January 30, 2024

A Few Words (or Numbers) on the Federal Debt, Part II

Last week, we wrote about how rising debt and rising interest rates are increasingly weighing on the Federal budget. Our rough math points to interest costs consuming as much as 21% of Federal revenues by 2025. We also added that “This math seems awful. Realistically, how likely is this to play out and what can investors do to mitigate, or even benefit?”

Our risk management process involves considering a wide range of possible macro scenarios. We are terrible at predictions, so we don’t make them. But, by accepting that the world is not risk-free and by recognizing risks early, we are better prepared to deal with them if they do materialize later.

So, just how likely is reaching the 21% burden by 2025? We would say there is at least a 50% chance that we hit this target. If economic growth is faster (implying higher tax revenues), if federal spending growth is slower, or if the Federal Reserve slashes interest rates to 3% or lower, the 21% burden would be pushed out a few years. However, as long as the direction of the burden is “higher,” our risk management process urges us to monitor it and explore possible ways to mitigate or benefit from it.

From a stock investing perspective, a higher Federal interest burden would likely mean more inflation, as people incrementally lose confidence in the dollar. This would imply that value stocks – inexpensive stocks of companies that generate a lot of cash – would likely do well. Stocks of growth companies would likely suffer as rising interest rates would weigh on their valuations and as investors shift away from cash-consuming and cash-neutral companies. Companies reliant on Federal revenues, like healthcare companies, could suffer as the government is forced to tighten its spending. Export-oriented companies might benefit disproportionally as their foreign currency revenues would be translated into more U.S. dollars. Higher-quality international stocks might do well, at least on a dollar basis, for the same reason.

Looking elsewhere: high-yield/low-quality bonds might perform well. Rising interest rates would almost certainly weigh on their valuations. But, interest and principal are repaid in nominal dollars, so rising inflation could greatly improve their ability to cover their debts. The resulting quality up-shift could more than offset the effect of rising interest rates.

Commodity companies would likely do well, including gold, silver and copper producers, as would direct holdings (or ETF equivalents) of these commodities. Other tangible assets like land would probably hold their value.

Obligations of the Federal government would likely fare poorly. Curiously, we could see yields of high-quality multi-national corporate bonds trade through (below) Treasuries. The Federal government may have its struggles, but people around the world will probably continue to drink Coca-Cola and use Procter & Gamble laundry detergents.

What about cryptocurrencies? Our view is that nearly all of these, perhaps even Bitcoin, are worthless, but we aren’t entirely certain. And, if the dollar loses credibility, people around the world could readily buy into the crypto concept, sending prices soaring. Bitcoin ETFs could be a big winner.

Fortunately, the future arrives only one day at a time, providing plenty of slow-moving visibility into how things might play out. Investors who think proactively about these future scenarios well in advance will be better prepared on the chance they actually arrive.

Share prices in the table and discussion below reflect Monday, January 29 closing prices. Please note that prices in the discussion below are based on mid-day January 29 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
Friday, February 2: NOV, Inc. (NOV)
Tuesday, February 6: Sensata Technologies (ST)
Thursday, February 8: Philip Morris International (PM)
Thursday, February 8: Gates Industrial (GTES)

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 and generates vast cash flow. Its announced deal for Splunk will drain most of its cash hoard but we see this as being replenished relatively quickly.

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

CSCO shares rose 1% in the past week and have 27% upside to our 66 price target. Based on 2024 estimates, unadjusted for the Splunk acquisition, the valuation is reasonably attractive at 9.7x EV/EBITDA and 13.2x earnings per share. BUY

Comcast Corporation (CMCSA) – 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.

On Thursday, January 25, Comcast reported an encouraging quarter, with results that showed steady or incremental improvement from a year ago and that were generally in line or above estimates. Guidance is for essentially more of the same: incremental pricing that offsets customer losses, with disciplined capital spending that preserves strong free cash flow. Comcast increased its share buyback authorization to $15 billion (about 8% of the current market cap) and raised its dividend by 7%. All-in, Comcast continues to navigate its competitive environment well while rewarding patient shareholders with cash returns. As the shares jumped to our price target, we are reviewing our rating.

In Connectivity & Platforms (broadband, video, wireless), revenues were flat as 4% higher domestic pricing offset the recurring downtick in the number of customers. Cash operating profits rose 3%.

