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Turnaround Letter
Out-of-Favor Stocks with Real Value

February 2020

With the market near record highs, many stocks are trading well above the $1,000/share price level. Investors tend to dismiss stocks with basement-level prices, so we explored this maligned group in search of neglected value.

In this issue, we look at the several of our recommended stocks in this range.

Cabot Turnaround Letter 220

STOCKS WITH LOW SHARE PRICES

In this Issue:
Stocks with Low Share Prices
Turnarounds in Japan
Recommendations:
Buy: Duluth Holdings
Ratings Changes
News Notes & Performance

With the market near record highs (even with the recent coronavirus-driven sell-off), many stocks are trading well above the $1,000/share price level. Berkshire Hathaway always leads in this regard (BRK.A, now at $336,476/share), yet Markel (MKL, $1,711), Cable One (CABO, $1,701) and Alphabet (GOOG, $1,441) have joined this prestigious group of ten companies. Our universe of 2,380 stocks includes nearly a hundred with per-share prices above $250, well-above the $38/share median.

Generally, these companies are successful, otherwise their share prices wouldn’t have reached such high levels. But they also reflect a decision to not split their shares, perhaps to help maintain some market cachet.

At the other end of the spectrum are stocks trading under $11 or so. To the extent that high-priced stocks indicate successful companies, perhaps low-priced stocks indicate struggling companies. Investors tend to dismiss stocks with basement-level prices, so we explored this maligned group in search of neglected value.

We remember a lesson learned long ago. It may seem logical to justify buying low-priced stocks by thinking, “You can’t lose much if the price is so low.” Yet, while a $3 decline in Procter & Gamble shares (with a $125/share price) may not hurt much, a $3 decline in a $3 stock means a 100% loss.

In our first foray into this group in April 2018, we found several interesting names. One company, Oaktree Capital Specialty Lending, looked appealing enough for us to put it on the Recommended List (August 2018, OCSL recommended price $4.91, with a total since-inception return of 25%).Listed below are five companies that fit the bill today. They each have real businesses with substantial operating assets and capable managements, and with shares that trade on either the NYSE or Nasdaq. These companies also have appealing fundamental changes underway that could lead to much higher share prices.

Several Turnaround Letter recommended stocks have prices in this range. Also, other sub-$11 stocks have been mentioned in recent Turnaround Letter articles, including US Steel, Livent, Michaels Stores, Fossil Group and Coty, but we omit them here to avoid redundancy.

Comstock Resources (CRK) – Like most energy companies, beaten-down Comstock Resources’ fortunes will rebound with any meaningful recovery in oil and gas prices. The company is the largest natural gas producer in the prolific Haynesville region in eastern Texas and Louisiana. Comstock recently acquired nearby Covey Park Energy, offering the potential for drilling and overhead synergies. An interesting twist is that Jerry Jones (owner of the Dallas Cowboys, who made his first fortune in the energy industry) is the majority shareholder. He recently added $650 million to his Comstock Resources stake to help fund the Covey deal. While Comstock carries some leverage, it has no maturities until 2024, providing time to allow commodity prices and operating efficiencies to help boost its profits.

Cornerstone Building Brands (CNR) – This company is the largest manufacturer of exterior building products in North America. After peaking in mid-2018, the shares tumbled 80% following its $1.2 billion deal to acquire residential-focused Ply-Gem due to investor disappointment and weak results. However, construction activity, particularly in the housing industry, appears to be strengthening and the company’s cost-cutting remains on-track. Cornerstone’s cash flows look capable of servicing its hefty $1.1 billion debt load.

Era Group (ERA) – One of the world’s largest helicopter operators, Era survived the sharp decline in the offshore oil and gas industry, although its shares remain well-below the $33 peak of 2014. The company recently announced a merger with competitor Bristow Group (which recently emerged from bankruptcy) in an all-stock deal. The deal concentrates capacity in fewer hands even as industry conditions may be improving. To be renamed Bristow Group, the new company will own about 82% of its fleet, and its much stronger cash flow should help it repay its moderately elevated debt. Era CEO Chris Bradshaw will lead the new company.

NOW, Inc. (DNOW) – Spun off from premier offshore rig components maker National Oilwell Varco in 2014, Now is a major distributor of energy industry consumable products and related parts and tools. While the company continues to struggle with declining revenues and profits, its execution remains exceptional. Cost efficiencies have helped bolster profit margins, while diligent cash management has allowed it to repay its long-term debt to zero. Now will likely continue to make selective acquisitions as quality assets become available at beaten-down prices. Last November, the CEO abruptly departed, so the company is currently searching for a replacement. The valuation appears elevated due to the depressed EBITDA. Yet, the profits and share price would likely rebound sharply in an industry recovery.

