July 21, 2021

More Weather in the Stock Market
Last week, we wrote about how the damp Boston-area weather matched the soggy stock market. Pressing our literary luck today, the market is following another New England weather meme: “if you don’t like the weather, wait a few minutes.”

As I write this, the sky is mostly sunny and the temperature is in the mid-80s, exactly the opposite of the rainy mid-60s weather on Monday. Matching the change in the weather, stocks are reversing their dismal 1.6% decline on Monday with a 1.7% surge today. If you don’t like the stock market, wait a day.

In this market, it’s a trader’s nightmare. Sentiment shifts sharply on unpredictables that include the course of the pandemic, the political fate of various trillion-dollar federal spending proposals, the relevance of “peak earnings and economic growth,” the inflation outlook, and even whether China will invade Taiwan (the chairman of Taiwan Semiconductor made some blunt comments on this matter recently).

Even longer-term investors can be caught glancing at the exits. With valuations elevated across the board, it seems like an easy decision to unload some cyclical stocks. Reflecting this, the Dow Jones Industrial Average, which is cyclical-heavy, dipped 2.1% on Monday.

Fulfilling the adage that the capital markets work to inflict the most pain they can for as many traders as possible, Treasury yields have plummeted against all expectations for higher yields. In early trading today, the 10-year yield fell to as low as 1.14%. Worries about the 5.4% inflation report have been lost in the current worries about an impending economic slowdown.

In a volatile market, when investors worry about losing some of their huge gains generated over the past year or so, emotions can run high. This may be part of the driver behind the drop in bond yields – a flight to safety from a possible stock market decline. To help reduce the damaging effect of emotional stock-selling, we encourage readers to stay with a price target methodology that helps balance the downside fears with the upside potential. Also, we encourage readers to stay within their targeted mix of equities as a percent of their total portfolio to help offset the urge to bail out of the market. For non-equity assets, instead of bonds we currently prefer cash or short-term CDs that can yield as much as 0.50%. These are available from major brokerage firms that usually waive the early withdrawal penalties. Unlike bonds, these instruments preserve a key value of cash – having it available at a moment’s notice to deploy when opportunities arise.

By the way, the weather forecast for Wednesday is for heavy rain, followed by clear skies and sunshine on Thursday. In crazy conditions, its good to bring both an umbrella and sunglasses.

We continue to improve the readability of the Cabot Undervalued Stocks Advisory weekly update. In this edition, we have condensed and italicized the investment summary for each company, helping to make it easier to find the comments and valuation discussions.

Share prices in the table reflect Tuesday (July 20) closing prices. Please note that prices in the discussion below are based on mid-day July 20 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)
August 4: General Motors (GM)

TODAY’S PORTFOLIO CHANGES
None

LAST WEEK’S PORTFOLIO CHANGES
None

GROWTH/INCOME PORTFOLIO
Bristol Myers Squibb Company (BMY) shares sell at a low valuation due to worries over patent expirations for Revlimid (starting in 2022) and Opdivo and Eliquis (starting in 2026). However, the company is working to replace the eventual revenue losses by developing its robust product pipeline while also acquiring new treatments (notably with its acquisitions of Celgene and MyoKardia), and by signing agreements with generics competitors to forestall their competitive entry. The likely worst-case scenario is flat revenues over the next 3-5 years. Bristol should continue to generate vast free cash flow, helped by a $2.5 billion cost-cutting program, and has a relatively modest debt level.

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

BMY shares were flat in the past week and have about 16% upside to our 78 price target. The share price is making some progress, now matching their highest levels since mid-2016. 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 (down a cent), 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) is facing revenue pressure as customers migrate to the cloud and thus need less of Cisco’s equipment and one-stop-shop services. Cisco’s prospects are starting to improve under a relatively new CEO, who is shifting Cisco toward a software and subscription model and is rolling out new products, helped by its strong reputation and entrenched position within its customers’ infrastructure. The company is highly profitable, generates vast cash flow (which it returns to shareholders through dividends and buybacks) and has a very strong balance sheet.

