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Turnaround Letter
Out-of-Favor Stocks with Real Value

September 2020

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The Turnaround Letter has been acquired by the Cabot Wealth Network, a family-owned business based in nearby Salem, Massachusetts. Founded in 1970 by Carlton Lutts, Cabot is celebrating its 50th year in business, having served hundreds of thousands of investors. The company focuses exclusively on publishing high-quality investment newsletters and currently has a portfolio of 20 advisory services.

In this issue you’ll read about an energy company and a powerful catalyst for turnarounds.

Cabot Turnaround Letter 920

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Where Few Dare to Tread: Energy Service Companies
With a small cadre of mega-cap technology stocks driving the stock markets to record levels, we are, as contrarian investors, looking for industries that are extremely out of favor yet remain fully relevant in the economy. One such industry is energy service. These companies provide all the services, drilling rigs and related equipment and supplies that oil and gas producers need to find, drill for and produce their hydrocarbons. In essence, they provide the picks and shovels. Producers long-ago outsourced these functions to the specialists.

Along with the entire energy sector, now a tiny 2.3% of the S&P500 and having a total market cap less than a third of Apple alone, the energy service industry is clearly out of favor. The OSX index, which measures the oil service sector, has fallen 89% since peaking in mid-2014 when oil prices reached over $100/barrel. Year-to-date, the index is down 56%, compared to the S&P 500 index’s gain of about 6%.

The consensus outlook for the oil and gas industry is dour. Commodity price trends are dismal, with oil seemingly capped in the low $40/barrel range. Investors expect that any increase in oil prices will be halted by a rapid increase in supply by domestic and overseas production. Investors also anticipate a period of sharply weaker demand for oil, driven by the pandemic that has led to curtailed travel in cars and planes. Adding to the overhang, the emergence of electric vehicles is viewed as another reason that oil demand won’t recover much.

There is little doubt that the energy service industry is in a depression. Revenues have fallen sharply from last year, as energy producers ranging from the super-majors to sovereign entities to small independents are slashing their exploration budgets. The domestic rig count, a measure of drilling activity, is currently at 256, down 72% from a year ago and among the lowest readings on record. The international rig count, at 799, is down 38% from a year ago. Previously healthy profits have evaporated into losses.

An additional overhang is the risk that fracking regulations may tighten following the upcoming U.S. presidential election.

Given this grim picture, perhaps it isn’t surprising that investors have fled. As most investors (including us) have suffered heavy losses on energy sector holdings, there is little if any appetite for yet another foray into the group.

Yet, in perhaps one of our most contrarian calls, while acknowledging all of the above, we see an opportunity emerging. Following the practice of highly successful investors including John Templeton, Warren Buffett, Sam Zell, Benjamin Graham and others, we are looking to “buy when others are fearful”.

First, oil and gas are by far the most dominant sources of energy that power the world economy. These fuels aren’t going away anytime soon. Oil demand has proven much sturdier than previously expected. By this year’s fourth quarter, global oil demand is projected to be back to about 95% of pre-pandemic levels. Electric vehicles capture the headlines but the high prices of these cars even after subsidies, along with cheap $2.25/gallon gasoline, will impede their widespread adoption for a long time. Natural gas demand is showing similar resilience.

Adding to the merits of the contrarian call, energy supplies may not always be as plentiful as they are today. To maintain steady energy supply, producers need to constantly find new sources of oil and gas, as the output at many wells, particularly shale wells, declines at perhaps a 10-20% rate per year. Yet, at $45/barrel, there is little incentive for new exploration spending to extract this replacement oil. The adage “the cure for low commodity prices is low commodity prices” is starting to have a positive effect.

Domestic oil production has already declined by roughly 2 million barrels/day, or about 17%. While controversial, we see a reasonable likelihood for a secular downshift in the productivity of U.S. shale drilling, as much of the low-cost shale supply has already been found, leaving mostly higher-cost (and now unprofitable) oil in the ground. Globally, the aggressive cutbacks in exploration spending mean less oil and gas production down the road. While it might take a year or more, it seems likely that oil prices can rise to $50-60/barrel once supplies taper off.

In a hydrocarbon world that needs to keep finding new oil and gas, the energy service industry remains highly relevant, resulting in cyclical but resilient revenues. To preserve cash to ensure their survival, energy services companies are aggressively cutting spending and dividends. There will be survivors for the next cyclical upturn.

