The Market’s Dampened Mood
In the Boston area, we’ve had nearly 8 inches of rain so far this month. This 0.7 inches-per-day average compares to the 0.6 inches-per-day average for a monsoon rainforest, the type found in the tropics along the equator.
Sounds a lot like the dampened mood of the stock market. Compared to the crisp 19% return for the average stock in the first half of the year, the 1% return so far this month seems soggy. Part of the reason is that there are too many mixed macro signals – rising inflation but falling bond yields, murkiness over whether the Biden administration’s large spending proposals will be passed, surging Covid cases despite what appeared to be the end of the pandemic, incredibly strong economic and profit growth which may be rolling over. Investors also are stuck in the mud of pre-earnings season, wondering whether high expectations will be exceeded or merely matched and worried that companies missing their estimates will be harshly punished.
A few rays of sunshine are reaching mega-cap tech stocks, as well as traditional IPOs and new SPAC issues. Investors have warmed to meme stocks again even as cryptocurrencies have lost some luster. (For a great look into the meme mindset, watch Matt Kohrs on YouTube). But these groups are outside the interest of value-oriented fundamental investors, and their current appeal recalls a great quote from Warren Buffett, “be greedy when others are fearful, and fearful when others are greedy.” The market’s mood may be water-logged, but it is also greedy. For value investors, it’s a time to wait for bargains to appear.
Performance for the average Cabot Undervalued Stocks Advisory recommended name matched the broad market. We’d attribute nearly all of the price movement to noise, as like last week there was little company-specific news. Our focus isn’t usually on weekly performance – we’d rather focus on fundamentals and valuation. With second quarter earnings season starting this week, we’ll get more color on the fundamentals of our companies, allowing us to weigh their valuations and overall attractiveness.
Share prices in the table reflect Tuesday (July 13) closing prices. Please note that prices in the discussion below are based on mid-day July 13 prices.
Note to new subscribers: You can find additional color on our thesis, 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.
UPCOMING EARNINGS RELEASES
July 21: Coca-Cola (KO)
July 22: Dow (DOW)
July 27: Sensata (ST)
July 28: Bristol-Myers Squibb (BMY)
July 29: MolsonCoors Beverage Company (TAP)
July 29: Merck (MRK)
Aug 4: General Motors (GM)
TODAY’S PORTFOLIO CHANGES
None
LAST WEEK’S PORTFOLIO CHANGES
None
GROWTH/INCOME PORTFOLIO
Bristol Myers Squibb Company (BMY) has been divesting 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 by continuing to develop its robust pipeline of new treatments while also acquiring new treatments (notably with its acquisitions of Celgene and MyoKardia). It is also defending its existing profit base by signing agreements with several generics competitors to forestall their competitive entry. The worst-case scenario is likely flat revenues over the next 3-5 years. Any indication that revenues could sustainably grow should boost BMY’s share price considerably. Helping mitigate 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 $149 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.
The Biden administration is directing government agencies to work with states and tribes to import prescription drugs from Canada, to increase support for generic and biosimilars, and to issue a comprehensive plan to combat high prices and price gouging in prescription drugs. While these are not new concerns, and it is unclear what effect the directives will ultimately produce, they are a reminder of government pressure on drug companies like Bristol to keep prices restrained – unlike years ago when pricing pressure was more market-based.
BMY shares rose 1% 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 (down a cent from last week). On 2022 estimated earnings of $8.06 (unchanged), the shares trade at 8.4x. 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.
There was no significant company-specific news in the past week.
CSCO shares rose 1% in the past week and have about 3% 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 16.6x 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 15.6x. On an EV/EBITDA basis on FY2021 estimates, the shares trade at a discounted 11.6x 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. A tax dispute 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’s balance sheet is sturdy, and its growth investing, debt service and dividend are well-covered by free cash flow.
In its second quarter earnings report, competitor PepsiCo, maker of Pepsi Cola and Frito-Lay snacks, said that it is seeing strong demand for its soda products and will be raising prices later this year. This bodes well for Coca-Cola, which reports earnings on July 21 before the market opens. Also, perhaps countering a snub from soccer star Ronaldo, Coca-Cola scored a bit of a win when Leonardo Bonucci, star defender on the Italian team that won the prestigious Euro Cup this past Sunday, very publicly swigged Coke during the post-game press conference.
