Bull Or Bear – 6 Ideas That May Make Money In The Next 12 Months18 min read
I do not publish frequently as I try to pick my spots and write compelling articles that have an impact and provide value to readers with stock ideas and analysis that are immediately actionable. I want to help investors FIND ALPHA. To be clear, I am advocating names that I own and have ultra-high conviction in my investment theses. This has been a challenging year for investors and I believe my “Top Six” ideas article is a great chance for readers to own six excellent companies with very asymmetric risk/reward characteristics.
We can debate whether this is a bear market rally or whether the bull market has resumed. Regardless of where your perspective lies, inflation continues to surge and is very clear in gas, groceries, and rents. There are clearly other measures, but those tend to hit the lower-end consumer hardest. We can also debate the impact of COVID, supply chains, etc. but interest rates are headed higher, and speculative no-earnings companies are likely to continue to see pressure, and value stocks are increasingly seeing the interest that they have not seen in over a decade. Valuation matters again and companies with strong free cash flow today are seeing a new level of interest from public and private investors. Regardless of whether one believes that the tech bellwethers that have led this market will continue higher or new leadership will emerge, the sectors I find most attractive have less government intervention at this time, excellent secular stories, and rock-bottom low valuations.
My top six stocks to buy now – Trinseo (TSE) and LANXESS (OTCPK:LNXSF) [LXS] in chemicals. Capri Holdings (CPRI) and PVH in retail. WestRock (WRK) in paper/packaging. And HeidelbergCement (OTCPK:HDELY) [HEI] for infrastructure and rebuilding Ukraine when the time comes – hopefully, sooner rather than later. I have written extensively on chemicals and my favorite names in the space. Chemicals – TSE and DOW. Chemicals – OLN. In paper/packaging – on WRK (Buy WRK). And, I have made many comments within my articles and on news releases highlighting my favorite names and the tweaks and changes over time. So while I will update my thoughts on TSE, LXS, and WRK, I will focus more on retail and why I like CPRI and PVH, and why HEI is likely to be a home run as well. I still like companies such as DOW and OLN and believe they will find their way to higher levels. However, as both DOW and OLN have recently hit 52-week highs, I prefer to focus on the six ideas in my portfolio with the most upside from current levels. And I have maximum position sizing in the six aforementioned top picks. While I still have small positions in DOW, OLN, REZI, SABR and a few others, the bulk of my portfolio is focused on my top six ideas.
On the consumer side, this article from the Wall Street Journal explains clearly and succinctly why the upscale consumer continues to spend while the lower-end consumer has been slowing down in the face of inflation. (Why Nordstrom Steamed Ahead as Old Navy Sank)
High-end retail is neither sensitive to interest rates nor oil prices.
From HSBC last week – “Erwan Rambourg and our luxury team hosted our flagship European conference in Paris this week and found the message from management, particularly market leader LVMH, to remain positive despite tough macro conditions. Bottom line luxury demand is still buoyant.“
TOP PICKS IN RETAIL – CPRI and PVH
NOTE – As both CPRI and PVH report tomorrow, I expect solid results and guidance. While I expect both stocks to respond well (and I have FULL positions), this is intended to be a longer-term call, and believe both of these stocks will be triple-digits by year-end.
There are four main drivers of differentiation in consumer names:
- Low-end versus high-end consumer
- Stay at home goods vs reopening goods
- Leveraged to the US vs non-US consumer
- Leverage to a recovery in tourism or not
During the pandemic, low-end consumers benefitted from government stimulus which recently ended, so consumers are not only hit with no additional stimulus but also higher oil prices which were reflected in low-priced retail companies (e.g. Walmart (WMT), Ross (ROST), Target (TGT)). IMHO, you want to stay away from these companies. This is not a buy-the-dip scenario with these stocks. On the flip side, during the pandemic, mid to high-end consumers saved a ton of money (there is detailed data to prove this) as more affluent people spend more of their money on frequenting restaurants and traveling so all this money accumulated as savings during the pandemic. So not only are these consumers less sensitive to higher oil prices but they also have a lot of money saved up in addition to the desire to go back to normal benefitting higher-end retailers (e.g. CPRI and PVH).
