Cabot Turnaround Letter Issue: March 6, 2024

Who Put Tonic in My Gin and Tonic? The Sober Case for Energy Stocks

Long ago, legendary comedian W.C. Fields, who was also quite the imbiber, was reputed to have cried out the above quote in disgust when his gin & tonic drink was improperly prepared. For him, a proper G&T was pure gin and no tonic.

By changing only a few key words, much the same can be said for today’s average fund manager. With the highly distilled roster of mega-cap tech stocks consuming a third of the S&P 500 and climbing ever-higher, intoxicated fund managers have no interest in diluting their portfolio with anything of lesser strength. If Mr. Fields were re-incarnated as a fund manager, he might say, “Who put energy stocks in my portfolio?” Only high-potency tech wonders will suffice.

Indeed, energy stocks have long been a diluter of returns. Over the past 10 years, the S&P 500’s energy sector has produced an uninspiring 49% total return. The zestier technology sector, however, has churned out a 630% total return. And, with the energy sector comprising a mere 3.7% of the S&P 500, managers have little incentive to add oil and natural gas stocks into their mixture.

In addition to the small weight and lackluster returns, what other reasons are commonly conveyed for avoiding energy stocks? One is that short-term energy stock performance is heavily influenced by commodity prices and that these prices are unpredictable. Saudi Arabia may decide some summer evening to boost production, or the arrival of a U.S. recession will slash demand and bring an oil price tumble. Few managers want to hold a stock that can have its legs knocked out by a seemingly random event.

A second reason is the trendy and powerful narrative that electrification will soon bring “peak oil demand” and with it a permanent slide in commodity prices. Electric vehicles are becoming more widely used, supported by government subsidies and mandates to end the sale of gasoline cars. Alternative sources of energy like wind and solar continue to expand in scale. Closely related, few managers want to be seen either publicly or privately (in front of consultants and clients) as denying the “inevitable” transition away from fossil fuels.

Investors also worry that energy company managements will return to their partying ways of old – spending heavily on drilling to re-assert their growth aspirations. Aggressive spending on oil drilling is almost literally pouring money into holes with little chance of generating a respectable return.

These worries, however, suffer from a few key flaws. The volatility of energy prices is no reason to forever avoid the group. Energy stocks already factor in much of this risk, as valuation multiples are routinely at 50% or greater discounts relative to the broad market. Also, energy stocks can sometimes, like today, be discounting a decline in commodity prices such that an oil price fall-off won’t result in lower energy company shares.

Regarding the electrification of society, this appears to be much further into the future than widely assumed. The “EV boom” is becoming an “EV bust” as demand for electric vehicles has sharply slowed, even with aggressive government subsidies which many developed countries are becoming tired of providing. And, few people other than high-end consumers can afford even subsidized EVs. The reality: gasoline-powered cars aren’t going away anytime soon.

Efforts to transition the developed economies to wind and solar power are stalling, as well, due to sharply rising costs along with the unreliability of the power that these alternatives provide. Some say the adoption of wind and solar will compare to the rapid shift in the early 20th century to oil, but that belief ignores the facts that oil was exceptionally cheap and plentiful and had vastly superior energy content relative to wood and coal – traits that wind and solar clearly do not share.

Providing an enduring floor to oil prices is the inexorable growth of the global economy. Economic growth is a major driver of the growth of oil consumption, particularly in emerging countries. Up-and-coming nations become more energy intensive as they grow, and the fuel of choice is oil. All in, global oil demand is likely to continue to grow at around 2 million barrels of daily consumption each year. This relentless demand growth is paired with the likely stunted global supply growth due to years of capital spending discipline. Domestic production in the U.S. appears capped at around 13 million barrels a day, and surplus Saudi capacity has its limits. Steady demand growth will eventually exceed supply. Perhaps it’s no wonder that crude oil prices have gradually ticked upwards and are now approaching $80/barrel.

Investors intoxicated by the party in tech stocks (and Bitcoin) may want to sip on a selection of the following six energy stocks in anticipation of times when sobriety returns to the markets. We would also include current buy-rated Dril-Quip (DRQ) and Cabot Value Investor buy-rated NOV (NOV).