In Content & Experiences (NBC, Peacock, Telemundo, Universal Pictures, Universal theme parks, Sky Studios), revenues rose 6% as Theme Parks revenues surged 12%. Adjusted EBITDA rose 2%, as record-high Theme Parks profits and a surge in Studio profits – from their highly successful movie slate – were nearly offset by a slump in Media profits due to falling advertising revenues.

Free cash flow was strong at $1.7 billion. The quarter caps another healthy year for Comcast, and 2024 is likely to bring more of the same – a grind-forward in sales, earnings and cash flow. Debt remains very reasonable and will fall with the anticipated Hulu proceeds.

The risk is that Comcast’s high-functioning algorithm gets disrupted by competition or other headwinds.

In the quarter, revenues rose 2% and were 3% above estimates. Adjusted earnings of $0.84/share increased 2% and were 6% above estimates. Adjusted EBITDA of $8.0 billion was flat compared to a year ago and fell 3% below estimates.

Comcast shares rose 6% in the past week and have reached our 46 price target. We are reviewing our rating on Comcast shares. HOLD

Philip Morris International (PM) – Based in Connecticut, Philip Morris owns the global non-U.S. rights to sell Marlboro cigarettes, the world’s best-selling cigarette brand. Cigarettes comprise about 65% of PMI’s revenues. The balance of its revenues is produced by smoke-free tobacco products. The cigarette franchise produces steady revenues and profits while its smoke-free products are profitable and growing quickly. The upcoming full launch of IQOS products in the United States, a wider launch of the IQOS ILUMA product and the recent $14 billion acquisition of Swedish Match should help drive new growth.

The company is highly profitable, generates strong free cash flow and carries only modestly elevated debt (at about 3.2x EBITDA) which it will whittle lower over the next few years. The share valuation at about 13.5x EBITDA and 15.6x per-share earnings is too low in our view. Primary risks include an acceleration of volume declines and/or deteriorating pricing, higher excise taxes, new regulatory or legal issues, slowing adoption of its new products, and higher marketing costs. A strong U.S. dollar will weigh on reported results. While unlikely, Philip Morris could acquire Altria, thus reuniting the global Marlboro franchise.

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

PM shares fell 1% in the past week and have 32% upside to our 120 price target. The shares offer an attractive 5.7% dividend yield. BUY

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 4% in the past week to above our $59 price target, so we are reviewing our rating. 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. While activist investor Cevian Capital has closed out its previous 5.2% stake, highly regarded value investor Dodge & Cox now holds a 5.0% stake, providing a valuable imprimatur and as well as ongoing pressure on the company to maintain shareholder-friendly actions.

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

Aviva shares fell 1% in the past week and have 27% upside to our 14 price target. Based on management’s guidance for the 2023 full-year dividend, which we believe is a sustainable base level, the shares offer a generous 7.7% yield. We anticipate a dividend increase for 2024. 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.

On January 16, the company reported disappointing 4Q gold production of 1.04 million ounces, which led to a miss of its full-year guidance. Barrick said it produced 4.05 million ounces for the full year, which fell 4% below the low end of its 4.2 - 4.6 million ounce guidance range. Copper production hit the low end of its guidance range. Barrick continues to struggle with meeting its gold production guidance, which suggests that the management is either too hopeful or is unable to generate new growth. Neither of these traits are encouraging. One risk is that Barrick overpays for an acquisition to buy growth.

Over the past week, commodity gold was unchanged at $2,026/ounce, after nearly reaching $2,100 recently. Gold seems to be holding its $2,000+ pricing. Foreign central banks have stepped up their buying, which is offsetting incrementally higher interest rates in the United States. But, financial investors including hedge funds continue to have low exposure to gold, based on government reports, which could be a bullish indicator.

Our view on gold prices avoids some of these technicals and is based on what we believe is a structural change to inflation levels (no longer at near zero). These changes include war, government spending, crime, oil prices and past-the-peak fading of the benefits of global free trade, in addition to a tight labor market. Aggregate inflation statistics include subcomponents that show starkly different pictures of pricing trends, and these trends can and have changed from month to month. Despite the favorable broad trend, there remains a reasonably good chance that inflation could remain above a 3% pace indefinitely. This would imply permanent 4-6% interest rates.

The 10-year Treasury yield ticked up 1 basis point to 4.11%. The U.S. Dollar Index (the dollar and gold usually move in opposite directions) ticked up fractionally to 103.73.

