January 17, 2023

No One Wants to Be Those Sellers

For many of your value stocks on the recommended list, the New Year’s rebound continues. Most of these shares were heavily over-sold late last year. Almost given up for dead, shares of Organon (OGN) have surged 38% since hitting an all-time low in mid-October. Similarly, shares of Barrick Gold (GOLD) are up over 43% since their nadir in November.

For value investors, a label often prefaced with “long-suffering,” these kinds of rebounds illustrate the importance of following valuations and fundamentals, not price trends. For Barrick, 58 million shares were traded on its low-price day, and over 2 million shares of Organon were sold on its low-price day. No one wants to be those sellers.

From here, we will continue to monitor, and if necessary, adjust our price targets. Several stocks are getting close: Comcast (CMCSA), Dow (DOW), Allison Transmission (ALSN) and Gates Industrial (GTES). Most of these names are high quality, rather than merely cyclical, and may readily be worthy of a higher target, but we’re hesitant to make changes this close to their respective earnings reports. We work to balance the risk of a disastrous near-term earnings report with the company’s healthy long-term fundamentals. While selling at the bottom is painful, not selling so close to a price target can be equally painful. No one wants to be those non-sellers.

Share prices in the table reflect Tuesday, January 17 closing prices. Please note that prices in the discussion below are based on mid-day January 17 prices.

Note to new subscribers: You can find additional color on our thesis, recent earnings reports and other news on recommended companies in prior editions of the Cabot Undervalued Stocks Advisor, particularly the monthly edition, on the Cabot website.

Send questions and comments to Bruce@CabotWealth.com.

Today’s Portfolio Changes

None

Last Week’s Portfolio Changes

None

Upcoming earnings reports

State Street Corporation (STT) – Friday, January 20

Sensata Technologies (ST) – Tuesday, January 31

Gates Industrial Corporation (GTES) – Monday, February 13

Barrick Gold (GOLD) – Monday, February 13

GROWTH/INCOME PORTFOLIO

Cisco Systems (CSCO) is facing revenue pressure as customers migrate to the cloud and thus need less of Cisco’s equipment and one-stop-shop services. Cisco’s prospects are starting to improve under a relatively new CEO, who is shifting Cisco toward a software and subscription model and is rolling out new products, helped by its strong reputation and entrenched position within its customers’ infrastructure. The company is highly profitable, generates vast cash flow (which it returns to shareholders through dividends and buybacks) and has a very strong balance sheet.

There was no significant company-specific news in the past week.

CSCO shares slipped 1% for the week and have 37% upside to our 66 price target. The valuation is attractive at 9.2x EV/EBITDA and 13.6x earnings per share. The 3.2% dividend yield adds to the appeal of this stock. BUY.

Comcast Corporation (CMCSA) – With $120 billion in revenues, Comcast is one of the world’s largest media and entertainment companies. Its properties include Comcast cable television, NBCUniversal (movie studios, theme parks, NBC, Telemundo and Peacock), and Sky media. The Roberts family holds a near-controlling stake in Comcast. Comcast shares have tumbled due to worry about cyclical and secular declines in advertising revenues and a secular decline in cable subscriptions as consumers shift toward streaming services, as well as rising programming costs and incremental competitive pressure as phone companies upgrade their fiber networks.

However, Comcast is a well-run, solidly profitable and stable company that will likely continue to successfully fend off intense competition while increasing its revenues and profits, as it has for decades. The company generates immense free cash flow which is more than enough to support its reasonable debt level, pay a generous dividend (recently raised 8%) and sizeable share buybacks.

Chatter is increasing about the possibility that Comcast will divest its Sky unit. The Britain-based satellite operation provides TV, mobile phone and internet service to 23 million customers in six countries (U.K., Italy, Germany, Austria, Ireland and Switzerland). Sky is Europe’s leading sports broadcaster and is home to Premier League Football and Formula 1 auto racing.

Comcast paid a sharply overpriced $40 billion for this asset (about 15x EBITDA) during a complex takeover battle in 2018 when Disney was bidding for 21^st Century Fox. Today, the business is probably worth about $15 billion, based on EBITDA of about $2.1 billion and a multiple of about 7x. Profits have slid from $3 billion in 2019 due to aggressive competition and cord-cutting. Reflecting the mistake, Comcast took an $8.6 billion charge last October. A divestiture doesn’t appear to be imminent, however, as change happens slowly at Comcast and as Sky is an integral component of its European operations.

