February 28, 2023

Tech Hype Cycle and Value Investing, Part IV

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.”

The chart below follows the same pattern as the Tech Hype Cycle chart while it more specifically traces the pattern of revenues and profits. The peak of the Hype Cycle corresponds, of course, to the peak of the Sales cycle in the Maturity Stage. Most tech companies follow the Decline Stage line into oblivion.

In Part II, we looked at how a few companies are able to recover and move upward along the “Slope of Enlightenment” curve. One way to accomplish this is with a “Life Cycle Extension” strategy. Almost invariably, post-peak tech companies work to extend their one-hit-wonder product into adjacent products with hopes of capturing incremental sales. These achieve varying degrees of success, but the most likely outcome is merely to taper the pace of the inevitable decline. Adjacent markets generally aren’t as lucrative as the core market even as they divert and dilute the efforts of the sales and engineering teams (of which many of the best have already departed for more prosperous companies).

An extreme version of the life cycle extension path is diversification. Companies use their mature and (hopefully still profitable) core product to expand into an entirely new business line – often linked to the core product by a thin thread of logic that only a consultant could justify. A very rare few are successful. Standing alone and towering above all other tech diversifiers is Apple: its core MacIntosh product achieved worthy growth but it was the jump into the smartphone market, with the iPhone in 2007 (fittingly, introduced at the MacWorld Expo) that launched the company into the $2.4 trillion market cap legend it is today. Impressively, it has successfully extended its iPhone franchise into apps, storage, payments and other services.

Two other tech companies that provide modern examples of successful diversification, although not quite to the same degree as Apple, are Microsoft and Amazon. Both expanded into cloud-based data storage, which is a long step away from office software and online retailing. Their cloud businesses have been so successful that perhaps 70% or more of Microsoft’s market value, and arguably 100% of Amazon’s value, is driven by the cloud business. Notably, both companies migrated into the cloud by organic efforts through already-in-place but embryotic products within their current operations, rather than by acquisition.

These stories fuel the diversification hopes of other fading tech giants. But they represent the slim 0.01%, the exceedingly rare few, that successfully make the jump. Most attempts fail. One of the largest and saddest blunders can be seen in Eastman Kodak. This once-iconic tech company had essentially a monopoly on consumer photographic film. Yet, rather than use its vast gusher of free cash flow to enrich shareholders, it embarked on a disastrous diversification strategy that included chemicals, pharmaceuticals, medical imaging equipment, inkjet printers and others. These all were substantial money-losers. Perhaps worse, the company neglected its core film business when Fuji Film entered the market. One obvious defense available to Kodak had it stayed focused on film: use its entrenched market position, low-cost structure and financial strength to institute a crippling price war that would have halted Fuji in its tracks. The arrival of, ironically, the iPhone wiped out Kodak’s market, but its shareholders could have been immensely enriched in the meantime, rather than having to suffer an eventual bankruptcy.

Two other notable examples of successful extensions can be found in Cisco Systems and Dell Technologies. Cisco used its entrenched position in routers to expand into a wide range of back-office communications equipment. Dell Technologies, with its various strategy and merger shifts, has successfully transitioned from a discount PC company to a diversified tech gear business. While their transitions took decades, both companies today have stable and moderately growing franchises, backed by respectable profit margins, strong balance sheets and robust free cash flow.

These charts help explain why value investors struggle with tech companies. The stocks are too expensive on the way up, and it’s exceedingly difficult to find enduring value in their business franchises once they begin their slide past their peak.

Long-mature tech companies like Cisco Systems and Dell Technologies have proven their endurance, and have enough breadth, margins and free cash flow history with a reasonably stable outlook that they can be valued on conventional metrics and become worthy investments. Nearly all of the rest will fade away.

