Cabot Turnaround Letter 1220

Thank you for subscribing to the Cabot Turnaround Letter. We hope you enjoy reading the December issue.

With the year-end approaching, investors often sell for reasons unrelated to a stock’s outlook. This month we describe some of these reasons, including tax-loss selling, window-dressing, performance bonus protection and the desire for a fresh start in the new year. We discuss seven stocks that look vulnerable to this type of selling yet seem likely to bounce once the selling pressure relents.

We also look at the airline industry – now in the throes of a near-term depression. We believe the outlook for a recovery is improving despite the recent “third wave” of rising Covid case counts. Clearly these stocks carry risks, most prominently that passengers don’t return to flying as much, even after a vaccine and other safety protocols should make flying safe again. Our discussion delves into some of the industry’s arcane metrics, as these help clarify (at least for those with a wonkish interest, like me) the drivers of the downturn and a likely recovery. We highlight five promising discount airline stocks.

Our feature recommendation is the office equipment company Xerox Holdings Corporation (XRX). The market tends to dismiss this company, but its robust cash flow, cash-heavy balance sheet, low valuation and 4.6% dividend yield offer strong value.

The letter also includes a summary of our recent sales of Peabody Energy (BTU), Weyerhaeuser (WY) and Barrick Gold (GOLD), our price target increase for Freeport-McMoran (FCX) and the full roster of our current recommendations.

Please feel free to send me your questions and comments. This newsletter is written for you. A great way to get more out of your letter is to let me know what you are looking for.

I’m best reachable at Bruce@CabotWealth.com. I’ll do my best to respond as quickly as possible.

Cabot Turnaround Letter 1220

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Year-End Selling Pressure — Their Losses Are Your Opportunity
For most of the calendar year, investors focus on buying and selling stocks based on where they believe the best returns are. However, as year-end approaches, other factors come into play that can create selling pressure unrelated to a stock’s outlook. Although we at the Cabot Turnaround Letter focus on longer-term profits based on business fundamentals and valuations, we can be tempted to briefly set aside this focus to capture shorter-term bargains created by these artificial selling pressures.

Tax-loss selling is one source of artificial selling pressure. Taxable investors will pay federal taxes on their profits at rates as high as 37%, and likely more when state taxes are factored in. These investors have a strong incentive to sell their losers to offset these gains, thereby reducing their tax bill. In a year when many investors aggressively sold stocks during the market downturn to preserve profits, and sold later in the year to capture profits from the rebound, taxable gains could be unusually large.

Window-dressing by professional investors can also create selling pressure. Managers want to be seen as holding “winners” when they show clients and consultants their year-end portfolios. Few want to explain why they continue to own “losers,” so these stocks are sold as December 31 approaches. Also, managers typically receive the bulk of their compensation through performance-based annual bonuses – so they sell weak/risky stocks to preserve their relative performance, only to become more risk-seeking when the calendar turns. Similarly, year-end can prompt investors of all types to sell their losers to provide a fresh start in the new year.

There are a lot of weak stocks this year. In the S&P 500, nearly 16% of stocks have lost at least a quarter of their value, compared to less than 3% a year ago. Losses in smaller-cap stocks are even more plentiful, with half of the roughly 2,100 stocks with market caps above $400 million showing year-to-date losses. Energy and biotech stocks dominate these lists.

Once the selling pressure fades around year end, many of the worst performing stocks bounce upwards, sometimes sharply. Nimble investors can capture some of the bounce before longer-term fundamentals return as primary drivers in late January or so.

Discussed below are seven stocks across a range of industries that look most promising for a bounce. Cabot Turnaround Letter stocks like Wells Fargo, Valero, Western Digital and Baker Hughes, initially recommended at beaten-down prices this year, may also experience year-end selling but also carry bounce potential, and more. If you have not yet taken a position in these stocks, or would like to add them, this could be a good time to do so.

Carnival Cruise Lines (CCL) – Like its peers, Carnival suffered from deep losses when most of its revenues evaporated (down 99% in the third quarter) during the pandemic. Carnival’s shares have shown the weakest bounce (almost none) compared to the company’s two peers, RCL and NCLH, due to its massive fleet size, relatively underinvested fleet quality and customer base that skews toward older passengers, as well as its tighter liquidity position and high $18 million daily cash burn. While the mid-term outlook for high-risk Carnival Cruise is somewhat daunting, the shares are so heavily beaten down that any relenting of dire investor pessimism, favorable changes to its strategic or operating direction or more encouraging news about a vaccine could provide a crisp New Year’s jump.

