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Cabot Undervalued Stocks Advisor 521

Thank you for subscribing to the Cabot Undervalued Stocks Advisor. We hope you enjoy reading the May 2021 issue.

The stock market, so far in May, hasn’t continued the robust momentum of the first four months. Treasury Secretary Yellen’s comment about the possible need to boost interest rates to ward off inflation seems to be the catalyst. The market and the broad economy will likely respond differently if rates increase. We briefly outline on our asset allocation philosophy, which helps guide us when the market is edgy, in our economic comments.

Earning and proxy voting are in full swing. We’re updating the earnings as they come in.

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 521

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Thoughts on the Stock Market in Early May
While the year-to-date 11.8% surge in the S&P 500 (helped by a 5.3% jump in April) has been impressively strong, the 40% annualized pace seemed unlikely to continue, at least without interruption. May hasn’t started out quite so exuberantly, with an early pull-back in the high-momentum tech stocks dragging down the broader indexes.

The immediate catalyst appears to be Treasury Secretary Yellen’s comments on Tuesday that interest rates may need to increase to ward off inflation. She appears to be reprising her role as Fed chair, yet balancing that with her new role as President Biden’s Treasury secretary. This has put her in the delicate position of being both a responsible voice that acknowledges the reality of rising prices, yet also a voice that avoids upsetting her boss’ efforts to pass large new spending programs that might produce more inflation.

The market’s foremost fear currently, of course, is higher interest rates. In the sweep of history, long-term risk-free interest rates at 2% to 3% would be seen as benign to the point of being boring. However, after a decade of zero interest rates at the short end of the yield curve and sub-1% at the 10-year horizon, with a financial system and broad economy that are being flooded with a gusher of money, and market sentiment that is exceptionally bullish/speculative, almost any increase in interest rates is bearish. If the 10-year Treasury yield were to somehow increase to 3%, the stock market would be “upset” to say the least, particularly regarding stocks whose valuations are justified by expectations for rapid and enduring revenue growth.

However, unless a market decline produces downward pressure on consumer and business spending, the broad economy will likely continue to grow. Almost certainly, a tweak upward in interest rates wouldn’t appear likely to bring the economy’s robust and accelerating momentum to a grinding halt. If anything, the chances of passage of the various stimulus bills would probably increase and the Fed’s resolve to raise interest rates would likely weaken. While the stimulus programs may not boost the economy’s ability to use its resources wisely, at least based on an Austrian school of economics way of thinking, they would help keep the economy moving forward.

At the margin, many of our stocks across both the Cabot Undervalued Stocks Advisor and the Cabot Turnaround Letter are nearing their price targets. Our approach to the market is to buy stocks that look attractive and sell stocks that don’t look attractive. This tends to drive our asset allocation – bottom-up rather than top-down.

Like many value investors, we tuned into the Berkshire Hathaway annual shareholders’ meeting this past Saturday. It was great to see Charlie Munger back on the stage this year after missing last year due to the pandemic. Overall, we heard fewer juicy investing nuggets than in prior years and are sensing that an era is passing as Buffett and Munger age. The heir-apparent, Greg Abel, looks like an excellent choice to succeed Buffett, but “it just won’t be the same.”

It is proxy season, and we encourage shareholders to vote all of their proxies. Voting is easy – as simple as visiting the proxy voting firm’s website (usually proxyvote.com), keying in your 16-digit code provided on the ballot you received by U.S. mail, and clicking on your choices.

You can also watch the annual shareholder meeting, available to both shareholders and the general public. This year, these meetings are held online. While usually dull, if a contentious issue is being weighed, they can be highly entertaining, if for no other reason than to watch the leadership squirm under investor pressure for change. One such meeting may be ExxonMobil, to be held on May 26th, as shareholders are demanding changes in how the company is overseen.

Also, since it is earnings season, consider listening to the management call that accompanies each report. You can find these under the company’s “Investor Relations” tab on their website. The calls are webcast and open to the public. Most are available for a few weeks or longer for those not able to listen to the live webcast. The management and brokerage analysts often use a lot of jargon, which can make it difficult to follow sometimes.

Fortunately, the companies usually provide a slide deck that highlights the results in a fairly straightforward manner (although they usually de-emphasize the “low-lights”). Often, clicking through a slide deck can quickly help you become more familiar with your company and its operations, which not only can help you keep your resolve when things slip but also provide a fascinating window into what your company is doing and its priorities.

Share prices in the table reflect Tuesday (May 4) closing prices. Please note that prices in the discussion below are based on mid-day May 4 prices.

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

Send questions and comments to Bruce@CabotWealth.com.

Upcoming Earnings Releases
May 5: Barrick Gold (GOLD)
May 5: General Motors (GM)
May 10: Tyson (TSN)
May 12: Arcos Dorados (ARCO)
May 19: Cisco (CSCO)
May 27: Aviva plc (AVVIY)

Today’s Portfolio Changes
None

Portfolio changes during the past month
New Buy: Arcos Dorodos (ARCO)
U.S. Bancorp (USB) – Moving from Hold to Sell.
JetBlue Airlines (JBLU) – Moving from Hold to Sell.
U.S. Bancorp (USB) – Moving from Buy to Hold.
Tyson (TSN) – Moving from Buy to Hold.

