Cabot Turnaround Letter Issue: October 25, 2023

Homegrown Turnarounds in Massachusetts

Much of the art of finding interesting turnaround stocks is looking at catalysts, tracking management changes and searching through lists of out-of-favor companies. Sometimes, however, good ideas can be found closer to home – literally – by looking through the roster of public companies in one’s home state.

Our state of Massachusetts is home to well over a hundred public companies. These companies range in size from mega-caps like Thermo Fisher Scientific (TMO) and Buy-rated General Electric (GE) to tiny Harte-Hanks (HHS). Reflecting its roots in technology and healthcare, the local roster is heavily populated with software and biotech firms, many of which are either already prosperous or would require low-odds turnarounds. Other companies are struggling but some have promising turnarounds underway. We discuss five of these below.

Azenta, Inc. (AZTA) – Azenta has its roots in Brooks Automation, a highly regarded pioneer in semiconductor process automation that expanded into the life sciences industry. In early 2022, Brooks sold its semiconductor operations to a private equity firm, which generated $2.4 billion in proceeds, and renamed itself Azenta. The newly focused life sciences company provides a range of tools, consumables and services for genomics research, sample sourcing and cryogenic storage to over 9,000 biotech and pharma companies, hospitals and research universities. Since the split, Azenta shares have tumbled 50%. Weaker demand, likely exacerbated by sliding venture capital funding and a wind-down of Covid research, along with an ensuing glut of consumables, is pressuring revenues and profits. Also, investors worry that the company will squander its remaining $1.3 billion cash hoard – a major issue as it comprises over 40% of Azenta’s market value.

Shareholders have a strong advocate in Politan Capital, a credible activist investor with a 7% stake in Azenta. Politan’s efforts appear to be working: the company is implementing a sizeable cost-cutting program and other initiatives that could boost its profit margins. Also, it may add to its sizeable repurchase program now underway. The shares are not statistically cheap at 30x EV/EBITDA, so investors may want to wait for a few more earnings disappointments to drag the shares lower before buying. But, with its solid business franchise in a key segment of a rapidly growing industry, its debt-free balance sheet and the arrival of a new outsider CFO, any meaningful sell-off could be a great time to buy the shares.

EverSource Energy (ES) – This company bills itself as “New England’s largest energy delivery company with 4 million customers in Connecticut, Massachusetts and New Hampshire.” Its services include wholesale and retail electricity delivery as well as natural gas and water delivery. EverSource is the product of a century of local utility company acquisitions, culminating in the 2012 merger of Northeast Utilities and NStar, plus the $1.7 billion acquisition of Aquarian Water Company.

EverSource’s shares have slid over 40% since their mid-2022 peak. Part of the decline is due to rising interest rates, which have weighed on all utility stocks. But EverSource trades at a sizeable discount to its peers due to its large investments in three offshore wind power projects, including Revolution Wind, South Fork Wind and Sunrise Wind. Rising input and financing costs are erasing much of the economic value of these projects, forcing write-offs and dilutive equity raises. EverSource is working to exit the offshore wind business but regulatory and other setbacks continue to delay these efforts and erode the projects’ remaining value. Once the clouds surrounding its wind projects have cleared, and the company reverts to a traditional utility, the share valuation should climb back upward as the discount fades. The 5.0% dividend appears safe and provides investors with a cash return while waiting.

Closing prices on October 20, 2023.
* Estimates based on fiscal years ending in calendar year 2024 or FYE June 30, 2024 for MRCY. Valuation for STT is P/Tangible book value.
Sources: Company releases, Sentieo, S&P Capital IQ, Nasdaq and Cabot Turnaround Letter analysis.