Citigroup (C) – Like most banks, Citigroup has had a rough 2020, with the pandemic pressuring its shares due to higher loan charge-offs and narrower interest-rate-driven profits. Trading at about 70% of tangible book value and 6.4x expected post-recovery earnings, Citigroup’s stock is discounting too dour of a future. The bank has a valuable commercial banking franchise and strong international operations that may help it recover sooner than domestic peers. Critically, Citi’s strong capital base and hefty reserves should amply support it through a credit downturn.

Helmerich & Payne (HP) – Similar to Cabot Turnaround Letter recommended Baker Hughes, “HP” is a drilling service company, although it specializes almost exclusively in renting out land-based drilling rigs. Its conservative management has long been a pioneer in steadily upgrading its rig fleet, boosting its appeal as drilling costs matter now more than ever. The industry depression has hit the company hard, but HP is experiencing only modest cash outflows and has nearly $580 million in cash, which exceeds its debt. The company continues to pay its $0.25 quarterly dividend, which generates a 4.8% yield (we anticipate the dividend will be suspended if conditions haven’t improved by early next year). Helmerich looks fully capable of surviving the industry depression.

Intel Corporation (INTC) – This iconic chip maker has lost its way recently, unable to match Taiwan Semiconductor in chip production and Advanced Micro Devices in chip design. Revenues and profits may not grow for years, particularly with Apple’s defection. Nervous growth investors have departed the stock, driving the shares down 33% year-to-date to three-year lows. Valuation is a discounted 9.3x this year’s earnings. Financially, the company is sturdy and produces immense profits and cash flow while its debt is only 1x its EBITDA, not including $18 billion in cash. New leadership has acknowledged Intel’s issues, which is the first step toward fixing them.

Marcus Corporation (MCS) – Milwaukee-based Marcus is the nation’s fourth-largest movie theater company. It also majority-owns eight high-quality hotels and operates 10 others. Revenues have dropped sharply this year, and MCS shares now trade near their year-to-date lows. Led by the founding Marcus family, who own 25% of the shares, the company has aggressively cut costs and pared its cash outflow. Its somewhat elevated debt is manageable while its liquidity is strong. Marcus owns 62% of its theater properties compared to only 9% for its peers, providing considerable relief from onerous lease payments. Once a vaccine is widely distributed, audiences should be drawn in by highly-anticipated movies including Top Gun Maverick, Mission: Impossible 7 and Black Widow. Marcus’ hotels and golf resorts already are seeing some customers return.

NOW, Inc (DNOW) – This company is a major global distributor of supplies and parts that are consumed in the drilling process as well as in the pipeline, refining and other industries. Caught in the oil and gas drilling depression, its revenues are running about 45% below year-ago levels. However, impressive cost-cutting has trimmed its third-quarter cash operating profits to only a modest loss, while free cash flow was a positive $57 million. The company has $325 million in cash and zero debt (net cash/share is about $3), providing robust financial strength and support for its ~$5.60 stock price. The company’s CEO was recently promoted from CFO, suggesting that cost discipline will remain a top priority.

Simon Property Group (SPG) – As the nation’s largest real estate investment trust that concentrates on shopping malls, Simon Property Group has seen some dark days this year. Yet this higher-risk story has some highly-valuable traits: its malls are filled with enduring brands like Apple; its balance sheet carries over $1 billion in cash with another $8 billion in available borrowing capacity; it’s producing sizeable cash flow and is led by the savvy David Simon. Adding both potential and risk, Simon is buying high-quality peer Taubman Centers and funding bankrupt retailers like JC Penney and Brooks Brothers. If investors turn to higher-risk stories, this company’s depressed shares look well-positioned to recover.

Closing prices on November 20, 2020. *Enterprise value/Earnings before interest, taxes, depreciation and amortization. Based on calendar year 2022 estimates. Multiple for Citigroup is price/tangible book value. Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Discount Airline Shares at Discount Prices
When a company’s primary metric is “cash burn” (or, total cash outflow from operating and capital spending), it is usually an early-stage, rapid-growth venture. If the company is in a competitive, mature, capital-intensive industry, it clearly has existential problems. Such is the state of the airline industry today. With no certainty on the timing and size of demand recovery, investors have severely punished airlines’ shares. Even with the recent bounce following the encouraging vaccine news, most of the stocks remain depressed. However, now is the time to put airline stocks on your radar screen, particularly the discount airlines that have lower cost structures and a leisure travel focus that should recover more quickly than the legacy airlines.

