Please ensure Javascript is enabled for purposes of website accessibility
Undervalued Stocks Advisor
Wealth Building Opportunites for the Active Value Investor

Cabot Undervalued Stocks Advisor Issue: September 7, 2022

Thank you for subscribing to the Cabot Undervalued Stocks Advisor. We hope you enjoy reading the September 2022 issue.

We’re not in the predictions business, so we have little use for predictions or forecasts. Our commentary includes perspectives from Warren Buffett and Yogi Berra.

This past month we covered a complicated earnings season and added two new stocks (State Street Corporation and Gates Industrial Corporation) while selling our position in The Coca-Cola Company.

Please feel free to send me your questions and comments. This newsletter is written for you and the best way to get more out of the letter is to let me know what you are looking for.

I’m best reachable at Bruce@CabotWealth.com. I’ll do my best to respond as quickly as possible.

Cabot Undervalued Stocks Advisor Issue: September 7, 2022

DOWNLOAD ISSUE PDF

Buffet and Berra
Last week, we wrote about our risk management process – how we focus on identifying risks and evaluating whether they are getting larger or smaller. An additional and critical component is that we don’t attempt to predict what will or will not happen. We’re not in the predictions business.

To quote a well-known investor, “We have long felt that the only value of stock forecasters is to make fortune-tellers look good.” Our risk management process extends this reasoning to economic and other macro forecasters.

A great example of the flaws of predicting (frequently polished up as “forecasting”) is how the world has changed so dramatically in the past few years. In late 2019, economic growth in the U.S. was 2.3% – reasonable but uninspiring, with similarly bland prospects for growth over the foreseeable future. Oil was stuck at $56/barrel, with nearly all commodities in a surplus situation. The 10-year Treasury yield was seemingly capped at sub-2.0% and inflation was languishing at 1.5% or so despite the Fed’s aggressive policies to drive costs higher. Sentiment leaned toward the U.S. dollar eventually losing its reserve-currency status.

The biggest threat to global peace was perhaps Iran’s tactics in the Middle East, as Afghanistan was still under the control of the United States, while Russia seemingly had limited ambitions at best and China was content to build defense systems on former reefs in the South China Seas.

In three short years, we’ve had a major pandemic, a brief depression followed by a surging recovery, and now the situation compared to late 2019 is almost the polar opposite. Inflation is surging at over 9% (the U.K. is on track for 20%), nearly all commodities are in short supply, the Fed is aggressively tightening, even as the 10-year Treasury yield climbs toward 3.5%. The dollar is surging to decades-long highs against most major currencies, with no limiting factor in sight. Russia has invaded Europe while China is regularly encroaching on Taiwanese territory with war-like behavior.

If someone had said in late 2019 that the stock market would be 22% higher in late 2022, even with all of the difficult market and geopolitical headwinds, they would have been dismissed out of hand.

Today, Wall Street strategists and commentators offer their sage predictions for markets and economies with the same confidence they did in 2019, and in every year since. In a month or so, we’ll start reading about predictions for 2023. Regardless of how smart, well-connected, or historically successful are these predictors, they are only guessing. No one can see the future.

We focus our efforts on the “easy” stuff, like understanding company-specific fundamentals and valuations, while avoiding the low-odds hard stuff like making predictions. As baseball legend and linguistics-challenged Yogi Berra once said, “It’s tough to make predictions, especially about the future.”

  1. Warren Buffett, Chairman of Berkshire Hathaway.

Share prices in the table reflect Tuesday (September 6) closing prices. Please note that prices in the discussion below are based on mid-day September 6 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
Gates Industrial Corporation plc (GTES) – New Buy
The Cola-Cola Company (KO) – Moving from Hold to Sell
State Street Corporation (STT) – New Buy
A

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.

Stock (Symbol)Date AddedPrice Added9/6/22Capital Gain/LossCurrent Dividend YieldPrice TargetRating
Cisco Systems (CSCO)11-18-2041.3244.517.7%3.4%66.00Buy
Coca-Cola (KO)11-11-2053.5861.3614.5%2.7%69.00SELL
Dow Inc (DOW) *04-01-1953.5048.52-9.3%5.8%78.00Buy
Merck (MRK)12-9-2083.4786.663.8%3.2%99.00Hold
State Street Corp (STT)8-17-2273.9667.81-8.3%3.7%94.00Buy

Current
price
Current 2022
EPS Estimate
Current 2023
EPS Estimate
Change in
2022 Estimate
Change in
2023 Estimate
P/E 2022P/E 2023
CSCO 44.66 3.53 3.810.0%0.0% 12.7 11.7
KO 61.58 2.46 2.610.0%0.0% 25.0 23.6
DOW 49.14 7.95 6.57-0.4%-0.8% 6.2 7.5
MRK 86.80 7.38 7.470.1%0.1% 11.8 11.6
STT 68.16 7.12 8.550.0%0.0% 9.6 8.0

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.

