March 1, 2024

This week, we review earnings reports from Advance Auto Parts (AAP), Berkshire Hathaway (BRK/B), Dril-Quip (DRQ), Elanco Animal Health (ELAN), Fidelity National Information Services (FIS), Gannett (GCI), Macys (M), Six Flags Entertainment (SIX), Viatris (VTRS) and Warner Bros Discovery (WBD).

Next week, we anticipate earnings from LB Foster (FSTR), Bayer AG (BAYRY) and Duluth Holdings (DLTH). 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.

Shares of LB Foster (FSTR) have reached our 23 price target. We will wait for the earnings report next week before making any ratings changes. For investors with excessive positions in the company given the sharp 75% share price increase, trimming in advance of the earnings report might make for sensible risk management purposes.

Our note today also includes the monthly Catalyst Report. We encourage you to look through this report – it is a listing of all of the companies that have reported a catalyst in the past month. These catalysts include new CEOs, activist activity, spin-offs and other possible game-changers. We source many of our feature recommendations from this list. You will find it nowhere else on Wall Street.

Reminder: The Cabot Turnaround Letter will be published with a one-week delay, on Wednesday, March 6, due to our vacation travels last week.

Comments on Earnings

Advance Auto Parts (AAP) – One of the four major auto parts retailers, Advance Auto continues to struggle as its aggressive acquisition spree overstretched its ability to operate efficiently. The board is finally taking aggressive action, including replacing its ineffective CEO with a more-capable leader, refreshing the board, undertaking a comprehensive operational and strategic review and slashing its dividend to preserve cash. We anticipate hearing significant details by early 2024. Debt is elevated but at fixed rates with no major maturities until 2026. Free cash flow is positive. The shares trade at a depressed multiple of depressed earnings.

Advance reported a sloppy quarter that reflected the company’s generally stable relevance to customers (flat revenues) and its dismal profit situation (a clean loss). However, guidance for 2024 was for continued revenue stability and much better earnings (roughly $4.00/share compared to $0.50 in 2023) that are above analysts’ dour forecasts. This better forecast, plus the encouraging comments and actions by the new CEO, pushed up the shares in Wednesday’s trading. Expectations are low for this turnaround, which continues to have fascinating potential.

The company continues to press, with urgency, for more discipline and accountability, as well as streamlined and smaller operations, helped by new CFO and chief accounting officer hires. Advance continues its process of searching for buyers for Worldpac and the Canadian operations. These exits make eminent sense but the challenge is to find a buyer willing to take them at a respectable price – a process that will take time yet is time-sensitive given the cyclical nature of the businesses.

The balance remains highly leveraged, but Advance is generating enough free cash flow to service the debt. Encouragingly, fourth-quarter free cash flow was $204 million, 25% above a year-ago. Full-year free cash flow was small at $44 million, but management guided to full-year 2024 free cash flow of a “minimum of $250 million.” As long as the company can maintain this amount of free cash flow until its profit turnaround is locked in, it will be readily able to survive.

In the quarter, revenues were flat and in-line with estimates. Net income, which had no adjustments, was a loss of $(0.59)/share, compared to a profit of $1.39 a year ago. Earnings sharply missed the consensus estimate for a $0.22 profit.

Berkshire Hathaway (BRK/B) – Recommended at the end of March 2020 in the depths of the market’s pandemic-driven sell-down, Berkshire Hathaway is an exceptionally well-managed financial and industrial conglomerate.

The company reported a strong quarter, with operating earnings of $8.5 billion increasing 28% from a year ago. A partial rebound in insurance underwriting profits and a boost in insurance investment income helped lift overall profits. Some of the increase was due to smaller foreign exchange losses. Full year operating profits of $37.4 billion were 21% above the 2022 profit.

The company repurchased $2.2 billion in shares in the fourth quarter even though one could reasonably argue that the shares are no bargain. Berkshire’s float of $169 billion, up $5 billion from a year ago, now comprises nearly 20% of the company’s $900 billion market value. All-in, the Berkshire machine continues to roll on. As always, we encourage shareholders to read Warren Buffett’s annual shareholder letter.