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 Added5/4/21Capital Gain/LossCurrent Dividend YieldPrice TargetRating
Bristol-Myers Squibb (BMY)04-01-20556417.1%3.1%78Strong Buy
Cisco Systems (CSCO)11-18-20425120.2%2.8%55Buy
Coca-Cola (KO)11-11-2054540.4%3.0%64Buy
Dow Inc (DOW)06-05-186866-3.1%4.2%70Hold
Merck (MRK)12-9-208376-8.4%3.4%105Buy
Tyson Foods (TSN)12-10-198978-12.7%2.3%82Hold
US Bancorp (USB12-29-20466130.9%2.8%58Sell

Bristol Myers Squibb Company (BMY) is a New York-based global biopharmaceutical company with over $45 billion in revenues. In recent years it has divested several major businesses to focus on high-value pharmaceuticals. BMY shares sell at a low absolute valuation and a sharp discount relative to peers due to worries over upcoming patent expirations for Revlimid (starting in 2022) and Opdivo and Eliquis (starting in 2026).

The shares are attractive for two reasons, described in more detail in the April 7 letter. First, low expectations (low valuation) minimize the downside risk should the anticipated weak fundamentals actually arrive, yet if the fundamental reality is stronger than feared the shares offer considerable upside potential.

Second, Bristol is reducing its fundamental risk through a multi-pronged revenue-and-profit-replacement strategy. Importantly, the underlying demand for its “key three” products is strong, such that the primary issue is pricing, not volumes. To extend its pricing strength (through patent protection), it has signed deals with several potential generics competitors.

Additionally, its acquisitions of Celgene and MyoKardia provide new growth potential that complements Bristol’s research expertise. Lastly, Bristol has a robust pipeline of internally-developed treatments that offer potentially sizeable new revenues. All-in, it is likely that the worst-case scenario is for flat revenues over the next 3-5 years. Any indication that revenues could sustainably grow should boost BMY’s share price considerably.

Also mitigating the risk, the company is aggressively cutting its costs, including the announced $2.5 billion efficiency program.

Earnings for 2021 are estimated to increase 16%, although tapering to 6-8% in future years. The company is positioned, backed by management guidance, to generate between $45 billion and $50 billion in cash flow over the three years of 2021-2023. This sum is equal to 35% of the company’s $136 billion market value. The balance sheet carries $13 billion in cash and its debt is only 2x EBITDA.

Bristol reported earnings per share of $1.74, about 1% higher than a year ago and 4% below the consensus estimate. Revenues of $11.1 billion were 3% above a year ago and in-line with consensus. BMY shares fell over 4% on the news, partly due to the earnings miss and partly as the market showed its skepticism regarding Bristol’s new treatment pipeline.

Revenue growth was positive, even when adjusting for currencies, and would have been perhaps +5% ex-currency assuming pre-Covid buying patterns were in place – granted, a mild stretch, but acknowledges that the 1% reported revenue growth probably was artificially suppressed. Combined sales of the top three treatments (Revlimid, increased 1%; Eliquis, rose 9%; Opdivo, fell 3%) rose 3% from a year ago.

Earnings increased fractionally, but for now this is good enough. The operating margin fell, largely on a narrower gross margin due mostly to foreign currency changes. Management reaffirmed their full year guidance for high single-digit (maybe 7-8%) revenue growth and for earnings between $7.35/share and $7.55/share, although the $7.45 midpoint is below the $7.48 consensus estimate.

The market is mostly concerned about the future of Bristol’s revenues as patent expirations are on the horizon. Fears appear over-stated: one sell-side analyst cast a dour view on the pipeline, but then projected that Bristol’s long-term earnings growth rate will be 6%. With the stock trading at 8.5x earnings (combined with generous free cash flow and a sturdy balance sheet), a 6% long-term growth rate would produce a much higher share price. Said a different way, Bristol shares are priced for a sharp earnings decline, so anything close to stability is a positive.

Bristol paid down its net debt balance by about 4% compared to year-end. The company also repurchased $1.8 billion of shares.

BMY shares fell 4% in the past week and have about 23% upside to our 78 price target. The earnings disappointment pulled the stock down to the middle of its one-year trading range. We remain patient with BMY shares.

The stock trades at a low 8.5x estimated 2021 earnings of $7.46 (down two cents from last week). On 2022 estimated earnings of $8.04 (down 1 cent), the shares trade at 7.9x. Either we are completely wrong about the company’s fundamental strength, or the market must eventually recognize Bristol’s earnings stability and power. We believe the earning power, low valuation and 3.1% dividend yield that is well-covered by enormous free cash flow make a compelling story. STRONG BUY.

BMY-20210504

Cisco Systems (CSCO) generates about 72% of its $48 billion in revenues from equipment sales, including gear that connects and manages data and communications networks. Other revenues are generated from application software, security software and related services, providing customers a valuable one-stop-shop. Cisco is shifting toward a software and subscription model and ramping new products, helped by its strong reputation and its entrenched position within its customers’ infrastructure.

The emergence of cloud computing has reduced the need for Cisco’s gear, leading to a stagnant/depressed share price. Cisco’s prospects are starting to improve under CEO Chuck Robbins (since 2015). 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 will participate in JPMorgan’s Tech, Media and Communications conference on May 24th, at 1:15pm EDT. This is one of the top institutional investor conferences in the industry. You can watch their webcast presentation and Q&A at Cisco’s website.

