January 28, 2022

This week’s Friday Update includes our comments on earnings from Altria Group (MO), Credit Suisse (CS), General Electric (GE), Polaris (PII), Western Digital (WDC) and Xerox Holdings (XRX).

Next week, Vodafone (VOD), Nokia (NOK), Shell (RDS/B), Elanco (ELAN) and Adient (ADNT) report earnings.

On Wednesday, we published the February edition of the Cabot Turnaround Letter. We comment on high-quality yet beaten down small-cap stocks and highlight Circor Intl (CIR), DistributionNOW (DNOW), Marcus Corp (MCS) and Unifi Corp (UFI). Initial public offerings were hot and now are not – we discuss three quality companies trading below their IPO price, including Krispy Kreme (DNUT), Petco Health & Wellness Company (WOOF) and Weber (WEBR).

Our feature recommendation is Polaris (PII). The company is the leading North American manufacturer of powersports equipment including off-road vehicles, snowmobiles, boats and other gear. Investors worry about stalling revenues, which we believe is unwarranted, have led to a bargain for longer-term investors. Polaris has an outstanding brand reputation, high-quality management, is producing strong cash flow and backed by a solid balance sheet.

Given the market’s recent volatility, which has dragged the S&P500 down 9.5% year-to-date through yesterday, we provide a brief update on our portfolio’s performance. As measured by average price change for all of the stocks, our recommended list of stocks has declined about 0.5% over the same period.

We had no price target or ratings changes this past week. We note that Marathon Oil (MRO) is trading above our 18 price target so this stock is under review.

Check out this month’s Catalyst Report. This covers every catalyst for companies in our universe, including CEO changes, new activist campaigns, spin-offs and other strategic changes. Our feature recommendations frequently first appeared on the Catalyst Report.

Earnings updates:
Altria Group (MO) – Altria is the largest seller of cigarettes in the U.S., with a 48% market share. Its Marlboro brand by itself has a 43% market share. Non-U.S. operations were separated years ago into Philip Morris International. The company has struggled with declining cigarette volumes, slow development of non-combustible products and its disastrous $12.8 billion JUUL investment. Other issues: possible new regulations on menthol cigarettes and nicotine content, an IQUS import ban, and the market’s focus on ESG-favored companies. However, Altria’s resilience and value is underestimated by investors. Led by a new CEO, the company continues to generate stable/rising earnings and cash flow, even as it develops new non-combustible products. Altria returns about 80% of its free cash flow to investors, including a generous dividend.

Altria reported mildly encouraging fourth-quarter results. Revenues of $5.1 billion rose fractionally compared to a year ago and were about 1% above estimates. Adjusted earnings of $1.09/share rose 10% from a year ago and were a cent above estimates. Guidance for 2022 is for between $4.79 and $4.93 in earnings per share – the midpoint of $4.86 is 2 cents above the consensus estimate of $4.84. Compared to 2021’s earnings of $4.61, this growth would be just over 5%. For Altria, almost any increase is good, given that it is a cash flow story.

Altria won’t likely become much of a growth company, even with its investments in non-combustible tobacco. Its on! brand of oral nicotine pouches continues to grow its market share of the oral tobacco market (now 3.9% from 1.1% a year ago), but its revenues are tiny. Its EQUS heated tobacco product has zero revenues following a government import ban. The JUUL device is highly controversial and not likely to be a driver of growth. All-in, these products remain side-shows within Altria despite their being highlighted as the company’s future.

Cigarettes and to a lesser extent moist tobacco (including Copenhagen) drive the company’s present and future. The business model is that slow declines in cigarette consumption in the industry – which returned to its trend of slipping 6% in full-year 2021 – are offset by higher pricing. In the fourth quarter, Altria’s cigarette revenues rose 2.3% despite a 5.9% slippage in volumes. Cigarette segment profits rose 5%. For the full year, Altria’s smokable product revenues rose 1% and segment profits rose 3%.

Moist tobacco product revenues rose 5% in the fourth quarter, while segment profits fell 5%. Higher operating and marketing costs and unfavorable mix more than offset higher pricing. This segment generally produces sluggish but steady revenues and profits for Altria.

Looking forward, premium cigarette volumes will likely continue to slip and pricing may be a tad harder to realize, as consumers are feeling pressure from rising gasoline, food and other costs. However, Altria seems to have built this into their guidance, providing encouragement that it can continue to generate large free cash flows.

In 2021, Altria returned $8.1 billion in cash to investors even as reduced its net debt by $1 billion. We don’t expect quite this strong of result in 2022, but anything close is good enough for our thesis.

Credit Suisse (CS) – This Swiss bank never recovered from the Global Financial Crisis, so it is shifting its strategy to more stable Switzerland banking and global investment management and away from weak/volatile trading and investment banking. The bank is struggling with chronic bad decision-making and a loose risk-control culture that could threaten its existence if not aggressively addressed.

