Cabot Top Ten Trader Issue: February 20, 2024

Volatility Increases, but Trend Still Up

The market isn’t without potholes, but overall things are still mostly constructive. The trends of the indexes remain up and the leading growth stocks remain firm, although many big tech names are showing signs of entering what appears to be an overdue pullback.

Breadth remains solid overall, but volatility as measured by Wall Street’s favorite fear gauge, the VIX, is starting to act up again. All in all, a classic split tape is emerging with some sectors weakening while others show strength. We’re keeping a weather eye out for any sudden changes, but for now, we’ll leave our Market Monitor at a level 7, holding our winners but also building some cash, while taking advantage of recent rotation into less-growthy areas of the market.

This week’s list features a mix of old and new economy industries that have benefited from both rotation and earnings. For our Top Pick we’re going with AppLovin (APP), a name which is making waves in the app publishing market while also harnessing the power of AI to grow its customer base (last week’s earnings reaction was exceptional). Some post-earnings weakness is possible, but we’re OK nibbling here.

Stock 1

AppLovin (APP) ★ Top Pick ★

Why the Strength
AppLovin’s mobile platform enables developers of all sizes to market and publish their apps while advertising their offerings to potential new customers. The company also offers Internet-based TV marketing and owns a growing mobile game development business. But its software platform is the main attraction here (nearly 60% of revenue), and it’s capturing Wall Street’s attention with its eye-popping growth—thanks in large part to a new artificial intelligence-powered advertising engine. A major institution just upped its share price target for the stock in the wake of the new AI-based ad service, the AXON 2.0, which it said is “driving more efficient ad spending for AppLovin’s clients,” most of which are in the mobile gaming industry, by using predictive machine learning to target app-install ads to users most likely to download those apps. Last week, the company’s rapid growth was highlighted in the Q4 report, which featured consensus-beating revenue of $953 million that increased 36% from a year ago, plus earnings of 49 cents that beat estimates by 40%. Software platform sales grew 88% to $576 million, while segment-adjusted EBITDA soared 126% to $420 million (a 73% margin). The firm’s apps portfolio also performed well in Q4, with 5% growth from the prior quarter while maintaining a consistent 15% adjusted EBITDA margin. Management attributed the stellar results to growth in the mobile advertising market, the expansion of its advertiser base, higher advertising budgets and a market shift to real-time bidding. For Q1, the top brass guided for revenue of $965 at the midpoint (up 35% if realized) and adjusted EBITDA of $485 million (up 77%). Going forward, the company believes its free cash flow generation and share management will generate long-term value for shareholders, and to that end, just increased its share repurchase authorization by $1.3 billion. Analysts see a sizable bottom-line jump (average estimated increase of 150%) for 2024.

Technical Analysis
APP was the dog’s dinner in 2022, falling from a high of almost 100 at the start of that year to a low of 10 by the end of it. But the release of its AI-powered ad service helped dig the stock out of the doldrums in 2023, with shares turning the corner in the spring. APP met resistance at 45 last summer and spent several months building a high-level base while the 200-day line caught up. Last week’s earnings broke the stock out of the base on monster volume, with the start of this week seeing a minor (and normal) pullback. There could be a bit more weakness near term, but we’re OK nibbling here.

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Stock 2

Automatic Data Processing (ADP)

Why the Strength
A multi-year low in unemployment, coupled with continued acceleration in remote work, has contributed to more jobs being outsourced by large companies in need of workers—in turn creating a growing demand for firms that specialize in human resource management (HRM). New Jersey-based Automatic Data Processing (commonly known as ADP) offers cloud-based payroll and HRM software and is a top provider of employment outsourcing solutions. The company’s operations are divided into two major segments: Employer Services (HR solutions) and PEO Services (HR outsourcing), with both segments showing impressive growth in fiscal Q2 (ending December 31). ADP reached new record bookings volume in the quarter for Employer Services, with growth being “especially robust” in its small business portfolio and international business, and with retention said to be “strong.” For the PEO segment, new business bookings momentum was also solid and described as “ahead of expectations,” with additional acceleration expected in the second half of the year. Total revenue of $4.7 billion increased 6% year-on-year, with Employer Services revenue jumping 8% and PEO sales rising 3%, while earnings of $2.13 beat estimates by three cents (all reasons for the stock’s strength). Continuing the generative AI theme, the company just rolled out ADP Assist, a GenAI-powered cross-platform solution that aids companies in making HR decisions while streamlining everyday tasks. Management guided for fiscal 2024 revenue to increase around 7%, thanks to a “healthy” new business pipeline and an expanding addressable market (estimated at $150 billion), with EPS projected to grow 12% this year. An added bonus is ADP’s reputation as a top-level dividend payer (current yield 2.2%), with the firm set to become a Dividend King—a company that has grown the dividend for at least 50 straight years—in November.

