October 17, 2023

Antici…

…pation. That seems to be where the stock market is right now. Not a lot is happening, but soon a lot will happen.

Tech earnings are just around the corner, which should help reveal whether the Magnificent Seven mega-cap tech stocks are worth their current prices. Apple (AAPL) shareholders nervously wait for signs that revenue growth isn’t truly stalled even though the company’s new product offerings don’t quite have the appeal as earlier ones. Broadly, investors of all types wonder how consumer and industrial goods producers will fare, given rising pressures from inflation, inventory de-stocking, global outlook worries and student loan repayments. Bank investors await results from Bank of America (BAC) and other banks to glean whether we are headed into a second round of deposit runs. Stocks are not cheap, especially in a world of 5-6% Treasury yields … how much, if at all, will this matter?

Macro forecasters carry widely differing opinions on what kind, if any, of a landing is ahead for our economy. Will the statistically healthy economy remain robust, or will the 5+% of the economy that is solely supported by federal deficit spending, and geared toward a narrow roster of recipients, lead to wider deceleration? Inflation reports are ahead, as are Fed meetings, an eventual new leadership in the House of Representatives and a possible government shutdown. Where are oil prices headed? Gold? We are in an information dead zone for now.

The start and outcome of the next stage of yet another war, as well as its later stages, are completely unknowable, as are the effects of emerging political fissures far beyond the battle zone.

We will get some answers to the earnings and economic pictures over the next month or so, but there won’t be full clarity. Other answers may take months, or years, longer. So much seems to be teetering, but on what edge and in which direction will things fall?

Antici … pation. For commentators, it is painful. For contrarians, it creates opportunity.

Share prices in the table reflect Monday, October 16 closing prices. Please note that prices in the discussion below are based on mid-day October 16 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

Last Week’s Portfolio Changes
None.

Upcoming Earnings Reports
Thursday, October 19: Philip Morris Intl (PM)
Wednesday, October 25: Allison Transmission (ALSN)
Thursday, October 26: Comcast (CMCSA)
Friday, October 27: NOV, Inc (NOV)
Tuesday, October 31: Sensata Technologies (ST)

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 (which it returns to shareholders through dividends and buybacks). 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% for the week and have 22% upside to our 66 price target. Based on fiscal 2024 estimates, unadjusted for the Splunk acquisition, the valuation is attractive at 9.5x EV/EBITDA and 12.8x earnings per share. 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 were flat in the past week and have 4% 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.

Philip Morris reports third-quarter earnings on Thursday, with estimated earnings of $1.62/share.

PM shares rose 1% in the past week and have 29% upside to our 120 price target. The shares offer an attractive 5.6% 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 slipped 1% 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 U.K., Ireland and Canada operations following her divestiture of other global businesses. The company now has excess capital which it is returning to shareholders as likely hefty dividends following a sizeable share repurchase program. We expect that activist investor Cevian Capital, which holds a 5.2% stake, will keep pressuring the company to maintain shareholder-friendly actions.

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

Aviva shares rose 2% this past week and have 37% 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 7.7% 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.

Barrick reached an agreement with the government of Papua New Guinea to restart the Porgera gold mine. The mine was essentially expropriated by the country’s government about three years ago, leading to a suspension of activity (placed into “care and maintenance” mode). Hiring is ramping up, with only a compensation agreement left to be negotiated. Production is expected to start by year-end. The deal is a clear if not major positive for Barrick: it removes an overhang and buttresses the company’s production volumes.

Barrick announced preliminary production results for the third quarter. Compared to the second quarter, gold volumes were about 3% higher and copper volumes were about 5% higher. We estimate that the company will reach but not much exceed the low end of its full-year production guidance for gold (4.2 – 4.6 million ounces) but seems likely to miss its guidance range for copper (420-470 million pounds). Gold production needs only a 7% year/year increase to hit the low end, but copper needs an 18% increase.

Barrick also said that its per-ounce gold and copper costs were lower in the third quarter compared to the second quarter.

Over the past week, commodity gold ticked up 3% to $1,929/ounce. Gold prices seem stuck between about $1,800 and $2,000. Until the price shifts meaningfully outside of this range, in one direction or another, we consider most of the movements to be noise. The 10-year Treasury yield ticked down to 4.70%.