On August 17, Cisco reported adjusted fiscal fourth-quarter earnings of $0.83/share, down 1% from a year ago but 1% above the consensus estimate. Revenues were flat but were about 2% above consensus. Going into the report, market sentiment on Cisco shares was pessimistic, so the above-consensus results provided enough encouragement that the shares jumped about 6% on the news. We remain on board with the Cisco position.

Cisco is grinding through the secular and near-term supply chain and other headwinds, supported by resilient yet flattish demand for its products and services. The company will likely continue to show modest revenue growth. Guidance for fiscal 2023 is for 2-4% growth, about the same pace as this past year, which seems reasonable to us. Cisco is showing its cash generation powers with its nearly $4 billion in combined dividends and share repurchases in the quarter. For the year, the company returned $14 billion to shareholders (about 7% of its market value). Since a year ago, the share count is down 2.4%. The balance sheet has $9.8 billion in cash in excess of debt – this is about $3 billion lower than a year ago as Cisco used some of its cash for dividends and buybacks. We’re fine with this use of excess cash. We also note, encouragingly, that Cisco seems to be slowing its pace of acquisitions, which not only conserves cash and shares but also shows that the company can increase revenues organically without relying on “buying” revenues through acquisitions.

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

CSCO shares fell 1% in the past week and have 48% upside to our 66 price target. The valuation is attractive at 8.9x EV/EBITDA and 12.7x earnings, the shares pay a sustainable 3.4% dividend yield, the balance sheet is very strong, and Cisco holds a key role in the basic plumbing of technology systems even if its growth rate is only modest. BUY

CSCO_CUSA_9-7-22

The Coca-Cola Company (KO) – Last week, we moved the shares from Hold to Sell. The shares trade only modestly below their all-time high and have essentially reached our price target. We see little fundamental reason to increase our price target at this point. Our decision to sell is not an indication of any fundamental problems with the company – it is performing quite well – but primarily one of valuation. We would be more than pleased to repurchase the stock if the price fell noticeably.

Since our initial Buy recommendation in November 2020, the shares have produced a 25% total return. SELL

KO_CUSA_9-7-22

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/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 we expect the company to continue its strong dividend, reduce its pension and debt obligations, repurchase shares slowly and restrain its capital spending.

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

The quarterly dividend appears readily sustainable and provides an appealing 5.7% yield. The shares trade at a low 4.4x EV/EBITDA multiple. Barring a deep recession, collapse in oil prices or a surge in supply, Dow’s fundamental earnings picture seems solid. Dow shares fell 4% in the past week and have 59% upside to our 78 price target. BUY

DOW_CUSA_9-7-22

Merck (MRK) shares are undervalued as investors worry about Keytruda, a blockbuster oncology treatment (about 30% of revenues) that faces generic competition in late 2028. Also, its Januvia diabetes treatment may see generic competition next year, and like all pharmaceuticals, it is at risk from possible government price controls. Yet, Keytruda is an impressive franchise that is growing at a 20% rate and will produce solid cash flow for nearly six more years, providing the company with considerable time to replace the potential revenue loss. Merck’s new CEO, previously the CFO, is accelerating Merck’s acquisition program, which adds return potential and risks to the story. The company 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.

On Monday, September 12, at 2:15 PM (EDT), the company will present at the Morgan Stanley 20th Annual Global Healthcare Conference. The presentation will be live-streamed through the Merck investor relations website.

Merck shares were flat in the past week and have about 14% upside to our 99 price target. The company has a strong commitment to its dividend (3.2% yield) which it backs up with generous free cash flow, although its shift to a more acquisition-driven strategy will slow the pace of dividend increases. While the shares have pulled back, we are retaining our Hold rating as rising interest rates reduce the upside potential value of its shares. HOLD

MRK_CUSA_9-7-22

State Street Corporation (STT) – Based in Boston, State Street is the world’s largest custodian bank, with $38 trillion in assets under custody/administration. In its early days, State Street provided back-office services for investment managers, including holding securities for safekeeping and processing investment fund transactions. Over time, the bank added middle-office and front-office services, including client reporting, electronic trading and full enterprise solutions for investment managers. Today, all of these services comprise about 56% of the bank’s revenues.

