July 28, 2021

The New “Endemic?”
The stock market reached yet another record high on Monday, but it just doesn’t seem the same as earlier records. Investors (and everyone else) is starting to wonder if Covid is now endemic – an inherent component of everyday life. Will cases surge in the winter months and just after holidays instead of going away with a single vaccine cycle? We won’t likely be going back to widespread lockdowns, but previously unfettered socializing and traveling could be restrained, thus suppressing earnings and valuations for many companies.

Inflation seems endemic as well. Not only are government and industry-supplied data and even Fed chairman Powell pointing to ongoing inflation, but this quarter’s earnings reports are filled with comments about rising input costs, which are then passed along as higher prices to customers. Inflation, and the uncertainty that it creates for the Fed’s interest rate policy, weighs on many stocks.

Risks from China’s government are becoming endemic to the stock market and beyond. From the crackdown on highly profitable mega-cap tech stocks and their capitalist billionaire leaders, restrictions on Western IPOs and tightening control of student education to banning profits in some companies, China is increasingly acting like, well, a Communist country. As such, investors are wondering how far the government will go in increasing its control over society and the economy. Is this just the start of banning profits? Will acrimony with Western-style businesses lead to a squeeze-out of Western-based businesses? While seemingly highly unlikely, this wasn’t even considered a sane question two years ago, but here we are. Needless to say, such a move would have devastating consequences for nearly all Western companies.

Sketchy deals are becoming endemic. A flurry of SPAC offerings and traditional IPOs is bringing to market a full roster of highly speculative companies with suspect business models. Meme trading is based on sentiment that is untethered to anything resembling the often-precarious underlying company fundamentals. We recently learned of Lordstown Motors’ $400 million stock offering scheme – looking into the details, this is essentially a plan to fob off new shares onto unsuspecting retail investors rather than a placement of shares with a buy-and-hold investment firm.

As value investors, we look to Buffett’s advice: “Be greedy when others are fearful, and fearful when others are greedy.” The stock market can keep rising, but investors are tilting toward the greedy side. Valuations for many stocks are full. We see rising volatility for the rest of the year. This should provide attractive buying points for stocks that we are watching.

Share prices in the table reflect Tuesday (July 27) closing prices. Please note that prices in the discussion below are based on mid-day July 27 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 28: Bristol-Myers Squibb (BMY)
July 29: MolsonCoors Beverage Company (TAP)
July 29: Merck (MRK)
Aug 4: General Motors (GM)
Aug 9: Barrick Gold (GOLD)
Aug 11: Arcos Dorados (ARCO)
Aug 12: Aviva (AVVIY)
Aug 12: Organon & Co. (OGN)

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.

Bristol reports earnings on July 28, with a consensus earnings estimate of $1.90.

BMY shares rose 1% in the past week and have about 16% upside to our 78 price target. The shares remain just below their highest level since mid-2016. We remain patient with BMY shares.

The stock trades at a low 9.0x estimated 2021 earnings of $7.46 (down a cent from last week). On 2022 estimated earnings of $8.06 (up 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 3% in the past week to our 55 price target. We think there are more fundamental improvements ahead but we are now re-evaluating our price target.

The shares trade at 17.2x 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 16.1x. On an EV/EBITDA basis on FY2021 estimates, the shares trade at a 12.1x 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 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 over-sized 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.

Coca-Cola reported adjusted second-quarter earnings of $0.68/share, beating the consensus earnings estimate of $0.56/share and much stronger than the $0.42 earned a year ago during the depths of the pandemic. The company raised its full-year organic revenue growth guidance to 12-14% (from about 9%) and raised its full-year adjusted EPS guidance to $2.20 to $2.24 (about 4% higher than their prior guidance). All in, an encouraging quarter.

Revenues grew 42% from a year ago, driven by 26% growth in volumes and 11% improvement in pricing and mix, with a 5% tailwind from currencies. The increases are flattered by the easy comparison to the year-ago quarter which suffered the worst of the pandemic. Compared to two years ago, unit case volumes matched the two-year-ago level, not bad considering that parts of the global economy remained subdued.

Gross margins and operating margins expanded, as we had expected, as more of the incremental revenues fell to the bottom line due to Coke’s somewhat fixed cost base.