CSCO shares fell 2% in the past week and have about 9% upside to our 55 price target. While we generally would move the shares to a Hold due to the limited upside, we believe Cisco’s earnings potential is higher than currently estimated, which leaves room for more upside to the shares.

The shares trade at 15.6x estimated FY2021 earnings of $3.23 (unchanged in the past week). On FY2022 earnings (which ends in July 2022) of $3.44 (unchanged), the shares trade at 14.7x. On an EV/EBITDA basis on FY2021 estimates, the shares trade at a discounted 11.0x multiple. CSCO shares offer a 2.9% dividend yield. We continue to like Cisco. BUY.

CSCO-20210504

Coca-Cola (KO) is best-known for its iconic soft drinks but nearly 40% of its revenues come from non-soda brands across the non-alcoholic spectrum, including PowerAde, Fuze Tea, Glaceau, Dasani, Minute Maid and Schweppes. Its vast global distribution system offers it the capability of reaching essentially every human on the planet.

Coca-Cola’s longer-term picture looks bright despite the clouded near-term outlook due to the pandemic as well as the secular trend away from sugary sodas, high exposure to foreign currencies and always-aggressive competition. Another overhang is the tax dispute that could cost as much as $12 billion – we don’t see an immediate resolution but consider $12 billion to be a worst-case scenario.

Relatively new CEO James Quincey (2017) is reinvigorating the company by narrowing its oversized brand portfolio, boosting its innovation and improving its efficiency. The company is also working to improve its image (and reality) of selling sugar-intensive beverages that are packaged in environmentally-insensitive plastic. Coca-Cola is supported by a sturdy balance sheet. Its growth investing, debt service and $0.42/share quarterly dividend are well-covered by free cash flow.

On April 19th, Coca-Cola reported adjusted first quarter earnings of $0.55/share, up 8% from a year ago and 10% above the $0.50/share consensus estimate. Revenues of $9.0 billion increased by 5% from a year ago and were 4% above consensus estimates. On an organic basis, which removes the effects of currency changes and acquisitions/ divestitures, revenues grew 6%.

Coke’s results were flattered by a calendar quirk which added five days to the quarter, compared to a year ago. Excluding this effect, volumes were unchanged and profits would likely have been only incrementally above a year ago. However, these results showed that investors have underestimated the speed of the company’s recovery – especially as the year-ago quarter was almost entirely pre-pandemic (the lockdowns hit full-stride in mid-March 2020). As much as half of Coke’s revenues come from on-premise sales, so a flat result with on-premise still subdued is highly encouraging.

Once the recovery is fully underway, the company will likely see higher volumes and profits compared to the pre-pandemic periods. However, with the recovery outside of the U.S. still sluggish, it could be several quarters yet until that strength arrives.

The company’s efficiency programs are working. Underlying operating margins expanded by 30 basis points (100 basis points = 1 percentage point) even though the underlying gross margin fell 110 basis points on unfavorable changes in the product mix. Coke alerted investors to rising input costs but was fairly confident in their ability to offset them with higher pricing and through hedging.

Coke re-affirmed its full-year guidance, which calls for 8-9% organic revenue growth and perhaps 8-12% comparable earnings per share growth which includes a 2-3% positive effect from a weaker dollar (this in effect is a raise, as prior guidance assumed a 3-4% positive effect from a weaker dollar).

The company’s free cash flow production improved sharply to $1.4 billion, up from $0.2 billion a year ago due to higher profits, improved working capital and lower capital spending. Coke’s balance sheet remains strong, with $12.6 billion in cash, and $32 billion in debt net of cash. To help monetize some latent value and also streamline its operations, the company will spin off its South Africa-based bottling operations.

Overall, the Coca-Cola story remains on track.

There was no significant company news in the past week.

KO shares rose 1% the past week and have about 18% upside to our 64 price target. While the valuation is not statistically cheap, at 24.9x estimated 2021 earnings of $2.18 (unchanged in the past week) and 23.0x estimated 2022 earnings of $2.36 (up a cent), the shares are undervalued while also offering an attractive 3.1% dividend yield. BUY.

KO-20210504

Dow Inc. (DOW) merged with DuPont in 2017 to temporarily create DowDuPont, then split into three companies in 2019 based roughly along product lines. The new Dow is the world’s largest producer of ethylene/polyethylene, the most widely used plastics. Dow is primarily a cash-flow story driven by three forces: 1) petrochemical 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 to maintain their margins).

Dow continues to participate in the economic recovery. For 2021, analysts estimate revenue growth to be 15%, aided by higher prices and volumes. The strong U.S. dollar may be a modest headwind as it makes revenues produced in other currencies less valuable when translated into dollars. Generous free cash flow will partly be used to trim Dow’s debt.

On April 22, Dow reported strong first quarter results. Adjusted earnings of $1.36/share were more than double the $0.59/share earnings a year ago and about 18% above the consensus of $1.15. Revenues of $11.9 billion rose 22% from a year ago and were about 7% above consensus estimates. All of the revenue growth was produced by higher prices, as volumes were steady compared to a year ago. Pricing was strong across all segments and regions, with the greatest impact coming from the commodity packaging and specialty plastics segment due to strong demand and tight supplies. EBITDA rose 44% from a year ago, with the margin expanding to 19.1% from 16.0%.

