April 13, 2022

What We Currently Think About Valuations
In a market that is transitioning from 10-year Treasury yields of below 1% (essentially zero) to “not zero” and perhaps 10-year Treasury yields that could reach 3% or higher, valuations increasingly matter.

We see valuations for fast-growing companies compressing. The transition in interest rates makes their out-year profits worth considerably less. For slow-growing companies that also generate sizeable amounts of cash, their valuations could easily increase, if for no other reason than their new-found relative attractiveness. If interest rates rise sharply, to perhaps 5%, few stocks will be capable of withstanding the discounting pressure and will succumb.

In the Cabot Undervalued Stocks Advisor portfolio, shares of Bristol-Myers Squibb (BMY) are entering record-high territory and trade just below our price target. Yet they remain reasonably valued, particularly if the company’s drug pipeline continues to show promise. Stocks with these traits occupy a world that is a bit unfamiliar to value/contrarian investors.

Shares of Coca-Cola (KO) have surpassed our price target. The valuation is not stretched, but no longer a bargain, either. Like shares of Bristol-Myers, Coke shares are surging into record-high territory. Our note below describes the outcome of our wrestling with these issues.

We are adding a new name, BigLots (BIG), a discount general merchandise retailer with stores across most of the United States. One major appeal is the exceptionally discounted shares, which trade at a 3.1x EV/EBITDA. Its clean balance sheet, positive free cash flow and “good enough” management leave plenty of room for disappointments. In a world where interest rate increases could weigh heavily on stocks, it would seem improbable that a 3x multiple would experience much more compression if fundamentals remain respectably stable. The presence of an outside investor highlighting this low valuation is an incremental positive.

Another stock, which we aren’t yet ready to recommend, is Dropbox (DBX). This company’s shares trade at a discount even as its balance sheet is clean, and its operations generate considerable free cash flow. The biggest uncertainty is whether revenue growth will erode as competitors like Microsoft and Amazon remain aggressive. Ideally, we would like to see investors sell this stock down further, which would create a better entry point.

Valuation is an art, and while the picture being painted by the market isn’t getting prettier, some obscure works sit undiscovered.

Share prices in the table reflect Tuesday (April 12) closing prices. Please note that prices in the discussion below are based on mid-day April 12 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
New Buy: BigLots (BIG)
The Coca-Cola Company (KO): Raising price target from 64 to 69

Last Week’s Portfolio Changes
None.

Upcoming Earnings Reports
Thursday, April 14: Citigroup (C)
Thursday, April 21: Dow (DOW)
Monday, April 25: The Coca-Cola Company (KO)
Tuesday, April 26: Sensata Technologies (ST)
Thursday, April 28: Merck & Company (MRK)
Thursday, April 28: Allison Transmission Holdings (ALSN)
Friday, April 29: Bristol-Myers Squibb (BMY)
Friday, April 29: Molson Coors Beverage Company (TAP)

Growth/Income Portfolio
Bristol Myers Squibb Company (BMY) shares sell at a low valuation due to worries over patent expirations for Revlimid (starting in 2022) and Opdivo and Eliquis (starting in 2026). However, the company is working to replace the eventual revenue losses by developing its robust product pipeline while also acquiring new treatments (notably with its acquisitions of Celgene and MyoKardia), and by signing agreements with generics competitors to forestall their competitive entry. The likely worst-case scenario is flat revenues over the next 3-5 years. Bristol should continue to generate vast free cash flow, has a solid, investment-grade balance sheet, and trades at a sizeable discount to its peers.

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

BMY shares rose 3% in the past week, crossing the prior all-time closing high of 76.77 set on July 14, 2016. The shares remain just below our 78 price target. Valuation remains reasonable compared to its peers and the company seems to be executing on its strategy while also maintaining a solid financial posture, so we are inclined to let the stock at least reach 78 before deciding on what changes to make to the rating and/or price target. BUY

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.

Citibank downgraded Cisco to a “sell” earlier this week on concerns that the company’s products and services will lose market share to rivals. The downgrade added to pressure on the shares. We recognize the Citi analysts’ concerns but are more confident in the company’s future and the merits of its once-again cheap share valuation.