KO shares rose 2% in the past week and have about 16% upside to our 64 price target.
While the valuation is not statistically cheap, at 25.3x estimated 2021 earnings of $2.18 (unchanged in the past week) and 23.4x 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: 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. A strong U.S. dollar may be a modest headwind as it makes revenues produced in other currencies less valuable.
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.
There was no significant company-specific news in the past week.
Dow shares rose 1% this past week and have 25% upside to our recently increased 78 price target.
The shares trade at 11.5 estimated 2022 earnings of $5.42 (up 10 cents this past week). The estimate for 2021 earnings rose about 3% going into earnings season – an encouraging sign although the boost makes an earnings “beat” incrementally more difficult. Analysts are somewhat pessimistic about 2022 earnings (they assume a 21% decline from 2021). 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 4.5% dividend yield adds to the shares’ appeal. HOLD
Merck (MRK) – Shares of pharmaceutical maker Merck sell at a significant discount, as Keytruda, a blockbuster oncology treatment representing about 30% of total revenues, will face generic competition in late 2028. Another overhang is possible generic competition for its Januvia diabetes treatment starting in 2022, and the possibility of government price controls. Merck spun off its Organon business in June. We see Merck divesting its animal health at some point over the next several years.
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.
Merck is highly profitable and has a solid balance sheet with $9 billion of fresh cash from its Organon dividend. The low valuation, strong balance sheet and sturdy cash flows provide real value. The attractive 3.4% dividend yield pays investors to wait.
There was no significant company-specific news in the past week, other than to note that the new Biden administration directives regarding drug pricing, as mentioned in our Bristol-Myers comments, also apply to Merck.
Merck shares fell 1% this past week and have about 28% upside to our 99 price target.
Valuation is an attractive 13.3x this year’s estimated earnings of $5.84 (down fractionally 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
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 2% in the past week and have about 17% upside to our 57 price target. The stock trades at about 18.7x estimated 2021 earnings of $2.61 (unchanged this past week) and offer an attractive 3.2% dividend yield. BUY
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 reopen. 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.
There was no significant company-specific news in the past week.
ARCO shares fell 3% this past week and have about 30% upside to our 7.50 price target.
The stock trades at 18.6x estimated 2022 earnings per share of $0.31 (unchanged from a week ago). While the 2021 estimate slipped a cent to $0.16, the 2023 estimate ticked up by 10% to $0.36. Arcos shares have been volatile, reflecting Latin America’s struggles with the pandemic as well as general economic uneasiness in Brazil and perhaps the rise of autocratic governments and economic instability in many Latin American countries. Investors were also likely disappointed in the stock dividend, preferring as we do a cash dividend. 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 has divested operations around the world to aggressively re-focusing the company on its core geographic markets (UK, 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.
There was no significant company-specific news in the past week.
Aviva shares slipped 3% this past week and have about 26% upside to our 14 price target. The stock trades at 7.3x estimated 2021 earnings per ADS of $1.52 (unchanged) and at about 94% of tangible book value. AVVIY shares offer an attractive and likely solid and recurring 5.2% 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.
The company said its giant Kigali mine is on-track to achieve its annual production guidance. Kigali contributes about 8% of Barrick’s annual production, so its health is a useful indicator of overall Barrick’s condition.
Barrick shares rose 1% this past week and have about 26% upside to our 27 price target. Sentiment on the company and gold prices appears to be bottoming out. The price target is based on 7.5x estimated 2021 EBITDA and a modest premium to its $25/share net asset value. Commodity gold rose about 1% to $1,812/ounce.
On its recurring $.09/quarter dividend, GOLD shares offer a reasonable 1.7% dividend yield. Barrick will pay an additional $0.42/share in special distributions this year, lifting the effective dividend yield to 3.6%. 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.
The shares perked up after brokerage firm Wedbush initiated coverage of GM with an “outperform” rating and an $85 price target. We’ve thankful for the support, but GM’s shares near-term will likely be driven by the company’s 2nd quarter earnings results, guidance for the third quarter and full-year, and its commentary on EVs and other initiatives. While the earnings outlook continues to show sizeable improvements, GM shares have gone nowhere since early January and it would seem that expectations are high going into the August 4th report.
GM shares rose 2% this past week and have 18% upside to our recently raised 69 price target.
