January 26, 2024

This week, we review earnings reports from Capital One Financial (COF), General Electric (GE), Nokia (NOK), Western Digital (WDC) and Xerox Holdings (XRX).

Next week, we anticipate earnings from Polaris (PII) and Janus Henderson Group (JHG). Please know that some reporting dates are estimated based on the companies’ reporting history, others are confirmed dates. As always, it’s likely that some companies will report on a day different from what we anticipate.

Comments on Earnings

Capital One Financial (COF) – Capital One is one of the nation’s largest banks, with over $440 billion in assets and 775 branches. A major difference from other banks is its focus on credit card lending, which comprise 40% of total loans. It is the third largest issuer of Visa and Mastercard credit cards. Auto loans (27%) and commercial loans (32%) comprise the balance. Its shares are depressed from worries about rising credit costs and, like all banks, its ability to retain deposits at costs that don’t erode its net interest margin. However, the bank is well-managed, has robust capital and credit reserves and strong underlying profitability. For patient investors, Capital One shares look like a true contrarian bargain.

The company reported a reasonable quarter that missed estimates and showed that credit costs continue to increase. Revenues were up 1%, and pre-provision operating profits, which exclude credit costs, fell 4% as the bank spent more on occupancy (up 13%) and marketing (up 12%). All-in, the shares remain attractive, trading at 9.7x earnings and 1.4x tangible book value of $99.78/share.

Net interest income rose 4%, as higher earning assets offset a modest decline in the net interest margin. The bank has been able to generally maintain this margin even as it has to pay higher rates on its deposits. Loan and deposit growth were nil.

Credit costs are rising as the bank is having to charge off more loans, in particular its credit card loans. In the fourth quarter, Capital One charged off 5.33% of its credit card balances compared to 3.22% a year ago. Consumer and commercial charge-offs increased but at a slower pace. Delinquency and non-performing rates continue to tick up, pointing to higher charge-offs in upcoming quarters. However, the bank is maintaining its reserve strength and holds plenty of capital to deal with these likely losses.

The share price has surged since last November in anticipation of Fed rate cuts and on-going economic strength, yet we see little chance of the shares reaching our price target until credit costs roll over. Continued economic growth is a tailwind for now. The bank is able to price-up its loans to match higher rates, so we see changes in interest rates as less of an issue.

In the quarter, revenues rose 1% and were in-line with estimates. Adjusted earnings of $2.24/share fell 21% and were 16% below estimates. The primary difference between reported and adjusted earnings was the $289 million FDIC special assessment.

General Electric (GE) – Led by impressive new CEO Lawrence Culp, GE finally appears to be righting its previously severely damaged businesses. Key priorities include much better execution and a strategic emphasis on cash flow and debt reduction. Following the spin-off of GE Healthcare (GEHC) in January 2023, General Electric is now comprised of GE Aerospace (commercial and military jet engines) and GE Vernova, which includes the Renewables segment (on-shore and offshore wind power) and the Power segment (gas turbines, coal, nuclear). GE Aerospace and GE Vernova will separate in 2024.

GE reported a decent quarter which handily beat estimates but provided mildly lower guidance for the two segments (GE Aerospace and GE Vernova) than analysts’ expectations. However, both segments are performing well and guidance is for more improvements in 2024. We also believe that guidance is being intentionally low-balled to provide some wiggle room and upside when these units are split up in early April.

All-in, it was a solid year for GE overall, with revenues, profits and free cash flow improving noticeably from a year ago (all excluding the effects of the spin-off) and for GE Aerospace and GE Vernova individually.

Our comments are brief as we look ahead to more color on the post-split companies at their investor days in early March.

In the quarter, organic revenues rose 13% and were 10% above estimates. Adjusted earnings of $1.03/share rose 56% and were 14% above estimates. The operating margin of 9.6% expanded from 9.1% a year ago.

Nokia (NOK) – Initially recommended in 2015, Nokia has struggled for years to regain its competitiveness. New CEO Pekka Lundmark (March 2020) is finally getting the company back into the game.

Nokia’s 4Q results and 2024 outlook were modestly encouraging and were backed by a new €600 million share buyback announcement. Investors have given up on Nokia as the 5G cycle is fading to well below most expectations while the 6G cycle (which will likely be a legitimate blockbuster) is at least six years away. However, Nokia is showing that it has a real chance of maintaining or even increasing its profits despite the 5G bust. We like its new organizational structure that pushes autonomy and accountability deeper into the organization.

Guidance for 2024 is for operating profits of between €2.3 billion – €2.9 billion, up about 9% at the midpoint compared to 2023.

