That ‘70s Show
Some time ago, there was a television show with the above title that pulled viewers back into the 1970s. It used that earlier era to create a somewhat unique vibe that inadvertently highlighted how much has changed in our world over the decades.
However, if a headline reader from the 1970s time-travelled to today, they would wonder what, if anything, has actually changed. In both eras:
- we appear to be on the cusp of surging inflation following a massive federal spending splurge
- our nation is winding down a protracted war in a remote country with a humiliating evacuation debacle
- we have seen domestic unrest over civil rights and unfair treatment
- a sitting president faced impeachment
- we are struggling to address the effects of pollution on the environment
- severe shortages are disrupting our daily lives
- taxes are going up
- we are facing the ambitions of a rival major superpower, and,
- we are sending new and daring missions into space.
That ‘70s Show, indeed.
There are, of course, important differences. Perhaps most important, our economic growth is robust, albeit supported by fiscal and monetary stimulus that would have been unthinkably excessive half a century ago. And, while inflation has recently jumped to the mid-5% range1 after a decade or more in the sub-2% range, it may indicate merely a one-time upward shift in prices rather than an ongoing upward spiral.
Today, energy supplies are plentiful while oil and natural gas prices are cheaper in inflation-adjusted dollars than at almost any other time in the past century. Interest rates today are remarkably low – not at the 7%+ rate for the 10-year U.S. Treasury bond (which reached 10% by late 1979 on its way to a 15% peak rate in 1981).
Can we use the similarities to the 1970s to help us develop a macro-economic outlook today?
As much as we would like to apply the lessons from long ago, we don’t think this would be productive. Not only are there too many critical differences, but we believe that macro-forecasting is far too inaccurate and unreliable to be used as a major lever for making investing decisions. As Howard Marks, the highly-regarded co-founder of Oaktree Capital, recently wrote, “It’s one think to have an opinion, but something very different to assume that it’s right and bet heavily on it.”
In our presentation for this year’s “Smarter Investing Greater Profits” conference currently underway, we outline our view on using macro – we want to be macro-aware but not macro-driven. It’s clearly important to know the current conditions, even if their causes and effects aren’t entirely understandable. And it’s equally important to look toward the horizon to identify risks that can grow to become major problems (or opportunities), even if we can’t know when or if they will fully form. We want to identify possible risks so that we aren’t completely surprised or overwhelmed if they play out.
Our list of clouds includes many risks that will never materialize into much, and we will completely miss some potentially major risks. One risk that didn’t appear even a week ago was the abrupt and chaotic U.S. evacuation from Afghanistan. This may have only a minor ripple effect in coming months and years, or it could have a compounded effect on geopolitics that can’t yet be comprehended.
Our approach isn’t to become worry warts, as this would probably drive us to sell everything! We take an optimistic view about the future: “Assume greenery, but stay alert to the risks and their odds.”
We work to stay focused on the individual security, the underlying company and the company-specific changes underway that could make it more valuable. This gives us a chance to prosper regardless of the macro conditions.
One risk we don’t see on the horizon: a return to bell bottoms and disco. Let’s hope our forecast is right about that.
- Official inflation rates are not directly comparable, as inflation is calculated differently today from how it was calculated in the 1970s, particularly with respect to housing costs.
Share prices in the table reflect Tuesday (August 17) closing prices. Please note that prices in the discussion below are based on mid-day August 17 prices.
Note to new subscribers: You can find additional color on our thesis, recent earnings and other news on recommended companies in prior editions of the Cabot Undervalued Stocks Advisor on the Cabot website.
Send questions and comments to Bruce@CabotWealth.com.
Upcoming Earnings Releases
Aug 18: Cisco Systems (CSCO)
Today’s Portfolio Changes
None
Last Week’s Portfolio Changes
Bristol-Myers Squibb (BMY) – Moving the shares from Strong Buy to Buy.
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, helped by a $2.5 billion cost-cutting program, and has a relatively modest debt level.
On July 28, Bristol reported encouraging second-quarter results with revenues growing 13% from the pandemic-weakened quarter a year ago. Revenues were 4% above the consensus estimate. One of the major debates on Bristol is its ability to grow revenues, so the “beat” is an indicator that we are on the right track.
