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Turnaround Letter
Out-of-Favor Stocks with Real Value

April 2020

With consumers focused on social distancing and lockdowns to help prevent the spread of the coronavirus, many restaurants have no revenues, while others are generating a little income through delivery and pick-up. Yet, despite this uncertain outlook, the crisis will eventually subside.

In this issue, we highlight six restaurant companies with both the survivability and price discount traits.

Cabot Turnaround Letter 420

TIME TO PLACE AN ORDER FOR RESTAURANT STOCKS

In This Issue:
Restaurant Stocks
Navigating the Turbulent Market

Recommendations:
Buy: Berkshire Hathaway (BRK.B)
News/Notes
Performance

Restaurant companies might appear to be awful investments right now. With consumers focused on social distancing and lockdowns to help prevent the spread of the coronavirus, many restaurants have no revenues, while others are generating a little income through delivery and pick-up. There is considerable uncertainty about when the medical and economic crisis will abate.

Yet, despite this uncertain outlook, the crisis will eventually subside. As consumers are creatures of habit, once liberated from the Covid-19 threat, they will return to their dining-out patterns. At first, the recovery may ramp up slowly, or happen in a surging mini-boom. Eventually, more normal conditions will restore prosperity to the restaurant industry, albeit perhaps at a reduced level or with some unexpected but mild structural change in consumer preferences.

Two traits are key to finding opportunities in restaurant stocks. The first is survivability – the company must be able to endure the downturn and then have reasonable prospects to prosper in the eventual recovery. Companies best positioned have mainstream appeal, already-successful concepts, sturdy balance sheets, geographically diverse operations and affordable menu prices. Many restaurants, particularly fast-food varieties, will see a more mild impact as their drive-thru windows, which can produce half or more of total revenues, remain open. Also, lower revenues are partly offset by lower labor, food and other variable store-level costs, helping to reduce losses. In normal times, franchise fees provide a stable source of income, but as the payments are typically based on store revenues, parent companies can’t count on these fees. Critically, companies with sizeable cash balances and access to large lines of credit will be best able to meet their compensation, rent and other obligations.

The second key trait is a sufficiently discounted stock price (or valuation). While few restaurant stocks had much appeal at mid-February prices, many have much greater appeal at late-March prices. Even if the fundamentals take a long time to improve, shares of many high-quality restaurant companies are selling at such low prices that the margin of safety is vast. Said a different way, if only one of the two traits are present, the opportunity could be a mirage, but with both present the opportunity is real. As share prices remain highly volatile, investors will want to pick their entry points accordingly.

Listed below are six restaurant companies with both the survivability and price discount traits. As with all investments, there are trade-offs – some companies will emerge fundamentally unscathed but trade at less of a price discount while others have larger discounts but may emerge a bit shaken.

In the table, we show the shares’ valuation relative to actual 2019 results. While the companies may not fully return to these profit levels in the near future, investors might consider them as “post-recovery” guidelines.

Bloomin’ Brands (BLMN) – Home to Outback Steakhouse, Carrabba’s Italian Grill and other brands, Bloomin’ Brands has 1,450 locations across the United States and 22 other countries. Steady revenues and solid +2.7% same store sales growth in the prior quarter reflect the company’s healthy customer appeal. The relatively new CEO, under the close watch of respected activist JANA Partners (9.3% stake) is streamlining the company’s operations. A recent strategic review, now interrupted, was considering all options including a company sale. Bloomin’ Brands has a reasonable amount of debt, with sizeable cash reserves that it boosted to over $400 million with a credit line draw. To further save cash, the company suspended its just-raised dividend. Bloomin Brands’ turnaround may be interrupted but the company should make a healthy recovery.

Brinker International (EAT) – Brinker is the parent company of Chili’s Bar & Grill and Maggiano’s Little Italy, with over 1,600 restaurants in 31 countries. Recent efforts to simplify its menus have improved its service levels and reduced its costs, while new drinks and other specials have bolstered customer appeal. Recent same store sales growth of +2.9% at Chilis, along with wider profit margins, suggest that the business has substantial value. In normal times, Brinker generates strong free cash flow, supported by franchise fees that comprise nearly half of its operating profits. Brinker is somewhat leveraged at 3.3x EBITDA, which produces some financial risk. While its cash on hand was only $12 million, the company has over $400 million of untapped capacity on its credit line. While it hasn’t announced a dividend suspension, we anticipate that this will happen soon. Although Brinker’s franchise strength is not among the top tier, it is likely to survive anything but a protracted downturn and its shares remain more discounted than many other restaurants.

