Our concluding 2022 Roundtable installment features Meryl Witmer, of Eagle Capital Partners; William Priest, of Epoch Investment Partners; Rupal J. Bhansali, of Ariel Investments; and Scott Black, of Delphi Management.
Illustration by Alvvino
Fed be nimble, Fed be quick. The quicker, the better, in fact. Hike interest rates, shrink your balance sheet, and let’s be done with it all before the stock market sinks even further.
The market’s recent selloff began in late December, and has gathered considerable steam since the annual Barron’s Roundtable took place on Jan. 10 on Zoom. The Federal Reserve’s pivot toward more restrictive monetary policy helps explain why most of the Roundtable panelists see losses mounting in the year’s first half, although the group generally is more sanguine about the second-half outlook. It also explains why these 10 razor-sharp investors expect 2022 to be a much better year for stockpickers than index investors.
Our concluding 2022 Roundtable installment features the recommendations of four such pros: Meryl Witmer, of Eagle Capital Partners; William Priest, of Epoch Investment Partners; Rupal J. Bhansali, of Ariel Investments; and Scott Black, of Delphi Management. Even if you don’t cotton to some of their particular picks, it’s hard not to admire–or learn from–their research and financial analysis of the companies whose stocks they fancy.
Many of these shares joined the market’s rout in the past three weeks, presumably making them even better buys now than in early January. In the edited conversation that follows, our final four panelists crunch the numbers on 20 prospective winners.
Meryl, where are you finding good values now?
Meryl Witmer: My first pick is Dollar Tree [ticker: DLTR]. It has 225 million shares, and the stock is trading at $140. The market cap is about $31 billion, and the company has $2.5 billion in net debt. Dollar Tree operates the Dollar Tree and Family Dollar stores. It has done a terrific job with the Dollar Tree stores, and a subpar but improving job with Family Dollar. It has done a poor job with capital allocation, having overpaid for Family Dollar in 2015, and was slow-footed more recently in buying back shares, given its pristine balance sheet. The company did a great job of paying down debt after the Family Dollar acquisition. I congratulate them for that.
Dollar Tree is under pressure from an activist investment firm, Mantle Ridge, which has proposed a full slate of directors and wants the board to consider Richard Dreiling in a leadership role. Dreiling was CEO of Dollar General [DG] from 2008 to 2015. That stock quadrupled during the time he was CEO, after going public at the end of 2009. I consider him one of the finest retail executives. He was able to improve Dollar General’s sales per store from $1.16 million to $1.6 million, and Ebit [earnings before interest and taxes] from $31,000, or a 2.7% margin, to $150,000, a 9.4% margin. This came from an improvement in supply-chain merchandizing and the culture.
I am not sure how the activist situation will play out, but my preference would be for Dreiling to take the executive chairman role and fix Family Dollar. The Dollar Tree merchandisers are extraordinary; it is really at Family Dollar where he could make a difference. Hopefully, this all happens amicably. Otherwise, we’ll see how shareholders vote.
Illustration by Alvvino
Dollar Tree has raised prices on most items at the Dollar Tree stores from a dollar to $1.25, and is rolling out items priced at $3 and $5 at many stores. The combination of shipping costs and wage and product inflation pushed the company to do this. Dollarama [DOL.Canada] in Canada moved in this direction in 2009, and its stock did well. It has operating income margins of more than 20%. This should happen in the Dollar Tree segment, also, and lift earnings to more than $11 a share, growing to $13 a share if the company executes this properly and shrinks the share count. If Mantle Ridge is successful, I can see earnings approaching $15 a share in 2024. My earnings-multiple range is 16 to 20 times, which results in a target price range of $200 to $300 a share sometime in early 2024.
What will happen if the activists fail?
Witmer: It’s a win-win, because increasing the price of most items to $1.25 will lift margins. But Dreiling would add huge value at Family Dollar. When he was at Dollar General, he tried to buy Family Dollar, but Dollar Tree outbid him.
My next pick, Sylvamo [SLVM], was spun out of International Paper [IP] in October. It has about 44 million shares outstanding and a stock price of $29.75, for a market cap of $1.3 billion. Net debt is about $1.4 billion. International Paper could have been kinder when it spun out Sylvamo, but Sylvamo can handle the debt and pay it down.
Sylvamo produces uncoated freesheet paper, or UFS, used to make copy paper and envelopes, and used in commercial printing. It also produces pulp for tissue and specialty paper, and coated paperboard for liquid packaging. It has operations in Latin America, North America, and Europe.
