August 22, 2023

It’s Getting Interesting…

The capital markets are always interesting, and seemingly more so now. A lot of trends are coming together that could drive some late-year turbulence.

Artificial Intelligence (“AI”) is this year’s hot topic. Following a remarkably strong outlook last quarter, chipmaker and AI beneficiary Nvidia (NVDA) is scheduled to report earnings on Wednesday. The company’s shares surged on Monday in advance of the report as speculators place bets for another blow-out report. Other Magnificent 7 tech stocks are riding the wave. If Nvidia’s revenues, earnings and guidance are uninspiring, tech stocks will have a rough year-end.

Interest rates continue to tick up. The 10-year U.S. Treasury yield crossed the 4.30% mark and is now at the highest level since October 2007. Interest rates can be viewed as the price of money – the price of renting capital, as it were – so the jump from free rent to 4.3% rent will continue to pressure the economy in ways not yet seen. Segments that benefited from free money, well beyond the previously highly visible private equity unicorns that are now increasingly scarce, will likely see more evaporation of their capital sources and prospects. Job losses in the tech space are rising.

Gold prices are driven largely by interest rates and the dollar. Despite pressure from both, gold remains only 5% or so below its all-time high. This seems unnatural unless something else is supporting gold. Perhaps concerns about the chronic U.S. federal budget deficit or global military and geopolitical unrest, or the yet-to-be-tamed problems of inflation are helping buoy the precious metal. Economic and political turbulence across South America and parts of Africa no doubt have a role.

Starting soon, millions of Americans with student debts will be resuming payments. The much-stated average monthly payment of $450 per student certainly won’t boost overall consumer spending. More likely, it will siphon off dollars that otherwise would have gone into the pockets of retailers, airlines, restaurants and other discretionary spending outlets. Perhaps Netflix will see a surge in new subscribers, as $15.49/month may seem like a bargain.

Presidential debates start soon and may bring true surprises, particularly as the leading Republican candidate is facing a flurry of legal problems. The leading Democratic Party candidate may also face a meaningful challenge due to well-publicized legal complications. Where this all goes, nobody really knows.

China’s economy is slipping backwards after 40 years of hefty growth. The country faces a somewhat unique risk among major economies: its economic fate is driven largely by the policies of its leader and the population is well aware of this. A faltering economy could drive protests against the government and, while exceptionally unlikely, could result in regime change. Needless to say, the risk of such a change, and the actual change itself, would dramatically shift global geopolitics.

Other macro issues are pushing their way into this mix, as well. And, this all is happening in an environment where corporate earnings growth remains dull and stock prices are elevated. The rest of the year has all the markings of a fascinating finish.

Share prices in the table reflect Monday, August 22 closing prices. Please note that prices in the discussion below are based on mid-day August 22 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.

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 reported a solid fiscal fourth quarter, with adjusted earnings of $1.14/share increasing 37% and beating the $1.06 estimate by about 8%. Revenues rose 16% and were about 1% above estimates. Revenue metrics were robust and profits were further boosted by expanding gross margins. Guidance for full-year 2024 was for 1% revenue growth and 4% earnings growth, supporting our case that the company is a slow but steady grower with a fortress balance sheet ($18 billion more cash than debt) that is returning much of its prodigious free cash flow to shareholders through dividends and share buybacks.

A prior concern was that Cisco was generating revenue growth by burning through its backlog. However, the fourth quarter’s revenue performance suggests that demand is strong enough to push the backlog higher (up 11%). Product revenues rose 20%, and although new product orders slipped 14%, this is directionally an improvement over the 23% decline posted in the prior quarter. Product orders jumped 30% from the third quarter, further suggesting enduring strength. With products comprising nearly 75% of total sales, it is a major driver of overall Cisco’s health. Cisco is showing revenue resilience in a difficult tech spending environment.

Software revenues are about 30% of total revenues (primarily in the Product segment) and grew 17%, helped by 20% growth in subscription revenues. Cisco’s migration to subscription software is improving its revenue predictability and is a key component of its business model transition. Nearly 85% of all software revenues and 43% of total revenues are now from subscriptions. More recurring revenue will allow Cisco to earn a higher valuation multiple.

On the call, management used the term “AI” eighteen times, which may have helped ignite the shares. But, there is a legitimate tailwind as cloud and other companies ramp their AI spending. Aside from AI, the company continues to innovate enough to keep enough customers in the Cisco universe. Cisco doesn’t need to be leading-edge to keep its customers from defecting to other product and service providers.

The gross margin expanded to 65.9% from 63.3% a year ago, alleviating concerns over otherwise chronic erosion. Product margins expanded sharply, driving the overall margin expansion. Margins expanded due to higher pricing and a larger mix of high-margin products.

Operating expenses rose 14.7%, slower than revenues, helping buoy overall profits. Cisco remains reasonably restrained on its spending.

CSCO shares rose 3% for the week. The shares have 19% upside to our 66 price target. Based on fiscal 2024 estimates, the valuation is attractive at 9.8x EV/EBITDA and 13.7x 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 as worry 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.

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

Comcast shares fell 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 fell 2% in the past week and have ticked above our recently raised 59 price target. The shares offer a reasonable 1.6% 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 reported first-half earnings of £0.20/share, increasing 10% from a year ago and beating the consensus estimate of £0.19. The company continues to grind forward with healthy performance following its shrink-to-growth turnaround.

Gross premiums written rose 12% and funds continue to flow into its wealth products. Costs remain controlled with no increase from a year ago on an adjusted basis despite 7% underlying inflation. Operating profits rose 8% and capital strength is sturdy. Aviva generated 26% growth in its funds generation. The company is on track to meet or exceed its targets.

Aviva shares fell 1% this past week and have 45% 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 8.6% 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 of 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 $1,919/ounce. The 10-year Treasury yield ticked higher to 4.34%, reaching a 15-year high. The last time the yield was at 4.34% was 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 103.46. Rising yields are pushing up demand for the dollar but weighing incrementally on gold prices.

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 fell 7% in the past week and have 74% 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.

The London Financial Times reported that Citi is considering breaking up its largest division, the Institutional Clients Group, into three separate divisions. ICG, as it is called, generates nearly 75% of the bank’s total revenues, spread across its investment and corporate banking, global markets and transaction services segments. The plan would essentially skip replacing the soon-to-be-departing ICG head, with each of the three segment heads reporting directly to CEO Jane Fraser. Our view is that this is a good move, as it removes a layer of bureaucracy and puts more direct accountability onto the segment leaders.

Citi shares fell 4% in the past week and have 101% upside to our 85 price target. The shares remain attractive as they trade at 49% of tangible book value of $85.34. The recently raised $0.53 quarterly dividend looks sustainable and offers investors a 5.0% 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. Following several sell-downs, Blackstone has a 43% 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.

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

GTES shares were flat in the past week and have 37% upside to our 16 price target. Given the recent 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 down about 1% in the past week to $81.44/barrel, as resilient demand seems to be meeting stable-at-best supplies. The price of Henry Hub natural gas fell 5% to $2.61/mmBtu (million BTU). Natural gas prices are driven by domestic demand, as import/export volumes are minuscule.

NOV shares fell 1% in the past week as investors seem to be increasingly confident that a floor is being set under oil prices. NOV shares have 22% 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 6% in the past week and have 100% 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

Current price is yesterday’s mid-day price.

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.