Darden Restaurants (DRI) – Darden owns the Olive Garden, LongHorn Steakhouse, Yard House and other popular brands. The company has nearly 1,800 restaurants across the United States as well as footholds in Latin America and the Middle East. Darden owns and operates almost all of its restaurants. The company has the financial resources to endure a downturn of potentially a year, as it added $750 million in fresh cash from its credit line to its $250 million in cash already on hand. Darden carries modest debt of 2.5x trailing EBITDA, so it started from a position of financial strength. To further preserve cash, the company suspended its otherwise generous dividend. Operationally, the leadership is highly capable, particularly following the replacement of its entire board of directors, and subsequently the CEO, by an activist investor in 2014. Strong earnings in the most recent quarter, which didn’t include any virus effects, reflect Darden’s enduring value.

Denny’s Corporation (DENN) – After many difficult years when Denny’s was a tired icon, the company has undergone a broad overhaul to increase its appeal and relevance to younger customers. By the end of 2019, nearly 90% of its 1,700-plus restaurants have been modernized, with a refreshed look, better menu items, improved late-night service and upgraded digital/delivery capabilities. Recent growth in domestic same store sales and wider operating margins reflect the improvements. An expanding base of 144 restaurants outside of the United States offer new growth opportunities. Nearly all of its stores are franchised, with franchisees providing marketing support, helping to stabilize Denny’s healthy cash flows when normal times return. To adapt to the sharp downturn, Denny’s recently suspended its buyback program (which has reduced the share count by 20% over the past three years), as well as raised cash from its credit lines. Once the pandemic has passed, we expect that customers will steadily return to Denny’s.

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McDonald’s Corporation (MCD) – With 38,700 restaurants in 119 countries, McDonalds is one of the most widely recognized and respected brands in the world. Nearly 93% of its restaurants are franchised, which normally provides a sturdy profit stream. The company owns or controls (through long-term leases) most of the restaurant properties, preserving a solid asset base while still allowing tight control of the actual store operations. While the company’s profits will certainly be weakened temporarily, the iconic company enters the downturn from a position of strength: comparable sales last year were up 5.9%, helped by domestic price increases and international strength, with an expanding profit margin. The balance sheet’s 3.2x EBITDA debt level is reasonable given the business’ value. McDonalds’ immense geographical spread, healthy cash balance, liquidity and its status as an embedded part of the world’s dining habit provide it the strength to endure. So far, the company has not announced any changes to its dividend.

Texas Roadhouse (TXRH) – Led by Kent Taylor, who founded the business in 1993, the company operates 484 Texas Roadhouse restaurants as well as the smaller “Bubbas 33” restaurant chain. Its 611 total stores are spread across 49 states (only 74, or about 12%, are in Texas) and ten other countries. It emphasizes steak dinners at moderate prices in a full-service, casual dining atmosphere. The company is well-managed, as shown by its long-term success, recently strong fourth quarter comparable sales growth of 4.4% and expanding store-level profit margins. Going into the downturn, Texas Roadhouse had no debt. It recently drew $190 million from its line of credit (with another $200 million available) to add to its $100 million in cash already on hand. As it owns about 28% of its locations, recently suspended its dividend and has considerable discretion in its capital spending program, the company looks well-positioned to survive. In a gesture that its employees will almost certainly appreciate, the CEO recently said he would forego his salary for the rest of the year.

STOCK MARKET, OR MARKET OF STOCKS?

THREE STRATEGIES FOR NAVIGATING THE TURBULENT MARKET

An age-old trading question asks, “is it a stock market or a market of stocks?” If most stocks tend to move together, as they have over the past several years, one can generally consider the stock market as a singular entity. However, with the broad market lurching up or down by 3% or more a day, and individual stocks diverging wildly from each other, it clearly is a market of (individual) stocks.

In such a market of stocks, many investors may feel that the volatility is too high and that the economic outlook is too uncertain, impelling them to reduce or even eliminate their stock holdings.

However, one of our most basic investment beliefs is that you shouldn’t try to time the market. Just as the low volatility and an apparently clear economic outlook made it tempting to add to shares last year, the recent conditions make it tempting to bail out now. Timing the market can lead to financially damaging “whipsaw” investing – bailing just before the market rebounds and then diving back in just prior to a drop.

We recommend that investors consider three general strategies to tailor their mix of stock holdings to more precisely match their tolerance for risk and uncertainty – without necessarily changing the total size of their stock holdings. These strategies leverage the merits of looking at individual stocks, as each company has its own quality, risk and valuation traits.