Adjusted earnings per share of $1.93 rose 18% from a year ago and were slightly higher than the $1.90 consensus estimate. The company reiterated its full-year 2021 revenue and earnings guidance. Net debt was trimmed about 7% from the year-end – an important metric that we are watching.
There was no significant company-specific news in the past week.
BMY shares rose 2% in the past week and have about 14% upside to our 78 price target. The shares have moved to near their 2020 pre-pandemic high and trade just below their 2018 high. We remain patient with BMY shares and continue to have strong conviction in the company’s underlying fundamentals. But, given the shares’ recent appreciation, they no longer warrant a Strong Buy rating. We are moving the shares to a Buy.
The stock trades at a low 9.2x estimated 2021 earnings of $7.49 (unchanged from last week). On 2022 estimated earnings of $8.07 (unchanged), the shares trade at 8.5x. Either we are completely wrong about the company’s fundamental strength, or the market must eventually recognize Bristol’s earnings stability and power. We believe the earning power, low valuation and 2.9% dividend yield that is well covered by enormous free cash flow make a compelling story. 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.
There was no significant company-specific news in the past week.
Cisco reports fiscal fourth-quarter results on August 18, with a consensus estimate of $0.83/share.
CSCO shares was flat in the past week and have about 8% upside to our 60 price target.
The shares trade at 17.4x estimated FY2021 earnings of $3.21 (unchanged in the past week). On FY2022 earnings (which ends in July 2022) of $3.41 (unchanged), the shares trade at 16.3x. On an EV/EBITDA basis on FY2022 estimates, the shares trade at a 11.9x multiple. CSCO shares offer a 2.7% dividend yield. We continue to like Cisco. BUY
Coca-Cola (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.
On July 21, Coca-Cola reported encouraging second quarter results, with adjusted earnings of $0.68/share, beating the consensus earnings estimate of $0.56 and much stronger than the $0.42 earned a year ago during the depths of the pandemic. Compared to two years ago, unit case volumes matched the two-year-ago level, not bad considering that parts of the global economy remained subdued. The company raised its full-year guidance for organic revenue growth, adjusted EPS and free cash flow. All in, a good quarter.
There was no significant company-specific news in the past week.
KO shares rose 1% in the past week and have about 12% upside to our 64 price target. The stock continues to reflect Coke’s earnings power even as the pandemic resurgence may delay a full return to normal in consumption patterns.
While the valuation is not statistically cheap, at 25.4x estimated 2021 earnings of $2.25 (flat in the past week) and 23.5x estimated 2022 earnings of $2.43 (flat), the shares remain undervalued given the company’s future earning power and valuable franchise. Also, the value of Coke’s partial ownership of a number of publicly traded companies (including Monster Beverage) is somewhat hidden on the balance sheet, yet is worth about $23 billion, or 9% of Coke’s market value. This $5/share value provides additional cushion supporting our 64 price target. KO shares offer an attractive 2.9% dividend yield. 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 and its cyclicality. 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). Investors worry about a cyclical peak and whether Dow will squander its vast free cash flow. 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.
On July 22, Dow reported a strong second quarter, with adjusted earnings of $2.72/share, about 16% above the consensus estimate of $2.35 and sharply higher than the $(0.26) loss a year ago in the depths of the pandemic. Management has an encouraging outlook for volumes and pricing and for its ability to generate higher profits on comparable revenues. While profits may be peaking in coming quarters, they will likely remain elevated rather than fall off sharply. Industry capacity increases are coming next year, but we do not see large price cuts from our current vantage point. We would like to see Dow generate more free cash flow, trim its debt and issue fewer stock options.
There was no other significant company-specific news in the past week.
Dow shares slipped 3% this past week and have 27% upside to our 78 price target.
The shares trade at 10.4x estimated 2022 earnings of $5.89 (up two cents this past week). The estimate for 2021 earnings also rose two cents.
Analysts are somewhat pessimistic about 2022 earnings (they assume a 31% decline from 2021). If the 2022 estimate continues to tick up, the shares will likely follow, although Dow’s cyclical earnings and investor fears of an eventual downcycle will ultimately limit Dow’s upside. The high 4.6% dividend yield adds to the shares’ appeal. In a prolonged downcycle, the dividend could be cut, but that could be years away and even then a cut isn’t a certainty if Dow can manage its balance sheet and down-cycle profits reasonably well. HOLD
Merck (MRK) shares are undervalued as investors worry about Keytruda, a blockbuster oncology treatment (about 30% of revenues), facing 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, will likely accelerate Merck’s acquisition program, which adds both return potential and risks to the story. The company is highly profitable and has a solid balance sheet. It spun off its Organon business in June and we think it will divest its animal health sometime in the next five years.
