Cabot Turnaround Letter Issue: January 25, 2023

Searching Through the Rubble for Busted IPOs

Most investors agree - initial public offerings (IPOs) can be thrilling. Few market events can match the quick gains from a hot new stock on its first trading day. For some of the hottest IPO stocks, the first-day “pop” can easily be 100% or more. Outside of a casino, such huge and immediate profits are nearly impossible to find. And, the temptation to buy even after these early price surges can be overwhelming.

Yet, most investors also agree on two additional traits of IPOs. First, for the hottest deals, very few private investors get enough shares allocated to them at the pre-IPO price to be worthwhile. Most of these high-demand shares go to large institutional investors who are important clients of the underwriting brokerage firms.

And second, the quick pop can routinely be more accurately described as “pop and drop.” Last year, IPO price performance averaged a loss of (16)%. Many over the past few years are down 70-90%. Buyers of shares after the opening day usually end up losing money. Why? Because IPO can also mean “It’s Probably Overpriced.”

Effervescent IPO markets in 2020 and 2021 brought public 618 new companies (excluding at least an equal number of blank check SPAC companies) raising $220 billion – by far the most activity in living memory. Nearly all of these companies were speculative, hyper-growth technology or biotech companies with minimal earnings or large losses yet reliant upon a single high-risk product. Even the tighter markets last year, which produced a crop of only 71 operating-company IPOs that raised a paltry $8 billion, by far the weakest on record, produced few worthy contrarian opportunities. These kinds of stocks are far outside of our wheelhouse as fundamentals-and-valuation contrarian investors.

To explore the post-IPO bubble rubble for bargains, we searched through the list of companies that completed an IPO in the past three years. We focused on real companies that produce worthwhile products and generate real profits, with shares that trade at or below their IPO price and have a reasonable valuation. Listed below are four of the most interesting such stocks.

As interest rates return to a more normal 5% or so, and as capital markets become more discerning, we anticipate that far fewer low-quality, over-priced companies will launch IPOs. Recession fears and other risks may well dampen valuations for higher-quality companies – those with real products, real earnings and real management. This is a much more favorable IPO market for contrarians, and we look forward to this year’s launch calendar. We hope to find more gems like our timely pick of Albertsons (ACI) in late July 2020 that went on to produce a 94% return.

Closing prices on January 20, 2023.
* Enterprise value/earnings before interest, taxes, depreciation and amortization. Based on consensus estimates for calendar years ending in 2023.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Core and Main (CNM) – This company is a major distributor of water-related pipes, fittings, valves and related products for wastewater, storm drainage and fire protection. Core and Main has 300 branch locations in 48 states that offer these products from 4,500 suppliers to over 60,000 customers. This specialized expertise is highly valued by the company’s customer base of municipalities, private water companies and professional contractors, which serve municipal, non-residential and residential end markets. After an initial post-IPO pop in August 2021, the shares have slid back to the $21 IPO price as investors worry about slowing economic growth, potentially tighter municipal and construction markets, and the risk of overpaying for its frequent acquisitions.

However, municipal budgets seem healthy with additional support from rising federal infrastructure spending. The company’s most recent earnings report showed robust growth and margin strength that should endure. Free cash flow is hefty, and the balance sheet is arguably underleveraged. Its acquisitions are primarily of other closely related distributors, so the integration process is straightforward and relatively uneventful. Core and Main is 58% owned by respected private equity firm Clayton, Dubilier & Rice, helping its highly capable leadership team to remain a disciplined allocator of capital. Core and Main is somewhat of a hidden gem, with added appeal from its overly discounted shares that trade at a low 6.4x EV/EBITDA.

Hayward Holdings (HAYW) – This company is a leading designer, manufacturer and marketer of a broad range of pumps, automation/sanitization, heating, filtering and other equipment and systems for residential swimming pools. Supported by a mild secular tailwind and the strong pandemic surge in demand, the company has built one of the world’s largest installed bases of customers, helping support recurring replacement sales – a feature that pool builders do not have (shares of several of those companies are out of favor but face more serious cyclical issues). Management appears strong and capable, backed by highly respected private equity firm CCMP, formerly named JPMorgan Partners. Also, the private equity firm of Michael Dell was an early backer, suggesting that Hayward has a solid business franchise. As investors worry about slowing pool sales, an economic slowdown and an inventory de-stocking that resulted from overproduction, the shares have tumbled. Despite the recent New Year’s bounce, Hayward shares remain 24% below their $17 IPO price. Earnings estimates have fallen sharply over the past year, but Hayward is still likely to produce strong profits (with an attractive 25% margin). The balance sheet is somewhat leveraged at 3.6x EBITDA, but cash flow is more than adequate to service the debt. Trading at only about 10x EV/EBITDA based on normalized earnings, the shares look like a bargain purchase of an out-of-favor company.