Management provided second quarter guidance that looks to be ahead of estimates and somewhat conservative. However, investors were a bit leery about how Dow will be incrementally increasing its capital spending and about whether pricing conditions won’t materially improve from here. Management pointed out that volumes will likely improve and that pricing could expand.

Dow’s Sadara chemicals joint venture (with Saudi Arabia) is changing from a consumer of cash to a producer of cash, with the 2021 inflow expected to be about $350 million. The company contributed over $1 billion to its pension plans, indicating that it is feeling confident in its ability to generate cash. The contribution will reduce Dow’s annual expense by about $200 million, helping to boost EBITDA which drives the share price.

Dow finished the quarter with $4.1 billion in cash balances, down about $1 billion, as cash from profits was offset by cash consumed in building inventories and other working capital items.

With about two years now as an independent, post-spin-off company, Dow is generating huge free cash flow. Management’s priorities are to support the dividend, reduce debt/pension liabilities, slowly ramp up capital spending to the level of depreciation, and repurchase shares to offset dilution (which clearly highlights the effect of share-based compensation). If it continues to generate vast cash flow after its current usage priorities are completed, Dow will have many options, but there has been little commentary about the company’s long-term strategic direction. We will dig further into this in future updates.

Dow shares rose 4% this past week and have about 8% upside to our recently raised 70 price target. The shares trade at 13.3x estimated 2022 earnings of $4.90, although these earnings are more than a year away. This estimate was unchanged in the past week.

The high 4.3% dividend yield is particularly appealing for income-oriented investors. Dow currently is more than covering its dividend and management makes a convincing case that it will be sustained. HOLD.

DOW-20210504

Merck (MRK) – Pharmaceutical maker Merck focuses on oncology, vaccines, antibiotics and animal health. The shares sell at a significant discount to its peers, as Keytruda, a blockbuster oncology treatment representing about a third of total revenues, will face generic competition in late 2028. Also, hanging over the stock is possible generic competition for its Januvia diabetes treatment starting in 2022, and the possibility of government price controls.

Keytruda remains an impressive franchise that is growing at a 20+% annual rate. The company is becoming more aggressive about replacing the potentially lost revenues, even though it has nearly seven years to accomplish this. The new CEO, previously the CFO, will likely accelerate Merck’s acquisitive program, which adds both risk and return potential to the Merck story.

To tighten its focus, Merck will spin off its Women’s Health, biosimilars and various legacy branded operations, to be named Organon, by mid-year 2021. These businesses currently generate roughly 15% of Merck’s total revenues yet comprise half of its product roster. We estimate that Organon is worth about $3.75 per MRK share. The spin-off will produce a $9 billion cash inflow to Merck. Longer term, we see the company spinning out or selling its animal health business. Merck has a solid balance sheet and is highly profitable. Merck’s earnings for 2021 and 2022 are estimated to increase by about 10%. Longer term, the low valuation, strong balance sheet and sturdy cash flows provide real value. The 3.4% dividend yield pays investors to wait.

Merck reported first quarter adjusted earnings of $1.40/share, about 7% lower than a year ago and nearly 14% below the consensus estimate of $1.62. Revenues were unchanged from a year ago but about 4% below the consensus estimate. Management provided full-year guidance that was unchanged other than to slightly reduce the currency tailwind, in effect fractionally raising underlying profit expectations.

Management attributed the weak-ish sales to pandemic-related delays in doctor visits (this sounds reasonable, and reflected foregone sales of 5%) and to loss-of-exclusivity effects in some of its smaller treatments.

Sales of Keytruda (about a third of total sales) grew 19%, while Januvia (#2 product at about 10% of total sales) grew 1%. Gardasil fell 16%, attributed to changes in buying patterns in the U.S. and the timing of shipments to China (which dragged down product sales by an estimated 25%). Sales for the Animal Health segment grew 17%. Earnings were mostly affected by lower revenues and a modest narrowing of the gross margin.

Overall, the revenue and earnings misses seem mostly due to temporary issues while the longer-term outlook for replacing Keytruda’s revenues remains positive. With a new CEO transiting in, the company reiterated its commitment to the dividend but provided no meaningful color on capital allocation. No balance sheet or cash flow information was released.

At its May 3rd investor briefing on the upcoming June 2nd spin-off of Organon, Merck said the business will produce 2021 revenues of around $6.25 billion that should grow in the low to mid single digits. The new company will have about $9.5 billion in debt, of which $9 billion of the proceeds will be distributed to Merck. We anticipate having a more detailed review next week.

Merck shares fell 2% this past week, masking a 5% sell-off, then recovery, on the earnings news. The shares have about 39% upside to our 105 price target. Valuation is an attractive 11.7x this year’s estimated earnings of $6.46 (down about 1% in the past week). Merck produces generous free cash flow to fund its current dividend as well as likely future dividend increases, although its shift to a more acquisition-driven strategy will slow the pace of increases. BUY.

