March 8, 2024

In today’s note, we discuss the recent earnings reports from Bayer AG (BAYRY), Duluth Holdings (DLTH) and LB Foster (FSTR).

We are moving shares of LB Foster from a BUY to a SELL. The turnaround continues to grind forward, but the stock has moved above our 23 price target and we see little reason to increase it. The likelihood of the company reaching its 2025 guidance is fairly high, so the only upside would be from earning a higher valuation multiple. We’ll take our certain profit today instead of letting it ride on the possibility of more profits in the future, balanced by the possibility of a backward slide. The shares have generated a 79% return since our July 2023 recommendation.

In this month’s edition of the Cabot Turnaround Letter, we offer a tonic for a momentum-intoxicated stock market that will eventually develop a hangover. Energy stocks remain out of favor, but oil prices remain resilient, which is allowing energy companies to generate immense free cash flow. In some cases, energy companies are on track to distribute to shareholders the equivalent of their entire market cap over the next five to six years. We highlight Chesapeake Energy (CHK), Marathon Oil (MRO), Occidental Petroleum (OXY), Ovintiv (OVV), Sitio Royalties (STR) and W&T Offshore (WTI).

Our Buy recommendation this month, VF Corporation (VFC), is a major producer of apparel and accessories. The shares of this former market darling have collapsed 83%, but an unusual selection as the new CEO is undertaking a complete overhaul of the company.

Comments on Earnings

Bayer AG (BAYRY) – Bayer is a major German crop science, pharmaceutical and consumer health products conglomerate. Weak leadership led to underperforming operations and the disastrous $63 billion deal for Monsanto in 2018 which brought major liabilities amid allegations that glyphosate, the active chemical in Roundup, causes cancer. Other worries include litigation risk from PCBs, glyphosate pricing pressure, and upcoming patent expirations on Xarelto and Eylea, its two largest pharmaceuticals. However, the company is significantly undervalued, despite the legal issues, with sizeable and stable profits and cash flow. The new outsider CEO should bring stronger operational execution and perhaps major strategic changes (break-up). The balance sheet carries a reasonable debt burden.

Bayer reported a strong quarter, with encouraging revenue growth and strong profit increases. Guidance for 2024 was uninspiring as it called for only 1-4% revenue growth and a 1% decline in adjusted EBITDA. The Consumer Health segment remains strong, the Crop Science segment continues to suffer from pricing pressure, and the Pharma segment has a weak pipeline that is weighing on near-term and long-term profits. Net debt increased and free cash flow was strong in the fourth quarter but did not make up for decay in the first three quarters of the year.

In the quarter, revenues (organic) rose 6% and were 1% above estimates. Adjusted earnings of €1.85/share rose 37% and 31% above estimates. Adjusted EBITDA of $3.0 billion rose 23% and was 33% above estimates. Full-year results, however, were markedly weaker almost across the board.

All-in, tangible progress remains murky but the turnaround is in the ugly and early stages. No change to our rating.

Bayer’s new leadership is playing the long game. We’re fine with that, but apparently no one else is. The shares slid this week as new CEO Bill Anderson said that the company won’t pursue a split-up for now, but rather will focus on fixing its current businesses and paying down debt. “For now” means the next 2-3 years. We have essentially no doubt that a break-up will happen eventually. But the segments need to be revitalized first. Bayer’s culture and internals are apparently awful – slow, bureaucratic, risk-averse and expensive. This is not a surprising position for a stodgy, poorly run European conglomerate formerly led by empire-builders. Bayer’s elevated debt isn’t surprising, for the same reason.

The company also has leaks from litigation losses related to its Roundup crop treatment that remain unplugged – and from the legal bills to defend itself. We conservatively estimate these legal bills alone – extra in-house lawyers, outside lawyers, an army of staff and a pile of related expenses – at $50 million a year which might equate to $500 million (half a billion) in capitalized value, or about 2% of the company’s market value.

Anderson is shifting the company to a decentralized teams approach, a process now underway but that will take the rest of the year, or probably longer, to be fully rolled out. It will likely take another year for these teams to start functioning at a higher performance level.

This turnaround is complicated but the overall strategy is sound. The greatest risk comes from the Roundup litigation, as hefty payouts to claimants could financially cripple the company. The next greatest risk is some unexpected deterioration in the Consumer Health segment, as this is the cash flow engine that keeps the rest of the company afloat until the Pharma and Crop Science segments turn around. Selling the Consumer Health unit now might assuage shareholders but could threaten the entire turnaround effort. The third risk is from the patent cliff that threatens the profitability of the Pharma segment. All three of these risks are sizeable, hence the share price burndown.

We remain patient given the low valuation, credible turnaround effort now underway and the pending arrival of credible activist investor Jeff Ubben (ValueAct) to the board.

