Cabot Turnaround Letter 321

Thank you for subscribing to the Cabot Turnaround Letter. We hope you enjoy reading the March 2021 issue.

This month we look at post-bankruptcy energy stocks. Companies that have emerged from bankruptcy are generally shunned by investors, as are energy stocks in general in the current market. Combined, these two traits offer some attractive investment opportunities. We discuss four of them.

We also look at tobacco stocks. Shares of these companies have fallen sharply in recent years due to an acceleration in the decline rate of cigarette volumes. However, that trend appears to be moderating, leaving the shares undervalued yet paying high dividend yields. Our feature recommendation, Altria Group (MO), is a stand-out value among the group.

We also include comments on recent price target and rating changes, including our recent Sell recommendations on Trinity Industries (TRN) and ViacomCBS (VIAC).

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 321

[premium_html_toc post_id="226012"]

Opportunities in Post-Bankruptcy Energy Stocks
The energy industry has been through a remarkably difficult time in the past seven years. The collapse of oil prices in mid-2014, from over $110/barrel to less than $25/barrel in early 2020, exerted immense stress on energy companies, particularly those that were bloated with debt from their overzealous pursuit of growth. At the same time, capital markets curtailed their financing of energy companies, worn out by the chronic lack of free cash flow. Several of these companies slid into bankruptcy, yet now look like interesting investment opportunities.

When companies file for bankruptcy, they enter a complicated legal realm with its own rules. Shares of most companies in bankruptcy become worthless, so we strongly advise that investors avoid buying these stocks. If companies have good assets but too much debt, they can be restructured, with debt holders usually becoming the new shareholders. In some cases, once a company emerges from bankruptcy, its new equity will return to publicly traded markets. A post-bankruptcy company can emerge re-energized, more efficient and more focused, with a discounted share price – often a good combination for new shareholders.

In the ideal case, a newly-emerged company will have fresh leadership (the former leadership that got them into trouble isn’t likely to do much better the second time), a minimal debt burden, fewer legacy legal or contractual liabilities and strong, profitable operations. The shares often can be available at an unusually discounted price that is temporarily weighed down by investors with bad memories of the pre-bankruptcy company who avoid the newly-emerged shares and by former creditors that offload their accidentally-acquired shares.

Listed below are five recently-emerged energy companies. They have a mix of appealing traits and some notable risks, yet all stand to benefit from rising oil and natural gas prices. We are modestly optimistic on energy prices – domestic production will likely remain subdued while global demand has essentially returned to pre-pandemic levels even though some petroleum-driven demand for gasoline and jet fuel hasn’t fully recovered yet. Investors want to make sure that managements adequately balance their production declines with strong capital discipline. And production discipline from the OPEC+ countries is a wildcard but so far has continued to be a tailwind. While the shares have surged year-to-date, they appear meaningfully undervalued. We exclude Chesapeake Energy as its executive team is unchanged, it still carries considerable midstream liabilities, and its fields have high production decline rates.

California Resources Corporation (CRC) – This company is a true California business: it operates only in the state and is the state’s largest oil and gas producer. While the state’s stringent regulatory environment is widely recognized, what is not widely known is that California is the second largest petroleum basin in the United States, with likely even more oil yet to be discovered. Many of CRC’s wells produce high quality oil – which yields premium prices – and have moderate decline rates, so they have relatively more reliable and enduring production. The company owns much of its processing and transport pipes as well as an integrated power plant, helping it control its destiny. California Resources was spun off from Occidental Petroleum in 2014, yet ironically the weight of its $5.1 billion in debt that funded a dividend to its former parent drove it into bankruptcy in July 2020. Newly emerged in October, it eliminated all but $1.7 billion in debt and was relieved of other financial obligations. The company is searching for a new CEO to lead a full-scale business review that will likely result in divestitures of lower-ranking assets. The board is entirely new, with one member being the chair/CEO of Oasis Petroleum. The company has hedged about 75% of its 2021 oil production and promises to spend no more than 60% of its sizeable discretionary free cash flow on new drilling, helping produce returns for investors.

Denbury (DEN) – Denbury is an unusual oil and gas producer that focuses on using CO₂ to push oil up from older wells. It sources all of its CO₂ from naturally occurring underground deposits and from industrial plants where it is an otherwise unwanted byproduct. Denbury then links these sources to its oil fields through a proprietary pipeline network. The company emerged in September 2020 after a brief 53-day bankruptcy process, relieved of all but $154 million of its previous $2.1 billion in debt. Four of the seven board members are new, and, coincidentally, one is the CEO of Whiting Petroleum. Perhaps not ideal: the CEO and CFO remained in their seats following emergence, although they are now focused on avoiding the debt problems of the past. Another issue is that some of its oil is produced in the Rockies, which sells at a discount to benchmark oil prices, but this is often offset by the premium it can receive on its Gulf Coast oil. Denbury has hedged about 58% of its 2021 production, providing some downside protection to its cash flow if oil prices slide.

