The Sky operations were uninspiring, as revenues were flat excluding the effects of the weak British pound but fell 15% on a reported basis. Sky’s customer base showed incremental growth.

Even with the weaker ad revenues, Comcast’s profits increased by 6% as measured by adjusted EBITDA. The company kept its expenses restrained (falling 5%), helping increase the profit margin to a healthy 32% from 30% a year ago. Cable profits were a record, and profits at NBCUniversal rose 25%. Sky profits fell 16% adjusted for the weak British pound, reflecting ongoing cost increases as well as upfront programming costs for the 2022 FIFA World Cup.

Debt net of cash on the balance sheet rose an incremental $1.3 billion from a year ago, but the leverage ratio declined incrementally due to higher profits. Comcast used its healthy free cash flow of $3.4 billion (+5% from a year ago) to repurchase $3.5 billion of shares and also paid its $1.2 billion in quarterly dividends.

Our price target for Comcast shares is 42, based on 6.5x EV/EBITDA using a conservative estimate for 2024 results.

Comcast shares were flat for the past week and have about 32% upside to our 42 price target. The shares offer an attractive 3.4% dividend yield. BUY

Dow Inc. (DOW) merged with DuPont to create DowDuPont, then split into three companies in 2019 based on product type. The new Dow is the world’s largest producer of ethylene and polyethylene, the most widely used plastics. Investors undervalue Dow’s hefty cash flows and sturdy balance sheet largely due to its uninspiring secular growth traits, its cyclicality and concern that management will squander its resources. The shares are driven by: 1) commodity plastics prices, which are often correlated with oil prices and global growth, along with competitors’ production volumes; 2) volume sold, largely driven by global economic conditions, and 3) ongoing efficiency improvements (a never-ending quest of all commodity companies). We see Dow as having more years of strong profits before capacity increases signal a cyclical peak and expect the company to continue its strong dividend, reduce its pension and debt obligations, repurchase shares slowly and restrain its capital spending. Dow shares are a recommended Buy in our sister publication the Cabot Turnaround Letter.

On October 20, Dow reported third-quarter operating earnings of $1.11/share, which were 60% lower than a year ago but about 3% ahead of the consensus estimate of $1.08/share. Sales fell 5% but were 8% above the consensus estimate. Excluding the effect of the strong dollar, sales would have declined by only 1%. Overall, it was a reasonable quarter that showed the effects of modestly weaker demand combined with higher raw material and energy costs compared to a year ago and to the prior sequential quarter (Q2).

The company’s European operations were hit particularly hard, as weaker demand combined with sharply higher natural gas input prices. The company provided fourth-quarter sales guidance that was about 5% below the current consensus and pointed to continued weak markets. It will provide its 2023 outlook with fourth-quarter results.

Some useful nuggets: Dow said that it has $1 billion of new cost-cutting initiatives (about 2% of full-year revenues) on tap to help buttress profits in the weakening environment. Also, the company is cutting global polyethylene production by 15% and is actively adjusting to the difficult natural gas market in Europe and elsewhere. Dow trimmed its full-year 2022 capital spending guidance by about 10%. Nearly all of its debt is fixed-rate, so the impact of higher interest rates won’t directly weigh on its profits. The company is likely to halt its share repurchases to build up its cash balances in advance of further weaker end markets.

Our view on Dow is that, while the peak of the highly profitable commodity cycle is clearly in the past, the shares have overshot on the downside and now discount a dark but highly unlikely future for Dow.

In the quarter, local prices increased 3% from a year ago, although on a sequential basis local prices fell 6%. Volumes fell 4% from a year ago and 3% sequentially. North America and Asia Pacific showed growth, while Europe/Middle East/India fell as perhaps expected due to the immense economic difficulties in Europe.

Free cash flow was a robust $1.5 billion, although this declined by 35% from a year ago. This remains 3x the quarterly dividend payout. Dow repurchased $800 million of its shares in the quarter – a smart buy at discounted prices. The balance sheet remains robust.

Dow shares slipped 2% in the past week and have 28% upside to our newly adjusted 60 price target (same as in the Cabot Turnaround Letter). The quarterly dividend appears readily sustainable and provides an appealing 6.0% yield. The shares trade at a modest 6.3x EV/EBITDA multiple and 10.8x EPS on recession-minded 2023 estimates.

