The Earnings Deluge is Here
We are entering the heart of earnings season. So far, the results are unimpressive. The entire retail sector is on alert after Walmart’s pre-announcement about weaker earnings due to their accelerating efforts to offload surplus inventory. Our Big Lots position is directly affected, partly as they too carry a glut of inventory but also because they compete directly with Walmart (we are reviewing Big Lots due to its elevated risk position). Even Amazon won’t be immune to the downturn.
General Motors reported sloppy results, partly due to ongoing problems with semiconductor supplies and supply chain congestion. Demand seems to be healthy but the company is girding for a slowdown.
Tech sector earnings haven’t been glowing, either. Seagate Technologies, which makes disk drives for the cloud, computers and other devices, said demand is slipping. Pandemic beneficiaries like Spotify, Snap and Netflix, as well as tech giants like Google and Meta/Facebook, are laying off staff following excessive hiring and perhaps some revenue slippage. Twitter missed its estimates. AT&T and Verizon are indirectly tech companies as their networks connect everyone’s tech gear – both reported weak results due to fresh competitive pressures.
Consumers currently prefer to go to McDonald’s (reported strong results) and travel by air as American Airlines and Delta are reporting better profits. Our positions in The Coca-Cola Company and Arcos Dorados are aligned with these trends.
More earnings are ahead, and we’ll soon learn a lot more about where there may be danger, and opportunity.
Share prices in the table reflect Tuesday (July 26) closing prices. Please note that prices in the discussion below are based on mid-day July 26 prices.
Note to new subscribers: You can find additional color on our thesis, recent earnings reports and other news on recommended companies in prior editions of the Cabot Undervalued Stocks Advisor, particularly the monthly edition, on the Cabot website.
Send questions and comments to Bruce@CabotWealth.com.
Today’s Portfolio Changes
Last Week’s Portfolio Changes
Upcoming earnings reports
Thursday, July 28: Merck (MRK)
Tuesday, August 2: Molson Coors Beverage Company (TAP)
Wednesday, August 3: Allison Transmission Holdings (ALSN)
Thursday, August 4: Organon (OGN)
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.
While Cisco shares’ roundtrip from our initial recommendation at 41.32 to 64 and back to around 43 is frustrating, this is not the time to sell the stock. The fundamentals remain reasonably stable and likely to tick back upward, and profits seem likely to improve, as well. The shares will likely come back to life as earnings reports show favorable growth and profit trends, so investors will need some patience. If we have a recession in global tech spending, Cisco would likely feel the downturn but not as severely as other technology companies due to the mission-critical nature of its products and services.
There was no significant company-specific news in the past week.
CSCO shares were flat in the past week and have 49% upside to our 66 price target. The valuation is attractive at 9.0x EV/EBITDA and 13.2x earnings, the shares pay a sustainable 3.4% dividend yield, the balance sheet is very strong and Cisco holds a key role in the basic plumbing of technology systems even if its growth rate is only modest. BUY
The Coca-Cola Company (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 a solid quarter – a “beat and raise” in Street parlance. Revenues rose 12% and were about 7% above the consensus estimate. Comparable earnings of $0.70/share rose 4% from a year ago and were 4% above the consensus estimate. The company raised its full-year organic revenue growth guidance to +12-13% from +7-8%, as it sees continued strength in demand and pricing. Coke also raised its guidance for comparable currency-neutral earnings per share growth to +14-15% from +8-10% due to the higher revenues.
The company is participating in the global post-pandemic recovery as consumers shift to out-of-home activities including travel, while also being able to raise its prices to help offset cost inflation.
Organic revenue growth (which excludes the effects of currency changes and acquisitions/divestitures) was a healthy 16%. Revenues were strong across nearly all product groups and geographies. Higher pricing and more sales of higher-priced products contributed 12% to revenue growth, while volumes added 4%. Overall, Coca-Cola is seeing a good recovery around the world and has been able to raise prices without scaring away much demand.