On July 29, Merck’s reported satisfactory second-quarter results. Revenues grew 19% from a pandemic-weakened year-ago quarter (excluding favorable currencies) and were slightly ahead of consensus estimates. Keytruda sales were strong. Adjusted earnings increased 28% from a year ago but fell slightly short of the $1.33 consensus estimate. Higher costs led to the earnings “miss” but this seems more like analysts being too optimistic rather than any fundamental issues weighing on the company. Merck’s balance sheet and cash flow looked solid. The company raised its full-year revenue guidance, reiterated its confidence in its new product pipeline and is planning on small-to-large acquisitions.
There was no other significant company-specific news in the past week.
Merck shares rose 4% this past week, and have about 26% upside to our 99 price target.
Valuation is an attractive 14.1x this year’s estimated earnings of $5.56 (unchanged in the past week. Merck produces generous free cash flow to fund its current dividend (now yielding 3.3%) as well as likely future dividend increases, although its shift to a more acquisition-driven strategy will slow the pace of increases. BUY
Otter Tail Corporation (OTTR) is a rare utility/industrial hybrid company, with a $2 billion market cap. The electric utility has a solid and high-quality franchise, with a balanced mix of generation, transmission and distribution assets that produce about 75% of the parent company’s earnings, supported by an accommodative regulatory environment. The industrial side includes the Manufacturing and Plastics segments. Otter Tail has an investment grade balance sheet, produces solid earnings and prides itself on steady dividend growth. The unusual utility/manufacturing structure is creating a discounted valuation, which might make the company a target for activists, as the two parts may be worth more separately, perhaps in the hands of larger, specialized companies.
On August 2, Otter Tail reported strong second-quarter results, with earnings rising 141% from a year ago and were nearly double the consensus estimate. Full-year guidance was raised by about 40%. The profit surge was driven by the Plastics segment, as PVC resin supplies were exceptionally tight, largely due to the Texas winter storms, creating a PVC pipe shortage that allowed Otter Tail to sharply raise its PVC pipe prices. The company anticipated that these unusual conditions would last through 2021 but moderate into 2022. Electric segment profits rose a steady 5%. The company is progressing through its Minnesota rate case – we anticipate a benign outcome. Otter Tail’s balance sheet remains in good shape, although the steady expansion of its electric utility rate base continues to siphon off considerable cash flow.
There was no significant company-specific news in the past week.
OTTR shares were flat this past week after a sharp run-up last week. The stock has about 7% upside to our 57 price target. The stock trades at about 16.4x estimated 2021 earnings of $3.26 (unchanged). This consensus doesn’t reflect the company’s guidance for about $3.58 in earnings. At this guide point, the stock trades at an attractive 15.0x multiple. The shares offer a 2.9% dividend yield. BUY
Buy Low Opportunities Portfolio
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. Arcos’ leadership looks highly capable, led by the founder/chairman who owns a 38% stake. The shares are undervalued as investors worry about the pandemic, as well as political/social unrest, inflation and currency devaluations. However, the company is well-managed and positioned to benefit as local economies re-open, and it 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.
On August 11, Arcos reported encouraging second-quarter results. Revenues rebounded sharply, with systemwide same store sales (“systemwide” includes both Arcos-operated and sub-franchisee-operated stores) nearly equal to the two-year-ago period, despite many of its restaurants still under government capacity and operating hours restrictions. Effective use of digital, drive-thru and delivery strategies, as well as popular promotions and a highly-regarded mobile app, are contributing. About 75% of all of its restaurants are in full operation with other partly opened.
Adjusted EBITDA was strong but still shy of where a fully-recovered Arcos would produce. Net financial debt increased as the company produced negative free cash flow. Once at full-strength, we would expect cash flow to be robust.
