September 12, 2023

Emerging Opportunities in IPOs?

While nearly dormant last year, the market for initial public offerings (IPOs) is starting to warm up. Mediocre or obscure companies like Pixie Dust Technologies (PXDT) and BioNexus (BGLC) inspired no one with their IPOs earlier this year. Shares of Vietnamese electric car marker VinFast Auto (VFS) surged over 300%, to $90, following their recent deal at $22, but have now collapsed to about $16 as the shares were subjected to all of the market manipulations that one would expect from an exceptionally thinly traded, poorly executed offering. Even Oddity (ODD), up about 6% from its issue price, left much to be desired.

However, a few marquee names are teed up to go public this month. These could go a long way toward rekindling investor interest. Instacart (CART), the popular and highly recognized grocery delivery platform, is scheduled to raise around $600 million, resulting in a $9 billion market value. Hedging its issue, the company sold $175 million of preferred stock to PepsiCo alongside the deal.

Boston-based Klaviyo (KVYO) debuts with a $500 million offering, which would give the company an $8 billion market value. The company sells automated digital marketing campaigns. Another Boston area firm, Neumora Therapeutics (NMRA), would have a $2.8 billion market value if its $250 million IPO works out.

Arm Holdings (ARM) starts trading on Thursday, September 14, following its $4.7 billion offering of shares. If successful, the deal would place Arm’s market cap at about $51 billion. A strong opening would also boost the shares of SoftBank Group, the now-beleaguered promoter of hyped technologies that is rivaled only by Cathie Wood’s ARK Innovation fund.

IPOs both reflect investor enthusiasm and create investor enthusiasm. If these deals go well, it would likely be due to the improved confidence that investors have toward stocks in general, as well as perhaps some savvy timing and maybe a little modesty in pricing the shares. And, just as a crowd attracts a crowd, a strong first day of trading could lift second- and third-day prices. Few events can boost investor enthusiasm like sustained increases in post-IPO shares.

Are any of these companies worth investing in? Perhaps. Much depends on the valuation of the shares and on the underlying business fundamentals. Our preferred approach is to discard low-quality companies – those with no earnings, a speculative product or business model, average management or an over-leveraged balance sheet. We also prefer to wait for a company to trade for at least a short while to let the IPO enthusiasm fade. This also gives us time to evaluate the company’s fundamentals more thoroughly and more intelligently determine what value it should trade for. We’ve learned from experience that the term “IPO” also means “It’s Probably Over-priced.”

Some IPOs have spectacular debuts and we will miss out on these gains. A few will have sustained performance – both in terms of their shares and their fundamentals. But most IPOs will languish, or worse, supporting our reasons for discarding most newly public companies. To us, the ideal IPO is a quality company that other investors discard for technical or short-term reasons. It has been a while since quality companies have hit the markets. We’re sharpening our pencils.

Share prices in the table reflect Monday, September 11 closing prices. Please note that prices in the discussion below are based on mid-day September 11 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
Sensata Technologies (ST) – Reducing price target from 75 to 57.

Last Week’s Portfolio Changes
None.

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.

CSCO shares fell 2% for the week and have 16% upside to our 66 price target. Based on fiscal 2024 estimates, the valuation is attractive at 10.1x EV/EBITDA and 13.4x 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.

Comcast and Disney are moving up the start of their negotiations to September 30 regarding who will buy the other’s Hulu stake and on what terms, sooner than the previous January 2024 starting date. Comcast owns a one-third stake and is expected to sell this stake to Disney, which owns the balance.

At the Goldman Sachs conference last week, Comcast’s CEO Brian Roberts spoke reasonably convincingly about how well the company is positioned for the wind-down of linear television. Comcast has a strong and high-margin broadband business, based on their fiber and cable infrastructure to millions of homes and businesses, that will become more valuable as consumers switch to streaming and all users switch to more data-intensive applications. He described the linear TV business today as mostly a low-margin pass-through business. Most of the other businesses, including NBCUniversal, are doing well and were described as “growth” businesses with a strong future.

Roberts, negotiating in public, as it were, compared the value of Hulu’s #2 market share to the $200 billion value of Netflix’s #1 market share. However, Hulu’s negotiating value will be much lower than $200 billion but almost certainly higher than the $27.5 billion minimum value that is commonly mentioned. He said that much of the proceeds would be applied to share buybacks.

All-in, we see the company’s broadband foundation as solid and increasing in value, despite the slide in the value of the traditional cable-TV business. The content side of Comcast looks reasonably solid except for the NBC and other linear TV programming due to its fading value to viewers and advertisers.

Comcast shares fell 1% in the past week and remain roughly at 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

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 ticked down 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 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 fell 1% this past week and have 47% 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 8.5% 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 fell fractionally to $1,946/ounce. The 10-year Treasury yield ticked up to 4.28%. Rising bond yields are weighing on gold prices but not by much, it appears. Usually, these two prices move in opposite directions. Perhaps the growing awareness of the tenuous U.S. Federal government financial picture, highlighted by the Fitch downgrade, as well as the hefty new bond issuances, are pushing yields higher.

The US Dollar Index (the dollar and gold usually move in opposite directions) was essentially unchanged at 104.47. Rising yields are pushing up demand for the dollar but weighing incrementally on gold prices.

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 1% in the past week and have 69% 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.

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

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 48% of tangible book value of $85.34. The recently raised $0.53 quarterly dividend looks sustainable and offers investors a 5.2% 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 were down 5% in the past week and have 35% upside to our 16 price target. The recent price dip, due apparently almost entirely to the Blackstone sale, offers a worthwhile opportunity to add to positions. 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 fractionally to $87.57/barrel. Saudi Arabia’s extension of its volume cuts, perhaps well-timed to boost the value of Aramco’s share offering, is helping support oil prices, as is the enduring strength of the U.S. economy. The price of Henry Hub natural gas was essentially unchanged at $2.62/mmBtu (million BTU). Natural gas prices are driven by domestic demand, as import/export volumes are minuscule, although supply disruptions in Australia are leading to incrementally higher local prices in the U.S. The domestic oil and gas drilling rig count continues to down-tick, but healthier oil prices are supporting the shares as elevated/sustained prices will eventually translate into stabilized rig demand.

NOV shares fell 3% in the past week, and have 19% 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 ticked down 1% in the past week and have 100% upside to our 75 price target. We have reduced our price target to 57 from 75. Our initial model assumed that the company could reach a 26% EBITDA margin and earn a 12x EV/EBITDA multiple, as well as retain about $1 billion in incremental free cash flow that would accrue to shareholders. However, the company spent much of its cash flow on acquisitions with lower margins in an effort to boost its revenue growth prospects. This strategy has diluted the value of the company. Given the 52% upside potential to our new target, we are retaining our Buy rating. 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.