Estimates for 2022 ticked up this past week – a rare event recently for Dow. The shares are in the part of the cycle where, barring a confidence-eroding economic climate, long-term investors will look through the earnings trough to an eventual recovery. This may lead to a counter-intuitive situation where the valuation multiples increase as earnings estimates decline. BUY

Merck (MRK) is working aggressively to replace profits likely to be lost when Keytruda, a blockbuster oncology treatment (about 30% of revenues) faces generic competition in late 2028, and when its Januvia diabetes treatment likely sees generic competition soon, and also is exposed to government price controls. The company’s new CEO is accelerating Merck’s acquisition program. Merck is highly profitable and has a solid balance sheet. It spun off its Organon business in June 2021 and we think it will divest its animal health segment sometime in the next five years.

As Merck shares traded up near their all-time high and “close enough” to our 99 price target, we moved the shares from Hold to Sell earlier this month. While there certainly could be upside in the stock from here, and there is nothing wrong with the company, its strategy, financial condition or outlook, we would rather devote our attention to stocks that are more deeply undervalued, particularly in this market. SELL

State Street Corporation (STT) – Based in Boston, State Street is the world’s largest custodian bank, with $38 trillion in assets under custody/administration. About 56% of its revenues are produced from back-, middle- and front-office services including custody, client reporting, electronic trading and full enterprise solutions for investment managers. The balance is produced from investment management fees on ETFs, foreign exchange fees, securities financing fees and net interest income. The industry has combined into four dominant firms due to economies of scale. State Street’s shares are out of favor and unchanged since 2007 due to concerns over its anemic growth and steady pricing pressure from competitors. However, we see State Street as a solid, well-capitalized franchise that provides critical services, with a slow-growth but steady revenue and earnings stream. Our interest in STT shares is that we can buy them at an attractive valuation. We also find the dividend yield appealing

On October 18, State Street reported a good quarter, with adjusted earnings of $1.82/share falling 9% from a year ago but beating the consensus estimate by about 3%. Revenues fell 1% but were essentially in line with estimates. Expenses were flat, so the pre-tax margin slipped to 29.1% from 29.9% a year ago. The bank said it would repurchase about $1 billion of its shares in the fourth quarter – nearly 5% of shares outstanding and a savvy purchase as the stock is considerably undervalued.

Services related to asset management are the core of State Street’s business, and as most of these revenues are directly linked to the value of stock and bond markets, services revenues fell 8%. Within services, however, strong foreign currency services (+14%) helped offset lower asset-driven fees.

Part of what drives the State Street story is that it needs to maintain or incrementally increase its market share and, on this count, it seems to be doing reasonably well, earning perhaps a B+ grade for the quarter.

Essentially fully offsetting lower services revenues was a 36% surge in net interest income. Net interest income was about 22% of total revenues in the quarter. Rising interest rates drove the increase. We will hopefully get more color on the conference call regarding how sustainable this level of net interest income is.

Expenses were flat compared to a year ago, although, excluding the favorable effect of the strong dollar, expenses rose 4%. Part of the increase was due to higher marketing expenses, the return of business travel, higher wages and headcount. As the bank faces steady pricing headwinds, tight expense control is crucial to its long-term health. We would give the bank a B grade for this quarter on expenses

As lending is a tiny component of its business, and as it lends to highly credit-worthy clients, its credit losses are essentially zero.

The buyback is supported by State Street’s excess capital position. With its 13.2% capital ratio (using the overly complex CET1 metric), the bank is well above its 11-12% target range.

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

State Street shares rose 4% in the past week and have about 26% upside to our 94 price target. The company’s dividend (3.4% yield) is well-supported and backed by management’s strong commitment. BUY

Buy Low Opportunities Portfolio

Buy Low Opportunities Portfolio stocks include a wide range of value opportunities, often with considerable upside. This group may include stocks across the quality and market cap spectrum, including those with relatively high levels of debt and a less-clear earnings outlook. The stocks may not pay a dividend. In all cases, the shares will trade at meaningful discounts to our estimate of fair value.

Current price is yesterday’s mid-day price.