Part of the value of Sky is that it provides Comcast with a global streaming platform. Sky is rolling out its Peacock streaming service gradually, launching it in Europe first on a country-by-country basis to consumers who may have no idea what Peacock is or offers. This roll-out differs from, say, what Netflix can do. The Netflix brand is widely known around the world, allowing the company to almost instantly gain a sizeable market share upon entering a new country.

Comcast shares rose 2% in the past week and have 8% upside to our 42 price target. The shares offer an attractive 2.8% dividend yield. BUY

Dow Inc. (DOW) is the world’s largest producer of ethylene and polyethylene, the most widely used plastics. Investors undervalue Dow’s hefty cash flows and sturdy balance sheet largely due to its uninspiring secular growth traits, its cyclicality and concern that management will squander its resources. The shares are driven by: 1) commodity plastics prices, which are often correlated with oil prices and global growth, along with competitors’ production volumes; 2) volume sold, largely driven by global economic conditions, and 3) ongoing efficiency improvements (a never-ending quest of all commodity companies). Recent concerns about a recession have send Dow shares to well-below our estimate of their fair value, even as the company’s long-term prospects and ability to maintain its dividend are attractive. Dow shares are a recommended Buy in our sister publication the Cabot Turnaround Letter.

There was no significant company-specific news in the past week.

Dow shares rose 2% in the past week and have jumped 14% year-to-date. The stock has 4% upside to our 60 price target (same as in the Cabot Turnaround Letter). After a long slog since this name was originally recommended in April 2019, before the current analyst arrived, the Dow investment is finally showing a profit relative to our cost.

The quarterly dividend appears readily sustainable and provides an appealing 4.9% yield. The shares trade at a reasonable 7.5x EV/EBITDA multiple and 13.1x EPS on recession-minded 2023 estimates.

We are retaining our Buy rating for now, but given the small upside to our price target, we are putting the rating under review. BUY

State Street Corporation (STT) – State Street is the world’s largest custodian bank, with $38 trillion in assets under custody/administration. About 56% of its revenues are produced from custody, client reporting, electronic trading and full enterprise solutions services for investment managers. The balance is produced from investment management fees on ETFs, foreign exchange fees, securities financing fees and net interest income. The industry has combined into four dominant firms due to economies of scale. State Street’s shares are out of favor and unchanged since 2007 due to concerns over its anemic growth and steady pricing pressure from competitors. However, we see State Street as a solid, well-capitalized franchise that provides critical services, with a slow-growth but steady revenue and earnings stream. Our interest in STT shares is that we can buy them at an attractive valuation. We also find the dividend yield appealing.

State Street reports earnings on Friday, January 20, with a consensus earnings estimate of $1.96/share.

State Street shares rose 2% in the past week and have 13% upside to our 94 price target. The company’s dividend (3.0% yield) is well-supported and backed by management’s strong commitment. BUY

BUY LOW OPPORTUNITIES PORTFOLIO

Allison Transmission Holdings, Inc. (ALSN) – Allison Transmission is a midcap manufacturer of vehicle transmissions. While many investors view this company as a low-margin producer of car and light truck transmissions that is destined for obscurity in an electric vehicle world, Allison actually produces no car or light truck transmissions. Rather, it focuses on the school bus and Class 6-8 heavy-duty truck categories, where it holds an 80% market share. Its EBITDA margin is sharply higher than its competitors and on par with many specialty manufacturers. And, it is a leading producer and innovator in electric axles which all electric trucks will require. The company generates considerable free cash flow and has a low-debt balance sheet. Its capable leadership team keeps its shareholders in mind, as the company has reduced its share count by 38% in the past five years.

There was no significant company-specific news in the past week.

ALSN shares rose 1% in the past week and have 11% upside to our 48 price target. The stock pays a respectable and sustainable 1.9% dividend yield. BUY

Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc, hired as CEO in July 2020, is revitalizing Aviva’s core U.K., Ireland and Canada operations following her divestiture of other global businesses. The company now has excess capital which it is returning to shareholders as likely hefty dividends following a sizeable share repurchase program. We expect that activist investor Cevian Capital, which holds a 5.2% stake, will keep pressuring the company to maintain shareholder-friendly actions.