To frame the industry’s issue, it’s helpful to look at some metrics, using JetBlue as an example. The most basic is capacity, or how many seats an airline flies, called available seat miles (ASM). JetBlue had 6.9 billion ASM in the third quarter. This fell 58% compared to a year ago, as the company parked its unused planes and flew fewer flights with its remaining in-service planes.

Next is capacity utilization, measured by the load factor. With a load factor of only 43%, JetBlue’s planes on average were not even half full, compared to 86% a year ago. Half-empty planes make for more pleasant (and healthier) flights but are not conducive to pleasant or healthy profits. Multiplying the ASM by the load factor gives us RPM (revenue passenger miles), or how many of its available seats actually had paying passengers sitting in them. JetBlue’s RPM was 2.9 billion, down 79% in the third quarter. The collapse in RSM was the primary reason why JetBlue’s passenger revenue fell 78%.

One other metric, the yield, is the average fare one passenger pays to fly one mile. JetBlue’s third-quarter yield was about 15 cents. So, if you flew, say, from New York to Houston, roughly 1,400 miles, your one-way ticket would cost on average about $210. JetBlue’s yield increased 14%, as it prioritized its most valuable flights.

JetBlue’s TrueBlue mileage rewards program, which sells miles to banks, produced about 10% of total third-quarter revenues (compared to perhaps 4% in a normal period), falling a relatively modest 42%. Mileage programs have immense value to airlines, which can be tapped as collateral for loans.

Costs are partly fixed, with crew and other salaries being the largest expense and one that airlines are reluctant to cut. JetBlue’s third quarter salary expense fell 17%. Fuel is generally the second-largest expense, and fell 78%, due to fewer flights and cheaper fuel prices. All in, JetBlue’s cash costs declined by perhaps 50%. So, with total revenues down 76% but costs down only 50%, further weighed down by buying jets and equipment, JetBlue burned $566 million in the quarter, or about $6 million per day.

Despite the recent “third spike” in Covid cases, the industry is on its way to recovery. Passengers are returning, particularly for leisure travel. What will drive more recovery? Most important is passenger confidence, which is a function of their actual safety and their perception of safety. On actual safety, masks and safety protocols are effective and widely in place, while a widely-administered vaccine is likely six to nine months away. There is a strong chance that a combination of a vaccine, rapid pre-flight testing, warmer springtime weather and an immense pent-up demand will produce a surge in air traffic by mid-next year.

We believe the perception of safety is improving, as well. Your chief analyst recently flew from Boston to San Diego (full disclosure: on JetBlue) and found the conditions and passenger behavior to be exemplary. And, yes, my post-flight Covid test was negative.

Another driver is the “need” to fly. The most profitable passengers are business travelers due to their lower price sensitivity, but their need to fly is currently low, partly due to the (likely permanent) step-up in video calling. However, we believe that over the next few years this group will return in force, as face-to-face meetings are an integral aspect of business life.

Finally, tempered price competition is important. If airlines aggressively seek market share, everyone’s profits will suffer. We are optimistic that the industry will maintain its discipline of recent years, but are also well aware of its unflattering past in this regard.

Airlines have slashed costs and reduced their capital spending to trim their cash burn. The sudden shut-off of demand this past March and April caught the airlines by surprise, but the speed and scale of their adjustments over the past eight months has been impressive. We believe that most airlines will be cash-burn breakeven sometime next year. A surge in traffic would hasten the arrival of positive cash flow.

The recovery may not happen as steadily as we expect, and rising fuel costs and labor disruptions might impede profits. Also, the recent jump has removed some of the potential share price upside. However, we believe investors should start to nibble on one or more of the stocks listed below, with more buying on weakness. A recovery seems almost inevitable and should lead to significant share price gains.

Alaska Air Group (ALK) – Alaska Air Group has a strong franchise and market position serving the West Coast/Alaska/Hawaii/ markets, while also reaching into major U.S. cities and a few Latin American cities. It also has a valuable mileage program. Third-quarter results were a tad behind expectations and revenues were down 71% from a year ago, but the cash burn of $4 million/day should decline as the company has aggressively cut costs and is trimming its fleet even as flights to Hawaii are returning. With $3.8 billion in cash, and its debt net of cash (at $1.7 billion) unchanged from year-end 2019, the company has navigated the crisis well. The shares have spiked recently so investors might consider waiting for a pullback.