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 35% 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. Another indicator of its advanced capabilities: Allison was selected to help design the U.S. Army’s next-generation electric-powered vehicle. 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.

On October 26, Allison reported a strong quarter on an absolute basis although profits were only about 4% above estimates. The company used its profits to repurchase about 3% of its total share base in the quarter – an impressive nod to shareholders.

The company incrementally raised its full-year guidance across the board, but the new guidance is only a tad above current estimates. However, at a time when companies are missing estimates and reducing guidance while investors worry about recessions and industrial downturns, an incremental increase is clearly positive news.

In the quarter, earnings of $1.45/share rose 63% from a year ago and were 1 cent above the consensus estimate. Revenues increased 25% and were 4% above estimates. Adjusted EBITDA of $245 million was 30% above a year ago and 4% above estimates. The EBITDA margin of 34.5% increased from 33.3% a year ago.

The balance sheet remains solid, and free cash flow increased 20% from a year ago. Allison is an understated and undervalued company that continues to make progress with its operational and strategic initiatives while also generating attractive financial performance.

Allison shares rose 8% in the past week and have 14% upside to our 48 price target. The stock pays a respectable and sustainable 2.0% dividend yield. BUY

Arcos Dorados (ARCO), which is Spanish for “golden arches,” is the world’s largest independent McDonald’s franchisee. Based in stable Uruguay and listed on the NYSE, the company produces about 72% of its revenues in Brazil, Mexico, Argentina and Chile. The shares are depressed as investors worry about the pandemic, political/social unrest, inflation and currency devaluations. However, the company has a solid brand, high recurring demand, impressive leadership (including founder/chairman who owns a 38% stake) and successful experience in navigating local conditions, along with a solid balance sheet and free cash flow.

Macro issues have a sizeable impact on the shares’ trading, including local inflation and the Brazilian currency. Since early 2020, the currency has generally stabilized in the 1.00 real = $0.20 range – a remarkably favorable trait given the sharp declines in other currencies around the world. As the company reports in U.S. dollars, any strength in the local currency would help ARCO shares.

In the October 30 presidential election in Brazil, former president Lula won 50.9% of the votes, compared to 49.1% for current president Bolsonaro, in the closest race in the country’s history. While we are not political experts, this outcome seems favorable to Arcos as it could bring incrementally more spending stimulus yet will likely result in little major spending changes due to the narrowness of the victory margin. One risk among many is that, since the current president has not conceded, Bolsonaro’s supporters may rally/riot with allegations of voting fraud. This disruption would likely hurt sentiment toward the Brazilian stock market and currency. So far, the Brazilian stock market has had a mildly positive reaction to the election results.

ARCO shares rose 8% this past week and have 12% upside to our 8.50 price target. 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.

We look forward to an update on Aviva’s capital position and outlook when it reports interim results on November 9.

Based on management’s estimated dividend for 2023 (which remains credible but is subject to a smaller increase than the current guidance for a 48% boost), the shares offer a generous 8.6% yield. Based on this year’s actual dividend, the shares offer an attractive 5.8% dividend yield.

Aviva shares rose 1% in the past week. The shares have about 46% upside to our 14 price target. 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 new and 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.

Barrick reports earnings on November 3, with a consensus estimate of $0.12/share.

Over the past week, commodity gold slipped fractionally to $1,648/ounce. The 10-year Treasury yield slipped to 4.07%. Investors are anticipating the “end-game” in which Treasuries peak at a roughly 4.5% to 5.0% yield to roughly match or slightly exceed the anticipated inflation rate in a year or so. If this scenario pans out, gold and equity prices in general should rise.

The U.S. Dollar Index, another driver of gold prices (the dollar and gold usually move in opposite directions), ticked up modestly to 111.62.

Any wavering by the Fed in its now-strident rate hike campaign would also likely result in gold rebounding sharply. Until this happens, gold will probably remain out of favor. Investing in gold-related equities is a long-term decision – investors shouldn’t allow near-term weakness to deter their resolve.

Barrick shares were flat in the past week and have about 77% upside to our 27 price target. Our resolve with Barrick shares remains undaunted through the recent sell-off. 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 dismal first-quarter results although second-quarter results, while dismal, were better than the market’s dour consensus. The company needs to offload its still-bloated inventory at sharp discounts while also now loading the company with what is probably permanent debt.

