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

Investors are facing two forecasts that wouldn’t seem to be possible at the same time: pending recession and stable/rising earnings estimates. We look at how our cyclical stocks have been beaten down even as their earnings estimates remain largely steady.

It has been a quiet month for new recommendations and ratings changes as we patiently wait for great opportunities.

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.

Thanks!

Cabot Undervalued Stocks Advisor Issue: July 6, 2022

DOWNLOAD ISSUE PDF

Can There Really Be Two Elvises?
In the old joke about two people showing up to a convention, each saying that they are the reincarnated Elvis Presley, at least one of them must be wrong.

The same can be said about two seemingly opposite economic conditions: the current macro-economic consensus that the U.S. is headed into (or already in) a recession, and the rock-steady consensus estimates for full-year corporate earnings. One of them must be wrong, yes.

After crashing the shares of unprofitable companies and those with hyper-growth expectations (often the same thing) due to tighter financial conditions, investors are now punishing shares of economically sensitive companies due to recession worries.

The economic slowdown worries are somewhat legitimate. Most interesting in this regard is the newly dour update of the GDPNow forecast from the Atlanta Federal Reserve Bank. As the Bank describes, this measure is a “running estimate of real GDP growth based on available economic data for the current measured quarter. There are no subjective adjustments made to GDPNow—the estimate is based solely on the mathematical results of the model.” The concerns: that the most recent second-quarter forecast is for a 2.1% decline in GDP, and that this pace has deteriorated sharply from a positive +0.7% forecast as of June 28. Most of the slide is driven by slowing “final sales” which includes consumption, business capital spending and housing. If this estimate is anywhere near accurate, the U.S. would be in a recession now, and the abrupt decline would portend poorly for future quarters.

Yet, on the other hand, the consensus estimate for second-quarter earnings for S&P 500 companies has hardly budged. The current consensus is for +4.1% earnings growth, only slightly weaker than the +5.9% estimate at the end of March. And, estimates for the full-year 2022 have actually increased, as have estimates for full-year 2023.

Can both a slipping economy and rising earnings estimates happen at the same time? It would seem that only one of these can be right, and possibly both will be wrong … we could get flat economic growth and flat earnings growth.

Let’s look at our Recommended List for some additional color. Many of our companies are economically sensitive – and as such have seen their shares hit hard. Since the end of May, the worst performers include Dow (-26%), Big Lots (-15%), Sensata Technologies (-18%) and Arcos Dorados (-18%). Our best performers have been non-cyclicals, like The Coca-Cola Company (-1%), Merck (-1%) and Molson Coors (-2%).

Yet, by looking just at the changes in earnings estimates, it’s nearly impossible to detect any of the economic worries. Over the same one-month-plus-a-week period, full-year 2022 earnings estimates for Dow and Sensata have slipped only fractionally (-0.2% and -0.8%, respectively). Estimates for Big Lots have increased 15%, but that was mostly a rebound following its dour warnings after the quarter. Estimates for Arcos Dorados have surged 23% following its impressive outlook. Full-year 2022 estimates for the rest of the recommended companies have hardly budged.

Earnings reports will soon flood the market. Results for the second quarter will clearly be interesting (how did revenues and profits hold up) but the most intriguing will be managements’ comments on what they see for the third quarter and beyond. Is it possible that companies can continue to produce healthy earnings growth, or will estimates be coming down, perhaps meaningfully?

The tension between macro and micro is creating a nail-biter of a July. But we’ll have to wait to find out. Like the tabloids say about the two Elvises and now about the economy and financial markets, “enquiring minds want to know.”

Separately, with higher interest rates, many of our price targets are likely too high. As earnings are reported, we will update these targets as necessary.

Share prices in the table reflect Tuesday (July 5) closing prices. Please note that prices in the discussion below are based on mid-day July 5 prices.

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

Send questions and comments to Bruce@CabotWealth.com.

Today’s Portfolio Changes
None.

Portfolio changes during the past month
None.
A

Growth & Income
Portfolio

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

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.

While Cisco shares’ round-tripping from our initial recommendation at 41.32 to 64 and back to 41 or so is frustrating, this is not the time to sell the stock. The fundamentals remain reasonably stable and likely to tick back upward, and profits seem likely to improve as well. The shares will likely come back to life as earnings reports show favorable growth and profit trends, so investors will need some patience. If we have a recession in global tech spending, Cisco would likely feel the downturn but not as severely as other technology companies due to the mission-critical nature of its products and services.

