Cabot Early Opportunities Issue: January 17, 2024

Stocks in This Issue

Portfolio Updates

With earnings season picking up steam and a stacked portfolio of 12 positions, let’s jump right in and discuss the most significant recent developments with portfolio positions.

Alight (ALIT) was added last month and since then has received several positive coverage notes and a few price target upgrades from analysts (Wedbush, Citigroup, UBS). The projected earnings report date is February 21. No major updates. Alight is a software company providing HCM solutions and is transitioning to a more efficient, cash-generating company. BUY

Cellebrite (CLBT) was added in September and we’re up about 5% since. The company sells digital intelligence software to law enforcement, government and enterprise markets. Earnings are scheduled for February 15. The company recently released an expanded platform (Case-to-Closure, or C2C) for examiners and investigators to solve cases faster. The stock recently hit a 52-week high of 8.9 and has since pulled back to 8. We’re going to book a modest gain here to make space in our portfolio for fresh ideas and remove risk of a break lower wiping out our profit. SELL

Construction Partners (ROAD) was added last month, came up against its all-time high (near 45) shortly thereafter and was one of the stocks that promptly sold off (on no news) once the New Year hit. Shares have been inching higher over the last seven sessions. Earnings are scheduled for February 9. The company’s acquisition-led growth strategy came back into focus in the first week of January when management announced the acquisition of two road construction companies, Huntsville, Alabama-based SJ&L General Contractor and Waycross, Georgia-based Littlefield Construction. This looks like a buyable dip. BUY

Crocs (CROX) was added last month. This is a story of a solid core business (Crocs brand, 80%+ of revenue) trading at a discounted valuation with a likely recovery business (HEYDUDE) thrown in for “free”. At the ICR Conference last Monday (January 8) management updated guidance for Q4 and next year with 2024 guidance about as expected (no reason to overstate potential yet) and Q4 better than forecast. Revenue in Q4 is seen up 1% vs. consensus expectations of -2.4%. The company also disclosed it paid down $277 million in debt in Q4 and repurchased $25 million in stock. The update drove a wave of price target increases (Wedbush, Raymond James) and pushed CROX stock, which had been struggling, 17% higher. We’re now looking for some follow through. BUY

Elastic (ESTC) continues to look strong and we’re up over 40% as of yesterday’s close. No major updates lately and we’re now looking to the earnings report, expected on March 1, to keep momentum going. Given that it’ll be a month and a half and that we have a solid gain on ESTC already, moving to hold today. HOLD HALF

Gitlab (GTLB) is also acting well and, similar to Elastic, won’t be reporting until March. That will mean some patience is required here. Mizuho Securities just upgraded the stock to buy from neutral last week (price target 73, stock closed at 62.7 yesterday). BUY

Krystal Biotech (KRYS) struggled in November after Q3 sales missed, likely because patients didn’t convert to Vyjuvek as quickly as expected once the drug was approved. But KRYS got back into a groove in December and is currently pushing up against overhead resistance near 130 – 133. The big questions lingering from the Q3 call surround conversion of new patients and pricing. My hunch is that we won’t know much more until around March 12 when KRYS is expected to report and without new information shares won’t be able to break significantly higher. I like KRYS but am a little concerned about what could happen to the stock if Q4 results don’t address all the issues from Q3. Therefore, with some questioning of the decision, I’m going to sell KRYS today for a modest gain (about 5%) and keep an eye on it through the next earnings report. If all looks good we may revisit the name. SELL

Microsoft (MSFT) is doing exactly what we hired it to do and is now the most valuable publicly-traded company in the world. It’s also the best-performing stock in our portfolio. What else is there to say? BUY

Pinterest (PINS) hasn’t done much since I added the stock a month ago. The next big thing is to see if the company’s partnership with Amazon (AMZN), announced last April, will begin to bear fruit early in 2024. That’s the expectation. From there the next opportunities are more partnerships and international expansion. Revenue growth is already expected to double in 2024 (to roughly 18%) while EPS should grow north of 20%. We’ll learn more in early February, when Pinterest is expected to deliver Q4 2024 results. BUY HALF