USA Technologies (USAT) – This company is one of the largest producers of electronic payment devices for vending machines. Its rapid growth, large market share and nearly debt-free balance sheet should make it highly profitable and valuable. However, accounting and governance issues felled the shares by 75% last year, prompting activist Hudson Executive Capital to aggressively press for changes. Hudson is unique - it is comprised of current and former public company CEOs and led by Douglas Braunstein, the former vice chair and CFO of JPMorgan. Hudson’s efforts have helped force out USA Technology’s chairman and CEO, but the activist wants to replace more of the board through a proxy battle. While the stock has rebounded some and is not cheap on traditional measures, it remains well-below its peak price, offers considerable growth potential and could be an acquisition target.

TURNAROUNDS IN JAPAN

For many investors, the Japanese stock market remains an enigma. The companies often are un-wieldy conglomerates with businesses that are difficult to value, have opaque governance, unclear financial communications and share-holder unfriendly capital allocation policies. Compounding this, the Japanese market generally has been hostile to shareholders hoping to campaign for improvements.

This relatively closed environment is beginning to open up. Share buybacks have nearly doubled from a year ago, while shareholder pressure to re-focus expansive corporate operations and cut costs has produced a growing number of divestitures. Activist investors hold roughly $31 billion of Japanese shares – while small it is double the level of four years ago.

Corporate executives, worried about not being reappointed, have begun to listen to share-holders, while traditionally quiet Japanese professional investors are becoming (ever so gradually) more vocal. As this letter goes to press, Japanese real estate company Unizo remains subject to new rounds of bidding in a hostile takeover battle.

Below are four Japanese stocks that are out-of-favor yet have changes underway that could produce significant turnarounds. All are large, widely-recognized and high-quality companies that trade either directly on a major U.S. exchange or indirectly through American Depository Receipts.

Honda Motor Company (HMC) – Honda has a solid franchise thanks to its reputation for high quality engines and vehicles, fuel-efficient cars and world class motorcycles. Like all auto manufacturers, Honda faces chronic industry oversupply, slowing demand and an eventual transition to yet-unproven autonomous and electric vehicles. Recent programs to increase Honda’s use of common parts across models, close its excess capacity in Europe and Latin America, and other efforts to increase its efficiency should help boost the company’s auto-making profits, which historically have lagged the industry and remain a drag on the shares. The leadership is also working to improve governance. Honda’s strong cash generation continues to build its cash holdings, which now exceed its non-financial services debt, allowing the company to repurchase shares.

Kirin Holdings (KNBWY) – With $18 billion in revenues, Kirin is Japan’s second largest brewer, with operations centered around alcoholic (including the namesake Kirin Beer) and non-alcoholic beverages. Yet, Kirin is also a conglomerate that operates beer pubs and produces pharmaceuticals, dairy products and various types of machinery. The company recently completed a streamlining program, sold its Australian cheese business, and is selling its Australian dairy and soft drink operations. Its controversial new growth strategy appears to be focused on diversifying into health-related businesses, which it labels “bridging pharma and food & beverages.” The sizeable share price decline may be attributed to Kirin’s newly-intended direction. Activist investor Independent Franchise Partners, which holds a 2% stake, has been vocal in asking the company to instead focus exclusively on beer. Either way, there appears to be considerable value locked up in Kirin Holdings.

Nomura Holdings (NMR) – As Japan’s largest independent brokerage firm, Nomura has a sizeable 30%+ market share of the nation’s brokerage accounts. It carries a solid reputation in its domestic retail and wealth management business, but its investment banking and wholesale finance operations have difficulty competing with global banks. Last year, Nomura was censured and omitted from a Japan Post share sale due to its leak of information to clients. Partly as a result, this coming April the company will promote its senior operations executive to the CEO role, which will help provide an opportunity for the firm to accelerate its cost-cutting and restructuring programs. Also, Nomura is expanding its wealth management business to the rest of Asia. In China, the bank is hoping to capture a share of the rapidly growing market there for high net worth financial services, with access to the mainland boosted by its recent award of a license to operate a majority-owned joint venture.

