September 19, 2023

Private Equity Feels the Heat

As readers may know, we are generally not the biggest fans of private equity. Our biggest concern is that, while earlier private equity and venture capital funds were remarkably successful in identifying and capturing highly profitable investments for their clients, more recent vintages, going back perhaps 10-20 years, have mostly produced large profits for the fund managers. News that many Johnny-Come-Lately funds will actually lose significant money on the Instacart IPO highlights this problem. High-quality and early movers will likely post enormous profits.

Similarly, decades ago, pioneering private equity funds were rare, so they had an open field of very attractive targets. Today, there are so many of these funds that most of the best targets have been privatized already. As Warren Buffett once said, “What the wise do in the beginning, fools do in the end.”

Another problem is their claim to lower asset volatility relative to public markets. This may sound like a valuable trait, but it is an illusion. As private equity funds value their assets only once a quarter, they are by definition, of lower volatility than public equities which have daily marks. The term “volatility laundering” humorously (or not) was coined to highlight this bug.

Similarly, private equity funds get to value their investments at whatever price they want. Sometimes, these values can merely loosely reflect public market valuations. Often, the valuations reflect aspirations rather than reality. Any public equity investor that reported aspirational prices rather than market prices would be fired by their clients and likely referred to the SEC.

Public equity investors may be getting the short end of the stick by missing out on some early-stage wonders. But, value investors can pick up worthwhile bargains as growth investors focus on the remaining public unicorns.

This week, we highlight Philip Morris International (PM) as one of these worthwhile bargains. See below for why this stock looks appealing.

Share prices in the table reflect Monday, September 18 closing prices. Please note that prices in the discussion below are based on mid-day September 18 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
New Buy: Philip Morris International (PM)

Last Week’s Portfolio Changes
Sensata Technologies (ST) – Reducing price target from $75 to $57.

Growth/Income Portfolio

New Buy: Philip Morris International (PM) – Based in Stamford, Connecticut, this company (also called PMI) split off from the original Philip Morris Companies through a 2008 initial public offering. PMI owns the global rights, excluding in the United States, to sell Marlboro cigarettes, the world’s best-selling cigarette brand. Marlboro accounts for about 38% of PMI’s cigarette shipment volume. The company also sells additional highly valuable cigarette brands including Parliament, Bond Street, Chesterfield and L&M. All-in, cigarettes comprise about 65% of PMI’s revenues. The balance of its revenues (35%) is produced by smoke-free tobacco products, including heat-not-burn, vapor and oral nicotine products. While PMI operates a research-driven Wellness and Healthcare segment, its revenues and losses are trivial.

Philip Morris shares are attractive for several reasons. First, the company maintains a dominant international cigarette franchise that produces steady revenues and profits. While cigarette consumption is ticking lower at perhaps a 3-5% pace, PMI’s volumes are declining at a slower 1.5% - 2.5% pace. Critically, price increases are boosting cigarette revenues into positive territory. In the most recent quarter, 9% higher prices drove cigarette revenues up 7.4% on an organic basis. We see continued cigarette revenue growth ahead, although perhaps not at the second-quarter pace.

Second, the company’s relatively new smoke-free tobacco products provide the potential for considerable revenue and profit growth. As an example, in the most recent quarter, revenues grew 18% on an organic basis, and adjusted operating income grew 7%. Adjusted earnings per share increased 17%. Its smoke-free platform, led by the IQOS brand, is growing rapidly as it expands its availability around the globe: second-quarter end-market volumes increased 16% and its market share grew 1.6 percentage points to 9.2%. A key growth opportunity is PMI’s upcoming full launch of IQOS products in the United States – providing the potential for immense growth. In addition, the IQOS ILUMA product, following its successful launch in Japan, will be rolled out to 50 other markets by year-end.

Additional growth will come from the recent $14 billion acquisition of Swedish Match, a premier company that is also the world’s largest maker of oral nicotine products. The deal provides PMI with a meaningful presence in nicotine pouches, snus and moist snuff. Also, Swedish Match owned the ZYN nicotine pouch business, giving Philip Morris rights to a fast-growing (+50%) product. In the second quarter, Swedish Match’s revenues grew 19%.