We think Sylvamo is a free-cash-flow machine. UFS is a much better business than people perceive. The company has only sparse coverage among securities analysts, which sets up the opportunity. We became familiar with UFS when we owned Packaging Corp. of America [PKG], which owns some UFS mills. While demand in North America may be declining long run, the industry structure is good. High-cost mills get converted to containerboard mills or are closed, keeping supply and demand in balance. In North America, Sylvamo has the lowest-cost mill. The other big player, Domtar, was acquired by Paper Excellence in Canada, which is converting UFS mills to containerboard.
In Latin America, Sylvamo is the largest UFS producer, with a 34% share. It owns forest plantations near its mills for a low-cost source of fiber. About 70% of this paper is sold in 26 countries in Latin America, and the rest is exported, mainly to Europe. Demand for UFS is expected to grow in Latin America, and as this occurs, all things being equal, Sylvamo will export less and make more money selling locally. In Europe, Sylvamo has a great mill in Russia, on the border with Finland, and a good mill in France.
Dollar Tree / DLTR
Sylvamo / SLVM
Ardagh Metal Packaging / AMBP
Hillman Solutions / HLMN
Holcim / HOLN.Switzerland
While Sylvamo saw decreasing demand during the pandemic, demand is so strong now that it and the industry are running full-out, increasing prices and passing along cost increases. We see normalized Ebitda [earnings before interest, taxes, depreciation, and amortization] in the $600 million to $700 million range, and capital expenditures are about $140 million. Picking the midpoint of our Ebitda range, and after $140 million of depreciation, we see operating income of about $510 million next year, interest expense of about $60 million, and taxes of 30%, for normalized earnings of $7 a share. Over the next couple of years, the catalysts for a higher stock price are paying down a lot of debt, proving how good the business is, and paying a large dividend.
Sylvamo has a fantastic management team. Insiders have purchased shares, and I can see a dividend of more than $3 a share in a couple of years from a company earning over $7 a share and trading at more than $50 a share.
What else are you recommending?
Witmer: My next three picks I’ve recommended in the past. The first, Ardagh Metal Packaging [AMBP], is an aluminum can manufacturer. We really like it, especially at this lower price of $8.66 a share, compared with $10 at the time of the midyear Roundtable. It traded down as sales growth slowed for hard seltzer, which is about 5% of the business, and as raw material prices increased. But demand for cans continues from a broad range of customers in sparkling waters, energy drinks, and soft drinks, and the shift away from plastic to aluminum for environmental reasons continues.
The company has contracts for its incremental capacity coming on-stream over the next three years, and is targeting discretionary free cash flow in 2024 of $800 million, or $1.18 a share, on 684 million shares. That share count assumes full dilution from 60 million warrants, which strike in five tranches at prices from $13 to $19.50. If the stock doesn’t achieve those prices, the warrants won’t be earned, and there will be fewer shares outstanding. So, earnings per share could be higher if the warrants aren’t earned, and this mechanism offers some EPS protection on the downside.
We also still like Hillman Solutions [HLMN], which faced more headwinds than I anticipated with the port situation, and also experienced a lag time in passing through increased raw material costs, which affected margins. Hillman supplies fasteners and hardware for construction and is the dominant supplier of keys and key-cutting machines. The company called in warrants at year end, bringing down a possible incremental 24.7 million shares of dilution to 6.3 million shares.
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Hillman has a great management team that is working through cost increases. The company has increased its inventory levels, which comes at a cost of less debt pay-down, but as supply chains normalize in 2023, that investment should turn back to cash and be used to reduce debt. Hillman has gained some new customers and is working through the issues that Covid-19 has thrown in its way. All this has delayed by a year the progress I thought Hillman would make. I still see them earning about 90 cents a share of after-tax free cash flow, but in 2023, not 2022.
Henry Ellenbogen: Meryl, how do you think about these companies’ decisions to go public through SPACs [special purpose acquisition companies]? SPACs have been significantly worse performers than IPOs [initial public offerings] over any period of time.
Witmer: Ardagh has a savvy management team, and what they did made a lot of sense. This was a good way for the parent company, Ardagh Group, to spin off the can division. Hillman also has an excellent management team. Some SPACs have done well over the years. Ardagh Metal Packaging and Hillman are two quality companies with good market share and competitive advantages.