Dril-Quip (DRQ) – A major supplier of subsea equipment, Dril-Quip is struggling with the downturn in offshore oil and natural gas drilling. It generates positive free cash flow and has a sizeable cash balance yet no debt, all of which should allow it to endure until industry conditions improve.

The company reported a mixed quarter. Headline revenue growth looked strong but was less inspiring after removing the favorable effects of the Great North acquisition. Profit numbers similarly looked decent – but the company provided no data on the effects of the Great North acquisition so we have no way to separate out the underlying business performance. Management seems disingenuous on this matter, and we are further put off by its lack of year-over-year income statement comparisons. We are left to wonder whether management mis-reads the intelligence of its audience/shareholders or lacks understanding of the seasonal nature of its business. Neither is good.

Nevertheless, the business continues to grind forward. For 2024, management guided for a 15-20% increase in revenues and a roughly 50% increase in adjusted EBITDA. Capital spending will fall 40% to a more normal level after a jump in 2023. With higher profits and lower capital outlays, the company said it would be free cash flow positive (compared to the outflow of $25 million in 2023). The new order cycle seems to be building some momentum, which should move Dril-Quip’s profits and shares higher over time.

The balance sheet remains fortress-like with $217 million in cash and zero debt. Dril-Quip repurchased zero shares this past year. We want the company to move forward on share buybacks: If it is generating cash, it doesn’t need over $200 million on its balance sheet. Given the currently depressed share price, Dril-Quip could repurchase 14% of its shares using only half the cash balance. Without more color on its business acquisitions, we have no way of knowing if it can execute sensible deals, and our inclination is that any deals would be value-neutral.

In the quarter, revenues rose 31% and were 6% above estimates. Excluding the Great North acquisition, revenue growth was 10%. Adjusted earnings of $0.04/share fell 33%. Adjusted EBITDA of $16.5 million rose 61% but fell 3% shy of estimates.

Elanco Animal Health (ELAN) – Elanco is one of the world’s largest providers of pet and farm animal health products, ranging from flea and tick collars to prescriptions and farm animal nutritional supplements. Its share price has tumbled since our initial recommendation, weighed down by concerns over its Seresto flea and tick collar, lackluster new product roster and elevated debt. The shares have admittedly been a value trap – a falling share price but no change in valuation as earnings have tumbled. However, the company may finally be getting its act together: it has now fully integrated its Bayer Animal Health acquisition, has a promising new product pipeline and is seeing stabilization in its revenues, helped by price increases.

Elanco reported a mixed quarter and gave uninspiring guidance for 2024 that called for incremental revenue increases and essentially no EBITDA increase, implying a weaker profit margin. The company remains excessively in debt although $1 billion in proceeds from its pending Aqua business sale will help trim its leverage burden.

The company is relying on new products, and its strong Farm Animal franchise, to boost sales, as its Pet Health segment is struggling with weak Seresto and Advantage group products.

We view Elanco as having average management that is showing little urgency to fix its revenue, margin, working capital, research pipeline and debt problems. The competition is aggressive and Elanco will continue to lag until management steps up its game, or is replaced. We remain patient but even our patience has its limits. The increasing pressure provided by activist investor Ancora (2% ownership) is encouraging as it both exposes the lame management team and exerts pressure for change. Our 44 price target is aggressive given the sluggish pace for revenue and profit gains, the increased share count and weaker valuation multiple due to our dimmer view of management’s capabilities.

In the quarter, revenues rose 5% and were 3% above estimates. Adjusted earnings of $0.08/share fell 58% and were 20% below estimates. Adjusted EBITDA of $165 million fell 4% and was 3% below estimates.

Fidelity National Information Services (FIS) – Fidelity National provides technology and processing solutions that are critical to the operations of financial institutions and other companies. Fidelity has a long and convoluted history and was led by a growth-focused management with little interest in efficiency and durability, which left the company a poorly integrated sprawl of loosely related services unable to adapt to a changing marketplace. Changes are underway to finally move Fidelity in the right direction, including a board refresh and new executive leadership.

Fidelity reported a decent quarter and full-year 2024 guidance that showed that the turnaround, still in its early stages, is making progress. Results and 2024 guidance were subjected to considerable adjustments due to the sale of 55% of Worldpay, which closed last month. The company raised its share buyback program to $4.0 billion by year-end 2024 from $3.5 billion.