Closing prices on March 1, 2024.
* Enterprise value/earnings before interest, taxes, depreciation and amortization. Based on consensus estimates for calendar years ending in 2024.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Chesapeake Energy (CHK) – Once the largest natural gas producer in the United States, Chesapeake collapsed in 2020 due to weak commodity prices and excessive leverage. Following a restructuring that restored its financial stability and brought in new leadership, Chesapeake emerged from bankruptcy protection in early 2021 with a focus on the Marcellus (Pennsylvania) and Haynesville (Louisiana) regions. Earlier this year, the company agreed to acquire Southwestern Energy in a major $7.5 billion all-stock combination. We like the new proposed company: its scale will offer considerable potential to exert negotiating power over its suppliers while reducing overlapping internal costs ($400 million identified so far), the balance sheet will likely become investment grade (reducing financing costs while increasing access to more capital) and the bigger scope will strengthen its position in the attractive LNG export market. The valuation looks reasonable at essentially no premium to the pre-deal market price. The new company should retain its capital spending and shareholder return discipline. Brookfield Corporation, sometimes called the “Berkshire Hathaway of Canada,” holds a 5.3% stake in Chesapeake, a testament to Chesapeake’s leadership and a source of pressure to retain its discipline. All-in, the new Chesapeake has the acreage, operational capabilities and capital to become a major contender in the U.S. and global energy markets, along with providing attractive shareholder returns in most natural gas pricing environments.

Marathon Oil (MRO) – Following our downgrade to a Sell in June 2022, which booked a 166% profit, shares of this company have slipped 22%. Marathon is a well-managed, oil-focused company with a high-quality production base. It also has a large stake in a natural gas exploration and production business in offshore West Africa that provides growing exposure to the global LNG market. Marathon generates strong free cash flow each year, helped by its low breakeven point of around $40/barrel. Its capital allocation discipline is to invest enough to maintain production volumes, then return most of the excess cash to shareholders through dividends and share buybacks. In the most recent fourth quarter, for example, Marathon generated $624 million of free cash flow, then distributed 67% of this as dividends and buybacks. Over the past two years, this formula has led the company to reduce its share count by 27%, even while increasing its dividend by over 250% and maintaining a low $5 billion debt balance. Management’s 2024 outlook is for much the same, which would imply a distribution yield (buybacks plus dividends divided by market capitalization) of over 15%. Higher oil prices would push this yield upward. All-in, Marathon is a worthy selection for investors looking for a sizeable cash return with leverage to higher oil prices.

Occidental Petroleum (OXY) – Occidental is a major energy company with oil and gas production in three major basins including the Permian, Rocky Mountains and offshore Gulf of Mexico. It also has production operations in Algeria and the Middle East, a chemicals segment and various pipelines, storage facilities and transportation businesses and a promising but speculative carbon capture venture. When oil prices collapsed early in the pandemic, Occidental’s excessive debt burden, spawned by its expensive and huge $36 billion acquisition of Anadarko Petroleum in 2019, pushed it to the brink of bankruptcy. However, with the rebound in oil prices, plus several asset sales, Occidental’s fortunes have recovered, such that it is now working to close its $12 billion deal to acquire privately owned CrownRock, LP, a coveted oil producer focused on the prolific Permian Basin. Some investors are put off by this attractive purchase as it likely precludes share buybacks until Occidental can pare its deal-related debt burden, but we think this is short-sighted. Occidental has a disciplined capital spending philosophy and efficient operations, an investment-grade credit rating and generates strong free cash flow with an increasing sensitivity to oil prices. The dividend was recently increased by 22%. Management has the approval of Warren Buffett, whose Berkshire Hathaway now has a 28% stake in Occidental.

Ovintiv (OVV) – Ovintiv is an oil and gas producer with operations in the Permian, Montney Canada, Uinta (Rockies) and mid-states regions. Investors still consider it to be undermanaged, but its 2020 name change from “Encana” and its relocation from Calgary (Canada) to Denver, along with pressure from at least one activist investor, seem to have reinvigorated the company. Many of its lower-quality assets have been divested, including most recently its Bakken assets sold last year for $734 million. Ovintiv subsequently purchased $4.4 billion of assets in the Permian, which upgraded its overall production base. The company is becoming a more efficient and productive operator, reflected in its encouraging guidance during the fourth-quarter call that points to a 40% increase in free cash flow even at incrementally lower oil prices and capital spending. The company follows a formula by which at least 50% of free cash flow goes to shareholders through share buybacks and dividends, with up to 50% going to repay debt and do small bolt-on deals. This formula will allow the company to relatively quickly pare its modest but temporarily elevated acquisition-related debt. Highly regarded value investor Dodge & Cox retains a still-large 8.5% stake following a recent trimming of its position.