The first strategy emphasizes higher quality companies with strong businesses and financial positions that assuredly will survive the downturn, yet whose shares now trade at lower prices. Listed in the table below are six companies that meet these criteria. We would include McDonald’s (MCD), discussed in the above article on restaurants, in this group. True to the Turnaround Letter ethos, many have value-enhancing strategic changes underway.

Investors may find these stocks to be useful holdings if choosing to reduce their riskier positions. If the market takes another sharp downturn, these stocks may become available at truly great prices, providing potentially outsized long-term returns. Our Purchase Recommendation this month falls into this category as well.

The second strategy is to buy harder-hit stocks of companies that generally have the financial strength to survive all but the most debilitating downturn. Often these companies offer high dividend yields, such that even if the dividend were cut in half the yield would still be appealing.

Looking for generous dividends that compensate you while you wait for the stock price to rebound is a favored strategy of the Turnaround Letter, and we would put many of our currently recommended names into this group.

The third strategy emphasizes high-risk, high-return stocks, which may not be appropriate for most investors, but may be appealing to some. This approach focuses on debt-laden companies or companies in the early stages of a potential turnaround whose stocks have the potential for a three-fold or more increase if the economic downturn is shallow.

However, if the recovery doesn’t happen in time, the stocks of these distressed companies would likely go to zero if the company files for bankruptcy. These stocks may best be viewed as speculative options given their exceptionally high level of risk.

We currently would include airlines, cruise lines and many energy sector companies in this category. With much of their revenues stream now threatened, Turnaround Letter recommended names that fall into this category include Amplify Energy, AMC Entertainment, and Washington Prime Group, and possibly Brookdale Senior Living and Macy’s.

BlackRock (BLK) – Much of BlackRock’s revenues are driven by fees on its $7 trillion in assets under management, now likely lower given the market’s recent drop. However, the company has an immense and highly diverse investment product franchise that won’t likely be disrupted, and its broad array of adjunct services remains embedded in the daily processes of professional investors.

BlackRock’s corporate bond ETFs will likely see inflows from the Federal Reserve’s new stimulus initiative. Near-zero interest rates may impel the company to waive its fees on its money market products, but most of these are held by low-fee professional investors so the impact would likely be relatively small. BlackRock’s balance sheet is sturdy and the dividend is well-covered.

IBM (IBM) – While in recent years it has struggled to produce revenue and earnings growth, IBM remains a technology giant (and holder of a valuable monopoly in mainframes) that is embedded in the core operations of many of its customers. This stickiness has usually been underrated. New and separated leadership in the president, CEO and board chair seats will likely bring fresh perspectives and a heightened pace of improvements in IBM’s revenue and profit structure.

The company’s strong free cash flow should be more than adequate to repay its Red Hat debt while also covering the dividend. With the now-reduced valuation of 8.3x earnings, and paying a 6.0% dividend yield, IBM shares look like a safe haven in the current storm.

Kimberly-Clark (KMB) – As a producer of household paper products, diapers and other disposable personal care products, Kimberly-Clark has a steady revenue and profit stream that will likely see at least a temporary uplift from heightened consumer demand. Longer term, as consumers and retailers maintain higher inventories, Kimberly-Clark could easily see a permanent step-up, as well.

A new leadership team is helping to accelerate the company’s revenue and profit growth. Kimberly-Clark’s debt level is modest. The shares now trade at their early 2016 price, with a reasonable valuation and an above-market dividend yield that is well-supported by cash flow.

Merck (MRK) – At a minimum, Merck appears to be well-insulated from the Covid-19 slowdown. The company has a diverse range of high-margin treatments and a healthy pipeline of new drugs. Much of its patent expiration risk has passed. Following the upcoming spin-off of its women’s health, legacy brands and biosimilars (a specialized type of biological generic) products, Merck will have a concentrated and faster growing product line centered around its blockbuster Keytruda, which treats cancer. Merck has a cash-laden and low-debt balance sheet, and its dividend appears well-covered.

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PepsiCo (PEP) – This iconic company is well-positioned in the snacks business and maintains a strong franchise in non-alcoholic beverages, particularly in the United States. Its recently announced acquisition of Rockstar Energy demonstrates its commitment to staying up-to-date in beverages. PepsiCo appears to be somewhat insulated from an economic downturn as its products have low price-points, are widely preferred and readily accessible around the world.

