September 26, 2023

Cisco Splurges on Splunk

Cisco Systems (CSCO) announced a huge $28 billion deal for security software specialist Splunk (SPLK). Regardless of concerns over the economy, rising interest rates, the incipient tech-driven Cold War II, rising government focus on anti-trust and other macro issues, there will always be blockbuster deals. We dig into the deal in our comments below on Cisco.

Share prices in the table reflect Monday, September 25 closing prices. Please note that prices in the discussion below are based on mid-day September 25 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
None

Last Week’s Portfolio Changes
New Buy: Philip Morris International (PM)

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.

Cisco announced that it is acquiring Splunk (SPLK) for $28 billion in an all-cash deal. The $157/share price is a 31% premium to Splunk’s prior closing price but 30% below the shares’ 2020 high of over $220. Overall, we see this deal as somewhat richly priced but a good strategic fit for Cisco. The valuation works out to be about 7.4x revenues, 29.6x EBITDA and 41x adjusted per-share earnings – not cheap but not out of line with its peers. Cisco has $26 billion in cash on hand and generates almost $20 billion a year in free cash flow, so it can readily afford this large purchase. Strategically, Splunk adds new capabilities that will help Cisco maintain the relevance of its end-to-end product offering and also furthers its drive into software and the cloud. The deal is scheduled to close in the third quarter of 2024.

Cisco says the combination will be cash flow and non-GAAP accretive in year two. However, “Year Two” starts in calendar 2026 given the 3Q24 closing date.

Founded in 2003, Splunk is an enterprise software company focused on cybersecurity and network observability (visibility into everything related to a company’s tech network including performance monitoring and analysis). These are considered critical needs in a modern tech operation. Splunk’s technology is widely regarded as top-notch. The company has grown rapidly (revenues grew at a 16% pace in the most recent quarter) and will likely produce nearly $4 billion in sales this year. Splunk is not profitable on a GAAP net income basis. However, it has reversed large losses under a new CEO (since early 2022), with adjusted EBITDA approaching $1 billion this year (for a healthy 25% margin). Free cash flow will be close to $900 million. However, essentially all of this free cash flow is due to the avoidance of cash wages, as annual stock options expenses are approaching $850 million a year.

A challenge for Cisco will be retaining the Splunk talent, as many/most of its employees probably prefer its smaller, entrepreneurial culture and may have little incentive to stay after cashing out their stock options (all of which will likely immediately vest). A sizeable engineering challenge will be integrating the Splunk products with Cisco hardware and software, since this may be needed to make the combined offering most effective.

One of our issues with Cisco is that it boosts its profits and free cash flow by tamping down its research and development spending, only to “buy” R&D through acquisitions. With the $28 billion Splunk deal, Cisco is in effect increasing its $7.6 billion in annual R&D spending by about 25%, assuming one can spread the cost over 15 years. This is not the worst practice in business, as long as investors understand the strategy and the effect it has on the numbers.

A related concern is that Cisco doesn’t truly generate all of the $20 billion in free cash flow that it says, as it plows much of this into “R&D substitution” acquisitions. This is one reason why many investors (including us) strongly prefer dividends and share buybacks, as this is hard cash going back into our pockets.

We are refining our numbers to see what a combined Cisco-Splunk valuation would look like. For now, we are keeping our price target and Buy rating on shares of Cisco.

CSCO shares fell 5% for the week and have 24% 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 12.6x 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 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 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

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.

In news since our recommendation: This past week the company said it is looking to reduce its interest in its Wellness and Healthcare business. This segment was built on the back of three pharmaceutical company acquisitions in 2021, totaling $2 billion, in an effort to diversify away from cigarettes. These efforts have not been financially productive and apparently, there is limited visibility into any meaningful improvement. Philip Morris said it could pursue a partial sale of its Vectura Group business, or arrange a licensing, royalty, partnership or other kind of deals.

For current Philip Morris shareholders, the acknowledgment that this segment, which produces a trivial amount of revenues and profits/losses, is a bust is a positive sign for the company’s finances and self-awareness. The decision also indicates that the company’s strategy of focusing on its expertise (tobacco and nicotine) is the right one, and is starting to produce plenty of encouraging non-combustible tobacco results.

The company is holding its 2023 Investor Day on September 28, with a live video webcast available on its website. The presentations start at 9:55 a.m. CET time (3:55 Eastern Time U.S.) as the conference is being held in Switzerland.

PM shares fell 3% in the past week and have 28% upside to our 120 price target. The shares offer an attractive 5.5% 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 2% in the past week and remain slightly above our recently raised 59 price target. The shares offer a reasonable 1.6% 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.

The company is acquiring AIG’s United Kingdom life insurance operations for £460 million (about $560 million) in a sensible deal.

Aviva shares fell 2% this past week and have 44% 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 8.2% 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 $1,941/ounce. The 10-year Treasury yield jumped to 4.52%, the highest yield since 2007. Rising bond yields are having minimal effect on gold prices, suggesting other forces like foreign central banks accumulating gold, and general fears about the long-term value of the U.S. dollar due to chronic and uncontrolled over-spending by the U.S. government.

The U.S. Dollar Index (the dollar and gold usually move in opposite directions) continues to tick higher to the current 105.95 level. Rising yields are maintaining demand for the dollar, despite the budget deficits.

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 7% in the past week and have 74% 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 4% 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 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 declined 1% in the past week and have 38% 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 pulled back by about 2% to $89.63/barrel. Saudi Arabia’s extension of its volume cuts, perhaps well-timed to boost the value of Aramco’s share offering, has helped support oil prices, as has the enduring strength of the U.S. economy. The price of Henry Hub natural gas increased 7% to $2.91/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 and Russia are constraining supplies of diesel fuel even as demand remains strong. We see this trend as having little influence on near-term drilling demand.

The national average retail price for gasoline ticked above $4.00/gallon this past week, matching its year-ago price after sliding to an average of $3.20/gallon this past January.

NOV shares fell 2% 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 fell 4% in the past week and have 56% 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.

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