Guidance for 2024 calls for 4% revenue growth and roughly 30 basis points (or 0.3 percentage points) of EBITDA margin expansion which includes stranded Worldpay costs. The company raised its cost-savings targets. Per-share earnings guidance is for about 6% growth.

In the quarter, excluding the discontinued Worldpay operations, revenues rose 3% on an adjusted basis and were in-line with estimates. Adjusted net income of $0.94/share fell 4%. Adjusted EBITDA of $1.1 billion increased fractionally. There appears to be little consistency in earnings estimates regarding the treatment of the Worldpay exit, so we are uninterested in whether the company beat or missed these estimates.

Gannett (GCI) – Gannett, publisher of the USA Today and many local newspapers, is racing to replace its declining print circulation and ad revenues with digital revenues. It also is aggressively cutting costs to maintain its profits and help cut its expensive and elevated debt. The biggest challenge for Gannett is to overcome investors’ perception that the company is not viable.

Gannett reported a reasonable quarter. Given the turnaround’s long-term nature (measured in years) compared to Wall Street’s horizon (measured in quarters), we pay little regard to whether the company meets or misses consensus expectations. What we want to see is stable revenues, lower costs, and more free cash flow that goes to debt repayment. The company’s fourth quarter and full year results show continued incremental progress along these metrics. Gannett is a marginal company that investors view as a dead company. This mis-pricing will be resolved the slow way – through incrementally improving free cash flow that eventually will start to be paid to shareholders once the debt is whittled to respectable levels. The mis-pricing could be resolved the fast way – through a buyout – but we view this as unlikely for at least three years. Our $9 price target is overly aggressive given the business erosion, but we’ll leave it there for now.

In the quarter, revenues fell 8%. Print revenues, which are in secular decay as fewer people read paper versions, were responsible for nearly all of the $62 million decline in quarterly revenues. Print revenues (circulation and advertising) generated 54% of total revenues.

Digital revenues, which represent the future of Gannett and comprise 41% of total revenues, grew fractionally, or $7 million. Progress here is uneven due to the volatility of ad revenues, but the company is maintaining its relevance, as digital-only subscriptions rose 2% and average digital pricing rose 20%. Traffic to Gannett’s news sites rose 4%. The Digital Marketing Solutions business is producing incrementally positive growth.

Adjusted EBITDA fell 18%, as the $45 million decline (about 7%) in expenses wasn’t enough to offset the $62 million decline in revenues. Next to revenue stability, cost-cutting is Gannett’s most important performance metric. In essence, it needs to cut dollar costs faster than the decline in dollar revenues. We’ll grade the fourth quarter as a “B” on this metric.

Free cash flow was $13 million in the quarter, an encouraging improvement from the $(2) million outflow a year ago.

Full-year results show similar progress. The $281 million decline in revenues (about 10%) was entirely due to print revenue decay, as digital revenues rose by $11 million (about 1%). EBITDA expenses fell $292 million, more than offsetting the revenue decline such that EBITDA increased by $11 million. Free cash flow of $56 million improved from an outflow of $(5) million a year ago.

Total debt fell by $141 million, or about 11%. Grinding down this debt load sharply reduces Gannett’s risks and increases the value to shareholders (theoretically, debt reduction is a dollar-for-dollar increase in equity value).

Guidance for 2024 was encouraging, calling for about a 4% revenue decline, with higher EBITDA and free cash flow. We take this guidance with a grain of salt, as the company usually misses its full year guidance. Management provided an outlook for 2025 and 2026, offering 2% or so revenue growth and 30-40% growth in free cash flow. Hitting these metrics would do wonders for Gannett’s financial position and for investor sentiment. This outlook is no doubt contingent on overall economic growth, tame cost inflation and no acceleration in print revenue erosion.

The adjusted loss of $(18.2) million compared to $(41.0) million a year ago. Gannett’s fully diluted share count can vary widely due to the accounting treatment of shares related to its convertible notes, so we exclude per-share results in this quarter’s comparison. Adjusted EBITDA of $74.1 million fell 18%.