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

CSCO shares rose 1% in the past week, showing decent resilience in a sloppy market. The stock has about 2% upside to our 55 price target. The company doesn’t report earnings until August 18th, so there will likely be little interim news. In a market with concerns about the Covid delta variant or peak earnings, Cisco’s turnaround prospects and low valuation are likely supporting the shares. We think there are more fundamental improvements ahead but won’t officially reevaluate our price target until the shares reach/exceed it.

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 11.6x 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 yet nearly 40% of its revenues come from non-soda beverages across the non-alcoholic spectrum. Its global distribution system reaches nearly every human on the planet. Coca-Cola’s longer-term picture looks bright but the shares remain undervalued due to concerns over the pandemic, the secular trend away from sugary sodas, and a tax dispute which could cost as much as $12 billion (likely worst-case scenario). The relatively new CEO James Quincey (2017) is reinvigorating the company by narrowing its oversized brand portfolio, boosting its innovation and improving its efficiency, as well as improving its health and environmental image. Coca-Cola’s balance sheet is sturdy, and its growth investing, debt service and dividend are well covered by free cash flow.

The company said it is tweaking Coke Zero to have a “more iconic Coke taste.” Rightfully, the company is being hammered in the popular media for this high-risk, low-return move that is reminiscent of its 1985 change in the regular Coke taste, which is widely recognized as among the biggest blunders in marketing history. While it isn’t the first change to the Coke Zero formula, it’s surprising that the company would risk alienating its now-sizeable customer base. Ultimately, we see little impact on Coca-Cola overall, but believe the impact will be incrementally negative.

Coca-Cola reports earnings on July 21, with a consensus earnings estimate of $0.56/share.

KO shares rose 2% in the past week and have about 14% upside to our 64 price target. The stock showed good resilience in the past week – despite the possibility that a pandemic resurgence could reduce consumption of Coca-Cola products. The shares continue to trade near post-pandemic highs.

While the valuation is not statistically cheap, at 25.7x estimated 2021 earnings of $2.18 (unchanged in the past week) and 23.7x 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 to create DowDuPont, then split into three companies in 2019 based on product type. The new Dow is the world’s largest producer of ethylene/polyethylene, the most widely used plastics. Investors undervalue Dow’s hefty cash flows and sturdy balance sheet largely due to its uninspiring secular growth traits and its cyclicality. The shares are driven by: 1) commodity plastics prices, which are often correlated with oil prices and global growth, along with competitors’ production volumes; 2) volume sold, largely driven by global economic conditions, and 3) ongoing efficiency improvements (a never-ending quest of all commodity companies). Investors worry about a cyclical peak and whether Dow will squander its vast free cash flow. We see Dow as having more years of strong profits before capacity increases signal a cyclical peak, and expect the company to continue its strong dividend, reduce its pension and debt obligations, repurchase shares slowly and restrain its capital spending.

Dow reports earnings on July 22, with a consensus earnings estimate of $2.35/share. We are looking for solid earnings and cash flow, and some commentary on the commodity pricing cycle, industry capacity utilization trends and on Dow’s cash usage.

Dow shares fell 6% this past week, as the stock is sensitive to economic growth and to investors’ fears of a peak in the economic and profit cycle. The stock has 32% upside to our 78 price target.

The shares trade at 10.7x estimated 2022 earnings of $5.51 (up about 1% this past week). The estimate for 2021 earnings rose another 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 22% 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 4.8% dividend yield adds to the shares’ appeal. In a prolonged downcycle, the dividend could be cut, but that could be years away and even then, a cut isn’t a certainty if Dow can manage its balance sheet and down-cycle profits reasonably well. HOLD

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

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

Merck shares fell 1% this past week and have about 28% upside to our 99 price target.