Hawaiian Airlines (HA) – Hawaiian Airlines flies to major destinations throughout the Pacific region and to 11 gateway U.S. east and west coast cities. As Hawaii was under a mandatory 14-day self-quarantine for all incoming travelers, the airlines’ revenues fell a sharp 90% in the most recent quarter, partly due to a low 26% load factor. Aggressive cost-cutting should prune its fourth quarter cash burn to about $2-3 million/day. Hawaiian’s balance sheet holds $1 billion in cash with only $1.3 billion in debt and leases. Once the quarantine is fully lifted (it is now lifted only with proof of a negative test), which we believe is inevitable, its prospects, and share price, should recover sharply. Hawaiian has a highly valuable mileage program that may be worth considerably more than the airline itself, although this is somewhat widely known and partly factored into the stock price.

JetBlue Airlines (JBLU) – Started in 1999, JetBlue has grown to serve nearly 100 destinations in the United States, the Caribbean and Latin America. The airline has among the highest customer satisfaction ratings. This, plus its route base and customer profile, makes it likely to be among the first to see a step-up in post-vaccine traffic. JetBlue’s cash balance of $3.1 billion gives it plenty of time to recover, given its $6 million/day-and-shrinking cash burn, although its debt is somewhat elevated at $4.8 billion. While JBLU shares have jumped recently, and near-term it remains vulnerable to rising quarantine risks in the Northeast, its longer-term outlook is promising.

SkyWest (SKYW) – Major airlines like United, American, Delta and Alaska generally outsource their branded regional flights – and SkyWest is often the company that operates those flights. SkyWest has long-term, fixed-fee code-share agreements, and is reimbursed for direct expenses like fuel, providing valuable stability. This structure has limited its daily cash burn to less than $250,000. Third quarter revenues fell 39% from a year ago and the company produced a $34 million net profit. It owns a third of its fleet, with another 12% provided by its airline partners, which limits its lease expense overhang. The firm is highly regarded, earning awards including Fortune Most-Admired Companies for 2019 and the Glassdoor Employees’ Choice Best Places to Work 2020. While it carries a high $3.1 billion in debt, its tiny cash burn and $822 million in cash balances, along with generous government relief programs, SkyWest has little liquidity risk.

Spirit Airlines (SAVE) – Spirit is the nation’s largest “ultra-low-cost carrier,” serving 23 of the top 25 domestic cities as well as the Caribbean and Latin American markets. Its customer base skews toward younger leisure travelers interested in the lowest prices and highly reliable service. Historically, Spirit’s margins are among the highest in the industry: it packs more seats onto its planes and fills more of them, uses an efficient and uniform fleet of new aircraft, and earns considerable revenues from add-on fees for baggage and other perks. Spirit’s modest $2 million/day cash burn continues to shrink. Third-quarter results and fourth quarter guidance were encouraging. An incremental risk is a rising cost structure that may impede its longer-term profits. While Spirit raised equity this year, its balance sheet now carries $2.1 billion in cash and looks able to internally finance its recovery from here.

Closing prices on November 20, 2020. * Enterprise value/Earnings before interest, taxes, depreciation and amortization. Based on calendar year 2022 consensus estimates. Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Recommendations

Purchase Recommendation: Xerox Holdings Corporation

Xerox Holdings Corporation 201 Merritt 7 Norwalk, Connecticut 06851-1056 (203) 968-3000 xerox.com

Symbol: XRX Market Cap: $4.3 billion Category: Mid-Cap Business: Office Equipment Revenues (2020E): $7 billion Earnings (2020E): $312 million 11/20/20 Price: $21.91 52-Week Range: $39.29-14.22 Dividend Yield: 4.6% Price target: $33

Background
Xerox is a leading producer of printers and copiers. The company also has a sizeable managed print services business that helps customers efficiently and securely operate their printer networks, as well as provides repair and other services. In addition, Xerox sells a range of related supplies including paper and cartridges. Equipment sales represent about a quarter of total revenues, with the balance coming from post-sale revenues including a small contribution from its equipment leasing segment. About 35% of sales are produced outside of the Americas.

