December 6, 2024

In today’s note, we discuss a number of earnings results and new developments for several of our portfolio positions, including American Airlines (AAL), Atlassian (TEAM), Duluth Holdings (DLTH), Intel (INTC), SLB Ltd. (SLB) and Super Hi International Holding (HDL).

The broad market outlook remains bullish for the rest of this year and early next year, but with the possibility for weakness to emerge heading into 2025.

We take a closer look at the challenges faced by Intel in its turnaround strategy.

We’ll also discuss some catalysts for an attractive company in the beaten-down healthcare sector.

Comments on Portfolio Holdings

We took a one-quarter profit in American Airlines (AAL) after the stock rallied 17% on Thursday on positive airline trend news. The position is up nearly 30% since being added to the portfolio in late October. Both American Airlines and its competitor, Southwest Airlines, provided bullish forecasts for the holiday traveling season this week, which was the catalyst for the latest show of strength across the broader airline industry.

Specifically, American disclosed that it raised its Q4 adjusted earnings forecast to a midpoint of 65 cents a share, up 30 cents from the previous forecast. This compares favorably to the consensus estimate for Q4 adjusted EPS of 39 cents.

After taking the partial profit, we’ll retain the remaining three-quarters position with a Hold rating.

Shares of collaboration software leader Atlassian (TEAM) shot up 7% on Wednesday and reached a 12-month high after the company announced it has entered a multi-year deal with Amazon Web Services (AWS) to accelerate enterprise cloud migration. The strategic collaboration agreement will support the migration of millions of enterprise users to Atlassian Cloud, powered by Amazon.

Per Atlassian, “To support the scale of cloud migrations, Atlassian and AWS will set up a cloud center of excellence to streamline complex migrations for large enterprises, reducing migration time by up to 50%. This initiative will also equip specialized solution providers with cloud and AI skills to resell Atlassian Cloud offerings powered by AWS.”

The stock is up 50% since we initiated it in the portfolio back in October. After taking a 50% profit in November, the remainder of the position retains a Hold rating in the portfolio.

Workwear and accessories provider Duluth Holdings (DLTH) reported third-quarter results that featured revenue of $127 million that decreased 8% from a year ago and a per-share earnings loss of 41 cents that missed estimates by nine cents.

Direct to-consumer net sales decreased by 8%, driven by lower site conversion compared to the prior year. Retail store net sales also decreased by 8% due to slower store traffic, but were partially offset by strong conversion rates. Consequently, operational losses widened to $16 million from $12.5 million in the year-ago Q3.

Continued debt expansion remains a problem for Duluth as the company ended the quarter with $44 million of outstanding debt on its line of credit. However, Duluth’s liquidity position remains strong and management said it expects to end the year with no debt and liquidity of over $200 million—an increase of over 20% from current levels if realized.

The top brass further guided for full-year 2024 net sales of around $640 million, which is in-line with consensus estimates, and it expects to continue to benefit from lower year-over-year product costs. However, driven by higher promotional activity and a move to reduce seasonal inventory levels, Duluth is projecting a full-year gross margin reduction of around 1.2%.

In view of these results, I think a turnaround remains a distinct possibility next year. That said, we need to see some improvements rather soon to let us know that management is on the right track. I’m prepared to give Duluth some additional leeway for now, but I’ve got it on a tight leash and am watching it closely. I’m also downgrading the shares from Buy to Hold.

On Thursday, I issued a sell alert for our holding of Intel (INTC). I had high hopes for the chip giant’s turnaround prospects when I first recommended this company back in late September, but the CEO turned out to be a disappointment for investors. Pat Gelsinger stepped down this week less than four years after taking charge of the company amid concerns that Intel’s turnaround strategy wasn’t working. Under Gelsinger, Intel invested $20 billion in new chip factories in Arizona and Ohio as part of a strategy to restore Intel’s dominance in chip making while reducing the nation’s reliance on Asian manufacturing hubs.

I started noticing last week an increase in selling pressure in Intel, including some abnormally high put buying activity in the options market, which is normally not a good sign for the short-term outlook. Then came the unwelcome management change news, and with shares folding I decided to cut the position before it potentially got worse.

I think before we can regard Intel as being worthy of another stake in our turnaround portfolio, we need greater clarity on the company’s ability to execute its transformation plan and become free cash flow positive next year. And of course, the market needs to see the right CEO in place before Intel is ready to turn the corner in a sustained fashion. For now, the stock remains in the wait-and-see category.

