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Value Investor
Wealth Building Opportunites for the Active Value Investor

May 30, 2023

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Enough is Enough

Longer-term subscribers are no doubt familiar with our immense patience with beleaguered discount retailer Big Lots (BIG). Its shares initially sagged due to bloated inventory, similar to other more highly regarded retailers like Target and Walmart, leading to our initial recommendation. We had expected that its earnings would be weakened as it offloaded its excess goods at sizeable discounts, but also that it would ultimately work its way out of its difficult but by no means impossible situation. At the time, Big Lots had a cash-heavy, nearly debt-free balance sheet, was generating positive free cash flow and traded at a depressed 3x EV/EBITDA multiple. What could go wrong?

As it turned out, plenty could go wrong. The company was not only unable to fully work down its excess inventory, but it then experienced other problems. The deteriorating environment for its core customers (their buying power squeezed by inflation and the slowing economy) had no doubt weighed on Big Lots’ fortunes, rising interest rates have made its interim financing more expensive, and one-offs like the abrupt closure of a major supplier constrained its merchandise offerings. Along the way, we moved our rating from Buy to Hold, cautioning that the name carried elevated risk but that a turnaround still seemed reasonably possible.

However, even our patience has its limits – and with the shockingly weak first quarter results, enough is enough. We are pulling the plug on our Big Lots recommendation, moving our rating from Hold to Sell. We have no confidence in the company or its management’s ability to extract itself from its downward spiral.

The most recent results, reported last Friday just before the long weekend (the timing itself is a testament to a dated and sad practice), were all-around awful. The operating loss was much deeper than we and anyone else had expected, and inventories remain way too high. The management has shown little in the way of aggressive and creative actions to fix its inventory, merchandising and pricing problems. Management provided unconvincing excuses for the company’s weak results, and its general outlook (excluding its call for a depressing second quarter) for an imminent recovery carries no credibility.

The balance sheet is now larded with an overbearing $500 million debt burden. Short on cash to finance its ongoing losses, Big Lots is selling most of its remaining assets (California distribution center, corporate headquarters and stores). This clearly will help near-term liquidity but is akin to burning the furniture for winter heat. We expected the dividend suspension, so that was no surprise to us, although dividend speculators likely sold the shares on the news.

Big Lots needs an exceptionally unlikely confluence of exceptionally favorable events (sharp upturn in the economy, return to cheap/easy corporate credit terms, stunning array of highly discounted yet high-margin goods while competitors have none, and such) to even partially recover. A change-out among board members, the CEO seat and perhaps other top seats might help, and wouldn’t be a complete surprise, but given the tightening jaws of financial pressure, Big Lots’ ability to survive is no longer clear.

Not every investment idea works, unfortunately. Nevertheless, a lack of losses indicates that an investor isn’t taking enough risk. And, one should learn from every investment loss, which amounts to a “tuition” payment. Our takeaways from Big Lots are a deeper understanding of value traps, balance sheet/inventory risks and the risks of retailers operating on the fringes of mainstream commerce when the mid/lower-tier segment of the economy weakens and another lesson on the merits of a quality management team. As I personally own shares of every Cabot Value Investor stock, in meaningful size, I am a full participant in the loss on the Big Lots investment idea.

Enough is enough. Time to move on.

Share prices in the table reflect Tuesday, May 30 closing prices. Please note that prices in the discussion below are based on mid-day May 30 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.

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Today’s Portfolio Changes
Big Lots (BIG) – Moving from Hold to Sell.

Last Week’s Portfolio Changes
Comcast (CMCSA) – Raising price target to 46 and changing rating from Hold to Buy.

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.

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 3% 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 slipped 2% in the past week and have 17% upside to our new 46 price target. 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 were flat in the past week, have 11% 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.

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.

Aviva shares slipped 4% 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 up fractionally to $1,977/ounce. The 10-year Treasury yield was unchanged at 3.71%. The U.S. Dollar Index (the dollar and gold usually move in opposite directions) rose 1% to 104.15.

Investors and commentators offer a wide range of outlooks for the economy, interest rates and inflation. We have our views but hold these as more of a general framework than a high-conviction posture. Investing in gold-related equities is a long-term decision – investors shouldn’t allow near-term weakness to deter their resolve.

Barrick shares fell 6% in the past week and have 61% 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 our opening comments 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.