The company will participate in several conferences over the next few weeks: JPMorgan Brazil Consumer and Healthcare Checkup Conference on August 19; Santander Annual Conference on August 18 and 20; Credit Suisse Ag, Food and Beverages Conference on August 23; and the UBS Mexico Consumer Roundtable on August 26. It is not clear whether these will be available via webcast, but we would anticipate at least a mildly positive stock reaction to the conferences.
ARCO shares fell 7% this past week and have about 37% upside to our 7.50 price target. The stock will likely remain volatile until we have more clarity on its earnings and the effects of the pandemic, including the Delta variant, on its outlook. We remain steady in our conviction in the company’s recovery. The low share price offers a chance to add to or start new positions in ARCO.
The stock trades at 18.9x estimated 2022 earnings per share of $0.29 (up a cent from a week ago). The 2021 estimate slipped a cent to $0.03. The 2023 consensus estimate of $0.35 rose a cent. BUY
Aviva, plc (AVVIY), based in London, is a major European insurance company specializing in life insurance, savings and investment management products. Amanda Blanc was hired as the new CEO last year to revitalize Aviva’s laggard prospects. She has divested operations around the world to aggressively 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.
On Thursday, August 12, Aviva reported first half 2021 earnings of £0.21/share, down 11% from a year ago and below the £0.25/share consensus estimate. On a dollar basis for the ADS, the company reported $0.58, compared to the $0.69 estimate. Operating profits of £725 million rose 17% from a year ago, but were slightly behind the consensus estimate.
Earnings grew sharply from a year ago, reflecting the improvements and divestitures over the past year. Overall, results were good with some segments showing strong performance. A major reason for the “miss” was a discretionary charge taken by management to boost reserves in its life insurance legacy products – real money but more reflective of prior errors than going-forward results. Regardless of analyst estimates, the company is making important and meaningful changes to its core business.
Much of our interest in Aviva is in what it plans to do with its current and future excess capital. The company announced encouraging news that it is accelerating the timing of its share buybacks and dividend increases.
With its £7.5 billion in eventual proceeds from divestitures, the company raised its interim dividend by 5% to £0.35/share (about $0.97) and will return at least £4 billion (about $5.5 billion) by 2H 2022, mostly through share buybacks. It will complete £750 million starting “immediately.” The balance of the proceeds will go toward debt paydown.
Activist investor Cevian (owns 5% stake) was not satisfied and is pressing for at least £5 billion in capital returns. We’re fine with having a highly credible and capable activist like Cevian in our corner – they are correct that Aviva has plenty of excess capital and can return more than it is currently offering. We believe that, over time, Aviva will relent to Cevian’s pressure but not fully right away.
There was no other significant company-specific news in the past week.
Aviva shares rose 2% this past week and have about 23% upside to our 14 price target.
The new £0.0735 per share interim dividend is equivalent to $.20/share. We anticipate that the company will pay a year-end dividend of about twice this amount, for a full-year dividend of about $0.60/share. On this, the shares would produce an annual dividend yield of about 5.5%. In an era that features investment grade bond yields of 1.6%, Aviva makes an interesting bond proxy, particularly given what appears to be a resilient base dividend. The likely upcoming special dividends on top of this add extra appeal.
The stock trades at 8.4x estimated 2021 earnings per ADS of $1.35 (down 2 cents in the past week) and at about 100% of the new tangible book value. 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%). The market has little interest in Barrick shares. Yet, 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 more cash than debt. 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 mixed second-quarter results. Adjusted earnings of $0.29/share rose 26% from a year ago and were about 12% above the consensus estimate. A production issue reduced its Carlin (Nevada) mine output but the company said it remains on track to meet full-year total company production guidance. Barrick continues to invest in new mining projects while maintaining a reasonable capital spending budget. We would have liked to have seen better results on volumes and costs. Barrick is a free cash flow story, so the negative free cash flow this quarter was disappointing, and tipped the balance sheet back into a net debt position (compared to the net cash a quarter ago).
The threat of local governments taking control of gold mines remains. As the free world shrinks, autocratic governments become more assertive about taking assets from Western companies. Most of Barrick’s production comes from countries unlikely to expropriate, but takings at the margin will weigh on the shares.
There was no significant company-specific news in the past week.
Barrick shares rose 1% this past week and have about 35% upside to our 27 price target. The price target is based on 7.5x estimated 2021 EBITDA and a modest premium to its $25/share net asset value.