Operating profits, when adjusted for currency changes and acquisitions/divestitures, rose 15%. However, the margin shrank by one percentage point due to the effects of acquiring lower-margin Bodyarmor, higher operating costs and higher marketing costs as Coke continues to spend on its brand building. Currency changes also weighed on margins.
Free cash flow and the balance sheet remained sturdy.
KO shares rose 1% in the past week and have 9% upside to our 69 price target. Coca-Cola’s fundamentals remain sturdy with respectable revenue, profit and free cash flow growth. Management continues to focus on execution in its core business while generally avoiding any major non-core commitments. HOLD
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, its cyclicality and concern that management will squander its resources. 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). 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.
On July 21, Dow reported good second quarter and third-quarter guidance that was basically in line. But the macro environment (pricing and costs) is shifting from a tailwind to neutral/negative and investors worry about a domestic and global recession, so the shares may remain out of favor. However, the company is likely to remain highly profitable, in a strong competitive position, with an underleveraged balance sheet. The quarterly dividend provides a 5.5% yield, and the shares trade at a low 4.5x EV/EBITDA multiple. Barring a deep recession, collapse in oil prices or a surge in supply, Dow’s fundamental earnings picture seems solid.
Revenues rose 13% and were fractionally ahead of the consensus estimate. Operating earnings of $2.31/share fell 15% from a year ago but were 8% above estimates. Operating EBITDA of $3.1 billion fell 14% from a year ago but was about 5% above estimates.
Volumes were flat compared to a year ago – essentially in line with the prior several quarters where volumes fluctuated around zero. The driver of Dow’s revenue growth and huge profits are the sharply higher prices it receives. In the second quarter, local price (excludes currency translations into the U.S. dollar) rose 16%. This is a hefty price increase, but this pace has decelerated from +39% in the fourth quarter and +28% in the first quarter of this year, suggesting that the company’s ability to raise prices may be reaching a limit.
Profits fell primarily due to rapidly increasing raw material and energy costs, and to a lesser extent due to lower profits in its joint ventures and lower volumes due to planned downtime for maintenance at some of its facilities. It appears that rising costs are eclipsing Dow’s ability to raise its prices. Dow has a global customer base across its three primary segments, so each region and segment has its variances, but these variances generally point in the same direction and when aggregated paint a reasonably consistent story.
Free cash flow remains robust at $1.4 billion, which mostly went toward share repurchases and dividends. The balance sheet is sturdy with no major maturities until 2027, and Dow paid off $750 million in notes. A favorable side effect of rising interest rates is that Dow’s pension obligations have a lower present value. This could slash its previously large $6 billion net pension liability to nearly zero by year-end, for an $8.50/share positive swing in value.
Dow shares fell 2% in the past week as recession fears increased. The shares have 52% upside to our 78 price target and offer an attractive and what appears to be sustainable 5.5% dividend yield. BUY
Merck (MRK) shares are undervalued as investors worry about Keytruda, a blockbuster oncology treatment (about 30% of revenues) which faces 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 is 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, is accelerating Merck’s acquisition program, which adds 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 2021 and we think it will divest its animal health segment sometime in the next five years.
Merck is expected to report adjusted earnings of $1.70/share.
Merck shares slipped 1% in the past week and have about 8% upside to our 99 price target. The company has a strong commitment to its dividend (3.0% yield) which it backs up with generous free cash flow, although its shift to a more acquisition-driven strategy will slow the pace of dividend increases. While the shares have pulled back, we are retaining our Hold rating as rising interest rates reduce the upside potential value of its shares. HOLD
Buy Low Opportunities Portfolio
Allison Transmission Holdings, Inc. (ALSN) – Allison Transmission is a midcap ($6.4 billion market cap) manufacturer of vehicle transmissions. Many investors view this company as a low-margin producer of car and light truck transmissions that is destined for obscurity in an electric vehicle world. However, Allison produces no car and light truck transmissions, instead it focuses on the school bus and Class 6-8 heavy-duty truck categories, where it holds an 80% market share. Its 35% EBITDA margin is sharply higher than its competitors and on-par with many specialty manufacturers. And, it is a leading producer and innovator in electric axles which all electric trucks will require. Another indicator of its advanced capabilities: Allison was selected to help design the U.S. Army’s next-generation electric-powered vehicle. The company generates considerable free cash flow and has a low-debt balance sheet. Its capable leadership team keeps its shareholders in mind, as the company has reduced its share count by 38% in the past five years.