Rivian (RIVN) continues to be a flighty stock that has failed to get into a real groove. But I remain optimistic that the long-term potential here is significant, despite many bumps in the road ramping up production and developing new models. Still, big picture Rivian stands out among the new breed of EV manufacturers. And more of its vehicles are hitting the road every week. Keep shares tucked in your back pocket. BUY

Shopify (SHOP) reached a new 52-week high above 80 late last week even though there are plenty of haters out there. It will be interesting to see how the holiday season wrapped up for the company. We’ll learn details in mid-February when results come out. We’re expecting revenue to be up about 20% in Q4 with EPS launching to $0.69 from $0.07 in the year-ago quarter. With shares up over 20% since we jumped in we’ll back off a little. Moving to hold. HOLD HALF

Varonis (VRNS) has been acting very well among a fantastic backdrop for cybersecurity stocks (lots of bullish analyst commentary). The irony is that what’s good for these stocks is generally bad news for IT departments (rising threats). Varonis’ earnings date isn’t far off, it’s been confirmed for February 5. We’re looking for Q4 revenue growth of 6.5% ($151.8 million) to cap off a year of roughly 5% growth and for EPS of $0.23 to bring the 2023 total to $0.32. Looking into 2024, revenue growth is seen accelerating to nearly 10% (cloud transition still working well) and EPS growth should be at least 20% ($0.39 expected). VRNS is a well-liked stock among the analyst community and while the stock is looking a little stretched I think any dips should be bought. BUY HALF

What to Do Now

Stocks had a fantastic stretch at the end of 2023. While forward earnings estimates also crept higher into the end of the year stock valuations, especially for the Mega-cap 8, ascended to a level where a pause in the rally seemed entirely reasonable.

That appears to be what we’re seeing now.

In early 2024 forward earnings estimates have come down a little and investors have begun to question whether the magnitude and cadence of Fed rate cuts will be as bullish for stocks as previously hoped. The next FOMC meeting at the end of January will shed light on the Fed’s latest thoughts. Current market odds say there’s a 63% chance of the first rate cut in March.

There’s also the conflict between Israel and Hamas-led Palestinian militant groups, potentially impacting supply chains and the price of oil (which has gone down lately, oddly enough).

In short, there’s enough to worry about out there that the screaming rally from late 2023 has fizzled, for the time being. In my view, that’s a good thing for overall market health. We don’t want the market to get overcooked.

That said, earnings season is a bit of a wild card for individual stocks. Stepping back, my best guess is we’ll see the broad market mostly tread water for a spell while individual stocks will bounce around based on earnings results and updates at conferences.

That means it’s likely a good time to keep new buys somewhat limited (we add three positions today) and look for opportunities to book modest gains on stocks lacking momentum. We continue with that strategy by logging two more gains today, meaning six of seven stocks sold since November 1 have been for positive gains.

STOCKS

Gen Digital (GEN)

Gen Digital (GEN) is a consumer-focused cybersecurity company playing in a large and growing market where most of the public players are focused on selling to businesses.

Meanwhile, the average consumer still needs protection. With malware being created with GenAI tools, it’s tough to keep up. Probably not a stretch to say the average person doesn’t even know what they need protection from anymore.

That’s where Gen Digital comes in. The company’s solutions span identity theft protection, malware protection, antivirus and digital privacy. The main competition comes from Microsoft (MSFT) and McAfee.

Gen Digital’s family of brands is well-known and includes Norton, LifeLock, Avira, CCleaner, AVG, Reputation Defender (by Norton) and Avast.

Avast was the latest acquisition. Gen Digital acquired the brand in September 2022 for $9 billion. It’s no coincidence that Gen Digital currently has just over $9 billion in debt ($7.6 billion raised to fund Avast), and that level of debt is one of the reasons the stock has struggled.