Commodity gold prices rose about 3% to $1,784/ounce, likely helped by the decline in yield, to about 1.25%, by the 10-year Treasury yield.
On its recurring $0.09/quarter dividend, GOLD shares offer a reasonable 1.8% dividend yield. Barrick will pay an additional $0.42/share in special distributions this year, lifting the effective dividend yield to 3.9%. BUY
General Motors (GM) is making immense progress with its years-long turnaround. It is perhaps 90% of the way through its gas-powered vehicle turnaround, and is well-positioned but in the early stages of its electric vehicle (EV) development. GM Financial will likely continue to be a sizeable profit generator. GM is fully charged for both today’s environment and the EV world of the future, although the underlying value of its emerging EV business is unclear.
On August 4, GM reported strong results that were nevertheless held back by the chip shortage and a large $1.3 billion warranty expense. It appears that the company’s ability to generate ever-higher profits is maxxed out. Future profits (adjusted for these one-time costs) will not likely be higher, but we see a tapering decay rate rather than a cliff. However, we also wonder what the eventual profitability of electric vehicles will be and the return on GM’s vast capital outlay. GM Finance and the overall balance sheet both look sturdy.
The shares reflect conservative but reasonably strong gas-powered vehicle profits but assign essentially no value to the EV operations. This zero-value almost certainly is wrong but the EV operations have no sales or profits so the valuation is by definition speculative at this point. We’re keeping GM a Hold for now, as the risk/return balance isn’t as favorable as we would like for the Cabot Undervalued Stocks Advisor.
There was no significant company-specific news in the past week.
GM shares fell another 7% this past week and have 37% upside to our 69 price target due to the complicated and weak-versus-expectations quarter.
On a P/E basis, the shares trade at 7.2x estimated calendar 2022 earnings of $6.96 (up a cent this past week). The 2021 estimate was unchanged. The P/E multiple is helpful, but not a precise measure of GM’s value, as it has numerous valuable assets that generate no earnings (like its Cruise unit, which is developing self-driving cars and produces a loss), its nascent battery operations, and its other businesses with a complex reporting structure, nor does it factor in GM’s high but unearning cash balance which offsets its interest-bearing debt. However, it is useful as a rule-of-thumb metric, and provides some indication of the direction of earnings estimates, and so we will continue its use here. HOLD
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 straight-forward – 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.
The company’s second-quarter report on July 29 was encouraging. Revenues rose 14%, powered by a resurgence in Europe. Revenues were about 4% ahead of the consensus estimate. Adjusted net income rose 2% from a year ago and was 17% above the consensus estimate. However, adjusted EBITDA fell 1%, as the company spent more on marketing and battled rising transportation, brewery and packaging materials costs. Beating the revenue and earnings estimates is important as it supports our view that investors don’t fully appreciate the resiliency in Molson’s business. The company reaffirmed its 2021 full-year guidance. Molson’s debt balance is unchanged from year-end but cash is starting to accumulate.
There was no significant company-specific news in the past week.
TAP shares slipped 3% in the past week and have about 39% upside to our 69 price target.
The shares trade at 12.4x estimated 2021 earnings of $4.01 (unchanged this past week). Estimates for 2022 were also unchanged.
On an EV/EBITDA basis, or enterprise value/cash operating profits, the shares trade for about 8.5x current year estimates, still among the lowest valuations in the consumer staples group and below other brewing companies. 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.
On August 12, in its first quarter as an independent company, Organon reported encouraging results, reaffirmed their full-year guidance and initiated a $0.28/share quarterly dividend which would produce a 3.7% yield.
Revenues of $1.6 billion rose 5% from a year ago and were about 4% above the consensus estimate. Revenues fell 1% net of currency changes. Excluding currency changes, sales rose 16% in the Women’s Health segment and 35% in the Biosimilars segment but fell 10% in the Established Brands segment. Sales grew or were flat, ex-currency, in every geography except Asia-Pacific/Japan, where sales fell 29% due to patent expirations of Zetia in Japan. The company reaffirmed their outlook for $6.1 billion -$6.4 billion in full-year revenues, helping to build our confidence in its stability. While the headwinds we highlighted in our initiation report remain in place, Organon highlighted on the conference call a wide range of initiatives and end-market trends that provide support for its positive outlook.
