Cabot Turnaround Letter 521

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

With the stock market continuing to reach record highs, and with most stocks either participating in the rally or facing structural, fundamental challenges that they won’t likely overcome, finding new ideas can be a challenge. As contrarians, we want to look for stocks in places which others find too unconventional or uncomfortable, as bargains may be found there. One such place is in stocks with low share prices, generally under $10. We discuss five interesting turnarounds among this group.

Real estate investment trusts, or REITs, have surged since Pfizer announced on November 9, 2020 that they had developed an effective Covid vaccine. Yet some REITs haven’t fully participated. We review six laggards that have quite favorable risk/return traits.

Our feature recommendation is Dril-Quip (DRQ). This company manufactures highly-engineered drilling and production equipment for offshore oil and natural gas projects. The shares are heavily out-of-favor yet offer considerable upside, backed by a solid company with a large cash hoard and zero debt.

We mention our April 1st price target increase for Mohawk Industries (MHK) from 180 to 220. As several companies continue to show strong fundamental improvements, we are raising our price targets on Adient (ADNT), Western Digital (WDC) and Wells Fargo (WFC), while moving Jeld-Wen (JELD) to a HOLD. Also, we update our article from last month on high yield bonds.

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 521

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Turnarounds in Stocks with Low Per-Share Prices
With the stock market continuing to reach record highs, and with most stocks either participating in the rally or facing structural, fundamental challenges that they won’t likely overcome, finding new ideas can be a challenge. As contrarians, we want to look for stocks in places that others find too unconventional or uncomfortable, as bargains may be found there. One such place is in stocks with low share prices, generally under $10.

Most investors have a bias toward stocks with prices in the $20-$150/share range, implicitly associating a high number with successful companies and a low number with an unsuccessful company. General Electric is a good example of the role of this perception: it is asking shareholders to approve a 1:8 reverse split that would change its $13/share price to $104/share. The reason provided in its proxy statement: “to increase the per share trading price of our stock to levels more typical for a company with GE’s market capitalization.” This is savvy marketing, as what GE really wants is to be associated with the comfort and prestige that comes with a high share price.

However, the share price, per se, has nothing to do with a company’s health or valuation. General Electric’s 1:8 reverse split will raise the share price but reduce the number of shares outstanding, leaving investors with the exact same dollar value.

In looking at low-priced stocks, we remember another mis-perception lesson learned long ago, this one related to risk. It may seem logical to justify buying low-priced stocks by thinking, “I can’t lose much if the price is so low.” But, if you lose $3/share on a $4 stock, it produces a 75% loss.

As we searched for attractive stocks trading under $10 or so, we eliminated the many broken, biotech, overly specialized technology and otherwise unsuitable companies. The list of five companies, described below, have turnaround traits, real businesses with substantial operating assets and capable managements, and with shares that trade on either the NYSE or Nasdaq. These companies also have appealing fundamental changes or cyclical catalysts underway that could lead to much higher share prices. Some of the valuations appear elevated, but that is primarily due to depressed earnings.

Several Cabot Turnaround Letter recommended stocks have prices in this range, including Gannett, Oaktree Specialty Lending, Conduent and Nokia.

Arcos Dorados (ARCO) – Spanish for “golden arches,” Arcos Dorados is the world’s largest independent McDonald’s franchisee, operating over 2,200 restaurants and holding exclusive rights in 20 Latin American and Caribbean countries. Based in stable Uruguay and listed on the NYSE, the company produces about 72% of its revenues in Brazil, Mexico, Argentina and Chile. Its leadership looks highly capable, led by the founder/chairman who owns a 38% stake.

The company’s shares remain 36% below their year-end 2019 level as the pandemic has weighed on revenues, while the Venezuelan economic mess, political/social unrest, inflation and currency devaluations in other countries create profit headwinds and investor angst. However, the company’s fourth quarter 2020 revenues were back to 95% of pre-pandemic year-ago levels (ex-currency), supported by sharp increases in drive-thru and delivery sales. While profits were about 33% lower, they are showing healthy improvements, and consensus estimates point to a full profit recovery in two years. Debt is reasonable relative to post-recovery earnings, and the company is currently producing positive free cash flow, which buys it time until the recovery arrives.