During the pandemic companies with exposure to stay-at-home goods over-earned, and as a consequence their businesses are slowing and margins will come down as too much inventory in the channel will cause discounting (e.g. PTON, ZM, DocuSign on the tech front and TGT, BBY, DKS). You also want to stay away from these companies. On the flip side, there were companies that suffered as people spent their money on lululemon pants to stay at home as opposed to nice clothes to go out or go to work at the office. Now that the economy is reopening, the mix is shifting back to these companies. There is one more consideration, according to Levi’s, over 40% of their customers changed waist size during the pandemic, so a lot of these going out / going back to work clothes need to be replaced as they no longer fit. So you want to buy retailers CPRI and PVH for this exposure.
During the pandemic, the lockdowns in the US were less severe and shorter than in Europe and Asia, so the amount of pent-up demand is greater in these markets. Therefore, you want to buy companies with more exposure to these geographies outside of the US (again – CPRI and PVH).
During the pandemic, tourism basically disappeared so companies selling stuff to tourists suffered (e.g. CPRI, PVH, RL). As tourism has started to come back, these companies will see earnings accelerate due to increasing sales to tourists. As an example, both CPRI and PVH lost $2 in EPS from zero tourism, so we are now starting to see international air travel ramp and with that, those tourist sales are returning and ramping. As an investor, you want to own companies leveraged to a recovery in travel.
Just a few weeks ago, CPRI hit a new 52-week low of $36.90. I commented quite a bit during the few days CPRI was below $40 (See May 11 and 12 comments) that CPRI and PVH (along with TSE) were among my highest conviction ideas. The stock was irrationally punished as it was lumped in with retail in general, and because of Russia/Ukraine fears along with higher crude, when the stock was already substantially undervalued at $72. To see this stock cut in half over three months was ridiculous. The main fears I have heard repeatedly were that Russians stopped buying and that high oil prices would curtail consumer spending.
(1.) Russian customers are less than 2% of the market. Ferragamo recently reported and said that there was no impact from the war in the daily data they examine since the war began – from Russia or in general.
(2.) The luxury market is so undersupplied that even if they were to slow (which I do not expect), the remaining 98% of the market demand should easily absorb the extra product if any.
(3.) Sensitivity to crude is a legitimate impediment to discretionary spending for low-income consumers. For the luxury consumer, the impact of higher oil and gas prices is de minimis if at all.
(4.) A lot of the crushing shorting and selling in any consumer name happened when Brent crude ripped to $130 on the way up (Crude spikes to 13-year high of $130, then gives up most of that gain), largely through machines as the general rule of thumb historically is that the economy slows when oil goes above $120. Oil has now pulled back under $120 and there are a lot of oil forecasts, but as price moves higher, global production typically increases. CPRI was fundamentally trading at ~1/3 of its fair value at $72. At $48 and change per share, the stock is down ~34% since they last reported blow-out numbers, and the CPRI story continues to improve. I expect tomorrow morning’s report to be strong.
CPRI is unleveraged, generates a ton of cash, and continues buying back its shares. From these levels, I believe the stock can quadruple, to get to fair value of ~$202 per share (18.5x earnings which I estimate will be just shy of $11 per share two years out). 18.5x is the blended multiple of 25x on the 35% that is true luxury (Hermes trades at ~40x, LVH trades at ~25x, and these are the multiples AFTER the selloff), and 15x on the remaining 65% that is now “affordable luxury. Even using conservative assumptions into next year and a slowdown into 2023, CPRI should generate at least a double for investors from current levels.
(1.) Net debt as of 12/31/2021 was $741 million, which is 0.5x net debt to EBITDA. The company will repay this debt and be completely debt-free by end of this year since they generate so much cash.
(2.) I estimate EPS will be $6.40 in calendar 2022 and $7.50 in calendar 2023
(3.) FCF per share is even higher than EPS because depreciation and amortization are higher than CAPEX, so FCF for 2022 is $6.75 and for 2023 is $7.80. This is a ~17.5% FCF yield for an unleveraged company owning two of the most desirable luxury brands in the world. Given the enormous scarcity of true luxury brands and the desire of LVMH and Kering (which owns Gucci) to buy more brands, the likelihood of a takeout is high in my view. I think this valuation disparity and the “left for dead” approach to this company by the street make CPRI an ideal company for value investors.