Duluth Holdings (DLTH) – This retailer of rugged workwear and outdoor gear struggled with a disjointed and overly aggressive store expansion strategy. Duluth ousted the CEO in September 2019, terminated the failed strategy, and hired a new, permanent CEO in May 2021. The founder continues to be a major shareholder. Duluth has immense opportunities – its challenge is to strike a successful balance between pursuit and execution.

Duluth reported a mixed quarter. Revenue growth was incrementally positive, suggesting that the brand is retaining its relevance. The gross margin shrank as Duluth had to discount its merchandise to sell it. Overhead costs fell 4% on lower advertising costs and as the benefits of its new fulfillment center started to make an impact. Sales grew despite the lower ad spending – a positive sign in our view. The massive, newly built fulfillment center is up and running, so Duluth will not only see better customer service and lower overhead costs, but also its capital spending will be cut in half to about $25 million in 2024 from $55 million in 2023.

The 2024 guidance was for flat sales but for 27% higher EBITDA. Duluth has struggled to meet its profit guidance in the past so we will take the current guidance with a grain of salt, but are encouraged that the guidance is moving in the right direction.

The balance sheet is reasonably healthy with net cash at $5 million, excluding the $26 million of TRI debt that we classify as having zero net economic impact on Duluth. Inventories look lean and the company is managing its working capital better, which helped limit the size of the free cash flow drain to about $(10) million in 2023 from $(28) million in 2022.

From an investment perspective, Duluth is in no-man’s land. Its turnaround is finally but ever-so-slowly making some progress under the new leadership, the core fundamentals appear to have stabilized and the shares are highly out of favor at 3.6x estimated 2024 EBITDA. But, the company’s ability to execute, and its long-term relevance to consumers, is unclear at best. Our 20 price target is probably unreachable but if the company can reasonably deliver in 2024 the shares could readily double. So, we will patiently sit on our position.

In the quarter, revenues rose 2% and were 1% above estimates. Earnings of $0.21/share fell 9% and were 22% below estimates. Adjusted EBITDA of $21 million rose about 1% but was 15% below estimates.

LB Foster (FSTR) – After years of weak share price performance, this small-cap manufacturing and distribution company, with a focus on railroad industry products and precast concrete structures, is undergoing a strategic overhaul. A new leadership team, refreshed board and a halt to its previously steady stream of acquisitions and divestitures are allowing the company to emphasize improving its operating efficiency and trimming its unwieldy debt burden. This slow-moving turnaround seems to be on the right track but the stock market hasn’t recognized this yet.

Foster reported a mixed quarter, with stronger sales (organic) but weaker profits (down 18%) and orders (down 16% organic). The gross margin expanded 2 percentage points, helped by divestitures, volume and pricing. Overhead costs rose but this was partly due to one-offs. Guidance for 2024 is for flat sales but an incremental profit increase over 2023. Management reiterated their 2025 goal of $600 million in sales and $50 million in EBITDA. Debt net of cash fell by an impressive 40% as essentially all of Foster’s free cash flow went to debt paydown.

Full-year results showed much progress over 2022 results, but the directional weakness in the fourth quarter weighs on our optimism.

In the quarter, sales fell 2% but were 6% above estimates. Adjusted for divestitures, sales rose 8%. The net loss of $(0.04)/share compared to a profit of roughly $0.11 (the company provided no adjustments despite considerable one-time charges) and was 1 cent below estimates. Adjusted EBITDA, a cleaner measure of underlying profit, fell 18% but was 27% above estimates.

As mentioned in our opening comments, we are moving shares of L.B. Foster from Buy to Sell.

Friday, March 8, 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 13 minutes and covers:

• Comments on earnings
• Comments on recommended companies
  
  • General Electric (GE) – encouraging updates on upcoming GE Power and GE Vernova spin-offs.
  • Macy’s (M) – bidders raise offer to $28/share.
  • Western Digital (WDC) – separation making progress.
  • Walgreens Boots Alliance (WBA) – won’t be selling its Shields Healthcare Solutions segment anytime soon.
  • Agnico Eagle Mining (AEM) – gold approaching $2,200/ounce.
  • Xerox Holdings (XRX) – shares fall on news of not-great terms for its convertible and senior note offerings.
  • Western Union (WU) – expands relationship with Visa.

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

Portfolio

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.

Copyright © 2024. All rights reserved. Copying or electronic transmission of this information without permission is a violation of copyright law. For the protection of our subscribers, copyright violations will result in immediate termination of all subscriptions without refund. Disclosures: Cabot Wealth Network exists to serve you, our readers. We derive 100% of our revenue, or close to it, from selling subscriptions to our 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. Employees of Cabot Wealth Network may own some of the stocks recommended by our advisory 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. Buy/Sell Recommendations: are made in regular issues, updates, or alerts by email and on the private subscriber website. Subscribers agree to adhere to all terms and conditions which can be found on CabotWealth.com and are subject to change. Violations will result in termination of all subscriptions without refund in addition to any civil and criminal penalties available under the law.