Cabot Turnaround Letter 621

Thank you for subscribing to the Cabot Turnaround Letter. We hope you enjoy reading the June 2021 issue.

Good investing ideas can come from anywhere. One useful source is to borrow ideas from some of the best value-oriented investors. Their holdings can be found in the 13F and 13D regulatory filings which are required every quarter. In the letter, we briefly describe these filings, how we use them, and six stocks that look attractive from the many holdings we analyzed.

A slightly shocking source of turnaround ideas can come from the electric utility industry – about the last place that contrarians might look these days. We discuss three with interesting stories and strong upside potential.

Our feature Buy recommendation, Vistra Corporation (VST), comes from this illuminating search through the utility sector. Vistra is the nation’s largest independent power producer with an emerging retail business. Its shares were jolted by the winter storms yet look like an attractive turnaround situation.

We also mention our May 12th move from Buy to Sell on shares of Mohawk Industries (MHK).

Please feel free to send me your questions and comments. This newsletter is written for you. A great way to get more out of your letter is to let me know what you are looking for.

I’m best reachable at Bruce@CabotWealth.com. I’ll do my best to respond as quickly as possible.

Cabot Turnaround Letter 621

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13F and 13D Filings: Borrowing Ideas from Other Investors
Good investment ideas can come from anywhere. One useful source is to borrow ideas from like-minded investors. While major institutional investors want to keep their best ideas secret, they are required by the Securities and Exchange Commission to file regular reports that disclose their holdings. Once disclosed, anyone can view them. Several online aggregators provide convenient access to these reports.

All institutional managers of $100 million or more are required to file 13F reports within 45 days of the end of every calendar quarter. The most recent filings were due on May 15. Some family offices, like the notorious Archegos Capital Management, can be exempt from these filings.

The Form 13D is another useful required filing. Any investor accumulating a beneficial ownership of 5% or more of any voting class of a company’s SEC-registered equity securities must report their position within 10 days of reaching the threshold. This filing can tip off the market that an activist is preparing a campaign against a company. In many cases, activist investors buy just under 5% to avoid this report, or may rush to accumulate larger positions within the 10-day window before revealing their stake. In some cases, if an investor declares that they have no intent of influencing control and own less than 20% of the voting shares, they may file a 13G instead, which has easier reporting requirements. When a 13G investor switches to become a 13D investor, it can signal the onset of an activist campaign.

Institutional investors have vast resources that allow deep due diligence into stocks that most other investors can’t match. Seeing that a like-minded and highly-regarded manager owns a particular stock can add confidence to stock picking.

These filings are a regular part of the Cabot Turnaround Letter’s toolkit. From our evolving roster of over 50 value-oriented managers, we concentrate on where they are adding to their top holdings. This indicates a high degree of confidence and favorable timing. We then cull the list to more precisely match our criteria. As long-term investors, we have an advantage – longer holding periods for these stocks means that the regulatory filings remain current for longer. It doesn’t make much sense to see what a momentum investor was holding on March 31 if their high-turnover strategy means they probably have sold the position by May 15.

The 13F and 13D reports also allow us to identify the major holders of potential Cabot Turnaround Letter candidate stocks – valuable input into the mosaic of information about the consensus view: is the stock a “hedge fund hotel” (mostly held by hedge funds, which have notoriously fickle attention spans), heavily-owned by index or vanilla funds, activist investors, or savvy long-term value investors? We also keep tabs on our currently-recommended holdings to see who is entering and exiting.

As a side note, our recent search showed where many of today’s hot SPACs are held. Not surprisingly, hedge funds were major holders of SPACs, highlighting the trendy and temporarily lucrative nature of these vehicles while also pointing to the post-fad dangers for all other investors.

CoreCivic (CXW) – This company is the largest private owner/operator of corrections and detention facilities in the country, with over 70,000 beds in 47 facilities, as well as 26 residential re-entry centers and 15 other properties. While CoreCivic has historically generated steady profits, it is increasingly controversial. A class action lawsuit alleging misleading statements by the company (then named Corrections Corporation of America) in 2016 remains a cloud. President Biden’s executive order on January 26 banning the Department of Justice from renewing private prison contracts capped years of earlier steps in that direction, threatening at least 23% of CoreCivic’s revenues. Adding to its difficulties, the pandemic has led to reductions in its population. As a real estate investment trust, Core Civic required capital market access to fund its growth, but skeptical investors constrained this access. In response, the company converted to a taxable corporation in January, relieving them of the obligation to pay out scarce cash as dividends. The shares have declined 80% from their 2014 peak and trade at long-time lows.

