Cabot Value Investor Issue: May 2, 2023

Woodstock for Capitalists

This coming weekend, Berkshire Hathaway is hosting its Annual Shareholders Meeting. Once a small gathering of investors, it has morphed into a four-day circus as upwards of 30,000 value-minded investors descend on Omaha (population: 490,000). Berkshire itself has events running (literally, including the Brooks 5K Race) from Friday morning through 4 p.m. on Sunday. To help shareholders navigate the vast array of activities, the company publishes a 24-page guide, aptly naming the events a “Festival.”

Like all festivals, this one offers opportunities for others to showcase their wares. Highly respected Markel Corporation, often called a mini-Berkshire, is hosting a brunch on Sunday morning. Investment-related social media platforms are offering a variety of speakers and trinket-purveying events. “JunkStock” is a local feature sure to draw some attention, as well.

The unofficial name for the Berkshire/Omaha festival, “Woodstock for Capitalists,” would seem to fit perfectly.

Your chief analyst will be making his inaugural visit – attending solely as a spectator and Berkshire shareholder. Having watched the online version for years, it is time to finally visit the Mecca of value investing to see Warren and Charlie in person. I’ll be bringing my 16-year-old son, who is a wonderful traveler and has an expansive mind capable of digesting the proceedings.

We’ll report back what we learned in next Tuesday’s edition of our newsletter.

Share prices in the table reflect Monday, May 1 closing prices. Please note that prices in the discussion below are based on mid-day May 1 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
NOV Inc. (NOV) – New Buy

Upcoming Earnings Reports

Tuesday, May 2: Molson Coors Beverage Company (TAP)
Wednesday, May 3: Barrick Gold (GOLD)
Thursday, May 4: Gates Industrial (GTES)
Wednesday, May 17: Cisco Systems (CSCO)
Wednesday, May 24: Aviva, Plc (AVVIY)
Thursday, May 25: Big Lots (BIG)

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.

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 were flat this past week and have 39% upside to our 66 price target. The valuation is attractive at 8.9x EV/EBITDA and 12.6x earnings per share. The 3.3% 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.

Comcast reported a strong quarter, with adjusted earnings of $0.92/share increasing 7% from a year ago and beating the $0.82 consensus estimate by about 12%. Revenues fell 4% although the year-ago results included the Beijing Olympics and the Super Bowl. Revenues were incrementally ahead of estimates. Free cash flow was robust at $3.8 billion even though it was 20% below year-ago results. All-in, another quarter of stable results with good execution.

We see the revenue decline due to the Olympics and the Super Bowl as reasonable. The Olympics are not held every year, of course. The Super Bowl broadcast rotates annually among three broadcasters (CBS, Fox, NBC) with ABC joining the rotation in 2024 but not broadcasting the game until the February 2027 Super Bowl.

Total customer relationships in the Connectivity & Platforms segment rose incrementally, but the domestic video customer count fell 12%, reflecting the secular shift away from cable television. However, segment revenues were flat while profits increased 4%, helped by higher pricing.

Strong demand drove Theme Parks revenues up 25% and profits up 46%, while Studios profits increased 13%. The strong early-April release of the new Super Mario Brothers movie, which has already generated $1 billion in revenues, is providing a strong start to the second quarter.

Despite the decline in revenues, cost-cutting helped drive EBITDA to a 3% year-over-year increase. The Peacock streaming service produced a large $(704) million loss, worse than the year-ago $(456) million loss, but revenues rose 45% and the subscriber count increased to 22 million. These traits suggest that customers are willing to pay for the service, but that it needs to eventually find a way to become profitable.

Capital spending remains elevated, up 44% from a year ago, as the company spends to maintain and upgrade its cable and telecom infrastructure and build the Epic Universe theme park in Orlando.

Comcast’s share count continues to decline, down 1% from the fourth quarter and down 7% from a year ago, even as the balance sheet remains sturdy.

This past week brought news that Hollywood writers may go on strike. We have no insight into when an agreement will be reached. We would like to see a quick and fair resolution – following a protracted strike years ago, the quality of movies that were subsequently released were stark reminders of the skill that these writers bring. We would not like to see anything impair the strong appeal of (revenue-producing) streaming content or the rebound in demand at movie theaters.

