Cabot Value Investor Issue: June 6, 2023

New Netflix Series: The 2024 Elections

The ink is still drying on the new bipartisan debt ceiling agreement. And, just when it seemed like the drama flowing out of Washington D.C. would fade, the biggest production in the nation’s capital is just starting: the quadrennial presidential election. If the November 2024 election, “only” 17 months away, is like recent past elections, the winner will be unpredictable until late into election night. The Senate and House elections will add further unpredictability – if neither party wins control of both chambers, the ability of whoever is elected president to implement their agenda will likely be limited.

The drama is scripted like a Netflix streaming special. Season 1, as it were, is dedicated to the expanding roster of candidates. Politico lists Republican candidates Ron DeSantis and Donald Trump as “The Favorites” while Nikki Haley and Mike Pence are seen as “Contenders,” with at least a dozen more tallied as “Long Shots.” Reuters lists current president Joe Biden as the obvious frontrunner for the Democrats, with Marianne Williamson and Robert Kennedy Jr. providing some competition. Others may join the race on both sides, with a possibility of a third-party candidate entry.

Season 2 will feature the winnowing process that produces only two candidates – one for each major party. There might be a plot complication if a third-party candidate occupies the political center that could draw moderates from Republican and Democratic candidates. Media attention will focus on how each candidate does on the campaign trail, in the debates and primaries, and in the polls.

Season 3 will cover the final stretch including the election results and possibly an encore episode about the transition of power, especially if President Biden isn’t the winner. The media will be abuzz with guesses about the effects on tax, spending, industrial, foreign and other policies, as well as which stocks “will” be the winners and losers.

We put predicting election outcomes in the same bucket as economic forecasts: almost impossible to get right and unworthy as a foundation for picking individual stocks. The drama may be high, as will emotions, but investors will want to avoid having their investing become swayed by the political and media winds. Media of all types generate immense ad revenue during election seasons, and unfortunately, most are thrilled to overplay news to generate more attention.

Our practice is to completely separate the two worlds of elections: the personal voting process and the investing process. By all means, fully engage in the personal voting process by evaluating and choosing candidates to reflect your views. However, this should be kept completely separate from the investing process, which is based on an unemotional analysis of company-specific fundamentals and risk/reward potential, which are usually completely unrelated to the election outcome.

It’s going to be a fascinating 17 months.

Share prices in the table reflect Monday, June 5 closing prices. Please note that prices in the discussion below are based on midday June 5 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.

Today’s Portfolio Changes
None.

Portfolio Changes Since Last Month
Big Lots (BIG) – Moving from Hold to Sell.
Comcast (CMCSA) – Raising price target to 46 and changing rating from Hold to Buy.
Comcast Corp (CMCSA) – Moving shares from Buy to Hold.

Growth & Income Portfolio

Growth & Income Portfolio stocks are generally higher-quality, larger-cap companies that have fallen out of favor. They usually have some combination of attractive earnings growth and an above-average dividend yield. Risk levels tend to be relatively moderate, with reasonable debt levels and modest share valuations.

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.

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.

On May 17, Cisco reported a reasonable quarter, with earnings of $1.00/share, which were 15% above year-ago profits and 3% above consensus earnings estimate of $0.97/share. Revenues, non-GAAP income, non-GAAP per-share earnings and operating cash flow were all quarterly records.

Revenues rose 14% and were about 1% above estimates. Adjusted EBITDA of $5.2 billion rose 11% but fell incrementally below estimates. Cisco incrementally raised its full-year revenue and profit guidance. It also said that it will produce modest (yet positive) revenue growth in FY2024 and grow earnings per share at a rate faster than revenues. Cisco will step up its share repurchases given its immense cash hoard (fortunately, rather than making a large acquisition).

New product orders fell 23%, suggesting that demand continues to fall off from the strong pace last year. However, with the guidance for positive fourth-quarter and full-year 2024 growth, it appears that the sharp order decline pace will flatten.

In the quarter, Cisco saw strength in its security and software offerings and said that it continues to overcome the supply constraints of prior quarters. As usual, the company is restraining its costs. While margins improved from the second quarter, they fell compared to a year ago. Cisco’s cash production remains impressive. The company produced nearly $5 billion of free cash flow in the quarter, then used just over half of this to repurchase shares and pay the dividend. Net cash increased by $1.7 billion.