There was no significant company-specific news in the past week.

Aviva shares fell 3% in the past week and have 30% upside to our 14 price target. Based on management’s estimated dividend for 2023, the shares offer a generous 7.0% yield. BUY

Barrick Gold (GOLD), based in Toronto, is one of the world’s largest and highest-quality gold mining companies. About 50% of its production comes from North America, with the balance from Africa/Middle East (32%) and Latin America/Asia Pacific (18%). Barrick will continue to improve its operating performance (led by its highly capable CEO), generate strong free cash flow at current gold prices, and return much of that free cash flow to investors while making minor but sensible acquisitions. Also, Barrick shares offer optionality – if the unusual economic and fiscal conditions drive up the price of gold, Barrick’s shares will rise with it. Given their attractive valuation, the shares don’t need this second (optionality) point to work – it offers extra upside. Barrick’s balance sheet has nearly zero debt net of cash. Major risks include the possibility of a decline in gold prices, production problems at its mines, a major acquisition and/or an expropriation of one or more of its mines.

Barrick reported fourth-quarter gold production that rose 13% from the third quarter, but this was about 1% below the guided volume, leading to a modest sell-off in the shares. Meeting production guidance is an indicator of management’s credibility and grip on its operations. While Barrick’s “miss” was modest, it suggests that the gold mining operations are not performing to management’s expectations, which implies either that management was caught off-guard or that some trait in its production profile made the target unachievable. We don’t see this quarter’s miss as a problem as long as it was a one-off miss.

Over the past week, commodity gold lifted 2% to 1,910/ounce. Since late October, the gold price has lifted 17%. The 10-year Treasury yield ticked down to 3.53% while the U.S. Dollar Index (the dollar and gold usually move in opposite directions), fell 1% to 102.48. The dollar has fallen 10% from its high of 114.10 this past September 26.

Investors and commentators offer a wide range of outlooks for the economy, interest rates and inflation. We have our views but hold these as more of a general framework than a high-conviction posture. Investing in gold-related equities is a long-term decision – investors shouldn’t allow near-term weakness to deter their resolve.

Barrick shares fell 3% in the past week but have surged 43% since bottoming at $13.10 on November 3. The stock has 43% upside to our 27 price target. BUY

Big Lots (BIG) – Big Lots is a discount general merchandise retailer based in Columbus, Ohio, with 1,431 stores across 47 states. Its stores offer an assortment of furniture, hard and soft home goods, apparel, electronics, food and consumables as well as seasonal merchandise. Our initial case for Big Lots rested with its loyal and growing base of 22 million rewards members, its appeal to bargain-seeking customers, the relatively stable (albeit low) cash operating profit margin, its positive free cash flow, debt-free balance sheet and low share valuation. Our thesis was deeply rattled by the company’s surprisingly large inventory glut in the first quarter 2022, likely burdening it with new and permanent debt.

There was no significant company-specific news in the past week.

Big Lots shares remain high-risk due to the permanent debt balance and the likelihood of a suspension of the dividend.

We reiterate our view that Big Lots shareholders who are not willing or able to sustain further losses in the shares should sell now. There is no reasonably definable floor to a stock like Big Lots when fundamentals and valuation are ignored while investors reduce their risk exposure.

Big Lots shares fell 5% this past week but have gained 20% year-to-date. The stock has 42% upside to our revised 25 price target. The shares offer a 6.8% dividend yield, although, as noted, investors should not rely on this dividend being sustained. HOLD

Citigroup (C) – Citi is one of the world’s largest banks, with over $2.4 trillion in assets. The bank’s weak compliance and risk-management culture led to Citi’s disastrous and humiliating experience in the 2009 global financial crisis, which required an enormous government bailout. The successor CEO, Michael Corbat, navigated the bank through the post-crisis period to a position of reasonable stability. Unfinished, though, is the project to restore Citi to a highly profitable banking company, which is the task of new CEO Jane Fraser.