Petco Health and Wellness Company (WOOF) – We have highlighted shares of this company once or twice in the past, and as the shares have slid to new lows, we find them even more appealing. Today, the shares are trading only incrementally above their post-IPO low – down 40% from its $18 IPO price and down 60% from its post-IPO surge. The valuation, at 7.2x estimated cash operating profits, undervalues this quality company. Petco’s debt, at 2.8x EBITDA, is readily serviceable and being reduced with Petco’s healthy free cash flow. Unlike many other retailers, the company’s inventory level going into the holiday season was appropriately sized. Also unlike many retailers, estimates for future profits aren’t getting trimmed. Through its 1,500+ retail stores and several recent initiatives, the company continues to strengthen its already robust customer loyalty while building upon the pandemic-driven surge in same-store sales. The company has a favorable secular tailwind as consumers spend more on their pets. Petco is increasing its physical and online market shares while restraining costs, even as it invests in new technology and growth initiatives. Investor worries are primarily short-term: rising labor costs, a cyclical shift in demand toward lower-margin consumables, and a slowing economy that might dampen growth. One other concern is that its $1.6 billion in debt is floating rate, so its interest costs have jumped higher. But even at the current level, its interest payments are readily serviceable and appear likely to have reached a peak. We see these issues as acceptable near-term challenges that create an opportunity to make a long-term investment at an attractive price.

Sun Country Airlines (SNCY) – The share price of this ultra-low-cost carrier, based in Minneapolis, have descended 22% since the March 2021 IPO at $24. Investors worry about tough competition, high fuel prices, staff shortages and an eventual slowing of consumer demand. Its flights emphasize leisure travel to sunny locations and for visits to friends and family. However, unlike many carriers, Sun Country’s flights are concentrated on north-south flights with a narrow focus on a single northern city (Minneapolis). And, to a much greater degree than other airlines, the company utilizes a flexible format that allows its pilots to fly all of its planes and allows its flight capacity to adjust to sharply changing demand seasonality.

Sun Country has another attractive and unique trait: nearly 30% of its revenues are generated from steady-demand cargo flights for Amazon and charter flights for the U.S. Defense Department, sports teams and leisure sponsors like casinos. These flights are based on long-term contracts with favorable fuel cost hedges. The company’s overall cost structure is low and well-designed, such that Sun Country posted only a small loss in pandemic-stricken 2020 and now produces meaningful profits. The airline owns most of its aircraft, providing an immense lift to profits even as its balance sheet carries modest debt net of its cash balance. All-in, this impressive company has considerable appeal, particularly as its shares trade at a modest 5.6x EV/EBITDA.

On Our Radar Screen: A Look at our Research Process Using an Approaching Opportunity in Fidelity National Information Services (FIS)

Each day, we sort through dozens of stocks in search of the few gems that fit our criteria: a strong enough core business and financial condition to support a turnaround, a capable management team, and a share price that is out-of-favor enough to provide upside potential that makes the risks worthwhile.

Investing successfully in turnarounds requires in-depth fundamental and valuation research using a consistent process. Our process can be thought of as a funnel. Every stock we come across enters at the top. Many names are immediately rejected with only a cursory review as they are overly popular, expensive, complicated to understand or too low in quality. The more worthwhile a name becomes, the deeper its moves into the funnel, with progressively more research applied to the narrowing number of stocks. By the time a name gets to the bottom of the funnel (the 0.1%), it looks highly promising. Our research includes these sources and processes:

We research the company’s fundamentals using sources that include:

• Financial statements, SEC filings, news releases, presentations and other materials that describe the company’s business, strategy, risks and history
• Quarterly conference calls
• Field research
• Trade associations, media, brokerage research and other sources.

