Bad Market, Promising Opportunities

Stocks globally have been on the defensive since President Trump announced new tariffs on China on Aug. 1.

Although we are having a big rally today following President Trump’s announcement that implementation of the new tariffs will be delayed until Dec. 15, they still represent an overhang on the market, especially given several false starts we have had on tariff progress in the past.

The market’s perception is that global economies, already showing some signs of softening, will be further hurt by the added costs to global trade tariffs present. While the just-completed, second-quarter earnings season went pretty much as expected, there will now be a lot of anxiety about third-quarter earnings, especially as we head into a seasonal period that often has proven challenging for the market.

Therefore, I do not believe we are quite at a bottom right here. However, low interest rates, which have driven stocks higher despite a 5% decline in S&P 500 earnings estimates for 2019 since the start of the year, should continue to provide support.

Some sectors already have experienced a bear market, with the Retail Sector SPDR (XRT) trading at a 12-month low, despite good performance this year from major components like Walmart (WMT) and Target (TGT). This is an example of how the value indexes this year have masked a lot of weakness in individual names.

However, I believe we could be in for change in that environment, and many individual names that have already come under pressure will begin to outperform the indexes. There are pockets of value that we can turn to in what may be a challenging environment for a while. Our new pick this month, Valvoline (VVV), is a good example of that, and the stock has done very well for us so far. The quick big win we enjoyed in Universal Healthcare (UHS) is another example of a great value that was able to overcome market weakness.

So, no matter what the market does, I am optimistic we will get a snapback in some of our underperformers, many of which have been sold off to levels approaching absurdity. I also will continue to look for new names that can generate consistent cash flows that have been overly punished in the current market environment to continue the success we have had with Universal Health Services and Valvoline, and to a lesser extent Packaging Corp of America, which has been a strong relative performer for us so far. While I am cautious on the market near term, I believe we can enjoy good returns in our Value Authority stocks through the end of the year.

Valvoline-Lubricating its Growth Engines

Valvoline (VVV) is an iconic brand name. Established in 1866, it was the petroleum industry’s first trademark branded motor oil. Its products include motor oil, which are 86% of product sales, but also anti-freeze, brake chemicals and filters, sold in 30,000 retail stores, with 12,000 installers and 1,242 company owned and franchise stores.

The company also has a very strong international presence, operating in over 140 countries. International sales accounted for 26% of the company’s total revenue in the September 2018 fiscal year. The company considers its international business a growth segment and expects foreign sales to be a higher percentage of the total in the future

VVV also expects to see growth through its Valvoline Instant Oil Change (VIOC) and service center stores. Through acquisitions, its store base has expanded from 1,068 at the time of its initial public offering (IPO) in 2016 to 1,787 now. Including in this number are 347 Express Care locations, in which independent operators sell Valvoline products. In addition to store acquisitions, the company is seeking to grow the business through customer acquisition and retention programs and has expanded its services beyond oil changes. The quick-lube services accounted for 29% of fiscal 2018 sales.

Although Valvoline has been in existence for over 150 years, the company did not take its current form until 2016 when it was spun-out from petrochemical company Ashland Global Holdings and had an IPO in September 2016, with Ashland distributing its 83% interest in Valvoline to its shareholders in May 2017.

Valvoline had good financial results in the fiscal year ended September 2018, with earnings per share (EPS) increasing to $1.29 from $1.19 a share, as operating income rose 4.5% and a lower tax and a reduced share count helped EPS comparisons. There were some moving parts though behind these numbers. The core North American lubricant business saw operating income fall 13.5%, as volumes were unchanged, but the company had significant raw material increased. However, this was compensated by strength in international lubricants, with volumes up 4% and operating income up 10%. Valvoline Instant Oil Change saw sales grow 22% and operating income jump 18%, as same-store sales grew 8.3% and the store base rose 10%.

Fiscal 2019 got off to a slow start for the company, as cost pressures and volume weakness continue to weigh on domestic lubricants and foreign currency impacted the results of the international business. However, those businesses stabilized in the third quarter, and with continued growth at its quick-lube locations, Valvoline posted a strong result, with EPS of $0.37 vs. $0.32 on a 6.4% increase in revenues. The strength of the quarter led to a sharp jump in the stock price and a nice early gain for our position.

Nine months into the current year, EPS estimates of $1.32, up slightly from $1.29 last year, look safe and could be conservative. I am optimistic that continued growth in the quick-lube service centers and stability, if lubricants can bring EPS to $1.45 next year, which would make my $25 stock price target achievable. Longer-term, the company’s strong free cash flow generation should help finance its growth, while still allowing the company to buy back stock, with its average share count down 6% so far this year, and provide a dividend, all of which will add to shareholder value. VVV is a buy below $21.50.

Review of Existing Positions

Big Lots (BIG) will report fiscal second-quarter results sometime in the first week of September. Expectations are for EPS of $0.41 vs. $0.59 on a 2.3% gain in revenues to $1.25 billion, as higher freight costs as well as expenses related to the company’s ongoing growth initiatives will cut into profitability. The stock continues to suffer from tariff-related and consumer spending fears, with investors ignoring the company’s recent progress in growing the top line and its very inexpensive valuation of just over 6X this year’s EPS. The company’s dividend yield is close to 5%, which appears very secure based on its current level of earnings and cash flow. The market at this point seems to be questioning whether the company can sustain EPS of more than $2.00 a share over the long-term, versus current estimates this year of $3.78 a share. I just believe a wave of emotion in the market right now regarding tariffs and retail stocks is causing indiscriminate selling, which I believe will reverse sometime before year end, as the company demonstrates it remains on the right track for an earnings recovery once its investment period passes. My new buy under price for BIG is $26. My target is $38.

