July 1, 2022

This week’s Friday Update includes a summary of the recent Cabot Turnaround Letter and comments on earnings from Walgreens Boots Alliance (WBA). There were no ratings changes. We also summarize the podcast and include The Catalyst Report.

We encourage you to look through The Catalyst Report. It includes a listing of all companies that have reported a catalyst in the past month, including 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.

On Wednesday, we published the July edition of the Cabot Turnaround Letter. We provided our mid-year stock market update, where the 17% loss year-to-date for the S&P 500 is proving that our 5% gain estimate offered last year end was wildly optimistic. The selloff is, of course, widespread, with only the energy sector showing positive returns. The top stock in the S&P 500, Occidental Petroleum (+98%), was more than double ExxonMobil’s +42% gain. Netflix fell 68% and lost $226 billion of market value.

We provide a brief tour of value/growth, small-cap and international markets. We also discuss how the outlook for the rest of the year is unpredictable but doesn’t look very good right now due to earnings risk and likely more interest rate hikes. Fortunately, the market’s broad valuation is actually slightly below its long-term average. We end with a suggestion that it is probably time for value investors to start selectively using their cash reserves to buy more beaten-down stocks with real value.

Our call to avoid high-yield bonds at the end of last year was spot-on. We’re not high-yield bond market savants, but when year-end bonds were priced for perfection and were paired with near-perfect conditions, there was only one reasonable call to make: down. Subsequently, high-yield bond returns were dismal, down 13%. Today, the lower price and higher yield makes these bonds more attractive, but not highly attractive. Private investors have the luxury of being very patient until conditions become highly attractive. Read our commentary for more color.

Our feature recommendation this month is a recent spin-off: ESAB Corporation (ESAB). This old-line company is a fully modernized producer of a niche industrial product – welding and cutting tools. Management is solid, profits and cash flow are healthy, the competitive environment is quite favorable and the balance sheet is reasonably sturdy. We are just a bit wary of the connected asbestos liabilities but believe this risk is readily manageable. ESAB shares trade at a low valuation, and it appears investors are overlooking this gem.

Check out our letter for all the details on each of these articles.

Earnings Update
Walgreens Boots Alliance (WBA) – Once a retail pharmacy powerhouse, Walgreens faces hefty secular challenges from an overbuilt and mature store base, with customers who have plenty of alternatives to visiting its often poorly run and expensively priced stores. And, pricing pressure from private and government payors is squeezing its prescription profit margin. Walgreens is concentrating on the United States market where it is developing its stores into a healthcare network, led by the much-needed fresh perspective from the new CEO. The company’s shares are bargain priced even as Walgreen’s is in solid financial condition and produces large and stable profits and cash flow.

Walgreens reported a sloppy quarter with many adjustments and many moving parts, including no longer having Covid-driven sales and store traffic tailwinds. Adjusted earnings of $0.96/share fell 30% but were 3 cents above the consensus estimate. Revenues fell 4% but were fractionally above estimates. The company maintained its full-year/fourth-quarter per share earnings guidance. The shares continue to slide but now yield nearly 5% that looks readily supportable.

Overall, the core business continues to grind along at a modestly positive pace, the Boots U.K. business is doing relatively well, and the healthcare initiatives continue to make progress. The company doesn’t appear to have an inventory problem.

Revenue from continuing operations fell 4%. The strong dollar weighed on growth, as local currency sales fell 3%. The AllianceRx Walgreens mail-order/specialty pharma business dragged total sales down by 7 percentage points. Operating profits after many large adjustments fell 35% from a year ago.

U.S. segment sales fell 7%, due entirely to an 11% decline at AllianceRx Walgreens. Comparable sales rose about 2%. The adjusted operating profit fell 34%, partly due to strong Covid-related results a year ago. International sales rose 9% on a local-currency basis, as Boots’ U.K. sales rose 14% and German wholesale business sales rose 7%. Adjusted International operating profits on a local currency basis rose to $174 million, more than double the year-ago results. Walgreens Health segment sales rose 65% on a pro forma basis but operating losses fell to $(129) million compared to $(17) million a year ago.