Toshiba Corp. (TOSYY) – Currently on the Turnaround Letter Recommended list, Toshiba is narrowing its focus and rebuilding its core profits after selling a major stake in its memory chip operations in 2018. While it still operates across a wide range of light and heavy industries, recent results indicate that several of its core businesses, including Energy Systems, Infrastructure and Digital, are improving their profitability. Outside investors have two board seats, and activist investor King Street Capital holds a 5.2% equity stake, helping to keep the company focused. Toshiba holds a sizeable amount of cash that exceeds its debt, providing it with financial flexibility.

Purchase Recommendation: Duluth Holdings

Background:

Duluth Holdings is a specialty apparel company that sells rugged work-oriented outdoor clothing through a colorful marketing approach. Founded in 1989 by three construction workers in Duluth, Minnesota, who created an innovative canvas tool organizer, the company initially sold its products by mail-order catalog. In 2000, it merged into a company owned by the current chairman, and completed an initial public offering in November 2015. Through the Duluth Trading brand, the company has grown into an omni-commerce retailer with 61 stores across the United States.

Following its IPO, the company’s sales increased rapidly, earning a reputation among investors as a rare, fast-growing apparel concept. By late-2016, optimism about its long-term prospects drove its shares to over $37, more than triple its $12 IPO price. Despite subsequent concerns about its profitability, which led to a sharp share price decline, renewed investor confidence pushed the shares back near record-highs by mid-2018.

However, the focus on revenues caught up to the company. Its aggressive store expansion, adding 52 stores in four years to its 9-store base at its IPO, overwhelmed its infrastructure and management capabilities. Compounding its problems, the company’s poor retail site selection led to weak store productivity, which prompted even more marketing spending, further weighing on profits. These blunders produced an unrelenting cadence of dis-appointing results. Operating income for the current fiscal year will likely be below its pre-IPO level. Investors also worry about its lease obligations, which may impede its ability to close stores. Growth investors have lost confidence in Duluth Holdings shares, which now trade 25% below the IPO price.

Analysis:

Duluth’s problems are almost entirely self-inflicted and appear fixable. Most important, the company is acknowledging its problems.

The founder/chairman (who holds a controlling stake and recently added to his position) has publicly stated that the company will meaningfully slow its new-store expansion, instead emphasizing growth by improving the productivity of its existing stores and its catalog/ecommerce channels, as well as by introducing new products. Profit margin expansion has returned to a top priority. The CEO behind the failed strategy has departed for another company, allowing Duluth to find a new chief executive who is better suited to the new priorities.

The company is implementing a major upgrade to its infrastructure, including a newly-completed order/inventory manage-ment system which should curtail margin-eroding markdowns. An upgrade to its Belleville distribution center should improve its distribution efficiency. In 2020, the company’s new point-of-sale system and customer data analysis system should be on-line.

Despite all of the operational missteps, the company remains sturdy. The unique and high-quality brand is strong, particularly in the core upper Midwest markets. Even with the low-productivity stores, retail sales per square foot is a healthy $450. Duluth continues to generate GAAP net profits. The flat operating income mostly reflects the rising burden of non-cash depreciation such that EBITDA for this year should be 35% higher than four years ago. The company’s balance sheet is modestly levered at 2x EBITDA, which will likely decline to about 1.2x when it pays down its line of credit with holiday sales.

The company’s shares trade at a low valuation of 5.3x our expected FY2020 EBITDA. While the turnaround will likely take at least a year or two, during which time the shares could be volatile, Duluth is taking the necessary steps to return to a more profitable and highly-valued business that shareholders should find quite rewarding.

We recommend the PURCHASE of shares of Duluth Holdings (DLTH) with a $15 price target.

RATINGS AND PRICE TARGET CHANGES:

On January 16th, we moved Citigroup to a Sell. The company is performing well across the board. However, the operational turnaround is largely complete, its legacy assets are nearly gone, and credit costs are starting to tick upwards. The shares essentially reached our price target of $85, leaving the risk/reward no longer favorable. Citigroup produced a 79% total return.

We moved shares of SeaWorld Entertainment to a Sell on January 21st. The company has undergone a remarkable turnaround since the Blackfish scandal in 2013. The shares have reached our $35 price target (previously raised from the initial $27 target), have fully recovered to their pre-Blackfish price, are nearly at their post-IPO high, and discount most of the turnaround. SEAS shares produced a 66% return.

Signet Jewelers (SIG) pre-released strong fiscal 2020 holiday results, lifting its shares by over 40%. Given the strong start to the turnaround, the likely sizeable improvements in sales and profits still ahead, and the still-undervalued share price, we raised our price target to $35.

Performance