Technical Analysis
ADP hit a record apex at 270 in late 2023, but found the level too strong to overcome, turning tail and falling for the next several months before finding support around 210 last June. It then promptly reversed course and ran back up to within reaching distance of the old high by September, but once again fell victim to strong selling during the October broad market shakeout. However, it found strong support at 210 later that month and has since recovered nicely. There’s some overhead supply nearby, but we’re OK taking a swing on dips.

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Stock 3

CDW Corp. (CDW)

Why the Strength
Illinois-based CDW is a top provider of technology products and services for businesses, governments, healthcare and education institutions in the U.S., the U.K. and Canada. The company’s original name was Computer Discount Warehouse, and it mainly sold desktops, laptops and printers. But a broadening of the firm’s offerings—as well as a spate of acquisitions— in recent years has turned CDW into a Fortune 500 company and S&P 500 component, while its product lineup has expanded from hardware and software to integrated IT solutions such as security, cloud, hybrid infrastructure and digital experience. Although hardware solutions (notebooks and mobile devices) still account for the lion’s share of CDW’s annual sales at around 80%, the firm is putting more of its focus on software and services going forward, as it sees the market for its software offerings in particular (cloud, analytics, cybersecurity and data center product to name just a few) expanding far more rapidly. Although revenue of $5 billion decreased 7% year-on-year in Q4 (which CDW blamed on delayed hardware spending among its customers due to economic uncertainty), per-share earnings of $2.57 increased 3%, while gross profit margin rose 6% and increased across all customer markets (a reason for the share price strength). The company noted that enterprise customers are increasingly turning to CDW to address mission-critical needs across the full IT solutions stack and lifecycle and said the firm is on track to outpace broader domestic IT market growth by 3% on a currency basis this year. CDW is also confident that 2024 will see higher hardware and software spending and just increased its share repurchase authorization by $750 million (more than double the remaining authorization). Wall Street sees modest, single-digit sales and earnings growth for 2024, but this will likely prove conservative as enterprise hardware spending growth is projected to re-accelerate this year.

Technical Analysis
CDW rallied up to a multi-year high at 215 last February, but it proved to be a resistance too tough to overcome. The stock folded back in the weeks that followed, eventually bottoming out at 160 in late April. But a character change occurred in May, with shares marching on to a series of rising peaks into the fall and winter months, with the latest earnings report producing another pop higher on good (but not great) volume. Aim for dips if you want in.

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Stock 4

Fastenal (FAST)

Why the Strength
As its name implies, Fastenal is all about fasteners—for the industrial and construction markets to be exact. It specializes in the wholesale distribution of fasteners for markets and industries across North America, including railroads, farming, mining and oil/gas production, and its offerings range from things like threaded fasteners, screws, bolts, nuts and washers to supplies and hardware like pins, rivets, machinery keys, concrete anchors and metal framing systems. Admittedly, it’s not the sexiest story out there, but the demand for Fastenal’s offerings is immense in light of increased infrastructure- and manufacturing-related construction spending in the U.S. and Canada. Construction and manufacturing are the company’s biggest customers, and to that end, the growth can be seen in the rising number of Fastenal’s Onsite Inventory Solutions locations at related firms (but also available to other major industries). Onsite locations are basically mini-Fastenal outlets specifically dedicated to meeting the supply needs of their customers, allowing them to access critical supplies and expert advice on an as-needed basis. Fastenal opened 58 Onsite locations in Q4, resulting in a total of 326 new location signings for 2023 (the company plans to sign up to 400 new locations in 2024.) Onsite’s rapid growth is a big reason for the share price strength, but the recent Q4 report provided some additional impetus: Revenue of $1.8 billion increased 4% from a year ago and sailed past estimates, while earnings of 46 cents a share was in line with expectations. The company saw higher unit sales in Q4, thanks mainly to the growth of Onsite locations among larger customers. It also improved the balance sheet, produced record operating cash and returned record capital to shareholders in the quarter. For 2024, Wall Street expects 7%-ish top- and bottom-line growth (likely conservative). It’s a cyclical-but-solid story.