Coca-Cola generated $3.9 billion of operating cash flow in the quarter and has generated $5.5 billion year-to-date, much stronger than the year-ago $2.7 billion a year ago. The company is on track to generate $9 billion of free cash flow this year, up from their prior guidance for $8.5 billion.

From a capital allocation perspective, Coke is doing the right things. As a mature company that generates a lot of free cash flow, it is paying out about 70-75% of its free cash flow as dividends, even as its makes sound investments in its business and prunes its cost structure. Most of the rest of the free cash flow is being used to pay down debt. The company has cut its debt by $2.9 billion, or close to 10%, so far this year.

KO shares rose 3% in the past week and have about 11% upside to our 64 price target. The stock continues to reflect Coke’s earnings power even as the pandemic resurgence may delay or reverse a full return to normal in consumption patterns.

Earnings estimates increased about 3%, reflecting the strong earnings report. While the valuation is not statistically cheap, at 25.6x estimated 2021 earnings of $2.25 (up 3% in the past week) and 23.7x estimated 2022 earnings of $2.43 (also up 3%), 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 2.9% 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 reported a strong second quarter, with adjusted earnings of $2.72/share, about 16% above the consensus estimate of $2.35 and sharply higher than the $(0.26) loss a year ago in the depths of the pandemic. Even compared to the first-quarter earnings of $1.36, the second quarter was impressive. Sales grew 66%, but the pandemic year-ago period makes this comparison meaningless. Dow saw strength across all of its segments. Management has an encouraging outlook for volumes and pricing and its ability to generate higher profits on comparable revenues. While profits may be peaking in coming quarters, they will likely remain elevated rather than fall off sharply. Industry capacity increases are coming next year, but we do not see large price cuts from our current vantage point.

While the company showed strong profits, only about half of its cash operating profits (EBITDA) flowed through to cash flow. This is a bit surprising, as more should make its way to cash flow. Also, while the company paid down $1.1 billion of debt, the net debt is actually slightly higher than at year end – again, surprising as we would have expected at least a $1-2 billion net debt reduction.

Perhaps a tad annoying, Dow’s share count rose by 13.6 million shares over the past year (even after the share repurchases), worth a total of $816 million at the current share price. This almost-2% increase is too high, and would consume over 8% of the company’s annual pre-tax profits if converted into an expense.

Overall, we are holding tight with our Buy rating as the shares look undervalued compared to their earnings and cash flow generation prospects.

Dow shares rose 6% this past week, buoyed by its encouraging earnings report. The stock has 26% upside to our 78 price target.

The shares trade at 10.6x estimated 2022 earnings of $5.85 (up about 6% this past week reflecting strong second quarter earnings and expectations for a slower decline after reaching peak earnings, estimated to occur in the third quarter). The estimate for 2021 earnings rose 20%. Analysts are somewhat pessimistic about 2022 earnings (they assume a now-wider 31% 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. 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 rose 2% this past week, and have about 27% upside to our 99 price target.

Valuation is an attractive 13.9x this year’s estimated earnings of $5.61 (unchanged in the past week, perhaps as analysts are satisfied with their models ahead of the July 29 earnings report). Merck produces generous free cash flow to fund its current dividend (now yielding 3.3%) 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 were flat in the past week and trade essentially at their post-pandemic high. The stock has about 14% upside to our 57 price target. The stock trades at about 19.2x 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 re-open, 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 rose 3% this past week and have about 31% upside to our 7.50 price target. The stock’s slide from nearly 7.00 to its current price has been disappointing, and brings the price back near our cost. We remain steady in our conviction in the company’s recovery. Arcos Dorados reports earning on August 11, and there will likely be little interim news from the company until then.

The stock trades at 19.7x estimated 2022 earnings per share of $0.29 (unchanged from a week ago). The 2021 estimate remained at $0.06 after a sharp cut last week, likely due to a slower-than-anticipated post-Covid recovery. The 2023 consensus estimate of $0.35 increased a cent from last week – encouraging not only in the increase but that the number suggests some confidence by analysts in a strong recovery. 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 rose 2% this past week and have about 31% upside to our 14 price target. The company reports earnings on August 12 – only a few weeks away but seemingly an eon in the current earnings season.

The recurring quarterly dividend of $0.14/share produces a 5.4% yield. In an era that features investment grade bond yields of 1.7%, Aviva makes an interesting bond proxy, particularly given what appears to be a resilient base dividend. The likely upcoming special dividends on top of this add extra appeal.

