August 15, 2023

Our Final Thoughts on the Fitch Downgrade

Last week, our opening comments chastised the U.S. Government for such profligate spending that the most likely path as forecast by the Congressional Budget Office is for remarkably high and steady budget deficits into the distant future. We hesitated to write such a gloomy note – and didn’t mention that this is perhaps the greatest risk that long-term investors face (making blips like the next Fed rate decision or Amazon’s next earnings report seem irrelevant).

We worried that we were taking a grim outlier perspective after so many others had dismissed the Fitch credit rating downgrade. However, recent articles in The Wall Street Journal and other high-quality media outlets vindicate our math and view. This is little comfort – I wish that I were totally wrong and that my math or outlook was missing some key facts.

Our closing comments offered a suggested place to invest in such a world: “…solid companies that can earn real profits. And, we also have a holding of gold-related assets.” A world with a partly hobbled United States would be very different from the post-Cold War era, with the dollar tumbling and risks of all kinds surging. However, the optimist in us sees the ingenuity and creativity of Americans working to counter-balance these problems. And we see other Western nations stepping up to help carry the burden of maintaining global economic stability. The winning and losing companies may be very different from today’s, but this is how change creates opportunity. Fortunately, the world changes only one day at a time, and we have plenty of time to adjust. And, as we wrote at the end of last week’s missive, “We are also trying not to think about any of this stuff too much.” So, we’re done with it for now.

Share prices in the table reflect Monday, August 14 closing prices. Please note that prices in the discussion below are based on mid-day August 14 prices.

Note to new subscribers: You can find additional color on past earnings reports and other news on recommended companies in prior editions and weekly updates of the Cabot Value Investor on the Cabot website.

Send questions and comments to Bruce@CabotWealth.com.

This Week’s Portfolio Changes
None.

Last Week’s Portfolio Changes
None.

Upcoming Earnings Reports
Tuesday, August 15: Aviva, plc (AVVIY)
Wednesday, August 16: Cisco Systems (CSCO)

Growth & Income Portfolio

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.

Cisco reports earnings on Wednesday, August 16, with the consensus estimate at $1.06/share.

CSCO shares rose 1% for the week. The shares have 23% upside to our 66 price target. The valuation is attractive at 9.8x EV/EBITDA and 14.1x earnings per share. BUY

Comcast Corporation (CMCSA) – With $120 billion in revenues, Comcast is one of the world’s largest media and entertainment companies. Its properties include Comcast cable television, NBCUniversal (movie studios, theme parks, NBC, Telemundo and Peacock), and Sky media. The Roberts family holds a near-controlling stake in Comcast. Comcast shares have tumbled due to worries about cyclical and secular declines in advertising revenues and a secular decline in cable subscriptions as consumers shift toward streaming services, as well as rising programming costs and incremental competitive pressure as phone companies upgrade their fiber networks.

However, Comcast is a well-run, solidly profitable and stable company that will likely continue to successfully fend off intense competition while increasing its revenues and profits, as it has for decades. The company generates immense free cash flow which is more than enough to support its reasonable debt level, generous dividend and sizeable share buybacks.

Comcast was the subject of a favorable article in Barron’s this past weekend. The article included favorable (not surprising) comments from the company’s leadership but also an endorsement from Craig Moffett at research firm MoffettNathanson. Moffett is a highly regarded telecom/cable analyst and one of the few who deeply understands the economics of the industry. The gist of the article: Comcast’s growth opportunities, including residential internet service and mobile wireless, along with its parks, studios and other businesses, more than offset the dying cable business, while threats from rival fiber optic networks and 5G fixed wireless are fading. The article also covers the option value that comes with Comcast’s Hulu stake, which will likely be acquired by Disney next year at a high price. The article doesn’t discuss the downside if Comcast decides to buy out Disney’s stake, which could potentially be a massive $40 billion purchase, even if this is a remote possibility.

Comcast shares rose 2% in the past week and have ticked above our 46 price target. We are re-evaluating this target and our rating in light of the strong earnings report. HOLD

Buy Low Opportunities Portfolio

Allison Transmission Holdings, Inc. (ALSN) – Allison Transmission is a midcap manufacturer of vehicle transmissions. While 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, Allison actually produces no car or light truck transmissions. Rather, it focuses on the school bus and Class 6-8 heavy-duty truck categories, where it holds an 80% market share. Its 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. 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.