Technical Analysis
FAST peaked at 60 in early 2022, then ground its way lower during the broad bear market, but established support above 45 in the last part of the year. It spent a few more months rounding out a nice basing pattern, which was completed last November. This served as a launching pad for the take-off in December, with shares reaching a record 71 earlier this month. The stock has spent the last couple of weeks tightening just under this level, and while it’s not completely free and clear, we’re OK starting a position on a bit more weakness.

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Stock 5

Howmet Aerospace (HWM)

Why the Strength
After undergoing numerous setbacks during the Covid years, the global aerospace industry is projected to see a “strong surge” (in the words a major industry group) in deliveries over the next three years as the supply chain fully recovers and backlogs are worked off. Consequently, industry-wide order books are brimming for new commercial passenger and business jets, which is one reason for the optimism surrounding aerospace leader Howmet. The company provides engineered metal products—mainly aluminum and titanium—used in aerospace, defense and commercial transportation applications, as well as fastening systems, bearings and forged aluminum wheels for heavy trucks. Howmet operates through four segments: engine products, fastening systems, engineered structures and forged wheels, but aero engine products (including airfoils and rolled rings for engines and gas turbines) are Howmet’s largest and fastest growing market. In Q4, that segment led a 14% year-on-year increase in quarterly revenue for the company of $1.7 billion, with per-share earnings of 53 cents increasing 21% and full-year free cash flow reaching a record of $682 million. Engine products sales soared 16%, to $852 million, due to growth in the commercial and defense aerospace, industrial gas turbine and petroleum markets, with segment-adjusted EBITDA rising 22%. Fastening systems revenue of $360 million jumped 26%, also led by the commercial aerospace market, including an emerging wide-body aircraft recovery. Meanwhile, engineered structures revenue of $244 million rose 6% and forged wheels sales of $275 million were up 3%. Looking ahead, management said record backlogs at aircraft OEMs support continued strength in the commercial jet market, and Howmet guided for “above-trend” growth in 2024, commenting that the balance sheet “has never been stronger.” Wall Street likes what it sees here and predicts 20%-ish bottom-line growth in each of the next three years.

Technical Analysis
After spending the better part of 2022 bobbing and weaving, HWM soared out of the gate heading into 2023 and was in a controlled ascent until running into strong resistance at 51 in July. That prompted the sellers to step in, pushing shares lower by eight points until the bulls returned in late October. HWM turned on a dime at the start of November, gapping higher on earnings and gaining ground in each month since. Last week’s Q4 report saw another big push forward, but we’re OK using controlled weakness to nibble in.

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Stock 6

Installed Building Products (IBP)

Why the Strength
Installed Building Products is one of the nation’s largest installers of various types of insulation into residences, primarily into new construction single and multifamily homes. IBP also installs complimentary building products, such as garage doors, gutters, fireproofing and closet shelving, among other services. The company operates in 45 states and has been very active in acquiring local competitors to expand its reach. It’s generally a growth business but obviously takes a hit when domestic housing starts are depressed. Still, IBP has been able to outperform the industry average in recent quarters. In last year’s Q3, U.S. single-family housing starts were down 16% year over year, but IBP sales weren’t as bad, falling 14%; multifamily starts were much stronger, up 14%, and IBP posted a much better performance, with its multifamily revenue soaring 28%. The company says it doesn’t look to just improve volumes, but instead works with, or avoids, builders depending on the types of margins that work for them allows (including homebuilders with a national footprint or regional builders with a close working relationship). Housing starts nationally lagged the torrid pace set during 2021, but Wall Street sees IBP edging out a modest rise in sales this year, thanks to its solid focus on cost controls and its acquisition of fold-in businesses: it bought eight companies, adding $58 million in sales the first three quarters of 2023 alone. Q4 results will be released before the start of trading on Thursday, with expectations for $682 million revenue and per-share earnings of $2.41, both basically unchanged from year-ago Q4 results. However, analysts see the bottom line growing 11% this year, and if industry predictions of lower mortgage rates materialize, that estimate will likely prove conservative.

