February 25, 2022

This week’s Friday Update includes our comments on earnings from Dril-Quip (DRQ), Elanco (ELAN), Gannett (GCI), Macy’s (M), Molson Coors (TAP), Kaman (KAMN) and Vistra Energy (VST). Berkshire Hathaway (BRK/B) reports tomorrow. As Kaman and Vistra reported this morning, our comments are brief and we will have more detailed analyses in our next Friday edition.

Next week brings earning from Viatris (VTRS).

This past week we published the March edition of the Cabot Turnaround Letter. In what could easily be a low-return market over the coming decade (ask us about our math behind this view), stocks of relatively boring companies have a better chance to shine. We highlight five companies with grind-it-out growth, low share valuations and often-generous dividends that could produce significant market-beating returns.

We also discuss six appealing stocks we found by trolling through the 13F/D filings of like-minded institutional investors.

Our featured recommendation this month is Goodyear Tire & Rubber Company (GT). An investment in Goodyear is an opportunistic purchase of an average company whose shares have fallen sharply out of favor for what look like short-term reasons. Volumes look poised to recover as drivers return to the roads. Pricing continues to more than offset higher raw materials, labor, transportation and other costs – but pricing risk is perhaps investors’ biggest worry. The company is getting valuable cost savings from its recent acquisition of Cooper Tire as well as from other efficiency initiatives. Goodyear shares fell 27% (creating our Buy window) on news that it won’t generate any free cash flow in 2022, but this is due largely to a one-time inventory build and elevated capital spending. Goodyear has $1 billion in cash, reasonable debt and trades at a depressed 4.5x EBITDA. We have set a 24.50 price target on GT shares.

Also included in this week’s note is the Catalyst Report. We encourage you to look through this listing, which is found nowhere else on Wall Street. Many of our featured ideas first appear on the report’s pages.

As a reminder, there will be no weekly update next Friday, March 4, as we will be traveling for the entire week.

Earnings updates:
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 reasonable quarter, but its outlook and changes announced by the new CEO were more encouraging.

In the quarter, revenues fell 6% and were about 6% light compared to estimates for a flat quarter. Adjusted EBITDA of $0.6 million fell 85% from a year ago and was sharply lower than estimates for a 44% increase. The depression in offshore drilling continues to pressure revenues and profits. Also, Dril-Quip incurred some one-time severance, incentive compensation and (hopefully one-time) bad debt expenses that weighed on profits.

The outlook is improving on two fronts. First, the order book has bottomed and is now turning up. Fourth-quarter orders were nearly $80 million, well-above prior company guidance for $40-60 million, and the company said it expects orders to increase 20% in 2022. High oil and natural gas prices are restoring incentives to drill in offshore environments.

Second, the company appears to be stepping up its game. The new CEO introduced initiatives to boost the company’s overall efficiency and effectiveness – an important step beyond just cutting costs – by splitting operations into three segments compared to the previous unitary functional structure. This should boost accountability and also lay the groundwork for either divesting a segment or expanding/emphasizing one or two.

From a capital perspective, Dril-Quip is sharpening its capital allocation plans, addressing a huge frustration on our part. The company has a small market value so small changes, like their plan to sell $40-60 million (or $1.43/share) in excess real estate, can make a big difference. Also, they repurchased 1.1 million shares in the fourth quarter and plan on more repurchases. The company will use some of its cash for internal projects and acquisitions (which we hope will be used effectively). Dril-Quip carries $356 million in cash, equal to $10/share, and no debt. We’d like to see them use at least $100 million of this to repurchase shares.

All-in, the company is tracking our price target model but it will still be a year or more before Dril-Quip can produce the kind of results that would convince investors to bid up the stock. We will remain patient.