Mercury Systems (MRCY) – Mercury makes proprietary processing components, modules and integrated sub-systems that go into defense communications, weapons and other equipment. Its products also have a broad array of commercial applications ranging from satellites and power grids to F1 racing cars. Mercury’s shares surged from 2013 into 2020 on strong revenue and profit growth but have since fallen 60% due to numerous problems including program delays, weak execution on several acquisitions, poorly designed contracts and a growing reliance on low-margin development projects. One notable issue has been the sharply rising prices of semiconductors – a key input for Mercury’s gear – which have damaged Mercury’s margins on its fixed-price contracts.

A structural headwind, similar to that of car component suppliers relative to major automobile producers, is that the company is reliant on a few major defense customers like RTX, Northrop Grumman and Lockheed Martin. Mercury’s weak negotiating position is a constant threat to its profits.

However, Mercury appears increasingly aware of its problems. To help right the ship, a capable new CEO, Bill Ballhaus, recently took the helm after successfully leading other companies. He is joined by a new outsider CFO. The team has identified and is working to fix the wide range of revenue and margin problems as well as cash flow problems from bloated inventories and slow billings. Mercury is aiming to return to 20% EBITDA margins from its current 14% pace. Its efforts to move into higher-margin subsystems and away from low-margin components should support its recovery. And, in a world where defense spending is likely to surge, Mercury is well-positioned to benefit. The turnaround is likely to succeed but will take some time, as its troubled contracts won’t roll off the books immediately. The share valuation is statistically high but based on depressed earnings. Activist investors Jana Partners (8% stake) and Starboard Value (5% stake) along with a sizeable holding by highly respected investment firm Wm Blair (11% stake) should help keep the leadership focused on shareholders.

State Street Corporation (STT) – State Street is the world’s largest custodian bank, with $40 trillion in assets under custody/administration. Originally a provider of back-office services for long-only investment managers, today the company offers a full range of middle-office and front-office services to managers of all kinds of funds, which produces about 56% of the bank’s revenues. The company is also a major issuer of index exchange-traded funds (ETF), which generate about 17% of total revenues. Net interest income and foreign currency services produce the balance of revenues.

Shares of this well-managed, high-quality bank are out of favor with investors. Since reaching $104 in early 2022, the shares have declined about 36% and are essentially unchanged since 2007. Near-term concerns include sluggish service fee growth, ETF fee sensitivity to stock and bond markets, cost pressures and headwinds on net interest margin as customers move deposits from interest-free products to interest-earning products. While we acknowledge these issues, we see State Street as a solid, well-capitalized franchise that provides critical services, with slow but steady revenue and earnings growth. In its recent third-quarter earnings report, the company reported good results and management provided healthy full-year guidance, assuaging concerns over the headwinds that investors worry about. The share valuation, at 9.0x estimated 2024 earnings and 1.8x tangible book value, doesn’t reflect the enduring fund services and ETF franchises within State Street. And, the bank’s 11% CET1 capital level is conservative and at the high end of management’s targeted 10-11% range, supporting the bank’s share buyback program and dividend.

TripAdvisor (TRIP) – Founded in 2000, TripAdvisor is the world’s largest travel website. It provides user-generated reviews and other information for consumers about travel destinations. The firm was acquired by Expedia/IAC in 2004, then spun out in late 2011. Its shares surged into mid-2014 and rebounded again during the pandemic but have since slid sharply to essentially all-time lows. Pressure in its core TripAdvisor business, as Google siphons off incremental demand, has weighed heavily on investors’ minds. But TripAdvisor is a long way from oblivion. Its impressive 90+% gross margins offer considerable room for wider operating profits from cost improvements recently initiated by the new CEO. The core business generates sluggish single-digit growth but strong 30% EBITDA margins and healthy free cash flow, allowing TripAdvisor to invest in two promising new platforms, Viator and TheFork. Viator is growing at 50%, while TheFork is growing at close to 20%, and both are nearly EBITDA breakeven. If TripAdvisor can keep costs in these two units flattish while revenues continue to surge, profits will turn sharply positive. In the meantime, the company has a sturdy balance sheet with $1.1 billion in cash compared to only $840 million in debt and is backed by positive free cash flow. The shares trade at a modest 5.2x EBITDA. Any convincing amount of profits in its new segments, plus ongoing proof of profit stability in its core business, could send the shares on a pleasant journey.

