Please ensure Javascript is enabled for purposes of website accessibility
Turnaround Letter
Out-of-Favor Stocks with Real Value

March 2019

Already the S&P500’s crisp 20% peak-to-trough drop ending on December 24th seems like a distant memory. Since last quarter, over 90% of all S&P500 stocks have advanced. Being contrarians, this prompted us to look at stocks that haven’t fully participated in the upturn.

In this issue, see the seven stocks whose shares remain well below their two-year highs, yet might have latent recovery potential.

Cabot Turnaround Letter 319

In This Issue:

Turnaround Stocks Left Behind

Oil Services Companies

Recommendations:

Buy: Mohawk Industries

Sell: Civeo

News Notes

Performance

Turnaround Stocks Left Behind

[vc_row][vc_column][vc_column_text]It’s only the end of February, but already the S&P500’s crisp 20% peak-to-trough drop ending on December 24th seems like a distant memory. Since then, the broad market indicator has rebounded nearly 19% and sits only 4.5% below its record high. Over 90% of all S&P500 stocks have advanced since then. Being contrarians, this prompted us to look at stocks that haven’t fully participated in the upturn. Our search included the S&P500 and other sizeable companies, focusing particularly on those whose shares remain well below their two-year highs, yet might have latent recovery potential. Seven stocks that fit this category are discussed below. While their discarded shares give the appearance of a poor outlook, each has some type of turnaround underway now or likely will very soon. Most of them have decent dividend yields to compensate you in case you have to wait a while for the turnaround to take hold.[/vc_column_text][/vc_column][/vc_row][vc_row][vc_column][vc_single_image image="5001" img_size="full”][/vc_column][/vc_row][vc_row][vc_column][vc_column_text]

Bunge Ltd (BG) – As the world’s largest soybean processor, Bunge buys soybeans, wheat, corn and other crops from farmers, then processes and sells them to food and beverage companies. Its vast global network of storage, transportation and milling facilities provide deep insight into global supply and demand conditions. As an intermediary, Bunge is vulnerable to unfavorable commodity and end-market price changes. While profits in 2018 were better than in 2017, the company has not met its own earnings targets due to weak risk management, problems with their Brazilian operations and fallout from the China trade dispute. With credible activist investors circling, the board has replaced four directors with three more retiring soon, a new CEO search is underway, the company is evaluating significant asset sales and is accelerating its $250 million cost-savings program. At 8.9x EBITDA, with a reasonable balance sheet and a 3.7% dividend yield, Bunge shares may be ready to sprout.

Goodyear Tire (GT) – Recently demoted from the S&P500, Goodyear is struggling with high oil prices (a critical raw material) as well as slowing sales in China, a strong dollar and stalled growth in domestic vehicle sales. While the three consecutive years of declining profits have scared off investors, it more reflects a return to normal after unusually high earnings. Much of GT’s revenues are from replacement tires, a remarkably steady market that declined only 3% during the past two recessions. The company is also closing high-cost plants and making other adjustments. Debt is reasonable at 3x EBITDA, with no major maturities until 2023. Its $800 million cash hoard brings added stability. Trading at a low 5.2x EBITDA with a 3.3% yield, Goodyear Tires may be worth a test drive.

Kraft Heinz (KHC) – Hopes were high in mid-2015 when Kraft and Heinz merged with the backing of Berkshire Hathaway and Brazil’s 3G Capital. Profits initially surged from its zero-based budgeting, an approach where all expenses are scrutinized rather than routinely continued from year-to-year. The company’s shares peaked at over 95. However, this budgeting method discourages investing in new products, leaving Kraft Heinz at a real disadvantage against innovative competitors. Last week, Kraft Heinz reported alarmingly poor results as well as an accounting issue, and cut its dividend, sending its already weak shares down another 27%. While the accounting issue appears mild, Kraft Heinz’s strategic issues are real. However, they are fixable. Already the company is looking to sell its Maxwell House coffee brands. Other major changes are likely. In spite of shifting consumer tastes, many of the company’s brands remain powerful. While most investors are fleeing its shares, for patient inventors (which include Warren Buffett, who said he has no plans to sell his stake), Kraft Heinz shares could prove very tasty.