Comcast shares jumped 12% in the past week and have nearly reached our 42 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.

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.

The company reported a strong quarter, with earnings of $1.85/share increasing 42% from a year ago and beating the $1.53 estimate by 21%. Sales rose 9% to a first quarter record and were about 3% above estimates. Allison raised its full-year revenue guidance by 3% and its earnings guidance by about 10%. In the quarter, the company raised its quarterly dividend by 10% and repurchased 1% of its shares.

Demand was reasonably healthy, with particular strength in aftermarket sales and North America On-Highway medium- and heavy-duty specialty trucks. Better pricing helped Allison expand its gross margin by 1.45 percentage points. Expenses increased to support the higher business activity, with warranty costs also increasing. Adjusted EBITDA rose 13% to produce an impressive 37.2% margin. Free cash flow of $169 million rose 19%. The net debt balance edged lower in the quarter as cash accumulated.

ALSN shares rose 4% in the past week, have 10% upside to our 54 price target and offer a 1.9% 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.

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

Aviva shares rose 1% this past week and have 32% upside to our 14 price target. Based on management’s guidance for the 2023 dividend, the shares offer a generous 7.7% 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.

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

Over the past week, commodity gold ticked up to $1,992/ounce. Gold prices can be impressively volatile and have risen 22% since troughing late last year at $1,630. The recent surge is likely due to growing popularity of the view that the Fed’s rate hike campaign is approaching its limit even as inflation remains well above the 2% Fed target. The Fed’s next rate decision is due this Wednesday.

This past week, the 10-year Treasury yield was essentially unchanged at 3.54%. The U.S. Dollar Index (the dollar and gold usually move in opposite directions) was also essentially unchanged at 102.13.

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 reports earnings on Wednesday, May 3, with a consensus earnings estimate of $0.12/share.

Barrick shares were flat in the past week and have 42% 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. Its stores offer an assortment of furniture, hard and soft home goods, apparel, electronics, food and consumables as well as seasonal merchandise. Our initial case for Big Lots rested with its loyal and growing base of 22 million rewards members, its appeal to bargain-seeking customers, the relatively stable (albeit low) cash operating profit margin, its positive free cash flow, debt-free balance sheet and low share valuation. Our thesis was deeply rattled by the company’s surprisingly large inventory glut, now resolved, but which leaves the company with a hefty and permanent $300 million debt burden.

Big Lots shares remain high-risk due to the new debt balance, weak fundamentals and the possibility of a suspension or reduction of the dividend. Sentiment in the shares is very weak – investors unwilling or unable to sustain further losses in the shares should sell now, as sentiment could weaken further and drive the shares lower.

Regarding the dividend, Big Lots now has every incentive to eliminate it. Investors clearly are not convinced that it will be maintained, given the company’s likely weak profits for at least the current fiscal year. And, eliminating the $35 million in cash payouts would help the company retire its $300 million debt as well as ease future seasonal borrowings.

Bed Bath & Beyond, which filed for bankruptcy, will be liquidating its stores. Bargain hunters may be diverted to these stores, producing a near-term headwind for Big Lots. Longer term, the elimination of a competitor should be a positive for Big Lots.

Big Lots shares fell 6% this past week and have over 100% upside to our revised 25 price target. The shares offer a 13.7% dividend yield, although, as noted, investors should not rely on this dividend being sustained. We continue to hold onto Big Lots’ shares as we believe the company will ultimately rebuild about half of its prior earnings base. The shares’ highly discounted valuation provides a reasonable valuation cushion, even as investor sentiment continues to push the shares lower. 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 April 14, Citigroup reported a good first quarter, with adjusted earnings of $1.86/share falling 1% from a year ago but 11% above the $1.67 consensus estimate. Return on assets of 0.76% improved incrementally from 0.74% a year ago. Return on equity of 9.5% also improved incrementally from 9.0% a year ago. These return metrics are improving but still well below a 1.0% ROA and 12% ROE that we would consider reasonable targets. Guidance for 2023 was unchanged.