The industry has consolidated into four dominant firms, including #2 Bank of New York Mellon, JPMorgan and Citigroup, due to the economies of scale that allow larger firms to offer more and better services at lower costs. A recent indicator of these economies is that State Street acquired the back-office operations of Brown Brothers Harriman (BBH), adding $5.4 trillion in assets under custody/administration, as BBH wanted to focus on its core investment management activities.

The bank’s State Street Global Advisors subsidiary is a major issuer of index exchange-traded funds (ETF), with $3.5 trillion in assets under management. SSGA produces about 17% of total revenues. In addition, the bank earns interest income on its portfolio of investments, which contributes about 16% of total revenues. The balance of revenues is produced from foreign currency transactions.

Shares of this well-managed, high-quality bank are out of favor with investors. Since reaching 104 in January, the shares have declined about 30% and are essentially unchanged since 2007. Near-term concerns include the bank’s fee sensitivity to stock and bond markets, cost pressures from wages (about half of total expenses), travel and other expenses, the likely loss of some cash deposits as customers shop around for higher returns on their short-term cash balances, and potential integration issues with the BBH combination. Longer-term concerns include slow industry revenue growth along with steady pricing pressure from competitors.

While we acknowledge these issues, 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 8.6x estimated 2023 earnings. This is below what we believe is a fair valuation at about 11x. The valuation on tangible book value (TBV), at about 1.9x, is also at the low end of its post-financial crisis valuation range. We place a more appropriate valuation at about 2.1x TBV based on likely 2023 tangible book value. We also find the dividend yield appealing.

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

State Street shares fell 1% in the past week and have about 38% upside to our 94 price target. The company’s dividend (3.7% yield) is well supported and backed by management’s strong commitment. BUY

STT_CUSA_9-7-22

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.

Stock (Symbol)Date AddedPrice Added9/6/22Capital Gain/LossCurrent Dividend YieldPrice TargetRating
Allison Transmission Hldgs (ALSN)02-22-2239.9936.02-9.9%2.3%48.00Buy
Arcos Dorados (ARCO)04-28-215.417.2934.8%2.2%8.50Buy
Aviva (AVVIY)03-03-2110.759.94-7.5%5.6%14.00Buy
Barrick Gold (GOLD)03-17-2121.1314.78-30.1%2.7%27.00Buy
Gates Industrial Corp (GTES)08-31-2210.7110.64-0.7%0.0%14.00Buy
Big Lots (BIG)04-12-2235.2421.17-39.9%5.7%35.00Hold
Citigroup (C)11-23-2168.1048.02-29.5%4.2%85.00Buy
Molson Coors (TAP)08-05-2036.5351.6941.5%2.9%69.00Buy
Organon (OGN)06-07-2131.4228.97-7.8%3.9%46.00Buy
Sensata Technologies (ST)02-17-2158.5739.41-32.7%1.1%75.00Buy

Current
price
Current 2022
EPS Estimate
Current 2023
EPS Estimate
Change in
2022 Estimate
Change in
2023 Estimate
P/E 2022P/E 2023
ALSN 36.17 5.75 6.680.0%0.0% 6.3 5.4
ARCO 7.25 0.46 0.550.0%0.0% 15.8 13.2
AVVIY 9.97 1.08 1.342.3%1.8% 9.2 7.4
GOLD 14.88 1.02 1.04-0.7%-2.2% 14.5 14.3
GTES 10.73 1.22 1.32nana 8.8 8.1
BIG 21.50 (4.55) 1.4062.5%-20.5% (4.7) 15.4
C 48.43 7.29 7.180.0%0.0% 6.6 6.7
TAP 52.04 3.95 4.210.3%0.5% 13.2 12.4
OGN 29.34 5.00 5.440.6%-0.5% 5.9 5.4
ST 39.41 3.40 3.950.0%-1.3% 11.6 10.0

Current price is yesterday’s mid-day price.

Allison Transmission Holdings, Inc. (ALSN)Allison Transmission is a mid-cap ($6.4 billion market cap) manufacturer of vehicle transmissions. 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. However, Allison produces no car and light truck transmissions, instead, 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.

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

Allison shares fell 2% in the past week and have 33% upside to our 48 price target. The stock pays an attractive and sustainable 2.3% dividend yield to help compensate investors while waiting for the recovery. BUY

ALSN_CUSA_9-7-22

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, as well as political/social unrest, inflation and currency devaluations. However, the company has a solid brand and high recurring demand and is well-positioned to benefit as local economies re-open. The leadership looks highly capable, led by the founder/chairman who owns a 38% stake, and has the experience to successfully navigate the complex local conditions. Debt is reasonable relative to post-recovery earnings, and the company is currently producing positive free cash flow.