CSCO shares slipped 4% in the past week and have 26% upside to our 66 price target. The dividend yield is an attractive 2.9%. BUY

The Coca-Cola Company (KO) is best-known for its iconic soft drinks yet nearly 40% of its revenues come from non-soda beverages across the non-alcoholic spectrum. Its global distribution system reaches nearly every human on the planet. Coca-Cola’s longer-term picture looks bright, but the shares remain undervalued due to concerns over the pandemic, the secular trend away from sugary sodas, and a tax dispute which could cost as much as $12 billion (likely worst-case scenario). The relatively new CEO James Quincey (2017) is reinvigorating the company by narrowing its over-sized brand portfolio, boosting its innovation and improving its efficiency, as well as improving its health and environmental image. Coca-Cola’s balance sheet is sturdy, and its growth investing, debt service and dividend are well-covered by free cash flow.

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

KO shares rose 4% in the past week and now trade above our 64 price target. We are (tepidly) raising our price target to 69. Coca-Cola’s fundamentals remain sturdy with respectable revenue, profit and free cash flow growth. Management continues to focus on execution in its core business while generally avoiding any major non-core commitments. We wonder if the management will be tempted to buy-in the rest of Monster Beverage or make other acquisitions, but for now it (thankfully) appears they remain constrained by the risk of a $10 billion cash payment to the IRS to settle a tax matter.

We are tepid, as KO shares now trade noticeably above their record high and have healthy upward momentum even as valuation is no longer “cheap” – traits that are a tad unfamiliar and uncomfortable for a value/contrarian investor. However, we also rarely have the chance to own a high-quality and enduring franchise like Coca-Cola, so we will be a bit more patient with the shares. BUY

Dow Inc. (DOW) merged with DuPont to create DowDuPont, then split into three companies in 2019 based on product type. The new Dow is the world’s largest producer of ethylene/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). We see Dow as having more years of strong profits before capacity increases signal a cyclical peak, and expect the company to continue its strong dividend, reduce its pension and debt obligations, repurchase shares slowly and restrain its capital spending.

Industry conditions will likely be strong for a while. Dow remains well-positioned to generate immense free cash flows over the next few years, even as the stock market cares little about cash but rather is focused on the incremental newsflow related to economic growth, energy prices and any industry capacity changes. In the meantime, Dow shareholders can collect a highly sustainable 4.4% dividend yield while waiting for more share buybacks, more balance sheet improvement, more profits and a higher valuation.

Dow took a minority stake in a new German LNG facility that will process natural gas imports, as that country moves more aggressively to reduce its reliance on Russian energy supplies.

Earnings estimates continue to tick upward this past week. The 2022 earnings estimate today is nearly double what it was a year ago, reflecting the enduring strength of the current plastics price recovery.

Dow shares were flat in the past week and have 22% upside to our 78 price target. BUY

Merck (MRK) shares are undervalued as investors worry about Keytruda, a blockbuster oncology treatment (about 30% of revenues) which faces generic competition in late 2028. Also, its Januvia diabetes treatment may see generic competition next year, and like all pharmaceuticals it is at risk from possible government price controls. Yet, Keytruda is an impressive franchise that is growing at a 20% rate and will produce solid cash flow for nearly seven more years, providing the company with considerable time to replace the potential revenue loss. Merck’s new CEO, previously the CFO, is accelerating Merck’s acquisition program, which adds return potential and risks to the story. The company is highly profitable and has a solid balance sheet. It spun off its Organon business last June and we think it will divest its animal health segment sometime in the next five years.

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

Merck shares rose 3% in the past week and have about 15% upside to our 99 price target. The company has a strong commitment to its dividend (3.2% yield) which it backs up with generous free cash flow, although its shift to a more acquisition-driven strategy will slow the pace of dividend increases. BUY

Buy Low Opportunities Portfolio
New Buy: BigLots (BIG) – BigLots 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. The company has a large and loyal customer base of 22 million Rewards program members, which has growth steadily over the past decade. Also, as the economy shifts into a slower, higher-inflation gear, BigLots’ lower-cost merchandise offerings are likely to benefit.

While cash operating profit margins are generally low, at about 5.5%, they appear to be stable, even with growing cost inflation and other pressures. We acknowledge that the first quarter will likely be weak, as management guided, and that investor expectations for the full year may be incrementally too high.

