📍 TLDR:

• Amid a resurgence in value stocks, former blue chips have performed quite well — but there are concerns.

• General Mills has driven growth — but are investors pricing in too much of the same going forward?

• A revenue cliff for IBM provides an interesting test case for the market.

• Is the ‘new’ AT&T new enough?

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There is a vein of investment advice that, roughly speaking, is “buy established, well-known companies with strong dividends and defensive characteristics and hold them for a long time.” Often there’s a suggestion that this is precisely what Warren Buffett does (it isn’t). Other times the admonition from Peter Lynch to “buy what you know” is added, and while quoted correctly, almost always misinterpreted

During the 2010s, that advice was pretty close to disastrous. It steered investors away from growth stocks, which as we discussed last month crushed the returns of the overall equity market. Instead, it pushed them toward older, established, widely-held and supposedly “safe” issues that badly underperformed the market as a whole, not just their faster-growing counterparts.

General Electric is perhaps the poster child for that phenomenon. Returns including dividends for the entirety of the 2010s were negative 1.3%, against 415% for the NASDAQ 100. Kraft Heinz has been a massive disappointment since its blockbuster merger closed in 2015. Those are far from the only examples, however. Simply put, last decade new was better than established.

Proponents of buying established companies would argue (and at the time did argue) that the underperformance was driven by the zero interest rate environment. With the collapse of so many unprofitable growth stocks over the past 22 months, most no doubt believe they’ve been vindicated in blaming external factors.

There’s probably some truth to their argument. But it’s certainly not the whole story. Growth stocks did well for the entirety of the decade because so many were growing so quickly. Their established counterparts, meanwhile, were being threatened by precisely the drivers of that growth: rapid technological change, the fragmenting of consumer markets, and the ability for smaller rivals to, essentially, rent scale

But here in 2022, as value investing has made a comeback, some of those dinosaurs are showing real signs of life. That’s been particularly true over the last few weeks. The question for these names is whether there’s a legitimate change in the operating environment that suggests upside ahead — or if investors are making the same mistake all over again.

General Mills

General Mills seems like a business that could be headed for hard times. The company’s strategy (such as spending over $9 billion acquiring Blue Buffalo Pet Foods and the pet snacks business of Tyson Foods) shows management’s unease with growth prospects in legacy categories like yogurt and cereal.

Yet GIS stock has been a huge winner of late. Shares are up 29% so far this year, double the returns of rival Kellogg. More impressively, they’ve gained 160% from 2019 lows. And it’s not the pivot into pet supplies doing the heavy lifting. Fiscal 2022 operating profit in the Pet segment was $471 million, suggesting the company probably paid ~15x EBITDA across the two acquisitions. That’s a price that might suggest M&A added some value. But it’s a tiny fraction of the roughly $30 billion in market cap added from the 2019 bottom.

It’s been the legacy business that has done the heavy lifting. Overall, General Mills has returned to growth. FY23 guidance suggests a 4-year compound annual growth rate for earnings per share above 6%. The pet business has played a role: segment operating profit should come close to doubling between FY19 and FY23. But roughly ~one-third

What’s really changed, however, is the multiple investors are assigning to General Mills earnings. At early 2019 lows, GIS was valued at barely 10x actual earnings for that fiscal year. At the moment, GIS trades at 21x FY23 consensus. The P/E multiple here has doubled.

Those lows admittedly were brief, but the broad point here still holds. What has driven GIS higher is not just growth in earnings, but a sharply increased confidence that they will continue to grow. General Mills, in other words, is being treated by the market as if it is the ‘old’ General Mills, with dominant franchises, steady growth, and the ability to compound earnings over time.

Recent results suggest some reason for that interpretation. General Mills has increased profit margins in an inflationary environment, a trend that suggests its brands are as strong as ever.

That said, there seem to be real concerns here. Yogurt and cereal still drive over 20% of sales. Margins are improving amid inflation, yes. But it also comes amid a still-strong U.S. consumer (international sales were 23% of the FY22 total). The awaited shift to private label/lower-cost options in the grocery space hasn’t really arrived yet, but may do so when consumer spending actually starts to moderate.

Wall Street shares those concerns. The average analyst target price for GIS suggests about 9% downside from current levels. That kind of price divergence is pretty rare among well-covered large-caps. Either the market is right in pricing in years of consistent growth — or investors are chasing any kind of perceived safety in a highly volatile market. Short interest totaling more than $1.3 billion (2.5% of the market cap) suggests some traders are betting on the latter explanation.

IBM

Jim Gillies @JimPGillies

Has anyone else noticed that, in a year where: * The S&P500 is down 15.1% YTD, and * The NASDAQ is down 27.5% YTD, that FREAKIN' $IBM is UP 13.1%? Before dividends. (Currently sports a yield of 4.4%). What the heck?

4:32 PM ∙ Dec 14, 2022

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"What the heck?" is a fair question. So far in 2022, IBM has outperformed not only the market, but the same Big Tech names that ate its lunch for roughly a decade.

