Ciena Needs More Chips To Pull Out Of The Dip

Bullishness on Ciena (NYSE:CIEN) has gotten me nowhere this year, as this large optical networking company has been hamstrung by its inability to secure the parts and components it needs to satisfy demand. While that demand has remained strong, and the company will head into 2023 with a strong backlog, the name seems to be a non-starter with the Street until the company can guide to meaningful sequential revenue growth and margin re-expansion.

Over the longer term, I still like Ciena’s leverage to service provider and webscale deployments, as well as opportunities to grow its routing and PON businesses, and I think the shares can deliver an annualized double-digit return. In the short term, though, it’s hard to see much upside beyond $50 unless and until the supply problems ease and management can guide to meaningful sequential revenue acceleration.

 

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Ciena Needs More Chips To Pull Out Of The Dip

United Community Banks Combines Solid Execution With An Ongoing M&A Growth Story

Banks are not very popular at the moment, and banks that lean heavily on M&A to drive growth are even less popular … and yet, United Community Banks (NASDAQ:UCBI) shares are up about 5% since my last update, outperforming the regional bank group by around 10%. UCBI management has continued its acquisitive ways, but has also been delivering on strong asset sensitivity and operating leverage, driving better-than-expected results for the year.

I continue to believe that UCBI operates in fundamentally attractive markets, and I like the company’s overall strategy with respect to lending and deposit-gathering, including meaningful operations in “second-tier” metro areas where there is still good population and income growth, but less competition from non-local banks. Valuation is challenged by the reliance on an M&A model, but I do believe the shares are still modestly undervalued.

 

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United Community Banks Combines Solid Execution With An Ongoing M&A Growth Story

Between Weakening Crypto And A Questionable Deal, Semtech Is On Its Heels

The last few months have not been easy ones for Semtech (NASDAQ:SMTC). A collapse in the value of Helium HNT cryptocurrency (down 95% over the past year) threatens one of the recent sources of momentum in the key LoRa business, while the acquisition of Sierra Wireless (SWIR) looks questionable at best. If that weren't enough, handset volumes are weak, and it looks like PON, data center, and 5G deployments are slowing.

Should the Sierra Wireless deal go forward, I think it will ultimately destroy value for shareholders. That's offset by good long-term trends and opportunities in home broadband and data center, not to mention the longer-term potential of LoRa in the IoT space. The valuation does look too low now, but it's hard for me to recommend a stock where I disagree with management's strategic priorities, and that's the case for me now with Semtech.

 

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Between Weakening Crypto And A Questionable Deal, Semtech Is On Its Heels

Innospec Continues To Hit Its Marks, And Performance Chemicals Is Showing Exciting New Potential

I'm accustomed to quiet excellence from Innospec (NASDAQ:IOSP), a small ($2.7B market cap) specialty chemical company with operations in fuel additives, personal/home care, and oilfield services. Typically not well-covered by the Street, Innospec has generated mid-teens long-term returns for investors and has continued to build the business through a combination of organic reinvestment and selective acquisition. It's been a while since I've written about the company, but it has continued to execute well. Up about 10% since my last update, Innospec has beaten the market over that time, as well as many of its specialty chemical peers.

With management reinvesting more aggressively in growth opportunities within specialty chemicals for personal care and looking to drive improved operating leverage in the oilfield services business, I'm still bullish on the company and I find the valuation more interesting here. If mid-single-digit revenue growth and mid-to-high single-digit FCF growth are credible, these shares could still offer double-digit annualized return potential from here.

 

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Innospec Continues To Hit Its Marks, And Performance Chemicals Is Showing Exciting New Potential

With Short-Cycle Markets Expected To Fade, Fortive's Next Big Testing Is Around The Corner

Writing about Fortive (NYSE:FTV) back in March of this year, I expressed some concerns about whether the company was really living up to its billing as a "compounder" that could consistently add value through M&A. While liking the company's efforts to build up strong recurring revenue and exposure to long-term secular trends like automation, electrification, ESG, productivity, and safety, as well as the company's prospects for above-average growth, I still had some concerns about the margins, M&A discipline, and valuation.