Our qualitative research helps us understand and evaluate:

• Capabilities, priorities and incentives of the management and board of directors
• Company culture and approach to its business
• Revenue stability, margin structure and capital intensity
• Turnaround plan, potential and risks
• Industry and competitive forces
• Other external pressures and tailwinds.

Our quantitative research focuses on the numbers, and for some names, we will build a financial model to more precisely assess the opportunity:

• Balance sheet
• Free cash flow
• Existing assets
• Financial flexibility.

We want to understand how the undervaluation will be resolved and the potential outcomes:

• Market recognition
• Breakup
• Takeover/go private
• Liquidation
• Other.

No stock will meet all of our criteria, but that’s not the point. The objective is to get a triangulation of criteria that is close enough. Names that are close enough become “buys” and those that don’t are set aside until their shortcomings are cured (often through a catalyst).

A “live” example is Fidelity National Information Services (FIS). The change in the CEO last October (duly recorded on the Catalyst Report), triggered our curiosity. The shares’ 50% tumble from their 2021 peak, putting them flat with their 2016 price level, heightened our interest. Now, with activist investors applying pressure, and significant changes in the membership and structure of the board of directors, the name clearly has our attention.

Having only a passing knowledge of the company, we researched the company’s roots, going back to its creation. We have found that by understanding its history, we gain an understanding of how a company got to its current situation, which provides valuable context and a sense of the magnitude of its issues.

With Fidelity National, we learned that it has a long and convoluted story. In the 22 years following its 1968 creation as data processing firm Systematics, the company had a relatively quiet existence. However, that changed with its acquisition in 1990 by ALLTEL, followed by its acquisition in 2003 by title insurance company Fidelity National Financial. It was then combined with Certegy in 2006 in a $2.2 billion deal, soon followed by a split-off from its former parent as Fidelity National Information Services. Since then, it embarked on an aggressive acquisition program including Metavante in 2009 ($3 billion), Sungard in 2015 ($9.1 billion) and WorldPay in 2019 ($35 billion), among many other smaller deals. Today, the company offers somewhat of a soup-to-nuts array of back-office processing services for banks, brokerage firms and merchants, with revenues of nearly $15 billion.

Our qualitative research showed that the company’s revenue growth is slowing, and its margins are under pressure from specialized upstarts like Toast and from more established and better-managed competitors. The company’s fourth-quarter outlook was surprisingly weak. Much of the problems stem from the addition of the WorldPay operations, but Fidelity National’s overly complex acquisition-driven structure (gleaned from our research into its history) appears to have made it a poorly integrated sprawl of loosely related services unable to adapt to a changing marketplace. The leadership has been focused on growth rather than efficiency and durability. We also were not surprised to learn that the leadership’s incentive compensation packages tended to produce excessive compensation not matched by strong execution.

Looking into the company’s news releases and integrating this with media and other commentary, we see that the board appears to be getting the message. The ouster of the highly compensated CEO brought Stephanie Ferris into the seat. Ferris is an industry veteran, starting with her early days at Fifth Third Bank’s tech processing unit, followed by an impressive rise through the ranks during several acquisitions to become the CFO of WorldPay, and then president of Fidelity National in early 2022. She clearly knows the industry and Fidelity’s operations – we see her as a capable new leader. Her promotion was to occur on January 1, but this was accelerated to “immediately” on December 15. Also, the former CEO was to stay on the board as executive chairman, but he instead has fully exited all roles at the company. Fidelity also announced a new board structure, with leadership provided by a newly appointed independent chairman. Two other board members were recently replaced, as well.

Activist campaigns by widely respected DE Shaw and JANA Partners have resulted in standstill agreements almost certainly in exchange for the recent board shake-up, a new strategic review and the heightened urgency. We view all of these changes as highly encouraging that the company’s core problems might now be addressed.

We see immense potential to improve the company’s fundamentals and share valuation by re-focusing and streamlining its current operations, divesting weak-fit businesses and fending off competitors. But, based on our research as well as our experience with turnarounds of this scale and complexity, this process will take considerable time and resources. Near term, the problems are likely to only get worse. Our view is that unless the share valuation is cheap enough to discount the pre-turnaround fundamental erosion, the investment case isn’t quite ready yet.