CPRI has for the last 5 consecutive years (prior to the pandemic) bought back an average of $644 million worth of stock per year or 10% of the company per year. The run rate for the current year is similar now that the pandemic is behind us. Keep in mind that they did this before the company bought Jimmy Choo and Versace so now they have even more cash flow to repurchase shares. Given the growth in FCF as the company optimizes and monetizes the new brands, the company will generate enough cash to buy back the entire company in 7 years. And this is without any debt on the balance sheet. The company could leverage up and take itself private in a few years – perhaps not a bad idea given how much stock the founders/management team owns. If this does not happen, and the stock stays at these levels, LVMH or Kering are likely to try to acquire CPRI. Not only did these two companies want to buy Versace and Jimmy Choo when CPRI bought them, but LVMH has been trying to buy RL as they want an American “affordable luxury” brand. Ralph Lauren won’t sell, so Michael Kors fits the bill pretty well. With LVMH wanting to buy all three of CPRI’s assets I doubt they will pass this opportunity up.
There is extensive basic information on PVH available and a link to a recent article advocating for PVH explains the company basics fairly well. (Recent PVH article on SA). The problem with PVH is that it is misunderstood by the street. I believe there is a lack of proper modeling and extrapolating the numbers and looking at historical performance within the upscale brands segment. I believe it is fear-based and many sell-side analysts are discouraged from venturing far from consensus numbers or doing any sensitivity analysis within their models.
So far there have been no real indications of any weakness in the consumer at the mid to high end. DECK crushed the print and VFC came in line which was good enough for a bounce even though their guide was a little lower due to an issue with one of their brands. Watches of Switzerland reported strong print and said no change in the end market or their order lists. ROST, which sells to low-end consumer, however, blew up as they gave weak guidance. This is the same as TGT, low-end consumer. In the case of ROST, I also think they mismanaged the inventory mix (like TGT). They did say that apparel was the better performing category. Both DECK and VFC said inventories are low and they could have sold more if they had more product. This is consistent as ROST does well when there is excess inventory in the market as their business thrives from buying inventory on the cheap and reselling it to bargain hunters (low end).
Three weeks ago Ferragamo beat and provided strong guidance. Barclays (BCS) came out at the same time and said pricing is even strong for dressy clothes brands like CPRI and PVH. Not even in the great depression of 1930 did strong brands trade at 5x cash EPS with no debt.
I was bombarded with questions following the big misses and stock declines in WMT and TGT. CPRI and PVH are mainly leveraged to markets outside the US, to a recovery in travel, and to mid to high-end consumers. These businesses have been very resistant to recessions in the past. The stocks never got their fair multiple 12 months ago because investors only wanted to buy tech. Then they were decimated because of the China lockdowns which are now reversing. Then they got beaten up because of recessions fears. They are starting to recover in front of earnings, but first, they both found new 52-week lows because the low-end consumer suffers from our self-imposed record gas prices (Again – see WMT and TGT). What you have is some of the strongest global brands, which GREW through the last recession, massively leveraged to a reopening of the economy as so much of their business is helped by tourism, trade at 6x cash EPS with clean balance sheets, buying back ~20% of their stock a year, when the fair multiple is over 20x.
KSS missed numbers and with the exact same story as Target (Target was worse because they were even more aggressive in building inventory of stay-at-home categories). And yet, the stock was up in a down tape when they reported. More than half the miss of KSS was due to their home category (benefitted from lockdown and now hurting as the economy is reopening). The other half was due to children’s clothing which is very sensitive to weather as this year weather was abnormally bad. They actually backed this up by stating that the difference between the states impacted by weather and the ones not was 800 bps. They said weakness was most pronounced overall in March as they lapped stimulus checks (widely expected impact on lower-end consumers), but business has accelerated in May. Randomly they mentioned that brands like Calvin Klein and Tommy Hilfiger (both brands of PVH) were particularly strong. So in summary, it is the same story as with WMT and TGT – the issue is mainly in stay-at-home categories and low-end consumers. The fact that CPRI and PVH were crushed makes no sense. Not only are these companies in mid to high-end consumer, but they also do nothing in stay-at-home and they have much more exposure outside the US so they are not impacted by the stimulus dynamics.