Technical Analysis
IBP shares have been less volatile compared to the overall housing market than might be expected. From late summer 2020 to November 2023, shares moved in a broad range between 75 and 150 but rarely veered too far away from its 200-day line. Better-than-expected Q3 results broke shares out of that range, rallying recently to an all-time high of 214. If you want in ahead of Thursday’s earnings report, we think a bit more weakness would be ideal.

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Stock 7

Ralph Lauren (RL)

Why the Strength
A long-established brand, Ralph Lauren appears to be making good strides in engaging younger consumers. The efforts at attracting this customer base include livestreaming fashion events on metaverse platforms, offering digital outfits in the popular game Fortnite—and real-life versions in its stores—and even selling Ralph Lauren-branded skateboards. It also continues to have good traction in China (notwithstanding the slumping consumer market in that nation). Those things, combined with the easing of inflationary pressures on cotton fabric, led the company to exceed analysts’ expectations in its recent earnings report. Specifically, fiscal Q3 (ended December 30) revenue of $1.93 billion increased 6% from a year ago, while earnings of $4.17 a share blew consensus estimates out of the water (by 17%). The company seems to have found a happy middle ground between continuing to sell luxury items to wealthier, older consumers—especially in the U.S. and Asia (a new line of handbags is selling very well there)—while building out digital channels to attract younger consumers. Lauren further made progress worldwide in its digital segment, mostly from younger buyers. It posted mobile gains of 4% in North America, 12% in Europe and 25% in Asia (though Asian digital growth is coming off a smaller base). Despite potential headwinds from the economy and from currency conversions, management guided for Q4 revenue to rise 2% to around $1.6 billion. Further out, a renewed focus on reducing costs, helped along by continuing improvement in the cost of cotton and the price of transportation, should allow Lauren to expand margins. Wall Street sees earnings per share of $1.64 for Q4, which would be an 80% leap from the comparable period.

Technical Analysis
RL spent the eight weeks leading up to the Q3 report building out a tight base while the 50-day line caught up, which set the stage for the recent breakout. The earnings announcement resulted in the strongest volume in nearly three years, with the stock rocketing to its highest level since 2015. Near-term volatility wouldn’t surprise given the extent of the run-up, but we’re fine using pullbacks to nibble.

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Stock 8

Shake Shack (SHAK)

Why the Strength
Shake Shack has been likened to an updated version of the classic roadside burger stand but with a menu designed to appeal to customers of varied tastes (including beer, wine, designer frozen custard and even treats for the family dog). The company operates 518 locations around the world, serving a modest menu of higher-than-fast-food-quality burgers, chicken sandwiches, fries and shakes, among other items. Demand has never been an issue for Shake Shack, which has generally enjoyed high volume since it opened in and around New York City two decades ago as an outgrowth of white tablecloth chef Danny Meyer’s empire. The recent challenge for the company has been managing margins given that prices for better-quality ingredients, especially beef, have been on the rise. That said, the company still managed to beat expectations in the latest quarter, the results of which were released last week. Revenue of $286 million increased 20% from a year ago, while system-wide sales jumped 21%. Meanwhile, per-share earnings of two cents beat estimates by a penny. Even more impressively, restaurant-level margins rose three percentage points to 20% overall, which is excellent by industry standards, and with management seeing even more room for improvement in the coming quarters. Same-store sales were up nicely too, at 4%, thanks in part to the opening of 15 new domestic company-operated Shacks in Q4. (There were 44 new licensed Shacks opened in all of 2023, including locations in Thailand and the Bahamas.) Looking ahead, management predicts strong 2024 growth in operating margins and international sales, while Wall Street expects a lofty bottom-line leap of 75% compared to the prior year.

