Cabot Early Opportunities Issue: December 20, 2023

Stocks in This Issue

All I Want for Christmas Is Four Rate Cuts

My wife’s family has a Christmas tradition wherein the kids ask Santa Claus for three things; something they want, something they need and something to read.

It works fantastically. And not just for the kids, but for the adults too.

This year I’m putting my own twist on the tradition. Instead of writing to Mr. Claus, I’m writing to Jerome Powell.

Given how the Fed’s fiscal policy decisions and FOMC member’s commentary around the inflation trajectory have had such a dramatic impact on the stock market, I feel this is entirely reasonable.

After all, even Santa Claus must have felt the pinch of higher prices and a roughly two-year bear market.

Here’s my letter.

Dear Santa Powell,

First, I appreciate that you dropped an f-Bomb when climate protestors interrupted your November speech at the IMF in Washington, D.C.

It let us know you’re human.

This year I’m following my wife’s family tradition of asking for three things for Christmas; something I want, something I need and something to read.

Santa Powell, I want four 25 bps rate cuts to the Federal Funds Rate (FFR) in 2024.

I know that’s one more than you and the other Fed elves are thinking. But I feel like four is entirely reasonable. Not too greedy, not too conservative. Not enough to signal a recession, not too much to inflate a stock market bubble.

Juuuuuuust right.

Santa Powell, I need your four rate cuts partly because I need interest rates to come down so we can finance part of the cost to put an addition on our house.

I know, I know, this sounds more like a “want” than a “need.” That’s fair. The lines are blurry.

But the context is that when we sold our too-small house a few years ago, the plan was to have more space for our growing family of four. Instead of buying a bigger house on a mediocre lot, we bought a house half as big as our already too-small house in a fantastic location, with the plan to add on.

But then interest rates shot to the moon. Honestly, I don’t mind living in this tiny house. I actually kind of like it. We don’t have room to accumulate unnecessary items and the relative simplicity is refreshing, most of the time.

But I think my wife’s patience dealing with two young boys – and one slightly older one (i.e., yours truly) – in a confined space is wearing thin.

I have building plans ready to go. The last piece of the puzzle is a reasonable variable lending rate.

Guy to guy, happy wife, happy life. Am I right?

Santa Powell, I’d like to read a Summary of Economic Projections (SEP) for next September (September 2024) that suggests your fellow FOMC elves see the Federal Funds Rate (FFR) dropping to under 3.2% in 2025, without a recession (your latest one of 3.6% is too high IMHO).

I won’t get into specific GDP targets, just pencil in a reasonable buffer, please.

If you could please get under that 3.2% threshold the stock market should continue to do reasonably well into the end of 2024 and beginning of 2025. And interest rates, including the variable rate on my house addition loan (details TBD), will continue to fall.

As you’re likely aware, all three of my requests are pretty much the same thing, all tied to four 25 bps interest rate cuts in 2024. I hope you find this to be reasonable and agreeable.

Your friend,

Tyler Laundon

What to Do Now

The broad market continues to act very well as the forward trajectory of the Federal Funds Rate (FFR) and interest rates point lower while the trajectory of corporate earnings is higher.

That’s a powerful combo!

Lean into this broadening momentum by adding incremental market exposure. Just keep in mind that the market is looking a little overbought. Beware of chasing too many stocks that have gone vertical and look for opportunities to book profits in stocks that appear to have topped out for the time being.

As always, position sizing is key. It’s OK to ramp up exposure over time.

STOCKS

Alight (ALIT)

Alight (ALIT) is a cloud-based software company providing Human Capital Management (HCM) software for some of the biggest companies out there. HCM software is used by HR departments to help companies manage talent, payroll and other crucial HR functions.

Alight covers healthcare and retirement programs, salary and stock-based compensation systems, and career development (talent onboarding, training, etc.).

In Alight’s own words, the company, “Provides mission-critical services across health, wealth and payroll at unrivaled scale.”

At the latest count, Alight covers 36 million employees and dependents across more than 5,000 clients, has 70% of the Fortune 100 as customers, retains 98% of the previous year’s revenue (not bad in a market with cost-cutting) and generates 84% of revenue from existing customers.

The company is making progress on strategic projects, like converting to a cloud-based platform (Alight Workforce) with all the attendant benefits (recurring revenue, upselling/cross-selling, product development efficiency, etc.).

The transformation from legacy, spread-out systems hosted on private cloud servers to a centralized, cloud-based platform isn’t easy, especially for a company that’s been an active acquirer of various HCM-type companies and assets since it was formed in 2017.