Oasis Petroleum (OAS) – Oasis is an oil exploration company primarily focused on the Bakken fields in Montana/North Dakota with additional production in Texas’ Delaware Basin. Oasis holds a controlling interest in Oasis Midstream Partners, LP, a publicly traded firm which is a source of valuable free cash flow but only limited debt exposure for Oasis. Oasis Petroleum’s November 2020 emergence from bankruptcy brought a $1.8 billion reduction in debt (now at only $273 million) and a completely new board of directors and CEO. The new board chair/CEO, Doug Brooks, is an industry veteran with operating and merger experience and, interestingly, is a new member of the California Resources board. Perhaps not ideal: the president, CFO and general counsel remain in place. However, tight CEO/board oversight, a shareholder-friendly compensation plan with a reduced salary and 3-4 year vesting without grants in 2022 or 2023, and a highlighted commitment to disciplined spending could keep the management in line. The company reports its first post-emergence financial performance this Thursday, February 25.

Weatherford (WFTLF) – Weatherford is a global energy service company that was created by an aggressive, decades-long acquisition strategy that worked well as long as oil prices remained high. However, when oil prices collapsed, its unintegrated mash-up of businesses was unable to service its hefty $10 billion debt burden, despite an impressive turnaround effort by a new CEO, leading to its July 2019 bankruptcy. Still carrying $2.6 billion in debt when it emerged in December 2019, the company narrowly avoided another bankruptcy in 2020 when lenders extended all of its debt maturities to 2024. With a new lease on life, a new leadership team, and improving energy industry conditions, Weatherford can continue to rationalize its operations and rebuild its franchise. While the debt burden will remain a chronic overhang, the company has a realistic chance of turning the corner.

Whiting Petroleum (WLL) – Whiting’s excessive $2.9 billion in debt drove it into bankruptcy in April 2020. In addition to low energy prices, Whiting’s oil and gas production was (and still is) based in land-locked North Dakota, Montana and Colorado, so it must settle for discounted prices relative to industry benchmark prices like WTI and Henry Hub. Whiting emerged the following September, with only $360 million in debt (about 0.8x leverage), a reduced workforce and improved midstream contracts. The new CEO and CFO once led Kodiak Oil & Gas, which Whiting acquired in 2014, and then moved on to run another company which was sold in a well-timed deal. The board of directors is led by the vice chair of Kayne Anderson Capital Advisors and includes Dan Rice, both of whom are likely high-attuned to shareholder interests. The new Whiting is focusing closely on capital discipline and free cash flow generation, although it has left open the possibility of making opportunistic acquisitions. While the risk of a shutdown of the Dakota Access Pipeline remains an overhang, the company appears much better positioned to prosper.

Closing prices on February 19, 2021.
* Enterprise value/Earnings before interest, taxes, depreciation and amortization. Based on calendar year 2021 estimates where available and Cabot Turnaround Letter analysis.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Tobacco Stocks—Not Up In Smoke Just Yet

Investor interest in companies that meet high environmental, social and governance standards (ESG) has grown rapidly in recent years. By some measures, as much as a third of all U.S. professionally-managed investments currently emphasize ESG criteria. Yet, long before formal ESG-oriented strategies emerged, some investors already avoided “sin” stocks – those of companies involved in tobacco, alcohol, weapons and gambling. It’s really a matter of personal choice whether to invest in sin stocks, but sometimes they can represent good value opportunities. For example, right now the tobacco stocks look like bargains.

In the past two decades, the tobacco industry has become a mature, highly concentrated and heavily regulated and taxed industry, particularly in the United States. Cigarette consumption in the U.S. and most developed countries is slowly declining, propelling consolidation such that the top four U.S. makers hold a 92% market share.

The landmark Master Settlement Agreement in 1998 largely shielded domestic tobacco companies from medical liability in exchange for their making large annual payments to states in perpetuity and terminating most marketing activities. The FDA fully regulates tobacco products and as much as 44% of the retail price of cigarettes is comprised of federal, state and excise taxes

Tobacco company shares have fallen out of favor, with some share prices down 40% or more from their 2017 highs even as the stock market has surged. First, the growing influence of ESG-minded investors has weighed on the shares. From a fundamental perspective, a major issue has been the acceleration in the decline rate of domestic cigarette volumes. Typical annual volume declines have been in the 3-4% range, but this rate increased to 4.5% in 2018 and 5.5% in 2019. The federally-mandated increase in the minimum age to purchase tobacco from 18 to 21 may be reducing demand. More recently, the possibility of new menthol regulations and higher taxes has pushed away investors.