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 were flat in the past week, largely on the disappointing gold production numbers. The shares remain depressed despite gold prices above the $1,800 - $2,000 range, indicating that investors have no confidence in gold prices and little confidence in the company’s ability to generate higher cash flow. Barrick shares have 73% 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. Investors have lost hope in Citigroup, creating an impressive bargain.

On Friday, January 12, Citi reported a highly scrubbed but reasonable quarter. Scrubbed revenues rose 2% while scrubbed earnings fell 24%. The Services segment and the U.S. Personal Banking business produced strong results, but Markets and Banking results were sloppy and the Wealth segment was weak. CEO Fraser said that the new five-segment structure is now in place and that “2024 will be a turning point” for the transformation, although 2024 guidance seems a bit optimistic. Capital and credit remain healthy while deposits and loans were reasonably steady. Citi has set aggressive revenue and cost-cutting targets as CEO Fraser has stepped up her massive full-company overhaul. The shares trade at 60% of the updated tangible book value of $86.19/share, as investors have little confidence in a favorable outcome. The dividend appears solid, and Citi repurchased about $500 million of shares in the quarter, indicating that management and regulators have some elevated degree of confidence in Citi’s capital level and capital generation. No change to our rating.

In the quarter, revenues of $17.4 billion fell 3% and were 7% below estimates. Excluding the impact of divestitures, revenues rose 4%, or +2% if the Argentina currency devaluation were also factored in. Adjusted earnings of $0.84/share fell 24% but were 22% above estimates. Earnings in both periods were highly scrubbed, and in different ways, so the comparison even on adjusted earnings isn’t entirely clean. Major adjustments included the $1.7 billion FDIC special assessment, a $1.3 billion reserve build for Russia and Argentina, an $880 million revenue impact from the Argentine currency devaluation and a $780 million charge for Citi’s restructuring programs.

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

Citi shares rose 2% in the past week and have 58% upside to our 85 price target. The shares remain attractive as they trade at about 62% of tangible book value of $86.19. The dividend offers investors a 3.9% yield.

When comparing Citi shares with a U.S. 10-year Treasury bond, Citi offers about the same yield and considerably more upside price potential. Clearly, the Citi share price and dividend payout carry considerably more risk than a Treasury bond, but at the current valuation, Citi shares would seem to have a remarkably better risk/return trade-off. BUY

CNH Industrial (CNHI) – This company is a major producer of agriculture (80% of sales) and construction (20% of sales) equipment and is the #2 ag equipment producer in North America (behind Deere). Its shares have slid from their peak and now trade essentially unchanged over the past 20 years. While investors see an average cyclical company at the cusp of a downturn, with a complicated history and share structure, we see a high-quality and financially strong company that is improving its business prospects and is simplifying itself yet whose shares are trading at a highly discounted price. See our November 30 Alert and the December 5 Monthly letter for more color on our thesis.

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

CNH’s shares rose 2% in the past week and have 25% upside to our 15 price target. The 3.3% dividend yield offers a worthwhile interim cash return. 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 37% stake today.

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

Gates shares rose 1% in the past week and have 23% 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.

NOV is scheduled to report earnings on Friday, February 2 pre-market. The consensus earnings estimate is $0.40/share.

The price of West Texas Intermediate (WTI) crude oil ticked up to $76.90/barrel. Rising tensions in the Middle East are supporting oil prices. The oil markets seem well-supplied for now.

Outcomes in wars are unpredictable. The potential for sharp oil price volatility is higher with the increasingly complicated game of shifting geopolitical and economic alignments. Geopolitical conditions in the Middle East continue to inch closer to a hot regional conflict, which would almost certainly drive oil prices to at least $150/barrel.

The price of Henry Hub natural gas ticked lower to $2.07/mmBtu (million BTU). Cold weather across much of the United States has been priced in for now and appears to be relenting. While natural gas prices have collapsed 45% from their $3.75 pre-winter peak, they have rarely dipped below $2 in the past 20 years. The current volatility points to the capricious nature of the natural gas outlook in winter.

NOV shares rose 5% in the past week and have 20% 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.

The shares will likely remain weak or stagnant for the near term due to the company’s weak fundamentals and average leadership. We will wait for a favorable change in investor sentiment but are poised to pull the plug. ST shares rose 1% in the past week and have 61% upside to our recently reduced 57 price target. HOLD

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.

Current price is yesterday’s mid-day price.
CSCO: Earnings estimates are for calendar years.

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