Clear Channel Holdings (CCO) – One of the world’s largest outdoor advertising companies, Clear Channel owns over 450,000 billboards and other analog and digital displays in 31 major countries around the globe. As advertising spending plummeted during the pandemic, so did Clear Channel’s revenues. First quarter 2021 prospects are improving but still likely to show year over year revenues down over 25%. Cost-cutting has kept EBITDA in the black, but the 19% margin is down sharply from 28% a year ago and the reduced free cash flow is exerting pressure on its already-highly-leveraged balance sheet.

However, as American drivers, pedestrians and metro riders return, advertising should pick up, with much of the incremental revenues dropping to the bottom line. The recovery outside of the U.S. will be slower, though. But, Clear Channel has $785 million in cash with no debt maturities for another three years, so it should be able to ride out the storm to a more prosperous future.

Coty (COTY) – Based in New York, this company is a world leader in fragrances and cosmetics. Coty shares performed well following their 2013 IPO, but then began a long slide that ended in late 2020 with the price down 90% from their peak. The $14.8 billion acquisition in 2016 of Procter & Gamble’s mass-market cosmetics operations started the downturn, but Coty’s mismanagement across all of its operations contributed to the problems. Following several unsuccessful CEO replacements, the company appears to have found a winner in Sue Nabi, who took the helm in mid-2020. Nabi is a highly regarded industry veteran, with an impressive record at L’Oreal, one of the best-managed companies in any industry. Coty is working aggressively, as outlined in its April 23rd strategy update that was well-received by investors, to revive its brands, build its presence in higher-margin and faster-growing categories and update its e-commerce and other distribution capabilities. Its still-overbearing debt burden is being modestly tamed by higher earnings and refinancings. While Coty faces an uphill battle, its capable leadership makes this worth a closer look.

OneSpaWorld (OSW) – This company holds a dominant 90% share of the cruise ship wellness/spa market, with facilities on 163 cruise ships. It also has health and wellness centers at 54 land-based destination resorts including Marriott, ClubMed and Four Seasons. Following a four-year stint as a private company under the tutelage of respected investment firm Catterton, the company returned to public ownership in 2019 through a special purpose acquisition company. OneSpaWorld is a well-established business – its operations date back to the 1960s with the world’s first at-sea spa services on ships including the Queen Mary. The company has strong relationships with nearly all the major cruise lines that average 20 years and has a 94% contract renewal rate. Not surprisingly, its revenues collapsed during the depths of the pandemic. However, following a $75 million equity raise in June 2020, a top-up $12 million equity raise late last year, drastic expense cuts and the return of the previously retired CEO, and supported by its asset-light business model, the company appears capable of enduring the downturn without any further new funding. This is a high-quality company firmly established in an unusual niche that should prosper as cruise ships return to the waters.

Party City Holdings (PRTY) – Party City is the leading party goods retailer in North America, with 831 stores. It also designs, sources, manufactures and wholesales party goods to domestic and international customers, making it the world’s largest vertically integrated party goods supplier. Going into the pandemic, Party City was already struggling with competition and execution problems, and the lockdowns only made its struggles more difficult to overcome.

However, in April 2020, the CEO was replaced by a recent hire who previously led pet supplies retailer Petco. Additional new leadership, including the CFO and several new board members, is supporting the turnaround. Key areas of improvement include better merchandising, service and pricing (part of the next generation store conversion) along with an upgrading of its e-commerce presence. Party City’s strength as a major manufacturer and wholesaler will also be leveraged. The company carries a hefty debt burden, but as the pandemic lifts and the new leadership executes its plans, the shares could bring some celebrations by its shareholders.

Closing prices on April 23, 2021.
* Enterprise value/Earnings before interest, taxes, depreciation and amortization. Based on consensus estimates for fiscal years ending in 2022.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.
Opportunities in Laggard REITs
Real estate assets are inherently “in-person” assets – which, of course, were severely shaken by the pandemic-related lockdowns. Not surprisingly, shares of real estate investment trusts, or REITs, fell harder than most stocks early last year. Yet, when Pfizer announced on November 9, 2020 that it had developed an effective vaccine against Covid, REIT shares surged. Since then, the average stock in our universe of 164 non-mortgage REITs rose 43%, with 35 rising more than 70%. Within this group, there is a wide divergence of returns, ranging from +140% for Innovative Industrial Properties (IIP) to -64% for The GEO Group (GEO).