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 new normal.

The U.S. Dollar Index (the dollar and gold usually move in opposite directions) was unchanged at 106.44. Rising yields and relative safety are maintaining demand for the dollar. The U.S. Dollar Index reached a peak of 119 in early 2001, a price that is around 10% 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 U.S. 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 7% this past week and have 71% 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.

Citi reported a reasonably decent quarter. In its two core businesses (Institutional Client Group and Personal Banking/Wealth Mgt), revenues rose 11% and profits rose 10%. Overall credit costs are rising but remain low and are backed by strong reserves. Deposits ticked lower but remain a minor issue. Non-core results were mixed. Capital is strong with CET1 at 13.5%. Citi remains burdened by excessive regulatory and other costs as well as unproductive capital. The return on equity of 7.7% is about half what it should be, implying that the bank either needs to double its earnings or cut its capital base in half. We believe that a combination of both efforts, driven by new and aggressive efficiency improvements and the eventual divestiture of non-core assets will move Citi close enough to a 15% ROE, but this will take yet more time, likely measured in years. Citi’s full-year guidance was uninspiring but not disappointing. The shares trade at less than half of tangible book value of $86.90/share and carry a sustainable dividend that provides a 5.1% yield. No change to our Buy rating.

In the quarter, total revenues of $20.1 billion rose 9% from a year ago and were in line with estimates. Adjusted earnings of $1.52/share increased 2% from a year ago and were about 16% above estimates.

The two core businesses produced decent results compared to a year ago and the second quarter and are moving in the right direction. Core segment net interest income provided a healthy boost, increasing by 14% from a year ago and contributing about 80% of the total revenue growth of the core segments. While the bank’s deposits slipped and its cost of deposits rose sharply, so did its earnings on its various investments including credit cards. Also, the benefit from zero-cost deposits was a huge boost to net interest income, as these “free” deposits can be redeployed into investments yielding over 6%, whereas a year ago those investments yielded about 3.7%. Fee income growth in the core segments looked encouraging, as well. Management implied that expenses, while high, are plateauing, suggesting higher profits as revenues increase. Citi said it would provide more color in January on the expense effects of its latest and huge restructuring program.

Credit costs are “normalizing” according to management, but this is a guess as no one knows where the economy or credit quality are headed. “Normal” is defined as a 3-3.25% loss rate for Citi branded cards (compared to a loss rate of 2.72% in 3Q) and 5-5.5% for co-branded and private-label cards (compared to a loss rate of 4.53% in 3Q). Reserves are strong at 2-3x annual losses. All-in, we currently have minimal worries about Citi’s credit picture, although this could change quickly.

As mentioned earlier, Citi has a long way to go to reach a respectable ROE. The 10% ROE in the Institutional Client Group is moderately encouraging. The 8.8% ROE in the Personal Banking/Wealth Mgt group is well off the mark. The Legacy Franchises (to be divested) and the Corporate operations produced a near-zero ROE. With time, these two operations will eventually go away – but until then they will remain drags on company results.

Citi will be changing its reporting structure to five segments from two. This will help provide more clarity on strengths and weaknesses, as well as boost accountability within the bank.

Citi shares were flat 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 $86.90. The recently raised $0.53 quarterly dividend looks sustainable and offers investors a 5.2% yield.

When comparing Citi shares with a U.S. 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 2% this past week and have 44% 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 ticked up about 1% this past week to $87.00/barrel. Oil prices appear to be quiet and largely unmoved by the Israel-Gaza conflict, but the potential for sharp volatility seems higher with the increasingly complicated game of shifting geopolitical and economic alignments. A major new catalyst, in addition to all of the others, would be export or production cuts from the Middle East should Iran become directly or even explicitly indirectly involved (including if the U.S. restores its sanctions).

The price of Henry Hub natural gas slipped 9% to $3.17/mmBtu (million BTU). Prices had been strong on worries about low storage volumes headed into the winter, as well as the shutting of Israeli offshore gas fields.

NOV shares rose 3% in the past week and have 21% 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.

ST shares were flat in the past week and have 53% upside to our recently reduced 57 price target. BUY

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: Estimates are for fiscal years ending in July of 2023 and 2024