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, prescription treatments and farm animal nutritional supplements. Following its September 2018 IPO at $24 as part of its spin-off from pharmaceutical giant Eli Lilly, Elanco shares have been lackluster, due to weak revenue growth, high expenses and an uninspiring new product pipeline. Veteran activist investor Sachem Head recently gained a board seat, likely leading to an upturn in the company’s execution and driving its undervalued shares higher. The August 2020 acquisition of Bayer Animal Health offers additional opportunities for improved results.

Elanco reported an encouraging quarter. Revenues fell 2% from a year ago but were roughly flat excluding currency changes. Revenues were in line with consensus estimates. Adjusted earnings of $0.21/share rose 75% and were about 24% above estimates. EBITDA of $212 million increased 20% and was about 3% better than consensus estimates. Guidance for 2022 revenues, EBITDA and earnings per share were in line with estimates. The shares responded well as the results and guidance confirmed that fundamentals are improving for the company.

Helping profits in the quarter: sales of higher-margin products, improvements in manufacturing efficiency, and various productivity initiatives that restrained overhead and research spending. Overall, the company is making progress with its new product development, but there is more yet to be done.

Reasonably strong free cash flow is helping the company reduce its unwieldy $6.4 billion in debt following its Bayer Animal Health acquisition. Year-end net debt/EBITDA fell to 5.5x and the company is targeting 4.75x at year-end 2022.

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 weak quarter and the shares fell on a volatile, war-driven trading day. Revenues fell 6% and were about 2% below the consensus estimate. Adjusted EBITDA of $115 million fell 23% and was about 17% below the consensus estimate.

Revenues were held back by secular print headwinds although Digital Marketing Solutions revenues rose 6%. Lower publishing margins, due to weaker print revenues, higher raw materials and labor costs, and higher development spending weighed on profits.

Gannett is a free cash flow story. The company fell short of our model for 2021 (we were about a year too early with our estimates) but spoke of stronger free cash flow in 2022 and beyond. The company will continue to whittle away at its debt even as it spends more – both in its operations and with capital spending – to invest in its digital products and operations. Even at the elevated spending, the company said it will generate about $170 million of free cash flow. At this level, the company would be able to fund more debt repayments as well as part of its new $100 million share repurchase program. For perspective, if it repurchased all $100 million today, Gannett could retire 13% of its shares.

We discount management’s guidance as the business model is in transition while the competitive environment is intense and rapidly evolving. However, the margin for safety is wide enough, in our view, that the company could underperform its guidance yet still make for a strong stock.

Macy’s (M) – With a capable new CEO since February 2018, Macy’s is aggressively overhauling its store base, cost structure and ecommerce strategy to adapt to the secular shift away from mall-based stores. Its sizeable debt is not crippling the company but remains an overhang. Macy’s was hit hard by the pandemic, setting back its turnaround from a financial perspective, but the company’s acceleration of its overhaul shows considerable promise.

Macy’s reported a strong fourth quarter and remains on track with our model. We are retaining our Hold rating for now. This is a “true” Hold – the shares are worth keeping but not quite appealing enough to merit a Buy rating at this point.

In the quarter, revenues rose 28% and were about 3% above consensus estimates. Adjusted earnings of $2.45/share were sharply higher than $0.80 a year ago and about 23% above consensus estimates. Adjusted EBITDA of $1.2 billion rose 58% from one year ago and 8% from pre-pandemic 2019.

Macy’s appears to be successfully transitioning to modern retailing: e-commerce seems to be making good progress, with digital penetration rising to 39% of sales; Macy’s use of tech to improve its merchandising and marketing is helping bolster margins and bring in new customers; the increasingly automated supply chain is improving deliveries while reducing costs and inventory.

Macy’s is a cash flow story, and on this trait it is delivering. For the year, free cash flow was $2.3 billion – a huge sum compared to its $7.7 billion market value, particularly considering the toll taken by the pandemic and Macy’s mall-based structure. The company has used its cash to cut its previously lofty debt burden (net of cash) in half over the past year, re-initiate and raise its dividend, and repurchase 6.5% of its shares. Macy’s credit rating could return to investment grade this year – quite an accomplishment for a company that was nearly given “last rites” in 2020.

