Cabot Turnaround Letter 721

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

This month we look into major pharmaceutical stocks, which are selling at their widest discount to the market in decades. We discuss some reasons behind the market’s pessimism and why, for value investors with patience, the shares of five companies offer considerable appeal.

We also include our mid-year stock market update and mid-year bankruptcy review. Stocks have been remarkably strong so far this year and appear poised for more gains, yet we encourage value investors to remain selective and patient amidst the exuberance while keeping the long-term horizon in view.

Easy financial market conditions have helped shrink the number and size of bankruptcies to a fraction of their long-term average. We discuss this phenomenon and why investors in distressed securities should wait for conditions to become favorable again.

Our feature Buy recommendation, Organon & Company (OGN), is a recent spin-off from Merck. Investors have discarded the shares due to revenue concerns, but the bargain valuation and our more optimistic outlook make the shares appealing.

It was a busy month in the portfolio. We raised our price targets on Signet Jewelers (SIG), Molson Coors Beverage Company (TAP) and General Motors (GM), and moved four stocks to Sell: Biogen (BIIB), BorgWarner (BWA), The Mosaic Company (MOS) and Jeld-Wen Holdings (JELD).

Please join us for the our 9th Annual Smarter Investing, Greater Profits Online Conference, held on Tuesday, August 17 through Thursday, August 19. You can see presentations by all of our analysts, which will include updates in their areas of expertise and discussions of their best picks.

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 721

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Big Pharma at a Big Discount
Major pharmaceutical stocks are clearly not “the place to be” in today’s market. Investors much prefer fast-growing yet expensive technology (including biotech) and cyclical re-opening stocks. After years of stagnant share prices while the S&P 500 surged, the group now sells at about a 40% price/earnings discount to the market, its largest in decades and well below the historical premium valuation. For value investors with patience, the shares offer considerable opportunity.

Unlike their more specialized biotech peers, the major pharmaceutical companies generally have diversified portfolios of treatments, vast cash flows that fund the high cost of new products, global in-house manufacturing capabilities and large sales and marketing forces. All of these traits make them inherently slower growth and thus less appealing relative to the potential (if not reality) for hyper growth elsewhere.

Further weighing on the shares is the worry that the industry’s best days are behind it. Many of the most common ailments already have treatments, leaving fewer new blockbuster-scale opportunities while also straining the ability of research teams to replenish their product pipelines. Yesterday’s patent-protected profits are today’s profit-draining patent expirations. And, powerful government and private-sector buyers continue to demand aggressive price cuts, such that the “gross-to-net” (a measure of the average discount from list prices) is approaching 50%. The industry is in essence selling its products for half off. Investors wonder if many of the companies face a downward spiral in which falling revenues forces the shrinking of research budgets, which further pressures revenues, and so on. It seems a little like having a vast hoard of cash but no properties in a Monopoly™ game, when all the other players have hotels.

However, many major pharma stocks have become too cheap to ignore. Several trade at less than 10x earnings, a huge discount to the market’s 20.2x earnings multiple on 2022 earnings, while offering generous dividend yields backed by strong cash flow. Many of these companies are narrowing their focus while boosting their growth, and have new leadership to drive the changes. And, in addition to considerable upside potential, these stocks have valuable defensive traits: they tend to be insensitive to rising interest rates while having resilient earnings and financial stability to help them ride through the next recession (in case we ever have another one). Investors’ skepticism about the research pipelines appears to be overblown, as well. Weak first-quarter results seem generally attributable to pandemic-related disruptions, with pharma companies maintaining or raising their full-year guidance.

Listed below are five major pharmaceutical companies with attractive fundamentals and discounted share prices. To this list we also include our Buy-rated Viatris (VTRS), new Buy recommendation Organon (OGN), and note that Bristol-Myers Squibb (BMY) has a Strong Buy rating and Merck (MRK) has a Buy rating in the Cabot Undervalued Stocks Advisor.

