Inflation is Here … Now What?
We’ve seen signs of it everywhere. Retail prices for homes, apartments, food, gasoline, cars and everyday services are higher than they were a year or two ago and are going higher. Upstream from these consumer-facing prices, input prices for raw materials, semiconductors, crops, wages, energy and transportation are going up. Inflation is no longer around the corner – it is here.
From an investment perspective, it’s not clear that the market fully anticipates the knock-on effect that broad inflation will have on share prices. Earlier this year, investors focused only on the favorable tailwinds from rising revenues and surging demand, as consumers “emerge to splurge” following a year of pandemic-driven spending restraint.
Once inflation reaches the official government statistics, the Fed will have a more difficult time avoiding questions about when or whether it will raise its short-term interest rates or slow its pandemic-driven $120 billion/month bond-buying program. If inflation reaches the 3-4% rate for a sustained period, investors will want to anticipate that 10-year Treasury rates could reach 2-3% or more. The inflation-indexed TIPS bonds currently anticipate 2.5% inflation.
A likely short-term effect of rising interest rates is lower share prices. We’ve already seen a sharp burndown in many high-momentum, high-valuation tech and speculative stocks. If the economy continues to surge with minimal let-up in demand or inflation, investors may want to prepare for interest rate headwinds to hit value-oriented stocks, as well, which have acted like momentum stocks since late last year.
Rising interest rates aren’t likely to derail the recovery. Pent-up demand and government stimulus are too strong, at least for the next six to nine months.
Thinking further down the road, we’re asking ourselves: how high will inflation get before it crests? How long until it crests? Will it peak and then fade to a 1-2% rate when consumers taper their spending to normal rates, as government stimulus programs expire and as industrial capacity expands to meet the higher demand? Or, will 3-5% inflation become a permanent feature of the landscape, much as it has in other periods throughout history? If inflation eventually stalls while economic growth remains positive, without any financial accidents, what might that environment look like?
We don’t pretend to have any insight into these, but just asking the questions helps us avoid being caught completely off guard. Our inclination is to “fade the sugar high,” that is, we assume that it won’t last, but that is based more on our skeptical instinct and our understanding of history than any factual evidence. Never a dull moment in this very fascinating investing year, so far.
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 www.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 change 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 also 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 11) closing prices. Please note that prices in the discussion below are based on mid-day May 11 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 on the Cabot website.
Included with each stock discussion below are summaries of each thesis and any recent earnings reports. For more lengthy commentaries on these, please refer to the issue that correspond to our “New Buy” rating or the issue immediately following the earnings release.
Send questions and comments to Bruce@CabotWealth.com.
UPCOMING EARNINGS RELEASES
May 12: Arcos Dorados (ARCO)
May 19: Cisco (CSCO)
May 27: Aviva plc (AVVIY)
TODAY’S PORTFOLIO CHANGES
None
LAST WEEK’S PORTFOLIO CHANGES
None
GROWTH/INCOME PORTFOLIO
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. 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. Bristol has a robust pipeline of internally-developed treatments that offer potentially sizeable new revenues. Additionally, its acquisitions of Celgene and MyoKardia, and potentially future acquisitions, provide new growth potential that complements Bristol’s research expertise. And, Bristol has signed agreements with several generics competitors, reflecting the strong underlying demand for its “key three” products, such that the primary issue is pricing, not volumes.
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. Helping mitigating the risk, the company is aggressively cutting its costs, including a $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.
The first quarter 2021 earnings report delivered mixed news, so investors will need to remain patient. Revenue growth was a positive 3%, and likely would have been faster but for Covid’s impact on buying patterns. Combined sales of the top three treatments (Revlimid, increased 1%; Eliquis, rose 9%; Opdivo, fell 3%) rose 3% from a year ago. Revenues fell below consensus estimates, incrementally fueling investor skepticism regarding Bristol’s new treatment pipeline.
Earnings rose 1% but fell 4% below the consensus. 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 was below the $7.48 consensus estimate. Bristol paid down its net debt balance by about 4% in the quarter even as it repurchased $1.8 billion of shares.
There was no meaningful company-significant news in the past week.
BMY shares rose 1% in the past week and have about 21% upside to our 78 price target. The shares have mostly rebounded from their post-earnings pull-back. We remain patient with BMY shares.
The stock trades at a low 8.7x estimated 2021 earnings of $7.46 (unchanged from last week). On 2022 estimated earnings of $8.05 (up 1 cent), the shares trade at 8.0x. 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 3.0% dividend yield that is well-covered by enormous free cash flow make a compelling story. STRONG BUY.