I can also give an update on PVH given the new CEO (rock start behind H&M and Old Navy) and his plan just laid out at the analyst day this past month. His plan calls for generating 60% of the market cap of the company over the next three and a half years, in addition to growing earnings to $18 per assuming current share count. This assumes cash just sits on the balance sheet which it won’t as the company increased the buyback and said a significant part of the excess cash to be used for buybacks. If they were to use all the excess cash to buy back stock at the current price, EPS would be $41.3 per share, which at the historical multiple of 15x implies a share price of $620 or 8.5x the current share price of $71. Do I really need to say more with regard to why this is a compelling risk/reward?
I have written extensively on WRK. (Buy WRK) and (The WRK Disconnect) among others. So, rather than diving into this name again since they just had an investor/analyst day recently, and there is ample research on the company, I will simply say that I believe the new management team set a very conservative low bar and the upside is substantial from here and it is a very low-risk stock to own with a nice dividend to collect as management unlocks shareholder value.
I also want to address the single most frequently stated concern from investors. If the consumer slows spending (high and/or low) what is the risk that WRK will fall short of expectations. At the investor/analyst day a few weeks ago, management basically provided a “worst-case scenario” with the numbers, and I believe poorly communicated that this was the “worst-case” and that their internal expectations were substantially higher. (WRK Shares Suffer Sharp Drop). WRK sells 40% of its product to the food industry, the rest is all sorts of consumer goods people will continue to order even if some people trade down from one product to another product to save money. arguably, because gas prices are high it is cheaper to get stuff sent to your home (which means more boxes) than driving to the store as it is the companies that pay for shipping and not the consumer. In sum, WRK is a low-risk name with huge upside. It clearly makes my “Top SIX” best ideas.
Lanxess AG (LXS – German Market) – ADR – LNXSF
Note – the ADRs are very thin, and I recommend for anyone buying more than a couple of hundred shares to consider buying the ordinary shares in the German market (LXS). I am not sure what brokerage firms offer this, but I use Interactive Brokers to purchase international stocks.
There is ample general information available to get the gist of Lanxess and their specialty chemical business. I suggest visiting the company website (Lanxess) and perhaps reading a basic article on the company. I believe the “investment Doctor” has a reasonable primer to understand the company (Buy Lanxess). In a few sentences, LXS is a German specialty chemicals company based in Cologne, Germany that was founded in 2004 via the spin-off of the chemicals division and parts of the polymers business from Bayer AG (OTCPK:BAYZF). It is a great company with an excellent management team. (Buffet owns a stake at much higher prices.)
There was a very significant announcement this morning that boosted the stock by ~11%. I think the stock is much more compelling following the announcement and the initial move up than it was yesterday.
Lanxess UPDATE from today, May 31, 2022
This deal is even better than I had expected. Points from the call:
- They are selling this division (which was the lowest multiple division of the group fundamentally) for a minimum of 12x EBITDA.
- They are getting at least €1.1 billion upfront in cash (which will be used to repay debt and buy back stock) plus 40% of the JV (their assets combined with DSM’s engineering plastics assets)
- They will sell their stake in this JV after 3 years. The valuation for this stake will be at 12x EBITDA but EBITDA will then be higher than today as the auto industry recovers from the trough today (today auto production is at 2009 lows due to supply chain) and they get 12x their share of the synergies also.
- Synergies for this type of deal will be 5% of revenues conservatively so call it €150 million. At 12x this is 1.8 billion so Lanxess’s share is 0.4*1.8 billion or €720 million. The EBITDA of the JV today is €510 million. I think with the recovery of auto WITHOUT synergies this number is at least €600 million three years out. So Lanxess gets 12x * 0.4 * 600 million or €2.880 billion. So they get €720 million from the value of the synergies, plus €2.880 billion. The total is €3.600 Billion plus the €1.1 billion they get in cash upfront. Subtract €1 Billion for debt. So they just got €3.7 billion of value with this deal, and the market cap is less than €4 billion today for Lanxess. It is beyond incredible that the stock was not up A LOT more today. The stock should have doubled on this news IMHO.