However, at least one savvy investor, Michael Burry, of Scion Asset Management and The Big Short fame, raised his position to 1% of the company’s market cap. What he may see is that CoreCivic appears sharply undervalued on a per-bed asset basis, there may not be many alternative locations for federal incarcerations, and the company is aggressively shoring up its balance sheet. CXW shares carry considerable risk and social taint, but appear to offer sharp upside potential if conditions turn in the company’s favor.

Five Point Holdings (FPH) – Formed in 2009 to acquire Newhall Land & Farming, Five Point Holdings is a developer of three mixed-use, master-planned communities in Valencia, California (north of Los Angeles), the Candlestick/San Francisco Shipyard, and Great Park Neighborhoods (Irvine, California). Its properties are in high-quality, desirable locations in attractive markets. The company’s primary source of revenue is the sale of residential and commercial land sites to homebuilders, commercial developers and other buyers. Management looks impressive, led by former senior executives of housing giant Lennar. One complicating factor is an unwieldy ownership structure which potential investors will want to get comfortable with.

With the boom in housing demand following the pandemic, Five Point is seeing sharply higher sales as well as higher underlying asset values for its properties. To capture more value and provide steady cash flow, the company may retain and rent multi-family and commercial properties. Recognizing this, Third Avenue Management, the value-focused firm built by late founder Marty Whitman, incrementally added to FPH, which is their largest holding at nearly 9% of assets. Trading at 0.9x tangible book value, the long-term shareholder prospects look attractive.

Garrett Motion (GTX) – Spun off from Honeywell in 2018, auto components maker Garrett Motion filed for bankruptcy in 2020 as its heavy payments back to Honeywell to cover allegedly unrelated asbestos claims overwhelmed its finances. The company also struggled with the secular shift in Europe away from diesel-powered vehicles which were major users of its turbochargers. However, Garrett Motion emerged from bankruptcy this past April, with $1.3 billion in new equity from Oaktree and others including existing shareholders, greatly reduced debt, and the elimination of any asbestos liability, although it is required to make $100 million in annual payments to Honeywell from 2023-2030.

Baupost Group, the Boston-based fund led by legendary value investor Seth Klarman, holds a 5.5% stake in this company. Garrett is benefitting from the surge in post-pandemic car production, and is shifting into hybrids and related EV components to adapt to the industry’s transition. In its most recent quarter, the company produced a wide 17.7% EBITDA margin and generous free cash flow. The valuation looks undemanding at best.

Imperial Brands (IMBBY) – Imperial is the world’s fourth-largest tobacco company outside of China, with about a quarter of its revenues coming from the United States. We mentioned Imperial Brands in our March 2021 Cabot Turnaround Letter (“Tobacco Stocks – Not Up In Smoke Just Yet”), and the shares are getting a strong endorsement from highly-regarded value investor Dodge & Cox. In its $43 billion International Stock Fund, the manager raised their holdings by about 8%, putting their ownership at about 3.1% of Imperial’s total shares.

Imperial stumbled badly in recent years, but new leadership, including board chair Therese Esperdy (former head of several of JPMorgan’s global investment banking operations) and CEO Stefan Bombard, who brings considerable turnaround experience, are aggressively rebuilding the company. First-half 2021 results, reported in mid-May, show encouraging market share stability, improvements in product pricing, and higher underlying operating profits. Better profits plus tighter financial controls led to a sharp increase in free cash flow and debt reduction. With its financial outlook stabilized, Imperial is taking initial steps to re-start its next generation product efforts. Imperial shares trade at a discounted valuation and offer a generous 8.4% dividend yield.

Tidewater, Inc (TDW) – This company, founded in 1955, owns and operates a fleet of 172 offshore support vessels used primarily by the global oil and gas industry. While well-run, Tidewater slipped into bankruptcy in 2017 in the wake of the sharp decline in energy prices. It emerged later that year, and now carries a relatively clean balance sheet with cash nearly fully offsetting its modest debt. The company is producing positive free cash flow and selectively selling some boats to help streamline its operations while using the proceeds to further trim its debt – all helping Tidewater to patiently wait for what appears to be a slowly-arriving industry recovery.

TDW is the fourth-largest position (at 13%) of well-regarded value investor Moerus Capital Management, and is the only one in the top eight that they added to. Also, Tidewater recently added Robert Robotti, an outside investor who has been pressuring the company for better governance, to its board of directors.