We are retaining our HOLD rating for now: investor expectations are sufficiently depressed to provide some downside cushion, while management should be able to extract itself from the worst of the inventory problem over the next few quarters. Nevertheless, the Big Lots investment is now high-risk due to the new debt balance, the lost value from the inventory glut and the likelihood of a suspension of the dividend.

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

Big Lots shares jumped 16% this past week on improving sentiment about the broad economy. The 2023 earnings estimate jumped 35%, but this is largely meaningless until we hear from the company on its third-quarter results and outlook.

We reiterate our view that Big Lots shareholders who are not willing or able to sustain further losses in the shares should sell now. There is no reasonably definable floor to a stock like Big Lots when fundamentals and valuation are ignored while investors reduce their risk exposure.

The stock has 82% upside to our $35 price target. The shares offer a 6.3% dividend yield, although, as noted, investors should not rely on this dividend being sustained. 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 October 14, Citi reported adjusted earnings of $1.50/share, down 39% from a year ago and about 3% above the consensus estimate. Revenues excluding divestitures fell 1% and were fractionally below the consensus estimate. Overall, a reasonable quarter for Citigroup with a moderately encouraging outlook as the bank maintained its full-year revenue and expense guidance. Its major divestitures (Mexico consumer and Asia consumer) are on track. The Citigroup turnaround remains a slog, measured in years rather than quarters, but appears likely to be successful. Citi shares offer a 4.7% dividend yield and considerable upside potential (>100%) for patient investors. The valuation, at a discounted 54% of tangible book value, compared to well over 100% for its major peers, supports our upside case.

Revenues were boosted by net interest income which rose 18% from a year ago. This was driven mostly by a shift to more interest-earning assets, as the spread between the yield on its earning assets and the cost of its deposits and other funds widened by only 0.07 percentage points.

Institutional Client Group (ICG) services revenues rose 33%, but this was more than offset by weaker ICG equity market, institutional banking and corporate lending fees.

Personal banking revenues, which includes credit cards, rose 10%, although this was partly offset by lower wealth management revenues due to the weak stock and bond markets.

Expenses rose by 7% excluding the effect of divested businesses, as the bank continues to spend more to turn around its operations and invest for future growth and incurs some cost inflation. These more than offset productivity and other tailwinds. Credit costs remain remarkably subdued, and the Citi added to its already-generous credit reserves.

Like most banks, Citi is seeing cheap deposits trickle out (down 3%). The average loan balance fell 2%. Capital remains robust at 12.2%, above the 12% new requirement starting this coming January 1. The bank is tweaking its risk-weighted asset mix to reduce the amount of capital it requires. The return on tangible capital of 7.5% continues to be sub-par and declined from 11.0% a year ago. Tangible book value per share rose a modest 2% from a year ago, but this pace includes reductions due to the generous dividend.

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

This past week, the yield spread between the 90-day T-bill and the 10-year Treasury bond, which approximates the drivers behind Citi’s net interest margin, shrank from zero to negative 7 basis points (100 basis points in one percentage point).

Citi shares trade at 57% of tangible book value and 6.7x estimated 2023 earnings. The remarkably low valuations assume an unrealistically dim future for Citi.

Citi shares rose 2% in the past week and have about 84% upside to our 85 price target. Citigroup investors enjoy a 4.4% dividend yield. We anticipate that the bank is done with share buybacks until there is more clarity on the economic and capital market outlook, which could readily be a year or more away. 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.

Gates reports earnings on November 3, with a consensus estimate of $0.31/share.

GTES shares rose 2% in the past week and have about 24% upside to our 14 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.

Coors reported a reasonable quarter but one that was below the consensus estimate. Forward guidance was generally maintained, although full-year underlying profits will likely increase around 7% or so compared to the prior guidance of perhaps 9%, due to weaker demand in Central and Eastern Europe (impact of Ukraine war?) and higher cost inflation. The earnings “miss” plus the guidance trim drove the decline in the shares.

Revenues rose 4% and were about 2% above estimates. Coors generates considerable sales in Europe, so the strong dollar weighed on revenues, Ex-currency, revenues rose 8%. All of the revenue increase came from stronger pricing across both the Americas and the rest of the world, as volumes slipped fractionally.