Citigroup reported bland fourth-quarter results. Earnings (excluding the effect of divestitures) were $1.10/share, which fell 45% from a year ago and was about 8% below the $1.19 consensus estimate. Revenues (excluding the effect of divestitures) rose 5% from a year ago and were about 1% above estimates.

Rising interest rates helped boost net interest income, but this was more than offset by higher credit costs and elevated transformation and other expenses. Citi’s already-healthy capital strength increased further. Overall, nearly two years into CEO Jane Fraser’s term, the bank is making progress with its turnaround. But, given the paltry 5.5% return on tangible equity compared to its medium-term goal of 11-12%, the bank has a long way to go.

In the quarter, net interest income rose 23% from a year ago, as the net interest margin expanded to 2.39% from 1.98% a year ago. Partly offsetting the higher margin, loans balances fell 2%. However, excluding to-be-divested Legacy businesses, loans grew 2%. Fee income fell 27% (ex-divestitures): better trading profits were more than offset by weaker asset management and investment banking fees.

Operating expenses rose 5% (ex-divestitures), which we find disappointing as we would like these to remain flat given all of the efficiency improvements underway. However, we recognize that with most turnarounds, expenses increase as the company spends on new staffing, software and other upgrades before it removes older costs, creating an expensive but temporary redundancy. This appears to be where Citi is today.

Credit costs surged to $1.8 billion compared to a negative ($465 million) a year ago. We view this sharp reversal as a return to more normal credit costs. Loan losses increased 36% but impressively were still below 0.2% of average loans. Non-accruing loans also remain low. The bank increased its reserves by a reasonable $593 million, compared to the unusual post-pandemic $1.2 billion reduction a year ago. Total reserves are now 2.6% of total loans, a size we consider healthy. In the credit card segment, reserves are 7.6% of these loans, also robust even as the economy slows. For perspective, the credit card portfolio is about 23% of total loans – indicating that this bucket is a sizeable driver of Citi’s growth and profits.

Citi’s capital of 13.0% (using the CET1 ratio) is sturdy, particularly when combined with its 2.6% credit reserves. However, despite this strength, the bank has no immediate plans to repurchase shares given the macro and market exit uncertainties.

For 2023, the bank expects revenues to increase 5%, coming almost entirely from higher fee income as it anticipates minimal improvement in net interest income. Expenses will increase 7%, with credit costs continuing to normalize (increase). Overall, 2023 will likely be an uninspiring year for profit improvement at Citigroup. We see stronger results in 2024, as the benefits of the turnaround become clearer. Exits of the legacy businesses in Mexico, Asia, Russia and Poland are underway and likely to be mostly done by year’s end or so.

With the shares trading at only 61% of the $81.65/share tangible book value, we have plenty of patience to wait.

This past week, the yield spread between the 90-day T-bill and the 10-year Treasury bond, which approximates the drivers behind Citi’s net interest margin, widened incrementally to negative 109 basis points (100 basis points in one percentage point). This spread is the widest since at least the early 1980s. Our interpretation is that investors are assuming that the Fed rate hikes and other macro drivers will drag inflation down to sub-5% or less this year. Given that the inflation metrics are flattening out or declining (inflation over the past four or five months has been tame at sub-3%), this assumption seems reasonable.

Citi shares trade at 61% of tangible book value and 8.0x estimated 2023 earnings. The remarkably low valuations assume an unrealistically dim future for Citi.

Citi shares rose 4% in the past week and have 69% upside to our 85 price target. Citigroup investors enjoy a 4.1% dividend yield. We anticipate that the bank is done with share buybacks until there is more clarity on the economic and capital market outlook, which could readily be a year or more away. BUY

Gates Industrial Corp, plc (GTES) – Gates is a specialized producer of industrial drive belts and tubing. While this niche might sound unimpressive, Gates has become a leading global manufacturer by producing premium and innovative products. Its customers depend on heavy-duty vehicles, robots, production and warehouse machines and other equipment to operate without fail, so the belts and hydraulic tubing that power these must be exceptionally reliable. Few buyers would balk at a reasonable price premium on a small-priced part from Gates if it means their million-dollar equipment keeps running. Even in automobiles, which comprise roughly 43% of its revenues, Gates’ belts are nearly industry-standard for their reliability and value. Helping provide revenue stability, over 60% of its sales are for replacements. Gates is well-positioned to prosper in an electric vehicle world, as its average content per EV, which require water pumps and other thermal management components for the battery and inverters, is likely to be considerably higher than its average content per gas-powered vehicle.