A large and multi-year investment program, led by a relatively new CEO (October 2018), will weigh on near-term earnings growth but should position the company for better profits down the road. Debt will remain at modest levels even after the Rockstar deal.

VF Corporation (VFC) – Maker of casual and performance-oriented gear under The North Face, Timberland and Vans brands, VF is a well-managed company with a modest level of debt and a sizeable cash balance. Its function-oriented products will likely remain staples even in a downturn.

To help focus its efforts, VF recently spun off its Wrangler and Lee blue jeans businesses as Kontoor Brands, and announced plans to spin off its Dickies and other occupational brands. The dividend appears well-covered and the shares have fallen sharply from their peak, losing much of their previously-high valuation.

Purchase Recommendation Berkshire Hathaway (BRK/B)

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Background:

Berkshire Hathaway is a company like no other. Led by the legendary Warren Buffett, one of the most successful investors in history, it owns a wide range of businesses including insurance companies, railroads, utilities, retail stores and food producers as well as a $392 billion cash/investment portfolio.

Buffett acquired a controlling stake in Berkshire Hathaway, a struggling textile mill, in 1965. Over time, he diversified the company into more promising businesses, notably with an initial stake in insurance company GEICO in the late 1970s. The company has since expanded through organic growth as well as from new businesses purchased with internally generated cash and funds from a growing pool of insurance capital. Berkshire maintains a minimal headquarters staff of about 25 people, preferring to delegate the management of its businesses to each unit’s highly capable leadership team. Buffett’s primary focus is the allocation of capital within and across each of the companies.

While Berkshire shares have vastly outperformed the S&P 500 over the past 20+ years, their return over the past decade has essentially matched the index and have lagged in the past five years through year-end 2019. Investors wonder if the company has grown too large to find meaningful new growth opportunities or acquisition targets, worry about Buffett’s advanced age (89), whether his conservative investment strategy has become outdated and what a post-Buffett Berkshire might look like. The company’s insurance operations face heavy competition as well as the remote possibility of a large casualty loss (as with any insurer), and an economic downturn will likely lead to near-term earnings declines in many of its businesses.

Analysis:

The current market downturn has provided an attractive entry point for investors looking to buy Berkshire shares. Since the market’s peak in February, its share price has declined 22%, unwinding almost three years of appreciation. We consider book value per share, which is about where the stock currently trades, to be a floor valuation level. Over the past decade, the shares have traded at a considerable premium to book value (averaging at least 30%). Buffett has nibbled at share repurchases at valuations above book value, and we anticipate that he will become more aggressive now.

If anything, Berkshire’s hesitancy to make large acquisitions has proven to be prescient rather than outdated. The recent market decline was partly driven by an over-valued and overly optimistic market returning to a more reasonable valuation. Buffett was showing his patience and skill by waiting. While we acknowledge that Berkshire’s scale and scope create practical limits to its ability to grow by acquisition, we expect the company to use its large cash hoard to become more active in making acquisitions, helping to rekindle profit and book value growth.

Buffett clearly can’t run Berkshire forever. He has installed capable leaders to replace him in key functions, but a post-Buffett Berkshire may lose some of the luster that has been generated by the reputation of the man himself. However, given that book value probably undervalues the combined entity, and that over time the Berkshire entity may be unwound, any drop in the share price surrounding his passing should be only temporary.

Berkshire’s exceptionally well-capitalized and highly diverse businesses, strong company-level leadership and unusually low valuation provide investors with not only a sturdy port in the current storm but also an opportunity for longer-term capital appreciation. For most investors, the Class B shares, which are economically equivalent to 1/1500th of a Class A share and hence trade at about 1/1500th of the price of a Class A share (currently at $274,021/share), offer a more accessible way to invest in Berkshire Hathaway.

We recommend the PURCHASE of shares of Berkshire Hathaway, Class B (BRK/B) shares with a $250 price target.

NEWS/NOTES

To help preserve cash, many Turnaround Letter recommended companies have recently suspended their dividends, including AMC Entertainment, Macy’s, Signet Jewelers, Peabody Energy and Freeport-McMoran. Amplify Energy and Washington Prime Group have sharply reduced but maintained at least some of their dividend, although we expect both will completely eliminate their dividends.

We anticipate that more Recommended companies will cut their dividends, with the most likely being Gannett, General Motors, Mosaic, Volkswagen and Credit Suisse. While we are disappointed by these dividend suspensions and reductions, they are under-standable in the current situation. With many of these stocks now trading at much lower prices, these dividend changes do not by themselves change our recommendations.

PERFORMANCE

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