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

The valuation is attractive at 8.6x EV/EBITDA and 12.3x earnings, the shares pay a sustainable 3.7% dividend yield, the balance sheet is very strong, and Cisco holds a key role in the basic plumbing of technology systems even if its growth rate is only modest. We are keeping our Buy rating.

CSCO shares slipped 4% in the past week and have 60% upside to our 66 price target. BUY

The Coca-Cola Company (KO) is best-known for its iconic soft drinks yet nearly 40% of its revenues come from non-soda beverages across the non-alcoholic spectrum. Its global distribution system reaches nearly every human on the planet. Coca-Cola’s longer-term picture looks bright, but the shares remain undervalued due to concerns over the pandemic, the secular trend away from sugary sodas, and a tax dispute which could cost as much as $12 billion (likely worst-case scenario). The relatively new CEO James Quincey (2017) is reinvigorating the company by narrowing its oversized brand portfolio, boosting its innovation and improving its efficiency, as well as improving its health and environmental image. Coca-Cola’s balance sheet is sturdy, and its growth investing, debt service and dividend are well-covered by free cash flow.

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

KO shares rose 1% in the past week and have 10% upside to our 69 price target. Coca-Cola’s fundamentals remain sturdy with respectable revenue, profit and free cash flow growth. Management continues to focus on execution in its core business while generally avoiding any major non-core commitments. HOLD

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

Industry conditions are healthy, but investor worries about a global recession are pressuring Dow’s shares. The primary concern: slowing demand could weigh on pricing – which is the primary driver of Dow’s exceptionally strong earnings. Tight supplies and high energy inputs have driven up the prices that Dow’s products command, but as demand weakens, pricing could slip. Fortunately, global prices are being propped up by Europe’s very high local natural gas prices (due to falling imports from Russia).

Dow’s volumes would decline, but this is a lesser concern as volumes tend to change moderately even in slowdowns. And, Dow’s volumes are supported by its status as one of the world’s lowest-cost producers, helped by relatively cheap domestic natural gas prices.

Dow took great advantage of its recent high-profit period to improve its balance sheet and upgrade its operations. Even in a slowdown, we see the company sustaining its dividends, backed by what will likely be still-sizeable free cash flow.

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

Dow shares slipped 5% in the past week as investors continue to worry about the outlook for the U.S. and global economy. However, estimates for 2022 and 2023 earnings ticked fractionally higher this past week. We will get considerably more color on the post-earnings conference call.

The shares have 56% upside to our 78 price target and offer an attractive 5.6% dividend yield. BUY

Merck (MRK) shares are undervalued as investors worry about Keytruda, a blockbuster oncology treatment (about 30% of revenues) which faces generic competition in late 2028. Also, its Januvia diabetes treatment may see generic competition next year, and like all pharmaceuticals it is at-risk from possible government price controls. Yet, Keytruda is an impressive franchise that is growing at a 20% rate and will produce solid cash flow for nearly seven more years, providing the company with considerable time to replace the potential revenue loss. Merck’s new CEO, previously the CFO, is accelerating Merck’s acquisition program, which adds return potential and risks to the story. The company is highly profitable and has a solid balance sheet. It spun off its Organon business in June 2021 and we think it will divest its animal health segment sometime in the next five years.

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

Merck shares fell 1% in the past week, coming a bit off their recent all-time high of 95.72. The shares have about 8% upside to our 99 price target. The company has a strong commitment to its dividend (3.0% yield) which it backs up with generous free cash flow, although its shift to a more acquisition-driven strategy will slow the pace of dividend increases. While the shares have pulled back, we are retaining our Hold rating as rising interest rates reduce the upside potential value of its shares. HOLD

Buy Low Opportunities
Portfolio

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

Current price is yesterday’s mid-day price.