We’re intrigued by Meta Platforms’ efforts to diversify into the metaverse, although we have our doubts. But, last December in our Cabot Turnaround Letter we saw an immensely profitable cash flow machine whose shares were discarded, such that we could put a value on its enduring franchise. The shares traded at a bargain-basement earnings multiple. Our thesis required only a mild relenting of the company’s surging spending on the metaverse to produce a fundamental turnaround. The company’s management announced just that, and the sharp gains that followed allowed us to book a quick 58% profit in Meta Platform shares. At the right price, and with enough fundamental strength, even a just-past-its-peak tech company can occasionally be worthy of investment.

Share prices in the table reflect Monday, February 27 closing prices. Please note that prices in the discussion below are based on mid-day February 27 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.

Last Week’s Portfolio Changes
Allison Transmission (ALSN) – Raising our price target from 48 to 54.

Upcoming Earnings Reports
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.

On February 15, Cisco reported impressive fiscal second-quarter results that were ahead of consensus estimate and raised its full-year revenue and earnings guidance by about 6%. The company raised its dividend by 1 cent per quarter, to $0.39/share. Overall, the company is maintaining its position as a critical provider of a broad array of tech gear and software even as other mega-cap tech companies that focus on only one or two niches are having to retrench. The company’s cash flow machine is running at full tilt, with operating cash flow of $4.7 billion nearly doubling the year-ago pace. Cisco’s balance sheet strengthened despite the $2.8 billion in year-to-date share buybacks and dividends. Cash in excess of debt rose by $3.4 billion, to a total of $13.2 billion. However, we are wary of the ongoing gross margin slippage and the sharp decline in new orders. For now, we will keep our Buy rating.

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

CSCO shares fell 4% for the week and have 35% upside to our 66 price target. The valuation is attractive at 9.1x EV/EBITDA and 13.0x 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 fell 4% for the past week and have 12% 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 2.9% 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.

On February 15, Allison reported a strong fourth quarter, capping an impressive year in which revenues rose 15% and earnings per share rose 34%. The company generated strong free cash flow, allowing it to repurchase 8% of its share count in the year, even as it has trimmed its already-reasonable net debt by 5%. Allison provided incrementally favorable 2023 guidance for a 4% increase in revenues and a similar increase in adjusted EBITDA. Free cash flow was guided to $505 million, about 3% above the 2022 pace. We consider the guidance to be reasonable but perhaps a bit conservative.

The company announced that it raised its quarterly dividend by 10%, to $0.23/share.

ALSN shares fell 4% in the past week. Given the capable management, healthy fundamentals and reasonable valuation, we recently raised our price target to 54. The shares have 13% upside to this new target. The stock pays a respectable and sustainable 1.9% dividend yield. BUY

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

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

Aviva shares slipped 1% 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.

On February 15, Barrick reported a reasonable fourth quarter. Adjusted earnings of $0.13/share were flat compared to a year ago but 1 cent above the $0.12 consensus estimate. The company is increasing its gold reserves, which rose 10% from a year ago. However, it is missing its gold production goals even as it is spending more to maintain that volume. In brief, we see that Barrick incrementally is trading profitability for growth. Our thesis is based on stable production growth that meets the company’s guidance, and on stable profits and cash flow that can be returned to investors through dividends and buybacks. Barrick is incrementally falling short on all of these metrics – not enough to be worried but we clearly want the company to return to meeting these key checklist items in 2023. Barrick said it would repurchase up to $1 billion of its shares this year. We anticipate that some of this will be funded from borrowings given the nearly debt-free ($342 million) balance sheet and tighter free cash flow. Overall, Barrick remains a solid and well-managed company, and we are keeping our current rating.

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

Over the past week, commodity gold ticked about 1% lower to $1,824/ounce. The 10-year Treasury yield ticked up to 3.92% while the U.S. Dollar Index (the dollar and gold usually move in opposite directions) ticked up incrementally to 104.76.

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 5% in the past week and have 69% 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.

Big Lots reports earnings on Thursday, March 2, with analysts estimating a loss of $(0.66)/share. We anticipate that the results will produce a volatile stock price, but we have no idea about the direction.

Big Lots shares fell 12% this past week. The stock has 70% upside to our revised 25 price target. The shares offer an 8.2% 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 unchanged at negative 90 basis points (100 basis points in one percentage point).