Helping in the digital transformation is Wipro (WIT), an India-based IT services and consulting company. The transformation appears to be going OK so far. It’s certainly crucial, as customers increasingly want to get away from their own hodgepodge of systems that don’t talk at all, or require a gazillion integrations that don’t work half the time and require a team of full-time consultants to keep up and running.

All of Alight’s clients are currently on the Worklife platform, with over $2.5 trillion worth of activity moving through it on an annualized basis. That means customers can really zero in on where they can trim redundancies (i.e., costs) and Alight is beginning to shift its focus to helping customer IT departments build their own tools on top of the platform.

Management’s goal is for Alight to become a more efficient, cash-generating, modest-growth company.

On the road to that goal, analysts see the company growing revenue by about 11% this year (9.5% in Q4) and about 6% to 7% next year. EPS is seen up 17% this year ($0.67) and 9% in 2024 ($0.73).

These types of “good client base companies evolving to better suit the market and deliver higher long-term growth, profits and cash flow” aren’t particularly rare, especially since cloud software has become so pervasive. But they often work, if you get the timing right.

It looks like the timing is good right now so we’ll jump in and see if we can catch an updraft.

The Stock
ALIT was born out of the benefits outsourcing department of Aon Hewitt and came public via SPAC IPO in June 2021. The stock did OK initially, peaked at just over 13 a few months after the IPO then got caught in the down market. A year after it came public ALIT bottomed in the low 6s. The stock worked for some short periods through mid-2022 but a real trend never developed and it consistently topped out around 10.1. Then ALIT sold off hard in August and September 2023, once again landing near 6.3 (October 5). The trend since has been mostly up and to the right, with the Q3 report on November 1 helping to stoke investor enthusiasm. ALIT has been flirting with its 200-day moving average line since last week. BUY

Construction Partners (ROAD)

We kicked the tires on Construction Partners (ROAD) last month and it felt pretty good. But I held off from adding to our portfolio because the stock jumped 7% the day before we published.

Four weeks later, shares have had a chance to digest that move so we’ll take ROAD for an official spin this month.

The story hasn’t changed much since November 15, other than that we’ve had another earnings report. We’ll get to that in a minute.

First, let’s refresh our memory. The backstory is that Construction Partners is a vertically integrated (i.e., supplies its own materials) pure-play roadway construction and maintenance company operating in the southeast U.S.

It is currently focused on the five states of North Carolina, South Carolina, Georgia, Alabama and Florida.

The company works on both public (60% of revenue) and private (40% of revenue) infrastructure projects, including highways, roads, bridges, airports and commercial and residential developments.

It also sells construction materials to third-party customers, including hot-mix asphalt, aggregates, liquid asphalt and ready-mix concrete.

High exposure to Southeast recurring paving and public sector road work is a significant attraction.

Over the last three years, funding for pavement-related projects in ROAD states has grown by 47% to $81 billion. Additional, unspent highway funds of $1.2 billion have also been directed to these states by the Federal Highway Administration, yet another signal that Sunbelt states will see several more years of roadwork.

That backlog provides revenue visibility. And shorter-duration projects help fuel operating cash flow, which in turn helps fund the company’s acquisition strategy (leans on cash rather than debt).

The company has completed 19 acquisitions since its 2018 IPO. Given the fragmented nature of the market, management sees roughly 200 potential asphalt production targets and 2,000 other opportunities (guard rail, earthwork, trucking, traffic control, etc.).

The bottom line is that fiscal 2024 revenue (reported November 29) grew by 20% to $1.56 and adjusted EPS grew by 130% to $0.94. Backlog at the end of the fiscal year was $1.6 billion (consistent with the end of Q3), up from $1.4 billion a year ago.

Next fiscal year (2025), management says revenue should be up a bit more than 14% at the midpoint of guidance (which is $1.75 - $1.83 billion). Analysts think that translates to adjusted EPS growth of about 35% ($1.27).

With ROAD stock continuing to work and fundamentals looking attractive we’ll jump in.

The Stock
ROAD came public at 12 in May 2018, starting strong, then faded soon after. Shares enjoyed a multi-year run beginning in 2019 and extending to late 2021 when the stock peaked near 45. The next year (2022) was a tough one as ROAD retreated into the low-teens by mid-year, though an early-summer rally pushed the stock back into the 24 to 32 range. That’s where ROAD stayed until June 2023 when the stock stepped up to 34.4. A quick pullback to 28 set shares up for a rally to fresh highs after the Q2 earnings report in August. ROAD has made a series of higher highs and higher lows on its way to the 40 – 45 range in the weeks since. The pop above 40 on November 14 has held, setting up a decent entry point now. BUY

Crocs (CROX) ★ Top Pick ★

Crocs (CROX) is a Colorado-based footwear company that was founded in 2002 and has two well-known brands, Crocs and HEYDUDE. If you don’t know what Crocs clogs are, I’m not sure what to say. Everybody but you has a pair!