Cognizant Technology Solutions (CTSH) gave back the gains it achieved following its positive second-quarter earnings report. Click here for details. This is largely due to the overall decline in the market, but I believe some cautious remarks made on the conference call by new CEO Brian Humphries also played a role, as he indicated the company must accelerate its offering to meet demands of modern digital IT departments to return to the company’s previous upper-single-digit-percentage revenue growth. However, CTSH has the technical and financial strength to succeed in executing this transition. In the meantime, cost realignment should help drive improved results. At just 15X next year’s EPS estimates, I believe CTSH is a worthwhile holding in the current market environment, as any signs of transformational success could drive the stock towards my $79 and beyond. CTSH is a buy below $65.

F5 Networks (FFIV) shares began to rally after the company reported fiscal third-quarter results, only to fall back sharply when NetApp (NTAP), which partners with FFIV on application launching solutions, preannounced a very bad quarter on Aug. 1. It should be noted that NTAP has struggled all year, while FFIV’s earnings have been all right in 2019, so maybe the connection investors try to make between the two companies (FFIV also declined following a disappointing result from NTAP on May 23) is overstated. FFIV remains a cash-generating machine with lots of recurring service revenues, with growth to be bolstered by its recent acquisition of NGINX, which is helping FFIV’s transition to a software-oriented company. FFIV is very cheap at 13X forward EPS with $16 a share in cash on its balance sheet. Buy FFIV below my new buy under price of $145. My target is now $165.

First Hawaiian Bancorp (FHB) shares have moved lower with the market after initially rise nicely post earnings. While the narrowing yield curve and the economy provide some concerns, FHB is performing solidly, and its over 4% dividend yield should provide support. In addition, the company announced last week it was buying back another $150 million in stock, which should support the shares and show management is confident about the outlook. Valuation is increasingly attractive at 12X this year’s EPS estimates. I recommend FHB below $26. My target is $30.

Ingredion (INGR) shares got some welcome news yesterday, as corn prices fell nearly 6% following the release of the United States Department of Agriculture (USDA) crop production report which showed better-than-expected corn supplies. While tariff and currency concerns continue to impact the stock, I believe yesterday’s news is a development which eventually should be every beneficial to the stock. I believe second-quarter earnings demonstrated the company is managing through the tough times well, and patient investors will be rewarded. INGR remains a buy below $90. My target is $105.

Morgan Stanley (MS) reported second-quarter EPS of $1.23 vs. $1.30, which was $0.09 better than estimates. As expected, the company had weak trading results in the quarter versus difficult comparisons. However, the company was able to compensate for this in part by solid results from its Wealth Management business, as individual investors were active in the second quarter. The gains in the stock price after the report was released were washed away by the recent market selling. However, the company is navigating the changing market environment well, and is managing risks prudentially. At less than 1.1X tangible book value, which should have a high-single-digit-percentage growth rate, the stock is cheap. Continue to buy MS under $46. My price target is $53.

Shares of Packaging Corp of America (PKG) have held up very well in a tough market environment since my July 2 recommendation of the stock. Second-quarter results of EPS $2.04 vs. $2.08 with flat revenues were pretty much as expected, with higher paper prices helping to offset weakness in containerboard. One reason I feel the stock is doing well, even with EPS expected to decline to $7.35 next year from $7.75 this year on the weaker containerboard prices, the stock is still attractively valued at 14X expected results, with an enticing dividend yield of 3.1%. PKG is a quality company with a good balance sheet and strong cash flows, and the shares should do well provided the global economy stays out of a recession. Buy PKG under $100. My target is $115.

Party City (PRTY) continued to weaken following the release of second-quarter results. While the decline is disconcerting, the bar is still set very low for a sharp rebound in the price of the stock. Aided by asset sales totaling $200 million and a working capital reduction of $100 million, the company should be able to meet its goal of reducing debt by $400 million this year and enter 2020 in a much better financial position. Also, the company noted on the conference call is that it expects to be in a much better position with regard to helium by mid-August, so much so that the company will be able to advertise its stores are the place to go to get balloons with helium. This could only help critical Halloween sales and aid the company with its debt-reduction goals, while meeting current EPS guidance of $1.26 to $1.36 a share. Accomplishing these goals, which are not a stretch, will allow the stock to move considerably higher. Buy PRTY under $5.50. My $9 target could ultimately prove to be conservative.

Like practically all bank stocks, shares of Valley National (VLY) have tumbled this month as the decline in long-term interest rates threatens to narrow interest margins, while economic uncertainty could mean higher credit costs at some point. While I will be mindful of the macro factors, I still believe we will avoid a recession, which should allow long-term rates to rise and the market to regain confidence in bank stocks. Meanwhile, the company is executing well, with its cost-cutting efforts paying off, while the company grew loans by 6% last quarter. These factors should set the company up for solid EPS growth in 2020 if the economy stays firm. VLY is a buy below $10. My target is $12.