Technical Analysis
Lingering inflation worries kept a lid on SHAK’s rebound in 2023, with 80 serving as the stock’s ceiling last August. A sharp drop followed over the next couple of months, with the 53 level attracting buyers and stemming the tide of selling in October around the time of the broad market low. SHAK turned the corner in November and made it back to the old resistance earlier this month, with last week’s earnings vaulting shares to a new high at 100 on monster volume. Round-number resistance is possible near term, but we’re fine taking a swing on pullbacks, as the path of least resistance is up.

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Stock 9

Shift4 Payments (FOUR)

Why the Strength
The apparent subsiding of inflation has done wonders for shares of Shift4 Payments, a new payments leader that focuses on the ease of transactions for entertainment venues, including its core market of restaurants, and a burgeoning grip on athletic events (think concessions, but also seat-side and mobile purchases). In addition to facilitating easier payments for its clients’ customers, Shift4 Payments provides a clear cost advantage for its own customers compared to traditional financial services competitors. What’s more, the company is increasingly winning larger clients. For most of its 24-year history, its typical customer was the neighborhood bar-restaurant; namely, location venues that gladly paid a good price for the efficiencies its technology brought. But now the business has an increasing presence in high-volume locations and chains, like Las Vegas hotels and stadiums, including with the NFL’s Miami Dolphins. That comes with a trade-off, however, since big clients demand cheaper rates. But management says its foothold in large venues such as arenas allows it to integrate other products and services, including ticket reselling, which has been only marginal for standalone companies but suddenly improves with seamless integration thanks to its platform. Overall, Shift4 is a fast-growing business (it has been profitable throughout its entire history) with high investor expectations; indeed, management just hiked full-year sales and earnings guidance and the consensus has moved up with it. Wall Street sees Q4 sales and earnings leaping 40% and 75%, respectively, with full-year EPS expected to double from 2022. Earnings are due out Tuesday, February 27 (pre-market).

Technical Analysis
FOUR broke out from a six-month-long correction in November on earnings, catapulting back above the 40-week line and following through to achieve a 27-month high in February. The rate of ascent has slowed in the last few weeks, however, as investors may be waiting for the upcoming Q4 report before fully committing. However, we like the pattern and see a nibbling opportunity here or (preferably) on dips of a point or two.

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Stock 10

Trane Technologies (TT)

Why the Strength
Thanks in part to its Thermo King subsidiary, Trane is a global leader in the interior climate and refrigeration business and has been positioning itself as a company that can help customers combat climate change (especially given that building emissions and food waste contribute 25% of worldwide greenhouse gas emissions). Indeed, the company has become a long-term beneficiary of the industrial and commercial building world’s move toward energy efficiency and decarbonization. While historically a heating and cooling provider, Trane’s HVAC systems are one of the technologies corporations and landlords have increasingly gravitated to in order to lower their carbon footprint and save energy costs (the firm’s systems are considered as much as four times more efficient than traditional HVAC systems). In Q4, Trane posted sales of $4.4 billion, up 9% from the year-ago quarter, plus per-share earnings of $2.17 that beat estimates by 4 cents. What’s more, both metrics beat the majority of its competitors in what was a volatile residential and transportation heating and cooling market. Global commercial HVAC continues to be a strong market, prompting Trane to predict 2024 will allow it to grow organic revenue by around 7% and earnings by more than 11%. Further, its customers are starting to benefit from the company’s smart software that optimizes how building climates are managed. To boost its expertise in that area, Trane recently bought Nuvolo, which makes software for companies to manage all their facilities through a single cloud-based gateway. That and other buys are expected by analysts to set the business up for significant improvements in long-term cash flow. Wall Street sees bottom-line growth of around 12% this year and next.

Technical Analysis
TT broke out decisively above long-held resistance at 210 in November, powered by earnings results, and the stock further advanced 45% to an all-time high just below 280 earlier this month. Since then, shares have been consolidating in a narrow, lateral range above 270 while the 25-day line catches up. A pullback is possible, but we’d view this as a buying opportunity.

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Previously Recommended Stocks

The next Cabot Top Ten Trader issue will be published on February 26, 2024.

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