Oilfield services giant SLB Ltd. (SLB) just announced a joint venture with Saudi Aramco and industrial gases company Linde (LIN) to build a carbon capture and storage (CCS) project at Aramco’s main refining and chemicals hub in Jubail, Saudi Arabia.

The project, which is expected to become one of the world’s largest CCS hubs, will be 60% owned by Aramco, while SLB and Linde will each own 20%. The project’s Phase 1 is expected to be complete by the end of 2027, capturing and storing up to 9 million metric tons per year of carbon dioxide. It’s also considered to be a key to Aramco’s plans to use a large amount of the natural gas from its giant Jafurah development to produce blue hydrogen and ammonia.

We took a one-quarter profit in Super Hi International Holding (HDL) earlier this week after the stock shot up 21% on no news in particular in the wake of last month’s mixed third-quarter earnings report. The stock continues to act well, hitting new six-month highs as of Thursday and gaining 32% since initiating the position in October. It remains a Hold rating in the portfolio.

RATING CHANGES: American Airlines (AAL) was changed from Buy to Hold.

Duluth Holdings (DLTH) was changed from Buy to Hold.

Intel (INTC) was changed from Buy to Sell.

Friday, December 6, 2024 Subscribers-Only Podcast:

Covering recent news and analysis for our portfolio companies and other topics relevant to value/contrarian investors.

Today’s podcast is about 17 minutes and covers:

• Liquidity indicators remain favorable for the rest of Q4, but investor sentiment looks shaky.
• Inflation is once again rearing its ugly head as retail food prices spike to new highs.
• Fallen medical device maker Dexcom (DXCM) looks poised to rebound despite the inflationary backdrop.
• Comments on portfolio holdings.
• Final note
  
  • SLB (SLB) and other energy players with a presence in both traditional and renewable energy form a major carbon capture joint venture in Saudi Arabia.

Turnaround Watchlist

For the last couple of years, economists have been assuring us that inflation has been all but tamed. But just when you thought consumer prices might be coming down, inflation has once again reared its ugly head. The most recent Consumer Price Index and Personal Consumption Expenditures Index provided reasons for believing that domestic inflation is no longer trending lower and sparked fears that the inflation rate might be stuck above the Fed’s 2% target.

Granted that this fall’s hurricane and strike-related disruptions are two reasons for the latest spike in the inflation readings, prompting Fed Chairman Jerome Powell to remark that inflation is a “little higher” than expected. But there are other, more recent developments that suggest consumer prices are headed much higher than even the most pessimistic forecasts are predicting.

In just the last two weeks, staple items like eggs have seen their prices soar by nearly 50% on the retail level in the wake of yet another outbreak of avian flu. Chicken prices are also increasing as a consequence of this ongoing problem, while beef prices continue to hover near record highs. Milk prices, meanwhile, are also on the rise due to a decrease in the number of cows, with Class III milk prices hitting the highest price in over two years.

As if that’s not enough, discretionary foods like chocolate are also witnessing skyrocketing prices this holiday season, due in part to diminished cocoa supplies from West Africa. And America’s favorite beverage has also witnessed a significant cost bump in the past few months due to an array of production challenges in key coffee-growing regions around the world.

Of special concern, my own personal U.S. retail food price index—which is based on a weekly average of 15 commonly purchased staple items—spiked 4% in the past week after spending the previous few weeks in a downward drift. The surge in retail prices resulted in a fresh two-year high for the index in a sign that consumers will face more pocketbook struggles during the critical Christmas shopping season. More to the point, the rising consumer prices are symptomatic of broader inflation pressures that are still plaguing the economy and showing no signs of dissipating.

With inflation again on the rise, it’s time to turn our attention to an area of the market that I think is poised to rebound in the coming months despite the inflationary headwind. I’m referring to the healthcare sector, and more specifically, to the beaten down drug and medical device makers. Stocks in the overall pharmaceutical category have had a tough time in the last half of 2024, with the NYSE Pharmaceutical Index (DRG) dropping 18% between September and November, with certain individual stocks in this category falling 30% or more.