All-in, it looks like Cisco should be able to maintain some reasonable revenue and profit strength as the tech cycle weakens.

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

CSCO shares rose 1% this past week and have 31% upside to our 66 price target. The valuation is attractive at 8.9x EV/EBITDA and 13.2x earnings per share. The 3.1% dividend yield adds to the appeal of this stock. 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 16% upside to our new 46 price target. BUY

Buy Low Opportunities Portfolio

Buy Low Opportunities Portfolio stocks include a wide range of value opportunities. These stocks carry higher risk than our Growth & Income stocks yet also offer more potential upside. This group may include stocks across the quality and market cap spectrum, including those with relatively high levels of debt and a less-clear earnings outlook. The stocks may not pay a dividend. In all cases, the shares will trade at meaningful discounts to our estimate of fair value.

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.

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 reached a 52-week high and are only about 6% below their all-time high. The shares rose 3% in the past week, have 8% upside to our 54 price target and offer a 1.8% dividend yield. BUY

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.

On May 24, Aviva reported its first-quarter trading statement (revenues only) and provided an update on its investment portfolio. Overall, the business continues to move forward. General insurance premiums rose 11%, Protection and Health insurance premiums rose 11%, Retirement/Annuities sales rose 17% and Wealth net asset flows were positive at £2.3 billion (about 6% of opening assets). The combined operating ratio (insurance claims, costs and expenses relative to premiums) was 95.4%. Revenues were incrementally above consensus analysis expectations, but other metrics were incrementally below.

The asset portfolio and capital levels remain strong, although the overly complex Pro Forma Estimated Solvency II shareholder cover ratio of 193% fell from 212% due to dividends, share buybacks, the weak bond market and other factors.

We attribute the weakness in the share price to the capital ratio and expectations for stronger pricing and combined ratio. The capital ratio is plenty strong and above management’s target ratio of 182%. But, if it was even stronger then Aviva could buy back more shares. Pricing in the Property & Casualty segment was strong, but the concern is whether it was strong enough to offset inflation. Management said it was confident in its margin outlook, but investors are concerned, nevertheless. The combined ratio is improving but analysts had expected more. We see the story as remaining on track even if not exactly aligned with Street expectations, and management reiterated their financial, operating and dividend outlook and expectations for additional share buybacks.

Activist investor Cevian Capital AB has sold nearly all of its position in Aviva. Cevian was instrumental in pressuring the company to increase its buybacks and otherwise improve its shareholder value and spoke of how Aviva and its current management have done an excellent job in rebuilding Aviva. The exit likely drove some of the share weakness over the past few weeks. Aviva will likely remain highly attuned to shareholder interests as the management team won’t want to invite renewed activist attention.

Aviva shares rose 1% this past week and have 38% upside to our 14 price target. Based on management’s guidance for the 2023 dividend, the shares offer a generous 8.0% yield. On a combined basis, the dividend and buyback provide more than a 10% return to shareholders. 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.

On May 3, Barrick reported a reasonable quarter, with adjusted earnings that fell 46% but were 2 cents above the $0.12/share consensus estimate. Adjusted EBITDA fell 28% although the margin (at 45%) was healthy. While gold production fell 4% and copper production fell 13%, these volumes were in-line with management’s guidance. Gold volumes sold fell 4% while cost of sales rose 16%, more than offsetting the 1% increase in pricing. The company maintained its full-year production guidance. Overall, the company continues to face rising costs and elevated capital spending, but the increases look contained. Barrick remains well-managed with high-quality assets.

Barrick’s net debt position ticked up to $400 million, compared to $342 million in the prior quarter and $(743) million a year ago. In essence, the company is funding about half of its 10 cents/share quarterly dividend with borrowing. We anticipate that higher cash flow the rest of the year will more than fund its dividend, although we anticipate zero bonus dividends. No change to our rating.

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

Over the past week, commodity gold ticked down fractionally to $1,962/ounce. The 10-year Treasury yield ticked up to 3.74%. The U.S. Dollar Index (the dollar and gold usually move in opposite directions) was unchanged at 104.30.