But we’re in a new generation of computing (thanks AI) that’s driving more potential customers toward Gen Digital. That revenue can fuel future debt repayments.

With about 500 million users and an efficient freemium business model (consumers come onboard for free then are upsold to paid services over time) that generates roughly $1 billion in free cash flow (FCF) per year and attractive 87% gross margins, Gen Digital has a compelling setup for the next few years.

Especially since the stock trades at a discounted valuation. There’s potential to cross-sell brands and expand more internationally (currently 35% of revenue) and there appear ample opportunities to strip out costs following the Avast acquisition (management says FCF could go up to $1.5 billion).

Big picture, Gen Digital offers modest revenue growth potential with more significant earnings growth as cash flow rises and debt repayments accelerate. It won’t take much for a few things to fall into place for revenue (and therefore EPS) growth to come in well ahead of expectations.

For fiscal 2024 (first two quarters already reported since fiscal year ends in March), look for revenue to grow just north of 6% (to $3.82 billion) and for EPS to grow by 9% (to $1.97). EPS growth could step up to around 15% next year.

The Stock
GEN has been around for a while, operating as NortonLifeLock until a rebranding and name change following the Avast acquisition. Shares traded as high as 23.7 last February and as low as 15.5 in March and May of last year. The most encouraging trend has been since the Q2 fiscal 2024 earnings report on November 6, 2023. At the time, GEN was trading near 17.5, then it rallied to a 52-week high of 23.4 just before Christmas. The stock is roughly flat over the last four weeks. It’ll take some doing to get through overhead resistance in the 23 – 24 range but should GEN break out, there’s a lot of white space to run in. BUY

Leonardo DRS (DRS)

Russia’s invasion of Ukraine and the conflict between Israel and Hamas-led Palestinian militant groups are just two of many reasons defense stocks are doing well.

Among the most attractive small-cap names is Leonardo DRS (DRS), a prime contractor and strategic subcontractor that provides technologies and services spanning land, air, sea, space and cyber arenas.

Leonardo is 73% owned by the Italian parent company Leonardo SpA (which is 30% owned by the Italian government) meaning the public float is pretty small here (27%). That may be a turnoff for some, but it also means DRS tends to be a stable stock and the potential for better liquidity could be an upside catalyst.

The company’s customer base includes all branches of the U.S. military (the Navy and Army make up almost 70% of business) as well as other contractors and allied governments and militaries.

Its two segments/key areas of technology include Advanced Sensing & Computing (ASC) and Integrated Mission Systems (IMS), which includes electric power and propulsion.

The company’s legacy solutions, including sensing and hardware solutions for ground systems, tanks and armored vehicles, generate consistent, high-margin revenue and remain in high demand. The 2024 President’s Budget request of $13.9 billion (+10.3%) for ground systems is the latest proof point.

Meanwhile, newer projects like electric power for the Columbia-class nuclear submarine (Leonardo makes the main propulsion magnet motor and drive component, among other parts) mean Leonardo is playing a strategic role in the increasingly important Indo-Pacific region.

These 12 ships (made by General Dynamics Electric Boat) are being repriced as they roll out of production, and Leonardo has recently announced a contract that raised revenue per ships number seven through twelve by about $100 million each, to roughly $430 million.

Other IMS opportunities remain out there too, including work on electric propulsion and power conversion solutions for the South Korean stealth destroyer program.

In terms of growth, the real attraction here is EPS growth. It is a defense stock after all. Revenue should grow by only around 2% in 2024 (almost $3 billion expected) but EPS should grow in the high teens, to around $0.84.

The bottom line is that, with this stock, we’re looking for an entry point that allows us to capture modest upside relatively quickly in a stable stock, with more upside potential should a few things fall into place.