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

ALSN shares rose 1% in the past week and have ticked above our recently raised 59 price target. The shares offer a reasonable 1.5% dividend yield. With the earnings report in the bag, we are re-evaluating our rating and price target. HOLD

Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc, hired as CEO in July 2020, is revitalizing Aviva’s core U.K., Ireland and Canada operations following her divestiture of other global businesses. The company now has excess capital which it is returning to shareholders as likely hefty dividends following a sizeable share repurchase program. We expect that activist investor Cevian Capital, which holds a 5.2% stake, will keep pressuring the company to maintain shareholder-friendly actions.

Aviva reports first-half earnings on August 15, with a consensus estimate of £0.19/share.

Aviva shares fell 1% this past week and have 43% upside to our 14 price target. Based on management’s guidance for the 2023 dividend, which we believe is a sustainable base level, the shares offer a generous 8.5% yield. On a combined basis, the dividend and buybacks offer more than a 10% “shareholder yield” to investors. 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 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.

Barrick reported a reasonable quarter, with adjusted earnings of $0.19/share falling 21% from a year ago but beating the consensus estimate of $0.18/share. Results were broadly improved from the prior quarter (first-quarter 2023). The company said it is on target to meet its full-year 2023 production guidance. Rising costs continue to chip away at otherwise decent profitability, but management seems well aware that they need to deliver on their production and profit goals. We are watching what effect achieving these near-term goals will have on Barrick’s long-term fundamentals.

In the quarter, the company received $1,972/ounce for its gold sales, up 6% from a year ago, while gold volumes sold fell 4%. The spread between the realized gold price and all-in sustaining costs of $617/ounce fell 5%, or $32, compared to a year ago, mostly due to rising costs. Copper volumes sold fell 11% while the realized price fell 1%. The spread between the realized copper price and all-in sustaining costs/pound was $0.57, down 33% from a year ago. Adjusted EBITDA of $1.4 billion fell 10% from a year ago.

Barrick declared a $0.10/share quarterly dividend. Net debt increased to $617 million as free cash flow was insufficient to fund the dividend. We have little concern over the current $0.10/share quarterly dividend.

Over the past week, commodity gold fell 1% to $1,944/ounce. The 10-year Treasury yield ticked higher to 4.16%, nearly reaching the peak reached last November. The high prior to November 2022 was set in October 2007. Rising bond yields are weighing on gold prices but not by much, it appears. Usually, these two prices move in opposite directions. Perhaps the growing awareness of the tenuous U.S. Federal government financial picture, highlighted by the Fitch downgrade, as well as the hefty new bond issuances, are pushing yields higher.

The U.S. Dollar Index (the dollar and gold usually move in opposite directions) ticked up incrementally to 102.95. With investors assuming that the Fed is nearly finished with its interest rate hikes, the appeal of the dollar is fading. Low interest rates and a weaker dollar generally are supportive of higher gold prices, although the link is not necessarily instantaneous or proportional.

Investors and commentators offer a wide range of outlooks for the economy, interest rates and inflation. We have our views but hold these as more of a general framework than a high conviction posture. Investing in gold-related equities is a long-term decision – investors shouldn’t allow near-term weakness to deter their resolve.

Barrick shares rose 1% in the past week and have 62% upside to our 27 price target. BUY

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.

Citi completed the sale of its Taiwan consumer banking operations. The bank will receive approximately $715 million in proceeds. About $1.2 billion in capital will be released that otherwise was tied up by local capital regulations.

Citi shares fell 4% in the past week and have 92% upside to our 85 price target. The shares remain attractive as they trade at 52% of tangible book value of $85.34. The recently raised $0.53 quarterly dividend looks sustainable and offers investors a 4.8% yield.

