May 16, 2023

A Few Thoughts on the Default Matter

Nearly impossible to ignore in the financial and mainstream media are updates about the ongoing negotiations to avoid a default on its obligations by the U.S. federal government. Accompanying the news is the countdown to the X Date, the unofficial date when the government will run out of authority to make further payments because it will exceed the $31.4 trillion statutory debt ceiling.

We view the most likely outcome, with a 99% chance, as being a last-minute agreement that raises the debt ceiling and thus relieving the default risk. The slow walk to an agreement appears to be entirely negotiation posturing. Financial markets have a similar view, despite reports of a surge in the prices of credit default swaps on near-term Treasuries and other hedges. We’d attribute some incremental increase in the price of gold to the default resolution slow-walk.

With a resolution, we would expect stock prices to briefly rally and gold prices to fade. However, the other macro issues remain, including a slowing economy, elevated inflation and a new 5% interest rate environment.

However, a 99% chance is not a 100% chance. As no reserve currency country in modern financial history has ever defaulted (thus rendering comparisons largely irrelevant), no one knows what would happen. There appear to be two general categories of outcomes.

The first broad category is a global financial calamity, outlined in articles by credible and qualified financial writers in legitimate and respected publications. The worst variant is that, with a default on Treasury securities, the core asset of the world’s financial markets could theoretically collapse in value, leading to what may be charitably called a financial Armageddon. This could readily spill over into the economy as contracts, retirement savings, transactions accounts and the underlying currency become unreliable. While possible, we see this outcome as having a near-zero chance of occurring.

The second outcome category is much more likely. In this scenario, a default would have little immediate impact. Almost no one believes that the U.S. would entirely skip interest or principal payments on technically defaulted bonds – it would only delay them – because the government has plenty of money to cover its obligations. This fact separates a U.S. technical default from defaults of Russia and Argentina, for example, which did not have the ability to cover their debts.

A “defaulted” Treasury would probably merely compound its interest until fully redeemed. Other financial instruments could likely trade relatively smoothly, as well. In this scenario, government obligations that can’t be immediately covered would still be money-good, just extend slightly longer in their maturity. A government shutdown (personnel, non-critical operations) would likely ensue, but this has happened in the past with little macro impact.

The key to a low-impact default is that the impasse over the debt ceiling is short-lived, perhaps measured in days. The longer the impasse goes, the more financial markets will become unsettled. Fortunately, the more the financial markets become unsettled, the faster the pace that the government works to raise the ceiling.

Longer term, the U.S. government is headed down a path that raises risks for investors. The proverbial “visitor from Mars” would see the last 20+ years of increasing deficits and debts (the federal government last produced a surplus in fiscal 2001) as being on the wrong track for the planet’s reserve currency nation. Warren Buffett said at the recent Berkshire Hathaway Annual Shareholders Meeting, “Nobody knows how far you can go with a paper currency before it gets out of control, particularly if you’re the world’s reserve currency...And you don’t want to try and pick out the point where it does become a problem because then it’s all over.”

For investors, this trend creates an immense dilemma – where to put one’s assets? I wish I knew the answer. As I am writing this, I guess this is the best answer I can think of: Perhaps run the government in a way that it can readily meet its obligations, and then we won’t have to have a more complicated answer. Next week, we’ll have a more upbeat note.

Share prices in the table reflect Monday, May 15 closing prices. Please note that prices in the discussion below are based on mid-day May 15 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.

Last Week’s Portfolio Changes
Comcast Corp (CMCSA) – Moving shares from Buy to Hold.

Upcoming Earnings Reports
Wednesday, May 17: Cisco Systems (CSCO)
Wednesday, May 24: Aviva, Plc (AVVIY)
Thursday, May 25: Big Lots (BIG)

GROWTH/INCOME PORTFOLIO

Cisco Systems (CSCO) is facing revenue pressure as customers migrate to the cloud and thus need less of Cisco’s equipment and one-stop-shop services. Cisco’s prospects are starting to improve under a relatively new CEO, who is shifting Cisco toward a software and subscription model and is rolling out new products, helped by its strong reputation and entrenched position within its customers’ infrastructure. The company is highly profitable, generates vast cash flow (which it returns to shareholders through dividends and buybacks) and has a very strong balance sheet.