The Stock
DRS corrected with the market in the first half of 2022 then spent the second half regrouping in the 9 – 12 range. Shares began to climb in December 2022 and continued their upward trajectory through 2023 (albeit with a few pauses here and there), ultimately closing out last year at around 20. The 20 to 21 price area has proven to be a zone of resistance since October. With a consolidation phase going on three months now, the odds of an upside move are rising. We’ll add DRS to our Watch List for now (earnings aren’t until March) and keep an eye out for an opportunistic buy point. WATCH

Nutanix (NTNX)

Nutanix (NTNX) is an IT infrastructure specialist best known for pioneering the Hyperconverged Infrastructure (HCI) market.

In a nutshell, HCI allowed companies to replace a lot of complex hardware components with a single, software-defined system that has all the networking, storage, compute and virtualization resources they need.

These systems are scalable, mean clients don’t need so many IT people, and make it a lot easier for geographically dispersed offices, partners, etc. to work together.

Today, Nutanix does a lot of complex things for large enterprises, most of which revolves around software for virtualization, database-as-a-service, software-defined networking and storage, and Kubernetes.

Importantly, the company has the ability to offer IT infrastructure that runs across both public and private clouds, as well as on-premises.

That means it works with all the major cloud providers (AWS, Azure, etc.), but if a company wants to run workloads on a bunch of servers on its own property (i.e., on-premises) Nutanix can do that too.

That on-premises capability seems to be increasingly important as companies face rising cloud costs and growing concerns around data security and privacy.

On the AI front, the company was working on AI before ChatGPT exploded and is currently rolling out its GPT-in-a-box offering. This is a turnkey solution built on Nutanix’s platform with features for customer support, information retrieval from documents, fraud detection and co-piloted software development.

Perhaps most important to the casual observer is that demand for the types of services Nutanix offers is on the rise and the company is a rumored buyout candidate in the wake of Broadcom’s (AVGO) acquisition of VMware (VMW) late last year.

The company beat expectations when it reported Q1 fiscal 2024 results on November 30 with revenue rising 18% to $511 million and EPS surging to $0.29 from just $0.03 in the comparable quarter from fiscal 2023.

Looking down the road, analysts see revenue up 13.5% this year ($2.13 billion) and 17% next ($2.47 billion). EPS should be up 54% this year ($0.92) and another 38% next year ($1.27).

The Stock
After a rough 2022, NTNX has come back with a vengeance. The stock spent the first three-quarters of 2023 building a base in the 25 to 31 range then blasted off in September after the Q4 fiscal 2023 report. Following that event, shares shot through 33 and traded as high as 39.6 in early October before a mild pullback to around 34 later in the month. Since then, NTNX has been grinding higher, hitting the 50 level last Friday and holding firm there yesterday. The next area of major overhead resistance is the 54 to 64 range, where the stock hasn’t been since 2018 - 2019. With the addition of digital infrastructure stock VRT today we’ll slide NTNX onto our Watch List. WATCH

Soleno Therapeutics (SLNO) ★ Top Pick ★

Soleno Therapeutics (SLNO) is a development-stage biotech company that burst onto the scene last September when its lead drug candidate, DCCR (Diazoxide Choline) was found to make a highly significant difference in a long-term study for the treatment of Prader-Willi syndrome (PWS).

PWS is a rare, genetic disease that affects 10K to 20K people in the U.S. and about 400K globally. It’s recognized within the first few weeks of life in the U.S. Affected babies will be “floppy,” with very little muscle tone. As they get older, body fat builds and muscle mass remains very low.

By seven or eight, hyperphagia is almost always present; that’s an insatiable desire to eat whatever comes by. Pizzas, cat food, cookies, fruit, whatever. It doesn’t matter.

The only way to control hyperphagia is to restrict access to food. So families with affected kids often need to lock cabinets and fridges and avoid restaurants and other public events. Understandably, the kids often develop all sorts of other issues. Their brain says eat, eat, eat and their parents and the rest of the world say stop.

