- The nature of corporate turnarounds
- Intel and Aramark
- How we monitor which direction turnarounds are turning
The markets are alive with the sound of opinions. But how should investors act when the melody turns into a cacophony?
Earlier this year, I took my car to an auto shop for an oil change. I told the mechanic that my car occasionally made two odd noises, and awkwardly mimicked these. He turned on my car, listened for no more than 10 seconds, and then told me the first noise was a quick fix, but the second noise indicated an aging water pump. Sure enough, within a few weeks I was back at the auto shop to replace the water pump. I wondered how someone could distinguish between important and unimportant noises so quickly. It got me thinking about a similar problem when it comes to investing in turnarounds: how do you know when the noise around them points to a “quick fix” or a much bigger problem?
The nature of corporate turnarounds
Corporate turnarounds are uncomfortable because they usually arise when a once-stable company runs into difficulty. Sometimes this difficulty is of their own making, such as an ill-timed acquisition, while other times the difficulty is out of their control, such as a natural disaster. Whatever the reason, investors understandably avoid turnarounds for many reasons: it seems too contrarian because the public coverage is often negative, it seems lonely because most market participants avoid owning it, and it seems foolish because the company could be headed for disaster.
However, we think turnarounds deserve a place in the portfolio because they sometimes allow us to find quality companies at discounted prices. When most market participants overwhelmingly share the same negative perspective, these negatives tend to be priced into a stock. It’s in these situations that we try to seeking out a differentiated view that may be overlooked in the consensus narrative. In the U.S. we recently added two companies in turnaround: Intel and Aramark.
Intel is one of the few leading semiconductor manufacturers globally and its chips power most of our computers. For the better part of 30 years, Intel led the microprocessor industry, generated higher margins, and had dominant market share. Some of us will remember the 1990s “Intel Inside” marketing campaign, which turned Intel into a household brand name. Intel had big advantages in an industry with short product lifecycles but ever-increasing capital requirements.
However, in the mid-2010s Intel began faltering after the prior management team lost its operational focus. Instead of aggressively fixing their persistent operational problems, that same team repurchased shares. In February 2021, Intel’s board finally accepted their harsh reality and brought in a new CEO tasked with turning around the company in the face of continued share and margin losses.
Figure 1: Intel Historical Context
Source: FactSet, CWB Wealth Management
Among this negative sentiment and uncertainty, we purchased Intel in May 2022 and recently added to the position. At current prices, we estimate Intel’s asset replacement value provides some valuation support. Intel’s manufacturing plants are valuable assets, and as the cost and complexity of new plants have grown over time, most competitors have permanently exited the industry. Governments and businesses are also beginning to view these plants as strategic assets, since chips are such an integral part of everything from vehicles, to data centres, to satellites.
It would be wrong to think we don’t share the market’s concerns over Intel’s problems – we do. Rather, we believe these negatives appear priced-in, as evidenced by the stock trading near our estimated replacement value. If Intel executes its turnaround strategy, we think it should earn healthy returns on capital since they operate critically important assets in a consolidated industry with long-term growth prospects.
Aramark is one of the top three global catering companies, in an industry which is otherwise fragmented with many small regional competitors. Aramark provides food catering services to businesses, hospitals, and other facilities like arenas.
Catering is a service-oriented business and for a long time Aramark underperformed in this respect, resulting in high customer turnover, and low organic growth rates and margins.
Figure 2: Aramark Historical Context
Source: FactSet, CWB Wealth Management
In 2019, an activist hedge fund recognized this operational underperformance, purchased a large stake, and installed a turnaround management team. Unfortunately, when COVID-19 hit, revenues from some of Aramark’s customers went to virtually zero overnight, resulting in lower cash flows and higher debt levels. We all remember the subsequent reopening starts-and-stops over the past two years, and this was no different for Aramark.
However, hidden “under the hood” of the macroeconomic noise, we believed the new management’s operational turnaround was showing positive results. The management team increased the salesforce, aligned their incentives with corporate key performance indicators, and gave employees more autonomy to directly resolve customer requirements.
We initiated our Aramark position earlier this year. While the market priced-in risks of the Delta variant, then Omicron, then inflation, we instead saw Aramark’s lower customer turnover and higher sales growth momentum and believed this demonstrated Aramark’s improving business quality which would lead to stronger financial performance in a post-COVID-19 world.
How we monitor which direction turnarounds are turning
We believe Intel and Aramark offer favourable risk-reward. However, they’re also new portfolio additions and their turnarounds are still playing out. This means we know our current assessments could be wrong, so we’re keeping a watchful eye.
To determine whether each investment is trending in the right direction, we must continuously compare our investment thesis with each company’s performance, including any key performance indicators that signal whether the company is on track or not. We must also always compare the current market value with our own valuation estimate and measure them against other opportunities.
As investors we’re most focused on owning quality businesses at attractive valuations. Sometimes we can find opportunities hiding in plain sight, while at other times we must sift through more noise as is the case with turnarounds. In either case, our job is to keep an attentive ear to whatever opportunities are out there.
Sources: FactSet, CWB Wealth Management
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