Trinseo PLC (TSE)
I have written the most detailed notes on Trinseo and most often as I believe this small-cap name is under-followed and covered poorly by the street, I have tried to help provide investors with a different perspective. In a nutshell, this is my single largest holding. CPRI, PVH, LXS, HEI and WRK are all about the same size for me and about as large as I want to take in any individual stock. For TSE, here are the three most recently published articles. TSE #1, TSE #2, TSE #3.
Getting to the bottom line regarding Trinseo, the CEO has transformed the company over the past few years, and it is now a specialty chemical player about to sell its last commoditized business, styrenics. This should be announced soon as management indicated on the last earnings call that this should be announced in calendar Q2. Thus, I expect TSE will announce this sale within the next month. I believe street expectations are very low. From analysts with whom I have spoken and in notes I have read from the sell-side, I believe consensus expectations for the styrenics sale is somewhere between $500mm at the low-end to $750mm at the high-end. My published range is $1 B to $1.8 B with my midpoint estimate being $1.4 B. Given the environment, perhaps my high-end is aggressive. If I were to tighten my range expectations, I still believe $1 B is likely the low and perhaps TSE could see as high as $1.3 or $1.4 B. Nevertheless, I think anything in the $1 B range +/- will far exceed analyst and investor expectations. At $47 and change, TSE is sporting a roughly $1.7 B market cap. If TSE can garner 60%+ of its market cap by selling its styrenics division, I suspect Trinseo’s stock price will re-rate very quickly to much higher levels. TSE already has a significant share repurchase program in place, and upon the sale, I expect the buyback to increase significantly.
Heidelberg has faced a series of economic shocks-the U.S./China trade war in 2018-2019, Covid-19 lockdowns in 2020-2021, and now the invasion of Ukraine in 2022. However, the long-term fundamentals of the Company have actually improved significantly (even if earnings were initially softer than hoped).
The Company installed a new CEO in 2020 who is a meaningful upgrade. While the prior CEO was more than adequate, he was less focused on optimizing capital allocations to unlock the dramatic undervaluation of the Company’s assets in the public markets.
Despite recent macro-economic challenges, the new CEO has successfully sold several underperforming assets at valuations up to 4x higher than the Company’s current public trading multiple. The Company used the proceeds to aggressively pay down debt, driving leverage to just over 1x EBITDA. In 2021, the Company commenced the first share buyback program in its history. The initial approval is to buy back at least 10% of the Company’s outstanding shares over two years. Management has indicated it would likely accelerate the buyback if the shares remain this undervalued.
Finally, the Company has increased the dividend to just under a 5% yield, which, including the buyback, implies a combined cash return to shareholders of 10% per year. Despite these shareholder-friendly moves, the valuation of the Company has compressed further from 8.3x to 4.0x EBITDA. This valuation dislocation is even more striking when considering mid-cycle EBITDA. On this metric, Heidelberg is trading closer to 3x EBITDA, similar to levels last seen in the aftermath of the 2008 Global Financial Crisis. For a Company generating an annual 10% cash return with a significantly under-leveraged balance sheet, this is hard to believe.
The bear case for Heidelberg focuses on the potential for higher European natural gas prices to substantially squeeze profits. Some bears further extrapolate this reasoning to a scenario where a full Russian gas embargo prevents Heidelberg from operating its manufacturing plants. I find these arguments unconvincing. The cement industry is almost entirely local as shipping costs are prohibitive over long distances. As a result, cement producers have already demonstrated consistent success passing along increased costs to their customers within a captive local market.
Addressing the second tenet of the bear case, when input/output prices in one region (Europe in this case) rise too far, supply and demand adjustments occur that bring the market back into balance as many are forced to cut back. This dynamic was demonstrated in the fertilizer and aluminum industries in Q4 2021.
HEI.GY shares trade with a significant margin of safety as they are a leading global player in a global market. The replacement value of the assets alone is estimated to be 300%-400% of the current share price. Consequently, I am happy to collect a 10% annual cash return until the market recognizes that the world travels over and lives atop cement.