The bank pre-announced disappointing fourth-quarter earnings, saying that it will produce break-even results. A larger-than-expected slowdown in the investment banking business (due to slowing activity) and weaker Wealth Management results were behind the disappointing news. As Credit Suisse reins in its overly aggressive culture, it will likely continue to lose business. The bank is also taking sizeable litigation charges – we see these as a positive as the bank is putting more of its problems behind it. Importantly, the bank said its capital base will remain above its 14% target. Complete results will be reported on February 10.

General Electric (GE) – Led by impressive new CEO Lawrence Culp, GE finally appears to be righting its previously severely damaged business. Key priorities include a primary focus on the Industrial businesses (and an exit from the financial businesses), much better execution and a strategic emphasis on cash flow and debt reduction. To help achieve its goals, GE is decentralizing its operations and pushing more responsibility and accountability down to each business line.

GE reported reasonably encouraging fourth-quarter results as its protracted turnaround continues to make progress. While organic revenues fell 3%, adjusted earnings per share rose 67%, and free cash flow was $3.8 billion. Guidance for 2022 points to more than 5% revenue growth, about 50% earnings per share growth and as much as $6.5 billion in free cash flow. Short-term investors appear to have been disappointed which led to a modest selloff in the shares.

GE is clearly making progress. It attributed some of the revenue weakness to supply chain disruptions, but orders were weak in its renewables segment due to a lack of clarity about critical tax subsidies. The efficiency programs led to a 2.8 percentage point expansion in its profit margin.

As GE Capital and other troublesome operations are now much smaller, GE has consolidated its unwieldy “three-column” reporting into “one-column.” This unfortunately creates lack of clarity and some confusion about which numbers are the right “adjusted” numbers. We would like GE to continue to break out the three-column data in its disclosures.

The company will host an Investor Update on March 10, where it will highlight its upcoming split into three companies: Aviation, Health, and Energy.

Polaris (PII) – Shares of this high-quality and market leading manufacturer of powersports equipment like off-road vehicles, snowmobiles, motorcycles and boats, have fallen out of favor with investors. Major concerns include the risk of a post-stimulus falloff in demand as well as supply chain disruptions that are weighing on margins by 3-4 percentage points. We believe the company’s long-term prospects remain intact. Polaris produces strong profits and free cash flow, has a solid balance sheet, and a strong, shareholder-friendly management team.

Newly recommended Polaris reported strong fourth-quarter results and provided encouraging and above-consensus 2022 guidance. As anticipated, the quarter showed minimal incremental progress with the supply chain and other manufacturing-related issues, so the shares moved little on the news.

In the quarter, revenues rose 1% to $2.2 billion from a year ago, and were fractionally ahead of the consensus estimate. Adjusted earnings of $2.16/share fell 35% from a year ago but were 6% above estimates. For 2022, Polaris guided to sales growth of 12% to 15%, and adjusted net income growth of 11% to 14%. Hitting these numbers would indicate that the recovery is on track.

Flat revenues were largely due to supply chain and component shortages. End-market sales by distributors and dealers fell 20-30% depending on the category. Polaris books revenues when it sells equipment to distributors and dealers, which have independent businesses. End-market sales are being crimped by lack of equipment on the showroom floor, even as Polaris books sales by shipping to distributors and dealers. Investors worry that the slow retail sales are foreshadowing a more permanent slowdown in customer demand, which would eventually work its way back to Polaris’ revenues. International sales and accessories sales were strong.

Pre-sold orders as a percent of total retail sales declined to 60% from 75% last quarter, indicating some progress with delivering equipment to showrooms. Historically, pre-sold orders have been near zero. North American dealer inventories remain 70% below their pre-pandemic levels.

Overall profits fell from a year ago primarily due to 19% lower gross profits. As a manufacturing company, Polaris’ gross profits are the driver of overall profits as marketing, research and other admin costs are largely fixed. Component shortages, production snarls and higher costs were only partly offset by higher selling prices. We anticipate that these issues will weigh on Polaris for a few more quarters.

Adjusted net income fell by $77 million, helped mostly by lower tax expense as various tax credits and other items were utilized.

Polaris generated about $140 million in operating cash flow – an improvement as it was able to trim its huge inventory, but it chose to pay suppliers with the incremental cash. The company repurchased an additional $50 million in shares during the quarter, funded by additional borrowing.

Polaris hosts its Analyst Day on February 24, which should provide more color on its new product initiatives and its revenue and gross margin progress.

Western Digital (WDC) – Western’s 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. The company generates free cash flow and holds plenty of cash to buy time for the turnaround and to help pay down its elevated debt.

Western Digital reported strong fiscal-second-quarter results but provided disappointing fiscal-third-quarter guidance so the shares fell sharply in the after-market. Revenues rose 23% (in line with consensus estimates) and earnings of $2.30/share were sharply higher than $0.69 a year ago (about 8% above consensus estimates). Next-quarter guidance for revenues of $4.45-$4.65 billion fell 3% short of the consensus while guidance for earnings of $1.50-$1.80 fell 15% short of the consensus. Also, Western announced the change-over in the CFO office.