In addition to having highly tangible assets (on their website, REITs almost always list every property they own, often with photos), they receive favorable corporate tax treatment: as long as they distribute at least 90% of their income as dividends, they are exempt from paying corporate income taxes.

With their surge, many REIT shares have fully discounted an economic recovery, particularly apartment REITs, as these properties have been resilient revenue generators during the pandemic. Our contrarian approach led us to look for value among the laggards, which in many cases were office property owners. There is considerable uncertainty over when and how many workers will return to their offices. Less office demand means lower occupancy and eventually lower rents – in a largely fixed-cost real estate business this weighs on profits. Also, debt that was previously readily serviceable can become problematic.

While work-from-home seems appealing and has taken a step upward, our view is that the office and other property segments will eventually fully recover, helped by economic growth and the intangible benefits of live, in-person interaction. Listed below are six REITs that we believe represent the most favorable risk/return opportunities. While they may be vulnerable to increases in interest rates, their low valuations offer appealing appreciation potential, along with (in most cases) attractive dividend yields which pay investors while they wait.

American Asset Trust (AAT) – This high-quality REIT focuses on office, retail and multi-family properties on the west coast and Hawaii. Its tenant base is diversified by customer type, helping reduce its risks, and its Hawaii market has high barriers to entry. However, the shares remain 25% below their year-end 2019 level as the local economies remain subdued. Yet, total rent collections are running at about 92%, with office (99%) and multi-family (95%) collections stronger than retail (82%) collections. The company has solid development projects underway, including a gutsy $175 million speculative new office building in a highly desirable San Diego location. Although the balance sheet is relatively sturdy, management is working to whittle down its debt. The dividend, while modest, looks well-covered.

Franklin Street Properties (FSP) – Franklin Street has 34 office buildings in central business districts and suburban locations, primarily in the Midwest and southeast along with others in Colorado and Texas. The shares remain 36% below their year-end 2019 price, as investors are emphasizing healthier office REITs with growth potential. Franklin Street’s surplus cash flow (after dividends) was already crimped pre-pandemic – and is more-so now. However, it is divesting between $350 and 450 million in properties this year to better align its balance sheet with current conditions. Its position should be bolstered further when its two re-development projects come fully on-line. Occupancy remains relatively steady at 85% in its 32 fully operating properties, and it is collecting 99% of its rentals due. The appealing dividend, while not covered by cash flows, was fully paid in the most recent quarter and the company appears committed to maintaining it.

Kilroy Realty Corporation (KRC) – Founded in 1947 and led by a Kilroy family member, the company has a portfolio of 117 Class A office buildings and two residential buildings in San Diego, Greater Los Angeles, San Francisco and Seattle. It emphasizes up-to-date properties in high-growth industries with an expanding roster of life sciences buildings. The shares remain 20% below their year-end 2019 level. Kilroy is well-regarded as a high-quality REIT with a solid balance sheet. It is a capable asset allocator, most recently demonstrated by its savvy $1.08 billion sale of The Exchange in San Francisco for a large profit. Near term, the company will likely remain hampered by the sloppy office market. While the dividend yield is modest, the company may distribute some of its recent sale proceeds, and the long-term capital appreciation potential is generous.

Netstreit (NTST) – Dallas-based Netstreit was formed in October 2019 and completed its IPO in August 2020. It now holds 203 properties across 38 states focusing on single-tenant properties in which a single company occupies the entire building. Its occupancy rate is 100%, collections are backed by its tenants’ high credit quality (70% are investment grade), and its stores tend to be in defensive/necessity segments of retail like 7-Eleven convenience stores, Lowe’s, Advance Auto Parts and Sam’s Club. In addition to its solid property base, the company is positioned to increase its size with more acquisitions, bolstered by a recent equity raise that was well-received by investors. As more investors discover this small-cap company, its shares will likely respond favorably.