Allison is expected to report earnings of $1.57/share.
Allison shares rose 3% in the past week and have 21% upside to our 48 price target. The stock pays an attractive and sustainable 2.1% dividend yield to help compensate for the wait. BUY
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. The shares are depressed as investors worry about the pandemic, as well as political/social unrest, inflation and currency devaluations. However, the company has a solid brand and high recurring demand and is well positioned to benefit as local economies re-open. The leadership looks highly capable, led by the founder/chairman who owns a 38% stake, and 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.
Macro issues, including issues in Brazil related to its economic conditions (in particular, inflation, running at an 11.7% rate), currency and the chances that a socialist might win this year’s Brazilian presidential elections, will continue to influence ARCO shares.
McDonald’s Corporation said its second-quarter comparable systemwide sales rose nearly 10%, with growth across all segments, which suggests healthy growth at Arcos Dorados restaurants.
ARCO shares were flat in the past week and have 27% upside to our 8.50 price target. BUY
Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc was hired as the new CEO in July 2020 to revitalize Aviva’s laggard prospects. She divested operations around the world to re-focus the company on its core geographic markets (U.K., 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 and share repurchases.
Much of our interest in Aviva is based on its plans for returning its excess capital to shareholders, including share repurchases and dividends. These distributions could be substantial. We also look for incremental shareholder-friendly pressure from highly regarded European activist investor Cevian Capital, which holds a 5.2% stake.
There was no significant company-specific news in the past week. Please note that the ticker symbol for the ADS has reverted back to “AVVIY” following their overly-complicated share buyback transaction.
Aviva shares fell 1% in the past week and have about 49% upside to our 14 price target. Based on management’s estimated dividend for 2023 (which we believe is highly credible), the shares produce a generous 8.8% yield. Based on this year’s actual dividend, the shares offer an attractive 6.0% dividend yield. 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%). 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 nearly zero debt net of cash. 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.
On July 14, Barrick reported preliminary second quarter unit volumes. Full results will be reported on August 8. In the preliminary report, the company said it produced 1.04 million ounces of gold and 120 million pounds of copper. It also said that it remains on track to meet its full-year gold and copper guidance. For long-term investors, the company’s ability to set healthy guidance numbers and then meet/exceed them is critical, as it indicates a predictable and controllable operating process and generally high quality mines.
Over the past week, commodity gold rose fractionally to $1,716/ounce, leaving gold down 6% year-to-date. The 10-year Treasury yield tumbled to 2.77% as investors worried more about a recession.
The US Dollar Index, another driver of gold prices (the dollar and gold usually move in opposite directions), rose fractionally to 107.22. The dollar continues to surge as investors flee lower-yielding markets including Europe and Japan, and as global instability leaves the United States as the best safe haven.
Barrick shares continued to slide, down 5% in the past week, and have declined 20% year-to-date. Earnings estimates are ticking down to follow gold prices. The shares have about 78% upside to our 27 price target. The price target is based on 7.5x estimated steady-state EBITDA and a modest premium to our estimate of $25/share of net asset value. BUY
Big Lots (BIG) – Big Lots is a discount general merchandise retailer based in Columbus, Ohio, with 1,431 stores across 47 states. Its stores offer an assortment of furniture, hard and soft home goods, apparel, electronics, food and consumables as well as seasonal merchandise. Our bullish case for Big Lots rests with its loyal and growing base of 22 million rewards members, its appeal to bargain-seeking customers, the relatively stable (albeit low) 5.5% cash operating profit margin, its positive free cash flow, debt-free balance sheet and low share valuation at 3.1x EV/EBITDA and 7.3x per-share earnings based on conservative January 2023 estimates.
