Thoughts on ‘How Much to Buy’
In most professional and personal endeavors, there are dozens if not hundreds of decisions to make. Manage a tech company? You need to decide who to hire/promote/fire, what responsibilities to give them, how much to pay them (base and bonus), resolve conflicting agendas, decide what products to promote, approve technical and strategic changes to each product or service, check quality control, help customers, set pricing … the list is essentially endless. Even a simple home landscaping project involves a long list of decisions: how much to spend, do it yourself or hire out, what to plant and where, and so on.
Active investors have only two decisions: Buy or Sell.
But this apparent simplicity belies a hidden decision, often an afterthought, which is arguably just as important as the buy/sell decision: how much to buy?1
Position size has a major impact on portfolio performance. If, for example, you hold a 0.25% position, its impact on your portfolio is negligible regardless of whether it doubles or goes to zero. Compare this to the effect of a 5% position: if this doubles it would get you halfway to a decent year for your entire portfolio, whereas if it goes to zero you would have a meaningful setback.
Active investors can choose from a vast array of strategies and approaches when sizing their positions. Investors might begin with one of the foundational strategies, then modify and evolve it over time to fit their particular style.
A basic foundational strategy is to weight each name the same when they are first purchased. The investor choosing this equal-weighting strategy can first decide either what per-stock weight seems to fit their risk tolerance and other considerations, or how many names they want to hold in total – which of course then implies the targeted equal-weighted size per name. Equal weighting is a common strategy in professionally managed private accounts – such an account may hold 80 stocks, so each position on average will have a 1.25% weight at purchase.
This simple approach has many merits – it is easy to implement and maintain, and provides a straightforward framework that requires no complicated math or murky opinions on which names are more attractive than others.
The first modification many investors make is to double-weight or triple-weight a few highly favored positions. In an 80-stock portfolio, this means some stocks get a 2.50% or 3.75% weighting. Offsetting this, other names must shrink in size: if four stocks on average have a 3% weight, the other 76 stocks drop to 1.16%, on average. A further step is to cut some names to restore the remaining stocks to 1.25% each. Removing six stocks would free up enough weight to do this.2 These modifications move the investor’s strategy in the right direction.
Mutual fund managers often use this approach, as well, but occasionally to an extreme. A typical mutual fund may hold 125 to 150 stocks, such that the average weight per stock is only 0.67% to 0.80%. But these sizes are way too small to be meaningful to performance. Even if a stock has a double or triple weight, perhaps up to 2.40%, the performance impact remains muted. And worse, it means that other holdings must have smaller weights, as tiny as 0.10% in some cases. If a professional manager’s highest conviction stock justifies only a 2.4% weight, and they hold stocks with a near-zero weight, their investors may want to re-think that manager’s justification for their high fees.
The individual investors we frequently talk with are comfortable with somewhere around 20-35 stocks in the active/risk-tolerant portfolios. Investors should determine how big this portfolio is within their total asset mix based on their own situation. This implies an average position size of between 2.9% and 5.0%.
In our next installment, we will look at additional position-sizing strategies.
Share prices in the table reflect Tuesday (June 15) closing prices. Please note that prices in the discussion below are based on mid-day June 15 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.
Send questions and comments to Bruce@CabotWealth.com.
Notes:
- One fascinating strategy would be to manage a portfolio comprised of only 25 randomly selected S&P 500 Index stocks. No names can be added or deleted, and each stock must be held with some minimum weight, perhaps 0.50%. In this strategy, the only variable would be weighting changes, not stock selection. A highly skilled investor might be able to readily outperform the index even under these constraints.
- The portfolio would have four stocks with 3% weight each (totaling 12% in combined weight) and 70 stocks at about 1.25% each (totaling 88% in combined weight).
TODAY’S PORTFOLIO CHANGES
None
LAST WEEK’S PORTFOLIO CHANGES
Organon (OGN) – New Buy (spin-off from MRK)
Dow (DOW) – Raising price target from 70 to 78
General Motors (GM) – Raising price target from 62 to 69
Molson Coors Beverage Company (TAP) – Raising price target from 59 to 69
Merck (MRK) – Reducing price target from 105 to 99
Tyson (TSN) – Moving from Hold to Sell
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 $144 billion market value. The balance sheet carries $13 billion in cash and its debt is only 2x EBITDA. The first-quarter 2021 report delivered mixed news, so investors will need to remain patient.
Bristol reported some success in a late-stage study that showed clinically meaningful benefits from its cancer treatment called Breyanzi. While we generally don’t mention most press releases from biopharma companies, as they usually have little standalone significance, BMY shares jumped on the Breyanzi news so we are including it here.
BMY shares rose 5% in the past week and have about 16% upside to our 78 price target. We remain patient with BMY shares.