My last pick is Holcim [HOLN.Switzerland], which makes cement, concrete, and roofing materials. I recommended it last year at 52.80 Swiss francs [$56.40], and we received CHF2 as a dividend. Today, the stock is CHF48. Holcim has an extraordinary management team that is making smart acquisitions. The company generates lots of cash, which we estimate will be over CHF6 a share annually in the next few years. It has a 4% dividend yield. We think it is a leader in its industry in environmentally forward thinking, and at some point, the stock should have outsize returns as the value it creates gets recognized.
Thanks, Meryl. Let’s turn to Bill.
William Priest: Last year’s winners were concentrated among relatively few stocks. This year, we expect much more market volatility as fiscal- and monetary-stimulus effects wear off and interest rates rise, with the Fed ceasing its accommodating stance. My first pick is Raytheon Technologies [RTX], formed in 2020 from the merger of Raytheon and United Technologies. The resulting company is the pre-eminent supplier of commercial aerospace parts and systems, and one of three major suppliers of jet engines for both defense and commercial aerospace applications. It is one of the five prime defense contractors in the U.S.
Commercial aerospace historically has been an attractive business, with air traffic growing roughly 5% annually, and contracting in only a few years over the past 30 years, at least until the pandemic. In 2021, Raytheon’s operating-income mix was roughly 90% defense and 10% commercial aerospace, but that will change rapidly. The split will be roughly 50-50 in the 2025 time frame, as commercial aerospace recovers.
Illustration by Alvvino
The defense side of the ledger provides ballast against exogenous events through its market-share positioning. It is a mid-single digit grower in cybersecurity, hypersonics, and radar, as well as foreign defense sales. The real driver of future value creation will come from the commercial aerospace operation. That will be a result of the recovery in air travel as the world learns to live with Covid in a more dynamic way. We expect Raytheon’s earnings to compound by roughly 20% a year from 2021 through 2023, and maybe 15% from 2021 through 2025, with commercial aerospace contributing roughly 90% of that earnings change.
The stock currently trades for $90. We think Raytheon could trade for $120 or so in a year, and $135 in two years. Annual free-cash conversion is roughly 90% to 100%. The company uses its cash flow mainly for reinvestment, as well as significant cash returns to shareholders through dividend payments and buybacks. They committed to returning $20 billion to shareholders in the four years since the merger. We think the stock is reasonably priced, but the caveat is you need some recovery in commercial aerospace.
What else do you like?
Priest: Vertex Pharmaceuticals [VRTX] has a $57 billion market cap and a good runway for growth for the next five-plus years. It has an interesting product pipeline and is reasonably valued at about a 5% cash-flow yield. Vertex’s primary market is cystic fibrosis, a rare lung disease; it accounts for almost all of the company’s $7 billion of revenue. We don’t see credible competitive threats on the market. Its leading drug, Trikafta, is patent-protected through 2037, and the core cystic fibrosis franchise should deliver peak sales of $8 billion to $10 billion in the next five years. A super-Trikafta version is in development that could extend the patent life into the 2040s. The next iteration also has the benefit of enhanced economics, as the royalty obligation would decrease from low-double digits to low-single digits, which would materially improve margins. At $220, Vertex shares represent a free option on the company’s pipeline. Vertex has $6 billion of net cash, and $3 billion of annual free cash flow.
Vertex has a joint venture with Crispr Therapeutics [CRSP] to develop a gene therapy to treat sickle cell anemia and beta thalassemia, both blood disorders. The program is showing good clinical progress and could be a $1 billion to $2 billion sales opportunity. They are on track to submit the drug to the Food and Drug Administration for approval by the end of this year. Other products in the pipeline, to treat diabetes and kidney disease, could represent a billiondollar opportunity.
During 2021, Vertex announced a $1.5 billion share-repurchase authorization, effective through 2022. A lot of biotech companies like to sit on their cash in the hope of finding the next blockbuster, which often doesn’t happen. We like that Vertex is accelerating its buyback program. There has been insider buying, too, with the CEO purchasing 10,000 shares on the open market in August. Vertex could earn $14 a share this year and $15 in 2023. Our target price is in the high $200s.
My next stock is Sony Group [6758.Japan], a global entertainment company with a good foundation in technology. Game and network services are about 30% of sales and roughly 32% of operating profits. Music is 10% of sales and 18% of operating profits, and the film business is roughly 8% of sales, 8% of operating profits. Electronic profits and solutions is 21% of sales and 13% of operating profits, but we think it can get a lot better. Imaging and sensing solutions is 10% of sales and 14% of operating profits, and finally, financial services is 19% of sales and 15% of operating profits.