Urstadt Biddle Properties (UBP) – Named for the two executives who built the company, Urstadt Biddle is a high-quality grocery-anchored shopping center REIT with 84 properties in suburban areas primarily in New Jersey, Connecticut and New York. Despite its high-quality property base and conservative management, its shares remain 24% below their 2019 closing price. Weak-ish occupancy as well as rent abatements and deferrals for dry cleaners, gyms, restaurants and other shops adjacent to the grocery anchors have hurt its immediate prospects. But, as the suburban economies recover, we expect Urstadt to return to prosperity, even though the shares imply only a minimal recovery. The dividend was trimmed but will likely need to grow as income recovers to preserve its REIT status. Investors should be aware that the company has two classes of stock, UBA and UBP, with the Class A shares having fewer voting rights but receiving no less than 110% of the UBP common stock dividend.

Washington Real Estate Investment Trust (WRE) – Self-described “WashREIT” focuses on the Washington, DC region, with a portfolio of 43 office, retail and multifamily properties. The company’s revenues and profits decayed from both lower lease pricing and volumes as well as credit losses. However, WashREIT’s occupancy rate was 91% in the fourth quarter, with rental collections running at a 99% rate, its finances remain strong and the leasing market is on the path to recovery, particularly for its multifamily properties. Employment in the region is exceptionally resilient. To better position itself, WashREIT is increasingly emphasizing its multifamily operations while reducing its retail and office exposure. The attractive dividend will likely be covered by cash flow later this year.

Closing prices on April 23, 2021.
* FFO, or Funds From Operations, is a non-GAAP metric that has been defined by the National Association of Real Estate Investment Trusts to standardize reporting, calculated as net income plus depreciation and amortization less impairments/gains. This number is adjusted for one-time adjustments at the company’s discretion to produce Adjusted FFO, or AFFO. Data in the table is based on consensus estimates for fiscal years ending in 2022.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Follow-Up to Last Month’s Article on High Yield Bonds
Last month we wrote about the historically slim yield premium that high-yield bonds offer relative to risk-free Treasuries. At the time of our writing, the yield spread was 361 basis points (3.61 percentage points). Investors’ appetite nevertheless remains robust, pushing the spread to as low as 325 basis points last week, as measured by the ICE BankofAmerica High Yield Index Option-Adjusted Spread. This puts April on track to have the narrowest monthly average premium since before the 2009 financial crisis, and threatening the May 2007 mark of 246 basis points, which remains the skinniest over the past 24 years. Optimism abounds.

Recommendations

Purchase Recommendation: Dril-Quip, Inc.

Dril-Quip, Inc. 6401 N. Eldridge Parkway Houston, Texas, 77041 (713) 939-7711 dril-quip.com

Symbol: DRQ Market Cap: $990 Million Category: Small-Cap Business: Oilfield Equipment Revenues (2021E): $348 Million Earnings (2021E): $(9) Million 4/23/21 Price: 28.28 52-Week Range: 40.62-22.25 Dividend Yield: 0% Price target: 44

Background
Dril-Quip is a manufacturer of highly engineered drilling and production equipment, primarily for offshore oil and natural gas fields. It emphasizes technically advanced equipment and services, making it a go-to choice of major integrated and national energy companies for their deepwater, harsh environment and severe location projects. Its operations are global, with manufacturing facilities in Houston, Singapore, Brazil and Scotland, supported by 20 service offices in major international energy markets. About 67% of its revenues are produced outside of the United States. Founded in 1981, Dril-Quip has been a public company since 1997, and is based in Houston, Texas.

Investors have shunned Dril-Quip’s shares, which have fallen 50% from their mid-2019 level and currently trade near their pandemic lows. The combination of low oil prices, which languished in the $40/barrel range for much of 2020, and ESG-driven pressure on its customers to shift their spending away from fossil fuel exploration, has pushed the drilling equipment industry into a depression. And, the steady threat of higher oil production from Iran and other OPEC+ nations only serves to further dampen activity in the expensive, risky and multi-year offshore projects that utilize Dril-Quip’s products. Investors might incrementally be put-off by a trade secrets theft trial against the company now underway. With surging stock prices elsewhere, accompanied by more convincing narratives, few investors have an interest in dull, out-of-favor companies like Dril-Quip.