Adding Luster with Gold Mining Stocks

Most investors reflexively bypass stocks of gold mining companies. In years long past, these companies emphasized highly speculative mining, aggressive hype and empire-building acquisitions. Sketchy mining companies that traded on the Vancouver stock exchange gave the entire industry a tarnished reputation.

However, the industry has matured over the past two decades, with professional, shareholder-friendly managements now in charge of most large and mid-sized operations. Companies emphasize meeting their production guidance, controlling their costs, maintaining low-debt balance sheets and generating free cash flow that is at least partly paid out to shareholders.

Another often-mentioned reason that investors avoid gold miners is their stocks’ considerable sensitivity to gold prices. Even when gold prices are high, like they are today, there can be doubt about whether those prices can be sustained – as a slide to the mid-$1,500 range would impair the value of many gold producers. One issue is that, unlike prices for commodities like oil, for example, which are driven by reasonably direct supply and demand metrics, gold prices tend to be driven by indirect metrics like interest rates, inflation and the U.S. dollar. Many investors find gold to be a “barbarous relic” (to use Keynes’ famous statement) with its price mostly a function of hocus-pocus rather than analyzable fundamentals.

Yet, despite this skepticism, gold has remained relevant in human society for over 10,000 years. That relevance isn’t likely to go away anytime soon. Companies that mine gold generate cash revenues, cash profits and cash dividends – these are clearly measurable and relevant to investors. Gold miners quite literally “mine money.”

Today, gold prices have surged to near $2,000/ounce and trade only 3% below their all-time high of $2,056 reached this past May. Yet, shares of major gold mining companies trade at sizeable discounts to their post-pandemic highs when gold last reached similar prices. Investors are giving gold miners little to no credit for commodity prices above about $1,600/ounce, even as gold margins (as measured by realized price less all-in sustaining costs) have expanded sharply.

Listed below are two major gold companies with capable shareholder-friendly managements, steady/strong production profiles, controlled costs and sturdy balance sheets. A third company, Agnico Eagle Mines Ltd (AEM) is this month’s Buy recommendation. These companies are building value in their own right. And, they offer option value: in a world sliding into widespread unrest, with elevated inflation and a U.S. federal government unable to control its spending, gold prices could lift even higher. In sum, it wouldn’t take much to restore some glitter to these companies’ shares.

Barrick Gold (GOLD) – Barrick is the world’s second-largest gold mining company. Based in Toronto, Canada, the company has mining operations around the world, with about 50% of production in North America, 32% in Africa and the Middle East and 18% in Latin America and Asia Pacific. The company also has smaller copper mining operations. Barrick has among the highest-quality mines in the industry, although about half of its output comes from higher-risk jurisdictions. Barrick’s Porgera mine, for example, closed three years ago when the Papua New Guinea government forced a renegotiation of terms. Favorably, this mine will soon reopen.

Barrick has an interesting history. It was a poorly managed company until 2014 when a former Goldman Sachs president, John Thornton, became chairman. Thornton oversaw a slashing of costs and the repayment of Barrick’s entire $13 billion of net debt. In early 2020, Barrick acquired Randgold, which brought valuable assets along with its (arguably more valuable) CEO and co-founder Mark Bristow. Bristow, a near-legend in the industry for his ability to effectively manage portfolios of gold mines, reduce costs and navigate the complicated process of operating mines in less-developed countries that yearn for the revenues that gold mines (which obviously can’t be relocated) generate, is Barrick’s CEO now.

Among his notable achievements, Bristow created a joint venture that combined Barrick’s and Newmont Mining’s Nevada gold mines into a single world-class operation, generating large cost and productivity improvements.