What is the bullish case?
Priest: Sony’s transformation from a legacy consumer-electronics company to more of a creative entertainment company has been under way for several years, and the stock has done well. Under the leadership of Chairman and CEO Kenichiro Yoshida, Sony has restructured its more mature cyclical business portfolio and shifted its focus to IP [intellectual property]-driven businesses with strong recurring revenue. It has leadership positions in games, music, and image sensors. These businesses operate in duopoly or oligopoly markets, so they have pricing power. We think Sony can continue to deliver more predictable and sustainable free cash flow than in the past. The management team is one of the best around. We expect Sony to earn 632 yen [$5.53] a share in the fiscal year ending in March. The stock is trading at JPY14,540, which implies a multiple of 23 times earnings. We see 25% to 30% upside in the shares.
Raytheon Technologies / RTX
Vertex Pharmaceuticals / VRTX
Sony Group / 6758.Japan
ON Semiconductor / ON
Coca-Cola Europacific Parterns / CCEP
T-Mobile US / TMUS
[Editor’s note: Following the Roundtable, Sony shares fell 12.8% in reaction to Microsoft ‘s [MSFT] proposed acquisition of Activision Blizzard [ATVI]. Here is Priest’s assessment: There is no near-term earnings risk to Sony from this deal, if consummated, and the time to close should allow Sony’s management to assess and form its strategic response.]
We also like ON Semiconductor [ON]. Data is the new oil. Wars will be fought over who controls data, and the semiconductor industry is at the heart of the argument. ON Semi focuses on power management and sensing. It manufactures a broad range of products, including many mixed-signal chips. The company has been undergoing a transformation that began with the hiring of former Cypress Semiconductor CEO Hassane El-Khoury and
other Cypress executives. The new team is shifting ON Semi’s focus to more higher-value, higher-margin products. The early progress is visible, and we think it will be successful over time, leading to higher profit margins and an acceleration of free cash flow. ON could generate about $2.50 a share of free cash flow in 2021. That could double over the next four years. We see the stock trading at 20 times free cash flow in two to three years, or around $110 a share, significantly above the current price of $64.
What is your next pick?
Priest: Coca-Cola Europacific Partners [CCEP] was formed last year when Coca-Cola ‘s [KO] European partners bought Coke’s Australian bottling company, Coca-Cola Amatil, which services Australia, NewZealand, and Indonesia. They are going to bring better management practices to the Amatil business. We think CCEP will simplify its portfolio, improve revenue growth, and boost profit margins. Inflation could be a headwind for 2022, but it is manageable. The management team is excellent and has focused for years on generating free cash flow and allocating among the five choices: pay a dividend, buy back stock, pay down debt, make an acquisition, or reinvest in the business. We expect leverage to come down to over three times by the end of this year or in 2023. The shares are trading at a roughly 6% to 7% free cash flow yield.
Now we come to my favorite stock, T-Mobile US [TMUS]. I recommended it last January, and again in July. It clicked, and then it went clunk. T-Mobile provides wireless communications and services. We think it is the single best play in 5G, the next generation of wireless connectivity. It is capable of delivering data rates as high as a gigabit per second, 20 times faster than current networks. But 5G is about a lot more than speed. It drastically increases the number of the simultaneous devices that can be managed on a wireless network. It opens lots of possibilities for wearables, machine-to-machine communications, and the Internet of Things, or IoT.
The merger of T-Mobile and Sprint in April 2020 gave the new T-Mobile scale to compete better with AT&T [T] and Verizon Communications [VZ] and, most important, a surfeit of spectrum. The biggest opportunity for T-Mobile will be the transition from providing solely mobile connections to becoming an edge platform for developers, with the cloud acting as an extension for edge computing and storage. New use cases include private networks, ultra-reliable and low latency communications, enhanced mobile broadband, and massive machine-type connectivity. These developments shift the revenue opportunity from one resembling a zero-sum calculation of the existing incumbents to exciting growth opportunities as AI transitions from the cloud to the edge. The wind of opportunity just started to blow toward the edge in consumer and enterprise technology. T-Mobile is well positioned to capitalize on this change. Unlike in prior ‘G’ transitions, the unit mobile economics of T-Mobile’s 5G network are superior to all its competitors’. Free cash flow could comfortably rise to $18 billion over the next three years. We think the stock will sell somewhere north of $175.
What caused the clunk in the stock?