On a P/E basis, the shares trade at 8.4x estimated calendar 2022 earnings of $6.96 (up about one percent this past week). The 2021 estimate rose about 3%. 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 is that the company has little or no 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. The company will likely re-instate its dividend later this year, which could provide a 2.7% yield.
There was no significant company-specific news in the past week.
TAP shares rose 1% in the past week and have about 32% upside to our 69 price target. The shares trade at 13.5x estimated 2021 earnings of $3.89 (unchanged this past week). Estimates for 2022 were unchanged.
On an EV/EBITDA basis, or enterprise value/cash operating profits, the shares trade for about 9.2x current year estimates, still among the lowest valuations in the consumer staples group and below other brewing companies. BUY
Organon & Company (OGN) is a mid-sized ($6.3 billion revenues) pharmaceutical producer that was recently spun off from Merck. About 80% of its sales come from outside of the United States. Organon is a member of the S&P 500.
The company has three segments. Established Brands (68% of revenues) is a collection of nearly 50 mostly off-patent cardiovascular, respiratory and other therapies. Women’s Health (23%) includes contraceptives and fertility products. The Biosimilars segment (9%) includes five approved treatments for autoimmune, arthritis and other diseases through a joint venture with Samsung Bioepis. Biosimilars are FDA-approved alternatives to patented biological drugs, which, unlike chemical pharmaceuticals, are created from living cells.
The market sees years of 3-4% revenue decay, or worse, as Organon is facing patent expirations in the Established Brands and the 2025-2027 patent expiration for its Nexplanon women’s health product (11% of total sales), as well as pricing pressure in China from government buying programs.
We have a more optimistic view. The marquee Nexplanon product is a highly valuable franchise, with solid 10% growth potential for years, a strong chance for an extension on its patent, a complex production process that can’t easily be replicated, and a likely hesitancy by women to select a discount alternative for the under-the-skin implant.
Organon’s fertility treatments are well positioned to grow, particularly in China, and the solid Biosimilars portfolio has double-digit growth potential.
Revenue risk in the Established Brands is somewhat limited, as only $250 million in revenues (6% of total company revenues) face patent expiration over the next four years, and its Chinese revenues appear to have already taken the step-down from the Volume Based Procurement (VBP) program. Nearly 40% of the company’s China revenues are produced through the retail channel, which is growing quickly and isn’t as vulnerable to VBP pressures.
Strategically, the company will likely make smart yet modest-sized acquisitions to expand its Women’s Health business, as this is its primary focus, and perhaps divest its Established Brands segment. The management and board appear capable, Organon produces robust free cash flow that is more than adequate to trim its modestly elevated debt, pay a reasonable dividend and support its acquisition program.
Like all turnarounds, OGN shares carry risk, but the shares’ discounted valuation and likelihood for fundamental improvement provide an attractive investment.
There was no significant company-specific news in the past week.
OGN shares slipped 5% in the past week and have about 56% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). Until the company reports earnings or other major news, the shares will bounce around on essentially nothing but conjecture and seemingly random funds flows as portfolio managers adjust their positions.
The shares trade at 4.8x estimated 2021 earnings of $6.12 and 4.9x estimated 2022 earnings of $6.08. These are remarkably low valuations. Estimates are starting to converge around these numbers, but still may be volatile. Notably, analysts are pessimistic about 2022 earnings, as they project a 1% year/year decline.
On an EV/EBITDA basis, or enterprise value/cash operating profits, the shares trade for about 7.2x 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. Nearly two-thirds of its revenues are generated outside of the United States, with China producing about 21%. Sensata has a sturdy balance sheet (arguably under-leveraged) and generates healthy free cash flow.
Reflecting its Tier One supplier roots, automakers provide about 60% of total revenues. Its innovations have helped increase its content per vehicle. 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.
Once a threat, electric vehicles are now an opportunity, as the company’s expanded product offering (largely acquired) allows it to sell more content into an EV than it can into an internal combustion engine vehicle.
Strong cyclically driven revenue and profit growth this year will taper to more sustainable rates next year. The semiconductor shortage has modestly weighed on 2021 results. 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 over-paying/weak integration related to its acquisitions.
There was no significant company-specific news in the past week.
ST shares were flat this past week and have about 30% upside to our 75 price target.
The stock trades at 14.2x estimated 2022 earnings of $4.06 (up two cents this past week). On an EV/EBITDA basis, ST trades at 11.0x 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.