Structural changes in the energy service industry offer the likelihood of better profits when drilling demand stabilizes. The most promising change is the emergence of technology. To make drilling more efficient and safer, service companies have been building more advanced drilling rigs that are faster, cheaper to operate, more accurate and require minimal human labor. Gone are the days of the oil-soaked rig worker grappling with steel pipes - today the most advanced rigs are almost free of any human labor and monitoring is increasingly done online, often in remote locations.

As few service companies can keep up with the pace of technology development, weaker competition is falling away. Similarly, marginal service companies will slide into bankruptcy, further concentrating industry power into fewer hands. Energy producers will likely have little interest in dealing with older, less-efficient equipment that dying companies leave about, removing another source of competition that historically has plagued the industry in past recoveries.

Our list below, including this month’s recommendation, Baker Hughes Company (BKR), emphasizes those with the best chances to endure the current depression. These companies are broadly cutting operating and capital spending costs, with most having slashed their dividends to conserve cash. Some have modestly elevated debt but are taking steps to minimize the risk that this carries.

Halliburton (HAL) – As the third-largest full-service energy service company, Halliburton provides services throughout the well lifecycle, from locating oil and gas deposits through managing production in mature wells. Revenues in 2020 will likely be about $14 billion, down about 35% from last year. Much of the sharp decline is due to Halliburton’s high exposure to the struggling North American market which provides 33% of its revenues. Recent second quarter results were encouraging, as the company has cut expenses and capital spending faster than many expected. Halliburton carries a modestly elevated debt balance of $10.8 billion, which is manageable as about 75% is due after 2030 and is partly offset by $1.8 billion in cash. The company is producing plenty of cash flow to sustain it through the downturn.

Helmerich & Payne (HP) – This domestic small-cap company specializes in renting out land-based drilling rigs to exploration companies. Its conservative management has long been a pioneer in steadily upgrading its rig fleet, allowing it to gain market share. The industry depression has hit Helmerich hard, with its second quarter revenues falling 53% from a year ago. While Helmerich is producing small operating losses, its aggressive cost-cutting has helped it trim its cash outflow to essentially zero, providing a lot of financial flexibility. The balance sheet has an investment grade credit rating, and holds a modest $527 million in debt, with no maturities until 2025, which is nearly fully offset by $492 million in cash. Investors collect the recently cut $0.25/quarterly dividend, although we anticipate it will be suspended if conditions haven’t improved by early next year. Helmerich looks fully capable of surviving the industry depression.

Liberty Oilfield Services (LBRT) – This unique company will become the third-largest North American oilfield services business following its just-announced deal to acquire Schlumberger’s One-Stim operations. Liberty is a relatively new company that completed its IPO in early 2018 at $17 and is backed by private equity firm Carlyle Group. Despite its youth, the company has grown rapidly and will hold a 22% market share. Its growth has been helped by its emphasis on technology, driven by its chief executive who holds an undergraduate degree in engineering from MIT. Despite its growth, Liberty has a sturdy balance sheet, as its $125 million in cash fully offsets its $106 million in debt. While it is a higher risk company due to its niche position in the struggling North American market, its prospects are intriguing. LBRT’s valuation is elevated due to its depressed earnings this year. Investors may want to wait until the recent spike from the deal news fades a bit before starting any new positions.

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Schlumberger (SLB) – The largest in the industry, Schlumberger is generally considered the highest quality company, with its highly-capable management team, top-tier and expansive scope of operations and healthy financial condition. It is well-positioned to survive the industry’s current depression and then return to prosperity in an upturn. In addition to aggressive cost-cutting, the new CEO is unwinding much of his predecessor’s strategy by reducing Schlumberger’s North American exposure while emphasizing capital-light but free cash flow producing businesses. Schlumberger’s large international operations remain a source of competitive strength. Earlier this week, the company sold its low-margin fracking operations to specialist Liberty Oilfield Services (LBRT) in return for a 37% stake in Liberty. Schlumberger cut its dividend by 75% to $0.125/quarter which still provides a 2.6% yield. The company continues to generate profits and free cash flow, and its $17.4 billion in debt remains readily serviceable and is partly offset by $3.6 billion in cash.

New CEOs – A Powerful Catalyst
All companies are collections of assets. These assets include the company’s brands, intellectual property, production facilities, contracts, real estate and cash. Yet the most valuable assets are the people that work for the company to develop and monetize all of the other assets. And, these employees take their directions from the CEO, who guides the company’s strategy, sets priorities for how the collection of assets are allocated, provides motivation and develops the company’s culture.