Treehouse Foods (THS) – With revenues of about $4.5 billion, Treehouse is one of the largest producers of private label food and beverages, as well as powdered coffee cream and other meal preparation products, for grocery, food service and industrial customers. Highly-regarded activist investor JANA Partners recently disclosed that they doubled their stake in Treehouse to 7.4%, making it their third-largest holding, likely in support of an agreement with the company to get two board seats. Treehouse could use the help, as it has struggled for years with poor strategic and operational execution in the face of aggressive competition and rising input prices.

JANA’s increased involvement likely means changes are coming: Treehouse has a new board chair, the chief operating officer announced his departure, and the CEO is reported to have sold his nearby mansion at a loss, hinting at a possible exit at the company, as well. Despite its challenges and 5% decline in first-quarter organic sales, the Treehouse business has considerable value, reflected partly in its sizeable $300 million annual free cash flow. With improved leadership and oversight, Treehouse should be able to improve its food quality, client service, profits, balance sheet and shareholder communications, which would lead to renewed prosperity for its currently undervalued shares.

Closing prices on May 21, 2021.
* Enterprise value/earnings before interest, taxes, depreciation and amortization. Based on consensus estimates for fiscal years ending in 2022. Due to lack of estimates, CXW valuation is based on calendar 2021 and GTX valuation is based on trailing 12 months ended March 31, 2021.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Electric Utilities: Turnarounds with Voltage
It would seem that looking for worthwhile turnaround stocks among the electric utilities would be highly unproductive. And, for the most part, it is. These companies typically have highly-conservative management that oversee low-growth and stable businesses, whose profits are limited by regulators that focus primarily on reliable electricity at fair prices to consumers. Further, in the current low interest rate environment, most utility shares carry historically high valuations, leaving little opportunity for contrarians.

However, these companies aren’t immune to problems, or to activist investors with ideas about how to improve shareholder returns. Noted activist investor Elliott Management has been active in the sector – it recently launched a campaign to split up Duke Energy, one of the largest electric utilities. Last year, the investor reached a settlement with Missouri-based Evergy that made meaningful changes to its board and its strategic focus, followed by its successfully pressuring Houston’s CenterPoint Energy to add two outside directors, receive a $1.4 billion equity infusion and create a board-level committee to review and redirect its strategy.

The electric utility isn’t entirely static, either. Growing emphasis on sustainability is boosting solar, wind and other energy sources while pushing out coal-fired generation. President Biden’s proposed infrastructure plans could allocate many billions of dollars (or more) to boost the electricity grid, while a shift to electric vehicles could create a vast new source of demand.

Listed below are three electric companies that have interesting catalysts along with out-of-favor stocks. This month’s Buy recommendation, Vistra Corporation (VST), fits into this group. Some of the names carry high risks, but offer potentially generous returns that would rival turnarounds in any industry.

First Energy (FE) – Ohio-based First Energy is primarily a regulated electricity transmission and distribution company with over six million customers in Ohio, Pennsylvania, West Virginia, Maryland and New Jersey. Excitement arrived at this otherwise prosaic utility last July when the Ohio House of Representatives speaker was arrested on federal bribery charges related to legislation to bail out a former First Energy nuclear power company. First Energy’s CEO and other senior executives were fired shortly thereafter, as it appears that First Energy used rate-payer money to help fund the bribery scheme.

While the ultimate outcome is uncertain, and the scandal could spill over into future rate-setting cases, there is a good chance that the utility will reach a settlement with the Department of Justice to put the issue behind it. First Energy has subsequently overhauled its governance and compliance culture, foremost through several key hires from the board of directors (including two Icahn Capital representatives) on down. The company is also selling assets to prevent a possible equity raise. First Energy’s underlying business remains sturdy, providing investors with upside potential and a 4.1% dividend yield.

Otter Tail Corporation (OTTR) – Based in northwest Minnesota, this company is a rare combination of an electric utility and a manufacturing business. Otter Tail’s power operations have 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. An accommodative regulatory environment is allowing the utility to continue to add capacity, although its projected rate base growth is likely to be incrementally slower than in prior years.

The manufacturing side includes four well-managed specialized metals and plastics companies. Here, stronger end-market growth should more than offset rising input prices. Otter Tail’s sturdy balance sheet is investment grade, earnings and cash flow are growing and the company prides itself on steady dividend growth. The unusual utility/manufacturing structure 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. The shares trade 15% below their pre-pandemic level.