The company recorded $1.3 billion of earnings adjustments, including the Florida opioid settlement, acquisition-related amortization charges and transformation-related charges. Some of these are (hopefully) one-off, especially the opioid settlement, but we found nearly a quarter of the total to be recurring. These adjustments are generous (but all too common) as the company wants to paper over the costs of its transformation strategy. Nevertheless, this issue is worth watching closely for abuse.

Free cash flow for the quarter was $1.3 billion, down 13% from a year ago due to lower post-Covid profits, higher healthcare spending and larger losses from the AllianceRx business. The balance sheet remains solid but is expanding as the company continues its acquisition program. While the company reports large adjusted profits, it’s important to remember that it generates cash through real profits, which need to improve to fund the healthcare initiatives.

Strategic initiatives update
Walgreens announced earlier this week that it is not selling Boots, its U.K. retail pharmacy business. The underlying reason: no buyer was willing to pay enough. The company didn’t disclose the size of the offers, but perhaps Boots’ reasonably strong third-quarter results (which Walgreens knew and perhaps disclosed to the buyers) tipped the negotiating power back to Walgreens. Once the capital markets settle down, with more clarity on valuation and more-accessible deal financing, we anticipate that Walgreens will listen to new bids.

Walgreens Health, which encompasses their initiative to transition the company from its mature retail business into a health care hub, continues its expansion. The losses from this business continue to expand as well.

The company sold 6 million shares of its Amerisource Bergen stake, raising $900 million.

Friday, July 1, 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 10½ minutes and covers:

• Comments on other recommended companies:
  
  • Walgreens Boots Alliance (WBA) – Sale of U.K.-based Boots making progress, but price may be disappointing.
  • M/I Homes (MHO) – complicated environment but we believe a 2008-style meltdown is highly unlikely.
  • Toshiba (TOSYY) – Reuters reports a possible ¥7,000/share bid – that is roughly $26/ADR. Lots of turmoil in front of shareholder meeting next week.
  • Wells Fargo (WFC) – Passed their annual stress test, likely leading to share buybacks.
  • Credit Suisse (CS) – Company hosts Deep Dive next week. We believe bank’s survival hinges on complete replacement of leadership.

• Elsewhere in the market:
  
  • Kellogg’s (K) announces a soggy but perhaps necessary split-up.
  • The new “Tax Belt”?

The Catalyst Report
June was an active month for catalysts, led by 20 CEO changes. With the end of the Covid stimulus tailwind and tighter capital markets along with rising recession risks, we anticipate that the number of CEO changes will remain elevated. Also, Revlon filed for bankruptcy in what we anticipate will be the beginning of a rising tide of failures.

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:

Banco Santander SA (SAN) $47.7 billion market cap – This bank is the largest in Spain. It has been undermanaged for years, and its botched hiring of a prior CEO further tainted its reputation. However, the new CEO appears highly capable and is well regarded, so perhaps a turnaround will develop. The shares trade at 60% of tangible book value and 5.1x earnings, so expectations are low.

Fresenius Medical Care (FMS) $14.6 billion market cap
– The world’s largest kidney dialysis firm is struggling mightily with changing U.S. government reimbursement rates and other issues. But the service is literally lifesaving, the shares have been hit 50% and now trade at 2007 prices, and an outsider has stepped in as CEO to help get this trainwreck back on track.

Xerox Corporation (XRX) $2.3 billion market cap
– Shares of this Cabot Turnaround Letter recommended company continue to slide as the weak return-to-office trend is jamming its prospects. The unexpected and sad news about the CEO’s passing may lead major shareholder and activist Carl Icahn to push for a value-boosting sale.

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.

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

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.