For companies that are struggling, a change in senior management can be a valuable catalyst for a turnaround. It indicates that the board of directors recognizes that the company is headed down the wrong path – the first and most critical step. A new chief executive officer can bring a new skill set tailored to address the company’s specific problems. The change also sends a signal that “business as usual” will be replaced with a new sense of urgency and frugality. This signal alone can redirect employees’ priorities and unleash productive new ideas.

Finally, a new CEO can free the company to meaningfully shift its strategic priorities, including how it allocates its capital, approaches its customers and operates its businesses. Outsiders in particular can be valuable, as they usually have a clear mandate from the board, bring a fresh perspective to identifying and solving the company’s problems, and are unhindered by previously sacred cows.

The announcement of a new leader is not always a sign that investors should immediately buy the company’s stock. Even the best chief executives may take time to revive a company, sometimes measured in years not quarters, and there may be more bad news still to come. Yet this change at the top is a very powerful catalyst (our favorite) and well-worth searching for.

Listed below are seven struggling companies that have recently replaced their CEOs. No fewer than 15 currently recommended Turnaround Letter companies have new leadership as key aspects of their turnarounds, including Signet Jewelers (SIG), Duluth Holdings (DLTH) and Wells Fargo (WFC). We highlight currently recommended Newell Brands (NWL) in our comments below.

Coca-Cola Company (KO) – While Coke replaced its long-standing CEO Muhtar Kent with James Quincey in 2017, we believe important changes are just now taking shape. One significant step was last week’s announcement of a reorganization of the company’s operating structure, along with layoffs, to streamline and accelerate Coke’s penetration in higher-priority products and geographies. Also, the company is reducing its product count, partly by de-emphasizing local brands that dilute its efforts to build its more powerful regional brands. Quincey’s heightened emphasis on healthier, non-soft drink brands is helping improve the company’s image and volumes among younger consumers. KO shares have severely lagged the S&P500 over the past seven years. Coca-Cola now appears well-positioned to return to favor.

Ford Motor Company (F) – Ford has been slow to adapt to the changing global automobile environment, which features chronic overcapacity, weak pandemic-driven demand, increasing competition in China (the world’s largest car market) and an eventual migration to electric vehicles. Only Ford’s market-leading F-Series trucks seem to be keeping it alive. Much of its woes can be traced to its ineffective leadership under Jim Hackett, the CEO who was appointed in 2017. Hackett’s replacement, who is set to take the helm on October 1, now makes Ford shares worth a closer look. Jim Farley, a true ‘car guy’ with immense car production experience, could bring meaningful improvements. He has many levers to pull: boosting Ford’s EV line-up, divesting its money-losing operations in Europe and Latin America, bolstering the credit quality at Ford Credit, emphasizing automotive basics and taking action rather than musing over fancy theoretical philosophies. He already has announced a 5% reduction in Ford’s salaried workforce. While clearly rough, the road ahead looks a bit smoother under the new leadership.

Harley-Davidson (HOG) – In the late 1980s, this maker of iconic motorcycles narrowly avoided bankruptcy, instead executing a complete turnaround that led to its shares becoming among the best performers over the next 30 years. The company is once again in turnaround mode, as its over-reliance on an aging demographic has led to declining profit and market share. Efforts to diversify into niche bikes and new geographies were unsuccessful and only added to Harley’s problems. However, the company expansive strategy is reversing under new CEO (since February) Jochen Zeitz, who once led an impressive turnaround at shoe maker Puma. His view is that the company has lost its way, and he doesn’t buy the demographics excuse. The strategy, to be further outlined later this year, will focus on producing fewer but better bikes, improving operational efficiencies, exiting low-value product lines and geographies – and making Harley-Davidson an aspirational brand. His model, perhaps, is Ferrari, a car company that has a market value approaching that of GM but produces a fraction of its car volume. This turnaround clearly has its challenges and skeptics, yet is worth a closer look.