Macro issues, including issues in Brazil related to its economic conditions (in particular, inflation, running at an 11.7% rate), currency and the chances that a socialist might win this year’s Brazilian presidential elections, will continue to influence ARCO shares.

ARCO shares were featured as the Cabot Stock of the Week this week.

ARCO shares fell 2% this past week and have 17% upside to our 8.50 price target. The ongoing rebound appears to be some recognition that the sell-off following the earnings report was not warranted. BUY

ARCO_CUSA_9-7-22

Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc was hired as the new CEO in July 2020 to revitalize Aviva’s laggard prospects. She divested operations around the world to re-focus the company on its core geographic markets (U.K., Ireland, Canada), and is improving Aviva’s product competitiveness, rebuilding its financial strength and trimming its bloated costs. Aviva’s dividend has been reduced to a more predictable and sustainable level with a modest upward trajectory. Excess cash balances are being directed toward debt reduction and potentially sizeable special dividends and share repurchases.

Much of our interest in Aviva is based on its plans for returning its excess capital to shareholders, including share repurchases and dividends. These distributions could be substantial. We also look for incremental shareholder-friendly pressure from highly regarded European activist investor Cevian Capital, which holds a 5.2% stake.

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

Aviva shares rose 4% in the past week and have about 40% upside to our 14 price target. Based on management’s estimated dividend for 2023 (which we believe is highly credible), the shares offer a generous 8.3% yield. Based on this year’s actual dividend, the shares offer an attractive 5.6% dividend yield. BUY

AVVIY_CUSA_9-7-22

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 announced two small sales of gold production royalties totaling up to $88 million. We consider these to be “curious” but not consequential.

Over the past week, commodity gold continued its slippage, declining 1% to $1,714/ounce. The 10-year Treasury yield rose to 3.32%, re-approaching its June peak of 3.48%. The U.S. Dollar Index, another driver of gold prices (the dollar and gold usually move in opposite directions), jumped another 1% to 110.17. The dollar index peaked in July 2001 at about 121 – a level not entirely out of reach in this cycle but one that would further pressure already-strained emerging and other countries.

The strong dollar and rising interest rates are weighing on the price of commodity gold, and hence Barrick’s share price. Investing in gold-related equities is a long-term decision – investors shouldn’t allow near-term weakness to deter their resolve.

Barrick shares slipped 1% in the past week and have about 81% upside to our 27 price target. Our resolve with Barrick shares remains undaunted through the recent selloff. BUY

GOLD_CUSA_9-7-22

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 bullish case for Big Lots rests with its loyal and growing base of 22 million rewards members, its appeal to bargain-seeking customers, the relatively stable (albeit low) 5.5% cash operating profit margin, its positive free cash flow, debt-free balance sheet and low share valuation at 3.1x EV/EBITDA and 7.3x per-share earnings based on conservative January 2023 estimates.

Our thesis was deeply rattled by the company’s dismal first-quarter results. Offloading its bloated inventory will require sharp discounts, which will weigh on profits while the $271 million in new borrowing ramps up the risk. 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.

Big Lots reported a second-quarter adjusted net loss of $(2.28)/share, compared to an adjusted profit of $2.75 a year ago and estimates for a $(2.47) loss. Revenues of $1.35 billion fell 8% but were fractionally higher than estimates. While the results were awful and the company is struggling with bulging inventories in a difficult retail and economic environment, its results were better than the dour expectations. The relatively favorable news, plus covering by short-trading investors, lifted the shares in mid-day trading on Tuesday.

Slowing economic conditions and weaker pricing weighed on sales. These factors drove comparable store sales down 9.2% in the quarter. On weaker sales combined with elevated discounting, the gross margin fell to 32.6% from 39.6% a year ago. All-in, gross profits fell $139 million from a year ago. This accounted for the entire decline in operating profits, as overhead costs were essentially unchanged. We view this as somewhat encouraging – once the company offloads its bloated inventory, profits should rebound.

However, how much profits rebound is an open question. There is of course no guarantee that this inventory will sell at respectable prices. The company guided for inventories to be under control by the end of the next quarter. This should help set them up for a respectable holiday season.

Big Lots’ balance sheet remains stressed. Cash is $49 million, down from $292 million a year ago. The company announced that it will pay its next dividend, but we see this as perhaps the last one for a while. Also, the company is working to update its borrowing programs, a clear positive in our view.