Revenues rose 12% due to higher interest rates, as fee income slipped 3%. The net interest margin of 2.41% improved from 2.05% a year ago and 2.39% in the prior quarter. Citi is having to boost the interest rate it pays on deposits to retain this funding source. The average rate paid in the first quarter was 2.72%, up from 0.33% a year ago. In the year-ago period, the 0.33% rate was about 50 basis points below the 90-day T-bill rate, while today the deposit interest rate is about 233 basis points below the T-bill rate. This incremental spread, plus the higher spread on non-interest-bearing checking deposits, is helping boost Citi’s net interest margin despite the inverted yield curve.

Non-interest expenses rose only 1% and remained controlled, particularly for a bank undergoing an aggressive overhaul. Citi’s efficiency ratio (operating expenses as a percent of total revenues) improved to 62% from 69% a year ago. Credit losses increased incrementally from the prior quarter but remained low. The bank boosted its reserves for losses to a hefty 2.65% of total loans, and the bank appears to be satisfied with this size.

Capital strength increased, with the CET1 ratio rising to 13.4% compared to 11.4% a year ago and 13.0% in the prior quarter. The bank did not repurchase any shares during the quarter. Data on the securities portfolio were not reported – we will get this from the 10Q which has yet to be filed. Deposits fell only 3% from the prior quarter and were unchanged from a year ago.

The sale of First Republic Bank to JPMorgan is an incremental positive for all banks, as it averts a highly likely collapse of the struggling bank. However, it seems unlikely that there will be no other fallout from the Fed’s aggressive rate hike campaign.

Citi shares remain attractive as they trade at 57% of tangible book value of $84.21 and offer a sustainable 4.3% dividend yield.

Citi shares declined 3% in the past week and have 78% upside to our 85 price target.

When comparing Citi shares with a U.S. 10-year Treasury bond, Citi offers a higher yield and considerably more upside potential (about 78% 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 lineup and quality, operating efficiency, culture and financial performance. Gates completed its IPO in 2018, with Blackstone retaining a 63% stake today.

Gates reports earnings on Thursday, May 4, with a consensus earnings estimate of $0.26/share.

GTES shares rose 2% in the past week and have 18% 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.

The company reports earnings on Tuesday, May 2, with a consensus earnings estimate of $0.26/share.

TAP shares rose 4% in the past week and have 14% 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 9.4x estimated 2023 results, still among the lowest valuations in the consumer staples group and below other brewing companies. BUY

NOV Inc. (NOV) – This high-quality, mid-cap company ($7.3 billion market cap) appears to be in front of an upshift in demand for drilling equipment even as its shares trade at a modest valuation.

Formerly named National Oilwell Varco, NOV is a major global supplier of oil and gas drilling equipment, with revenues of $8.5 billion. Based in Houston, Texas, NOV has its roots in the late 1800s, with the current company being the result of both organic growth and numerous mergers. The company is organized into three divisions. Wellbore Technologies (37% of sales) produces equipment to improve drilling results and efficiencies. Completion and Production (35%) focuses on well completion and production equipment. Rig Technologies (28% of sales) makes land and offshore drilling rigs and related equipment as well as gear related to wind towers. All three segments also produce aftermarket parts and provide related services. About 64% of NOV’s revenues are generated outside of the United States, with a customer base that includes independent, major and national oil companies, as well as service providers, with operations in every oil-producing region in the world.

NOV’s emphasis on proprietary technologies makes it a leader in both hardware, software and digital innovations, which boosts its relevance to customers and helps maintain its profit margins. 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.

Well aware of the emerging transition to alternative energy sources, NOV has become a leading designer and producer of equipment for offshore wind turbine installation vessels and onshore wind tower construction equipment. Its drilling expertise is also well-placed to meet the growing demand for carbon sequestration and geothermal wells.

A recovery in demand for drilling equipment appears to be under way, stimulated by the recovery and apparent stability of oil prices. Oil prices are being supported by relatively tight supply, bolstered by OPEC+ production discipline and slowing production growth by publicly traded majors under pressure to return more cash to shareholders. Further constraining oil production is nearly a decade of underinvestment by oil producers.

Resilient demand for oil is also supporting the commodity’s price. Demand remains robust at around 100 million barrels/day and is likely to continue to increase by about 1 million barrels a day every year into the foreseeable future, following the growth of the global economy.