The stock trades at 7.3x estimated 2021 earnings per ADS of $1.47 (up by 3 cents in the past week) and at about 92% 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.

There was no significant company-specific news in the past week. Barrick shares rose 1% this past week and have about 29% 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 $1,797/ounce. Sentiment remains sloppy for gold. Despite the recent report of 5.4% inflation, the 10-year Treasury yield settling into the 1.25% range, and tensions with China jumping, gold has hardly moved.

On its recurring $0.09/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 3.7%. 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.

GM, Cruise and Ford are battling over the “cruise” name. Ford introduced the “Blue Cruise” name for its autonomous vehicle unit, so GM and Cruise are right to fight this. But even if it loses, the heightened publicity that the dispute provides to Ford is worth millions in advertising. There was not much other significant company-specific news on GM in the past week.

GM shares fell 3% this past week and have 26% upside to our 69 price target. The shares have slipped on concerns that production growth will slow (partly due to the chip shortage) and partly due to concerns that economic growth will decelerate. Another risk that is increasing from “won’t happen” to “it conceivably could happen” is that China pushes Western car producers out of the country. Following China’s moves in previously-Westernized Hong Kong, its crackdown on major capitalist tech companies, and its new restrictions on IPOs in the United States, it isn’t entirely impossible that Western automakers are in-line for similar treatment, even if years down the road. Needless to say, such a change would be devastating for GM shares.

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 7.8x estimated calendar 2022 earnings of $7.04 (up 4 cents this past week). The 2021 estimate rose about 2%. 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 re-instated its dividend.

Boston Beer shares fell sharply last week – the company had way overestimated the demand for its hard seltzer beverages, leading to higher costs and removing a key pillar of its growth story. TAP shares fell only modestly. We see the Boston Beer news as a positive for MolsonCoors. Consumers probably aren’t drinking less, just less of the trendier beverages, meaning that Coors’ slow walk to add some of these beverages may turn out to be the right strategy after all. Coors reports on Thursday – we should get more color then.

The consensus estimate for MolsonCoors (reports July 29) is $1.35/share.

TAP shares fell 1% in the past week and have about 37% upside to our 69 price target.

The shares trade at 12.9x estimated 2021 earnings of $3.90 (up a cent this past week). Estimates for 2022 also rose a cent.

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.

OGN shares fell 2% in the past week and have about 58% upside to our 46 price target (using the same target as the Cabot Turnaround Letter).

The shares trade at 4.9x estimated 2021 earnings of $5.98 and 4.9x estimated 2022 earnings of $5.92. These are remarkably low valuations. Estimates continue to slide for this year and next year. Perhaps the analysts are getting subtle guidance from management, but just as likely they are hoping to be too pessimistic and thus help Organon report a “beat.” The company has yet to report as an independent company. Curiously, the consensus estimate for 2023 is a more robust $6.23.

On an EV/EBITDA basis, or enterprise value/cash operating profits, the shares trade for about 7.3x current year estimates, also quite low. BUY

Sensata reported second-quarter adjusted earnings per share of $0.95, sharply higher than $0.18 a year ago and above the $0.87 consensus estimate. Revenues of $993 million set a record, were 72% higher than a year ago and were also above estimates. The jump in revenues and profits reflects a rebound from pandemic-weakened conditions a year ago when many of Sensata’s customers were shut down. Compared to the industry, Sensata grew considerably faster.

The company raised its full-year guidance. Adjusted EPS guidance was raised by about 5% to $3.52, while sales guidance was raised about 1%. The guidance implies a modest further increase in Sensata’s operating margin to 21.0%, as the company seems confident that it can offset rising costs by raising its own prices. Sensata trimmed its auto industry production outlook.

Cash flow was robust and net debt increased modestly to fund the Xirgo acquisition. Rising earnings are helping reduce the company’s leverage as measured by net debt/EBITDA.

ST shares fell about 1% this past week and have about 38% upside to our 75 price target.

The stock trades at 13.3x estimated 2022 earnings of $4.07 (up a cent this past week). We anticipate that the 2022 estimate will increase following the encouraging earnings report. On an EV/EBITDA basis, ST trades at 10.6x 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.