The reason for the underperformance can be chalked up to a combination of cyclical factors and industry-specific issues, namely the hyper-elevated investor sentiment of the past few years meeting the reality of over-spending on drug development, plus lower revenue growth and sales per user in many product categories across the broader medical sector. Higher interest rates also played a factor to some extent.

But as AllianceBernstein’s Co-Chief CIO and portfolio manager Vinay Thapar recently observed, “Healthcare companies are quite resilient during periods of inflation because their products are not substitutable and they deliver innovation.” He gave the example of the rise of robotic surgery, which allows for greater precision and faster recovery times for patients with fewer complications associated with such surgeries. He thinks that during periods of inflation, new products like this actually have increased demand “because companies want to drive more efficient results.”

Another reason why healthcare stocks tend to outperform during periods of sustained inflation involves the typically higher margins generated along with the relatively lower commodity price exposure for such businesses. At the same time, healthcare is regarded as a “superior good,” which means companies in this sector don’t experience wild demand fluctuations that are commonly seen in other industries. And while consumers will reduce spending on discretionary goods and services during inflationary periods, spending on essential healthcare products and services are far less likely to get cut.

With that in mind, let’s turn our attention to one of the healthcare sector’s forgotten former leaders. The company I’m referring to is Dexcom (DXCM), a leading provider of continuous glucose monitoring (CGM) systems—a big advancement over traditional intermittent monitoring—which help intensive insulin and type 2 diabetics more efficiently manage their blood sugar levels. These devices are placed on the back of a patient’s arm and steadily measure their blood sugar, then transmit the data they collect to their smartphone or Apple Watch.

Providing context for the San Diego-based company’s opportunity, consider that innovative treatments for blood sugar ailments represents a huge growth industry for medical device makers—especially given that diabetes is the single fastest growing chronic disease in the world today. On the domestic level, the numbers are even more alarming: At least one in 10 Americans have some form of diabetes, 25% of U.S. healthcare dollars are spent on diabetes patients and by some estimates, as many as one in every three(!) people suffer from pre-diabetes. All told, that leaves a massive market opportunity for Dexcom.

The company’s woes began earlier this year as investors began to worry over Dexcom’s diminished sales growth and salesforce restructuring that had a negative impact on new customer acquisition, prompting management to lower revenue guidance. Then there were worries over Dexcom’s ability to retain its market share in light of competitor Abbot Laboratories’ FreeStyle Libre CGM device. As a result, the stock tanked more than 50% from its high of 140 a share earlier this year, falling to just above 60 by late July before establishing a bottom.

Meanwhile, Dexcom is working to stabilize its position in its domestic market while further accelerating its product expansion strategies. Among its recent innovations is the Stelo biosensor, which is the first over-the-counter glucose biosensor in the U.S. for adults with prediabetes and type 2 diabetes. It’s also available for purchase online without a prescription, which management called “a pivotal moment in the diabetes care and metabolic health landscape.”

The company also just launched its DexCom ONE wearable glucose monitoring system in France and Japan, which opens up a potential market of nearly two million new patients, with both of these markets opening up opportunities for Dexcom’s core insulin business as well. Dexcom is also opening up new market opportunities in the EU, including other markets that don’t have access to intensive insulin use for Type 2 patients. The firm said that such access will be a “big driver in the markets that we serve more than anything else over 2025.”

Key to DexCom’s recovery is the reengaging of its sales force within the firm’s durable medical equipment (DME) channel, along with addressing the factors that led to the revenue-related problems encountered earlier this year. But in view of DexCom’s established performance and double-digit sales growth in its key end markets, the company has demonstrated it has what it takes to successfully execute its turnaround strategy.

Analysts see the top line increasing 11% for 2024, with 15%-ish growth in each of the next two years as the turnaround strategy is presumably brought to fruition. But based on the strength of the pipeline, these expectations are likely to prove conservative. The stock remains high on my watchlist with a potential “buy” rating in the portfolio likely at some point in the near future.

Please know that while I don’t yet personally own shares of all Cabot Turnaround Letter recommended stocks, this will materially change in the coming weeks as I become fully integrated as your new chief analyst.

Please feel free to share your ideas and suggestions for the podcast and the letter with an email to either me at cdroke@cabotwealth.com or to our friendly customer support team at support@cabotwealth.com. Due to the time and space limits we may not be able to cover every topic, but we will work to cover as much as possible or respond by email.

Portfolio

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