November 30, 2022

Consequences

Last week, we wrote that The Game – the college football game between archrivals Ohio State and Michigan – didn’t really matter in the midst of a world anxious about war, civil violence, inflation, intense political disagreements, a dangerous bear market and a wide range of other serious problems. That the game was a chance for everyone to toss aside the big issues and focus on an event with no worldly consequences.

As it turned out, the game was so lopsided (much more than the 45-23 score implied) that fans were either elated (Michigan fans), incensed (Ohio State fans) or bored (everyone else). As a Buckeye fan, I probably should have turned the game off after the first quarter. But, Michigan played exceptionally well and reflected the previously hidden talents of head coach Jim Harbaugh. The game was immensely consequential for Harbaugh and Ohio State head coach Ryan Day – Harbaugh has been redeemed and Day is one Michigan loss away from being without a job.

Another event with consequences is the earnings report for recommended name Big Lots (BIG), scheduled for pre-market release on December 1. The company is struggling with an immense glut of inventory that will likely be sold down at excessive discounts. Just how large is this glut? Analysts are estimating that Big Lots will post a loss of $(3.00)/share, which compares to losses of $(0.18) and $(0.16) in the third quarters of 2019 and 2018, respectively, with most of the deterioration attributable to expected losses on its inventory. For perspective, the $(3.00) loss is about 17% of the company’s market value. Consequential, indeed.

For the rest of our recommended companies, little of consequence happened this past week. Few had any meaningful news and share prices hardly budged.

Note on the Valuation and Earnings table:

We recently rolled our valuation and earnings estimate table forward by a year, dropping the 2022 estimates and adding the 2024 estimates. By this time of the year, stocks are starting to trade on estimated 2023 earnings, so our table now reflects these numbers.

Share prices in the table reflect Tuesday (November 29) closing prices. Please note that prices in the discussion below are based on mid-day November 29 prices.

Note to new subscribers: You can find additional color on our thesis, recent earnings reports and other news on recommended companies in prior editions of the Cabot Undervalued Stocks Advisor, particularly the monthly edition, on the Cabot website.

Send questions and comments to Bruce@CabotWealth.com.

Today’s Portfolio Changes
None

Last Week’s Portfolio Changes
None

Upcoming Earnings Reports
Big Lots (BIG) – Thursday, December 1

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 November 16, Cisco reported a reasonably solid quarter. Results were ahead of the consensus estimates, and guidance for the next quarter and the full fiscal year were incrementally above current estimates. Cisco continues to generate prodigious amounts of cash flow, at $4 billion in the first quarter, up 16% from a year ago and reaching nearly 28% of revenues. Just over half of this $4 billion was spent on dividends and share buybacks – uses we find to be savvy given the shares’ depressed valuation. Cash net of debt increased to $10.7 billion. Valuation remains unchallenging as investors underestimate Cisco’s resilience. Please see our weekly note following the report for more detailed commentary.

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

CSCO shares were flat for the week and have 37% upside to our 66 price target. The valuation is attractive at 9.4x EV/EBITDA and 13.6x earnings. The 3.1% 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, pay a generous dividend (recently raised 8%) and sizeable share buybacks.

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

Comcast shares rose 1% for the past week and have about 19% upside to our 42 price target. The shares offer an attractive 3.0% dividend yield. BUY

Dow Inc. (DOW) is the world’s largest producer of ethylene and 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). Recent concerns about a recession have sent Dow shares to well-below our estimate of their fair value, even as the company’s long-term prospects and ability to maintain its dividend are attractive. Dow shares are a recommended Buy in our sister publication the Cabot Turnaround Letter.

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

Dow shares fell 2% in the past week and have 18% upside to our 60 price target (same as in the Cabot Turnaround Letter). The quarterly dividend appears readily sustainable and provides an appealing 5.5% yield. The shares trade at a modest 6.4x EV/EBITDA multiple and 11.5x EPS on recession-minded 2023 estimates. BUY

State Street Corporation (STT) – State Street is the world’s largest custodian bank, with $38 trillion in assets under custody/administration. About 56% of its revenues are produced from custody, client reporting, electronic trading and full enterprise solutions services for investment managers. The balance is produced from investment management fees on ETFs, foreign exchange fees, securities financing fees and net interest income. The industry has combined into four dominant firms due to economies of scale. State Street’s shares are out of favor and unchanged since 2007 due to concerns over its anemic growth and steady pricing pressure from competitors. However, we see State Street as a solid, well-capitalized franchise that provides critical services, with a slow-growth but steady revenue and earnings stream. Our interest in STT shares is that we can buy them at an attractive valuation. We also find the dividend yield appealing.