The shares did subsequently slip into the mid-$50's, a point where prospective returns would have been in the high single-digits, before rallying and outperforming the industrial group. Close to 10% higher now, Fortive has been delivering more of late, and it looks better-placed than many of its peers/comps to navigate this next phase of the economic cycle. Valuation is less exciting now, and unless you're willing to go back to the "good ole days" of 20x-plus EBITDA multiples, it's hard to make the case that Fortive is fundamentally undervalued.

 

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With Short-Cycle Markets Expected To Fade, Fortive's Next Big Testing Is Around The Corner

Allison Transmission Seeing Healthy Demand Today, But The Future Remains The Major Debate

Despite stronger near-term results, the “now versus then” debate on Allison Transmission (NYSE:ALSN) won’t go away, as analysts and investors continue to argue over the adoption curve of electrified trucks, what role Allison will play in electrified vehicles, and what the profitability of that role may be. In the meantime, Allison is looking forward to multiple potential growth drivers in its established business, but also faces the prospect of further cost ramps for electrification-related R&D.

I liked these shares back in August of 2021, and the stock has done alright since then – rising close to 10% and roughly doubling the return of the market, while also outperforming other commercial truck suppliers like American Axle (AXL), Cummins (CMI), and Dana (DAN). The valuation now is more “good” than “compelling”, and I’d lean more toward other names like Dana, but that’s largely splitting hairs.

 

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Allison Transmission Seeing Healthy Demand Today, But The Future Remains The Major Debate

Preferred Bank Executing On Rate Leverage, But The Street Isn't All That Interested

As far as managing what is within their control, I can’t find much fault with Preferred Bank (NASDAQ:PFBC) since my last update on this smallish ($5B in assets) California bank. Rate leverage has been very strong, operating leverage has been very strong, and credit quality has likewise been quite good. But, banks being out of favor, the shares have done only a little better than the average regional bank since my last update, falling about 5% - beating the market by around 10%, as well as peers like East West (EWBC), Hope Bancorp (HOPE), and Pacific Preferred (PPBI), while underperforming Cathay General (CATY) by a few points.

Macro headwinds remain real, and I don’t expect the Street to stop worrying about this issue for at least another quarter or two. Preferred still has some leverage to further rate hikes, but the bank is already seeing demand destruction for loans and I don’t see much sustainable operating leverage with loan growth. Long term, I still think this is a good bank and I think the valuation is attractive, but this could be stagnant money until the Street is ready to look past the coming slowdown.

 

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Preferred Bank Executing On Rate Leverage, But The Street Isn't All That Interested

Ternium Hit Too Hard On Near-Term Steel Price And Margin Weakness

Tougher times usually see investors run toward quality, but that hasn’t benefited Ternium (NYSE:TX) this year, as the shares of this Latin American steelmaker have fallen about 13% since my last update, underperforming Steel Dynamics (STLD) and Nucor (NUE) by a wide margin, as well as ArcelorMittal (MT) and Gerdau (GGB). Given Ternium’s leverage to a recovering North American auto industry and longer-term reshoring, I think this underperformance is short-sighted, but it is also true that Ternium is looking at weaker EBITDA margins through 2023/2024 and a competitive Mexican steel market.

I still believe Ternium is undervalued, and I further believe that the relative valuation has become meaningfully more attractive. This is likely not a name that will get much love over the next six months, as prices and spreads continue to weaken, but I see upside into the $40s as investors eventually come back to the strong margins, cash generation, and balance sheet and the positive growth outlook.

 

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Ternium Hit Too Hard On Near-Term Steel Price And Margin Weakness

Lennox Going Into 2023 With An Iffy Mix Of Headwinds And Tailwinds

Writing about Lennox International (NYSE:LII) over a year ago, I wrote that I was more bullish on the short-term opportunities for the company than the Street, but found the valuation unappealing, and particularly so given some longer-term challenges. Since then, the company has indeed executed well on its residential HVAC opportunities, as well as refrigeration, but the shares are down about 20%, lagging the broader industrial group and most of its HVAC peers (Carrier (CARR) has done a little worse, Daikin (OTCPK:DKILY), Johnson Controls (JCI), and Trane (TT) have done better).