The stock trades at a low 9.0x estimated 2021 earnings of $7.47 (unchanged from last week). On 2022 estimated earnings of $8.05 (unchanged), the shares trade at 8.3x. 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 2.9% 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 reported modestly encouraging fiscal third-quarter results. Fourth guidance was good enough but was slightly shy of consensus estimates. The numbers are moving in the right direction, but need to show more improvement, including reversing the slippage in profit margins, before the turnaround can be considered a success.
There was no significant company-specific news in the past week.
CSCO shares were flat in the past week and have about 2% 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 16.8x estimated FY2021 earnings of $3.21 (unchanged in the past week). On FY2022 earnings (which ends in July 2022) of $3.42 (unchanged), the shares trade at 15.7x. On an EV/EBITDA basis on FY2021 estimates, the shares trade at a discounted 11.8x multiple. CSCO shares offer a 2.7% 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, but investors will need to remain patient as on-premise sales remain subdued with consumers only slowly resuming their out-of-house activities.
Coca-Cola and other companies including Amazon, Apple and Nike, were mentioned in a recent Senate hearing as being complicit in Chinese forced labor. While we expect no direct immediate effect on any of these companies, the hearings are but one of many indicators of rising risks for companies that have significant operations or source raw materials or components from China (basically a large swath of publicly-traded American companies). While verbal skirmishes between the U.S. and China have been unofficial and mild, they are becoming more official and less mild, as seen in the recent G-7 statements. While outright hostilities would seem a long way away, they are not getting any further away.
KO shares slipped 1% in the past week and have about 16% upside to our 64 price target.
While the valuation is not statistically cheap, at 25.4x estimated 2021 earnings of $2.18 (unchanged in the past week) and 23.5x estimated 2022 earnings of $2.36 (unchanged), the shares remain undervalued given the company’s future earning power and valuable franchise. Also, the value of Coke’s partial ownership of a number of publicly traded companies (including Monster Beverage) is somewhat hidden on the balance sheet, yet is worth about $23 billion, or 9% of Coke’s market value. This $5/share value provides additional cushion supporting our 64 price target. KO shares offer an attractive 3.0% 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.
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. EBITDA rose 44%. 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: conditions are remarkably strong now, yet are likely to improve as domestic and global industrial and consumer goods production continues to rebound. This may last at least a few quarters, perhaps longer, before capacity increases across the industry signal a cyclical peak.
On the second, Dow is committed to the dividend and to debt and pension obligation reductions, with modest repurchase shares to cover dilution from stock options, while also keeping the constraints on its capital spending above its maintenance level.
Dow shares slipped 4% this past week and have 17% upside to our recently increased 78 price target.
The shares trade at 12.7x estimated 2022 earnings of $5.23 (up about 1% this past week). The estimate for 2021 earnings rose about 1%, as well. Analysts are somewhat pessimistic about 2022 earnings matching 2021 earnings (they assume a 20% decline). If the 2022 estimate continues to tick up, the shares will likely follow, although Dow’s cyclical earnings and investor fears of an eventual downcycle will ultimately limit Dow’s upside. The high 4.2% 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 acquisition program, which adds both risk and return potential to the Merck story.
The company spun-off its Organon business on June 2. Longer term, we see Merck spinning out or selling its animal health business. Merck is highly profitable and has a solid balance sheet with $9 billion of fresh cash from its Organon dividend. Longer term, the low valuation, strong balance sheet and sturdy cash flows provide real value. The 3.5% dividend yield pays investors to wait.
Post-spin-off, Merck’s revenues will decline by about $6.3 billion yet will have faster growth. Its profit margins will initially decline, but should fully recover, plus some, helped by the gradual elimination of redundant Organon stranded costs. We reduced our Merck price target by $6/share, from 105 to 99, to reflect the spin-off and to incorporate a slightly more conservative valuation multiple.
Merck signed a $1.2 billion deal to provide molnupiravir, an experimental treatment for patients with Covid, to the U.S. government. While modest compared to Merck’s $48 billion in revenues, it provides an incremental source of profits and opens the door, if slightly, toward another future product category to help offset the company’s patent expirations.
Merck shares rose 3% this past week. The shares have about 32% upside to our new 99 price target.
Valuation is an attractive 12.4x this year’s estimated earnings of $6.04 (down about 4% as analysts converge on post-spin-off estimates). 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
Otter Tail Corporation (OTTR) – Based in northwest Minnesota, this $2 billion market cap company is a rare combination of an electric utility and a manufacturing business. Otter Tail’s power operations have a solid and high-quality franchise, with a balanced mix of generation, transmission and distribution assets that produce about 75% of the parent company’s earnings. An accommodative regulatory environment is allowing the utility to continue to add capacity, although its projected rate base growth is likely to be incrementally slower than in prior years.
The manufacturing side includes four well-managed specialized metals and plastics companies. Here, stronger end-market growth should more than offset rising input prices.