Cisco Systems (CSCO) produces technology equipment (72% of revenues) that connects and manages data and communications networks, and also sells application software, security software and related services. As customers gradually migrate to cloud computing, Cisco’s equipment, and thus its one-stop-shop capabilities, are slowly becoming less valuable, leading to stagnant revenue growth and weak stock performance. To help restore growth, 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. 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.
There was no meaningful company-significant news in the past week.
CSCO shares rose 3% in the past week and have about 5% upside to our 55 price target. While we generally would move the shares to a Hold, we believe Cisco’s earnings potential is higher than currently estimated, which leaves additional potential upside.
The shares trade at 16.2x 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 15.2x. On an EV/EBITDA basis on FY2021 estimates, the shares trade at a discounted 11.5x multiple. CSCO shares offer a 2.8% dividend yield. We continue to like Cisco. BUY.
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 and the secular trend away from sugary sodas, its 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.
Coca-Cola’s first quarter results were encouraging, as the company’s revenues have nearly fully recovered from the pandemic. Still, investors will need to remain patient as on-premise sales remain subdued with consumers only slowly resuming their out-of-house entertainment activities. Revenues grew 6% on an organic basis, which removes the effects of currency changes and acquisitions/ divestitures although they were flattered by a calendar quirk which added five days to the quarter. Adjusted earnings of $0.55/share rose up 8% from a year ago. Free cash flow production improved sharply to $1.4 billion, up from $0.2 billion a year ago. 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.
The company’s efficiency programs are working, as underlying operating margins expanded by 30 basis points (100 basis points = 1 percentage point). 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).
There was no meaningful company-significant news in the past week.
KO shares were flat in 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.
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 25%, 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. Generous free cash flow will partly be used to trim Dow’s debt.
First quarter results were strong, with adjusted earnings more than double the year-ago results and about 18% above the consensus of $1.15. Revenues rose 22% 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%. Second quarter guidance was ahead of estimates and appears conservative. Dow’s balance sheet remains sturdy.
Two key questions for the Dow story: how much better can fundamentals get, and what will the company do with its vast free cash flow. Our view on the first is that conditions can get incrementally better over the next few quarters before capacity increases across the industry signal a cyclical peak. On the second, management’s cash flow priorities are to support the dividend, reduce its debt/pension liabilities, slowly ramp up capital spending, and repurchase shares. Current free cash flow readily supports all of these initiatives, so as long as the cycle remains robust investors can assume that debt paydown and share repurchases will continue. We are assuming no dividend increases, given the cyclicality of Dow’s business. We will continue our research into the company’s strategic use of its surplus cash.
There was no meaningful company-significant news in the past week.
Dow shares rose 3% this past week and have about 3% upside to our recently raised 70 price target. The shares trade at 13.7x estimated 2022 earnings of $4.97 (up just over 1% this past week). While Dow’s stock has minimum upside to our current price target, the estimates have continued to increase, which affords some flexibility. For now, we will hold onto Dow shares. The high 4.1% dividend yield adds to the shares’ appeal. HOLD.
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 30% 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.
Merck will spin off its Organon business in early June. 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 3.3% dividend yield pays investors to wait.
Merck’s first quarter earnings were lower than the market’s expectations, but our thesis remains unchanged. 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. Sales for the Animal Health segment grew 17%. Merck’s earnings were weakened by the lower revenue and a modest narrowing of the gross margin. Net debt was essentially unchanged from year-end.
With a new CEO transitioning in, the company reiterated its commitment to the dividend but provided no meaningful color on capital allocation. Management provided full-year guidance that was unchanged other than a slight reduction of the currency tailwind, in effect fractionally raising underlying profit expectations.
Merck’s spin-off of its women’s health, biosimilars and various legacy branded operations, named Organon, will begin trading on June 3, with when-issued trading beginning this Friday, May 14. We’re working through the investor day materials to evaluate the company’s value and the merits of either selling the new OGN shares or keeping them. We think the spin-off is a positive for Merck, as it trades away slow-growth operations for a $9 billion cash inflow.
Merck shares rose 3% this past week and have fully recovered from their post-earnings drop. The shares have about 35% upside to our 105 price target. Valuation is an attractive 12.1x this year’s estimated earnings of $6.46 (unchanged 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.