The company is making major fundamental progress. On year-over-year comparisons, its primary metric improved significantly – revenues (+23%), gross margins (expanded 7.2 percentage points to 33.6%), profits (adjusted net income +242% to $724 million), free cash flow (up +173%, to $407 million) and debt balance (down $1.4 billion or 16%). Western is producing strong revenue growth, is much more profitable, and cutting its sizeable debt burden.

Even the “disappointing” guidance points to a strong fiscal third quarter: revenues would be up 15% from the year-ago period and earnings would be 89% from the year ago period. But in a jittery market where stocks go up on good guidance and down on bad guidance, investors dumped Western shares.

Western said that its hard disk drive business was weaker than anticipated due to supply chain and component shortage issues that have impeded its ability to deliver products. Also, its customers are having their own supply chain issues, which has delayed their orders of Western’s drives. Also, its NAND outlook calls for weaker pricing in the near term. We note that competitor Seagate seems to be making headway despite their component issues so we wonder if there is anything else going on. Western was reasonably optimistic about the latter part of 2022 and into 2023. It is difficult to separate all of these issues from the outside, so we will remain vigilant.

The CFO’s departure seems like a positive. In the most recent proxy statement, on page 6 of the slide deck, the entire executive leadership team, except for the CFO, was either new since CEO Goeckeler’s arrival or highlighted as a valuable team member. The CFO apparently wasn’t working out, which happens, so a replacement is necessary. But, it still creates disruption and offers a hint of frustration on the CEO’s part with Western’s progress. The incoming CFO looks very capable with deep industry experience, so we would see this as an upgrade.

So, with the company becoming more profitable and stronger while the stock is trading around $48-$49/share, down 9% in the after-market, we like the shares more than we did yesterday. Western shares are about 25% above our cost.

Xerox Holdings (XRX) – While the near-term outlook remains clouded, as office workers remain in partial work-from-home mode, we believe the company’s revenue and cash flow will recover. 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 reasonable fourth-quarter results, with revenues down 8% from a year ago and were about 2% below estimates. Adjusted earnings of $0.34/share fell 41% from a year ago but were about 13% above estimates.

While investors generally were disappointed with the results, sending the shares down about 5% in a weak market, we found the results to be generally uninteresting. About the only item worth noting is that sales of mid-range and high-end new equipment remained weak, down perhaps 30% from a year ago. But, we find this isn’t surprising as the return-to-office trends were mixed at best in the quarter. Sales of smaller equipment as well as paper, supplies, services and other items reflective of daily usage were generally flat/positive.

When looking at full-year results, we see the same thing: not a lot is changing in any of the company’s financial statements. The past year (2021) was, pardon the pun, basically a copy of 2020. The only significant differences were the large $781 million goodwill impairment this year (of minimal interest to us), the $888 million share repurchase this year compared to $300 million repurchase last year (of immense interest to us) and the increase of about $100 million in free cash flow generation this year (also of immense interest to us).

The market wants Xerox to become a growth story. It never will be a growth story. It is a cash flow story. We would be welcome higher revenues, of course, as this would boost their cash flows. We like their efficiency programs – this boosts cash flows as well. If there is one trait that Xerox has demonstrated over the years, regardless of who seems to run it, it is cash flow generation.

The other trait we like (a lot) is that Xerox is carving out several segments (Xerox Financial Services, Palo Alto Research Center, among others) with what we believe are precursors to divestiture or other monetizing deals. We look forward to the Xerox Investor Day in February, which likely will feature more details on these.

Friday, January 28, 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 14 minutes and covers:

• Summary of this month’s Cabot Turnaround Letter
• Brief commentary on earnings reports
• Comments on other recommended companies:
  
  • Mattel (MAT) – wins back Disney Princess and Frozen franchises.
  • Molson Coors (TAP) – wins another (bigger) joint venture with Coca-Cola.

Catalyst Report
January was a quiet month for catalysts. There were only seven notable activist campaigns, perhaps due to the market’s volatility. The Blackwells/Peloton campaign was noteworthy for the lack of restraint in the activist’s rationale for why the CEO should be sacked.

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 here.

The following catalyst-driven stocks look interesting:

CIRCOR International (CIR) $537 million market cap – CIRCOR is a producer of severe service flow control and other precision equipment. Its eight-year CEO was just fired, following enduring weak stock performance and a series of CFO departures. The CFO situation is murky, but major positive changes may be forthcoming.

Unilever plc (UL) $132 billion market cap – The shares haven’t gone anywhere for almost five years, and severely lagged the broad market for well over a decade. Activist Trian Partners now has a stake. Trian’s stake in Procter & Gamble years ago led to major improvements in that company’s fundamentals and share performance, so maybe this will be the start of a turnaround at Unilever.

Intl Flavors & Fragrances (IFF) $34 billion market cap – IFF shares have flatlined for nearly seven years, and the hoped-for catalyst from buying DuPont’s Nutrition & Biosciences operations didn’t work very well. Activist Carl Icahn has now taken a 4% stake, and the company brought in a senior executive at Merck to be the new CEO. The shares aren’t particularly cheap but could perk up if earnings improve.

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

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.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.

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.