MRK-20210504

Tyson Foods (TSN) is one of the world’s largest food companies, with nearly $43 billion in revenue. Beef products generate about 36% of total revenues, while chicken (31%), pork (10%), and prepared/other contribute the remaining revenues. It has the #1 domestic position in beef and chicken with roughly 21% market share in each. Its well-known brands include Tyson, Jimmy Dean, Hillshire Farms, Ball Park, Wright and Aidells. Tyson’s long-term growth strategy is to participate in the growing global demand for protein. The company has more work to do to convince investors that its future is brighter, particularly as it is more of a commodity company (and hence has lower margins) compared to its food processor peers. Dean Banks, the new CEO, who previously was an Alphabet/Google executive, is starting to make necessary changes.

Tyson’s fiscal 2021 earnings (ends in September) are estimated to increase about 1% but accelerate to the 10% range in future years. Fiscal 2021 will be hindered by subdued volumes and pricing. The Prepared Foods segment will likely see higher profits, but this is a small segment for Tyson. Faster domestic and neighboring country (Mexico in particular) re-openings should help lift chicken and other meat prices and volumes.

The company will be marketing plant-based hamburgers and sausages in advance of the summer grilling season. A previous effort by Tyson, which blended beef and plants, was discontinued. Tyson is aiming for market share and wider adoption of plant-based meats in general, so it is pricing its burgers at $2/pound below Beyond Meat’s prices of about $10/pound (compared to perhaps $6/pound for organic, grass-fed beef generally). Our view is that once plant-based beef dips below traditional beef prices, its adoption rate will accelerate. For Tyson, this will likely remain an important but small experiment, but for Beyond Meat it is new and direct competition. For its part, Beyond Meat is launching a plant-based chicken product.

The stock rose 1% in the past week and has 6% upside to our recently raised 82 price target. While the near-term outlook is mixed, the new management is likely being conservative with its forward guidance. However, we reduced our rating to a HOLD given the relatively modest upside to our target. If the earnings report indicates that the company’s earning power is noticeably higher, we will re-evaluate our price target.

Valuation is reasonable at 13.3x estimated 2021 earnings of $5.84 (unchanged in the past week). Currently the stock offers a 2.3% dividend yield. HOLD.

TSN-20210504

U.S. Bancorp (USB), with a $70 billion market value, is the one of the largest banks in the country. It focuses is on consumer and commercial banking through its 2,730 branches in the Midwest, southwest and western United States. It also offers a range of wealth management and payments services. Unlike majors JP Morgan, Bank of America and Goldman Sachs, U.S. Bancorp has essentially no investment banking or trading operations.

We recently moved USB shares to a SELL. Fundamental improvements are likely to be steady but slow. The valuation is full, at 2.4x tangible book value and 12.8x earnings. The investment has produced a 26% total return since our recommendation at 46.15 on December 30, 2020.

We see low risk to USB shares, other than modest stock price risk. The bank is exceptionally well-managed, has an attractive payments, investment management and other services businesses, sturdy capital and a dividend yield (2.9%) that is modestly above-market. While our interest in USB as an undervalued stock has expired, readers may want to keep their shares as part of a diversified exposure to stocks generally.

Additional color on the earnings report: The bank reported 1st quarter earnings of $1.45/share, doubling its year-ago $0.72 earnings and 51% higher than the $0.96 consensus estimate. All of the increase in profits (actually, more than all) was driven by the huge improvement in credit conditions. A year ago, the bank raised its reserves by $993 million, while in the first quarter of 2021, it reduced its reserves by $827 million.

The rest of its business was lackluster. Profits from lending (net interest income, or the difference between what it earns on its lending compared to its funding expenses) fell 5% from a year ago. Part of this was due to fewer loans (-1%) while its net interest spread fell to 2.42% from 2.69%. Like nearly all banks, U.S. Bank is gathering a lot of deposits (+18%) but can’t reinvest those deposits in loans and must settle for investing them in Treasuries or other low-yielding securities. Its customers are flush with cash and have little need for even more.

Putting hard numbers on the problem: Deposits increased by $19 billion but loans fell by $4 billion. Nearly all of the surplus $23 billion was investing in near-zero-return investment securities. Hardly a way to create long-term profits.

Operating expenses rose while fee income fell compared to a year ago. This adverse position may reverse depending on some obscure accounting for mortgage servicing rights, but the outlook is uninspiring. Expenses remain well under control, but we see little chance for meaningful improvements given the bank’s already-impressive efficiency as well as its ongoing need for tech-related spending.

Credit quality is very high: loan chargeoffs were a tiny 0.31% while delinquencies fell. Reserves remain very strong at 2.4% of loans and 6.2x non-performing loans. Capital strength is healthy at a 9.9% CET1 capital ratio (a highly-complex regulatory measure of the simple concept of capital as a percent of assets). SELL.

USB-20210504

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 Added5/4/21Capital Gain/LossCurrent Dividend YieldPrice TargetRating
Arcos Dorados (ARCO)03-01-21563.6%7.5Buy
Aviva (AVVIY)03-02-2110116.0%5.3%14Buy
Barrick Gold (GOLD)03-16-2121225.8%1.6%27Buy
General Motors (GM)12-31-19375551.5%62Hold
JetBlue (JBLU)11-25-20161920.6%22Sell
Molson Coors (TAP)08-04-20375653.5%59Buy
Sensata Technologies (ST)02-16-215957-3.6%75Buy

Arcos Dorados (ARCO) – Spanish for “golden arches,” Arcos Dorados is the world’s largest independent McDonald’s franchisee, operating over 2,200 restaurants and holding exclusive rights in 20 Latin American and Caribbean countries. Based in stable Uruguay and listed on the NYSE, the company produces about 72% of its revenues in Brazil, Mexico, Argentina and Chile. Arcos’ leadership looks highly capable, led by the founder/chairman who owns a 38% stake.