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 and Ball Park. 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 reported modestly discouraging fiscal second quarter results. Revenues of $11.3 billion were 4% above a year ago and in-line with consensus estimates, while adjusted earnings per share of $1.34 rose 68% from a year ago and was 16% higher than consensus estimates. However, the optically pleasing results were artificially boosted by hedging gains, leaving clean profits somewhat uninspiring.
Pricing was strong across all segments and averaged +7.5% overall. The outlook for its beef and pork segments is reasonably healthy. However, the chicken segment is struggling with industry-wide and self-inflicted issues that the new chief operating officer is working to fix. Also, input costs including feedstock, labor and packaging are rising, creating additional headwinds in most segments. The balance sheet has only incrementally improved since year end.
TSN trades just below our price target, we are reviewing these Hold-rated shares. The stock rose 1% in the past week and has 4% 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.
Valuation is reasonable at 13.1x estimated 2021 earnings of $5.98 (up just over 2% in the past week). Currently the stock offers a 2.3% dividend yield. HOLD.
BUY LOW OPPORTUNITIES PORTFOLIO
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 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.
The company reports earnings on May 12th, with a consensus earnings estimate for a $(0.01) loss.
ARCO shares rose 13% this past week and have about 17% upside to our 7.50 price target. The stock trades at 22.0x estimated 2022 earnings per share of $0.29 (unchanged from a week ago). BUY.
Aviva, plc (AVVIY) – Based in London, England, Aviva is a major European insurance company specializing in life insurance, savings and investment management products. 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.
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 meaningful company-significant news in the past week.
Aviva shares rose 3% this past week and have about 23% upside to our 14 price target. The stock trades at 7.4x estimated 2021 earnings per ADS of $1.53 (unchanged this past week) and about 92% of tangible book value. AVVIY shares offer an attractive and likely solid and recurring 5.1% dividend yield. BUY.
Barrick Gold (GOLD) – Toronto-based Barrick is one of the world’s largest and highest quality gold mining companies. About 50% of its production comes from North America, with 32% from Africa/Middle East and 18% from Latin America/Asia Pacific. Our thesis is based on two points. First, that Barrick will continue to improve its operating performance (led by its new and highly capable CEO), continue to 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. 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, a major acquisition and/or an expropriation of one or more of its mines.
Barrick reported encouraging first quarter results. Revenues rose 9% from a year ago, helped by higher gold prices (averaging $1,777, up 12% from a year ago) and 90% higher copper revenues, partly offset by a 10% decline in gold volumes. Adjusted EBITDA rose 23%, as costs generally were subdued. Adjusted earnings per share were sharply higher than year-ago results. The company’s mines had strong operating results, overall free cash flow was strong, Barrick remains on track to meet its full-year production guidance, and the balance sheet net cash position improved to $500 million.
Barrick announced the first $250 million ($0.14/share) extra dividend, to be paid on June 15th, with the remaining two $250 million extra dividends to be paid later this year. If gold prices remain healthy and the company can refrain from making major acquisitions (no guarantees, although the chairman and CEO both have historically been disciplined stewards of capital), then Barrick could be poised to continue to make sizeable cash distributions to shareholders.
Barrick shares rose 8% this past week and have about 13% 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 rose about 3% to $1,837 this past week.
On its recurring $.09/quarter dividend, GOLD shares offer a reasonable 1.5% dividend yield. Barrick will pay an additional $0.42/share in special distributions this year, lifting the effective dividend yield to 3.3%. BUY.
General Motors (GM) – GM is making immense progress with its years-long turnaround from a poorly-managed post-bankruptcy car maker to a highly profitable gas and electric vehicle producer. We would say it is perhaps 85% of the way through its gas-powered vehicle turnaround, and is well-positioned but in the early stages of its EV development. GM Financial will likely continue to be a sizeable profit generator.
GM’s shares are at least partly trading on the prospects for President Biden’s $2 trillion infrastructure bill, which include as much as $100 billion in federal support for electric vehicles.
First quarter results were strong. Automotive segment revenue of $29.1 billion was unchanged from a year ago, while adjusted net income of $2.25/share compared to $0.62/share a year ago when the company aggressively adjusted its operations and credit reserves for the then-accelerating pandemic. Compared to the $1.05/share consensus estimate, results were sharply higher.
GM also reaffirmed its guidance for full-year EBIT of $10-11 billion (“seeing results coming in at the higher end of this range”). Guidance for EBIT of $5.5 billion for the first six months of 2021 implies a sharply weaker second quarter following the $4.4 billion first quarter EBIT. With all the concerns over the semiconductor shortage, the first quarter earnings and the forward guidance were encouragingly robust.
