February 14, 2023

Tech Hype Cycle and Value Investing, Part III

A few weeks ago, we introduced the Gartner Hype Cycle, which traces the path that all tech companies follow in what essentially is an immutable law of tech investing. Currently, tech stocks have passed the Peak of Inflated Expectations and are sliding down to the Trough of Disillusionment. A few will ascend back to prosperity along the “Slope of Enlightenment” if they maintain both their relevance and their competitive edge. But most will lose one or both of these traits and thus continue downward in what could be labeled the “Decline into Oblivion.”

What is it about tech companies that make their lives (and stock prices) so volatile?

Our view is that all technology companies start out as “one-hit wonders.” Just like musical artists that have a moment of inspiration and creativity that produces a single but highly memorable song, tech entrepreneurs develop a new and inspiring piece of hardware or software that addresses a specific need. If that need emerges into a rapidly growing niche, sales of the new product ride the upward wave of demand. AOL had a portal that allowed everyone to access the Internet. Cisco made devices that connected computers over the Internet. Microsoft: software that operated the PC. Meta Platforms’ original product was Facebook, which connected the world’s people to each other. Toast offers restaurant-specific point-of-sale.

A young tech company’s growth trajectory clearly follows the size and growth of its market. Some products have enormous markets (PC operating systems, cloud security), others have small markets. Eventually, however, every market reaches maturity. If they didn’t, that market would eventually eclipse the entire global economy – an impossible outcome. Cloud computing, for example, is currently seen as a vast market, but its growth rate has started an inexorable decay. And, when companies compete for growth in a slowing market, the result is typically price competition – which rapidly erodes profitability.

In technology, there are no permanent monopolies. Competitive edge is primarily produced by the talents of company leadership and staff, which can easily be hired away or copied. Some near-monopolies can last a long time (Google’s ad search, Microsoft Windows) but inevitably they are replaced or bypassed (Google is endangered by AI-driven chatbot searches, while Windows has a zero share of the now-critical smartphone operating system market). This intense competition adds further pressure to the outlook for one-hit wonders.

No tech investor (nor anyone else) has a supremely accurate estimate of the ultimate size or profitability of any given market. So, when a tech company reports slowing growth, narrowing gross margins, or both, tech investors exit aggressively over worries that the peak may be approaching. This is what produces the occasional eye-watering moves in tech stock prices.

And, it is the pincer moves of flattening market growth and aggressive competition that eventually render all tech companies’ founding technologies and their underlying profits valueless.

Our thoughts on this topic diverged a bit from where we were initially headed (toward a chart that provides a different view of tech companies’ revenue and profit cycle), so we will return to our plan next week. Thanks for bearing with us on our side trip.

Share prices in the table reflect Monday, February 13 closing prices. Please note that prices in the discussion below are based on mid-day February 13 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
Gates Industrial (GTES) – Raising our price target from 14 to 16.

Last Week’s Portfolio Changes
State Street Corp. (STT) – Moving the shares from Hold to Sell.
Dow (DOW) – Moving the shares from Buy to Sell.

Upcoming earnings reports
Cisco Systems (CSCO) – Wednesday, February 15
Allison Transmission Holdings (ALSN) – Wednesday, February 15
Barrick Gold (GOLD) – Wednesday, February 15
Organon & Company (OGN) – Thursday, February 16
Molson Coors Beverage Company (TAP) – Tuesday, February 21
Big Lots (BIG) – Thursday, March 2
Aviva plc (AVVIY) – Wednesday, March 8

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.

Cisco reports earnings on Wednesday, February 15, with the consensus estimate at $0.86/share.

CSCO shares were flat for the week and have 38% upside to our 66 price target. The valuation is attractive at 9.6x EV/EBITDA and 13.5x earnings per share. The 3.2% 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.

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

Comcast shares ticked down 1% for the past week and have 8% upside to our 42 price target. The shares have limited upside, but the earnings report was reasonable enough to keep the stock a bit longer. The shares offer an attractive 2.8% dividend yield. HOLD

BUY LOW OPPORTUNITIES PORTFOLIO

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.

Allison reports earnings on Wednesday, February 15, with the consensus estimate at $1.25/share.

ALSN shares ticked down 1% in the past week and have 5% upside to our 48 price target. The stock pays a respectable and sustainable 1.8% dividend yield. We will wait until the company reports earnings before deciding whether to make any ratings changes. 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 were flat this past week and have 31% upside to our 14 price target. Based on management’s estimated dividend for 2023, the shares offer a generous 7.1% yield. 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.

Barrick reports earnings on Wednesday, February 15, with the consensus estimate at US$0.12/share.

Over the past week, commodity gold was essentially unchanged at $1,866/ounce. The 10-year Treasury yield rose to 3.72% while the U.S. Dollar Index (the dollar and gold usually move in opposite directions) was essentially unchanged at 103.39.

