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Caterpillar, Adient among best ideas trading at discounts

Lex Hall  |  15 May 2019Text size  Decrease  Increase  |  
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The trade tensions buffeting equity markets this week have pushed some of the new entrants on Morningstar’s Global Best Ideas list to new discounts.

Market bellwether Caterpillar, Wyndham Hotels and Resorts and telco titan AT&T are trading at discounts of more than 20 pc. While carseat-making giant Adient – one of the most undervalued stocks you’ve probably never heard of – is sitting at a 60 per cent discount.

The tit-for-tat trade stoush between the US and China has forced big falls on Wall St. All three major US indexes lost ground on Monday in a widespread sell-off, with the tech-heavy Nasdaq posting its biggest one-day percentage loss this year.

The S&P 500 and the Dow both had their largest percentage drops since 3 January. However, the markets have since edged up after a few attenuating remarks by Donald Trump, who described the trade ructions as a “squabble between friends”.

Caterpillar

Caterpillar, the world's largest construction equipment maker, which is both vulnerable to tariffs on China and often considered a mirror of the US economy at large, fell by more than 5 per cent late last week. It has since regained ground, buoyed by plans to increase aftermarket revenue in the form of digital offerings and greater part sales. It carries a Morningstar fair value estimate of US$169 and is trading at a 26 per cent discount.  

“Caterpillar is our best pick in the heavy equipment sector,” says Morningstar equity analyst Scott Pope. “Caterpillar’s ongoing efforts to streamline and prune its manufacturing operations have led to significant operating margin expansion, which increased to 15.7 per cent in 2018, up from 13.8 per cent in its peak-revenue year in 2012.”

In its 2019 investor meeting, Caterpillar indicated it now aims to double parts and service revenue to US$28 billion by 2026 from US$14 billion in 2016. For Pope, this should enable the company to reduce cyclicality and increase operating margins that should stay within 10 to 21 per cent throughout the cycle. “The targeted operating margin is now 3 to 6 above historical levels, greater than the 2 to 5 per cent improvement suggested in 2017.”

Wyndham Hotels & Resorts

Another entrant to the best ideas list is Wyndham Hotels & Resorts. The hotelier operates 812,000 rooms across 20 brands. Its largest brand, Super 8, accounts for about 22 per cent of all rooms, with Days Inn (17 per cent) and Ramada (14 per cent) the next two largest brands. This time last year it acquired La Quinta, which Morningstar analyst Dan Wasiolek considers a catalyst for growth.

Wyndham last closed at US$54.89 but carries a fair value of US$74 – a 26 per cent discount.

Wyndham has 15 per cent and 5 per cent share of existing US and global hotel rooms, respectively, with a pipeline that represents around 22 per cent of its current unit base.

Wyndham has an edge over its chief rival, Choice Hotels, according to Wasiolek, who expects Wyndham’s room growth to average about 3 per cent over the next decade, above the 2 per cent long-term US supply growth average.

“Though it’s trading at an enterprise value/EBITDA discount to Choice Hotels, despite offering a similar growth profile over the next five years, we believe investors are discounting Wyndham's brand intangible asset and switching cost advantage,” Wasiolek says. “We expect Wyndham to gradually expand room share in the hotel industry, aided in part by its acquisition of La Quinta.”

AT&T

AT&T, the world's largest telecommunications company, has forged a place in Morningstar’s Best Ideas list on the back of an upbeat assessment of its cashflow and ability to pay down debt – a blemish that has threatened to tarnish its record as a dividend stock.  

Wireless communication remains AT&T’s largest business, contributing nearly 40 per cent of revenue. As the second-largest US wireless carrier, AT&T connects more than 100 million devices, including 63 million postpaid and 16 million prepaid phone customers.

In June last year, it acquired Time Warner, which now contributes just under 20 per cent of revenue with media assets that include HBO, the Turner cable networks, and the Warner Brothers studios.

Morningstar director Michael Hodel was initially sceptical of the Warner deal, but says it now stands the company in good stead.  “Looking at the firm as it is now, we believe both the wireless and media businesses remain well positioned competitively and that these units will produce stable cash flow for years to come, enabling the firm to quickly repay debt,” Hodel says.

“Since the end of the second quarter of 2018, when the Time Warner deal closed, net debt has declined US$7.7 billion to US$169 billion, taking leverage down to about 2.8 times adjusted EBITDA from 2.9 times.”

Hodel also applauds the sale of AT&T’s minority stake in Hulu, a video-on demand service, and real estate in New York. These two sales will reap nearly US$4 billion. Consequently, Hodel expects AT&T will cut net debt to US$150 billion by the end of the year, or about 2.5 times EBITDA.

“At current prices, AT&T shares are trading at less than 9 times our 2019 earnings projection and at a 16 per cent discount to our $37 fair value estimate.

Adient

We previously introduced you to narrow-moat Adient as one of the most undervalued stocks you’ve never heard of. Adient began trading in late 2016, when Johnson Controls, a global diversified tech conglomerate, spun off its automotive experience segment into this new company, which has since become the world’s no 1 carseat maker.

It is the leading seating supplier to the industry with nearly 40 per cent share in both North America and Europe as well as a dominant share in China of about 45 per cent.  Its Chinese joint ventures include a 30 per cent stake in the world’s largest automotive interiors firm Yanfeng.

Adient has had its share of problems, most notably in its metals business and its core seating business. Hence the slide in the stock price: from US$86.42 in September 2017 to the low US$12 range earlier this year. This led to the removal of chief executive Bruce McDonald and a dozen more legacy Johnson Controls executives and the suspension of Adient’s dividend.

However, a turnaround is afoot under the guidance of its new chief, Doug DelGrosso, who was hired in August 2018, and who previously rose to the top of no 2 carseat maker Lear.

But while the 60 per cent discount to fair value is mouth-watering, Morningstar sector strategist Dave Whiston warns investors to be patient as the turnaround will be long.

 

is content editor for Morningstar Australia

Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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