Allison Transmission Holdings, Inc. (ALSN) – Allison Transmission is a midcap ($6.4 billion market cap) manufacturer of vehicle transmissions. Many investors view this company as a low-margin producer of car and light truck transmissions that is destined for obscurity in an electric vehicle world. However, Allison produces no car and light truck transmissions, instead it focuses on the school bus and Class 6-8 heavy-duty truck categories, where it holds an 80% market share. Its 35% EBITDA margin is sharply higher than its competitors and on-par with many specialty manufacturers. And, it is a leading producer and innovator in electric axles which all electric trucks will require. Another indicator of its advanced capabilities: Allison was selected to help design the U.S. Army’s next-generation electric-powered vehicle. The company generates considerable free cash flow and has a low-debt balance sheet. Its capable leadership team keeps its shareholders in mind, as the company has reduced its share count by 38% in the past five years.

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

Allison shares fell 4% in the past week and have 30% upside to our 48 price target. The stock pays an attractive and sustainable 2.3% dividend yield to help compensate for the wait. BUY

Arcos Dorados (ARCO), which is Spanish for “golden arches,” is the world’s largest independent McDonald’s franchisee. Based in stable Uruguay and listed on the NYSE, the company produces about 72% of its revenues in Brazil, Mexico, Argentina and Chile. The shares are depressed as investors worry about the pandemic, as well as political/social unrest, inflation and currency devaluations. However, the company has a solid brand and high recurring demand and is well-positioned to benefit as local economies reopen. The leadership looks highly capable, led by the founder/chairman who owns a 38% stake, and has the experience to successfully navigate the complex local conditions. Debt is reasonable relative to post-recovery earnings, and the company is currently producing positive free cash flow.

Macro issues, including issues in Brazil related to its economic conditions (in particular, inflation, running at a 11.3% rate), currency and the chances that a socialist might win this year’s Brazilian presidential elections, will continue to move ARCO shares.

The black-market price of Argentine pesos plummeted recently as that country’s new economic minister is associated with far-left economic policies. Arcos Dorados has a sizeable presence in the country. The Brazilian real has reversed its appreciation against the U.S. dollar, sliding about 12% since late May. Much of Arco’s profits are generated in the Brazilian currency but are converted to U.S. dollars, so a weakening local currency reduces the value of Arcos in U.S. dollars.

ARCO shares fell 7% in the past week and have 33% upside to our 8.50 price target. BUY

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

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

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

Aviva’s earnings estimates for 2022 slipped 2.5% this past week due entirely to recent depreciation of the British pound against the U.S. dollar. The pound has fallen 15% in the past year.

Aviva shares fell 7% in the past week and have about 42% upside to our 14 price target. Based on management’s estimated dividend for 2023 (which we believe is highly credible), the shares produce a generous 8.4% yield. Based on this year’s actual dividend, the shares offer an attractive 5.7% dividend yield. BUY

Note: Due to a recent symbol change from AVVIY to AVVID, some quote and chart providers are reflecting inaccurate price history and symbols for these ADRs.

Barrick Gold (GOLD), based in Toronto, is one of the world’s largest and highest-quality gold mining companies. About 50% of its production comes from North America, with the balance from Africa/Middle East (32%) and Latin America/Asia Pacific (18%). Barrick will continue to improve its operating performance (led by its new and highly capable CEO), generate strong free cash flow at current gold prices, and return much of that free cash flow to investors while making minor but sensible acquisitions. Also, Barrick shares offer optionality – if the unusual economic and fiscal conditions drive up the price of gold, Barrick’s shares will rise with it. Given their attractive valuation, the shares don’t need this second (optionality) point to work – it offers extra upside. Barrick’s balance sheet has nearly zero debt net of cash. Major risks include the possibility of a decline in gold prices, production problems at its mines, a major acquisition and/or an expropriation of one or more of its mines.

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

Over the past week, commodity gold fell 3% to $1,766/ounce. The 10-year Treasury yield tumbled to 2.80% as investors worried about a recession. The yield decline may indicate that investors are less worried about inflation if economic growth turns negative, or perhaps indicates that the market believes the Fed will lose its resolve to fight inflation if the economy slows too much. The next CPI release is July 13^th, pre-market.

The U.S. Dollar Index, another driver of gold prices (the dollar and gold usually move in opposite directions), surged by over 2% to 106.68.

Barrick shares fell 7% in the past week and have about 57% upside to our 27 price target. The price target is based on 7.5x estimated steady-state EBITDA and a modest premium to our estimate of $25/share of net asset value. 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 bullish case for Big Lots rests with its loyal and growing base of 22 million rewards members, its appeal to bargain-seeking customers, the relatively stable (albeit low) 5.5% cash operating profit margin, its positive free cash flow, debt-free balance sheet and low share valuation at 3.1x EV/EBITDA and 7.3x per-share earnings based on conservative January 2023 estimates.

