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Value Investor
Wealth Building Opportunites for the Active Value Investor

October 10, 2023

Third-quarter earnings season is only days away. PepsiCo (PEP) will kick off the season on Tuesday, October 10. The “official” start is generally considered to be on Friday, October 13, when major financials like recommended stock Citigroup (C), as well as JPMorgan (JPM), Wells Fargo & Company (WFC) and Blackrock (BLK) report their results. For the S&P 500 members, Tuesdays, Wednesdays, and Thursdays are the busiest, as 20-50 companies report on each of those days. While weekends are almost cleanly bereft of reports, Berkshire Hathaway (BRK/B) provides a stand-out exception (estimated to report on November 4).

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Earnings Season Returns

Third-quarter earnings season is only days away. PepsiCo (PEP) will kick off the season on Tuesday, October 10. The “official” start is generally considered to be on Friday, October 13, when major financials like recommended stock Citigroup (C), as well as JPMorgan (JPM), Wells Fargo & Company (WFC) and Blackrock (BLK) report their results. For the S&P 500 members, Tuesdays, Wednesdays, and Thursdays are the busiest, as 20-50 companies report on each of those days. While weekends are almost cleanly bereft of reports, Berkshire Hathaway (BRK/B) provides a stand-out exception (estimated to report on November 4).

Quarterly earnings are the primary report cards for all companies, so we rely heavily on these updates. Traders, momentum investors, commentators and news outlets focus on whether companies beat or missed their estimates. This, of course, hides an intricate game between the sell-side analysts and companies. Companies want to beat the estimates but estimates are based closely on guidance that the companies provide. Analysts want their estimates to be as accurate as possible while not coming in above the actual results. Critically, ever since a regulatory crackdown in the early 2000s, companies can’t selectively disclose information to analysts only. So, the intricate game, almost a dance, allows analysts to adjust their estimates to make everyone happy most of the time. This is why a disproportionate number of earnings come in a penny above estimates.

As longer-term investors, our focus is mostly on the “why” behind earnings reports and other indicators of whether the turnaround or other improvements are moving in the right direction. Change doesn’t happen in a straight line, so our companies may report awful near-term earnings yet are making important progress that short-term investors don’t care about.

One tool we use to provide some context to the earnings “beat” is “estimate revisions.” These show the trends in estimates before actual earnings are reported. If a company beats the final estimate by a penny, but that final estimate was cut by eight cents in the weeks prior to the report, that tells us a very different story than if estimates were steadily rising prior to the report, yet the company still beat the final estimate.

Like much on Wall Street, what goes on behind the curtain can reveal a lot more than what is seen only in front of the curtain. And, yes, the allusion to “The Wizard of Oz” is on purpose.

Share prices in the table reflect Monday, October 9 closing prices. Please note that prices in the discussion below are based on mid-day October 9 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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This Week’s Portfolio Changes

Last Week’s Portfolio Changes

Upcoming Earnings Reports
Friday, October 13: Citigroup (C)
Tuesday, October 24: Sensata Technologies (ST)
Wednesday, October 25: Allison Transmission (ALSN)
Thursday, October 26: Comcast (CMCSA)
Friday, October 27: NOV, Inc (NOV)

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.

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

Cisco’s deal for Splunk makes strategic sense, as it adds to Cisco’s platform a critical new product line that customers clearly are demanding. As such, it strengthens Cisco’s end-to-end offering, which will help it retain its relevance and pricing power as well as potentially bring in at least a few new customers through cross-selling in both directions, and perhaps bring in some fence-sitters lingering in the background.

However, from a financial perspective, we see the deal as only incrementally positive. The valuation is full, acclaimed synergies will likely be offset by not-acclaimed dis-synergies, and, as we have mentioned before, Cisco’s immense free cash flow is not actually very large as it indirectly invests in research and development by way of acquisitions. “Buying” R&D is clearly lower-risk than in-house R&D for Cisco. The company knows the products work and these acquired companies come with a built-in customer base and franchise. But these benefits require a higher price, and Cisco seems to be paying no better than a fair price.

Splunk is portrayed as having healthy 25% EBITDA margins and $850 million of free cash flow. But, this is only because $800 million or so of stock-based compensation is excluded from both numbers. Add this expense back in, and the EBITDA margin and free cash flow vanish. So, Cisco is buying growth, which it will get, but taking a margin and cash balance hit even as its free cash flow remains unchanged. Management is almost certainly understating the financial benefits to investors, which helps tilt the deal’s merits in a favorable direction. All-in, this deal is on the positive side of a wash, in our view.

Cisco was recently named an Official Technology Partner of the New England Patriots. After Sunday’s 34-0 drubbing by the New Orleans Saints, and a pathetic 1-4 start, maybe Cisco should have chosen a different NFL team.

We are keeping our BUY rating and 66 price target. We anticipate more news, likely favorable, as both companies report their earnings and as the managements talk up the deal.

CSCO shares fell 1% for the week and have 23% upside to our 66 price target. Based on fiscal 2024 estimates, unadjusted for the Splunk acquisition, the valuation is attractive at 9.8x EV/EBITDA and 12.7x earnings per share. Note that estimates have been adjusted forward with the completion of Cisco’s July 2023 fiscal year. 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 as worry 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 fell 1% in the past week and have 5% upside to our 46 price target. For now, we are keeping our Hold rating. The shares aren’t particularly cheap, but the fundamentals continue to remain sturdy. 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 re-uniting the global Marlboro franchise.