Priest: It went from $100 a share to $150, and in the past six months fell back to the $100 area. There are two possible risks that could have been at play over the recent past. One is the deflationary effects from a deceleration in subscriber additions that could imply a price war for additional subscribers, and the other is the risk that cable-company business strategies could lead to a drain on the wireless profit pool for all competitors.
Thanks, Bill. Rupal, you’re next. Where in the world should investors shop now?
Rupal J. Bhansali: I’m a committed contrarian. I literally wrote the book on nonconsensus investing. My four recommendations are outside the U.S., which is a crowded trade. The lonely trade is international markets. Three of my four stock picks are in emerging markets, which should tell you where I see opportunity now. These stocks are highly out of favor, misunderstood, and mispriced. My picks also come with very high dividend yields because I expect dividends to be a much bigger source of total returns for investors in the foreseeable future, relative to share-price appreciation.
Given renewed inflation, there is a view that one should buy companies with pricing power. The problem with that thesis is that a lot of those companies’ stock prices are grossly overvalued, so all you’ve done is swap inflation risk for valuation risk. My nonconsensus idea is to buy companies that can grow earnings without needing to raise prices, despite the current inflationary environment. Direct Line Insurance Group [DLG.UK], the leading United Kingdom property and casualty insurer, can grow earnings by improving productivity and agility, rather than raising prices.
Illustration by Alvvino
This sounds counterintuitive in a mature industry like auto insurance, but remember that Costco Wholesale [COST] grows earnings in food retailing, a very mature industry. Direct Line undertook a major IT [information technology] overhaul in the past few years and digitized its processes to improve customer service, cost competitiveness, and market segmentation. The business has an attractive 15% return on equity, while the stock trades for only 10 times 2022 estimated earnings per share, and the dividend yield is an eye-popping 8%.
A dividend yield of that magnitude often spells trouble.
Bhansali: Direct Line is paying the dividend with cash flow, not borrowed money. The company is so free-cash-flow generative that it is augmenting its dividend with share buybacks that are highly accretive at current valuations. Earnings growth is in the single digits, which may be too slow for some investors. I don’t mind slow growth, as long as it’s solid growth. Between Brexit and the Covid pandemic, the U.K. stock market has underperformed a lot, as has the sterling. If the market multiple or the currency goes up, or both, U.S. investors can make better total returns than can be found at home.
Witmer: Was earnings growth in the same range in the past several years?
Bhansali: Direct Line’s earnings have been moribund since 2014, due to missteps in its core business. A new CEO came aboard in mid-2019 and is fundamentally transforming the company. The IT investments were hurting earnings, but are mostly behind them now. As they grow earnings, the stock should rerate.
Todd Ahlsten: How do you think about the impact of climate change and weather events on the P&C business?
Bhansali: Losses from catastrophic weather events typically fall on reinsurers, not primarily insurers such as Direct Line, so I am not too concerned about the impact of climate change on my thesis.
My next stock pick is Credicorp [BAP], the largest financial holding company in Peru. It has a 30% market share across many categories, including commercial and retail lending, microfinance, investment banking, deposits, insurance, and asset management. The beauty of investing in emerging markets is that a company can dominate in so many business segments that you’re not dependent on any one business unit for the stock to work out.
Credicorp has also invested heavily in fintech, and it now hosts the largest digital customer base. Credicorp’s earnings are likely to get a big boost from rising interest rates and improving loan demand. Peru is one of the world’s leading copper exporters, and copper prices have been robust. This will have a trickle-down effect in the economy and on loan growth. Insurance profits should improve because Covid mortality rates will drop this year.
Direct Line Insurance Group / DLG.UK
Credicorp / BAP
BB Seguridade Participacoes / BBSEY
Baidu / BIDU
Despite Credicorp’s great franchise and market position, the stock fell sharply in the middle of last year because emerging markets were hardest hit by Covid, and an election brought a leftist president to power, albeit by a slim margin. We believe he is unlikely to complete his term; his poll ratings have fallen dramatically. But the entire Peruvian stock market sold off, and Credicorp is one of the leading stocks in Peru. We think the bad news has been priced in.
So where to from here?
Bhansali: Consensus earnings estimates for Credicorp dramatically understate the earnings rebound that will occur in 2022. You can own what I would call the Bank of America equivalent in Peru for nine times this year’s expected earnings and a 4% projected dividend yield. Normalized return on equity is about 15% to 16%, notably higher than the 10% to 11% you get in developed markets, and the stock trades at a discount to its global peers.