Macy’s (M) – Macy’s is aggressively overhauling its store base, cost structure and e-commerce strategy to adapt to the secular shift away from mall-based stores.

The company reported decent operating results which showed revenue stability, higher profits and healthy free cash flow. Guidance for 2024 was disappointing, however, calling for stable revenues but a 13% decline in adjusted EBITDA and a 24% decline in adjusted per share earnings. The weaker profit outlook is due to higher expected SG&A expenses, partly offset by higher gross margins. Free cash flow is likely to improve as interest expense and capital spending should be lower in 2024.

Macy’s is under increasing pressure from activists who want to either acquire the entire company or at least convince Macy’s to divest much of its immense real estate portfolio. Feeling the heat, the new CEO, Tony Spring, announced aggressive moves to overhaul Macy’s real estate base and further update its merchandising.

The company will close 150 of its namesake stores over the next three years, helping boost margins and monetize the underlying real estate. While the 150 Macy’s stores are 30% of the total company locations, they represent only 10% of total company sales. These stores are apparently only marginally profitable. Proceeds from the exits, including distribution center exits, should total over $600 million, which will be partly used to reduce the debt.

Macy’s will emphasize its remaining 350 stores, revitalize the merchandise assortment toward luxury (particularly at Bloomingdales and Blue Mercury) and private label goods as well as upgrade the online presence. The company will also realign its operations to boost efficiency. As a nod to returning more cash to shareholders, Macy’s raised its quarterly cash dividend by 5% to $0.1737/share.

Management said the net result should be a return to perhaps 2-3% sales growth and 5% EBITDA growth, with moderate capital spending, in fiscal 2025.

We like the step up in urgency but our enthusiasm is dampened by the weaker revenue and profit outlook. We would like to see management relent to an acquisition but we recognize this may be unlikely. No change to our rating on these undervalued shares.

Fourth quarter revenues were reasonably stable (-2%) but were helped by an extra week. Same store sales on a constant 13-week basis fell 4.2%, indicating incremental weakness. Credit card revenues fell 26% due to higher credit losses. Macy’s participates in the credit card profits, which in the current quarter fell due to higher charge-offs, but is not on the hook for the credit balances. Macy’s Media Network revenues, which is a somewhat new source of ad revenues, increased to $60 million – an impressive and creative inflow that helps offset the card revenue decline.

Profits increased as the gross margin expanded by 2.6 percentage points due to better merchandising, lower discounting and lower delivery costs. Overhead costs ticked lower in dollar terms due to cost-cutting but partly offset by higher wages.

In the quarter, revenues fell 2% but were in-line with estimates. Adjusted earnings of $2.45/share increased 30% and were 23% above estimates. Adjusted EBITDA of $1.2 billion rose 28% and was 18% above estimates.

Six Flags Entertainment (SIX) – This company is one of the world’s largest theme park operators. The shares have collapsed due to stalled growth, over-expansion and the pandemic. Following a complete changeover in the board of directors and senior leadership, Six Flags is implementing a new strategy focused on raising prices while significantly improving the guest experience to attract more families. Investors worry that this strategy will not be successful. We see an asymmetric payoff: the shares assume a dour future but a reasonable turnaround could produce sharp gains. Six Flags generates considerable free cash flow that will help reduce the company’s elevated debt. A long-time 20% shareholder provides valuable shareholder-oriented oversight to keep management properly focused.

Six Flags reported reasonable results in the seasonally weak fourth quarter. Higher attendance (+6%) was partly diluted by weaker per-guest spending (-1%), but the overall 5% increase in revenues was acceptable. Profits fell as many guests used seasonal passes, which provides discounts for tickets and in-park items like food and beverages – seasonal passes are good for boosting attendance but are less-helpful for profits. Also, operating costs rose due to higher wages, new tech innovations and general inflation.

Full-year 2023 results were generally similar to fourth quarter results (5% higher revenues, 9% higher attendance, 5% lower guest spending, flat EBITDA profits).

Net debt remains unchanged from a year ago. Free cash flow remains too low and was incrementally weaker due to the 47% increase in capital spending.

Overall, the company isn’t making any meaningful financial progress yet but seems to have made considerable operational upgrades which should help profits in the future. The pending acquisition of Cedar Fair is likely to close by the end of June. This deal should bring additional margin benefits at some point, as well.