Bausch Health Companies (BHC) – Previously named Valeant Pharmaceuticals, Bausch has a tarnished history. The company grew rapidly starting in 2008 when J. Michael Pearson became CEO. He led a flurry of deals including Bausch & Lomb ($8.7 billion) and Salix Pharmaceuticals ($14.5 billion), along with failed attempts to buy Allergan, Actavis and Cephalon. While profits and the share price initially surged, expensive deals led to excessive debt, while pervasive ethics and accounting problems, catalyzed by a critical report from a noted short-seller, led to the company’s collapse. By mid-2017, the shares had fallen 97%.

Today, new leadership (since 2016) is focused on stabilizing the company’s operations, such that Bausch is on track to produce its first net profit since 2017. While still over-leveraged, its net debt has been reduced by more than 25%. An uplift could come from the spin-off of its Bausch & Lomb unit, likely in 2022. Bausch still has a difficult road ahead, complicated by lackluster new product development after years of research budget cuts, along with constant patent challenges to its valuable Xifaxan treatment. But, with more time, Bausch’s business, and share price, may yet return to health.

Bristol-Myers Squibb Company (BMY) – Bristol has a broad portfolio of hematology, oncology, cardiovascular and immunology therapies, after divesting several businesses to focus on high-value pharmaceuticals. Investors rightfully worry about patent expirations for Revlimid, Opdivo and Eliquis, which produce about 68% of the company’s total revenue.

However, Bristol has a robust product pipeline that offers potentially sizeable new revenues. Its acquisitions of Celgene and MyoKardia, and potentially future acquisitions, provide additional growth potential. And, Bristol has signed agreements with competitors to protect some of the “key three” profits. All in, the likely worst-case scenario is for flat revenues over the next 3-5 years. Any indication that revenues could sustainably grow should boost BMY shares considerably. Helping mitigating the risks: the company is aggressively cutting its costs. Earnings for 2021 are estimated to increase 16%, then taper to 6-8% in future years. Bristol is positioned, backed by management guidance, to generate between $45 billion and $50 billion in cash flow over the three years of 2021-2023 – a sum equal to a third of its $149 billion market value. The balance sheet carries $13 billion in cash and its debt is only 2x EBITDA.

GlaxoSmithKline (GSK) – London-based Glaxo focuses on immunology/respiratory, HIV, oncology and inflammation ailments. Its vaccine operations, which includes Shingrix, are the world’s largest by revenues. Relatively new CEO Emma Walmsley (since 2017), who had a successful career at exceptionally well-managed L’Oreal, is changing the strategy to prioritize specialty medicines and vaccines while running the general medicines business for cash to help reduce Glaxo’s debt.

The company’s research pipeline looks robust while its patent expiration risks are relatively minor other than for Advair. In mid-2022, the company will spin off its large consumer healthcare business (itself a joint venture with Pfizer), further narrowing Glaxo’s focus but also likely resulting in a dividend cut. Activist investor Elliott Management is pressuring Walmsley and her strategy, adding urgency to the initiatives. Glaxo’s near-term results have suffered from pandemic-related disruptions, but the company reaffirmed its full-year guidance for an 8-9% earnings decline. Post-spin-off “New GSK” is expecting 5% revenue growth and 10% earnings growth.

Merck (MRK) – Merck focuses on oncology, vaccines and antibiotics. Investors worry about the loss of patent protection in late 2028 for Keytruda, a blockbuster oncology treatment that generates about 38% of total revenues. Another overhang is generic competition starting in 2022 for its Januvia diabetes treatment. Partly offsetting the Keytruda concerns is the vast profit stream that the franchise will produce in the interim years, given its impressive market share and fast 20% annual growth rate. Supporting the company are healthy patent protections for the rest of its portfolio as well as a strong pipeline with several promising new treatments.