There are no treatments, though there have been several attempts. But Soleno may have cracked the code with a daily, oral, extended-release tablet of the choline salt of a known drug called diazoxide.

The short version is DCCR appears to shut down appetite, thereby reducing fat mass, increasing lean body mass and reducing aggressive, threatening and destructive behaviors.

This was shown over a two-to-four-year study where the data really showed benefit when kids went off treatment.

Because of the complexity of the data (it spanned the pandemic), Soleno has been working with the FDA to make sure they look holistically at what DCCR does. Relative to placebo, the data show it did better on all nine dimensions evaluated, with the difference between DCCR and placebo beginning early and widening over time.

All but one of the placebo patients are now back on the drug because it appears to work so well and the need is so great.

Soleno management says this market is so small and advocacy groups and affected patients are so aware of what’s out there (or not) for treatments that parents, pediatricians, psychologists, geneticists, etc. will know the treatment is coming. That means a very engaged potential market.

There are other potential indications where DCCR could work too, but that will come if/after DCCR is approved for PWS.

The team is now working on their NDA for the FDA (which would mark official approval, if granted) with a mid-2024 target for submission. Commercialization plans are in the works. The company has been raising money through secondary offerings and pre-funded warrants ($129 million raised in October) to help fund growth.

This is an exciting biotech story and while approval of DCCR this year is not a given, the odds are massively tilted in SLNO’s favor. The details of how much it will cost to bring the treatment to market and what the pricing will look like have yet to be ironed out, and there is considerable risk in all of that.

However, for those with a sizeable risk appetite, SLNO’s price action and the business development activities driving the stock should be tempting. We’ll jump in with a half-sized position and see how the story develops from here.

The Stock
SLNO was barely a five-dollar stock last fall. But the DCCR trial results announced on September 26 sent it up to 30 the next day. Shares settled down a little in the weeks after but never fell below 20. And since mid-November they’ve been walking higher, recently crossing the 40 level. With momentum behind biotech stocks (and some M&A) we’ll take a stab at SLNO. BUY HALF

Vertiv Holdings (VRT)

I added Vertiv Holdings (VRT) to our Watch List last month and nothing has happened with the company (or stock) since. That’s a good thing – it needed some time to chill out. With a four-week pause under VRT’s belt, we’ll step in today.

If you need a refresher on the story, Vertiv provides digital infrastructure solutions that power some of the biggest tech trends out there, including artificial intelligence (AI), cloud software and data warehousing.

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.

The bulk of revenue comes from data centers (70% of revenue) 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 late-November Investor Day, management suggested AI could add 3% to 4% to data center market growth through 2028. However, AI chip shipment forecasts suggest it could add closer to 10%.

With just one quarter left in the company’s fiscal 2023, total revenue growth is seen up almost 21% this year. That’s a decent jump over the 14% annual growth rate of the last two years.

That said, estimates for 2024 suggest revenue growth could moderate to 9% ($7.5 billion). 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.

The question is why. The leading candidates are concerns around supply chains and production expansion challenges, and competition. It may also be that analysts just don’t want to get too bullish given uncertainty on where AI tech will go.

VRT isn’t without risks, but the trends are in its favor and it has exposure to the biggest tech trends out there.

The Stock
VRT came public via SPAC IPO in May 2018 at 10, peaked near 29 in September 2021 and bottomed near 7.8 in July 2022. Shares 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 July. Another blastoff sent VRT to 35 on August 2, then it walked up to 50 by mid-December. Shares haven’t broken through that level yet, and VRT is at almost the exact same price as it was a month ago when I put it on our Watch List. BUY

Previously Recommended Stocks

Today Elastic (ESTC) and Shopify (SHOP) move to HOLD.

Today Cellebrite (CLBT) and Krystal Biotech (KRYS) move to SELL, for roughly 5% gains.

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 February 21, 2024.