I do agree that the company is going into 2023 with price/cost tailwinds at its back, not to mention healthy ongoing trends in refrigeration, but I also still believe that the company’s lack of leverage to commercial HVAC (particularly outside the U.S.) is a meaningful headwind. Valuation is more reasonable now than before, but not what I’d call compelling yet.

 

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Lennox Going Into 2023 With An Iffy Mix Of Headwinds And Tailwinds

Hologic Looks Reasonably Valued As Business Normalizes After The Pandemic

The pandemic is not completely finished, but the Street has nevertheless turned to the question of what the new normal will look like for Hologic (NASDAQ:HOLX) as high-margin COVID-19 testing fades. The pandemic left the company in an excellent position with respect to system placements, and I believe pandemic-driven placements will create a significant barrier to entry for newer systems. At the same time, normalizing procedure counts and improving component availability should help the surgical and imaging businesses.

Hologic shares are up about 10% since my last update, outperforming Abbott (ABT), Bio-Rad (BIO), bioMerieux (OTCPK:BMXXY), and Qiagen (QGEN) over that time. I expect long-term core revenue growth of around 5% to 6% from here for Hologic, but the company will have the liquidity to be more active in M&A if management can find suitable targets. I also see opportunity for higher margins from here, but the valuation anticipates a lot of this. Hologic is a good company and holding good companies at reasonable valuations can work long term, but I wouldn’t call this a screaming bargain.

 

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Hologic Looks Reasonably Valued As Business Normalizes After The Pandemic

Gorman-Rupp's Sell-Off Seems Overdone Relative To The Longer-Term Opportunities

Looking at Gorman-Rupp (NYSE:GRC) back in March of this year, I did like the company’s exposure to industrial markets like HVAC and longer-term opportunities in wastewater and stormwater/flood control, but I preferred names like Xylem (XYL) and Franklin Electric (FELE) on their combinations of end-market exposures and valuations. Since then, Xylem and Franklin Electric have both done better than the average industrial stock (up almost 25% and about 5%), while Gorman-Rupp has lost about a quarter of its value.

Gorman-Rupp’s has lagged many of its water/fluid control peers in terms of both organic growth and margins this year, and the acquisition of Fill-Rite brought considerable debt onto the balance sheet. Weaker margins and a higher discount rate (due to higher interest rates and a riskier balance sheet) do reduce my valuation some, but the market has more than corrected for this and I think the valuation is a little more interesting now.

 

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Gorman-Rupp's Sell-Off Seems Overdone Relative To The Longer-Term Opportunities

BankUnited: Valuation And Deposit Costs Offset Sound Growth Investments

There are certainly things to like about BankUnited (NYSE:BKU). This bank has significant operations in an attractive fast-growing market (Florida) and is using an organic growth strategy to expand into attractive markets like Atlanta and Dallas. The bank has also been focused on addressing past deficiencies in its core deposit base, while also returning meaningful capital to shareholders.

Despite those positives, the shares have lagged the larger regional bank group since my last article (up about 9% versus up 25%), as my concerns about the bank's deposit costs and valuation have played out. At this point, BankUnited shares do look undervalued, but so do many other bank stocks, and without more meaningful differentiation in loan growth, spread margin, and/or operating leverage, I don't see what really ought to drive a "buy this, not that" call for BankUnited.

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BankUnited: Valuation And Deposit Costs Offset Sound Growth Investments

Komatsu Beating Estimates And Raising Guidance, But Going Nowhere Fast

In my last article on Komatsu (OTCPK:KMTUY), I noted a growing rift between the performance of Komatsu as a company and the performance of its shares. Since then, the company has continued to execute well, handily beating expectations, but the shares have arguably still lagged what that performance should have earned. Komatsu’s local shares are up about 8%, while the ADRs are down about 8%, versus a 15% move in Caterpillar (CAT) shares, 3% moves at Deere (DE) and Terex (TEX), and a much weaker performance at Volvo (OTCPK:VLVLY) and Hitachi Construction Machinery (OTCPK:HTCMY).