The new CEO (June 2021), previously the CFO, replaced the retiring Ken Frazier and will be accelerating Merck’s acquisition program. To add deal firepower, the company recently spun off its Organon segment, bringing a $9 billion cash inflow to Merck. We see Merck eventually divesting its animal health business. The company is highly profitable, will generate over $17 billion of annual free cash flow and has a conservative balance sheet.

Pfizer (PFE) – Pfizer focuses on oncology, internal medicine, inflammation/immunology and rare diseases. Its Covid vaccine, created with BioNTech, highlights the growing strength of its vaccine segment. This business could become a major franchise, with its new technology allowing it to potentially create reliable defenses against a wide array of diseases. The annual nature of seasonal viruses, along with the considerable difficulty of replicating the manufacturing process, may eliminate most of its competition.

Pfizer produces enormous free cash flow, backed by its strong and diversified patent-protected portfolio and underleveraged balance sheet. Pfizer’s pipeline includes several highly-promising new cancer, immunology and heart disease treatments. The company’s marketing and sales forces are legendary. To help increase its focus, Pfizer recently spun off its off-patent Upjohn division into a combination with Mylan (to form Cabot Turnaround Letter-recommended Viatris). It is surprising that a company with these attributes is selling at such a discount.

Closing prices on June 25, 2021.
* Price/earnings based on consensus estimates for fiscal years ending in 2022..
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Mid-Year Stock Market Update: Time for Value Investors to Be Patient
At about the halfway point of 2021, the S&P 500 has returned 14.8% (a good annual return in most years), continuing its remarkable advance from the depths of the pandemic-led sell-off in March 2020. Our estimate for a 7% full-year return for the S&P 500 is looking well short of the mark.

Unlike last year, when mega-cap tech stocks led the gains, the advance this year has been broad-based. One indicator of the breadth is that the equal-weighted S&P 500 return of 19.5% is much stronger than the market-cap weighted return. Value stocks have surged 18%, perhaps as one would expect in a robust economic recovery, with energy (+46%) and financials (+25%) overpowering tech (+11%). All sectors have had positive returns, including the laggard (utilities, +2%). Growth stock returns of 12% have been respectable but not overwhelming. Small-cap stocks have prospered, gaining 19%, while developed country stocks have returned about 9%.

Interestingly, despite its sharp price advance, the S&P 500’s price/earnings multiple hasn’t changed much, as earnings estimates for 2021 have increased by more than 13% since year end. Despite signs of rampant speculation in non-S&P 500 stocks, the broad market rally has been driven by rising earnings. On estimated 2021 earnings, the market trades at a respectable 22.5x multiple – elevated but not extreme.

What do we see for the rest of 2021? The main supports for the market (strengthening earnings, an improving economy, low interest rates and a lack of major negative surprises) are likely to remain in place, so stocks will likely continue to move higher. However, as the powerful tailwinds behind earnings, the economy and low interest rates will soon moderate, the market seems unlikely to continue its year-to-date pace.

The initial public offering market will likely remain hot, as will meme investing and other forms of speculation. To us, cryptocurrencies are unanalyzable, so we won’t offer any commentary, except that we are absolutely certain that their value is somewhere between very high (if they replace fiat currencies as promised) and negative (due to production and environmental costs). We wonder if an inevitable stock market pullback will be exacerbated by newcomers who experience the pain of losing money for the first time.

After 40 years of weakening inflation, we wonder if a sleeping giant has been awakened by the generous synchronized global fiscal and monetary stimulus programs. Then again, the rush to expand productive capacity could combine with a post-pandemic consumer spending hangover, risking both deflation and a recession.

Our belief that the markets will be increasingly influenced by the “Two Easts” – the Near East (fiscal, monetary and regulatory policy from Washington, D.C.) and the Far East (China) remains steadfast.

For value investors, this is a time to be selective and patient amidst the exuberance while keeping the long-term horizon in view. The market cycle has yet to be repealed. High-quality stocks will become attractively priced again, while inevitable economic disruptions will provide compelling turnaround opportunities among the discarded but capable companies.