Sitio Royalties (STR) – Rather than drilling for oil and gas, this company owns the mineral and royalty interests on energy-producing properties and lets other firms do the hard work. Sitio’s properties are high quality, with 78% of its net royalty acres concentrated in the Permian Basin. Its base of operating partners is heavily weighted toward reputable firms like Chevron, ExxonMobil and Devon Energy. Sitio actively manages its portfolio, reflected by a large $114 million divestiture in 2023 paired with a $150 million acquisition of rights in Colorado that increased the quality of its overall asset base and its exposure to oil. One benefit of its structure is that its costs change little and it has minimal capital expenditures even as its asset base grows. As such, Sitio pays out to shareholders 35% of its discretionary cash flow as a minimum recurring dividend, with another 30% paid out as a flexible mix of dividends and share repurchases. The shares slipped recently on concerns about production volumes from its operating partners and elevated market prices for mineral rights deals that might limit Sitio’s ability to expand. However, we see the company as disciplined and focused on building a valuable business that could be 2-3x its current size over time. We note that savvy private equity firm Kimmeridge has a 23% ownership stake, which comprises 18% of the investor’s total assets, and also controls the CEO seat and several board seats, so it is committed and fully in charge.

W&T Offshore (WTI) – This small-cap company focuses exclusively on producing oil and gas in the offshore Gulf of Mexico region. Although this region is generally considered to be of average quality, W&T has a reputation as a skilled and disciplined operator that makes savvy acquisitions of properties that other producers are happy to discard. Adding to the appeal is that the founder, Tracy Krohn, remains fully in charge and holds 33% of the company’s shares. W&T is sensitive to both oil and gas prices, so its shares are somewhat beaten down as natural gas is currently selling for a near-record low price of $1.80/MMBtu. Also, investors have chronic worries about whether production can be maintained without large new capital outlays. But, the company has modest debt, is generating positive free cash flow and recent third-quarter results suggest that these worries are overdone. Also, the company is developing an innovative third-party funding vehicle that will allow W&T to increase its production with lower capital outlays. The valuation, at 3.3x EBITDA, assumes a dour future with no upside from higher commodity prices. Potential investors will want to know that the company reports fourth-quarter earnings pre-market on March 6.

RECOMMENDATIONS

Purchase Recommendation: VF Corp (VFC)

VF Corp (VFC) 1551 Wewatta Street Denver, Colorado 80202 www.vfc.com

Symbol VFC Market Cap $6.3 billion Category MidCap Business Specialty Apparel Revenues (FY2024e) $10.5 Billion Earnings (FY2024e) $420 Million 3/1/24 Price $16.24 52-Week Range: $12.85-26.95 Dividend Yield: 2.20% Price target: $25

Background:
VF Corporation is one of the world’s largest apparel, footwear and accessories companies, with over $10 billion in revenues. It owns a portfolio of highly iconic brands including The North Face, Vans and Timberland. About half of its sales are generated through its 1,200 retail stores and related e-commerce websites, with the other half sold through the wholesale channel to department stores and other third-party retailers. Over half of its revenues are generated outside the United States.

Founded in Pennsylvania in 1899 by John Barbey as the Reading Glove and Mitten Manufacturing Company, the company expanded into silk lingerie with such success that in 1920 it was renamed Vanity Fair Silk Mills. The company went public in 1951. Since then, it has acquired a vast portfolio of companies, including The North Face, Vans, Timberland, H.D. Lee (Lee jeans), Blue Bell (Wrangler, JanSport and Red Kap) and Smartwool. These deals utilized the buy-and-build strategy which drove much of the company’s growth.

The most successful example of this strategy is its purchase in 2000 of nearly bankrupt The North Face for $155 million when the mountain gear company generated only $240 million in sales. TNF now produces over $3.5 billion in sales and could easily be worth $8 billion. Similarly, the 2004 acquisition of Vans for $400 million, with about $330 million in revenues at the time, went on to generate $2.5 billion in sales and is worth as much as $4 billion today.