The company produces wide EBITDA margins, has a reasonable debt balance and generates considerable free cash flow. The management is high-quality. In 2014, private equity firm Blackstone acquired Gates and significantly improved its product line-up and quality, operating efficiency, culture and financial performance. Gates completed its IPO in 2018, with Blackstone retaining a 63% stake today.

There was no significant company-specific news in the past week.

GTES shares were flat in the past week and have 11% upside to our 14 price target. At the current price and based on estimated 2022 results, the shares offer a 10% free cash flow yield (free cash flow divided by market cap). This is a discount to what the company is worth. BUY

Molson Coors Beverage Company (TAP) is one of the world’s largest beverage companies, producing the highly recognized Coors, Molson, Miller and Blue Moon brands as well as numerous local, craft and specialty beers. About two-thirds of its revenues come from the United States, where it holds a 24% market share. Investors worry about Molson Coors’ lack of revenue growth due to its relatively limited offerings of fast-growing hard seltzers and other trendier beverages. Our thesis for this company is straightforward – a reasonably stable company whose shares sell at an overly discounted price. Its revenues are resilient, it produces generous cash flow and is reducing its debt. A new CEO is helping improve its operating efficiency and expand carefully into more growthier products. The company recently re-instated its dividend.

There was no significant company-specific news in the past week.

TAP shares were unchanged in the past week and have 36% upside to our 69 price target. The stock remains cheap, particularly on an EV/EBITDA basis, or enterprise value/cash operating profits, where it trades at 8.3x estimated 2023 results, still among the lowest valuations in the consumer staples group and below other brewing companies. BUY

Organon & Company (OGN), a spin-off from Merck, specializes in patented women’s healthcare products and biosimilars, and also has a portfolio of mostly off-patent treatments. It may eventually divest its Established Brands segment. The management and board appear capable as they work to boost internal growth augmented by modest-sized acquisitions. The company produces robust free cash flow, has modestly elevated debt and pays a reasonable dividend.

There was no significant company-specific news in the past week.

OGN shares rose 7% in the past week and are up 38% since troughing at 23.31 on October 14. The stock has 43% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). The shares offer an attractive 3.5% dividend yield. BUY

Sensata Technologies (ST) is a $3.8 billion (revenues) producer of nearly 47,000 highly engineered sensors used by automotive (60% of revenues), heavy vehicle, industrial and aerospace customers. About two-thirds of its revenues are generated outside of the United States, with China producing about 21%. Investors undervalue Sensata’s durable franchise. Its sensors are typically critical components that generally produce high profit margins. As the sensors’ reliability is vital to safety and performance, customers are reluctant to switch to another supplier that may have lower prices but also lower or unproven quality. Sensata has an arguably under-leveraged balance sheet and generates healthy free cash flow. The relatively new CEO will likely continue to expand the company’s growth potential through acquisitions. Electric vehicles are an opportunity as they expand Sensata’s reachable market.

There was no significant company-specific news in the past week.

ST shares rose 2% in the past week and have 67% upside to our 75 price target. Our price target looks optimistic in light of the broad market sell-off, but we will keep it for now, even as it may take longer for the shares to reach it. BUY

*Note: DOW price is based on April 1, 2019 closing price following spin-off from DWDP.

Buy – This stock is worth buying.
Strong Buy – This stock offers an unusually favorable risk/reward trade-off, often one that has been rated as a Buy yet the market has sold aggressively for temporary reasons. We recommend adding to existing positions.
Hold – The shares are worth keeping but the risk/return trade-off is not favorable enough for more buying nor unfavorable enough to warrant selling.
Sell – This stock is approaching or has reached our price target, its value has become permanently impaired or changes in its risk or other traits warrant a sale.

Note for stock table: For stocks rated Sell, the current price is the sell date price.

Current price is yesterday’s mid-day price.
CSCO: Estimates are for fiscal years ending in July of 2023 and 2024