Mid-Year Bankruptcy Review: Disaster Forestalled
Only one year after the onset of the crisp, pandemic-driven downturn, the number of bankruptcies has dwindled to near zero. At the mid-year mark, only nine non-financial public companies have filed for bankruptcy – a fraction of the average of about 70 over the past decade. Assets have totaled only $16 billion, less than a tenth of last year’s $172 billion mid-year level, pointing to not only fewer bankruptcies but much smaller ones, as well. The largest bankruptcy has been oil equipment provider Seadrill, at $7.3 billion in assets, compared to the year-ago collapse of rental car giant Hertz, with $26 billion in assets. This bankruptcy cycle has been the shortest and shallowest in living memory.

1. Aggregate of total pre-filing assets of all publicly-traded companies filing for Chapter 11, 7, or 15 (excluding financial companies).
Through June 25, 2021.
Source: BankruptcyData.com

Truncating the cycle has been the one-two punch of aggressive fiscal and monetary stimulus, which not only provided a powerful boost to the tottering economy but also restored capital markets to their current robust health. Bond investors hungry for yield and stock investors looking to play the rebound provided critically-needed cash to forestall Chapter 11s across the economy. Without the no-holds-barred stimulus, there is little doubt that airlines, cruise lines, energy producers and myriad other already-leveraged companies would have collapsed, which would have pushed the size of the bankruptcy roster well past prior records.

An additional and unexpected source of relief to over-leveraged companies is the seemingly irrational surge of meme-driven investing, which has allowed near-death companies like AMC Entertainment, Express and GameStop to raise equity at remarkably favorable prices.

Capital markets remain highly receptive to shaky borrowers, despite the Fed’s recent incremental tilt toward less easy monetary policy. One example: triple-C and lower-rated bonds, which are considered the junkiest of high-yield bonds, currently yield only six percentage points more than risk-free Treasuries. With the rare and foreboding exception of just prior to the 2009 financial crisis, this yield premium is the smallest by far over the past 25 years. There appears to be little chance of a new bankruptcy upcycle as long as investors remain inspired by optimism and driven by the search for yield-at-any-cost.

Of the three ingredients for a bankruptcy cycle – rising interest rates, stalling/shrinking economy and a tightening of access to capital – none are currently in place.

What could change investors’ generous moods? First, a major financial accident. After a decade of near-zero interest rates and exuberant markets, financial excesses seem certain. History provides plenty of examples of blow-ups, particularly when the margin for error is so thin.

Second, any relenting in Washington’s generous fiscal and monetary policies (one of the “Two Easts” that feature in our 2021 investing theme) could dampen investor attitudes toward risk-taking, particularly as markets are now exceptionally sensitive to these policies.

And, the business cycle has yet to be repealed, so a downturn is essentially guaranteed – it is just a matter of time. We anticipate that many companies that have recently borrowed heavily to stay afloat will founder in the next recession under their more elevated debt burdens. The pandemic stimulus programs were gargantuan in size – it is difficult to imagine how the size of the next bailout could be even larger, but arguably it will need to be, given that corporate debt burdens will be larger.

We would encourage investors looking for opportunities in bankruptcies to be patient. The bankruptcy cycle is measured in years if not decades. While it is impossible to see the future (Will inflation be transitory? Will growth taper to a sustainable rate?), conditions are exceptionally favorable for borrowers. Wait for conditions to be exceptionally favorable for investors.

1. Through June 25, 2021.
2. Assets at fiscal year-end prior to filing. Excludes financial companies.
3. Chapter 15.
Sources: BankruptcyData.com

Recommendations

Purchase Recommendation: Organon & Co.