Macy’s (M) – This Turnaround Letter- recommended retailer is in the midst of a turnaround of its chain of department stores. New CEO Jeff Gennette is leading numerous initiatives to reinvigorate growth and relevance through better merchandising, smarter online operations and other new initiatives. To free up cash and improve its focus, the company is shutting many of its weaker stores. Earlier efforts showed promise, but overly optimistic investors were disappointed by a reasonable (+2% comparable sales) but below expectations holiday season. Despite Macy’s shares’ 19% decline so far this year, the turnaround is making progress. Patient investors receive a likely sustainable 6.3% dividend while they try on Macy’s shares.

Newell Brands (NWL) Turnaround Letter- recommended Newell is undergoing a complete overhaul following its botched $19 billion acquisition of Jarden in 2016. With the board firmly in the control of activist investors Starboard Value and Carl Icahn, Newell is divesting about 35% of its revenue base, repaying debt and repurchasing shares. Remaining operations will be streamlined and reinvigorated. The sluggish pace of change and disappointing 2019 outlook have driven the shares sharply lower. These problems, however, will likely lead to the departure of the long time CEO who engineered the Jarden deal, reaccelerating the turnaround under a sharper leader. The Newell story is by no means over, and potential new investors can participate at these lower prices as well as enjoy a reasonably safe 5.3% yield.

Papa John’s International (PZZA) – Papa John’s is the world’s third largest pizza chain. Following the founder/CEO’s damaging behavior and his subsequent departure, Papa John’s is looking to rebuild its franchise under capable new leadership. Starboard Value, the activist that led the impressive turnaround of Darden Restaurants, now holds three of seven board seats (founder Schnatter holds one non-chairman seat) and is investing up to $250 million in convertible shares for a stake of up to 13.4%. After a period of significant mis-management, leaving its margins significantly lower than peers like Dominoes, there are plenty of opportunities to restore some flavor to Papa John’s battered share price.

Tapestry (TPR) – Formerly known as Coach, this company sells iconic luxury handbags and other branded accessories. Slowing sales in China and Europe, along with the ebbing luster from its Kate Spade brands due to the passing of its namesake founder, have investors worrying that the company’s best days are behind it. Like all fashion brands, newness and relevance are critical to attracting the eye of potential customers, and Tapestry has lagged in those areas over the last few years. However, it now appears to be recognizing its mistakes, responding with new vigor and better product management. With Tapestry’s shares at bargain-basement levels, unchanged from 2005, a sturdy balance sheet with cash nearly matching its debt and a well-respected stable of brands, investors can buy a top-notch company that is temporarily out of fashion.[/vc_column_text][/vc_column][/vc_row]

Oil Service Companies - Big Potential Upside for Patient Investors

[vc_row][vc_column][vc_column_text]Oil and gas exploration companies exist to drill holes in the ground with hopes of finding worthwhile energy deposits. Exploration companies typically spend every dollar they can muster on siting, drilling and servicing wells, an amount totaling $427 billion globally last year. Who is on the receiving end of this spending? Energy service companies. In the olden days, drilling was mostly manual work using crude equipment. Today, most of the labor has been replaced by technology. High-tech rigs, for example, operated by as few as two people, can drill a dozen horizontal wells nearly two miles long that radiate from the same drill site. Exploration companies readily pay up for this technology, especially for shale drilling, as it saves them time and money. For surviving energy service firms, it raises the barriers to entry. The fate of energy service firms remains tied to drilling activity, which is closely linked to commodity prices. As such, most of this group’s shares declined sharply following the 2014 oil price debacle, and many companies in this sector disappeared completely. The stocks of the survivors were hit hard again in the fourth quarter of 2018 when oil prices retraced some of their recent gains. Listed below are several beaten-down stocks that have enduring appeal at this low stage of the cycle. Interested investors are encouraged to check out their websites, particularly Schlumberger’s, for a useful industry outlook, as this is a popular time for presentations at conferences.[/vc_column_text][/vc_column][/vc_row][vc_row][vc_column][vc_single_image image="5008" img_size="Full”][/vc_column][/vc_row][vc_row][vc_column][vc_column_text]