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

State Street shares slipped 4% in the past week and have about 27% upside to our 94 price target. The company’s dividend (3.4% yield) is well-supported and backed by management’s strong commitment. BUY

Buy/Low 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.

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

The shares rose 1% in the past week and have 8% upside to our 48 price target. The stock pays a respectable and sustainable 1.9% dividend yield. 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. At our recommendation date, the shares were depressed as investors worried about the pandemic, political/social unrest, inflation and currency devaluations. However, the company has a solid brand, high recurring demand, impressive leadership (including founder/chairman who owns a 38% stake) and successful experience in navigating local conditions, along with a solid balance sheet and free cash flow.

Macro issues have a sizeable impact on the shares’ trading, including local inflation and the Brazilian currency. Since early 2020, the currency has generally stabilized in the 1.00 real = $0.20 range – a remarkably favorable trait given the sharp declines in other currencies around the world. As the company reports in U.S. dollars, any strength in the local currency would help ARCO shares.

On November 16, Arcos reported an impressive third quarter that reflects the abilities of its strong leadership and brand to navigate the post-pandemic period. Revenues rose sharply (+38% in constant currency) even with high inflation/currency erosion in Argentina that dragged reported revenues down to +17%. Revenues were about 3% above estimates. Adjusted earnings of $0.23/share nearly doubled from $0.12 a year ago and were nearly double the consensus estimate of $0.12/share. Adjusted EBITDA of $103 million rose 15% from a year ago and was 13% above estimates. In local currency, Adjusted EBITDA rose 27% but was weighed down by higher food, paper, royalty fees and overhead costs. Please see our weekly note following the report for more detailed commentary.

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

ARCO shares rose 1% this past week and have 16% upside to our 8.50 price target. 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.

On November 9, Aviva provided its third-quarter trading update, which included revenues, capital and dividends but not earnings. Overall, the company remains solidly capitalized, is producing strong operating performance and reiterated its dividend and buyback plans. Please see our weekly note following the report for more detailed commentary.

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

Based on management’s estimated dividend for 2023, the shares offer a generous 6.8% yield. Aviva shares were flat in the past week and have about 30% upside to our 14 price target. 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 November 3, Barrick reported a reasonable quarter, but the company’s profits and cash flows are being incrementally squeezed by modestly lower gold prices, modestly weaker production volumes and higher costs. The company’s financial and operating condition remains strong, but its underlying profitability is not as healthy as we had anticipated, even excluding the weaker gold price. We are staying with the Barrick position as it remains a well-managed company, is well-positioned to benefit from an eventual rebound in gold prices, has a solid balance sheet and pays a respectable base dividend that appears sustainable. Please see our weekly note following the report for more detailed commentary.

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

Over the past week, commodity gold was unchanged at $1,750/ounce. The 10-year Treasury yield ticked down to 3.73%. Investors are anticipating the “end-game” in which Treasuries peak at a roughly 5.0% yield to roughly match or slightly exceed the anticipated inflation rate in a year or so. If this scenario pans out, gold and equity prices in general should rise. Investing in gold-related equities is a long-term decision – investors shouldn’t allow near-term weakness to deter their resolve.

The U.S. Dollar Index, another driver of gold prices (the dollar and gold usually move in opposite directions), ticked down 1% to 106.63.

Barrick shares slipped 1% in the past week and have about 71% upside to our 27 price target. Our resolve with Barrick shares remains undaunted through the recent sell-off. 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 dismal first-quarter results although second-quarter results, while dismal, were better than the market’s dour consensus. The company needs to offload its still-bloated inventory at sharp discounts while also now loading the company with what is probably permanent debt.

Big Lots reports on Thursday, December 1, pre-market. Given the awful sentiment and equally awful inventory position, the shares could move 20% or more in either direction following the report, with the possibility of further gyrations during the day as investors respond to the company’s commentary on the conference call. There are several consensus earnings estimates floating around, but they all point to a loss of about $(3.00)/share.