The Michaels Companies (MIK) – It would seem that an old-fashioned business of selling arts and crafts supplies would be doomed in today’s digital economy. But revenues for this company have been remarkably stable in recent years and are surging in the pandemic economy as consumers look for stay-at-home activities and low-priced ways to improve their surroundings. In its most recent quarter, comparable store sales increased by 12%, ecommerce revenues tripled, and adjusted operating profits increased by 41% from a year ago. Further distinguishing the Michaels story from many other retailers is its new CEO, Ashley Buchanan, who previously was Chief Merchandising Officer and Chief Operating Officer for Walmart’s ecommerce business. His experience could lead to a transformation of Michaels’ operations and strategy. There is much to fix, as the company faces chronic pricing pressure from its many physical store and online competitors and carries considerable debt. The share price drop last week, as strong results still disappointed some investors, offers an attractive entry point.

Newell Brands (NWL) – Newell has struggled for years to digest its oversized and overpriced 2016 acquisition of Jarden. Its early efforts to shed a sizeable swath of its operations were not nearly as successful as anticipated, and the shares remain out of favor in the $16 range. We admit to being too early in our recommendation of NWL and had wondered if we were simply wrong, partly because the board of directors continued to support the then-CEO who had engineered the ill-fated acquisition. Fortunately, the board finally replaced that CEO last October with an exceptional new leader, Ravi Saligram. He produced impressive results in prior turnarounds that included OfficeMax and Ritchie Bros. Auctioneers. Encouragingly, Newell’s recent results were much higher than consensus estimates. Investors appear to be underappreciating Newell’s prospects.

ServiceMaster (SERV) – This company’s diversification beyond its core Terminix pest control business into maid services, disaster restoration, and commercial cleaning proved unsuccessful. These ServiceMaster Brands (SVB) operations were less than a quarter of the company’s total revenues, performance was unsatisfactory and investors never gave the shares much credit for their value. This story changed in February, with the departure of the CEO who championed the diversification and an announcement that ServiceMaster would explore a sale of the SVB operations. In August, Brett Ponton, former head of Monro (MNRO) joined as the new CEO, and last week ServiceMaster announced a deal to sell SVB for a high $1.6 billion. The remaining company will focus exclusively on pest control and change its name to Terminix. The company also has taken steps to limit its termite-related litigation exposure, another favorable step in its turnaround. There is a lot to like at this company.

Walgreens Boots Alliance (WBA) – We wrote about Walgreens last month, and continue to find it intriguing, given its highly discounted valuation. Strategically and operationally, the company seems adrift under the current CEO. We also share the concerns about the impact of the unusual role of the co-COO, with whom the CEO and her are “… partners and share a private residence” according to the company’s regulatory filings, and the role of two of the CEO’s children who are highly compensated Walgreens’ employees. What is encouraging about this company’s outlook is that the CEO has announced that he will be stepping down from the post. To restore the company’s favor with investors, we think the company needs an outsider with a clear and sound plan that is crisply executed at both the strategic and store levels. We would like to wait for the naming of the new CEO but are tempted now, with the shares trading at only 7.3x earnings and producing a 5.1% dividend yield.

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Recommendations

Purchase Recommendation: Baker Hughes Company (BKR)

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Background
Baker Hughes is one of the world’s largest diversified energy services company. With its roots in the tool company founded by Howard Hughes, Sr. in 1908, the Hughes Tool Company was acquired by Baker International in 1987 to form Baker Hughes. After a complicated and disruptive period starting in 2017 when General Electric acquired a controlling stake to find a home for the beleaguered GE Oil and Gas business, itself a collection of assets including Lufkin Industries and Dresser, Baker Hughes became an independent company again in September 2019. GE continues to hold 377 million shares (37% stake), which will be divested over the next three years.

Traditional oilfield services (including drilling, completion and production services) produce about half of Baker Hughes’ revenues. Oilfield equipment, with an emphasis on the subsea market, generates about 14% of revenues. Turbomachinery and Process Solutions (27% of revenues) provides turbine equipment and related services to the traditional and renewable energy industries. About 10% of sales are produced by the Digital Solutions segment, a technology business with clients in the energy, automation and aerospace industries About 60% of Baker Hughes’ revenues are produced outside of the United States.

The current industry depression will likely trim Baker Hughes’ revenues by 15-18% this year, and reduce its cash operating profits by as much as 35%. With energy industry conditions widely viewed as remaining chronically weak (see our discussion above in the article “Where Few Dare to Tread: Energy Service Companies”), investors have little appetite for the shares of companies like Baker Hughes.

Adding to these fundamental pressures, energy services stocks lack the strong popularity of mega-cap technology stocks like Apple, Microsoft, Amazon and others that are significant beneficiaries of the post-pandemic economy. A further overhang unique to BKR shares is the selling pressure from GE’s divestiture that will average nearly half a million shares per trading day, it’s not surprising that BKR shares remain 43% below their 2019 year-end price and down 60% from their post-GE merger peak.