While these two immensely successful deals were engineered by then-CEO Mackay McDonald, subsequent CEOs had less success with the strategy. Most notable was the $2.1 billion acquisition of Supreme in 2020, which loaded the company with debt but is likely producing less than $50 million of earnings. Strategic efforts to restore growth, including the 2019 spin-off of the jeans and outlet store business as Kontoor Brands (KTB) and the Occupational Workwear business sale in 2021, were marginally productive. The company’s headquarters relocation from North Carolina to Denver in 2019 could be termed a blunder, as it precipitated the loss of many experienced staffers. It also led to the Denver office becoming what activist investor Engaged Capital called the “Death Star,” an overly complex, centralized and highly expensive organization that stifled innovation and accountability. The management pressed for more growth, but since it had lost touch with what made Vans and other brands desirable to consumers, that growth actually diminished the brands and their profits rather than boosting them.

By mid-2023, debt had reached an unwieldy $6.6 billion, and the company’s margins were sliding. Disgruntled investors abandoned the shares. After reaching nearly $100 at the end of 2019, the shares hit $17, down 83%, unchanged from their 2006 price (over 17 years ago).

The company’s board finally took action, hiring Bracken Darrell as president and CEO in June 2023. Activist investor Engaged Capital acquired a stake in the company and publicly supported the new CEO in his efforts to make aggressive changes.

Now, nine months into the turnaround, many early and favorable changes are underway. However, the shares remain essentially unchanged at $16.24 as investors are skeptical that the overhaul will produce meaningful improvements.

Analysis:
We think the turnaround has nearly all the essential ingredients to be successful. The new CEO has an impressive track record of restoring prosperity to several companies. Darrell is an unusual choice given his former position as head of Logitech International, a technology products company. But, his efforts there as CEO for a 10-year term were clearly successful: a sharp improvement in operating and financial results that drove a 9x gain in the share price. Notably, Logitech focuses on consumer products, and Darrell’s prior experience at Proctor & Gamble, where he was global head of the Braun business and led the successful turnaround of the Old Spice operations, and at Whirlpool where he led the EMEA business, suggest he has a strong understanding of consumer product marketing, brand-building and operations. This skill should be readily transferrable to VF Corp.

The turnaround plan, named “Reinvent,” is credible and has a reasonably high chance of succeeding. The primary goal is to rebuild the brands and significantly improve the company’s operational performance. The initial steps include improving the dismal North America results, turning around the Vans business, reducing costs and strengthening the balance sheet.

Longer term, the company will emphasize rebuilding its brands. Its core brands are already valuable and provide a solid foundation for the turnaround. They are leaders in healthy product markets, so the plan is to restore the brands’ vitality and growth. This means developing clear brand-based strategies, introducing new and innovative products, and improving marketing to better reinforce the brands’ value.

So far, the early results are promising, even if the most recent quarter’s headline numbers (sales down 17% and operating profits down 45%) are awful. Key executive positions, including the CFO, the heads of Vans, Timberland, commercial operations and human resources are being replaced. Inventories have declined (down 17% from a year ago) such that the distribution channels are in much better shape while cash has been released. The company is on track to deliver $300 million in cost savings over the next few years as the company starts to simplify and right-size its operating structure. Unneeded assets, including the corporate jets, are being disposed of. The unwieldy debt has been trimmed by $440 million, with more to come. Darrell took the aggressive but necessary step of slashing the quarterly dividend by 70%, to $0.09/share, which frees up $325 million a year for further debt paydown.

Divestitures of entire brands are likely, particularly the three backpack brands, but the company hasn’t yet provided much commentary about this part of the plan.

Free cash flow remains reasonably healthy. Management reiterated their commitment to produce at least $600 million in free cash flow in fiscal 2024, with a strong likelihood of higher levels in future years. This provides the company with an extended timeline and financial flexibility to implement its turnaround plan.

Like all turnarounds, this one carries considerable risk. The major risk is that, because consumers can have fickle tastes, the brands’ former luster may not be restored. Additionally, economic headwinds, inflation, aggressive competition, pushback from wholesale customers and other pressures could derail VF’s recovery. The turnaround will not advance smoothly and will be measured in years rather than in quarters, so the market’s opinion will likely be volatile, as will the share price.

Despite the risks, the upside potential from a successful turnaround is sizeable. Using conservative assumptions, we have little trouble justifying our $25 price target, which would generate a 54% return, excluding the 2.2% annual dividend. Should the company execute better than we anticipate, the potential return would of course be higher.

We recommend the purchase of VF Corporation (VFC) shares with a $25 price target.

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 March 27, 2024.

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