Otter Tail’s sturdy balance sheet is investment grade, earnings and cash flow are growing and the company prides itself on steady dividend growth. The unusual utility/manufacturing structure might make the company a target for activists, as the two parts may be worth more separately, perhaps in the hands of larger, specialized companies.
There was no significant company-specific news in the past week.
OTTR shares rose 1% in the past week and have about 15% upside to our 57 price target. The stock trades at about 19.0x estimated 2021 earnings of $2.61 (unchanged this past week) and offer an attractive 3.1% dividend yield. BUY
Tyson Foods (TSN) is one of the world’s largest food companies, with nearly $43 billion in revenue. Last week, we moved TSN shares from Hold to Sell. The stock essentially reached our 82 price target. We see little justification in raising our price target, particularly given the revolving door leadership problem. The valuation is reasonable, but not interesting enough. The shares produced an 11% loss since our initial recommendation in December 2019, but have gained 32% since June 30, 2020, when I took over as chief analyst of this advisory. SELL
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. The company is well-managed and positioned to benefit as local economies re-open. 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.
Arcos reported a mixed quarter, with revenue rising 3.8% in constant currencies while 9.4% in constant currencies after some reasonable adjustments. Local results showed improvement, which is part of our thesis on Arcos. Brazil struggled due to rising Covid-related restrictions but these are being lifted in early May. Net debt remained essentially unchanged from year-end.
There was no significant company-specific news in the past week.
ARCO shares fell 3% this past week and have about 18% upside to our 7.50 price target. The stock trades at 21.2x estimated 2022 earnings per share of $0.30 (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 (U.K., Ireland, Canada). 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.
The company’s first-quarter trading update (sales and capital strength only, no profit update) was encouraging, yet more improvement is needed. Capital strength continues to improve, even as the company set aside funds for dividends and repaid some of its debt. With its ambitious global divestiture program now completed, Aviva can now fully concentrate on improving the performance of its remaining core businesses.
Aviva’s chief investment officer for equities is departing, and other key equity investment positions may be eliminated, under changes by the new head of investments.
Aviva shares slipped 1% this past week and have about 17% upside to our 14 price target. The stock trades at 7.8x estimated 2021 earnings per ADS of $1.52 (down a cent due to exchange rate changes) and at about 101% of tangible book value. AVVIY shares offer an attractive and likely solid and recurring 4.9% 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 with revenues rising 9% while adjusted EBITDA rose 23%. Barrick remains on-track to meet its full-year production guidance, and the balance sheet net cash position improved to $500 million.
There was no significant company-specific news in the past week.
Barrick shares slipped 1% this past week and have about 18% upside to our 27 price target. The price target is based on 7.5x estimated 2021 EBITDA and a modest premium to its $25/share net asset value. Commodity gold slipped fractionally to $1,862/ounce.
On its recurring $.09/quarter dividend, GOLD shares offer a reasonable 1.6% dividend yield. Barrick will pay an additional $0.42/share in special distributions this year, lifting the effective dividend yield to 3.4%. 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 is fully charged for both today’s environment and the EV world of the future, although much of its value is based on the unknown EV future.
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 despite concerns over the semiconductor shortage. Automotive revenues were unchanged but higher vehicle prices drove adjusted net income to $2.25/share, sharply higher than the $0.62/share a year ago and the $1.05/share consensus estimate. GM Financial remains highly profitable. GM’s Automotive balance sheet remains sturdy, with cash of $19 billion fully offsetting automotive debt of $18 billion. We are wary of GM’s vast capital spending although we recognize the merits of high EV investments.
The company announced that it will build additional electric vehicle battery factories in the United States. Also, would-be competitor Lordstown Motors appears to be collapsing.
GM shares fell 5% this past week and have 14% upside to our recently-raised 69 price target.
On a P/E basis, the shares trade at 9.0x estimated calendar 2022 earnings of $6.70 (up three cents this past week). The P/E multiple is helpful, but not a precise measure of GM’s value, as it has numerous valuable assets that generate no earnings (like its Cruise unit, which is developing self-driving cars and produces a loss), its nascent battery operations, and its 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. 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 1% decline in per share earnings in 2021. Profit growth is projected to increase to a 5-9% 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 and were better than consensus estimates despite headwinds from the pandemic, winter storms and a cybersecurity problem. Revenues fell 10% while underlying EBITDA fell 21%. The company maintained its full year guidance.
There was no significant company-specific news in the past week.
TAP shares fell 2% in the past week and have about 16% upside to our recently raised 69 price target. The shares trade at 15.3x estimated 2021 earnings of $3.90 (up a cent this past week). Estimates for 2022 were unchanged.
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. BUY
Organon & Company (OGN) is Merck’s spin-off of its women’s health, biosimilars and various legacy branded operations. The transaction was completed after the market closed on June 2. MRK holders received one OGN share for every 10 MRK shares held. The new company is now included in the S&P 500 Index.