Can Macy’s continue to generate this amount of cash? Not likely, as there were a few significant one-time boosts in 2021 including CARES Act tax refunds and as it plans on much higher capital spending (by 66%) over each of the next three years. And, pandemic-driven demand and competitive conditions were favorable but won’t be fully replicated in the future.

For 2022, the company guided to flattish sales but narrower EBITDA margins compared due to narrow gross margins. It appears that Macy’s growth and profits will flatten out and could be at a relatively permanent plateau – at least until its e-commerce business becomes large enough to carry the overall company and as long as consumer spending and competitive conditions remain healthy (it is murky as to whether these will continue).

Based on the company’s guidance, Macy’s will produce around $1.1 billion of free cash flow in 2022. While less than half of the unusually large $2.3 billion last year, this is still a generous 14% of the company’s market value. Another way to consider it: the $1.1 billion is about $3.60/share that accrues directly to shareholders. The company will continue to chip away at its debt while paying out more to shareholders through dividends and share repurchases.

The company said it is targeting between $3.2 billion and $3.6 billion in free cash flow over the next three years – plenty generous enough to keep us interested, acknowledging the risks that a recession or further mall-shopping erosion would significantly chip away at its cash flow.

It was mildly disappointing but not surprising that Macy’s will not be splitting off its e-commerce business. However, the company said it would accelerate its e-commerce initiatives – sensible in our view.

Macy’s shares have pulled back nearly 40% from their split-up peak – frustrating to us but we are keeping our position in M shares due to their still-low valuation and healthy fundamental outlook.

Molson Coors Beverage Company (TAP) – Molson Coors is struggling with weak growth yet is working under a new CEO to more aggressively develop specialty/higher-end beverages and reduce its reliance on mainstream and value offerings. Also, the company is increasingly focusing on its cost structure. Molson Coors continues to trade at a discount to its peers and its fundamental prospects.

Molson Coors reported a good quarter and remains on track with/fractionally ahead of our $69 price target assumptions.

In the quarter, revenues rose 14% and were about 3% above the consensus estimate. Adjusted earnings of $0.81/share more than doubled from a weak year-ago profit but fell about 6% shy of estimates. The $457 million in adjusted EBITDA rose 22% yet also fell about 5% below estimates.

The company is recovering from the pandemic slowdown in beer consumption, particularly as sales outside of the Americas rose 57% compared to a year ago. In those regions, volumes rose 21% (including contract brewing for third-party brands) as consumers returned to pubs and other drinking establishments and paid 17% higher per-unit prices. Consumers also traded up to higher-priced Molson beverages, further boosting revenues. Globally, sales rose 14%, helped by 7% volume gains and 4% price increases. EBITDA profits rose 22%, as rising input costs were more than offset by price increases, and as overhead costs were restrained to only a 3% increase.

For full-year 2021, the company’s strong fourth quarter was able to offset much of the weakness earlier in the year: sales increased 5% as higher prices (+4%) and favorable mix offset flattish volumes. Free cash flow was $1.1 billion.

Looking into 2022, the company is optimistic that it can continue to incrementally increase its sales about 5%, lift its profits by perhaps 8%, and generate around $1.0 billion in free cash flow. This $1 billion has been and will likely continue to be a steady-state outcome for Molson – seemingly no matter how good or bad profits are, it generates this amount of cash. The company is remarkably stable in this regard and provides us with the confidence to ride through periods of weak stock performance. From here, it is only a matter of the broad market joining us in that confidence and lifting the stock to our $69 target.

Molson raised its dividend by 12%, producing an appealing 3% dividend yield.

Kaman Corporation (KAMN) – Based in Connecticut, Kaman is a high-quality defense and aerospace company. A reconfigured board along with a new CEO and several other new senior executives are prioritizing Kaman’s high-value precision engineering operations and are emphasizing higher margins and shareholder returns while exiting/de-emphasizing the company’s lower value businesses. The company is profitable, and its sturdy balance sheet provides a solid foundation.