All-in, we see Philip Morris’ revenues growing at a roughly 7% pace over the next several years. We find the company’s goal of 50% of revenues coming from non-combustible products by 2025 possible but a stretch. Per share earnings should grow at a 5-10% pace. Management recently reiterated their guidance for 8.0% to 9.5% growth for full-year 2023.

The company is highly profitable. It generates gross margins of around 64% and Adjusted EBITDA margins of around 42%. Near-term profits are being incrementally weighed down by elevated costs and marketing spending, but we see improvement as soon as the fourth quarter. Free cash flow will approach $10 billion this year and close to $12 billion next year, providing plenty of coverage for its dividend as well as debt repayment and general financial flexibility. Philip Morris’ balance sheet carries modestly elevated debt (at about 3.2x EBITDA) due to its all-cash acquisition of Swedish Match, but we see the company whittling this lower over the next few years.

A major appeal is the company’s stagnant share price and low valuation. PMI’s shares remain unchanged for the past decade, despite the sizeable opportunity underway to decisively move away from cigarettes. The shares trade at about 13.5x EBITDA and 15.6x per-share earnings – too low in our view for a company with PMI’s traits. And, on reasonable earnings estimates for 2025, the shares trade at an unchallenging 11x EBITDA and 12.7x per-share earnings. The 5.4% dividend yield adds appeal. We note that the company recently raised its dividend, suggesting strong confidence by management in its sustainability.

All companies and stocks carry risks. Philip’s primary risks include an acceleration of volume declines and/or deteriorating pricing, possibly higher excise taxes, new regulatory or legal issues, slowing adoption of its new products, and higher costs if it needs to invest more behind its new brands. The company reports in U.S. dollars but most of its profits are earned overseas, which can weigh on results when the dollar is strong. Also, while unlikely, Philip Morris could acquire Altria, thus re-uniting the global Marlboro franchise.

We are setting a $120 price target for shares of Philip Morris International, about 24% above the current $97 share price.

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 1% for the week and have 17% upside to our 66 price target. Based on fiscal 2024 estimates, the valuation is attractive at 10.1x EV/EBITDA and 13.3x 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 rose 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 were flat 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 5% 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 8.1% 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 rose fractionally to $1,950/ounce. The 10-year Treasury yield ticked up to 4.32%. 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 U.S. Dollar Index (the dollar and gold usually move in opposite directions) was essentially unchanged at 105.42. Rising yields are maintaining 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 rose 4% in the past week and have 61% 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.

CEO Jane Fraser unveiled a major reorganization of the company although this was actually announced earlier. Fraser’s efforts to simplify the bank are steps in the right direction, as the bank’s inefficiencies are still huge, but the improvements will take time, as have a decade’s worth of similar changes. If lower headcount means more simplicity, a revealing indicator of progress is Citi’s headcount, or direct staff using the bank’s terms. In the most recent quarter, direct staff numbered 240,000, up 4% from a year ago. Compared to the 200,000 total in 2Q19, before the bank’s subsequent streamlining and divestitures, staffing is up 20%. This is unacceptable.

Compared to JPMorgan, Citi has 27% less revenue per employee and 29% less assets per employee. Clearly, the company has a long way to go before it reaches JPMorgan’s staffing efficiencies.

Citi shares rose 5% in the past week and have 100% upside to our 85 price target. The shares remain attractive as they trade at 50% of tangible book value of $85.34. The recently raised $0.53 quarterly dividend looks sustainable and offers investors a 5.0% 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 were down 2% in the past week and have 37% 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 continued to increase, by 5% in the week, to $91.60/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 increased 3% to $2.71/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.

Diesel prices are surging. Lower volumes of heavier oil (which is easier to refine into diesel) coming out of the Middle East are constraining supplies of diesel fuel even as demand remains strong. We see this trend as having little influence on near-term drilling demand.

NOV shares were flat in the past week and have 20% 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 rose 3% in the past week and have 50% upside to our recently reduced 57 price target. 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. 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.