Cactus (WHD) – Every oil and gas well needs a well head, and Cactus is the largest independent manufacturer of well heads with a 28% market share, up from about 14.5% three years ago. The company recently went public at $17. While the stock has risen sharply, it remains cheap at only 6.7x EBITDA. Its profit margins are among the highest in the oil services industry. Like any newly public company, this one comes with a limited track record. Yet, management has extensive industry experience and owns 30% of the shares, the company has $71 million in cash and no debt, and it produces strong cash flow.

Oceaneering International (OII) – This company is the world’s largest provider of undersea robots that facilitate offshore drilling, operations and maintenance. Its 28% market share and high-tech capabilities will help it prosper when offshore drilling activity eventually recovers. While its revenues and profits are still weak, its fleet utilization and backlog have been ticking up in recent quarters. Diversification through contracts with the U.S. Navy, NASA and commercial theme parks have partly offset the energy industry downturn, while initiatives in offshore windfarms could provide new growth. Its balance sheet has $354 million cash and reasonable debt with its nearest maturity five years away.

Schlumberger (SLB) – This company is by far the world’s largest and most diversified energy services company, and arguably the highest quality in terms of operational stability, financial strength and management capability. Growing use of fixed price drilling contracts increases Schlumberger’s risk profile but also offers the potential for higher profits resulting from better execution. Despite its admirable traits, the shares remain 62% below their 2014 peak. Even at this low ebb, the company generates sufficient cash flow to maintain and upgrade its operations, pay a generous dividend and repurchase its shares.

TETRA Technologies (TTI) – With its shares down 90% from their 2014 peak, TET-RA is clearly out of favor. This company manages the water and drilling fluids needed for fracking. Through its majority interest in Compressco LP, Tetra also sells equipment that compresses natural gas for delivery to pipelines. The company’s proprietary Neptune fluid holds tremendous promise, but several hurdles remain. Likely stimulating faster changes, earlier this week the company replaced its CEO. While 2019 free cash flow is expected to be minimal, the company’s borrowings, excluding debt at the Compressco partnership, are a reasonable $168 million.

Transocean (RIG) – Transocean is the world’s largest offshore drilling rig company, with a fleet of 54 massive-scale floating rigs. As it adapts to the severe downturn, the company has undergone a divest-upgrade-acquire cycle, including its recent $2.7 billion acquisition of Ocean Rig UDW. While the wait for an upturn may still be measured in years, and Transocean carries about $10 billion in debt, it is producing plenty of cash operating profits and has $2.2 billion in cash. Major oil companies have rising cash flows, which historically has been an indicator of more drilling ahead. When the upturn eventually arrives, Transocean’s profits should flow generously.

U.S. Silica Holding (SLCA) – About 75% of U.S. Silica revenues come from its specialized sand used to prop open underground oil and gas seams after fracking operations. The balance come from a wide range of industrial customers. Its operations cover the entire fracking spectrum, from sand mine to railcar to wellsite storage. The deeply out of favor shares are trading below their 2012 IPO price of $17. U.S. Silica generates free cash flow, and has a reasonable $1.2 billion in debt, partly offset by $202 million in cash. If the industry can eliminate its over-capacity issues, SLCA shares could become gushers.

Weatherford International (WFT) – Currently HOLD-rated Weatherford is struggling through a highly complicated restructuring to streamline the countless acquisitions made by the previous management team. Its notorious inefficiency, hidden by surging commodity prices earlier in the decade, was exposed by the subsequent price collapse. Now, new leadership, including Halliburton’s former CFO, is aggressively working to make. Weatherford a unified and economically sustainable business. While we have confidence in management’s ability to achieve its operational goals, the company’s weighty debt burden could require a highly dilutive refinancing when large maturities come due in 2021 and 2022, hence our HOLD rating.