Adjusted earnings of $1.72 per share fell 32% from a year ago but the comparison included unusual costs due to the mid-quarter split from Merck. Earnings were about 20% above the $0.43/share consensus estimate. Adjusted EBITDA of $627 million was about 12% above the consensus estimate. The 40.1% EBITDA margin was encouraging as the company has guided for only a 36%-38% full-year margin.
Management said that the dividend is their top capital allocation priority, after which is organic growth investments, then debt paydown/external growth opportunities. The company wants to maintain their investment grade rating and bring their net debt/EBITDA ratio down to 3.5x from the current 4x.
All in, a strong start for Organon.
Berkshire Hathaway reported taking a small $50 million stake in Organon. While microscopic relative to Berkshires’ $100 billion+ cash hoard, the stake does provide some validation for the stock’s undervaluation.
OGN shares rose 15% 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 trade at 6.0x estimated 2021 earnings of $5.84 and 6.0x estimated 2022 earnings of $5.88. Both of these estimates slipped in the past week following the earnings report. The consensus estimate for 2023 is a more robust $6.15. 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. Also, 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.
Once a threat, electric vehicles are now an opportunity, as the company’s expanded product offering (largely acquired) allows it to sell more content into an EV than it can into an internal combustion engine vehicle. Risks include a possible automotive cycle slowdown, chip supply issues, geopolitical issues with China, currency and over-paying/weak integration related to its acquisitions.
On July 27, Sensata reported encouraging second-quarter results. Its earnings were sharply higher than the pandemic-weakened results a year ago and about 10% above the consensus estimate. Revenues were 72% higher than a year ago and were also above estimates. The company raised its full-year revenue and earnings guidance. Cash flow was robust and net debt increased modestly to fund the Xirgo acquisition.
There was no significant company-specific news in the past week.
ST shares slipped about 1% this past week and have about 27% upside to our 75 price target. The stock trades at 14.1x estimated 2022 earnings of $4.17 (unchanged this past week). On an EV/EBITDA basis, ST trades at 11.3x estimated 2022 EBITDA. BUY
| Growth/Income Portfolio | |||||||
| Stock (Symbol) | Date Added | Price Added | 8/17/21 | Capital Gain/Loss | Current Dividend Yield | Price Target | Rating |
| Bristol-Myers Squibb (BMY) | 04-01-20 | 54.82 | 68.96 | 25.8% | 2.8% | 78.00 | Buy |
| Cisco Systems (CSCO) | 11-18-20 | 41.32 | 56.01 | 35.6% | 2.6% | 60.00 | Buy |
| Coca-Cola (KO) | 11-11-20 | 53.58 | 57.28 | 6.9% | 2.9% | 64.00 | Buy |
| Dow Inc (DOW) * | 04-01-19 | 53.50 | 62.31 | 16.5% | 4.5% | 78.00 | Hold |
| Merck (MRK) | 12-9-20 | 83.47 | 78.83 | -5.6% | 3.3% | 99.00 | Buy |
| Otter Tail Corporaton (OTTR) | 5-25-21 | 47.10 | 53.84 | 14.3% | 2.9% | 57.00 | Buy |
| Buy Low Opportunities Portfolio | |||||||
| Stock (Symbol) | Date Added | Price Added | 8/17/21 | Capital Gain/Loss | Current Dividend Yield | Price Target | Rating |
| Arcos Dorados (ARCO) | 04-28-21 | 5.41 | 5.44 | 0.6% | 0.0% | 7.50 | Buy |
| Aviva (AVVIY) | 03-03-21 | 10.75 | 11.47 | 6.7% | 5.1% | 14.00 | Buy |
| Barrick Gold (GOLD) | 03-17-21 | 21.13 | 19.97 | -5.5% | 1.8% | 27.00 | Buy |
| General Motors (GM) | 12-31-19 | 36.60 | 50.47 | 37.9% | — | 69.00 | Hold |
| Molson Coors (TAP) | 08-05-20 | 36.53 | 49.66 | 35.9% | — | 69.00 | Buy |
| Organon (OGN) | 06-07-21 | 31.42 | 35.38 | 12.6% | — | 46.00 | Buy |
| Sensata Technologies (ST) | 02-17-21 | 58.57 | 59.25 | 1.2% | — | 75.00 | 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.
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.
Buy – This stock is worth buying.
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.