Founded in 1906, Xerox’ copiers drove decades of growth. Its Palo Alto Research Center was the first to develop the computer mouse, the graphical user interface, PDFs and other now-commonplace desktop technologies. Xerox acquired ACS in 2010, then spun it out in 2016 as Conduent. Xerox was a Cabot Turnaround Letter recommended stock, which was sold in November 2019 at 38.85 for a 53% profit.

Xerox has suffered from a secular shift away from printing and copying as well as from this year’s pandemic-driven work-from-home trend. Weak demand led to its revenues declining 19%, and adjusted operating profits declining 50%, in the third quarter. Revenues from mid-range enterprise equipment, which produces 70% of total equipment sales and is a key driver of post-sale revenues, fell 15% in the quarter.

In addition to the weak demand outlook for equipment and services, investors worry about intense price competition. Printers, services and supplies are mostly commoditized in the lower and mid-tier size ranges, where substitution is common. Investors have pushed Xerox shares down 40% this year, even after the vaccine-driven bounce.

Analysis
Investors underestimate the value of Xerox shares. What makes the shares valuable is not their growth prospects (there are none) but rather the company’s generous free cash flow and cash-heavy balance sheet. While Xerox is working to develop new technologies, including packaging printing and digital documentation management, these won’t offset the secular headwinds. We conservatively estimate that Xerox’ revenues will recover to about 75% of their former level, then resume their 3-5% decline path.

Even with weak revenues, Xerox produces considerable free cash flow. Despite the weak third quarter, Xerox produced $131 million in operating profits and $88 million in free cash flow. In a recovery scenario, the company could generate close to $600 million in annual free cash flow, representing nearly 15% of its current market cap. Xerox pays a generous dividend (yielding 4.6%) and is a frequent repurchaser of its shares, including as much as $300 million this year.

Helping to maintain its focus on cash flows is the relatively new CEO, John Visentin. He brings technology and private equity leadership experience to Xerox, and is driving a sizeable cost and efficiency program to streamline the company’s operations.

The company’s balance sheet is solid. It carries $3.3 billion in cash, more than offsetting its $2.1 billion in corporate debt. Its financing subsidiary that funds customer purchases and leases carries an additional $3 billion in debt, but this is a low-risk business that is well-capitalized.

Overall, this re-purchase, at much lower prices, and trading at a low 5.4x EV/EBITDA, holds considerable turnaround promise.

We recommend the purchase of Xerox (XRX) shares with a 33 price target.

Sell Recommendations
On November 9, we moved Peabody Energy (BTU), Weyerhaeuser (WY) and Barrick Gold (GOLD) to Sell. Despite improving natural gas prices and rising steel production, Peabody’s weak cash flow strongly suggests that a bankruptcy filing or heavily dilutive restructuring is highly likely. The large loss on this trade is disappointing.

Weyerhaeuser is highly dependent upon lumber prices remaining high, which may not be sustainable. Also, the advanced age of this Buy recommendation influences our decision. Since our April 2012 recommendation, WY shares produced a 69% total return. Barrick Gold’s turnaround is well underway and increasingly priced into its shares. And, with the arrival of a Covid vaccine and the now-weaker chances of sizeable additional government stimulus, gold prices have less near-term and mid-term upside potential. Since our February 2019 recommendation, GOLD shares produced a 105% total return.

Shares of copper producer Freeport-McMoran (FCX) are surging on rising copper prices and expectations for a strong economic recovery. We are modestly raising our price target to 24.

Performance

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

Small Cap1 (under $1 billion) Current Recommendations

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

Large Cap1 (over $10 billion) Current Recommendations

Notes to ratings:* Please note corrections to the October 2020 issue: the Price at Recommendation for ViacomCBS is 59.57, not 35.52, due to a conversion error related to the Viacom/CBS merger. Target prices for BWA, ADNT and TAP were corrected, as well.

1. Based on market capitalization on the Recommendation date.
2. Price target in parentheses.
3. Total return includes price changes and dividends.
4. Prices and returns are adjusted for stock splits.
SP Given the higher risk, we consider these shares to be speculative.
* Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.
Bold font indicates that this stock is a “Most Timely” Buy recommendation.

Most Recent Closed-Out Recommendations

The next Cabot Turnaround Letter will be published on December 23, 2020.

Cabot Wealth Network
Publishing independent investment advice since 1970.

CEO & Chief Investment Strategist: Timothy Lutts
President & Publisher: Ed Coburn
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