Underlying net income of $1.32/share fell 25% from a year ago and was about 2% below estimates. Underlying EBITDA fell 8% and was 6% below estimates.

The Americas segment (about 80% of sales and includes Canada, the U.S. and Central/South America), performed reasonably well. Sales grew 7% on favorable pricing and mix. Volumes slipped marginally due to an ongoing strike in Canada but were helped by decent growth in Mexico. Underlying pre-tax profits rose 11%. Coors has been able to implement price increases that more than offset higher materials, transportation and energy costs.

The rest of the world (technically, called EMEA & APAC) is struggling. Sales rose 10% in constant currencies but fell 6% as reported. Volumes slipped about 3%. The average price rose over 14% (about twice that of the Americas’ increase) helped by both higher pricing and a pricier mix, but costs rose faster, cutting profits nearly in half.

Overall, Coors remains a stable, dull-ish company that generates considerable free cash flow, has a strong-enough balance sheet and pays a respectable dividend yield with shares that are undervalued.

TAP shares slipped 5% in the past week, including the mild sell-off on Tuesday, and have about 44% 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 8.6x estimated 2022 results, still among the lowest valuations in the consumer staples group and below other brewing companies. The 3.2% dividend yield only adds to the appeal. BUY

Organon & Company (OGN) was recently spun off from Merck. It specializes in patented women’s healthcare products and biosimilars, and also has a portfolio of mostly off-patent treatments. Organon will produce better internal growth with some boost through smart yet modest-sized acquisitions. It may eventually divest its Established Brands segment. The management and board appear capable, the company produces robust free cash flow, has modestly elevated debt and will pay a reasonable dividend. 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 reports earnings on Thursday, November 3, with a consensus earnings estimate of $1.10/share.

OGN shares rose 6% in the past week. Investors have basically given up on OGN shares.

The shares have about 76% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). The shares continue to trade at a remarkably low valuation while offering an attractive 4.3% dividend yield. 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.

On October 25, Sensata reported adjusted earnings of $0.85/share, down 2% from a year ago and in line with the consensus estimate. The effects of the strong dollar pulled down adjusted earnings by $0.08/share, so on a currency-adjusted basis earnings would have increased by 7%. We’ll take this as an indicator that Sensata’s fundamentals have forward, if slow, movement that is being obscured by the remarkable but likely not sustainable strength of the U.S. dollar. Revenues rose 7% on both a reported and organic basis and were slightly higher than the consensus estimate.

The company continues to grow faster than its end markets and is winning new business awards at a reasonable pace but tracking below its goals. Expenses rose faster than sales, so the adjusted operating margin of 19.4% fell from 21.1% a year ago. For Sensata, this margin pressure is an ongoing challenge. In this quarter, elevated spending on its new product development, as well as a lower margin mix of business and the effects of acquiring lower-margin/divesting higher-margin businesses weighed on its margins. Also, the effects of the strong dollar and some lingering supply chain issues dragged down the margin. Sensata said it expects to restore its 21% operating margin next year, but this effort likely remains a slog. Primary areas driving the forecast include higher product prices, higher volumes and better expense control.

Free cash flow was weak at $58 million compared to $89 million a year ago, due to a build-up of excess inventory and from acquisition-related compensation. Sensata took advantage of its weak share price by repurchasing 2.3 million shares, about 1.5% of total shares, in the quarter.

Fourth-quarter guidance was essentially in line with the consensus estimate.

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

ST shares rose 2% in the past week and have about 86% upside to our 75 price target. Our price target looks optimistic in light of the broad market sell-off, but we will keep it for now, even as it may take longer for the shares to reach it. BUY

Disclosure: The chief analyst of the Cabot Undervalued Stocks Advisor personally holds shares of every recommended security, except for “New Buy” recommendations. The chief analyst may purchase or sell recommended securities but not before the fourth day after any changes in recommendation ratings has been emailed to subscribers. “New Buy” recommendations will be purchased by the chief analyst as soon as practical following the fourth day after the newsletter issue has been emailed to subscribers.

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.

The next Cabot Undervalued Stocks Advisor issue will be published on December 7, 2022.