Cisco reports earnings on Wednesday, May 17, with a consensus earnings estimate of $0.97/share. A key issue will be its new order volume.

Separately, the company said it will begin manufacturing operations in India, with a goal of $1 billion of production within a few years.

CSCO shares rose 2% this past week and have 40% upside to our 66 price target. The valuation is attractive at 8.7x EV/EBITDA and 12.5x 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.

NBCUniversal’s head of advertising is leaving to become the CEO of Twitter. The Comcast unit has a deep bench, and becoming the head of any major company, particularly a high-profile company like Twitter, is a perfectly valid reason to leave. However, there is another executive departure at NBCUniversal following the recent termination of division chief Jeff Shell related to admitted inappropriate behavior. The two departures don’t appear to be related, although they do raise some questions.

Comcast shares fell 1% in the past week and remain just below our 42 price target, so we are reviewing these shares for either raising our price target or for selling. In the interim, the shares are rated as 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 were unchanged in the past week, have 12% 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 slipped 1% this past week and have 35% upside to our 14 price target. Based on management’s guidance for the 2023 dividend, the shares offer a generous 7.8% 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 of $0.14/share that were 46% below a year ago but 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. 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. No change to our rating.

In the quarter, profits fell largely due to a 4% decline in gold ounces sold and a 16% increase in the cost of sales per ounce of gold, which more than offset the 1% increase in the realized gold price. Copper profits also weighed on results: pounds of copper sold fell 21%, prices fell 10% and cost of copper sales per pound rose 46%. The company said that first-quarter total production will be the weakest of the year, as maintenance is completed at some mines and volume ramps at others. 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.

Over the past week, commodity gold dipped 1% to $2,018/ounce. Gold prices can be impressively volatile and have risen 24% since troughing late last year at $1,630. The recent surge is likely due to a 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, and that there is a non-zero chance (we’d place the odds at no more than 1%) of a government default.

The 10-year Treasury yield was unchanged at 3.50%. The U.S. Dollar Index (the dollar and gold usually move in opposite directions) rose 1% to 102.50.

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.

Competitor Newmont Corp (NEM) announced an agreement to acquire Newcrest Mining, an Australian gold mining company, for $17.8 billion in an all-share deal, following months of discussions. This combination will likely have little direct impact on Barrick. We are relieved that Barrick itself isn’t acquiring Newcrest or anyone else of consequence, although there is an outside chance that Barrick will have an opportunity to acquire the remaining stake in the Nevada Gold Mines operations that are 39% owned by Newmont (hopefully at an attractive price).

Barrick shares ticked down 3% in the past week and have 40% 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.

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

Big Lots shares fell 4% this past week and have over 100% upside to our revised 25 price target. The shares offer a 14.3% 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.

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

Citi shares declined 1% in the past week and have 85% 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 (about 85% 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 of $0.25/share fell short of the $0.26/share 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 0.5%, but 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%. Important to note, however, is that a credit loss of $11 million due to a customer bankruptcy, $5 million of costs related to the cyberattack, $6 million of restructuring costs and $10 million of stock-based compensation expenses were removed from Adjusted EBITDA. We understand the reasons why these costs were excluded, but it would be hard to convincingly argue that they truly are one-off items or not a part of the costs in today’s economy. With these costs, Adjusted EBITDA would have been $124 million, up 15% from a year ago, producing a healthy but less impressive 15.8% margin.

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 fell 3% in the past week and have 17% 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 re-instated its dividend.

On May 2, Molson Coors reported a strong quarter, with underlying earnings of $0.54/share rising 86% that were more than double the $0.26 consensus estimate. Revenues rose 6% (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 ticked down 1% 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 9.7x 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, 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 fell about 3% in the past week to $71.15/barrel, while the price of Henry Hub natural gas rose 4% to $2.53/mmBtu (or, million BTU). 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 fell 3% in the past week and have 64% 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 fell 1% in the past week and have 84% 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

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