3 turnaround stocks to watch

Stock market uncertainty is rife, as geopolitical tension and worries about inflation weigh on sentiment. Bargain hunters have started sniffing around some of the market’s beaten down stocks, but are there truly any undervalued diamonds in the rough?

It’s unusual for a stock to be lowly valued for no reason. The market tends to price in risk. But there are some companies with compelling turnaround potential that are worth a closer look.

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Facebook’s about-face

Facebook parent Meta’s valued near all-time lows following lacklustre fourth quarter results. Revenue growth of 20% was more than offset by rising costs, and operating income fell 1%. More concerning was management’s forecast for growth to slow considerably in the year ahead. This is a product of rising competition and shifting behaviours. The rising popularity of video content means Meta’s finding it hard to up the number of ads it can sell.

Things are tough. But we think the market’s reaction might have been too harsh.

Meta has an unparalleled trove of customer data. The company runs the largest social media group in the world. It has access to a wide range of customer information that advertisers need to get eyeballs on their product. That should hold it in good stead if inflation causes belt-tightening across the industry.

2021 Global app downloads (millions)

Source: Apptopia via Business of Apps

Meta’s also sitting on a rather large pile of cash. The group should be able to put those dollars to work. And there’s plenty of work to be done. We’d like to see Meta build out its messaging services and find a way to make money from them. With two of the top three messaging services sitting under the Meta umbrella, it’s an attractive opportunity.

Longer term, Meta seems focused on the metaverse. The group’s adamant that its ballooning spending won’t be funneled toward this ambition in the short term, but upgraded IT infrastructure and improvements to AI capabilities certainly won’t hurt it either. This part of the business is murky and loss making, so it’s been difficult to get excited about. There’s potential for the metaverse to become a future growth driver, but we’ll need a clearer strategy before we can count it as a positive.

The market is doubting Meta right now. Future-proofing a business is an expensive undertaking and advertising revenue will need to fund the transition. This is becoming something of an issue, but it doesn’t look unsolvable.

If management can find a way to better monetise video content and generate meaningful returns from messaging, Meta could find itself back on track.

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Royal Mail delivers change

The pandemic offered Royal Mail an opportunity to supercharge its operations. The structural shift away from sending letters meant the group had to find a way to put parcels at the heart of its operations. So far, we’re impressed with its progress – so much so that we chose it as one of our five shares to consider for a Stocks and Shares ISA this year.

The number of parcels passing through the post office has risen substantially. This is good for Royal Mail and its impact on the bottom line should be enhanced by the group’s turnaround efforts.

Parcel volumes (millions)

Source: Royal Mail Company accounts, May 2021

Just a few years ago, Royal Mail was sorting the vast majority of its parcels by hand. That’s an expensive and slow way of doing things which ate into margins. Fast-forward to this year and around half of the parcels that pass through Royal Mail are expected to be sorted automatically. This dramatically reduces costs and gives the business more flexibility to deal with higher demand during particularly busy periods like Christmas.

Getting the infrastructure in place to automate is expensive though. The group’s planning to spend over £400m next year in the UK alone.

We should also talk about the most important improvement – management’s relationship with unions.

Royal Mail’s largest outgoing is wages, so any meaningful efficiency improvements have to come with staff cuts and pay changes. So far, we’ve been impressed with management’s ability to bring the unions onboard with its cost-cutting drive. The next step will be reducing management positions by around 700, a change that would save the group around £40m per year. But getting the unions to agree is a big ask.

The group’s also home to an international business, GLS. This part of Royal Mail has been a growth engine with 8% operating margins, compared to Royal Mail’s 3.7%.

Management’s been growing this arm steadily through small acquisitions, a strategy that’s kept demands on cash low. The diversity that comes from this side of Royal Mail is a strength. But it does expose the business to added risks from economic slowdowns in other economies.

The market’s not convinced that the group can pull off its efficiency drive. Shares change hands for six times expected profits, which is relatively undemanding and well below the long-term average. At the time of writing, there’s an inflation-beating prospective dividend yield on offer, that’s well-covered by free cash flow. Though no dividend is guaranteed.

But there’s also reason to be cautious. If the group can’t get the unions on board with its efficiency ambitions, there will be little room for forward progress.

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Tate & Lyle’s sweet and sour recovery

Food ingredients business Tate & Lyle’s namesake sugar brand is no longer a part of the company. The group’s now focused on things like sweeteners, thickeners and bulk commodities.

It’s recently embarked on a major strategic overhaul – selling off the least profitable parts of the business and refocusing on higher-growth areas. That’s expected to complete in spring, bringing with it a £900m windfall, £500m of which has been earmarked for shareholders.

The disposal is more than a one-time benefit for shareholders though. The parts of the Primary Products business which are being sold have been holding back margins. Without them, operating margins rise from 11.1% to 14.8%.

Underlying operating profits (6 months to 30 September 2021)

Source: Tate & Lyle 2021 half year results.

Of course, changes of this size come with a healthy dose of uncertainty. The group’s planning to use what’s left over from the sale to reduce debt. We applaud this move, particularly with interest rates rising and debt becoming more expensive to service.

However, having flexibility on its own doesn’t make or break a company. We’d rather see Tate & Lyle do something with its more agile frame.

An increased focus on healthy eating is management’s first order of business, and one we support. The group’s in a good position to grow its presence in sugar-alternatives as a more health-minded public looks for ways to clean up its diet.

Then there are more pressing, near-term concerns. Ukraine’s a major exporter of corn, on which Tate & Lyle depends. Corn prices are now soaring, which has the potential to eat into margins if it continues. In the short term, the group’s previously agreed contracts should protect against too much disruption. But if prices stay high, a rude awakening could be looming.

Tate & Lyle looks to be on the brink of a fully-fledged turnaround. As long as management can stay the course and use its new cash pile wisely, the group could be on track for impressive growth.

The market’s starting to get excited as well with shares trading well beyond their long-term average. This represents a vote of confidence, but could increase ups and downs in the short term should any unforeseen speed bumps arise.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

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