The HEYDUDE brand hasn’t been around as long as the Crocs brand. HEYDUDE was founded in 2008 in Italy and acquired in 2022 by Crocs to the tune of $2.5 billion in cash and stock. Its best-known models are the “Wendy” and “Wally.”

CROX stock fell by more than 50% in the months after the deal was announced. The stock has since come back, but taking 12 months to get to even after a major acquisition isn’t exactly what CROX shareholders were looking for.

Granted, 2022 was a terrible year for many growth stocks, and not all of it is Crocs’ management’s fault. But some was surely self-inflicted.

The stock likely suffered because of a variety of sales, marketing and distribution challenges when the HEYDUDE brand was rolled out. Profit margins took a serious hit as wholesale accounts were flooded with inventory.

There are still some HEYDUDE shoes for sale on Amazon (AMZN) - put there by liquidators - selling for about half of what they sell for on heydude.com. Not great, but also a known issue that management said is in the final innings of being corrected.

That’s (mostly) the past (hopefully).

Looking forward, it bears noting that Crocs is the fourth-largest footwear brand in North America. While the company has debuted a variety of models over the years, the classic clog still drives around 80% of brand sales, and the Crocs brand drives just over 75% of company sales (i.e., HEYDUDE drives about 25%).

There’s a lot of potential to grow in China (100% growth in Q2 and 90% in Q3) where social media is helping to move the needle. Marketing collaborations are helping to put the brand front and center among various buyer groups. And some of the distributions, warehousing, ERP, etc. issues are being cleaned up.

There is, of course, some risk that operational issues could persist. Or that retailers and consumers just won’t gravitate toward the HEYDUDE brand. That’s why this is a potential recovery play.

Looking forward, it’s likely total company revenue growth in 2023 will be about 10% ($3.93 billion) while EPS growth will be about 7% ($11.67).

In 2024, estimates are conservative (remember, recovery story). Analysts are looking for revenue growth of 4.5% ($4.1 billion) and EPS of $12.17 (+4.3%).

In reality, Crocs could do a lot better. If it does, the stock could be off to the races.

The Stock
CROX is one of those stocks that can go from looking just rotten to blowing your hair back, then running higher and higher while you wonder what the heck is happening. The two latest runs were spring 2020 – December 2021 (under 10 to about 180) and mid-2022 – April 2023 (mid-40s to over 140). After April CROX trended down, ultimately seeming to find a bottom at 74 on November 2. Then shares began trending higher again, crossing above 100 on November 28 then back above the 200-day line at 106.7 last Thursday. Shares are modestly below that price level now. BUY

Pinterest (PINS)

Pinterest (PINS) is a name we’ve been in twice (2020 and 2022) and made a little money both times. We’re going back to the well today as shares pick up momentum on the back of a new management team and growth and cost-saving initiatives that began bearing fruit in Q3.

For those who aren’t familiar with Pinterest, the company is a social media platform that helps people share images and short videos, known as pins.

These pins include ideas for home decoration, remodeling, training for athletic events, places to visit/travel, what to wear, what to cook, makeup ideas and things like that.

The company has over 482 million users (+17% from Q2 to Q3) around the world completing a few billion searches every month.

That’s the user side of the equation. The business model isn’t all about providing inspiration for free, however.

Pinterest is a very powerful advertising platform that’s extremely good at monetizing the userbase. Advertisers use Promoted Pins to reach users on the platform and inspire them to purchase advertised goods and services.

Shares of Pinterest are looking better lately, but they’re still trailing many of the other quality social and advertising stocks. That could change soon.

Advertisers, which had pulled back in the post-pandemic months, are starting to allocate dollars to Pinterest’s platform and new ad partnerships – including one with Amazon (AMZN) in which the giant company becomes Pinterest’s first third-party ad partner – should start to drive revenue in 2024.

Pinterest is also working with AI integrations aimed at better targeting content to users and consequently driving better ad results. And there are projects like implementing direct links and working on pricing which appear to be improving ROI for advertisers.

Then of course there are margin expansion initiatives, which Wall Street analysts absolutely love. On the Q3 call, management reiterated its focus on profitability and margin expansion.

This isn’t all to say that things at Pinterest are clicking along perfectly. But progress is being made on both the top and bottom lines and it seems momentum in the business is building. If it continues, PINS could be off to the races.

In Q3, revenue of $763 million (+11.5%) beat by $19 million, average revenue per user (ARPU) of $1.61 beat by $0.04, and EPS of $0.28 (+155%) beat by $0.08. Factoring in Q4 revenue growth expectations of 12.7%, it looks like total 2023 revenue growth could be about 9.2%.