Analysis
While Dril-Quip is an old-school company – a manufacturer of equipment for fossil fuel production – it is by no means irrelevant. Oil and natural gas are essential to the global economy, providing over 50% of total energy demand today and likely as much as 48% in 2040. About 28% of global oil is produced from offshore fields, so this source of energy won’t fall away. To maintain current production volumes, long-term demand for offshore drilling, and the related gear, will need to remain healthy. Dril-Quip’s ongoing development of its leading-edge technical capabilities helps it maintain its relevance as well as expand the market for its products.

While fourth quarter 2020 revenues fell 20% from a year ago, they fell only 4% from the third quarter and appear to be at a trough. At least some of the year over year decline can be attributed to pandemic-related disruptions. A key indicator of future revenues, new orders, has stabilized, as well. Near-term orders will likely remain subdued but should begin to increase as 2021 progresses. Unlike prior downcycles, customer inventories are lean, suggesting that any rebound in drilling activity will quickly flow through to new orders. Management has credibly guided 2021 revenues to be steady compared to 2020 revenues.

Dril-Quip has remained profitable at the Adjusted EBITDA line, supported by a successful $20 million cost-cutting program, with more efficiency gains ahead in 2021. With a leaner cost structure, a high percentage of incremental revenues should fall directly to the bottom line. The company’s capital expenditure requirements are minimal at about $16 million for 2021, or about 4.5% of revenues. While free cash flow was negative $19 million in the fourth quarter, the company is likely to produce positive free cash flow of about $18-20 million for the full year 2021. Free cash flow is a primary focus of the management team.

A major source of strength is Dril-Quip’s balance sheet. It holds $346 million in cash and zero debt, which provides exceptional resilience while the company waits for a recovery.

We see the trade secrets trial, relating to a former employee of competitor TechnipFMC who joined Dril-Quip and allegedly took proprietary information, as a minor issue other than the legal costs required to defend against it.

Our target price of 44 assumes a reasonable recovery to $80 million in EBITDA, and a 14x EBITDA multiple which is comparable to its history across a range of market cycles. Prospective investors should be aware that the company reports its first quarter results after the market closes on Thursday, April 29, which may produce some share price volatility the following day.

Like all stocks, DRQ shares carry risks, and the recovery will take some time. But, with its deeply out-of-favor share price, even relatively modest relief from the currently depressed industry conditions should provide shareholders with a rewarding investment.

We recommend the purchase of Dril-Quip (DRQ) shares with a 44 price target.

Price Target Changes and Sell Recommendations
We raised our price target for Mohawk Industries (MHK) from 180 to 220 on April 1^st. The company is delivering on the fundamental improvements that we anticipated when we recommended the shares in March 2019. We had reduced the target price during the pandemic, but returned it to its original 220, as Mohawk looks to have side-stepped the downturn.

The turnarounds at Adient (ADNT) and Western Digital (WDC) have been impressive so far. We believe there are more improvements ahead with additional valuation upside, so we are raising our price targets on ADNT from 42 to 55 and on WDC from 69 to 78. Wells Fargo (WFC) is making early progress, with more earning power increases and more risk reduction ahead, so we are raising our price target from 43 to 49.

Jeld-Wen (JELD) is making good progress, but the valuation discounts a fairly prosperous future as the shares trade 8% above our price target. The company reports this Friday, before the market opens. We are moving our rating to a HOLD, and want to see the earnings report before making a bigger call.

Disclosure: The chief analyst of the Cabot Turnaround Letter personally holds shares of every “Buy” rated recommendation. The chief analyst may purchase securities discussed in the “Purchase Recommendation” section or sell securities discussed in the “Sell Recommendation” section but not before the fourth day after the recommendation has been emailed to subscribers. However, the chief analyst may purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time.

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. 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.

The next Cabot Turnaround Letter will be published on May 26, 2021.

Cabot Wealth Network
Publishing independent investment advice since 1970.

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