We are intrigued enough by the shares’ remarkably low valuation to make this stock a Buy. On conservative fiscal 2022 (ending in January 2023) estimates, the shares currently trade at 3.1x EV/EBITDA and 7.3x per-share earnings. These multiples imply a dour recessionary future for the company. The EV/EBITDA multiple, in particular, is sharply below an average of perhaps 11x for its peers. Even adjusting for scale and quality, a 70% discount for BIG is unwarranted.

From a historical perspective, BigLots’ shares trade unchanged from their 2007 price level and are down 50% from their stimulus-boosted peak at over $70 last year.

BigLots’ balance sheet carries only $4 million of debt compared to $54 million in cash. While the balance sheet ebbs and flows with its inventory needs, the company is operated primarily as a debt-free business. This provides BigLots with considerable endurance and flexibility. We would rate the management and board quality as “good enough.” BigLots generates positive free cash flow that is strong enough to provide a reasonably sustainable $0.30/share quarterly dividend. This dividend generates an attractive 3.4% dividend yield. The company also has been a repurchaser of its own shares.

The presence of investor Mill Road Capital (5.1% stake) is interesting. We doubt whether Mill Road has the financial firepower to execute a buy-out on its own and are also skeptical of its proposal for BigLots to lever up to do a share buyback. Nevertheless, Mill Road has publicly highlighted the company’s deeply discounted shares – a positive without a doubt.

All-in, while BIG shares carry higher risk, the risk/return trade-off appears compelling. We are setting an initial 45 price target on the shares. BUY

Allison Transmission Holdings, Inc. (ALSN) – Allison Transmission is a midcap ($6.4 billion market cap) manufacturer of vehicle transmissions. 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. However, Allison produces no car and light truck transmissions, instead it focuses on the school bus and Class 6-8 heavy-duty truck categories, where it holds an 80% market share. Its 35% 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. Another indicator of its advanced capabilities: Allison was selected to help design the U.S. Army’s next-generation electric-powered vehicle. 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.

Allison shares fell 6% in the past week and have 35% upside to our 48 price target. The market has been brutal to consumer cyclical shares, and while ALSN is more of an industrial cyclical it trades closely with automobile stocks. For risk-tolerant and patient investors, this might be a good time to incrementally add shares. The stock pays an attractive and sustainable 2.4% dividend yield to help compensate for the wait. BUY

Arcos Dorados (ARCO), which is Spanish for “golden arches,” is the world’s largest independent McDonald’s franchisee. Based in stable Uruguay and listed on the NYSE, the company produces about 72% of its revenues in Brazil, Mexico, Argentina and Chile. The shares are depressed as investors worry about the pandemic, as well as political/social unrest, inflation and currency devaluations. However, the company has a solid brand and high recurring demand and is well-positioned to benefit as local economies reopen. The leadership looks highly capable, led by the founder/chairman who owns a 38% stake, and has the experience to successfully navigate the complex local conditions. Debt is reasonable relative to post-recovery earnings, and the company is currently producing positive free cash flow.

Macro issues, including issues in Brazil including its economic conditions (in particular, inflation, running at a 10.5% rate), currency and the chances that a socialist might win this year’s Brazilian presidential elections will continue to move ARCO shares. Brazil is one of the most Covid-vaccinated countries in the world, which reduces pandemic-related demand risks.

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

ARCO shares were flat in the past week and have 8% upside to our recently increased 8.50 price target. BUY

Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc was hired as the new CEO in July 2020 to revitalize Aviva’s laggard prospects. She divested operations around the world to re-focus the company on its core geographic markets (UK, Ireland, Canada), and is improving Aviva’s product competitiveness, rebuilding its financial strength and trimming its bloated costs. Aviva’s dividend has been reduced to a more predictable and sustainable level with a modest upward trajectory. Excess cash balances are being directed toward debt reduction and potentially sizeable special dividends and share repurchases.

Much of our interest in Aviva is based on its plans for returning its excess capital to shareholders, including share repurchases and dividends. These distributions could be substantial. We also look for incremental shareholder-friendly pressure from highly regarded European activist investor Cevian Capital, which holds a 5.2% stake.