An emerging concern is the growth in “next generation” non-combustible tobacco products that are showing signs of developing into threats to cigarettes. The previously rapid growth of vaping products like JUUL, for example, may have contributed to the erosion of traditional tobacco volumes. In some ways, this mirrors the emergence of electric cars and trucks – demand for traditional products remains robust but a transition to new products is seen by investors as inevitable. As such, companies that are in the vanguard of this shift are viewed more favorably that those that lag. Another similarity: most of these initiatives have rapid demand growth from tiny bases but so far remain unprofitable.

All of these issues have created an investment opportunity in tobacco stocks. While a transition to non-combustible products may eventually occur, tobacco companies may continue to generate vast free cash flow for years to come, rewarding shareholders, as the transition won’t likely occur overnight. And the industry has many appealing traits that remain in place. Revenues are remarkably stable with slow but steady growth, as annual price increases more than offset declining unit volumes. Wide profit margins (45%+) and low capital spending requirements translate into steady profits and cash flow, much of which is paid out as dividends.

Supporting near-term fundamentals is that the accelerated volume decline appears to have stopped, with U.S. volumes flat in 2020. Whether this is a pandemic-related rebound in demand – driven by higher stress, higher disposable income, and fewer limits on where to smoke when at home – or a more enduring change is yet to be seen, but early indications are favorable. Several companies have new leadership that are driving a transition to non-combustible products. These managements also bring a greater awareness of investor and societal concerns about their products, which may at least partially alleviate some ESG concerns.

For value investors, a major appeal is that valuations are near long-time lows, while dividend yields are exceptionally high relative to the stock market. These stocks can also offer defensive traits in an over-priced market. Listed below are four tobacco stocks with good value. We also are highlighting Altria as a standout among this group as our new Buy recommendation this month.

British American Tobacco (BTI) – Following its recent acquisition spree, including its $30 billion deal for Lorillard in 2015 and its $49 billion buy-in of the remaining 48% of Reynolds American (2017), British American is one of the world’s largest tobacco companies. It has a 40% share of the global cigarette market, although the U.S. generates just under half of its total sales. Led by a new CEO since 2018, the company is accelerating its transition to non-combustible products to expand upon its market-leading position in this segment. Its vapor, oral and heated products already comprise 12% of total company revenues. Initiatives to simplify the company, reduce costs and release unproductive cash should boost core earnings. Once its non-combustible products turn profitable in four years or so, overall earnings growth could accelerate. Management guided to 3%-5% revenue growth in 2021, which, combined with possible widening of its 44% operating margin, should produce faster profit growth. Like its peers, British American Tobacco produces hefty free cash flow, pays a generous dividend and carries reasonable debt (which it plans to reduce further).

Imperial Brands (IMBBY) – Imperial is the world’s fourth-largest tobacco company outside of China. Its U.S. business, led by #3 market shareholder ITG, generates about a quarter of its revenues. Imperial Brands’ shares have lost 60% of their value in the past five years, partly due to its unsuccessful efforts with next generation products, as well as its declining revenues, poorly-positioned tobacco products, and overly tight cash flow that led to a 33% dividend cut last year despite the $1.3 billion sale of its Premium Cigar business. The flailing company is now in turnaround mode and appears to be waking up. Last year, the company replaced its board chair with the impressive Therese Esperdy, a former head of several of JPMorgan’s global investment banking operations. This was followed by a new CEO in May, Stefan Bombard, who brings considerable turnaround experience. Other senior positions have been replaced with fresh talent, as well. Bombard recently unveiled his turnaround strategy, calling for an aggressive pullback in its non-combustible programs, renewed focus on the core combustibles portfolio, a sharp cost and simplification initiative, and further debt reduction. In essence, Imperial Brands is getting its foundation in better shape now to provide it with more strength to adapt in the future. This sensible strategy goes against its competitors’ moves toward alternative products and clearly differentiates the Imperial Brands story.