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

PM shares were flat in the past week and have 31% 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 2% in the past week and remain slightly above our recently raised 59 price target. The shares offer a reasonable 1.5% dividend yield. We are keeping our Hold rating for now, given the acceptable valuation combined with the strong management and company fundamentals. 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 UK, 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.

Aviva shares jumped on Friday on rumors of a possible buyout by a foreign buyer. We put little credence in these kinds of stories.

Aviva shares rose 6% this past week and have 40% upside to our 14 price target. Based on management’s guidance for the 2023 dividend, which we believe is a sustainable base level, the shares offer a generous 8.0% yield. 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.

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

Over the past week, commodity gold ticked up 1% to $1,865/ounce following the news of the Hamas attacks on Israel. The 10-year Treasury yield jumped to 4.80%, the highest yield since late 2007.

The structural forces behind inflation may be permanent – 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 – which could keep inflation at the 3-5% pace indefinitely. Permanent inflation would imply permanent 4-6% interest rates. We see this as a reasonably acceptable normal, which is more in-line with history than the 0-3% rates of the past decade. The market has yet to fully digest this kind of new normal.

The US Dollar Index (the dollar and gold usually move in opposite directions) ticked lower to 106.28. Rising yields and relatively safety are maintaining demand for the dollar. The US Dollar Index reached a peak of 119 in early 2001, a price that is 11% above the current level. The world is a very different place than it was in the pre-9/11 era, so we have no way to effectively compare conditions across this time span. However, today, we see global capital moving to the safety of US dollar assets relative to most other developed nation currencies. Gold may be seen as a lesser source of safety, partly due to its illiquidity.

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

Barrick shares rose 4% this past week and have 82% 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.

The bank announced an agreement to sell its onshore China wealth management unit to HSBC Bank China. This unit is relatively small, with only $3.6 billion in deposits and investments but represents an additional step toward simplification and risk reduction.

Citi shares fell 1% in the past week and have over 100% upside to our 85 price target. The shares remain attractive as they trade at 47% of tangible book value of $85.34. The recently raised $0.53 quarterly dividend looks sustainable and offers investors a 5.3% yield.

When comparing Citi shares with a US 10-year Treasury bond, Citi offers a higher yield and considerably more upside price potential. 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. Following several sell-downs, Blackstone has a 43% stake today.

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

Gates shares fell 1% this past week and have 41% 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.

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

The price of West Texas Intermediate (WTI) crude oil slipped about 4% this past week to $86.15/barrel despite a jump on Monday following the Hamas attacks on Israel. The oil price is caught in an increasingly complicated game of shifting geopolitical and economic alignments.

The price of Henry Hub natural gas surged 17% to $3.35/mmBtu (million BTU). Prices have been strong on worries about low storage volumes headed into the winter.

NOV shares fell 3% in the past week and have 27% 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 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. 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 2% in the past week and have 52% upside to our recently reduced 57 price target. BUY

Growth/Income Portfolio

Stock (Symbol)Date AddedPrice Added10/9/23Capital Gain/LossCurrent Dividend YieldPrice TargetRating
Cisco Systems (CSCO)11/18/2041.3253.9230.50%2.90%66Buy
Comcast Corp (CMCSA)10/26/2231.544.0940.00%2.60%46Hold
Philip Morris International (PM)9/18/2396.7996.790.00%5.40%120Buy

Buy Low Opportunities Portfolio

Stock (Symbol)Date AddedPrice Added10/9/23Capital Gain/LossCurrent Dividend YieldPrice TargetRating
Allison Transmission Hldgs (ALSN)2/22/2239.9959.8749.70%1.50%59Hold
Aviva (AVVIY)3/3/2110.7510.06-6.40%8.30%14Buy
Barrick Gold (GOLD)3/17/2121.1314.85-29.70%2.70%27Buy
Citigroup (C)11/23/2168.140.74-40.20%5.20%85Buy
Gates Industrial Corp (GTES)8/31/2210.7111.366.10%0.00%16Buy
NOV, Inc (NOV)4/25/2318.819.986.30%1.00%25Buy
Sensata Technologies (ST)2/17/2158.5737.36-36.20%1.30%57Buy

Current price is yesterday’s mid-day price.

Growth/Income Portfolio

Current price2023 EPS Estimate2024 EPS EstimateChange in 2023 EstimateChange in 2024 EstimateP/E 2023P/E 2024
CSCO 53.61 4.06 4.240.0%0.0% 13.2 12.7
CMCSA 43.87 3.78 4.200.0%0.0% 11.6 10.5
PM 91.57 6.15 6.660.0%0.0% 14.9 13.7

Buy Low Opportunities Portfolio

Current price2023 EPS Estimate2024 EPS EstimateChange in 2023 EstimateChange in 2024 EstimateP/E 2023P/E 2024
ALSN 59.41 7.00 7.390.0%0.0% 8.5 8.0
AVVIY 9.97 0.39 0.450.0%0.0% 25.9 22.4
GOLD 14.82 0.88 1.13-2.4%-4.3% 16.9 13.1
C 40.24 5.72 6.000.2%-1.0% 7.0 6.7
GTES 11.31 1.20 1.350.0%0.0% 9.4 8.4
NOV 19.74 1.47 1.760.0%0.0% 13.4 11.2
ST 36.99 3.73 4.180.0%0.0% 9.9 8.8

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

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.