There are some reasons for optimism too. IBM’s 2019 acquisition of Red Hat appears to be working out reasonably well, as hybrid cloud revenues are growing at a rapid clip. The company that once dominated in hardware generated 59% of year-to-date segment-level profit from its software business. Overall, adjusted pre-tax profit has increased an impressive 38% year-to-date, with margins expanding 300 basis points.

History suggests some caution, however, and here too analysts agree. A decline in early trading Thursday pushed IBM back below the Street target price, but only by ~1%.

All that aside, there is a very interesting experiment about to take place with IBM. In early November of last year, the company spun off infrastructure provider Kyndryl. That spin has benefited IBM results, since sales to Kyndryl now are external, and thus added to overall revenue.

That tailwind has been substantial, contributing five points of top-line growth through the first three quarters, per IBM’s most recent 10-Q. But that tailwind moderates substantially in Q4, and then ends in Q1. Even with easier comparisons thanks to forex headwinds that we’ve discussed previously, the Street sees revenue growth of just 0.5% in 2023.

In theory, the boost from Kyndryl should be well-understood and thus priced in for such a liquid, large-cap name. In practice, perhaps it isn’t. The next few quarters for IBM thus provide an interesting test case for the idea that the market as a whole knows what it’s doing with large-cap names. If a decelerating top line leads IBM stock lower over the next few quarters, maybe the market isn’t quite as smart as some of us believe.

AT&T

A few weeks ago on Twitter, a user congratulated a short seller for riding a stock down — and then flipping bullish near the bottom. The user rightly pointed out that such a reversal is really hard to execute, simply because it’s so difficult to reset an investor’s sentiment.

I’m personally aware of that problem when trying to judge AT&T. I’ve been bearish (and publicly so) for years now, and on occasion sold bear call spreads on the stock.

I say that not to pat myself on the back. The bear case was pretty much self-evident: AT&T’s leadership was among the worst of any large-cap company this century. Add to that ongoing pressure in the wireline business (which still seems underappreciated) and the lack of returns in AT&T stock

It’s worth recapping the management failures here. Most investors are aware of the disastrous acquisitions of DIRECTV and WarnerMedia. But somewhat forgotten is the abject stupidity of the company’s attempt to buy T-Mobile back in 2011.

Elliott Management highlighted this fiasco in its 2019 mini-activist campaign against AT&T. Simply put, the acquisition was doomed from the jump.

There’s a rule of thumb that Republican commissioners on the Federal Trade Commission, tasked with approving mergers, will accept three competitors in a major market, while Democrats require at least four. Indeed, the wireless space itself provides evidence for this perception: Sprint and T-Mobile abandoned their merger in 2014 under the Obama Administration, then successfully moved forward with a tie-up under a Republican-controlled FCC a few years later.

Of course, when AT&T was trying to buy T-Mobile, it was Democrats who had the votes in the key agency. As a result, skepticism toward the deal was immediate. And when the FCC unsurprisingly sued to block the merger, James B. Stewart, an established financial journalist

It never got that far. Amid clear signs that the deal was not going to be approved, AT&T abandoned the acquisition and paid a break-up fee. The fee was $4 billion paid in cash and, more importantly, wireless spectrum access. That $4 billion in turn allowed T-Mobile to spend the next eleven years stealing AT&T’s subscribers. All for an acquisition that was pretty clearly dead on arrival the day it was announced.

Without exaggeration, it’s one of the dumbest consequential moves in American business history, and also one of the most underappreciated. Yet the bull case for AT&T stock here is that it doesn’t really matter.

The competitive environment is what it is at this point, and in that environment AT&T is starting to regain market share (though it’s now taking that share from Verizon rather than regaining it from T-Mobile). The CEO who “executed” the disastrous “strategy”, Randall Stephenson, is gone

Except…is it? The current CEO, John Stankey, was there for the entirety of the idiocy

Again, it’s difficult to truly change one’s sentiment on a stock they’ve followed for years. And so it’s very possible my long-held skepticism toward AT&T management is preventing me from appreciating the fact that this indeed is a different, and better, business.

But the bull case here does not seem all that different. The balance sheet is better, but hardly pristine. Investors still seem to be ignoring the wireline business, which accounted for ~30% of Communications EBITDA in 2021 and is in permanent, secular decline. Many still are focused on a headline dividend yield (at 6%), ignoring the fact that a high dividend is precisely what got so many investors into trouble over the last few years.

The bear case for T into the lows earlier this year was that AT&T was a poorly-managed, heavily-indebted business with questionable growth prospects. It’s possible a few quarters of admittedly improved market share suggest that bear case is outdated and backwards-looking.

It’s also possible, however, that investors are desperately trying to find value in a market that still isn’t providing much. During the rally that began in June, they bought up fallen growth angels, only for that strategy to fail. The concern is that they are now hoping once-great companies — instead of once-dearly valued stocks — will rebound. History suggests that strategy might not work out any better.

As of this writing, Vince Martin has no positions in any securities mentioned.

Tickers mentioned: GE 0.00, GIS 0.00, IBM 0.00, K 0.00, KD 0.00, KHC 0.00, T 0.00, TMUS 0.00, TSN 0.00, VZ 0.00, WBD 0.00, WMT 0.00

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