August 8, 2023

On Fitch

As most everyone knows, last week, Fitch Ratings downgraded the credit rating of U.S. Long-Term Foreign-Currency Issuer Default Rating (IDR) to AA+ from AAA. This follows by a decade a similar downgrade by Standard & Poor’s.

The response by politicians, media, capital markets participants and commentators was a big yawn at best, with more than a few sharp dismissals and denials of the report’s relevance, timeliness and accuracy.

In the real world, which is outside of the publicity bubble, what does the downgrade actually mean? In the near term, almost nothing. The ability of the U.S. government today to attract capital on respectable terms and repay its debts on time and in full is rock solid. Few if any sovereign debt has a repayment track record and underlying fundamentals that are as sturdy as that of U.S. government debt.

However, in the long term, the government’s ability to repay its debt is legitimately questionable. One clear problem is the annual fiscal deficits. The independent Congressional Budget Office (CBO) estimates that annual deficits will be nearly 6% of GDP every year for the next decade, at least. No entity can survive long-term with that scale of annual losses. In addition to spawning concern and doubt among lenders (which would raise their required interest rate), the math becomes difficult to manage.

One way to look at deficits is their size relative to the global pile of total capital. By some measures, there is about $125 trillion of investment capital in the world. A 6% deficit would average about $2 trillion a year, consuming perhaps $20 trillion in capital over a decade, or about 16% of total world capital. Remember that this is an incremental amount, on top of the roughly $32 trillion in U.S. debt already. It hardly seems plausible that U.S. federal debt would consume over 40% of global capital.

Even if it could, the interest on the debt would be suffocating. Today, the CBO estimates that total interest payments will be about $663 billion in 2023, rising to $1 trillion by 2028. This would consume 17% of all revenues collected by the federal government. The total assumes an average interest rate of only 3% – a generous assumption when short-term rates are over 5% and long-term rates are over 4%. An increase to an average rate of 4% would mean that interest would consume nearly 23% of federal revenues.

The CBO projections also make a generous assumption about the health of the U.S. economy. If an almost-inevitable recession arrives any time in the next decade, the CBO deficit projections will likely significantly understate the shortfalls. If we generate losses of 5% (of GDP) during boom times, we could readily slide into 8% deficits in recessionary times. If the country has another financial or economic crisis, the deficit could readily reach 10% of GDP.

Keynesian economics emphasizes government spending to boost an economy. But, chronic borrowing eventually raises interest expenses to what is called the “Keynesian Endgame.” This occurs when interest expenses consume all of a government’s revenues. While the U.S. is nowhere near this Endgame, the math is clearly pointing in this direction.

Many would say that the government can simply print new dollars to repay its debt. That is true as far as it goes. But the damage to the dollar would be severe, as lenders would need to factor in what could easily be a 20-50% deprecation in their real (inflation-adjusted) interest and principal receipts. And new borrowings would need to factor in this immense devaluation of the dollar. With the low credibility, U.S. government debt costs would surge. While Argentina can get repeatedly bailed out by the IMF, there is no such option for the multi-trillion-dollar U.S. debts.

A company in such dire straits would likely need to reign in its spending. But politicians of all stripes and across all times truly enjoy and are addicted to spending other people’s money. There is little encouragement that this will ever change.

After this long missive on our federal government’s sorry economics, where do we stand? We generally place our finances in solid companies that can earn real profits. And, we also have a holding of gold-related assets. We are also trying not to think about any of this stuff too much.

Share prices in the table reflect Monday, August 7 closing prices. Please note that prices in the discussion below are based on mid-day August 7 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 8: Barrick Gold (GOLD)
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.

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

CSCO shares rose 2% for the week. The shares have 25% upside to our 66 price target. The valuation is attractive at 9.8x EV/EBITDA and 13.9x 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.

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

Comcast shares were flat in the past week and have 1% upside to our 46 price target. Given the small upside remaining to our 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 reached 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.

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

Aviva shares fell 1% this past week and have 42% 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 8.4% 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 is scheduled to report earnings on August 8, with a consensus earnings estimate of $0.18/share.

Over the past week, commodity gold fell 2% to $1,967/ounce. The 10-year Treasury yield jumped sharply higher to 4.10%, the highest level since last November when it reached 4.20%. 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) was essentially unchanged at 102.13. 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 fell 5% in the past week and have 64% 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.

Citigroup is expected to pay $1.5 billion to help replenish the FDIC’s deposit insurance fund. This payment would be equal to about 1% of the bank’s tangible book value of about $164 billion.

Citi shares fell 4% in the past week and have 86% upside to our 85 price target. The shares remain attractive as they trade at 54% of tangible book value of $85.34. The recently raised $0.53 quarterly dividend looks sustainable and offers investors a 4.6% 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.

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.

Gates shares fell as the company said that demand is likely to slow in the second half of the year – hence, the 2% downtick in its full-year revenue guidance. However, its profitability initiatives will help boost its profits so the company is raising its full-year earnings guidance by about 3%. Conversion of profits to free cash flow should remain above 100% for the year.

GTES shares fell 6% in the past week and have 25% upside to our 16 price target. 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 rose 1% in the past week to $81.95/barrel, as resilient demand seems to be meeting stable-at-best supplies. The price of Henry Hub natural gas rose 4% to $2.72/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 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 3% in the past week and have 83% 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