My next pick is based in Brazil, another country with a lot of political risk, and one that did a poor job of handling Covid. Therefore, the Brazilian stock market has taken it on the chin. BB Seguridade Participa?oes [BBSEY] is the insurance arm of Brazil’s leading bank, Banco do Brasil [BBAS3.Brazil]. The bank has an unrivaled retail distribution network of 3,977 branches, not just in the major cities, but also in less-penetrated rural regions. Because BB Seguridade is a subsidiary of Banco do Brasil, which still owns 65%, it has access to this branch network at no cost to itself. It is a low-risk/high-return business. The bulk of the earnings come from the high-return-on-equity insurance broking segment and asset-management fees. Far less comes from the low-ROE business of underwriting insurance.
Covid hurt BB Seguridade’s profits because of higher mortality costs, lower interest rates, and the mismatch of inflation indexes. Also, investment returns were compressed because inflation increased, but interest rates didn’t, as we have seen in many markets. But all that is changing because Brazil’s central bank, like Peru’s, is raising interest rates now, while Covid-induced higher mortality costs are abating. The reversal of all these things will enable BB Seguridade to post record earnings in 2022. Return on equity is estimated at 60%, and the stock trades for barely eight times earnings.
And here’s the kicker: It sports a 9% projected dividend yield for 2022. Again, there is a tendency to think that such a high dividend yield is a head fake, but that isn’t the case for the reasons I described. Plus, the majority shareholder, Banco do Brasil, needs the dividend upstreamed to it, so the high dividend payout is very likely.
Good point. What is your fourth pick?
Bhansali: My fourth pick is in the country least-favored by U.S. investors, and one of the few that had a bear market last year: China. We are all familiar with the regulatory risk that emerged in China in the internet sector. In my view, it is increasingly priced into the stock market, whereas regulatory risk in the U.S. isn’t priced in.
One of the leading Chinese companies aligned with the government’s common prosperity agenda is Baidu [BIDU]. Being aligned with the government can bring opportunities. I recommended Baidu in the midyear Roundtable. The stock had already corrected sharply, falling from $350 to $180, and now it is about $150. It offers great value.
Baidu operates the leading internet search engine in China, with a 70% market share, not unlike Google in the U.S. Baidu enjoys attractive profit margins and cash flows in its core search business. It is reinvesting its cash in new areas like online video streaming and autonomous driving through its Apollo initiative, to leverage all of its capabilities in AI. While these investments could be attractive in the long run, they are cash-burning and dilutive to margins in the short run. But we think Baidu is successfully positioned. It is applying proven playbooks in Western markets in the context of the Chinese market.
Baidu sells for a midteens multiple of earnings, excluding its net cash. Much of the Chinese government’s crackdown was directed at consumer-facing businesses. Baidu, on the other hand, is transforming itself into a B2B [business to business] model, putting up data centers and offering AI as a service, enterprise cloud, and autonomous driving. People misunderstand the company, just as they misunderstood Microsoft years ago. A B2B business model takes longer to fructify, but it has a more enduring and sustainable payoff. That is what I expect to happen to Baidu, as investors realize that it has become a B2B business with a high moat around its capabilities.
Ellenbogen: The search business has an element of B2C [business to consumer]. Can you talk more about their relationship with the Chinese government?
Bhansali: The common prosperity agenda of the Chinese government is very clear. The government is basically saying that China’s mega internet companies have benefited from the meteoric rise in living standards in China and the economic prosperity the government created, but they aren’t giving back to society. Baidu, however, has done what the government wants these other companies to do–namely, reinvest in the economy. Baidu is spending a lot of money in areas such as AI where China wants to become a leader, so the company is viewed as a national champion, as opposed to a villain.
Thank you, Rupal. Scott, what are your favorite stocks?
Scott Black: We look for companies in growing industries, where a rising tide can lift all boats. We like companies with a high return on equity, rising earnings, and strong free cash flow, trading at low absolute price/earnings multiples, no exceptions. Two of my five picks this year are in commodities; the wind is at their back.
Ichor Holdings [ICHR], based in Feemont, Calif., is a leader in the design, engineering, and manufacturing of fluid delivery subsystems for the semiconductor capital-equipment industry. Their two biggest customers are LAM Research [LRCX] and Applied Materials [AMAT], accounting for 52% and 35% of revenue, respectively. Wafer spend is being driven up by demand from Intel [INTC], Taiwan Semiconductor Manufacturing [TSM], and Samsung Electronics [005930.Korea]. In 2021, it totaled about $85 billion, and the forecast for this year is $93 billion to $95 billion. Ichor specializes in chemical vapor deposition in wafer etch. That business is growing nicely, and should be about $32 billion for 2021, going up to $35 billion this year worldwide.