Six Flags remains an early-stage work in progress.

In the quarter, revenues rose 5% but were 2% below estimates. Adjusted earnings of $0.05/share fell 85% and were well below the $0.28 estimate. Adjusted EBITDA of $98 million was unchanged but 2% above estimates.

Viatris (VTRS) – Viatris was formed in November 2020 through the merger of pharmaceutical generics producer Mylan, N.V. and Pfizer’s Upjohn division. Declining revenues, limited drug pipeline visibility, elevated debt, and a confusing change in strategy have continued to drag the shares lower since our initial recommendation. However, a new CEO along with increased visibility into its new strategy and better operational execution offer the potential for a fundamental turnaround and a higher share price.

Viatris reported a reasonable quarter that met management’s guidance but generally fell short of estimates. Guidance for 2024 was in-line with estimates. Overall, it appears that revenue trends have stabilized – an encouraging development following years of erosion. Management says that revenues should actually grow in 2024 (albeit a modest 2%), driven by new products that should bring wider profit margins. For a company like Viatris, simply shifting the growth valence from “negative” to “positive,” even if fractionally, can be a game-changer for investor sentiment. Confidence in this shift was a major driver behind the 50% jump in the share price since last November. The turnaround has a long way to go, the shares remain undervalued and we are leaving our rating unchanged.

The company is arguably in much better hands under the new CEO, but there still are too many moving parts for us to get a clear picture of the endgame. This clarity may happen by the end of 2024, as the remaining divestitures will be completed by mid-year such that management and numbers will hopefully delineate a post-divestiture picture.

Creating less clarity is Viatris’ collaboration with biotech firm Idorsia now and possibly others later. Viatris is paying Idorsia $350 million in upfront cash, more later as milestones are met, to get decent rights to two in-development drugs. These drugs may be “blockbusters” as management says, or they may be busts.

Free cash flow is improving and being used, at the margin, to chip away at Viatris’ excessive debt burden. Also, the company is repurchasing shares, now with an increased buyback authorization of $1 billion.

In the quarter, revenues rose 1% on a “divestiture-adjusted operational basis” but were 1% below estimates. Adjusted earnings of $0.62/share fell 7% and were 5% below estimates. Adjusted EBITDA of $1.1 billion fell 8% and were 8% below estimates. On a “divestiture-adjusted operational basis” the EBITDA fell only 5%.

Viatris’ adjustments are extensive. The GAAP loss of $(766) million was magically converted into a non-GAAP profit of $747 million through over $1.5 billion of adjustments. While much of these adjustments were for impairments, gains and amortization, others were for litigation costs, deal-related costs and restructuring costs. We view “adjusted earnings” more like “ideal situation earnings” as they remove unpredictable and possibly one-time costs but ignore the normal profit vagaries of running a business. Viatris won’t get full credit for its profits until, at a minimum, it stops scrubbing its numbers so much.

Warner Bros. Discovery (WBD) – Warner Brothers Discovery is a global media company with a vast portfolio of properties including the Warner Brothers film studio, HBO, the Discovery Channel, The Learning Channel and CNN. Investors worry about the integration risks and enormous debt burden that accompanied its acquisition of the Warner Media operations from AT&T. Other concerns include Discovery’s streaming challenges and the secular erosion in its network segment. Acknowledging these issues, we see an investment primarily as a turnaround of the Warner Media assets within a stable and profitable Discovery business, led by an aggressive, determined and highly focused CEO. Legacy Warner Brothers is healthy and profitable and produces a large and growing stream of cash flow, buying it time for a turnaround while capably servicing its elevated debt.

The company reported a reasonable quarter. However, commentary on 2024 was almost non-existent while CEO David Zaslav didn’t swear off acquisitions, sending the shares lower, along with estimates. The company subsequently said it halted merger talks with Paramount. The most valuable guidance, as it distills all other guidance into one key metric, is that free cash flow would be robust again. Commentary on the new three-way sports app partnership was generally uninformative. All-in, the story remains on track with some edginess on our part regarding the revenue and profit flow-through picture.