I believe Komatsu is undervalued relative to what the market has typically paid for peak earnings, but I’m also concerned that demand for construction machinery in markets like North America isn’t likely to get much better, and that demand in Indonesia and across the mining sector could likewise soften from here. I see a trading opportunity here, but I’d be careful about not overstaying my welcome.

 

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Komatsu Beating Estimates And Raising Guidance, But Going Nowhere Fast

BRF Shares Look Almost Left For Dead, But Sustainable Momentum Is Still Lacking

Very little is going well for BRF S.A. (NYSE:BRFS) these days. High production costs are sapping margins, while high prices seem to be leading to some demand destruction in the Brazilian processed/branded food business. At the same time, new management has yet to give the Street a clear sense of what they will do differently or how they will achieve meaningfully better results than the frustrating run of inadequate profitability seen for many years now.

That gloom is amply reflected in the share price, which has fallen another 30% since my last update, noticeably worse than the weak results of other protein peers like JBS S.A. (OTCQX:JBSAY), Marfrig (OTCPK:MRRTY), Minerva (OTCPK:MRVSY), and Tyson (TSN). At this point, it’s not too much of a stretch to say that the market is valuing BRF as though it has almost no future and/or that Marfrig will make a lowball offer to sweep up the remainder of the company it doesn’t own.

I honestly don’t know what to tell investors at this point. The valuation seems harsh, but results aren’t going to get meaningfully better soon and I don’t see the company generating enough free cash flow to meaningfully reduce its debt for some time. At a minimum, while expectations may be washed out, investors should remember that it can always get worse from here and this is, at best, a high-risk deep value/turnaround story.

 

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BRF Shares Look Almost Left For Dead, But Sustainable Momentum Is Still Lacking

Carpenter Technology: Navigating Well Through A Turbulent Initial Aerospace Recovery Cycle

These early quarters of the commercial aerospace upswing have had their challenges, with OEMs forced to revise their production schedules in response to unpredictable component availability from their suppliers. This does set the stage for elevated performance risk in the short term, as quarter-to-quarter production may deviate from expectations, but I remain bullish on a multiyear trend of growing narrowbody and widebody aircraft construction.

Carpenter Technology (NYSE:CRS) shares have risen close to 15% since my last update on the company, making them an outperformer in a space where rivals like ATI (ATI), Hexcel (HXL), Howmet (HWM), and Universal Stainless & Alloy (USAP) have seen a little more turbulence in results and sentiment. I continue to believe that Carpenter is well-placed to leverage that growing aerospace demand into improved financials and valuation, and I believe the shares are still worth consideration here.

 

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Carpenter Technology: Navigating Well Through A Turbulent Initial Aerospace Recovery Cycle

Universal Stainless & Alloy Products Takes A Step Back As The Aerospace Recovery Cycle Lurches Forward In Fits And Starts

The recovery in commercial aerospace is real, but it has proven to be considerably less of a smooth upward ramp and more of a drunken lurch, as major OEMs like Airbus (OTCPK:EADSY) and Boeing (BA) struggle to balance uneven production rates and capabilities among suppliers, and those suppliers (and OEMs) continue to struggle with component/supply availability, input costs, labor availability, and just about anything else you care to name. Add in operational challenges (some self-inflicted, others not), and Universal Stainless & Alloy Products (NASDAQ:USAP) ("Universal Stainless") has struggled to maximize these still-early days of recovery.

Down about 10% since my last update, Universal Stainless has lagged other material and component suppliers to the aerospace industry, but only Carpenter (CRS) has really done well over that time, as ATI (ATI), Hexcel (HXL), and Howmet (HWM) have been more "meh" than magnificent.

I've never thought that Universal Stainless was the best operator of the bunch, but I've seen over many years across many cyclical industries that secular upswings tend to produce more dramatic improvements at the less-capable operators, and I believe that will still be the case here. By no means is this the cream of the crop, nor a long-term holding, but I do believe this unfollowed and thinly-traded supplier of specialty steels can still produce attractive returns for more aggressive investors.

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Universal Stainless & Alloy Products Takes A Step Back As The Aerospace Recovery Cycle Lurches Forward In Fits And Starts

Short-Term Noise Shouldn't Drown Out The Attractive Commercial Aerospace Story At ATI

Will the real commercial aerospace market please stand up?