The company’s shares remain well-below their year-end 2019 level as the pandemic has weighed on revenues, while the Venezuelan economic mess, political/social unrest, inflation and currency devaluations in other countries create profit headwinds and investor angst. However, the company’s fourth quarter 2020 revenues were back to 95% of pre-pandemic year-ago levels (ex-currency), supported by sharp increases in drive-thru and delivery sales. While profits were about 33% lower, they are showing healthy improvements, and consensus estimates point to a full profit recovery in two years. Debt is reasonable relative to post-recovery earnings, and the company is currently producing positive free cash flow, which buy it time until the recovery arrives.

McDonald’s Corporation reported strong earnings last week, but the read-through to Arcos Dorados is murky at best. Arcos fits into McDonald’s International Developmental Licensed segment, which includes nearly 15,000 system-wide restaurants. Other major regions in the segment include Asia and China. The segment produced comparable store sales growth of +6.4% in the first quarter – impressive, but Arcos runs only about 15% of segment stores so unless McDonald’s specifically highlights strength in Latin America (they didn’t), there isn’t much that investors can glean from the aggregate corporate McDonald’s information.

ARCO shares rose 4% this past week and have about 33% upside to our 7.50 price target. The stock trades at 19.4x estimated 2022 earnings per share of $0.29 (up about 11% from a week ago). BUY.

ARCO-20210504

Aviva, plc (AVVIY) – Based in London, England, Aviva is a major European insurance company specializing in life insurance, savings and investment management products. Its market cap is about $21 billion. Long a mediocre company, the frustrated board last July installed Amanda Blanc as the new CEO, with the task of fixing the business. She is aggressively re-focusing the company on its core geographic markets (UK, Ireland, Canada). Divestitures of its operations elsewhere, including across Asia and Europe, are nearly completed. The turnaround also includes improving Aviva’s product competitiveness, rebuilding its financial strength and trimming its bloated costs. The new leadership reduced the company’s recurring dividend, but to a more predictable and sustainable level, along with what is likely to be a modest but upward trajectory. Details on our thesis are described in the April 7 letter.

Aviva’s surplus cash flow, partly from divestitures, will be directed toward debt reduction and the recurring dividend. As it is over-capitalized, Aviva will pay out potentially sizeable special dividends to shareholders.

There was no significant company news in the past week.

Aviva shares were flat this past week and have about 26% upside to our 14 price target. The stock trades at 7.3x estimated 2021 earnings per ADS of $1.53 (up about 5% this past week) and about 90% of tangible book value. AVVIY shares offer an attractive and likely solid and recurring 5.2% dividend yield. BUY.

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Barrick Gold (GOLD) – Barrick is one of the world’s largest and highest quality producers of gold. Based in Toronto, Canada, the company has mining operations around the world, with about 50% of production in North America, 32% in Africa and the Middle East and 18% in Latin America and Asia Pacific. The company also has smaller copper mining operations. Barrick’s market capitalization is about $37 billion. This stock is out of favor (a classic contrarian trait) as investors have a dim view of the industry and as gold prices have weakened since mid-2020. See our note in the April 7 letter for more details on our thesis.

Our thesis is based on two points. First, that Barrick will continue to generate strong free cash flow at current gold prices, continue to improve its operating performance and return much of that free cash flow to investors while making minor but sensible acquisitions. The company will pay $0.42/share in special distributions this year, in addition to its regular $0.09/share quarterly dividend. The combined dividends this year will produce a 3.5% yield.

Second, Barrick shares offer optionality – if the enormous fiscal stimulus, rising taxes and heavy central bank bond-buying produces stagflation and low interest rates, then the price of gold will move upward and lift Barrick’s shares with it. Given their attractive valuation, the shares don’t need this second (optionality) point to work – it offers extra upside.

Major risks include the possibility of a decline in gold prices, production problems at its mines, making a major acquisition and/or an expropriation of one or more of its mines.

Barrick reports earnings on May 5th, with a consensus earnings estimate of $0.27/share.

Barrick shares rose 1% this past week and have about 24% upside to our 27 price target. The stock trades at a sizeable discount to our value estimate of 27, based on 7.5x estimated 2021 EBITDA and at a modest premium to its $25/share net asset value. Commodity gold was essentially unchanged at $1,776 this past week.

On its recurring $.09/quarter dividend, GOLD shares offer a reasonable 1.6% dividend yield. BUY.

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General Motors (GM) under CEO Mary Barra (since 2014) has transformed from a lumbering giant to a well-run and (almost) respected auto maker. The company has smartly exited many chronically unprofitable geographies (notably Europe) and trimmed its passenger car roster while boosting its North American market share with increasingly competitive vehicles, particularly light trucks. We consider its electric and autonomous vehicle efforts to be near industry-leading. We would say it is perhaps 75% of the way through its gas-powered vehicle turnaround and is well-positioned but in the very early stages of its EV development. GM’s balance sheet is sturdy, with Automotive segment cash exceeding Automotive debt. Its credit operations are well-capitalized but may yet be tested as the pandemic unfolds.