Streaming subscriber totals rose 1% from a year ago and 2% from the third quarter, but domestic totals fell 4% from a year ago and 1% from the third quarter. This trend bears watching as it is a key barometer of streaming segment health. The fourth quarter decay was reasonable, given the shifts in the company’s app and the 7% price increase, but we expect the company to adjust to stabilize the subscriber count. Streaming, or technically DTC, or direct-to-consumer, EBITDA was nearly break-even in the quarter, and was positive for the full year at $103 million. Management re-affirmed its guide for $1 billion in 2025 DTC profits.

Overall revenues slipped 5% due to the Hollywood strikes, some one-off big deals a year ago, slippage in ad revenue and cable subscription fees and the exit from the AT&T SportsNet business. Ad revenues are exceptionally high-margin, so weakness here weighs on earnings more than other types of revenue declines. We want to see stability in this line item but expect further weakness due to the secular decay of cable viewing and some overall ad market sloppiness. Expenses fell 18%, or $1.6 billion, reflecting the intense cost-cutting program. However, EBITDA fell 5% as cost-cuts weren’t enough to offset the decline in revenues.

Total debt fell by $5.4 billion, or about 11%, due to paydowns during the year. Most of the full-year free cash flow of $6.2 billion (up 86% compared to 2023) went toward debt repayment. Overall, the company is delivering on its free cash flow and debt paydown goals – a critical component of the Warner Bros Discovery thesis.

In the quarter, revenues fell 7% and were 1% below estimates. Adjusted EBITDA of $2.5 billion fell 5% and was 11% below estimates.

Friday, March 1, 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 16 minutes and covers:

• Comments on earnings
• Comments on recommended companies
  
  • General Electric (GE) – filed its registration statements for the spin-off
  • Newell Brands (NWL) – changes to board of directors
  • Walgreens Boots Alliance (WBA) – booted out of Dow Jones Industrial Average
  • Capital One Financial (COF) – huge deal to acquire Discover Financial Services
  • Vodafone (VOD) – reaches tentative deal to sell its Italy operations.

Please know that I personally own shares of all Cabot Turnaround Letter recommended stocks, including the stocks mentioned in this note.

The Catalyst Report

February featured a high number of CEO changes, along with several acquisitions and a few spin-off announcements. Cabot Turnaround Letter names Mattel (MAT) and Elanco Animal Health (ELAN) had fresh activist involvement.

The Catalyst Report is a proprietary monthly report that is unique on Wall Street. It is an extensive listing of companies that have experienced a recent strategic event, such as new leadership, a spin-off transaction, interest from an activist investor, emergence from bankruptcy, and others. An effective catalyst can jump-start a struggling company toward a more prosperous future.

This list is intended to be comprehensive. While not all catalysts are meaningful, some can bring much-needed positive changes to out-of-favor companies.

One highly effective way to use this tool is to pair the names with weak stocks. Combining these two traits can generate a short list of high-potential turnaround investment candidates. The spreadsheet indicates these companies with an asterisk (*), some of which are highlighted below. Market caps reflect current market prices.

The following catalyst-driven stocks look interesting:

Emergent Biosolutions (EBS) $166 million market cap – This life sciences company makes a form of the anti-opioid drug Narcan, along with small-pox vaccines and other unusual treatments. Several operational stumbles debilitated the company and it now teeters on bankruptcy. But the surprise arrival of Joseph Papa as CEO brings either a strong chance of a turnaround or a prelude to a bankruptcy filing. Either way, this story is worth watching.

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Mercury Systems (MRCY) $1.8 billion market cap – This defense technology company has struggled in recent years and its shares have tumbled to late-2016 levels. However, respected activist investor JANA Partners took a stake in 2021, gained a board seat and made leadership changes. What is interesting is that JANA recently raised its stake to 11% on further share price weakness, indicating confidence in Mercury’s fundamentals.

Disclosure: The chief analyst of the Cabot Turnaround Letter personally holds shares of every 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. Please feel free to share your ideas and suggestions for the podcast and the letter with an email to either me at bruce@cabotwealth.com or to our friendly customer support team at support@cabotwealth.com. Due to the time and space limits we may not be able to cover every topic, but we will work to cover as much as possible or respond by email.

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