Despite the company’s frustrating fundamentals, we are retaining our Hold rating on the shares.

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

Big Lots shares dropped 11% this past week. Much of the post-reporting jump was likely due to short-sellers covering their positions. The stock has 63% upside to our $35 price target. The shares offer a 5.6% dividend yield, although, as noted, investors should not rely on this dividend being sustained. HOLD

BIG_CUSA_9-7-22

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.

This past week, the yield spread between the 90-day T-bill and the 10-year Treasury note, which approximates the drivers behind Citi’s net interest margin, expanded to 0.44% from 0.26% a week ago.

A recession would likely increase Citi’s credit losses, a flatter yield curve would weigh on its net interest margin, and weaker capital markets would mean fewer investment banking revenues. However, a recession and tighter capital markets would likely weed out some competitors like buy-now-pay-later companies, crypto payment services and digital-only banks. Also, tech talent may become more available at reasonable wages and potential technology company acquisition targets would likely be cheaper. Citi might emerge from a recession even stronger.

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

Citi shares trade at 60% of tangible book value. This immense discount, which assumes a dim future for Citi, appears to be misplaced. For comparison, beleaguered Credit Suisse, which faces potential collapse, trades at 29% of tangible book value. One could accurately say that Citi is more than 2x as healthy as Credit Suisse.

Citi shares fell 1% in the past week and have about 76% upside to our 85 price target. Citigroup investors enjoy a 4.2% dividend yield and perhaps another 3% or more in annual accretion from the bank’s share repurchase program once it reaches its new target capital ratio and if a slowing/stalling economy doesn’t meaningfully increase its credit costs. BUY

C_CUSA_9-7-22

Gates Industrial Corp, plc (GTES) – This company is a specialized producer of industrial drive belts and tubing. While this niche might sound unimpressive, Gates has become a leading global manufacturer through innovation. 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. And, 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.

Based in Denver, Colorado, Gates was founded in 1911 and was owned by private equity firm Blackstone from 2014 until its IPO in 2018 (Blackstone retains a 63% stake today). Gates was poorly run by its prior owners, but during its Blackstone ownership, the company improved its product line-up and quality, operating efficiency, culture and financial performance. Today, its 20% EBITDA margin is on par with or above its larger and more diversified peers. It 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 management and board are high-quality, which helps it follow a disciplined operating and capital allocation strategy. Gates’ debt balance has been reduced to a reasonable level, with considerable support from robust free cash flow.

Near-term results continue to be pressured by sluggish sales in China (12% of revenues) and ongoing disruption to its supply of key raw materials. We see these problems fading over time.

Investor concerns over Gates’ near-term issues and macro headwinds have driven the shares down 40% from their late-2021 high, to nearly 45% below the 2018 IPO price of $19. The modest 7.2x EV/EBITDA significantly undervalues the company’s long-term fundamental strength. We are starting shares of Gates Industrial Corp (GTES) with a Buy and a $14 price target, approximately 30% above the current price.

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

GTES shares fell 1% in the past week and have about 30% upside to our 14 price target. BUY

GTES_CUSA_9-7-22
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 re-instated its dividend.

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

TAP shares were flat in the past week and have about 33% 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 2.9% dividend yield only adds to the appeal. BUY

TAP_CUSA_9-7-22

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.

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

OGN shares rose 2% in the past week and have about 57% 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 3.8% dividend yield. BUY

OGN_CUSA_9-7-22

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.

Overall, the Sensata investment remains sharply underwater as its revenue growth is challenged by new economic cycle pressures on top of the post-pandemic supply chain issues. The company is well-positioned for the post-recession, electric vehicle environment, but investors will have to wait for perhaps a year for that to arrive. The shares are still worth holding onto given their now-low valuation and ability to financially endure the downturn.

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

ST shares declined 3% in the past week and have about 90% 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

ST_CUSA_9-7-22

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 October 5, 2022.

About the Analyst

Bruce Kaser

Bruce Kaser has more than 25 years of value investing experience in managing institutional portfolios, mutual funds and private client accounts. He has led two successful investment platform turnarounds, co-founded an investment management firm, and was principal of a $3 billion (AUM) employee-owned investment management company.

Previously, he led the event-driven small/midcap strategy for Ironwood Investment Management and was Senior Portfolio Manager with RBC Global Asset Management where he co-managed the $1 billion value/core equity platform for over a decade. He earned his MBA degree in finance and international business from the University of Chicago and earned a Bachelor of Science in finance, with honors, from Miami University (Ohio).