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

Aviva shares fell 3% in the past week and have about 25% upside to our 14 price target. The projected dividend, which would produce a generous 7.4% yield, looks fully sustainable. 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 new and 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.

Over the past week, commodity gold ticked higher to $1,977/ounce, up about 3% from a week ago. The 10-year Treasury yield continues to lift, now at 2.70%. The spread between this yield and inflation widened to 5.8 percentage points (as inflation was reported at 8.5%) compared to a long-term average spread of perhaps one to two percentage points, strongly suggesting many more interest rate hikes ahead. The U.S. Dollar Index, another driver of gold prices (the dollar and gold usually move in opposite directions), rose to 100.06. This level is essentially at the highest level since 2003, when the dollar was slipping after reaching 118 a few years earlier.

US Dollar Index (DXY), courtesy of MarketWatch.

Barrick appointed a CEO of a newly created subsidiary that will begin development of a gold and copper project in Alaska. Also, the company said it is moving forward with a project to extend the useful life, past 2040, of its Pueblo Viejo mine in the Dominican Republic. Neither of these two announcements carry large significance, but rather reflect the company’s emphasis on internal growth, as opposed to acquisition-driven growth.

Barrick shares rose 5% over the past week and have about 5% upside to our 27 price target. The price target is based on 7.5x estimated steady-state EBITDA and a modest premium to our estimate of $25/share of net asset value. BUY

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 reports earnings on Thursday, April 14, with a consensus earnings estimate of $1.41/share, although one respected earnings aggregator has a $1.53/share consensus estimate. It is unusual to see this wide of a spread – a reflection perhaps of how unpredictable Citi’s earnings are due to the rapidly changing environment for interest rates and for investment banking and trading fees.

Citi shares fell 2% over the past week and have about 67% upside to our 85 price target. The flattened yield curve and concerns about a recession continue to weigh on the shares.

The valuation remains attractive at 64% of tangible book value and 7.9x estimated 2022 earnings. Estimates continue to slip such that the valuation isn’t improving much despite the lower share price. This stock may have some of the earmarks of a value trap, but we believe the underlying earning power and asset value remain solid despite the steady erosion of near-term earnings estimates.

As long as the bank can execute its turnaround, the shares remain highly discounted. Investors have largely lost patience with Citibank. We are holding tight to the shares as our confidence remains sturdy and the shares remain overly discounted on a price/book basis as well as on an earnings basis.

Citigroup investors enjoy a 4.0% dividend yield and perhaps another 3% or more in annual accretion from the bank’s share repurchase program. 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 reinstated its dividend.

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

TAP shares rose 5% in the past week and have about 28% 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 8.7x estimated 2022 results, still among the lowest valuations in the consumer staples group and below other brewing companies. The 2.5% dividend only adds to the appeal. BUY

Organon & Company (OGN) was recently spun off from Merck. It specializes in patented women’s healthcare products and biosimilars, and also has a portfolio of mostly off-patent treatments. Organon will produce better internal growth with some boost through smart yet modest-sized acquisitions. It may eventually divest its Established Brands segment. The management and board appear capable, the company produces robust free cash flow, has modestly elevated debt and will pay a reasonable dividend. Investors have ignored the company, but we believe that Organon will produce at least stable and large free cash flows with a reasonable potential for growth. At our initial recommendation, the stock traded at a highly attractive 4x earnings.

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

OGN shares were flat in the past week and have about 31% upside to our 46 price target (using the same target as the Cabot Turnaround Letter). The shares continue to trade at a remarkably low valuation while offering an attractive 3.2% 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 safely 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 fell 2% in the past week and have about 54% upside to our 75 price target. BUY.

Disclosure:The chief analyst of the Cabot Undervalued Stocks Advisor personally holds shares of every recommended security, except for “New Buy” recommendations. The chief analyst may purchase or sell recommended securities but not before the fourth day after any changes in recommendation ratings has been emailed to subscribers. “New Buy” recommendations will be purchased by the chief analyst as soon as practical following the fourth day after the newsletter issue has been emailed to subscribers.

*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.

CSCO: Estimates are for fiscal years ending in July.

Current price is yesterday’s mid-day price.