Philip Morris International (PM) – This company previously was Altria’s international division before its 2008 spin-off, and has essentially no U.S. revenues. The company’s portfolio of top-selling premium, mid-price and discount-price brands includes Marlboro, the #1 selling international cigarette brand that produces 37% of PMI’s total volume. Unlike its domestic peers, the company carries international product liability risk but this is likely to remain readily manageable. Combustible products are a relatively low 76% of total revenues, as its successful IQOS (heated not burned) products, which it sells globally and licenses to Altria for sale in the United States, boosts its alternatives operations. Volumes in 2020 were weak due in part to lower pandemic-related demand at duty-free shops, although operating income rose 5%. PMI expects mid-single-digit revenue growth in this year, with an expanding profit margin. The company’s balance sheet is strong, and its generous cash flow provided management with the confidence to recently raise its dividend by 2.6%.

Vector Group (VGR) – This tobacco company is the fourth largest cigarette manufacturer in the United States, producing discount-priced brands through its Liggett and Vector subsidiaries. It also owns Douglas Elliman Realty (the fourth largest residential real estate company in the nation) and holds direct ownership stakes in large real estate projects in four major markets. The company has a unique trait: its tiny cigarette market share at the time of the 1998 MSA exempted it from onerous perpetual liability payments for volumes up to a 1.93% market share. This permanent cost advantage has helped Vector expand its market share to 4.1%, although it retains some medical liability exposure. Its management team has long tenure with the firm, providing stability. Management and directors own a combined 8% of Vector’s shares, providing the incentive to maintain its competitiveness. Revenue and profit trends are favorable, although its real estate business is struggling, and its balance sheet remains sturdy.

Closing prices on February 19, 2021.
* Enterprise value/earnings before interest, taxes, depreciation and amortization. Based on consensus estimates for fiscal years ending in 2021.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Recommendations

Purchase Recommendation: Altria Group, Inc.

Altria Group, Inc. 6601 West Broad Street Richmond, Virginia 23230 (804) 274-2200 altria.com

Symbol: MO Market Cap: $81 Billion Category: Large-Cap Business: Tobacco Revenues (2021E): $21.2 Billion Earnings (2021E): $8.4 Billion 12/18/20 Price: $43.80 52-Week Range: $46.22-$30.95 Dividend Yield: 7.9% Price target: $66

Background
Altria is the largest tobacco company in the United States, with $26 billion in revenue. The company was launched in 1847, when tobacconist Philip Morris opened a shop in London on fashionable Bond Street. The shop named its cigarette brand ‘Marlboro’. Since then, Marlboro grew to become the largest brand in the United States, with a 43% market share, and the top-selling brand worldwide. Philip Morris expanded its tobacco offerings and diversified into a food and beverage powerhouse, leading to its membership in the Dow Jones Industrial Average from 1985 to 2008.

The shift in the regulatory environment, particularly after the landmark Master Settlement Agreement in 1998, along with changing strategic considerations, led Philip Morris to refocus on the domestic tobacco business. In 2003, the company changed its name to Altria Group and subsequently divested its Kraft Foods, Miller Brewing and international operations (named Philip Morris International). In 2008, Altria acquired US Tobacco (smokeless tobacco) for $10 billion, expanding its tobacco franchise. Today, 88% of Altria’s revenues are generated by smokable tobacco (mostly Marlboro), 10% from oral tobacco (including Copenhagen, Skoal and on!), and 2% from wine (including Ste. Michelle Wine Estates).

After a decades-long run that peaked in mid-2017, Altria shares have fallen over 40%. A major factor has been the acceleration in the decline rate of cigarette volumes to -4.5% in 2018 and -5.5% in 2019. Rapidly declining volumes disrupt the company’s cash flow model. Investors also remain frustrated that the management discontinued its traditional forecast for medium-term cigarette volume. The company lagged its competition in launching non-combustible products, then compounded its problems in 2018 by paying $12.8 billion for a 35% stake in vaping company JUUL, which is now nearly worthless. Its $1.8 billion purchase in 2018 of a 45% stake in cannabis company Cronos was also controversial. The regulatory environment remains unpredictable and complicated, with risks from potential limits on menthol cigarettes and nicotine content, a patent lawsuit against its promising IQOS product, and higher investor focus on ESG-favored companies that excludes Altria among the most notable.

Analysis
We think that investor doubts about the resilience of the tobacco industry are overdone. Over the past six months, domestic volume declines have moderated, with fourth-quarter volumes showing a fractional increase and Altria’s volumes growing 3.1%. While pandemic-related factors may play a role in this return to stability, the lack of cannibalization by vaping products is likely important, as well. Pricing power remains robust – Altria raised its prices by 6.1% in the fourth quarter.

From an investment perspective, the cigarette business is attractive. Moderately declining volumes are more than offset by price increases such that revenue growth has remained positive. Four companies hold a dominant 92% market share, barriers to entry are exceptionally high and capital requirements are low. Marketing costs are minimal as regulations prohibit most advertising. Brand loyalty is strong, particularly in the premium segment that Altria emphasizes, so market shares tend to be stable.