Air travel continues to recover, and airlines continue to look to refresh and expand their fleets, but the progression of the commercial aerospace recovery in 2022 has been choppier than expected. Orders continue to come in and lead-times continue to stretch for key materials and components, but unreliable supply chains and component availability has led to a slower ramp than initially expected.

None of this is particularly good news for ATI (NYSE:ATI) (formerly known as Allegheny Technologies) in the short run, but there is good news in an expanding order book, improving margins, and a multiyear opportunity to leverage strong commercial aerospace demand into cash flows.

ATI shares have risen about 7% since my last update, good enough to beat the market, as well as most other material and component suppliers like Carpenter (CRS), Howmet (HWM), Hexcel (HXL), and Universal Stainless & Alloy (USAP) over that time. Valuation is still relatively appealing, and I think these shares still offer upside.

 

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Short-Term Noise Shouldn't Drown Out The Attractive Commercial Aerospace Story At ATI

PRA Group Languishing Ahead Of New Supplies Of Charged-Off Debt

The pandemic was weird.

A normal cycle would have seen a surge in bad debts that banks and other creditors would ultimately write off and sell to recovery companies like PRA Group (NASDAQ:PRAA) and Encore (ECPG). Unlike prior cycles, consumers got an unusual level of government assistance this time, propping up their solvency and the credit quality of lenders. With that, the expected surge in write-offs never really happened, and PRA Group and Encore have been watching their inventory of charged-off receivables dwindle, hitting cash collections, revenue, earnings and cash flow.

PRA Group shares are down about 25% since my last update, while Encore has done slightly worse. I have no expectations that a quick turnaround in reported financials is around the corner, but I do see rising consumer debt, declining credit quality, and a tougher economic environment in 2023. Should that all play out, charge-offs will start increasing more meaningfully (likely in late 2023 or in 2024), PRA Group will have more to collect, and earnings will rebound. Whether investors want to wait for that rebound is up to them to decide, but the shares do look undervalued below the $40’s.

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PRA Group Languishing Ahead Of New Supplies Of Charged-Off Debt

ITT Pressured By Delayed Cost Recoveries And Weakening Short-Cycle Markets

Above-average organic revenue growth and margin expansion haven't helped sentiment around ITT (NYSE:ITT) all that much, as this diversified industrial has continued to underperform relative to the broader industrial group. A cautious tone from management about 2023 hasn't really helped (even if I think it's a more realistic view than what other companies have offered), and investors are trying to figure out just what the macro outlook for 2023 is going to be.

Down more than 10% since my last update on the company, I have mixed feelings about the stock. I think the company has better cycle exposure than the valuation reflects, but delays in driving better price/cost mix and a heavy exposure to auto builds are not what the Street really wants now. High single-digit long-term annualized return potential isn't bad, but I think it may take a few quarters for these shares to work again, and it's hard to call this a must-own when investors have a wider selection of undervalued industrial stocks to choose from at the moment.

 

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ITT Pressured By Delayed Cost Recoveries And Weakening Short-Cycle Markets

Margin Challenges And End-Market Worries Overshadowing Good Growth At Materion

This has been a tougher-than-expected year for Materion (NYSE:MTRN). While the company has seen strong demand in key core markets like semiconductors, industrial, aerospace, and energy, multiple margin headwinds have worked against the company, depressing reported profits and cash flows and leading to negative estimate revisions. The third quarter in particular was rough for sentiment, with a sharp drop pushing the shares down almost 10% since my last update – underperforming Johnson Matthey (OTCPK:JMPLY), but outperforming the semiconductor market that drives a substantial part of the business.

The margin challenges are disappointing, but not unsurmountable, and I think the share price has already paid the price for the reset of expectations. I do have some concerns about weaker semiconductor volumes in 2023, but I believe heavy industry, oil/gas, and aerospace should remain healthy. I’ve decided to take a more conservative “show me” stance on longer-term margin improvement, but even with those revisions, high single-digit growth can support a higher price for the shares.

 

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Margin Challenges And End-Market Worries Overshadowing Good Growth At Materion