Illustration by Alvvino
I build my own income statements. I’ll take you through the numbers. Revenue could rise 15% this year, to $1.27 billion, including an acquisition. Wall Street’s consensus estimate is $1.28 billion. We estimate operating income of $146 million and interest expense of $10 million, so that’s pre-tax income of $136 million. Taxed at 12%, that’s $120 million of net income. Divide by 29 million fully diluted shares, and we get an earnings-per-share estimate of $4.14. The Street is at $4.15. Return on equity, pro forma, is about 21%. As for the balance sheet, Ichor has $2.17 a share of net cash, but after the acquisition closes, it will have a net debt-to-equity ratio of 0.27.
Ichor has grown the top line by 23% a year for the past seven years, while the industry has grown by 16%. The company manufactures in the U.S., Malaysia, Singapore, Korea, and Mexico. In many markets, its factories are near its customers’, so there is no supply-chain disruption. LAM and Applied Materials are growing revenue at 15% to 20% this year, and both have tended to outsource more of their subassembly in recent years.
Tell us about Ichor’s stock.
The stock trades for about $44 a share, or 10.1 times this year’s expected earnings. Ichor should continue to benefit from the semiconductor industry’s growth.
Hercules Capital [HTGC], is a business-development company based in Palo Alto. The stock should appeal to people looking for yield. Hercules specializes in growth capital for ventures in technology and life sciences. Drug discovery is about 32% of their portfolio; internet services, 18%; and software, about 27%. The stock trades for $17.03 a share, and there are 116.2 million fully diluted shares, for a market cap of $1.98 billion. The dividend is $1.32 a share, for a yield of 7.75%.
Hercules is expected to earn $1.27 a share for 2021. The portfolio is $2.51 billion. They grew it about 6.7%, year over year, on a net basis for the first nine months of last year. Fee income last year likely totaled $280 million. We expect Hercules to earn $1.45 this year. The Street estimate is $1.39. Return on equity is about 12.5%, higher than most BDCs. The stock trades for 11.7 times earnings, and the price to net asset value is 1.47 times. The company has 71 equity positions that are worth $204 million, and 91 investees. The sweet spot for loans is about $30 million.
Hercules has grown net fee income in the past five years by 11.9% per annum, and total assets by 15.7%. Its cumulative loan-loss ratio since inception in 2005 is only three basis points [0.03% of the portfolio]. It has had only $65 million in write-downs over 16 years. It has excess cash of about $1.57 a share on the balance sheet, which it plans to reduce to 70 cents to a dollar, which means it either is going to pay a second special dividend this year, or bump up regular dividends.
This is a serendipitous way to play growth and technology. We can’t do what Henry Ellenbogen does. He buys growth companies. As a value investor, we need a surrogate way of playing growth, which is too expensive for us.
Priest: New Mountain Finance [NMFC] is another BDC that has done a nice job. The partners also invest in the company’s debt.
Black: We own a couple of others, but not New Mountain. Golub Capital BDC [GBDC] is well run, but doesn’t have a lot of growth. They are hard-nosed about adding to the portfolio. We also own TriplePoint Venture Growth [TPVG] in Menlo Park, Calif.
Mario probably knows my next stock well: Nexstar Media Group [NXST], an owner of television stations. It trades for $155 and has a market cap of $6.5 billion. The dividend is $2.80 a share, for a yield of 1.8%. Nexstar was expected to generate $4.64 billion in revenue in 2021, and about $17.47 in earnings per share. Political advertising was negligible last year, accounting for about $40 million in company revenue. In 2020, with races for the House of Representatives, Senate, state governors, and the presidency, it was well over $500 million. Core ad revenue accounted for about 37%, or $1.72 billion of revenue, in 2021. Retransmission, or fees cable companies and digital platforms pay local TV stations, was about $2.83 billion. The company thinks core ad revenue could grow by mid-single digits this year.