Barrick has been generally able to maintain its production level but is increasing its capital spending and costs to achieve this. Full-year production will likely come in at around 4.2 million ounces, at the low end of its guidance range, while all-in sustaining costs will likely be near the high end of its guidance range at about $1,250/ounce (and 22% above the 2021 level). Favorably, the company has refrained from acquisitions to focus on improving and expanding its current roster of mines.

Barrick’s balance sheet is sturdy with only $617 million of debt net of cash, or about 0.1x EBITDA. Free cash flow has been positive but weak this year, although it is likely to move higher as elevated gold prices flow through to the bottom line. The quarterly dividend has two components: a recurring $0.10/share base dividend and a special dividend of up to an additional $0.15/share if net cash exceeds $1 billion. So far this year, Barrick has not paid a special dividend.

The shares trade at a discounted 6x estimated 2024 EBITDA. Barrick is a current Buy recommendation in the Cabot Value Investor with a $27 price target.

Newmont Corp (NEM) – Denver-based Newmont is the world’s largest gold miner, with 2023 production likely to reach 6 million ounces. The company also has noticeable copper, zinc, lead and silver output. Newmont is the only gold miner in the S&P 500 index. Its mines are located in generally safe jurisdictions, with 43% of output generated in North America, 22% in Australia, 18% in Central/South America and the balance in Ghana. Newmont will soon be about 33% larger as it will add 2 million ounces of annual production from mines in Australia and Canada following its pending $17 billion acquisition of Australia-based Newcrest Mining Ltd. This deal follows its $10 billion acquisition of Goldcorp in 2019. The Goldcorp deal brought considerable synergies, and Newmont promises further benefits from the Newcrest deal. But, the company’s overall financial statistics look similar to its peers, suggesting that any synergies were lost amidst the larger scale.

Newmont’s balance sheet will remain sturdy after the Newcrest deal, as the transaction is essentially an all-stock deal. Net debt is about 1.7x EBITDA – higher than its major peers but still very manageable, especially given its low 4.1% average interest rate with the nearest maturity in 2029. Newmont generates modest free cash flow due to its incrementally higher cost structure and its elevated capital spending program. The company pays a $0.25/share quarterly base dividend, with a variable component based on incremental free cash flow. Newmont guided to a variable dividend for 2023 of between $0.40 and $0.80/share.

Closing prices on October 20, 2023.
* Estimates based on fiscal years ending in calendar year 2024. Newmont valuation is pro forma for Newcrest acquisition. Barrick yield assumes quarterly base dividend of $0.10/share. Newmont yield assumes quarterly base dividend of $1.00/share.
Sources: Company releases, Sentieo, S&P Capital IQ, Nasdaq and Cabot Turnaround Letter analysis.

Disclosure note: The chief analyst personally owns shares of Agnico Eagle (AEM) and Barrick (GOLD).

RECOMMENDATIONS

Purchase Recommendation: Agnico Eagle Mines, Ltd (AEM)

Agnico Eagle Mines, Ltd (AEM) 145 King Street East, Suite 400 Toronto, Ontario, Canada M5C 2Y7 www.agnicoeagle.com

Symbol AEM Market Cap $24.6 billion Category Large Cap Business Gold mining Revenues (2023e) $6.6 billion Earnings (2023e) $1.0 billion 10/20/23 Price $49.80 52-Week Range: $40.09-61.15 Dividend Yield: 3.20% Price target: $75

Background:
Agnico Eagle Mines Ltd company produces about 3.3 million ounces of gold, making it the third-largest gold miner in the world. The company was founded in 1957 when Cobalt Consolidated Mining renamed itself Agnico, using the periodic table of elements names for silver (Ag), nickel (Ni) and cobalt (Co). The firm later acquired gold miner Eagle Mines, producing its current name. On the back of the LaRonde mine, which today generates about 9% of the company’s output, Agnico expanded to become the major producer it is today.