Our thesis was deeply rattled by the company’s dismal first-quarter results. Offloading its bloated inventory will require sharp discounts, which will weigh on profits while the $271 million in new borrowing ramps up the risk. We are retaining our HOLD rating for now: investor expectations are sufficiently depressed to provide some downside cushion, while management should be able to extract itself from the worst of the inventory problem over the next few quarters. Nevertheless, the Big Lots investment is now high-risk due to the new debt balance, the lost value from the inventory glut and the potential for a dividend cut.

With major retailers like Target and Walmart struggling with excess inventory, companies like Big Lots are well-positioned to purchase worthwhile merchandise at huge discounts. This is both an opportunity and a risk for Big Lots – a chance to draw in customers who then drive high-profit sales for the company, yet it would also stretch Big Lots’ balance sheet even further with the risk that the merchandise doesn’t move.

Big Lots shares fell 7% in the past week. The shares have 69% upside to our recently reduced 35 price target. We would consider the dividend to be unsustainable and caution that investors should not count on any dividends from Big Lots. 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.

Citi is apparently in talks to sell its consumer and commercial banking operations in Russia to local buyers, following an announcement last year that it was exiting the consumer segment.

The spread between the 90-day T-bill and the 10-year Treasury note, which approximates the drivers behind Citi’s net interest margin, narrowed by 41 basis points to 1.07%. There are 100 basis points in one percent. Most of the narrowing was caused by the sharp decline in the 10-year yield on recession concerns. When commentators discuss the “flat yield curve,” they are referring to the current situation where yields on maturities of two years and longer are all essentially the same at around 2.8% or so.

A recession would increase Citi’s credit losses, a flatter yield curve would weigh on its net interest margin and weaker capital markets would mean fewer investment banking revenues.

Citi shares fell 3% over the past week. The shares have about 86% upside to our 85 price target. Citigroup investors enjoy a 4.5% dividend yield and perhaps another 3% or more in annual accretion from the bank’s share repurchase program once it reaches its new target capital ratio and if a slowing/stalling economy doesn’t meaningfully increase its credit costs. BUY

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.

Constellation Brands, owner of a variety of popular beer and other alcoholic beverage brands, recently reported strong revenues and earnings as both volumes and pricing were surprisingly strong. Unless Constellation is taking share from Molson, Molson is likely to report an encouraging quarter.

TAP shares slipped 2% in the past week and have about 26% 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 9.2x estimated 2022 results, still among the lowest valuations in the consumer staples group and below other brewing companies. The 2.8% dividend yield only adds to the appeal. BUY

Organon & Company (OGN) was recently spun off from Merck. It specializes in patented women’s healthcare products and biosimilars, and also has a portfolio of mostly off-patent treatments. Organon will produce better internal growth with some boost through smart yet modest-sized acquisitions. It may eventually divest its Established Brands segment. The management and board appear capable, the company produces robust free cash flow, has modestly elevated debt and will pay a reasonable dividend. Investors have ignored the company, but we believe that Organon will produce at least stable and large free cash flows with a reasonable potential for growth. At our initial recommendation, the stock traded at a highly attractive 4x earnings.

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

OGN shares fell 3% in the past week and have about 37% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). The shares continue to trade at a remarkably low valuation while offering an attractive 3.3% dividend yield. BUY

Sensata Technologies (ST) is a $3.8 billion (revenues) producer of nearly 47,000 highly engineered sensors used by automotive (60% of revenues), heavy vehicle, industrial and aerospace customers. About two-thirds of its revenues are generated outside of the United States, with China producing about 21%. Investors undervalue Sensata’s durable franchise. Its sensors are typically critical components that generally produce high profit margins. As the sensors’ reliability is vital to safely 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.

Sensata said it completed the sale of its Qinex semiconductor thermal test and control business for $219 million.

ST shares fell 8% in the past week and have about 91% upside to our 75 price target. Our price target looks optimistic in light of the broad market selloff, but we will keep it for now, even as it may take longer for the shares to reach it. BUY

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

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

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

The next Cabot Undervalued Stocks Advisor issue will be published on August 3, 2022.

About the Analyst

Bruce Kaser

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

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