Valuation is an attractive 13.7x this year’s estimated earnings of $5.61 (down 4% in the past week, perhaps as analysts continue to calibrate their models post-Organon). Merck produces generous free cash flow to fund its current dividend (now yielding 3.4%) 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) is a rare utility/manufacturing hybrid company, with a $2 billion market cap. The electric utility has 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, supported by an accommodative regulatory environment. The manufacturing side includes four well-managed specialized metals and plastics companies. Otter Tail has an investment-grade balance sheet, produces solid earnings and prides itself on steady dividend growth. The unusual utility/manufacturing structure is creating a discounted valuation, which 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 4% in the past week and trade essentially at their post-pandemic high. The stock has about 13% upside to our 57 price target. The stock trades at about 19.3x estimated 2021 earnings of $2.61 (unchanged this past week) and offers an attractive 3.1% dividend yield. BUY

BUY LOW OPPORTUNITIES PORTFOLIO

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

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

ARCO shares fell 3% this past week and have about 35% upside to our 7.50 price target. The stock’s slide from nearly 7.00 to its current 5.50 has been disappointing, and brings the price back to about our cost. We remain steady in our conviction in the company’s recovery. Arco Dorados reports earning on August 11, and there will likely be little interim news from the company until then.

The stock trades at 19.2x estimated 2022 earnings per share of $0.29 (down about 7% from a week ago). The 2021 estimate fell to $0.06, as it appears the company’s turnaround will take longer than anticipated. 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, is a major European insurance company specializing in life insurance, savings and investment management products. Amanda Blanc was hired as the new CEO last year to revitalize Aviva’s laggard prospects. She has divested operations around the world to aggressively re-focus the company on its core geographic markets (UK, Ireland, Canada), and is improving Aviva’s product competitiveness, rebuilding its financial strength and trimming its bloated costs. Aviva’s dividend has been reduced to a more predictable and sustainable level with a modest upward trajectory. Excess cash balances are being directed toward debt reduction and potentially sizeable special dividends.

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

Aviva shares slipped 6% this past week and have about 34% upside to our 14 price target. The stock tends to perform well (in the short term) when interest rates and the stock market rise – but this past week the opposite has occurred, leading to a modest sell-off in Aviva shares. Ironically, while not a substitute for bonds, Aviva shares now have bond-like traits due to the size and sustainability of its dividend yield.

The recurring quarterly dividend of $0.14/share produces a 5.6% yield. Aviva could readily pay special dividends on top of this – making it an appealing stock on dividends alone, particularly when interest rates return to their near-zero level.

The stock trades at 7.2x estimated 2021 earnings per ADS of $1.44 (the underlying earnings of the London shares increased by about 2% but this was overwhelmed by the decline in the British pound relative to the US dollar) and at about 89% of tangible book value. BUY

Barrick Gold (GOLD), based in Toronto, is one of the world’s largest and highest-quality gold mining companies. About 50% of its production comes from North America, with the balance from Africa/Middle East (32%) and Latin America/Asia Pacific (18%). The market has little interest in Barrick shares. Yet, Barrick will continue to improve its operating performance (led by its new and highly capable CEO), generate strong free cash flow at current gold prices, and return much of that free cash flow to investors while making minor but sensible acquisitions. Also, Barrick shares offer optionality – if the unusual economic and fiscal conditions drive up the price of gold, Barrick’s shares will rise with it. Given their attractive valuation, the shares don’t need this second (optionality) point to work – it offers extra upside. Barrick’s balance sheet has more cash than debt. 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 said its second-quarter gold production will fall about 5.4% from a year ago but remains on track to hit its annual production guidance. Maintenance-related and a one-off mechanical problem, mostly at its Nevada Gold Mine joint venture with Newmont, were cited as the reasons. Second-quarter copper production will fall about 15% compared to a year ago but will be in line with plans. Barrick will provide more details on its August 9 earnings report.

Barrick shares fell 2% this past week and have about 30% 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 fell fractionally to $1,809/ounce. Sentiment remains sloppy for gold. Despite the recent report of 5.4% inflation, and the collapse of the 10-year Treasury yield to 1.14% intra-day on July 20, gold has hardly moved. Recent strength in the US dollar may be behind gold’s surprisingly flat week.