Our quantitative and financial model analysis suggests that the valuation isn’t cheap enough. At an EV/EBITDA valuation of 9.7x, and a price/earnings multiple of 11x, (not much cheaper than better-positioned peers), the shares wouldn’t offer enough upside. And, this valuation may be illusory if earnings estimates continue to deteriorate. We would be hard-pressed to justify a share price target of, say, 110 to 120, in order to reach our 50% minimum return criteria. With stocks, of course, anything is possible, but the odds wouldn’t be in our favor at the current 74 price.

We like the company’s strong free cash flow, likely to be about $3.5 billion this year, which seems reasonably stable. However, debt is elevated at 3.0x EBITDA, and about a third of its free cash flow is siphoned off by the dividend (producing a 2.7% dividend yield). And, when converting the free cash flow into the valuation metric, the 8.3% free cash flow yield (free cash flow/market value) is too low to be enticing. We would like to see a 10-12% yield for this type of situation.

So, all-in, Fidelity National has much of what we are looking for in a turnaround and its shares made it through most of our research funnel. But, it’s not quite ready for an investment. We want to buy the shares at 55 (or lower, depending on how much the fundamentals deteriorate) to make it worthwhile. We’ll follow one of our core precepts: patience.

RECOMMENDATIONS

Purchase Recommendation: Bayer AG (BAYRY)

Bayer AG (BAYRY) Kaiser-Wilhelm-Allee 1 Leverkusen, North Rhine-Westphalia 51368 Germany www.bayer.com

Symbol: BAYRY Market Cap: $60 billion Category: Large Cap Business: Conglomerate Revenues (2022e): $54.7 Billion Earnings (2022e): $8.4 Billion 1/20/23 Price: 15.41 52-Week Range: 11.41-18.45 Dividend Yield: 3.50% Price target: $25

Background: Bayer is a Germany-based crop science, pharmaceutical and consumer health products conglomerate with $60 billion in revenues. Co-founded in 1863 by Frederich Bayer as a maker of dyes, the company created Aspirin® in 1899, one of the wonder drugs of modern medicine. Bayer then developed into a research-focused maker of chemicals, pharmaceuticals and agricultural protection products that were marketed around the world. As a conglomerate, the company has an extensive history of major changes to its portfolio. A landmark deal in 1994 allowed it to regain rights to the Bayer name in the United States. Other notable deals include the acquisition of Roche’s consumer health business and spin-off of Lanxess AG in 2005, the purchase of Schering AG and divestiture of the Bayer Diagnostics division in 2007, the acquisition of the consumer health business of U.S.-based Merck in 2014, the acquisition of Monsanto for $63 billion in 2018, and the sale of its animal health business to Elanco for $7.6 billion in 2019.

Today, Bayer’s Crop Science business is the largest in the industry and produces about 50% of the company’s revenues. Its core products focus on seeds and crop protection. The Pharmaceuticals segment generates about 38% of revenues, with an emphasis on cardiovascular, oncology and women’s health treatments. The Consumer Health business contributes about 12% of company revenues featuring over-the-counter products for nutrition, allergy and colds, and dermatology.

The Monsanto deal, which The Wall Street Journal has called “one of the worst corporate deals in recent memory,” was enormous in size (the all-cash deal was the largest buyout by a German company in post-war history) and a significant stressor on Bayer’s balance sheet. However, much more damaging than over-paying for what was supposed to be a healthy company was that within weeks of the deal’s closing, Monsanto started losing lawsuits alleging that glyphosate, the active chemical in its flagship pesticide Roundup, causes cancer. Investors quickly soured on shares of Bayer, cutting its share price in half in the year following the Monsanto acquisition – a loss of nearly $65 billion in value.

Other worries include litigation risk from PCBs, incremental glyphosate pricing pressure this year as new supply enters the market, and potential revenue declines as its patents begin to expire on Xarelto and Eylea, its two largest pharmaceutical products.

Investors remain reluctant to return to Bayer, given the potential glyphosate and PCB liabilities, unwieldy conglomerate structure and the lack of credibility of the leadership team that acquired Monsanto yet still runs the firm. The shares remain just above their 15-year low.