Until inflation relents to a 2% pace for perhaps 6 months, we see little chance for the Fed to declare “mission accomplished.” The recent CPI and other reports suggest that the 6-month clock hasn’t yet started.

Sentiment is shifting toward higher-for-longer interest rates, as inflationary pressures seem to be abating more slowly than most investors had hoped for. Some commentators are calling for the Fed Funds rate to approach 6%. Such a rate may not fully relieve inflation pressures but would clearly be a depressant for stock prices.

Citi estimated that its wind-down of operations in Russia would cost about $190 million. This equates to about $0.10/share, pre-tax.

Citi shares trade at 62% of tangible book value and 8.6x estimated 2023 earnings. The remarkably low valuations assume an unrealistically dim future for Citi.

Citi shares fell 1% 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 3.9%) and considerably more upside potential (about 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.

On February 9, 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. 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.

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

GTES shares were flat in the past week and have 13% upside to our new 16 price target. We recently raised our price target from 14 to 16 due to the company’s capable management, strong franchise within its market, still-improving fundamentals and reasonable valuation. 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.

On February 21, Molson Coors reported a healthy 4% increase in revenues (local currency) and a strong 22% increase in EBITDA. Weak volumes (down 5%) were more than offset by higher prices and favorable mix (+11%), suggesting that the company’s brands remain popular, that customers are accepting higher prices, and that the “premiumization” strategy is working. The quarter capped a good year for Molson Coors, in which revenues rose 7% (local currency) and underlying net income was essentially flat/stable. Full-year volumes slipped 2% but pricing added 9% to sales.

In addition to resilient full-year revenues, the company produced reasonably steady cash flow ($850 million) – a bit below our $1 billion baseline but due mostly to understandable increases in capital spending to upgrade its breweries. Net debt fell by 9%, or $560 million, and is below the 3.0x leverage mark.

Guidance for 2023 calls for incremental revenue and profit growth but about $100 million more in capital spending. Underlying free cash flow was guided to $1 billion, +/- 10%. In essence, for another year of stable results and generous free cash flow.

Overall, our thesis remains on track.

In the quarter, underlying net income of $1.30/share rose 61% from a year ago and was 22% above the consensus estimate. Revenues rose 0.4% but increased 3.8% in constant currency although this fell fractionally shy of estimates. Adjusted EBITDA of $556 million rose 22% from a year ago and was 2% above estimates.

Profits in the quarter were partly held back by input costs that rose 11.5%. Sharply lower marketing and overhead costs (down 14%) helped drive profits higher, nevertheless. We are encouraged by the lower marketing and overhead costs which had shifted higher in earlier quarters. A constant temptation for consumer product managers is to sacrifice profits for volume by spending on promotions. Coors seems to be mostly avoiding this trap.

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

TAP shares rose 3% in the past week and have 28% 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.

On February 16, Organon reported a complicated quarter that left us needing more time and information to assess where to go from here with our investment. The spin-off was to produce at least stable and large free cash flows with a reasonable potential for growth with, essentially, traits of a modern era “cigar butt” that was a dull but undervalued asset worthy of a higher share price. However, the management is morphing Organon into a company with more expensive growth aspirations that are weighing down free cash flow even as revenues continue to fall. The company released its balance sheet and cash flow statements on February 27, so we will have more analysis after our review.

Management is now clearly emphasizing growth, not profits or cash flow, which requires elevated spending on research and development as well as selling and promotions. Pressures on gross margin aren’t helping. While the company met its guidance for 2022 gross margins of mid-60%, forward guidance for 2023 is for about 63%. We get a sense that management has great confidence in its abilities to create impressive new products and identify/acquire others at bargain prices. We aren’t so confident.

So, with more questions than answers, but a somewhat cheap stock statistically (7.4x EV/EBITDA), we will continue to assess this position.

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

OGN shares fell 2% in the past week and have 80% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). The shares offer a 4.4% 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 4% in the past week and have 49% 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

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

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

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