Automotive profits were driven mostly by higher pricing: GM redirected its resources toward higher-margin and higher-demand vehicles to adjust to component shortage. While volumes were subdued, GM sold more higher-margin vehicles and gave fewer discounts. Higher prices were only partly offset by rising input costs. GM lost market share as retail inventory is tight (likely boosting 2Q sales and pricing) and as low-margin fleet sales were only 17% of sales compared to almost 28% a year ago. Automotive cash flow was $(1.1) billion, as a huge $4.7 billion inventory build consumed cash, partly driven by rising numbers of mostly-produced vehicles that are waiting on semiconductors.
GM International was break-even for the second consecutive quarter after years of losses. The China operation was decently profitable. GM Financial remains highly profitable, buoyed by charge-offs at only a 0.8% rate and retail delinquencies at a modest 1.9%. GM Financial’s results remain impressive at $1.2 billion in operating profits helped by low credit losses and higher used vehicle prices (boosting their proceeds when they offload cars coming off-lease). GM’s Automotive balance sheet remains sturdy, with cash of $19 billion fully offsetting automotive debt of $18 billion.
The company outlined their goal of “#1 EV market share in North America,” with “margins similar to or higher than ICE (internal combustion engines)” and selling 1 million+ EVs globally by 2025. These are simple and clear goals that indicate GM’s ambition as well as assuage investors’ worries about the profitability of EVs.
One frustrating aspect of GM is its vast capital spending. We appreciate the need for the heavy investment in EVs – this is a driver of GM’s future and is much-responsible for the surge in GM’s share price. However, the $9-10 billion in 2021 capital spending will consume all but $1-2 billion of the company’s cash flow this year and a good bulk of it next year (assuming that the auto cycle doesn’t fade and the company doesn’t make any major acquisitions or new investments). We recognize that GM said that the chip shortage will cost it $1.5-2.5 billion of free cash flow this year (implying FCF of $3-4 billion if no shortage, but this ignores the price-enhancing benefit of a car shortage that is produced by the chip shortage).
Low free cash flow places more pressure on the valuation of its emerging EV operations which are impressive but remain speculative. Helping support the valuation are recent investments in Cruise from Walmart, Honda, Microsoft and GM totaling $2.7 billion at a $30+ billion valuation.
GM is running on all cylinders, or rather, has fully-charged batteries in preparation for the future while maintaining solid profitability in its core gas-powered vehicle and credit businesses. We are balancing the impressive future prospects with today’s booming consumer economy and a likely post-boom slowdown, along with a generous but not over-zealous valuation.
GM shares were flat this 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. On any meaningful strength in the shares, we could move to a Sell.
On a P/E basis, the shares trade at 8.4x estimated calendar 2022 earnings of $6.60 (up about 4% this past week following the earnings report). 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.
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 2.4% yield.
Molson Coors’ first quarter results were encouraging, as revenues and profits showed respectable resilience. Revenues fell 10% from a year ago but were about 2% above estimates. Adjusted earnings per share of $0.01 was much better than 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. Molson produced reasonable results despite some notable headwinds, including closure of U.K. pubs, the Texas winter storms and a cyber-security problem. Its 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. Total and net debt were largely unchanged.
There was no meaningful company-significant news in the past week.
TAP shares rose 3% in the past week and have about 1% upside to our 59 price target. The shares trade at 15.1x estimated 2021 earnings of $3.86 (up three cents this past week).
On an EV/EBITDA basis, or enterprise value/cash operating profits, the shares trade for about 9.8x current-year estimates, still among the lowest valuations in the consumer staples group and below other brewing companies.
As the shares are essentially at 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 with contrarian appeal. However, the upside from here is less clear but still may be plenty interesting. BUY.
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, produces strong profits and free cash flow, has a reasonably sturdy balance sheet 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 trucking, 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, with adjusted earnings about 62% above year-ago results and 18% above consensus estimates. Revenues 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 its markets by over 9 percentage points. The 37.6% incremental EBITDA 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.
There was no meaningful company-significant news in the past week.
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 1% 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 32% upside to our 75 price target.
The stock trades at 14.0x estimated 2022 earnings of $4.04 (unchanged this past week). On an EV/EBITDA basis, ST trades at 12.5x estimated 2022 EBITDA. 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.