Analysis:

While the surface-level prognosis for Bayer is dour enough to motivate most investors to avoid the stock, further analysis suggests a deeply undervalued company that is getting a handle on its liabilities, with credible activist investors pressing for changes in the leadership and a break-up of the conglomerate structure.

Looking first at Bayer’s underlying operations, the three business segments combine to produce a relatively steady although slow-growing stream of revenues and profits. Its products have strong relevancy, and the company’s research and development efforts continue to protect its sturdy moat with new products. The Crop Science business has perhaps a 3-4% growth rate across a cycle, with seasonal and annual/cyclical volatility. Pharmaceutical segment growth is likely to be at a 2-5% rate. Consumer Health revenue growth is in the -3% to +3% range. Overall profitability is reasonably stable, with Bayer’s annual EBITDA margin, adjusted for litigation and other non-operating costs, generally in the 24-27% range. This stable and robust core provides a solid base for shareholder value.

Supporting this base is solid free cash flow backed by a sturdy balance sheet. Bayer generates about $6.5 billion in free cash flow each year. The $39 billion in debt is a reasonable 3.4x EBITDA and is bolstered by $9.8 billion in cash.

Next, we see many of the risks that worry investors as relevant but mostly already factored into the firm’s valuation. Regarding the incremental pricing pressure in glyphosate, we recognize the risks from rising Chinese production which will unwind much of the recently strong pricing power. But most of this weakness is already factored into earnings estimates and we see the potential for pricing power to taper less dramatically than widely assumed.

Regarding the pharmaceutical patent expirations, Xarelto (23% of segment sales) is currently facing patent expiration in China and Brazil and will begin to see patent expirations elsewhere starting in 2024. Eylea (17% of segment sales) will begin to see biosimilar competition this year in Japan and Canada. But patent protection for Eylea remains in place in several other major markets for another two years, and Bayer is developing new configurations that could readily extend its pricing power much longer. The impact from the pricing pressure in both Xarelto and Eylea appears to be fully baked into analysts’ earnings estimates. Furthermore, Bayer’s pipeline of new products, from internal development and from recent acquisitions, is showing promising current and potential revenue growth. We estimate that these new revenues will eventually more than offset the losses from Xarelto and Eylea.

The major risk to Bayer shareholders is an adverse outcome of the glyphosate debacle. While there are no guarantees, and the company continues to face new trials including two this month, the worst-case scenario of a huge tide of litigation losses and liability payments appears to be off the table. Top governmental health regulators in the United States, Europe and other major countries have concluded that glyphosate is not carcinogenic. After worrisome losses in three early courtrooms (in which the combined $2.4 billion in initial damage awards were later sharply reduced to $133 million), Bayer has won seven consecutive court cases, suggesting that there may be reasonable limits to its liability. Most cases appear to be settled out of court for small sums. There may be an opportunity for a unified settlement of all of the many hundreds of cases filed, which would allow investors to more precisely quantify and ringfence the total liability.

A key defense strategy for Bayer is to get rulings under state laws pre-empted by federal laws. Given the EPA’s approval of the warning labels on Roundup, if federal laws prevail, Bayer could see its liability reduced or eliminated. The case brought by Georgia resident John Carson, which could settle this issue, is winding its way through a complicated federal process that could end up at the Supreme Court. The outcome won’t likely be determined until early 2024.

Bayer’s liability for polychlorinated biphenyls, or PCBs, is becoming clearer. These chemicals were used in electrical insulation, paints and other similar applications. Monsanto voluntarily ceased production in 1977. Bayer recently settled with the State of Oregon for $698 million and has also settled with five other states, the District of Columbia and a nationwide class of municipalities. While additional lawsuits remain, we anticipate that the company can readily handle the associated liabilities.

A key component of our investment thesis is that investors are significantly over-penalizing the company for its litigation risks and conglomerate structure. Currently, the company is valued at 6.9x cash operating profits and 7.2x earnings per share. The current valuation also implies an appealing 11% free cash flow yield. In a litigation-free, break-up scenario for Bayer, we estimate that the ADRs would be worth over 28, more than 85% above the current 15.41 price. Even at this price, the valuation would be unchallenging: 10.0x cash operating profits and 13.3x earnings per share.