Our thesis was deeply rattled by the company’s dismal first-quarter results. Offloading its bloated inventory will require sharp discounts, which will weigh on profits while the $271 million in new borrowing ramps up the risk. We are retaining our HOLD rating for now: investor expectations are sufficiently depressed to provide some downside cushion, while management should be able to extract itself from the worst of the inventory problem over the next few quarters. Nevertheless, the Big Lots investment is now high-risk due to the new debt balance, the lost value from the inventory glut and the potential for a dividend cut.
Walmart slashed its second-quarter outlook, saying that profits will fall by as much as 13%. Its prior guidance suggested only a 1% decline. The company is aggressively slashing its prices to clear out excess inventories, a problem worsened by consumers’ weakening appetite for goods in a slowing economy and at a time when pandemic goods-buying is being replaced by travel and leisure spending.
For Big Lots, this news likely means more intense pressure on its own efforts to offload its excess inventory. If Walmart is slashing prices, consumers will see less merit to shopping at Big Lots.
As the retail environment sours and given Big Lots’ risks, we are reviewing this position.
Big Lots shares 15% this past week. The shares have 82% upside to our recently reduced 35 price target. We would consider the dividend to be unsustainable and caution that investors should not count on any dividends from Big Lots. HOLD
Citigroup (C) – Citi is one of the world’s largest banks, with over $2.4 trillion in assets. The bank’s weak compliance and risk-management culture led to Citi’s disastrous and humiliating experience in the 2009 global financial crisis, which required an enormous government bailout. The successor CEO, Michael Corbat, navigated the bank through the post-crisis period to a position of reasonable stability. Unfinished, though, is the project to restore Citi to a highly-profitable banking company, which is the task of new CEO Jane Fraser.
On July 15, Citigroup reported encouraging second-quarter results. Revenues rose 11% and were about 7% above the consensus estimate. Earnings of $2.30/share fell 19% and were about 39% above the consensus estimate. The company maintained its full-year revenue and expense guidance. Overall, a good report, particularly compared to the dour investor sentiment.
Revenues were boosted by 33% growth in Trade & Treasury Solutions, a crown jewel of the bank which represents 15% of total revenues. Fixed income trading revenues (about 20% of total revenues) jumped 31% as the bank took advantage of investor uncertainty over the direction of inflation and interest rates. Credit card revenues rose 10% due to higher interest rates on higher balances. As expected, investment banking revenues fell sharply (-46%) as deal volumes shrank.
Total loans fell 2% from a year ago while deposits rose 1%. Citi’s loan/deposit ratio, a simple metric that evaluates the bank’s capacity to make loans, is at about 50%, suggesting that the bank could readily fund faster loan growth. The net interest margin expanded to 2.24%, indicating a wider level of profits on its lending compared to the 1.97% margin a year ago.
Credit quality remains sturdy as credit losses fell 36% from a year ago. The bank’s CET1 capital level rose to 11.9% from 11.8% a year ago despite sizeable dividends and share repurchases. This capital is supported by loan loss reserves that are a generous 2.4% of funded loans.
This past week, the spread between the 90-day T-bill and the 10-year Treasury note, which approximates the drivers behind Citi’s net interest margin, narrowed by 22 basis points to 0.31%. There are 100 basis points in one percent. Short-term rates ticked up this past week while long-term rates fell.
A recession would likely increase Citi’s credit losses, a flatter yield curve would weigh on its net interest margin, and weaker capital markets would mean fewer investment banking revenues.
Citi shares trade at 64% of tangible book value. This immense discount, which assumes a dim future for Citi, appears to be misplaced.
Citi shares slipped 1% in the past week and about 65% upside to our 85 price target. Citigroup investors enjoy a 3.9% dividend yield and perhaps another 3% or more in annual accretion from the bank’s share repurchase program once it reaches its new target capital ratio and if a slowing/stalling economy doesn’t meaningfully increase its credit costs. BUY
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.