Citigroup has terminated its plans to sell its Banamex business to a strategic or financial buyer, citing an insufficiently high price. Rather, Citi will pursue an IPO of the business. The institutional banking arm in Mexico will remain part of Citigroup. Citi will complete the separation of Banamex, which also includes 1,300 branches, 12.7 million retail banking customers as well as the mortgage lending, credit card, pensions asset management and commercial banking operations, in late 2024 with the IPO scheduled for 2025.

While the news is disappointing, it is not unexpected, given the delays and weaker valuations for bank stocks in general this year. Favorably, Citi said it would resume its share buyback this quarter, although the pace will almost certainly be modest at best. Citi’s turnaround remains on track but at a grindingly slow pace.

Citi shares declined 3% in the past week and have 92% upside to our 85 price target. The shares remain attractive as they trade at 53% of tangible book value of $84.21 and offer a sustainable 4.6% 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 90% 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 3% in the past week and have 35% 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.

Molson continues to benefit from the fallout from the Bud Light Dylan Mulvaney debacle. As much as 15% of the light beer market shifted to Coors from Bud, leaving Budweiser to, in effect, give away its beer, literally for free, after coupons. Heineken is moving aggressively to enter the American light beer market, as well, although we see little likelihood of any major share gains.

TAP shares ticked down 2% in the past week and have 14% 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 9.5x 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 3% in the past week to $69.38/barrel, while the price of Henry Hub natural gas fell 10% to $2.28/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 6% in the past week and have 72% upside to our 25 price target. The dividend produces a reasonable 1.4% 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 2% in the past week and have 77% 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

Growth/Income Portfolio

Stock (Symbol)Date AddedPrice Added5/29/23Capital Gain/LossCurrent Dividend YieldPrice TargetRating
Cisco Systems (CSCO)11/18/2041.3250.2221.50%3.10%66Buy
Comcast Corp (CMCSA)10/26/2231.539.2424.60%3.00%46Buy

Buy Low Opportunities Portfolio

Stock (Symbol)Date AddedPrice Added5/29/23Capital Gain/LossCurrent Dividend YieldPrice TargetRating
Allison Transmission Hldgs (ALSN)2/22/2239.9948.7321.90%1.90%54Buy
Aviva (AVVIY)3/3/2110.7510.15-5.60%8.30%14Buy
Barrick Gold (GOLD)3/17/2121.1316.76-20.70%2.40%27Buy
BigLots (BIG)4/12/2235.245.42-84.60%22.10%25SELL
Citigroup (C)11/23/2168.144.65-34.40%4.60%85Buy
Gates Industrial Corp (GTES)8/31/2210.7111.8410.60%0.00%16Buy
Molson Coors (TAP)8/5/2036.5360.3565.20%2.70%69Buy
NOV, Inc (NOV)4/25/2318.814.65-22.10%1.40%25Buy
Sensata Technologies (ST)2/17/2158.5742.35-27.70%1.10%75Buy

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.

CVI Valuation and Earnings

Growth/Income Portfolio

2023 EPS
2024 EPS
Change in 2023 EstimateChange in 2024 EstimateP/E 2023P/E 2024
CSCO 50.32 3.81 4.040.1%-0.1% 13.2 12.4
CMCSA 39.40 3.68 4.090.0%0.0% 10.7 9.6

Buy Low Opportunities Portfolio

2023 EPS
2024 EPS
Change in 2023 EstimateChange in 2024 EstimateP/E 2023P/E 2024
ALSN 48.46 6.65 6.920.0%0.0% 7.3 7.0
AVVIY 10.12 0.54 0.62-1.8%0.3% 18.8 16.3
GOLD 16.74 0.95 1.150.1%0.0% 17.6 14.6
BIG 5.36 (9.75) (4.27)121.6%52.0% (0.5) (1.3)
C 44.38 6.16 6.54-0.2%-0.3% 7.2 6.8
GTES 11.83 1.18 1.350.0%0.0% 10.0 8.8
TAP 60.54 4.34 4.47-0.3%0.0% 13.9 13.5
NOV 14.52 1.36 1.68NANA 10.7 8.6
ST 42.26 3.84 4.330.0%0.0% 11.0 9.8

Current price is yesterday’s mid-day price.
CSCO: Estimates are for fiscal years ending in July of 2023 and 2024

Bruce Kaser has more than 25 years of value investing experience in managing institutional portfolios, mutual funds and private client accounts. He has led two successful investment platform turnarounds, co-founded an investment management firm, and was principal of a $3 billion (AUM) employee-owned investment management company.