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 3.8%. BUY

General Motors (GM) is making immense progress with its years-long turnaround. It is perhaps 85% of the way through its gas-powered vehicle turnaround and is well-positioned but in the early stages of its electric vehicle (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.

There was no significant company-specific news in the past week – surprising for a company like GM that always seems to have some news.

GM shares fell 5% this past week and have 24% upside to our 69 price target. The shares have stalled and are essentially flat with their mid-January price. Near-term, the market appears to be reluctant to upgrade its view of GM shares until there is more color on its 2021 and 2022 earning power.

On a P/E basis, the shares trade at 7.9x estimated calendar 2022 earnings of $7.00 (up 4 cents this past week). The 2021 estimate rose about 4%. 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) is one of the world’s largest beverage companies, producing the highly recognized Coors, Molson, Miller and Blue Moon brands as well as numerous local, craft and specialty beers. About two-thirds of its revenues come from the United States, where it holds a 24% market share. Investors worry about Molson Coors’ lack of revenue growth due to its relatively limited offerings of fast-growing hard seltzers and other trendier beverages. Our thesis for this company is straight-forward – a reasonably stable company whose shares sell at an overly-discounted price. Its revenues are resilient, it produces generous cash flow and is reducing its debt. A new CEO is helping improve its operating efficiency and expand carefully into more growthier products. The company recently reinstated its dividend.

The company reinstated its quarterly dividend, set at 34 cents/share. The reinstatement was well-telegraphed and was nearly spot-on with our 35 cent estimate. The company also reaffirmed its full-year 2021 outlook. This is mixed news as we had hoped for more, but the company is likely being conservative, particularly with the emergence of the Covid delta variant.

TAP shares fell 1% in the past week and have about 35% upside to our 69 price target. Unlike KO shares, TAP shares have traded down on rising worries about the Covid delta variant.

The shares trade at 13.2x 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 8.9x current-year estimates, still among the lowest valuations in the consumer staples group and below other brewing companies. BUY

There was no significant company-specific news in the past week. Organon reports earnings on August 12, so there may be little or no interim news until then, leaving the shares to trade mostly on noise.

OGN shares rose 1% in the past week and have about 56% upside to our 46 price target (using the same target as the Cabot Turnaround Letter).

The shares trade at 4.8x estimated 2021 earnings of $6.17 and 4.9x estimated 2022 earnings of $6.03. These are remarkably low valuations. Estimates are starting to converge around these numbers, but will probably be volatile until the company reports its results and provides some guidance. Notably, analysts are pessimistic about 2022 earnings, as they project a 2% 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 nearly 47,000 highly engineered sensors used by automotive (60% of revenues), heavy vehicle, industrial and aerospace customers. About two-thirds of its revenues are generated outside of the United States, with China producing about 21%. Investors undervalue Sensata’s durable franchise. Its sensors are typically critical components that generally produce high profit margins. Also, as the sensors’ reliability is vital to safely and performance, customers are reluctant to switch to another supplier that may have lower prices but also lower or unproven quality. Sensata has an arguably under-leveraged balance sheet and generates healthy free cash flow. The relatively new CEO will likely continue to expand the company’s growth potential through acquisitions.

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. 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. Taiwan Semiconductor reported record results but fell short of expectations, and the chairman made blunt comments about a possible China invasion, saying nobody wants a war in Taiwan as it would disrupt the global chip supply chain. For Sensata, China remains a murky risk, as we have no clear measure of the chances that Sensata’s sensors could be replaced by local manufacturing.

Sensata reports earnings on July 27, with the consensus estimate for $0.88/share in earnings and $971 million in revenues.

ST shares fell about 4% this past week and have about 37% upside to our 75 price target.

The stock trades at 13.4x estimated 2022 earnings of $4.06 (unchanged this past week). On an EV/EBITDA basis, ST trades at 10.3x 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.