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 3% in the past week. The stock has 51% 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 in the first quarter of 2022, likely burdening it with new and permanent debt.

Big Lots shares remain high-risk due to the permanent debt balance and the likelihood of a suspension of the dividend.

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.

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

Big Lots shares slumped 6% this past week. The stock has 52% upside to our revised 25 price target. The shares offer a 7.3% 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.

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, was essentially flat at negative 104 basis points (100 basis points in one percentage point). Our interpretation is that investors are assuming that the Fed rate hikes and other macro drivers will drag inflation down to sub-5% or less this year. Given that the inflation metrics are flattening out or declining (inflation over the past four or five months has been tame at sub-3%), this assumption seems reasonable.

An article in the London Financial Times said that the sale of Banamex, Citi’s retail banking business in Mexico, is progressing but will likely yield a price of only $6 billion to $8 billion, much less than the $10 billion recently estimated by many analysts and the $12.5+ billion estimated a year ago. Delays in completing a deal combined with a growing understanding that Citi had underinvested in Banamex have weighed on the likely price.

Related, the sole bidder, billionaire Germán Larrea, owner of mining company Grupo Mexico, is said to want Citi to retain a stake in Banamex. Larrea’s motivations are said to include keeping Citi engaged with the business and for it to continue to provide support and other services. While retaining a stake would delay Citi’s full exit, it might offer the possibility of a higher valuation in a later IPO.

Citi shares trade at 62% of tangible book value and 8.7x estimated 2023 earnings. The remarkably low valuations assume an unrealistically dim future for Citi.

Citi shares were flat in the past week and have 67% upside to our 85 price target. Citigroup investors enjoy a 4.0% dividend yield.

When comparing Citi shares with a U.S. 10-year Treasury bond, Citi offers a higher yield (4.0% vs 3.7%) and considerably more upside potential (nearly 70% 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.

Gates reported an encouraging fourth quarter and provided reasonably strong guidance for 2023 that implied steady-to-rising revenues and profits rather than a recessionary decline.

Adjusted earnings of $0.25/share fell 19% from a year ago but were about 9% above the consensus estimate of $0.23/share. Core revenues, which exclude currency and acquisition/divestiture effects, rose 16% and were about 5% above estimates. Adjusted EBITDA of $166 million rose 19% and was about 6% above estimates. The adjusted EBITDA margin of 18.6% improved from 17.1% a year ago.

Guidance for 2023 points to 1-5% organic revenue growth and - (1%) to +8% adjusted EPS growth. The midpoints of these ranges are incrementally above the current consensus estimates.

The company said demand remains strong in both the Power Transmission and Fluid Power segments. Pricing is moving ahead of higher costs, and the previous drag from supply chain issues is abating, helping drive higher sales and better profits.

Fourth-quarter free cash flow rose 55% as profits rose and inventory was sold down. Total debt fell about 3%. Leverage remains reasonable at 2.8x EBITDA, although it ticked up due to lower EBITDA.

Gates continues to follow a common strategy of companies owned/controlled by reputable private equity firms: generating wide profit margins and high free cash flow conversion (free cash flow relative to adjusted net income). We strongly agree with this strategy. While the $329 million in full-year free cash flow was healthy, it fell 19% from a year ago due primarily to weaker profits. Free cash flow conversion fell to 54% from 72% a year ago. Its 2023 guidance is for 100% conversion.

GTES shares rose 4% in the past week. Given the company’s capable management, strong franchise within its market, still-improving fundamentals and reasonable valuation, we are raising our price target from 14 to 16. The shares have 16% upside to our new 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.

Molson Coors ran an advertisement during the Super Bowl, its first in over 30 years after Budweiser ended its exclusive advertising rights. The company promoted the ad as a contest, a “bettable ad” about which of its brands would be the actual focus of the ad. Molson Coors linked up with DraftKings to share with customers a $500,000 prize for the correct guesses. Apparently, the winning brand, Blue Moon, was kept in total secrecy until the ad actually aired. Early accounts suggest this campaign was highly effective.

TAP shares fell 4% in the past week and have 34% 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 8.7x estimated 2023 results, still among the lowest valuations in the consumer staples group and below other brewing companies. BUY

Organon & Company (OGN), a spin-off from Merck, specializes in patented women’s healthcare products and biosimilars, and also has a portfolio of mostly off-patent treatments. It may eventually divest its Established Brands segment. The management and board appear capable as they work to boost internal growth augmented by modest-sized acquisitions. The company produces robust free cash flow, has modestly elevated debt and pays a reasonable dividend.

Organon reports earnings on Thursday, February 16, with the consensus estimate at $0.91/share.

OGN shares fell 2% in the past week and have 58% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). The shares offer an attractive 3.9% 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.

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

ST shares slipped 1% in the past week and have 44% 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

*Note: DOW price is based on April 1, 2019 closing price following spin-off from DWDP.

Buy – This stock is worth buying.
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.
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