Looking into 2024, analysts expect revenue growth to accelerate to north of 17% ($3.59 million) as ARPU moves from about $6.44 in 2023 to $7.04. Adjusted EPS of $1.30 in 2024 implies a nearly 20% improvement over 2023.

The Stock
PINS came public in April 2019 at 19 and peaked near 90 in the first half of 2021. Shares were back near 20 by the middle of 2022. Since then, they have been grinding mostly higher, despite a solid selloff from 29 to 20.6 in April 2023 (earnings). But buyers stepped back in and PINS spent most of July through October trading in the 25 to 30 range. Shares broke above 30 after the Q3 report on October 30 and have cruised up to 37 since. BUY HALF

Vertiv Holdings (VRT)

Vertiv Holdings (VRT) is one of those stocks that everybody seems to want to own right now. That’s because it provides digital infrastructure solutions that power some of the biggest tech trends out there, including artificial intelligence (AI), cloud software, data warehousing and more.

The company’s hardware solutions power, cool, deploy, secure and maintain a variety of electronics that process, store and transmit data. It also sells power management and monitoring products, integrated rack systems and modular solutions, all of which help to control digital infrastructure.

The bulk of revenue comes from data centers (70% of revenue), where Vertiv is a leading supplier, while telecom customers (20%) make up the balance.

The company grew revenue by roughly 14% in both 2021 and 2022, but AI is driving higher growth in the large data center market in 2023, and likely for several more years.

At the recent investor day in late November, management suggested AI could add 3% to 4% to data center market growth through 2028, though AI chip shipment forecasts suggest it would add closer to 10%.

That’s pretty significant, especially given that AI-related revenue is already driving an extra $250 million (about 4%) on an annualized basis. Looking at estimates, with just one quarter left in fiscal 2023, total revenue growth is seen up almost 21% this year. That’s a decent jump over the last two years.

That said, estimates for 2024 suggest revenue growth closer to 9% ($7.5 billion), which implies only half the growth rate for the current year. While EPS is seen expanding by 27% to $2.22 in 2024 (management guided for about $2.15) it seems analyst estimates might be a tad conservative.

That may be due to concerns that supply chains and production expansion challenges, along with some competition, might curb Vertiv’s ability to capitalize on all the current data center demand.

It may also be that, as a recent JPMorgan note acknowledged, some of the investor base is looking for “a shoe to drop on either earnings revisions or growth” and many analysts just don’t want to stick their necks out, especially after such a run-up in the stock price.

However, even if revenue growth moderates, the big picture fundamentals – EPS growth, share buybacks (roughly $3 billion), M&A potential – seem to imply decent setup for a company helping to power the biggest tech trends in the world.

The Stock
VRT came public via SPAC IPO in May 2018 at 10. It put up good performance during the pandemic (shares peaked near 29 in September 2021) but was equally bad in the selloff that followed (shares bottomed near 7.8 in July 2022). After those dark days, VRT was unremarkable but “fine.” The stock spent the first half of 2023 mostly in the 13 – 17 range. The change of character came at the end of May when VRT blasted through 18 and began a run that ended at 25 in early August. Another blastoff sent VRT to 35 on August 2, and it’s been creeping up to near 50 in the months since. Thank AI fever for the move. I want to monitor VRT for a bit before we buy. WATCH

Previously Recommended Stocks

On December 14 we booked a quick profit of 7% on TriNet Group (TNET) after holding for just four weeks and also booked a quick gain of 13% on Dynatrace (DT) after holding for two months.

From our Watch List this month I’m dropping Bentley System (BSY). It’s a perfectly fine company and stock but I see other opportunities out there these days that I like better.

An updated table of all stocks rated BUY, HOLD and WATCH as well as recent stocks SOLD, is included below.

Please note that stocks rated BUY are suitable for purchasing now. In all cases, and especially recent IPOs, I suggest averaging into every stock to spread out your cost basis.

For stocks rated BUY A HALF, you should average into a position size that’s roughly half the dollar value of your typical position. We may do this when stocks have little trading history (for instance, IPOs), when there is more uncertainty in the market or with a stock than normal, or if a stock has recently jumped higher.

Those rated HOLD are stocks that still look good and are recommended to be kept in a long-term-oriented portfolio. Or they’ve pulled back a little and are under consideration for being dropped.

Stocks rated SOLD didn’t pan out, or the uptrend has run its course for the time being. They should be sold if you own them. SOLD stocks are listed in one monthly Issue, then they fall off the SOLD list.

Please use this list to keep up with my latest thinking, and don’t hesitate to email with any questions.

Active Positions

Recently Sold Positions

The next issue of Cabot Early Opportunities will be published on January 17, 2024.