When comparing Citi shares with a U.S. 10-year Treasury bond, Citi offers a higher yield and considerably more upside price potential (over 70% according to our work vs. 0% for the Treasury bond). Clearly, the Citi share price and dividend payout carry considerably more risk than the Treasury bond, but at the current valuation Citi shares would seem to have a remarkably better risk/return trade-off. BUY

Gates Industrial Corp, plc (GTES) – Gates is a specialized producer of industrial drive belts and tubing. While this niche might sound unimpressive, Gates has become a leading global manufacturer by producing premium and innovative products. Its customers depend on heavy-duty vehicles, robots, production and warehouse machines and other equipment to operate without fail, so the belts and hydraulic tubing that power these must be exceptionally reliable. Few buyers would balk at a reasonable price premium on a small-priced part from Gates if it means their million-dollar equipment keeps running. Even in automobiles, which comprise roughly 43% of its revenues, Gates’ belts are nearly industry-standard for their reliability and value. Helping provide revenue stability, over 60% of its sales are for replacements. Gates is well-positioned to prosper in an electric vehicle world, as its average content per EV, which require water pumps and other thermal management components for the battery and inverters, is likely to be considerably higher than its average content per gas-powered vehicle.

The company produces wide EBITDA margins, has a reasonable debt balance and generates considerable free cash flow. The management is high-quality. In 2014, private equity firm Blackstone acquired Gates and significantly improved its product line-up and quality, operating efficiency, culture and financial performance. Gates completed its IPO in 2018, with Blackstone retaining a 63% stake today.

On August 4, Gates reported a good quarter that came in ahead of estimates across the board. The company incrementally raised its profit guidance for the year. Adjusted earnings of $0.36/share rose 13% from a year ago and beat estimates by about 9%. Revenues rose 3% (by 4% excluding acquisitions and currency effects) and were fractionally above estimates. Adjusted EBITDA of $197 million rose 9% and was 3% above estimates.

The company continues to execute well, illustrated by its expanding gross and EBITDA margins. Free cash flow was strong at 114% of net income. Gates repurchased $250 million in shares during the quarter, equal to about 7% of its market value. The balance sheet remains sturdy with cash essentially unchanged from a year ago although debt has ticked up incrementally to fund the share buybacks. Leverage at 2.8x EBITDA has improved due to stronger EBITDA.

This past week, Gates shares fell on news that private equity firm Blackstone is selling at least 15 million shares in a secondary offering (a single offering underwritten by several investment banks, similar to an IPO but Gates is not issuing any new shares). Blackstone took Gates private several years ago and is whittling down its stake. This transaction, which will likely close on August 14, will bring their stake to below 50%.

GTES shares fell 9% in the past week and have 38% upside to our 16 price target. Given the dip in price due entirely to the Blackstone sale, we view this as a worthwhile opportunity to add to positions. BUY

NOV, Inc (NOV) – This high-quality, mid-cap company, formerly named National Oilwell Varco, builds drilling rigs and produces a wide range of gear, aftermarket parts and related services for efficiently drilling and completing wells, producing oil and natural gas, constructing wind towers and kitting drillships. About 64% of its revenues are generated outside of the United States. Its emphasis on proprietary technologies makes it a leader in both hardware, software and digital innovations, while strong economies of scale in manufacturing and distribution as well as research and development further boost its competitive edge. The company’s large installed base helps stabilize its revenues through recurring sales of replacement parts and related services.

We see the consensus view as overly pessimistic, given the company’s strong position in an industry with improving conditions, backed by capable company leadership and a conservative balance sheet.

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

The price of West Texas Intermediate (WTI) crude oil ticked up incrementally in the past week to $82.11/barrel, as resilient demand seems to be meeting stable-at-best supplies. The price of Henry Hub natural gas rose 2% to $2.77/mmBtu (million BTU). Natural gas prices are driven by domestic demand, as import/export volumes are minuscule.

NOV shares rose 2% in the past week as investors seem to be increasingly confident that a floor is being set under oil prices. NOV shares have 21% upside to our 25 price target. The dividend produces a reasonable 1.0% 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 safety 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. Our Sensata investment remains an underperforming (from a business fundamentals perspective) work in progress.

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

ST shares fell 3% in the past week and have 88% upside to our 75 price target. Our price target looks optimistic and we are re-evaluating it in light of our concerns over the company’s management and strategy. BUY

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.
Buy – This stock is worth buying.
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.

Current price is yesterday’s mid-day price.
CSCO: Estimates are for fiscal years ending in July of 2023 and 2024