Our analysis places the discount for the combined glyphosate and PCB liabilities at about $30 billion, or $7.70 per ADR. Bayer has set aside reserves of around $7.5 billion, which is a fair assessment of the total liability. We estimate Bayer’s conglomerate discount to be $22 billion, or $5.50 per ADR. This discount allows for the lack of specialization and accountability inherent in conglomerates, particularly those led by executives that may underappreciate the primacy of shareholder value.

While the liability discount could take a year or more to be resolved, the conglomerate/leadership discount may see a more immediate resolution. Long-time shareholder Temasek, the sovereign investment fund of Singapore, continues to press for the CEO’s termination. More recently, notable and highly regarded activists Bluebell Capital and Jeff Ubben have joined the fray and have added new calls for a break-up of the company. The shareholder base also includes managers like Capital Research and Harris Associates – two highly regarded firms that quietly pressure companies to unlock trapped value. We believe that the CEO’s remaining tenure is likely to be brief, with his replacement receiving a mandate to sharply improve the firm’s shareholder value with changes that may include a major divestiture.

All-in, Bayer shares carry an unusually large and unwarranted discount. While it might take a year or longer to be realized, the firm is on a path to unlock considerable value for investors. During the wait, the company’s shares pay a highly sustainable dividend that yields 3.5%. We are setting our price target for the ADRs at 24 to allow for $15 billion in litigation settlement value and some flexibility to weigh the risks/returns along the way to a fuller valuation.

Investors are encouraged to start a new position at the current price, then add more aggressively if the shares unwind some of their New Year bounce widely attributed to news about activist investor interest and possible management changes. The ADRs, each of which represents ¼ of an Ordinary share, trade with considerable liquidity in the United States. Investors in Europe will likely prefer the underlying shares which trade on the Xetra exchange under the “BAYN” symbol.

We recommend the purchase of Bayer AG (BAYRY) ADRs with a 24 price target.

Ratings Changes

On January 6, we raised our price target for shares of Macy’s (M) to 25 as the shares ticked above our recently raised 20 price target. The company is executing well and its customer base seems to be doing fine as the labor market remains strong. Macy’s shares remain undervalued.

General Electric (GE) spun off its GE Healthcare Technologies (GEHC) business on Tuesday, January 4. GE shareholders received 1 GEHC share for every 3 GE shares owned. General Electric continues to own 19.9% of GE Healthcare but will gradually divest this stake. On January 6, we moved the shares from Unrated to Sell. For GE shares’ performance measurement purposes, we are treating the GEHC shares as a dividend worth the closing price (divided by 3) on January 6, 2023, the day we sold the shares.

Our view is that GE Healthcare may well be a decent company, but its growth rate potential is limited, and its profit margin expansion will be a grind, with the company struggling to even come close to its 18% EBITDA margin goal. We see 2023 as a transition year that will probably be uninspiring. The company has an over-levered balance sheet at 3.5x EBITDA. Its share valuation is reasonable at best, at 12x EBITDA and 17x per share earnings based on 2023 estimates. Over a 2–3-year period, we see the shares having perhaps 15-20% upside potential, which is respectable but not in the 50% range that we look for in turnaround situations. All-in, the shares aren’t attractive enough to include on our recommended list, so we are moving them to SELL.

Disclosure: The chief analyst of the Cabot Turnaround Letter personally holds shares of every company on the Current Recommendations List. The chief analyst may purchase securities discussed in the “Purchase Recommendation” section or sell securities discussed in the “Sell Recommendation” section but not before the fourth day after the recommendation has been emailed to subscribers. However, the chief analyst may currently hold and may purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time.

Performance

The following tables show the performance of all our currently active recommendations, plus recently closed-out recommendations.

Large Cap1 (over $10 billion) Current Recommendations

Mid Cap1 ($1 billion - $10 billion) Current Recommendations

Small Cap1 (under $1 billion) Current Recommendations

Most Recent Closed-Out Recommendations

Notes to ratings:
1. Based on market capitalization on the Recommendation date.
2. Total return includes price changes and dividends, with adjustments as necessary for stock splits and mergers.
* Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.
** BNRE return includes spin-off value of BAM shares.
*** GE total return includes spin-off value of GEHC shares at January 6, 2023 closing price to reflect our sale.

The next Cabot Turnaround Letter will be published on February 22, 2023.