PG&E Corp (PCG) – In early 2019, this California utility filed for its second bankruptcy in 20 years, this time due to costs from the tragic 2017-18 wildfires. The state’s controversial inverse condemnation laws, which create liability for wildfire damage caused by company-owned equipment regardless of fault, only exacerbated problems from PG&E’s bureaucratic culture. PG&E emerged from bankruptcy last July, and now appears to be on the right track. New leadership, provided by the addition of Patti Pape as CEO, is the driver. Pape previously was CEO of Michigan’s CMS Energy, widely-regarded as being among the best-run utilities in the industry. She has bolstered the leadership team by hiring top executives from other exceptional utilities like NextEra Energy and Berkshire Energy, who are upgrading PG&E’s culture and operating effectiveness. While future wildfire liability through inverse condemnation remains, several factors help tame these risks. First, PG&E is working to reduce the chances that its equipment could spark wildfires.

Also, under California’s recent AB 1054 law, the state established a $21 billion insurance fund to provide coverage of wildfire costs. While coverage is by no means guaranteed, the fund provides a valuable buffer against quick-rising and crippling losses. And, in many cases, the utility can recover wildfire costs through its rate base. Although PG&E will never get the valuation of a plain, non-California utility, and the shares carry high risks, the deep discount seems unwarranted given all of the favorable changes underway.

Closing prices on May 21, 2021.
* Enterprise value/earnings before interest, taxes, depreciation and amortization. Based on consensus estimates for calendar 2022.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Recommendations

Purchase Recommendation: Vistra Corporation

Vistra Corporation 6555 Sierra Drive Irving, Texas 75039 (214) 812-4600 vistracorp.com

Symbol: VST Market Cap: $8.0 Billion Category: Mid-Cap Business: Electricity Generation Revenues (2021E): $11.9 Billion Earnings (2021E): $(650) Million 5/21/21 Price: 16.68 52-Week Range: 24.20-15.47 Dividend Yield: 3.6% Price target: 25

Background
Vistra Corporation is the country’s largest independent power producer. Its core business is generating electricity, primarily from natural gas (63% of generation) and coal (29%), to sell into wholesale markets which ultimately provide power to retail, commercial and industrial consumers. Based in Irving, Texas, the company was spun off in 2016 from then-bankrupt Energy Future Holdings, which had collapsed after an ill-timed $45 billion leveraged buyout in 2007, the largest LBO in history. In 2018, Vistra acquired another independent producer, Dynegy, in a $1.7 billion all-stock deal. It later acquired Crius Energy Trust and Ambit Energy, which expanded Vistra’s retail customer base. Today, Vistra’s retail segment provides electricity and natural gas to about 4.5 million customers in 20 states.

Power generation can be a high-risk business of profiting from the spread between input prices (natural gas, coal and others) and local electricity prices. In normal times, the business produces large and steady profits and cash flow. However, occasional market imbalances, such as the recent Texas winter storm which inflicted over $2 billion in losses on Vistra in only a few weeks, highlight the risks.

Vistra shares have declined 40% from their 2019 highs, and trade almost unchanged from their 2017 post-bankruptcy debut on the NYSE at just over 15. The market has a lot of worries regarding Vistra: the risk of a winter debacle repeat in future years, various legislative proposals that would attempt to prevent similar problems but could impede Vistra’s profitability, rapid adoption of ESG investing principles which frown upon Vistra’s coal assets, growing generation from wind and solar facilities which could suppress electricity prices, and the company’s overall risk level due to its commodity exposure, leverage, complex hedging and intense competition. With this litany of worries, and the effort required to understand its business, most investors simply avoid Vistra’s shares.

Analysis
While recognizing the uncertainties, the narrative on Vistra is overly focused on the potential for more problems rather than the likelihood of a return to its strong profits and free cash flow. In 2019 and 2020, the company’s EBITDA margin was about 26%, resulting in over $3.5 billion in annual EBITDA profits and over $2 billion in annual free cash flow. There is a good chance that 2022 and future years will produce similar results.

Vistra’s long-term strategy is appealing. It is migrating to a vertically-integrated business model that provides it with end-customers who consume the energy that it produces. This greatly reduces its overall risk while maintaining its attractive profit margins. In technical terms, its “load-to-generation” is about 60%, meaning that its retail operations now use nearly 60% of the electricity that it generates. All in, its TXU Energy segment, the retail operations of Dynegy, and Crius and Ambit now comprise 25% of Vistra’s profits.