Organon & Co. 30 Hudson Street, Floor 33 Jersey City New Jersey 07302 (551) 430-6900 organon.com

Symbol: OGN Market Cap: $7.5 Billion Category: Mid-Cap Business: Pharmaceuticals Revenues (2021E): $6.3 Billion Earnings (2021E): $1.5 Billion 6/25/21 Price: 30.19 52-Week Range: 38.24-27.25 Dividend Yield: 0.0% Price target: 46

Background
Organon & Company (OGN) is a United States-based global pharmaceutical company with sales of $6.3 billion. About 80% of its sales are produced outside of the United States. Founded in the Netherlands in 1923, the business merged into Akzo Nobel in 1969, was acquired by Schering-Plough in 2007, then joined Merck when it acquired Schering-Plough in 2009. In June 2021, 100% of Organon’s shares were spun-off from Merck. Organon is a member of the S&P 500.

The company has three segments. Established Brands (68% of revenues) is a collection of nearly 50 mostly off-patent cardiovascular, respiratory and other therapies. Women’s Health (23%) includes contraceptives and fertility products. The Biosimilars segment (9%) includes five approved treatments for autoimmune, arthritis and other diseases through a joint venture with Samsung Bioepis. Biosimilars are FDA-approved alternatives to patented biological drugs, which, unlike chemical pharmaceuticals, are created from living cells.

Shares of Organon have fallen sharply since their debut at around 38. One reason is technical: many Merck shareholders likely have little interest in holding a small pharmaceutical company facing patent erosion risks, and thus have sold their shares regardless of price. More fundamentally, investors worry about patent-related revenue erosion in the Established Brands segment and the 2025-2027 patent expiration for its Nexplanon women’s health product (11% of total sales). Also, revenues from the Chinese hospital channel may continue to be pressured by government buying programs. The market sees many years of 3-4% revenue decay at best, amid fears of a sharper decline, for Organon.

Analysis
While acknowledging the revenue risks, we have a more optimistic view of Organon’s future. The marquee Nexplanon product is a highly valuable franchise, with solid 10% growth potential for years. There is a strong possibility that it can extend its patent to as late as 2030. Its complex production process could easily ward off generic competitors afterwards. And, as it is implanted under the skin, women may be hesitant to opt for a discount version. Organon’s fertility treatments are well positioned to grow, particularly in China. The Biosimilars segment offers double-digit growth potential: the industry is in its early innings, Organon has a solid portfolio, and the company has plans for new launches every 1-2 years, including a Humira biosimilar this year in international markets.

While revenue losses in the Established Brands are inevitable, most of the risks are behind it, as only $250 million in revenues, or about 6% of total company revenues, face patent expiration over the next four years. And, the highly diversified product roster minimizes the impact from any single treatment or country. Similarly, much of the pricing pressure from China’s Volume Based Procurement (VBP) program has been absorbed, as about 80% of the company’s portfolio will have full exposure to VBP by the end of this year. And, 40% of the company’s China revenues are produced through the retail channel, which is growing quickly and isn’t as vulnerable to VBP pressures.

Organon’s management team has deep leadership, operating and financial experience. The CEO, Kevin Ali, led Merck’s international business. The CFO previously was Allergan’s and Catalent’s chief financial officer. Other senior executives, as well as the board of directors, bring additional valuable capabilities. Given that the company’s products were neglected within Merck’s enormous operations, there are plenty of opportunities for this management team to rejuvenate Organon’s business.

Strategically, we see the company making smart yet modest-sized acquisitions to expand its Women’s Health business, as this is its primary focus. We would not be entirely surprised if Organon divested its Established Brands segment in a few years, as discarding this perceived albatross would be a significant share price booster.

The company’s robust $1.3 billion in annual free cash flow is more than adequate to trim the modestly elevated $9.5 billion in debt (which funded a $9 billion dividend back to Merck) while also supporting the acquisition program.

Like all turnarounds, OGN shares carry risk. Yet, the shares’ discounted valuation, at 7.2x estimated 2021 EBITDA and 4.6x estimated 2021 earnings, more than adequately reflects this. With improved revenue visibility (we model only 2% cumulative 3-year growth), incrementally wider margins from better oversight, plus the value of interim free cash flows, the shares have considerable upside potential. Additionally, Organon will likely pay out about 20% of its free cash flow in dividends, providing what we estimate will be a 2.7% yield.