The company is expected to report earnings of $1.19/share.
TAP shares slipped 1% in the past week and have about 19% upside to our 69 price target. The stock remains cheap, particularly on an EV/EBITDA basis, or enterprise value/cash operating profits, where it trades at 9.5x estimated 2022 results, still among the lowest valuations in the consumer staples group and below other brewing companies. The 2.6% dividend yield only adds to the appeal. BUY
Organon & Company (OGN) was recently spun off from Merck. It specializes in patented women’s healthcare products and biosimilars, and also has a portfolio of mostly off-patent treatments. Organon will produce better internal growth with some boost through smart yet modest-sized acquisitions. It may eventually divest its Established Brands segment. The management and board appear capable, the company produces robust free cash flow, has modestly elevated debt and will pay a reasonable dividend. Investors have ignored the company, but we believe that Organon will produce at least stable and large free cash flows with a reasonable potential for growth. At our initial recommendation, the stock traded at a highly attractive 4x earnings.
The company is expected to report earnings of $1.27/share.
OGN shares rose 5% in the past week and have about 39% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). The shares continue to trade at a remarkably low valuation while offering an attractive 3.4% dividend yield. 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. 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. Electric vehicles are an opportunity as they expand Sensata’s reachable market.
Sensata reported a reasonably good quarter but reduced its guidance for the full year.
Revenues rose 2.8%, to a quarterly record, although this was partly driven by acquisitions. On an organic basis, which excludes the effects of currency changes and acquisitions/divestitures, revenues rose 2.2%. Revenues were about 2% above estimates. Adjusted earnings of $0.83/share fell 13% from a year ago but were in line with estimates. Revenues and earnings were toward the high end of the company’s prior guidance.
While revenues were reasonably strong and outgrew the company’s end markets, and Sensata is winning important new business in its core product groups and the electric vehicle products, the company now expects its end markets to shrink 1% in the year.
The operating margin slipped by over two percentage points due to lower margins at its recently-acquired companies, higher research and development spending, cost inflation and supply chain challenges.
We are disappointed that the company made a sizeable investment in publicly-traded Quanergy Systems (QNGY), which has become essentially worthless and produced a $70+ million loss. While Quanergy develops radar-like sensing systems for autonomous vehicles, which fits with Sensata’s business, we are not clear on the investment rationale.
Sensata’s cash flow slipped along with profits but remains solidly positive. The balance sheet remains reasonably sturdy but at 3.0x EBITDA its leverage is higher than we would like to see. This somewhat limits the company’s ability to make further acquisitions – a positive as Sensata would benefit from slowing its pace, especially as the electric vehicle market is changing so quickly.
Overall, the Sensata investment remains sharply under water as its revenue growth is challenged by new economic cycle pressures on top of the post-pandemic supply chain issues. The company is well positioned for the post-recession, electric vehicle environment, but investors will have to wait for perhaps a year for that to arrive. The shares are still worth holding onto given their now-low valuation and ability to financially endure the downturn.
ST shares fell 3% in the past week and have about 82% upside to our 75 price target. Our price target looks optimistic in light of the broad market sell-off, but we will keep it for now, even as it may take longer for the shares to reach it. 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.
Buy – This stock is worth buying.
Strong Buy – This stock offers an unusually favorable risk/reward trade-off, often one that has been rated as a Buy yet the market has sold aggressively for temporary reasons. We recommend adding to existing positions.
Hold – The shares are worth keeping but the risk/return trade-off is not favorable enough for more buying nor unfavorable enough to warrant selling.
Sell – This stock is approaching or has reached our price target, its value has become permanently impaired or changes in its risk or other traits warrant a sale.
Note for stock table: For stocks rated Sell, the current price is the sell date price.
|CUSA Valuation and Earnings
|Buy Low Opportunities Portfolio
Current price is yesterday’s mid-day price.
CSCO: Estimates are for fiscal years ending in July.