Cabot’s options expert Jacob Mintz looked into Big Lots’ options prices. Currently, the options market is pricing in a move of 10.5% between Tuesday and expiration. Option activity has been relatively quiet in BIG headed into the announcement, although there has been buying interest on the December 20-strike call for $1. This is a set-up for a boom/bust trade: if the stock surges well above 20, the trade would be hugely successful, but it would likely be a complete loss if the stock is unchanged or goes down.

We are retaining our HOLD rating for now: investor expectations are sufficiently depressed to provide some downside cushion, while management should be able to extract itself from the worst of the inventory problem over the next few quarters. Nevertheless, the Big Lots investment is now high-risk due to the new debt balance, the lost value from the inventory glut and the likelihood of a suspension of the dividend.

Big Lots shares fell 3% this past week and have 88% upside to our 35 price target. The shares offer a 6.5% dividend yield, although, as noted, investors should not rely on this dividend being sustained.

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. 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.

One of the frontrunners for Citi’s Mexico retail operations, Grupo Financiero Inbursa, has dropped out of the bidding process. Other less-capable buyers remain, but Citi is likely to receive less-favorable terms than it had anticipated. Separately, Citi was faulted by regulators for an inadequate “living will” that would kick in should the bank file for bankruptcy (living wills are required for all major banks). We believe Citi can remedy this shortcoming. Citi’s turnaround is making progress, but these latest updates indicate that the progress is very slow.

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, widened to a negative 64 basis points (100 basis points in one percentage point), steepening the inversion of the yield curve over this horizon. This spread is essentially at its widest since at least the early 1980s. Our interpretation is that investors are assuming that the Fed rate hikes and other macro drivers will drag down inflation to sub-5% or so in a year.

Citi shares trade at 59% of tangible book value and 7.1x estimated 2023 earnings. The remarkably low valuations assume an unrealistically dim future for Citi.

Citi shares fell 3% in the past week and have about 78% upside to our 85 price target. Citigroup investors enjoy a 4.3% dividend yield. We anticipate that the bank is done with share buybacks until there is more clarity on the economic and capital market outlook, which could readily be a year or more away. 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 November 4, Gates reported a reasonable quarter but reduced its full-year guidance as currency and supply chain headwinds aren’t relenting as fast as the company had hoped. The company continues to improve its execution and trim its cost structure. Its future looks bright once Gates passes through the currently choppy macro environment. Debt remains modestly elevated, but this is not an issue given Gates’ management quality, business franchise and healthy-enough free cash flow. Please see our weekly note following the report for more detailed commentary.

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

At the current price and based on estimated 2022 results, the shares offer an 11% free cash flow yield (free cash flow divided by market cap). This is a sizeable discount to what the company is worth. GTES shares fell 3% in the past week and have about 23% upside to our 14 price target. BUY

Molson Coors Beverage Company (TAP) is one of the world’s largest beverage companies, producing the highly recognized Coors, Molson, Miller and Blue Moon brands as well as numerous local, craft and specialty beers. About two-thirds of its revenues come from the United States, where it holds a 24% market share. Investors worry about Molson Coors’ lack of revenue growth due to its relatively limited offerings of fast-growing hard seltzers and other trendier beverages. Our thesis for this company is straightforward – a reasonably stable company whose shares sell at an overly discounted price. Its revenues are resilient, it produces generous cash flow and is reducing its debt. A new CEO is helping improve its operating efficiency and expand carefully into more growthier products. The company recently reinstated its dividend.

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

TAP shares rose 1% in the past week and have about 25% 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 8.5x 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 November 3, the company reported a weak third quarter with flattish revenues but a narrower profit margin. While the results were ahead of estimates, it reflects a company that is seeing a slower erosion relative to expectations, but a company that is eroding nonetheless. Organon raised its EBITDA margin guidance for the full year, but its other guidance remained largely unchanged. Organon’s net debt remains unchanged from the spin-off date, and we are wondering why Organon’s financial team can’t manage to convert more profits into cash. Please see our weekly note following the report for more detailed commentary.

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

OGN shares fell 1% in the past week and have about 87% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). The shares offer an attractive 4.5% 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 fell 2% in the past week and have about 70% 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

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 subscribe

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

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

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

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