Kaman reported a mixed quarter and outlook, with revenues declining 5% and missing the consensus estimate for roughly flat sales. Adjusted earnings of $0.48/share rose 17% from a year ago and were about 7% above the consensus. Adjusted EBITDA of $24 million rose 37% but was slightly below the $25 million estimate.

The company is seeing continued incremental new sales to Boeing and Airbus and other aviation markets, but mixed trends in the medical and industrial products group as well as weakness in its JPF revenues. The balance sheet showed incremental improvement.

Its 2022 outlook is for 3% sales growth yet slightly weaker profits and cash flow. Kaman is in the early stage of its turnaround, and based on our preliminary review, it remains on track. We will have a more complete analysis in our next Friday update.

Vistra Corporation (VST) – spun off from then-bankrupt Energy Future Holdings in 2016, Vistra is the nation’s largest independent electricity producer. The merchant electricity business can be highly risky, but Vistra is led by a solid management team, has strong internal risk controls in place, has a sturdy-enough balance sheet and produces generous free cash flow. Vistra’s long-term strategy is appealing: it is migrating to a vertically integrated business model that provides it with end-customers who consume the energy that it produces. This greatly reduces its overall risk while maintaining its attractive profit margins. The shares trade at a discounted valuation and offer an attractive dividend yield.

Vistra reported a reasonable quarter with adjusted EBITDA rising 45% from a year ago although this was about 3% below estimates. Strength in Retail profits lifted overall results. The company provided an encouraging 2022 outlook for a 57% increase in profits. Vistra continued its commitment to shareholders by repurchasing shares and raising its dividend by 13%. Based on our preliminary review, Vistra’s turnaround remains on track, and we will have a more complete analysis in our next Friday update.

Friday, February 25, 2022 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 18 minutes and covers:

• Brief commentary on earnings reports.
• Comments on other recommended companies:
  
  • General Electric (GE) – said that the first two quarters of the year will be weaker than they previously thought.
  • Conduent (CNDT) – renewed an important contract.
  • Polaris (PII) – reaffirmed its 2022 guidance and highlighted its five-year financial targets.
  • Berkshire Hathaway (BRK/B) – reports on Saturday.

• Elsewhere in the Market:
  
  • War in Europe: wide range of possible outcomes.

Catalyst Report
February was a strong month for deals, with several large acquisitions including Intel for Tower Semi, the $13 billion private equity buyout of Citrix Systems and the small deal with a huge premium (100%) paid by Apollo Group for Tenneco. Activists were busy, as well.

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.

You can access our Catalyst Report

.

The following catalyst-driven stocks look interesting:

AT&T (T) $167 billion market cap
– This company is in the process of breaking up. There are many moving parts, but the shares continue to slip, paving an easier path to a 50% gain at some point.

Guess (GES) $1.4 billion market cap – Shares of this iconic company have seen a lot of volatility since 2006, but they haven’t made any progress. Activist investor Legion Partners now holds a 2.2% stake and is pressing for the removal of the two founding brothers from the board, as well as other strategic and operating changes. The shares are cheap, and the brand still carries immense cache overseas.

Newpark Resources (NR) $318 million market cap – This Houston, Texas oilfield services company has struggled for a long time due to the drilling industry’s depression and perhaps some mismanagement. Private investor Bradley Radoff (formerly of Dan Loeb’s Third Point hedge fund) holds a 5.5% stake and recently won at least one board seat in his efforts to boost the company’s prospects.

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

Market cap is as-of the Initial Recommendation date. Current status indicates the rating and Price Target in ( ). Prices are closing prices as-of date indicated, except for those indicated by a "*", which are price as-of SELL recommendation date.

Please feel free to share your ideas and suggestions for the podcast 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 limit we may not be able to cover every topic each week, but we will work to cover as much as possible or respond by email.

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.