General Motors is estimated to produce about 13% higher revenues in 2021, but earnings are expected to increase only about 7% (to about $5.27) due to near-term headwinds from tight semiconductor chip supplies. GM Financial will likely continue to be a sizeable profit generator.

GM’s shares are likely to start trading on the prospects for President Biden’s $2 trillion infrastructure bill. Estimates point to as much as $100 billion in federal support for electric vehicles – GM would be a major beneficiary. If the bill isn’t passed, or is passed in a diluted format, GM shares could be vulnerable.

The chip shortage is spreading, and although GM has said its 2021 guidance factors in $2 billion in direct and indirect impacts, we have no way of knowing what conditions are included in this guidance.

GM reports earnings on Wednesday, May 5, with consensus estimates for $1.05/share in earnings. GM announced that it will build an electric vehicle plant in Mexico, and a recall of 69,000 Bolt EVs due to risks of battery fires.

GM shares fell 6% in the past week and have 12% upside to our 62 price target. We are on the border of selling this stock, given the risks, but for now are keeping the Hold rating. As noted above, GM reports on May 5. If the report is strong, reflecting strong volumes and pricing, the shares will likely surge. If the report is disappointing, the shares will slump, perhaps significantly. We have no way of predicting the quarter and are not in the business of relying on a binary outcome of an upcoming report. On any meaningful strength in the shares, we could move to a Sell.

On a P/E basis, the shares trade at 8.7x estimated calendar 2022 earnings of $6.37 (unchanged this past week). The P/E multiple is helpful, but not a precise measure of GM’s value, as it has numerous valuable assets that generate no earnings (like its Cruise unit, which is developing self-driving cars and produces a loss), its nascent battery operations, its Lyft stake and other businesses with a complex reporting structure, nor does it factor in GM’s high but unearning cash balance which offsets its interest-bearing debt. However, it is useful as a rule-of-thumb metric, and provides some indication of the direction of earnings estimates, and so we will continue its use here.

Our 62 price target is based on a more detailed analysis of GM’s various components and their underlying valuation. HOLD.

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JetBlue Airlines (JBLU) is a low-cost airlines company. Started in 1999, the company serves nearly 100 destinations in the United States, the Caribbean and Latin America. The company’s revenues of $8.1 billion in 2019 compared to about $45 billion for legacy carriers like United, American and Delta, and were about a third of Southwest Airlines ($22 billion). Its low fares and high customer service ratings have built strong brand loyalty, while low costs have helped JetBlue produce high margins. Its TrueBlue mileage awards program, which sells miles to credit card issuers, is a recurring source of profits.

We believe consumers (and eventually business travelers) are likely to return to flying. JetBlue has aggressively cut its cash outflow to endure through the downturn. Although its $4.4 billion debt is elevated, its $2.0 billion cash balance gives the airline plenty of time to recover. JBLU shares carry more risk than the typical CUSA stock.

We recently moved JBLU shares to a SELL, partly on valuation and partly as the fundamental outlook is less favorable. The shares had about 11% upside to our (perhaps “stretch”) 22 price target, which originally was 20. Fundamentally, two new discount airlines are launching this year, raising the specter of new price wars and a collapse of pricing discipline. Fuel costs have risen this year along with oil prices, creating a profit margin headwind for 20-25% of its cost structure. Given the risk/return trade-off, we no longer saw the shares as an attractive holding. The stock produced a 20% return since our November 25, 2020 recommendation at 15.82. SELL.

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Molson Coors Beverage Company (TAP) – The thesis for this company is straight-forward – a reasonably stable company whose shares sell at an overly-discounted price. One of the world’s largest beverage companies, Molson Coors produces the highly recognized Coors, Molson, Miller and Blue Moon brands as well as numerous local, craft and specialty beers. About two-thirds of its $10 billion in net revenues are produced in the United States, where it holds a 24% share of the beer market.

Investors’ primary worry about Molson Coors is its lack of meaningful (or any) revenue growth as it produces relatively few of the fast-growing hard seltzers and other trendier beverages. Our view is that the company’s revenues are resilient, it produces generous cash flow and is reducing its debt, traits that are value-accretive and underpriced by the market. A new CEO is helping improve its operating efficiency and expand carefully into more growthier products.

Molson is estimated to produce about 5% revenue growth and a 2% decline in per share earnings in 2021. Profit growth is projected to increase to a 5-8% rate in future years. Weakness this year is closely related to the sluggish re-opening of the European economies, along with higher commodity and marketing costs. The company will likely re-instate its dividend later this year, which could provide a 2.5% yield.

Most or perhaps all of the 27 countries in the European Union may allow travel from the U.S. this summer. A re-opening would likely boost the prospects for higher beverage consumption by travelers and locals alike. It seemed like just a week ago several countries were re-locking-down their economies. Such is the fluidity of the pandemic.

On April 29, Molson Coors reported encouraging first quarter results and the shares jumped on the news. Revenues of $1.9 billion fell 10% from a year ago but were about 2% above estimates. Adjusted earnings per share of $0.01 compared to a $0.35 profit a year ago but compared favorably to the $(0.11) consensus estimate. Underlying (adjusted) EBITDA of $280 million fell 21% from a year ago. The company maintained its full year guidance, including for operating margins of between 7-10%, against more dour investor expectations.