Ichor Holdings / ICHR
Hercules Capital / HTGC
Nexstar Media Group / NXST
Civitas Resources / CIVI
Mosaic / MOS
Interestingly, one of the hottest areas in some markets is sports gambling, which will enhance core ad-revenue growth, bringing the total to $1.8 billion. Retransmission revenue is growing at 8% to 12%; I factored in 10% growth, bringing total retransmission revenue to $3.1 billion. Assuming their share of political advertising is 12% to 15% in the U.S., or $500 million this year, that gives you $5.44 billion in total revenue. After backing out estimated expenses, we get $390 million in incremental operating income over 2021’s, which works out to $25.25 in earnings per share for 2022. By the way, most television companies see earnings go down in a nonpolitical year, so it is remarkable that Nexstar’s earnings went up slightly.
Nexstar trades for 6.1 times earnings. It is ridiculously cheap. The enterprise value to Ebitda multiple is 6.6. Good television franchises get bought up at 10 to 12 times EV/Ebitda. This may be the best one in the industry. Nexstar owns 199 stations in 116 markets, covering the 36 top metropolitan markets in the U.S., and 39% of households, the maximum by law. It is the second-largest owner of NBC stations, which will carry the Super Bowl and the Winter Olympics. Nexstar has stations in 75 markets with competitive House races, seven in areas with competitive Senate races, and 14 with competitive gubernatorial races. Nexstar is well run, with the wind at its back.
What are your commodity ideas?
Black: The first one, Civitas Resources [CIVI] is based in Denver and is rolling up oil and gas companies in Colorado. It was formerly called Bonanza Creek Energy. Daily production is about 159,000 barrels of oil-equivalent. Many shale companies blew a lot of their free cash flow three or four years ago on more drilling. They wound up with negative free cash and levered up. When the price of oil declined, a lot of them went out of business. Civitas is spending only half its Ebitdax [Ebitda plus depletion, exploration expense, and other noncash charges] on exploration. Much of the rest is going toward dividends.
The mix is roughly 40% oil, 35% natural gas, and 25% NGLs [natural gas liquids]. That translates into 63,600 barrels of oil a day, 334 million cubic feet of gas, and 39.8 million barrel-equivalents of NGLs. Prices are hedged on some production; we expect $552 million in revenue from hedges this year. We are estimating an average spot oil price of $72.31 this year, which implies $1.1 billion in oil revenue. If natural gas sells for $3.84 per Mcf [thousand cubic feet], that’s another $264 million. NGLs are about $28 a barrel, bringing NGL revenue to $406 million. Combined, the company could have about $2.3 billion in revenue in 2022. Adding up cash expenses and DD&A [depreciation, depletion, and amortization], we get total expenses of $1.198 billion. Pretax profits could be $1.13 billion, and earnings, $822 million, or $9.58 a share. Our estimate is below the Street’s, at $10 a share. The stock is $55, and the P/E is 5.7. We estimate discretionary cash flow of $16.21 a share, so the price-to-discretionary cash ratio is 3.3 times.
Why is the stock so cheap?
Black: It was a roll-up of four companies, and isn’t well followed. From a breakup standpoint, Civitas could be worth $128 a share. The reserve life is about 10 1/2 years. For 2022, it has hedged the price of 34% of its oil production, and 44% of its gas output.
Lastly, the farm economy had an outstanding year. Todd [Ahlsten] talked about Deere [DE, in the first Roundtable issue], and Mario picked CNH Industrial [CNHI]. My pick is Mosaic [MOS], the largest fertilizer company in the U.S. The stock trades for $40, and the market cap is $15.1 billion. The dividend is 45 cents, and the yield is 1.12%. Mosaic has a 34% market share in North American potash production [potash is a key ingredient in fertilizer]. To build our earnings model, we have to estimate tonnage and pricing for potash and fertilizer. Doing so gets us to $14.85 billion in 2022 revenue. From there, we get $3.67 billion in operating income and about $2.62 billion in net income, or $6.90 a share. The stock is selling for 5.7 times 2022 earnings. My estimated return on equity is 22.6%. The net-debt-to-equity ratio is about 0.30. Management told us they intend to keep $500 million of cash on the balance sheet. It is a buffer through all market cycles. We project that free cash in 2022 will be about $2.5 billion.
China has banned phosphate exports, which limits oversupply. Mosaic’s internal inventory was down 26%, year over year. In India, the potash inventory is down 59%, year over year, and Belarus, which exports about 15% of the world’s potash, is blocked from doing so because of its immigration fight with the European Union. U.S. farm income was about $230 billion last year, the best year since 2012, which is another plus.
Thank you, Scott, and everyone.
Write to Lauren R. Rublin at email@example.com