All these favorable traits add up to wide profit margins (note Altria’s 55% operating margin). With slow growth but large and steady profits, dividend payouts are high and sustainable. Altria guided for 3-6% profit growth in 2021, with a renewed commitment to an 80% payout ratio. For a stock like MO that yields close to 8%, a three-year holding period would produce a 24% cash return even if the stock goes nowhere.

The apparent secular shift to alternative products brings risks but also opportunity. Altria is rolling out the IQOS heated-not-burned device, which holds considerable promise. Its oral nicotine pouch (named “on!”) is also showing growth. These not only could fend off market share losses, but may become attractively profitable at scale.

Altria’s new leadership should generate improved credibility. In April 2020, the former CEO departed, with company veteran Billy Gifford taking the helm, followed by a new CFO. The board also separated the chair and CEO roles, which should upgrade management oversight.

Altria is well positioned to continue to produce generous free cash flow, helping to support its recently raised dividend and a newly-announced $2 billion share buyback program. Net debt is low at 2.2x trailing EBITDA. Its 10% stake in Anheuser-Busch InBev, currently worth about $12.8 billion, or about $6.80/share before any tax liabilities, could be monetized after the October 2021 lockup expires, possibly leading to an additional payout to shareholders.

The shares trade at a low 8.7x EV/EBITDA and 9.6x earnings per share based on consensus 2021 estimates. While Altria shares have risks, investors have the opportunity to purchase a stable and generous dividend stream at a sizeable discount, providing the potential for a rewarding turnaround investment in an expensive market.

We recommend the purchase of Altria Group (MO) shares with a 66 price target.

Price Target Changes and Sell Recommendations
On February 12, we raised our price target on Western Digital (WDC) from 59 to 69, based on the impressive pace of its operational improvements and more imminent signs of a NAND upcycle. We also raised our price target on Signet Jewelers (SIG) from 42 to 49 as the turnaround appears to be much stronger than we anticipated.

We raised our price target on ViacomCBS (VIAC) from 54 to 65 and moved our rating from Buy to HOLD on February 17, then moved the shares to a SELL on February 23 after they jumped above the 65 target. The shares are now being priced at a premium to even our upgraded valuation metrics. The company’s fundamentals look healthy, so our call is driven by the valuation. ViacomCBS is increasingly becoming a “growth story” and has moved beyond the “turnaround story” that is the focus of our strategy. VIAC shares have produced a total return of approximately 19% from our initial recommendation in the January 2017 Cabot Turnaround Letter at 59.57 (adjusted for the Viacom-CBS merger) and a 77% year-to-date gain for investors who purchased shares last year.

On February 19, we moved Trinity Industries (TRN) from Buy to SELL as the shares moved above our 30 price target. The industry will likely remain depressed as the volume of railcars in storage is multiples of typical annual new railcar demand. And, while we recognize the value of the company’s transition to more of a leasing company than a manufacturer, this value appears to be somewhat fully priced in and requires more of a “growth investor” mindset than a turnaround investor mindset that is the focus of our strategy. TRN shares have produced a total return of 92% since our initial recommendation in September 2019.

Performance

The following tables show the performance of all our currently active recommendations, plus recently closed out recommendations. For additional details, please visit cabotwealth.com.

Small Cap¹ (under $1 billion) Current Recommendations

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

Notes to ratings:

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.

Large Cap¹ (over $10 billion) Current Recommendations

Most Recent Closed-Out Recommendations

The next Cabot Turnaround Letter will be published on March 31, 2021.

Cabot Wealth Network
Publishing independent investment advice since 1970.

President & CEO: Ed Coburn
Chairman & Chief Investment Strategist: Timothy Lutts
176 North Street, PO Box 2049, Salem, MA 01970 USA
800-326-8826 | support@cabotwealth.com | CabotWealth.com

Copyright © 2021. All rights reserved. Copying or electronic transmission of this information is a violation of copyright law. For the protection of our subscribers, copyright violations will result in immediate termination of all subscriptions without refund. No Conflicts: Cabot Wealth Network exists to serve you, our readers. We derive 100% of our revenue, or close to it, from selling subscriptions to its publications. Neither Cabot Wealth Network nor our employees are compensated in any way by the companies whose stocks we recommend or providers of associated financial services. Disclaimer: Sources of information are believed to be reliable but they are not guaranteed to be complete or error-free. Recommendations, opinions or suggestions are given with the understanding that subscribers acting on information assume all risks involved.