Comparisons to a year ago are complicated due to the numerous revenue and operational effects of the pandemic. However, Molson produced reasonable results despite some notable headwinds, including a full shut-down of all U.K. pubs, the Texas winter storm which closed a brewery for 11 days, and an unspecified cybersecurity problem (now fixed) that disrupted its operations. North American sales fell 6% but European sales fell 35% - reflecting a hole that should be filled in future quarters.

The company’s core brands gained market share and achieved 2% higher pricing. Non-beer/hard seltzer products appear to be selling well, and the company has a fairly aggressive new product introduction cadence that sounds encouraging.

Cash flow was a sizeable negative, at a $271 million outflow, but this appears mostly due to the timing of deliveries and payments. Total and net debt were largely unchanged.

TAP shares rose 8% in the past week and have about 5% upside to our 59 price target. The shares trade at 14.6x estimated 2021 earnings of $3.83 (up three cents this past week).

On an EV/EBITDA basis, or enterprise value/cash operating profits, the shares trade for about 9.6x current year estimates, among the lowest valuations in the consumer staples group and below other brewing companies.

As the shares are approaching our price target and have largely fully-recovered from the pandemic, we are evaluating the position. Molson Coors is a stable company trading at a low valuation and has contrarian appeal. However, the upside from here is less clear but still may be plenty interesting. BUY.

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Sensata Technologies (ST) is a $3 billion (revenues) producer of an exceptionally broad range (47,000 unique products) of sensors used by automotive, industrial, heavy vehicle and aerospace customers. These products are typically critical components, yet since they represent a tiny percentage of the end-products’ total cost, they generally can yield high profit margins. Also, they tend to have relatively high switching costs – vehicle makers are reluctant to switch to another supplier that may have lower prices but lower or unproven quality. Sensata is showing healthy revenue growth (+7% in the fourth quarter), produces strong profits and free cash flow, has a reasonably sturdy balance sheet (debt/EBITDA of about 3.5x) and a solid management team. The company was founded in 1916, owned by Texas Instruments for decades, and returned to public ownership in 2010.

Sensata’s growth prospects look appealing. The company is leveraged to the automobile cycle (about 60% of revenues), which provides cyclical growth, plus added growth as Sensata usually grows faster than the industry. It should benefit from overall economic growth as it serves heavy/off-road (trucking and construction), industrial and aerospace customers. As vehicles become more electrified, Sensata’s products will be used for more applications, further driving revenues. Recently, Sensata acquired Lithium Balance, which provides it with a valuable entre into the electric vehicle battery industry.

Risks include a possible automotive cycle slowdown, chip supply issues, geopolitical issues with China and difficulty integrating its acquisitions.

Revenues this year are projected to increase by about 24%, driven by a cyclical rebound, then taper to a 6% rate in future years. Profit growth of 54% in 2021, also boosted by the recovery, is estimated to taper to about 10-20% in future years.

Sensata reported strong first quarter results. Adjusted earnings were $0.86/share, about 62% above year-ago results and 18% above consensus estimates. Revenues of $943 million were a record high, about 22% above year-ago revenues, and about 6% above consensus estimates. The company raised its guidance for full-year 2021 adjusted per-share earnings to between $3.20 and $3.50, which suggests an increase (at the $3.35 midpoint) from current estimates of $3.29.

Revenues were boosted by higher demand from auto and heavy off-road producers – these segments generate about 75% of the company’s total revenues. Sensata outgrew their markets by over 9 percentage points, helped by favorable changes in China’s emission regulations. Adjusted EBITDA of $228 million rose 39% from a year ago, with the margin expanding to 24.2% from 21.2% a year ago. The 37.6% incremental margin suggests that there is more upside as revenues climb, although input cost and other supply chain issues will likely cap total margins at well below 37.6%.

Net debt was unchanged from the prior quarter as the company used surplus cash for acquisitions and capital spending.

Sensata announced a joint venture with Churod Electronics – while this isn’t a needle-mover it does add incrementally to the opportunity in China. On its conference call, Sensata also highlighted its opportunity in EV charging stations. The company remains well-positioned for the transition to electric cars, even as it is performing today in the strong gas-powered economy.

The company will participate in JPMorgan’s Tech, Media and Communications conference on May 24th, at 9:30am EDT. This is one of the top institutional investor conferences in the industry. You can watch their webcast presentation and Q&A at the Sensata website.

ST shares fell 4% this past week. The shares can twitch with the prices of other chip stocks, and weakness in the auto industry outlook can also weigh on the shares. ST shares have about 34% upside to our 75 price target.

The stock trades at 13.9x estimated 2022 earnings of $4.04 (up about 5% this past week, reflecting the strong earnings report). On an EV/EBITDA basis, ST trades at 12.5x estimated 2022 EBITDA. BUY.

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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.
Retired – This stock has been removed from the portfolio, primarily for being fully valued. We generally view the company as fundamentally solid with few problems. Investors may choose to hold these shares to minimize portfolio turnover, seek to capture continued upward share price momentum, or other reasons.
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.


The next Cabot Undervalued Stocks Advisor issue will be published on June 3, 2021.

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