Organon produces an array of established branded treatments (~68% of revenues), women’s health products (~23% of revenues) and biosimilars (a type of generic drug, at about ~9% of revenues). Revenues for 2021 should be about $6.6 billion. Revenue growth will be modest, at perhaps 3%, as the company’s products face patent-expiry erosion and generally are slow-growth. The marquee product is the Nexplanon contraceptive, which generates about 11% of sales – a valuable franchise but one that faces generic competition starting in 2028. Nearly 80% of Organon’s sales are produced outside of the U.S., offering some protection against faster patent-related erosion. A key component of its strategy is to accelerate its revenue growth. EBITDA profits will likely be about $2.3 billion (35% margin) this year.
The management seems capable but untested as leaders of a public company. Debt is elevated at almost 4x EBITDA. Organon will produce good free cash flow which it will use to pay down the debt, fund a reasonable dividend (at 20% of FCF, its annual dividend would be perhaps $1.60/share) and fund acquisitions. For reference, a $1.60 annual dividend on the current share price would provide a 5.2% yield.
While we are not particularly enthusiastic about Organon’s long-term prospects (“uninspiring but not dour”), the discounted price makes the shares appealing.
OGN shares rose 5% in the past week and have about 21% upside to our 37 price target. The shares trade at 5.0x estimated 2021 earnings of $6.13 (estimates are starting to converge around this number) and 4.9x estimated 2022 earnings of $6.17. These are remarkably low valuations. On an EV/EBITDA basis, or enterprise value/cash operating profits, the shares trade for about 6.3x current year estimates, also quite low. BUY
Sensata Technologies (ST) is a $3.8 billion (revenues) producer of an exceptionally broad range (47,000 unique products) of highly-engineered sensors used by automotive, heavy vehicle, industrial and aerospace customers. These products are typically critical components within cars, trucks, factories and jets, yet since they represent a tiny percentage of the end-products’ total cost, they generally yield high profit margins. Also, as their 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’s franchise provides it with a durable source of core revenues and profits.
Sensata is a truly global company. Nearly two-thirds of its revenues are generated outside of the United States, with China producing about 21%.
The company was founded in 1916, owned by Texas Instruments for decades, and returned to public ownership in 2010. Sensata’s foundation has long been as a Tier One supplier to automakers, which still provide about 60% of total revenues. Its innovations have helped increase its content per vehicle such that its automotive revenues are outgrowing the industry – in the most recent quarter by 9.1 percentage points. Sensata also benefits from rising secular demand for improved fuel efficiency, safety, emissions and customer conveniences like lane-keeping and other advanced driver-assist systems. As the light vehicle market is thriving, Sensata’s core business should ride along at a healthy clip. Its heavy vehicle/offroad segment (about 17% of sales) is also seeing strong growth, helped by the early stages of a cyclical rebound.
Since gaining its independence, Sensata has pursued new opportunities in adjacent markets. Called “megatrends” by the company, which include electric vehicles, autonomy and smart connected, these new markets offer considerable growth potential. Its Xirgo deal opens a new market in telematics and data insight for freight truck and cargo/container fleets. The Gigavac and Lithium Battery acquisitions build upon Sensata’s growing presence in the electric vehicle battery industry. Once a threat, electric vehicles are now an opportunity, as the company’s expanded product offering allows it to sell more content into an EV than it can into an internal combustion engine vehicle.
Revenues this year are projected to increase by about 24%, driven by a cyclical rebound, then taper to a 6% rate in future years. Despite the apparent strength, this year’s results are being constrained by the semiconductor shortage. Expected profit growth of 54% in 2021, also boosted by the recovery, is estimated to taper to about 10-20% in future years.
Sensata’s balance sheet is strong. Its $4 billion in debt is partly offset by nearly $2 billion in cash, with its net debt at only 2x EBITDA (a measure of cash operating earnings). This is arguably too conservative given the company’s franchise and wide 20%+ operating profit margin. Healthy free cash flow provides the company with considerable financial flexibility. Sensata’s relatively new CEO, Jeff Cote, who was promoted in March 2020, will likely devote some of its financial resources to additional acquisitions to continue to expand the company’s growth potential.
Risks include a possible automotive cycle slowdown, chip supply issues, geopolitical issues with China, currency and overpaying/weak integration related to its acquisitions.
ST is the featured stock in this week’s Cabot’s Stock of the Week issue. The article includes an expanded discussion of the stock, which is included above and replaces our previous text.
There was no significant company-specific news in the past week.
ST shares slipped 2% this past week and have about 27% upside to our 75 price target.
The stock trades at 14.7x estimated 2022 earnings of $4.04 (down 2 cents this past week). On an EV/EBITDA basis, ST trades at 12.7x 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.