NOV is a direct beneficiary of rising demand for oil drilling equipment. Oil at roughly $80/barrel is high enough to encourage producers to drill both onshore and offshore. Demand in the offshore market, usually the last to show growth yet which is NOV’s specialty, is gradually recovering, reflected in an increasingly tight market for drillships.

The company’s financial results fell sharply in recent years but are showing signs of recovery. Revenues in 2021 fell to $5.5 billion, down 35% from 2019, while EBITDA of $229 million fell nearly 75% from the 2019 level. However, last year, NOV saw revenues improve to $7.3 billion and EBITDA improve to $679 million. NOV’s backlog continues to tick up and was 8% above year-ago results in the most recent quarter. We see the company generating over $9 billion in revenues and $1.3 billion in EBITDA in three years as oil drilling more fully recovers.

NOV is well-managed by a respected team of company and industry veterans. Its financial strategy is conservative, reflected in its cash-heavy ($1.1 billion) and low-debt ($1.7 billion, or 1.7x EBITDA) balance sheet. Nearly all of its debt matures in 2029 or later and carries a fixed rate of interest of 3.90% or lower. The company is profitable and generates positive free cash flow. Over time, we anticipate that the company will deploy some of its excess cash into acquisitions and share buybacks.

Primary risks include the possibility of a sharp and/or prolonged decline in oil and natural gas prices, easing/termination of war-related Russia sanctions and elevated commodity and labor costs. Supply chain issues and weaker onshore gas drilling activity, as well as sizeable inventory increases in advance of expected demand, may impede near-term results.

At about 18.50, NOV shares trade at the low end of their 20-year price range of 10-85 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. NOV shares provide a reasonable 1.1% dividend yield. Our price target for NOV shares is 25, based on a 7.5x EBITDA multiple on our 2025 estimates.

NOV reported a good quarter, with revenue and profits rising sharply from a year ago. Orders exceeded shipments by 9%. Management commented that weaker North American natural gas prices and ongoing supply chain issues weighed on results but that the global demand picture is improving and “driving a steady increase in tendering activity and backlog.” All-in, encouraging results and any weakness on near-term issues is a good opportunity to accumulate shares.

Revenues of $2.0 billion rose 27% and were in line with estimates. Net income of $0.32/share compared to a $(0.13) loss a year ago and was about 45% above estimates. Adjusted EBITDA of $195 million rose 89% from a year ago but was 6% shy of estimates. The cash balance declined by about $300 million from year-end mostly due to an inventory build-up in advance of order-filling and some supply-chain-related bloat.

NOV shares fell 13% due to investor disappointment with the EBITDA results and the company’s weak free cash flow guidance. The shares have 52% upside to our 25 price target. 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 decent quarter, with adjusted earnings of $0.92/share increasing 18% from a year ago and beating the consensus earnings estimate of $0.87. Revenues rose 2% and were incrementally higher than estimates. The company is making progress toward its operational and strategic goals (favorable) but it appears that revenue growth is stalling for this cycle. Second-quarter guidance was incrementally below current estimates, leading to a modest sell-off in the shares. No change to our Buy rating.

In the quarter, organic revenue growth was 4.7%, roughly in line with its end-markets such that its “Outgrowth” was essentially zero. The operating margin increased (helped by cost controls) and the company is expecting steady improvements to continue. Sensata is making progress on integrating its recent acquisitions.

Free cash flow improved sharply to $60 million from $12 million a year ago. Sensata repaid $250 million of its floating rate debt and plans to repay the remaining $200 million this year, helping to reduce its interest costs. Further debt repayments are likely in future years as the company is working down its financial leverage. Earlier, the company raised its quarterly dividend by 9% to $0.12/share, throwing a bone to suffering shareholders.

Sensata’s spending on its electric vehicle opportunities is appealing but relies on steady increases in the demand for EVs. This is creating a bit of a speculative element to the story. The company is splitting out its Insights business into its own segment starting in the second quarter to help illuminate the value and likely inducing investors to develop a sum of the parts valuation that is more favorable. We will be watching this space.

ST shares fell 9% in the past week and have 73% 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

The next Cabot Value Investor issue will be published on June 6, 2023.