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 2% in the past week and have 56% upside to our 27 price target. BUY

Big Lots (BIG) – Big Lots is a discount general merchandise retailer based in Columbus, Ohio, with 1,431 stores across 47 states.

Big Lots reported awful results. Sales fell 18% and were about 5% below estimates. The adjusted net loss was $(99) million, or $(3.40)/share, compared to a loss of $(11) million, or $(0.39) a year ago. Estimates were for a loss of $(1.62)/share. Adjusted EBITDA was $(82) million compared to $24 million a year ago and expectations for a loss of $(24) million.

Given our lost confidence in the company and its leadership team, we are exiting our position with a miserable 79% loss after factoring in $1.20/share in dividends received. Please see the May 30 Update for more on our rating change. SELL

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.

Regulators are considering raising capital requirements by an average of 20% for banks over $100 billion in assets, which of course would include Citigroup. Banks more heavily involved in trading could see larger increases as they are assumed to be taking on more risk. Details of the plan have not been released. It is not clear what, if any, plan will be implemented, or when, and we anticipate considerable opposition by banks.

Citi shares rose 4% in the past week and have 84% upside to our 85 price target. The shares remain attractive as they trade at 55% of tangible book value of $84.21 and offer a sustainable 4.4% dividend 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 80% 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 May 4, Gates reported an encouraging quarter even though adjusted earnings fell incrementally short of the consensus estimate. Investors looked through the higher-than-expected tax rate and costs of a cyberattack as operating results were strong. Gates maintained its full-year guidance and authorized a $250 million (about 6% of current market cap) share repurchase program. In the quarter, sales rose 4% excluding currency and were fractionally below estimates. Adjusted EBITDA rose 12% and was 4% above estimates. The margin expanded to an impressive 19.4%, although without some scrubbing of otherwise legitimate business costs the margin would have been 15.8%.

Debt net of cash fell 15% from a year ago although only incrementally compared to year-end. Leverage ticked down to a reasonable 2.7x EBITDA, the share count fell 3%, and free cash flow improved with a 105% conversion (free cash flow to net income).

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

GTES shares rose 5% in the past week and have 31% upside to our 16 price target. 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 straightforward – 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 reinstated its dividend.

On May 2, Molson Coors reported a strong quarter, with underlying earnings rising 86% and more than double the consensus estimate. Revenues rose 8% ex-currency and were about 5% above estimates. Strong pricing, sales of higher-margin products, relatively stable volumes and flattish marketing spending drove the sharp increase in profits, even as raw materials costs rose 7%. Molson Coors reaffirmed its guidance for low-single-digit revenue and profit growth and for underlying free cash flow to be $1 billion (+/- 10%). All-in, the quarter shows that this company is a reasonably reliable profit and free cash flow generator that investors have overlooked. The shares are approaching our $69 price target.

Free cash flow improved from a year ago. Net debt was unchanged from the prior quarter but fell 10% from a year ago. Net debt relative to EBITDA was 3.0x and appears on track to reach the company’s 2.5x longer-term target. Reducing debt reduces the company’s risk and accretes value to shareholders.

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

TAP shares rose 6% in the past week and have 8% upside to our 69 price target. The stock remains relatively cheap, particularly on an EV/EBITDA basis, or enterprise value/cash operating profits, where it trades at 9.6x estimated 2023 results, still among the lowest valuations in the consumer staples group and below other brewing companies. However, given the nearness of the price target, the shares are a tepid Buy at best from here. 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.

The shares trade at the low end of their 20-year range due to investor expectations for an uninspiring future. We see this 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 5% in the past week to $72.51/barrel, while the price of Henry Hub natural gas was essentially unchanged at $2.26/mmBTU (or, million BTU). A 1 million barrel/day production cut by Saudi Arabia boosted oil prices, as did favorable reports about the durability of the economy. We have no insight into the direction of crude oil or natural gas prices. Our interest is in prices staying reasonably elevated to encourage continued/higher drilling activity, which seems likely given the current low level of activity across both oil and natural gas segments.

NOV shares rose 2% in the past week and have 62% upside to our 25 price target. The dividend produces a reasonable 1.3% 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 rose 1% in the past week and have 78% upside to our 75 price target. Our price target looks optimistic, 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 Value Investor 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.

The next Cabot Value Investor issue will be published on July 5, 2023.