The company’s balance sheet remains robust with €4.3 billion in net cash. Free cash flow in 2023 was €800 million and guidance for 2024 is encouraging at between €690 million and €1.7 billion – a wide range but clearly moving in the right direction.

Fourth quarter revenues were sloppy, weighed down by noticeable declines in all four segments. However, gross margins were stronger across the board. Even with the sharply lower gross profits (due to sharply lower sales) in patent-driven Nokia Technologies, the company-wide gross margin was almost flat, indicating decent production and procurement cost control.

Overhead costs fell 13%, helping to dampen the effects of weaker gross profits.

In the quarter, revenues fell 21% ex-currency and were 9% below estimates. Adjusted earnings of $0.10/share fell 38% and were 9% below estimates.

Western Digital (WDC) – Western’s relatively new and highly capable CEO, David Goeckeler, who previously ran Cisco’s Networking & Security segment, is making aggressive changes to improve the company’s competitiveness in disk drives and other storage devices, as well as bolster its financial strength. Following our initial recommendation, the shares approached our price target, then slid sharply due to a deep industry downturn. The company has plenty of financial strength to endure until the next upturn, offering considerable share price upside. The planned split-up of the company is an additional major catalyst.

Western reported a modestly encouraging quarter which showed that the company has passed the worst of the downcycle and is now seeing rising revenues and margins. But for a $156 million (or about $0.48/share) non-cash charge for factory under-utilization, the quarter would have been profitable. Guidance for the next quarter was above estimates and for a likely outright profit.

The upcycle has not fully arrived but Western is approaching positive quarterly free cash flow – a financial turning point in terms of the company’s ability to endure. The separation of the hard drive business from the NAND business is slated for later this year.

The company has $2.5 billion in cash, providing a solid margin of safety. Debt is exceptionally high at $9.3 billion including the convertible preferred stock. Ideally, we want to see a strong and prolonged upturn to allow Western to repay most of its debt. For this, we must wait, even as the stock is partly discounting the recovery already.

Revenues fell 2% and were in-line with estimates. The adjusted loss of $(0.69)/share compared to a loss of $(0.42) a year ago.

Xerox Holdings (XRX) – Investors underestimate Xerox’s value due to its zero growth prospects, but the company’s hefty free cash flow has considerable value. The balance sheet is strong, new and capable leadership is working to drive shareholder value higher, and its generous dividend looks reliable.

Xerox reported a reasonably encouraging quarter and provided some incremental confidence that it could reach its ambitious 2026 goal of $700 million in adjusting operating profits. Revenues and profits missed estimates, but the progress for the full year, compared to the prior year, suggests that Xerox’ business has reasonable resilience and that its cost-cutting efforts are bolstering earnings. The company hit its full year free cash flow target of “at least $600 million.”

Guidance for 2024 calls for a 3% decline in revenues (mostly due to exits from business lines and from the ending of backlog filling). Operating profit guidance is for a 7.5% margin, up from 5.6% in 2023 and 3.9% in 2022. Free cash flow is guided to “at least $600 million” again.

Our big-picture view: Xerox’ potential is underestimated by the market. The company is generating considerable free cash flow, even if much of it is from the run-off of its financing book. Management remains confident and provides at least some evidence that it can reach its ambitious 2026 profit goal. The balance sheet is being cleaned up – net debt is negative excluding its lease subsidiary debt – and the share count is down 21% after the repurchase of Carl Icahn’s stake.

The primary risk is that management can’t fully reach its margin target, either from running short of efficiency improvements or from sagging demand due to economic conditions or secular moves away from paper printing. Management is saying they will make high-return acquisitions – we see risk here from making a bad deal or from “buying” margin by acquiring a high-margin business to boost their chances of hitting their targets. We’re fairly confident that acquisitions will be made but are less sure of their merits. The generous $0.25/share quarterly dividend continues to be a top management commitment and is solidly covered.

As the company has much of its debt coming due over the next few years, it could see elevated interest costs but we see little problem with obtaining financing at respectable prices.

In the quarter, revenues fell 9% and were 3% below estimates. Adjusted earnings of $0.43/share fell 52% and were 23% below estimates.

Friday, January 26, 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 12 minutes and covers:

• Comments on earnings
• Comments on recommended companies
  
  • Walgreens Boots Alliance (WBA) – possible sale of Shields Health Solutions and UK Boots. Added a JPMorgan investment banker to its board.
  • Macy’s (M) – New buyout rumor from another private equity firm.
• Elsewhere in the markets
  
  • Tweet on “X” dispels doubts on tech bubble.

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