[/vc_column_text][/vc_column][/vc_row]

Purchase Recommendation: Mohawk Industries

march-2019-tl-mohawk-purchase-rec.png

Background: Mohawk Industries is the world’s largest flooring manufacturing company, with the leading market share in North America and significant sales of carpeting, ceramic and natural stone tiles, wood and other flooring around the world. The company was founded in 1875 by William Shuttleworth in New York’s Hudson Valley as a carpet weaving company. After a large merger in 1956 and a go-private transaction in 1988, Mohawk returned to public ownership in 1992. Since then, it has grown through over 40 acquisitions to become a fully-integrated manufacturer of all major flooring products with sales in over 170 countries. Investor enthusiasm for Mohawk’s impressive growth drove its shares to over $280 by early 2018. But then, emerging concerns about global economic growth, combined with a series of disappointing earnings reports starting in mid-2018, led investors to abandon Mohawk shares. The near-term outlook remains uninspiring: growth is slowing in North America, Europe and Australia; its costs for raw materials, freight and labor are starting to edge upwards; and the strong dollar is hurting its overseas profits. Costs related to the ramp-up of several new products and manufacturing facilities, which should produce strong long-term profits, are further weighing on near-term margins. The company guided toward weak first quarter results that were 10% below consensus estimates. Mohawk stock now trades for about half its prior high as investors seem to be in no mood to wait for better results.

Analysis: Despite investors’ frustrations, Mohawk remains a well-managed and well-positioned company. Its strong record of innovation and global expansion helps preserve its market-leading position and reputation for quality. Near-term costs related to new initiatives will be more than offset with new revenues when its facilities reach full production. Recent price increases should help recover much of its higher costs, while steps to reduce headcount and improve its operating efficiency will likely boost margins. New leadership in its North American flooring unit should lead to better execution. Its sizeable remodeling-driven revenues will dampen any risks of further slowing in demand from new construction. Also, its $250 million November acquisition of Eliane, a high-end leader in Brazil’s large and strengthening ceramics market, offers new growth opportunities. In Europe, Mohawk is shifting some production to more profitable facilities, as well as continuing to introduce new and innovative products to preserve its margins. Mohawk’s financial condition is healthy. Debt of $3.3 billion is less than 1.8x EBITDA, with all but $700 million in bonds due in 2022 or later. It produces generous free cash flow, likely to be $1 billion this year, as heavy spending on new capacity and acquisitions winds down. With its shares trading at about 8.2x this year’s EBITDA, Mohawk shares offer longer term investors the potential for solid returns.

We recommend the PURCHASE of shares of Mohawk Industries (MHK) with a 220 price target.

Sale Recommendation: Civeo Corporation

Civeo’s stock has surpassed our recentlyincreased price target. At current levels, we think the downside risk in the stock outweighs the potential for further gains, and so we recommend selling the shares at this time.

NEWS NOTES

With Bristow Group’s continued decay in earnings, combined with its terminated Columbia Helicopter deal and high debt, we moved BRS shares to a SELL on February 12.

Xerox reported strong earnings and raised their outlook for 2019. The company also guided to $4/share in earnings in 2020, combined with their expectation for over $3 billion in cumulative cash flow. Xerox shares have more than fully recovered from their sharp year-end sell-off.

Shares of General Electric have rebounded sharply this year. Recently, GE announced the sale of its BioPharma unit for $21 billion in cash and the closing of the spin-off/sale of its GE Transportation business to Wabtec for $2.9 billion in cash plus a 24.9% equity stake. Most of the proceeds will be used to reduce GE’s debt burden. Also, the highly respected Catherine Lesjak is joining its board of directors. All three of these announcements indicate that new CEO Lawrence Culp is making major, rapid and sustainable improvements to GE’s outlook.

Automotive seat maker Adient reported earnings in-line with its January pre-announcement. The turnaround is making progress under its highly capable new CEO, but the company is facing difficult external headwinds as it addresses its significant manufacturing problems. We remain confident in the company’s prospects.

PERFORMANCE

The tables below and on the next page show the performance of all of our currently active recommendations, plus recently closed out recommendations.

march-2019-tl-performance-small-mid.png

march-2019-tl-performance-large-closed-out.png

march-2019-tl-performance-end-disclosure.png