Analysis
Baker Hughes is an operationally and financially sturdy company with the capability to endure to the industry’s upturn. Its products and services are critical to global energy production, and its market position appears sustainable. Its revenue declines reflect cyclical not secular pressure.

While the 15-18% drop in this year’s revenues are un-nerving, they look likely to be nearly flat next year. For comparison, the company’s major peers are likely to see their revenues fall by 25-35% this year. Baker Hughes has lower direct exposure to drilling activity, particularly in North America, and is supported by a $15 billion services backlog.

Recent results provide some encouragement: the company’s second quarter revenues and margins were considerably stronger than consensus estimates, suggesting that the market remains too dour on its prospects. Helping its profits is a $700 million cost-cutting program that is on-track for completion this year. Better execution and integration of GE’s poorly-run businesses should further boost profits.

Baker Hughes has the financial strength to endure through the downturn. Even with grim industry conditions, the company has generated $215 million of positive free cash flow so far this year, supported by its aggressive operating and capital spending cuts. It is on-track to generate both positive net income and free cash flow for the full year despite $800 million in cash outlays for restructuring costs. Baker’s businesses require relatively little capital spending, at perhaps 3.5% of revenues, suggesting that spending reductions won’t overly crimp its future growth prospects.

While the company’s free cash flow will not cover its $744 million in dividends this year (implying the risk of a dividend elimination in a protracted downturn), the company’s sturdy cash balance and likely flat revenues next year, along with the absence of the large restructuring cash outflows, provides encouragement that the dividend will be maintained, which offers investors a 5% yield.

Baker’s balance sheet is healthy and carries a single-A investment grade credit rating. Its $7.7 billion in debt appears readily serviceable. Also, the nearest debt maturity is a $1.3 billion note due in December 2022, with nearly the entire remaining debt balance due in 2027 or later. The company has no borrowings outstanding under its $3 billion line of credit. Helping buttress its stability is $4.1 billion in cash.

A few highly reputable long-term value investors have large positions in BKR shares (Capital Research at 12% and Dodge & Cox at 9%), lending credibility to the Baker Hughes story.

BKR’s valuation, at 9.3x estimated 2020 EV/EBITDA, assumes essentially no recovery from the currently depressed industry conditions. With its relevant products and services, sturdy balance sheet and improving free cash flow, along with even a modest cyclical recovery, Baker Hughes shares look like a highly attractive contrarian investment.

We recommend the purchase of Baker Hughes (BKR) shares with a $23 price target.

Price Target Changes
We are reducing our price target on Molson Coors to $59 from $82. The global stay-at-home orders due to the pandemic have pushed out the company’s turnaround by perhaps a year or two. We remain convinced that the turnaround will succeed and that the stock will eventually reach $82, but this will likely occur beyond our normal 2- to 3-year horizon.

BorgWarner continues to benefit from the auto industry recovery and its migration toward electric vehicles. As the stock is now above our $40 price target, we are raising it to $46.

We reduced our price target on Adient to $28 from $64 following its second quarter earnings report to reflect the downshift in its long-term value due to the pandemic, although we continue to have high conviction in the turnaround. The company’s liquidity remains sturdy and will be boosted by the $500 million in proceeds it should receive by the end of this month from the sale of its China joint ventures.

Additional Comments on Recommended Energy Stocks
With our recommendation of Baker Hughes, we thought it might be helpful to comment on our views on Amplify Energy, Peabody Energy and Royal Dutch Shell. While we believe that higher energy prices are possible and perhaps likely, the key distinction between Baker Hughes and Royal Dutch Shell, compared to Amplify and Peabody, is the role of time. BKR and RDS have sturdy balance sheets, adequate cash flow and plenty of operating flexibility to survive in an extended downturn.

Amplify and Peabody, however, have much less time (likely less than a year) to wait for higher energy prices. Their ability to return to positive free cash flow through cost-cutting is limited and their debt service obligations can be put off for only so long. With our more optimistic outlook for commodity prices, we are willing to wait a bit longer with these two stocks rather than pull the plug now. However, our patience and their clocks are running out of time.

Performance

CTL-920-SmallAndMid

CTL - 920 - Large Cap


The next Cabot Turnaround Letter will be published on September 30, 2020.

Cabot Wealth Network
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