The Winter Storm Uri was a jarring but likely one-off disaster. Most of Vistra’s $2 billion in losses were caused by a severe shortage of natural gas to fuel its generators, which forced the company to buy natural gas on the open market at prices above $300/MMBtu, more than a hundred-fold the more typical $3 price. A major problem: suppliers improperly terminated their natural gas supply contracts when they were needed the most. Other causes included Vistra’s unusually high need for natural gas and problems with frozen natural gas pipelines.

To prevent future calamities, Vistra is hardening its fleet against cold weather, building increased fuel inventories, and working with Texas authorities to winterize gas infrastructure and power assets in general. We anticipate these costs will be readily manageable. We are optimistic, but recognize the risks, that potential regulatory reforms that aim to prevent a repeat of 2020’s problems will not have a meaningful impact on Vistra’s profit profile.

While the company had to temporarily increase its borrowing, its $11.3 billion total debt balance is reasonable. Vistra remains committed to achieving an investment grade credit rating, and was close to this goal just prior to the winter storms. It looks well-positioned to reach its targeted leverage of 2.5x EBITDA, probably enough for investment grade, sometime in 2022. The company suspended its share buyback program and has undertaken other efforts to pay down the extra borrowings, and a return to its normally high free cash flow in coming quarters should bolster its otherwise-healthy finances. Vistra’s liquidity is robust.

With respect to ESG, the company got the message. It plans to retire nearly all of its coal-based production by 2030, is building sizeable solar and battery operations, and has accelerated its pledge to be carbon-neutral by 2050, in addition to launching numerous smaller initiatives and taking a more proactive stance with its communications.

Overseeing Vistra’s complex business is a capable and experienced management team and board of directors, with deep experience in the strategic, operations, hedging, financial and regulatory aspects of keeping the company on an even keel.

The electricity industry overall appears to have a favorable secular tailwind. Rising demand for electricity, spurred by a shift to electric vehicles and fully-electric homes, along with robust economic growth in general, could lift wholesale electricity prices while at the same time reducing the demand (and prices) for the fuels used to produce it. Additionally, proposals by President Biden to invest in the grid may bring benefits to producers like Vistra.

Overall, the Vistra story has considerable appeal. The highly discounted price reduces the risks in VST shares while increasing the potential reward to a highly attractive level. Our valuation uses conservative assumptions for a 6.5x multiple on about $3.4 billion in EBITDA that points to a 25 price target. The 3.6% dividend yield appears solid as the company generates considerable free cash flow, reiterated its commitment to the dividend, and recently raised it by 11%.

We recommend the purchase of Vistra Corporation (VST) shares with a 25 price target.

Price Target Changes and Sell Recommendations
On May 12, we moved shares of Mohawk Industries (MHK) from BUY to SELL. The company’s turnaround appears complete, and the shares reached our 220 price target. From here, this cyclical company would likely need several things to go right: an enduring recovery in the residential market, stronger rebound in the commercial market, no more input cost inflation, no/minimal capacity increases within the flooring/ceramic industries, and no operational, legal or other problems over the next few quarters, at least. Some of these will no doubt go right, but needing all of them to go right is a bit too much to ask. The investment produced a 51% profit.

Disclosure: The chief analyst of the Cabot Turnaround Letter personally holds shares of every “Buy” rated recommendation. The chief analyst may purchase securities discussed in the “Purchase Recommendation” section or sell securities discussed in the “Sell Recommendation” section but not before the fourth day after the recommendation has been emailed to subscribers. However, the chief analyst may purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time.

Performance

The following tables show the performance of all our currently active recommendations, plus recently closed out recommendations.

Large Cap¹ (over $10 billion) Current Recommendations

Mid Cap¹ ($1 billion - $10 billion) Current Recommendations

Small Cap¹ (under $1 billion) Current Recommendations

Most Recent Closed-Out Recommendations

Notes to ratings:
1. Based on market capitalization on the Recommendation date.
2. Price target in parentheses.
3. Total return includes price changes and dividends.
4. Prices and returns are adjusted for stock splits.
SP Given the higher risk, we consider these shares to be speculative.
* Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.

The next Cabot Turnaround Letter will be published on June 30, 2021.

Cabot Wealth Network
Publishing independent investment advice since 1970.

President & CEO: Ed Coburn
Chief Investment Strategist: Timothy Lutts
Cabot Heritage Corporation, doing business as Cabot Wealth Network
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