The company’s stated strategy of “proven geological potential in premier jurisdictions” appropriately describes its exclusive focus on quality mines in the legally safe countries of Canada, Mexico, Australia and Finland. The Abitibi Gold Belt region in Ontario and Quebec contributes over a third of total production. In the past few years, Agnico has made several in-region acquisitions including Kirkland Lake in 2022 for $11 billion and Yamana Gold’s Canadian assets for $2.6 billion. The plan for the next five years is to fully integrate and improve these operations and grow production in its existing mines.

Agnico’s shares have fallen out of favor as investors worry about the durability of elevated gold prices, rising production costs and the resilience of its output volumes.

Analysis:
With its low price despite elevated gold prices, Agnico shares have become a bargain. The shares have tumbled 40% from their mid-2020 high despite gold trading 5% higher.

As the owner of some of the industry’s highest-quality mines, Agnico’s production volumes look steady for years to come. While some of its ten major mines, like Malartic and Fosterville, will see tapering output, nearly all of the others will have steady increases, driven by continued investment and exploration. On its second-quarter earnings call, the management’s comments strongly implied that it would approach the high end of its full-year production goals.

Keeping production volumes steady generally requires increased operating and capital spending costs. Agnico, however, continues to be an efficient operator, with all-in sustaining costs¹ (or AISC) of about $1,150/ounce, about 12% below the industry average. Helping its economics are the quality of its mines as well as the close geographic proximity of its Ontario and Quebec mines (in the Abitibi Gold Belt). In addition, its Detour Lake milling operation has unused capacity, allowing for higher throughput with minimal incremental costs. Full-year ASIC costs are tracking toward the low end of the company’s guidance. Capital spending, at about $1.5 to $1.8 billion, stepped up from around $1 billion before its recent acquisitions, is likely to remain relatively flat for the next several years.

Agnico’s financial condition is strong. The company generates net income of over $1 billion, with EBITDA (cash operating profits) of about $3.3 billion. Free cash flow this year will likely match net income, which includes spending to expand production. To only maintain its current production, we estimate that free cash flow would be nearly $800 million higher, indicating that the company has healthy economics that allow for generous growth spending.

If gold remains elevated at $1,900/ounce, Agnico’s cash flows would surge. Every $100/ounce brings in an additional $330 million in free cash flow, or an incremental 33%. The company has said it would use this cash to reduce its debt, advance various internal projects and return capital to investors through share buybacks.

The balance sheet is robust. Its $1.9 billion in debt is partly offset by $400 million in cash, such that net debt of $1.5 billion is only about 0.5x EBITDA. Agnico has paid cash dividends since 1983, and its enduring financial strength should allow it to pay dividends long into the future. The company currently pays a regular $0.40/share quarter dividend, up from $0.35/share in 2021, although it does not pay special dividends.

Agnico’s management matches the quality of its assets. Sean Boyd, the chairman, was the key architect of the company’s impressive development during his tenure as CEO from 1998 to 2022. He is widely regarded as one of the industry’s top leaders. The current CEO, Ammar Al-Joundi, is a company veteran and its former CFO. His background as a mechanical engineer is a key positive in our view.

The company’s shares trade at a discounted 7.5x estimated 2024 EBITDA compared to a normalized 10x multiple. Given this discount, the company’s operating and financial strength, and the incremental cash flow from current gold prices which could readily move higher, we believe Agnico shares offer an attractive value to contrarian investors.

Investors will want to know that Agnico reports earnings on Wednesday, October 25 after the market closes.

1. All-in sustaining costs, or AISC, is an industry metric that includes operating and overhead costs, as well as capital spending required to maintain production volumes, on a per-ounce of production basis.

We recommend the purchase of Agnico Eagle Mining Ltd (AEM) shares with a $75 price target.

Disclosure note: The chief analyst personally owns AEM shares.

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 November 29, 2023.