We recommend the purchase of Organon & Company (OGN) shares with a 46 price target.

Price Target Changes and Sell Recommendations
We raised our price target on Signet Jewelers (SIG) from 65 to 80 on June 11. The company’s blow-out first-quarter results and guidance indicate considerably more value than we anticipated. Signet’s turnaround is going well, yet the shares remain at a discounted valuation.

On June 7, we made several ratings and price target changes:

We raised our price target on Molson Coors Beverage Company (TAP) from 59 to 69. The company continues to make progress with its new product development and its efficiency initiatives, and is likely to see additional volume growth as its geographic markets fully re-open following the pandemic. TAP shares still do not adequately reflect the company’s value and earning potential.

We also raised our price target on General Motors (GM) from 62 to 69. General Motors’ fundamentals remain robust, even as its core earning power (gas-powered trucks and cars) is suppressed due to the chip shortage. EV competition from start-ups is fading, although Ford is showing a renewed vigor. GM has impressive management, earning power, solid positioning to be a winner in the eventual EV future and undervaluation on reasonably conservative metrics.

We moved Biogen (BIIB) from Buy to Sell as the shares surged well-past our 360 price target on the news that their aducanumab treatment for Alzheimer’s received FDA approval. We believe the treatment has immense potential, yet the share price embeds a tremendous amount of this potential. Also, some of the price surge is likely due to short-covering, which could lead to a fall-off in the price in the near-future. The Biogen investment produced a total return of 64%.

We also moved BorgWarner (BWA) from Buy to Sell. BorgWarner shares essentially reached our 57 price target, closing the sharp valuation discount that was present when we recommended the shares in August 2016. The risk/return trade-off is now unfavorable. While the company is executing reasonably well and is making progress with its transition to an electric vehicle world, it will likely spend most of its available capital on acquisitions of new-tech and e-tech companies. As the company is not likely to be price-sensitive in its acquisitions given the strategic (survival) imperative of its transition, we have little confidence that the future value will be worth the wait. The BorgWarner investment produced a total return of 70%.

As its shares traded at our 35 price target, we moved The Mosaic Company (MOS) from Buy to Sell. Conditions are exceptionally healthy in Mosaic’s markets: supply is tight, demand is strong and customers (farmers) are flush with cash from high corn, soybeans and other agricultural prices. However, we are starting to see fertilizer producers nudge up their output, and we see the ideal conditions as ripe for further production increases as well as eventual capacity additions. The cycle could extend for another year, but the risk/return is not favorable enough to warrant a higher target price for MOS shares.

Despite the sharp 250% price gain since the March 2020 lows, and the shares reaching nearly 6-year highs, the investment was essentially break-even, after dividends, from the September 2015 initial recommendation at 40.55. In hindsight, our outlook at our purchase was too optimistic and we paid too much for MOS shares. Not every investment works as initially expected, of course – we’d rather recognize the error and take a break-even outcome now than hope for a better outcome when the odds don’t favor it.

On May 25, we moved Jeld-Wen Holdings (JELD) from Hold to Sell as the shares reached our price target. The company is executing on its turnaround, led by the relatively new CEO. However, after our more detailed review of the company’s future prospects, the shares appear to fully discount a robust profit recovery. Their Investor Day was uninspiring – while the company is operating much better and has at least a temporary cyclical tailwind, the management is talking about aggressively pursuing its growth ambitions. For a somewhat capital-intensive business in a cyclical industry, with valuations for its potential acquisition targets likely not at a discount, this is not an encouraging strategy. Rather than being wasted on empire-building, we would prefer to see the cash flow returned to investors. The investment produced a 69% 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 July 28, 2021.

Cabot Wealth Network
Publishing independent investment advice since 1970.

President & CEO: Ed Coburn
Chief Investment Strategist: Timothy Lutts
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