Following yesterday’s historic rout, the danger that the coronavirus poses to the market is clear for all to see.
While the threat of an economic slowdown was always latent, we saw chaos in the credit markets yesterday, with even investment-grade corporate bonds plunging downwards, and the yield on the 10-year U.S. Treasury bond dipped below 0.50% in a dramatic flight to safety.
The rout was triggered by a plunge in the price of oil after OPEC failed to reach a deal for production cuts. Furthermore, the demand for oil is likely to wane due to the coronavirus as airlines have cut the number of their flights.
At the same time, the recent increase in oil production in U.S. shale regions was built on debt, with producers taking advantage of low interest rates to fund drilling activities. However, with the price of oil falling as supplies balloon and demand weakens, the ability of shale companies to service their debt will come into question. This, in turn, has implications for banks, which are already facing the potential of increased loan losses from the coronavirus. They also would have been short on reserves if it were not for the Federal Reserve’s extraordinary move to replenish the banking system with liquidity through repurchase agreements ever since September.
Despite today’s big bounce higher, I cannot say for sure that yesterday was the bottom. The number of coronavirus cases are likely to grow in the United States, creating headline risk. We will also likely see weakening economic data.
However, I do think we will get past this crisis. While the coronavirus is a tragedy that will claim thousands of lives, its impact will fade at some point. Travel will return to more normal levels. The price of oil will increase with renewed demand and the production cuts from the recent plunge. The Fed will continue to add liquidity, and more cuts in short term rates are very likely. A potential fiscal stimulus is also in the works, with President Trump scheduled to propose payroll tax cuts today. And although investment grade bonds took a hit yesterday, the yield on long-term BBB credit remains below 3%, a low level which will allow for healthy valuation multiples.
The key to surviving this difficult time is to have companies with strong balance sheets, consistent free cash flows and strong franchises with customers that can get by the current difficulties. I believe our companies meet these criteria. Even though all of them have taken a hit, I expect a strong recovery in their price between now and the year’s end.
3M: Roman is Leading the Empire to a Better Place
3M (MMM) is a company that has traditionally been admired and sold at a premium multiple when compared to other industrial stocks. A strong and diversified portfolio of businesses, below-average exposure to the economic cycle, high returns on capital and a high level of free cash flow as a percentage of net income has made it very admired by investors. Thus, it has always been on my watch list for potential Value Authority names. As recently as April of last year, just before first-quarter earnings were released, the stock traded at a neat $220 a share. This was over 20X earnings per share (EPS) that were expected at the time. However, MMM’s first-quarter results were disappointing, and it has almost been straight downward for the stock since.
The most recent disappointments completed a five-year period for 3M, which showed little growth in revenue and operating income, with EPS rising only due to share buybacks and the tax legislation in 2017. And there is little evidence, for now, that there is going to be a significant turnaround soon. However, with the stock under $150, or just 16X this year’s expected EPS with a 3.8% dividend yield, I thought that the stock was just too cheap to pass up. I also want to give CEO Mike Roman’s plans to rejuvenate growth and profitability a chance.
Mr. Roman, who has only been CEO since July 2018, is reorganizing the company by cutting five divisions to four through merging 3M’s transportation and electronics divisions. He also has shifted products between divisions to better align the company’s products to its target customers. As part of the reorganization, the company cut 1,500 jobs.
I believe we will also see 3M make more acquisitions than they have in the past. In May of last year, the company agreed to acquire medical products maker Acelity for $4.4 billion and the assumption of $2.3 billion in debt. The deal, which was the largest in the company’s history, fits in well with the company’s plans to grow its advanced wound care business.
3M’s four operating segments are:
Safety and Industrial Business — This segment includes businesses that serve the global industrial, electrical and safety markets. This business segment consists of personal safety, industrial adhesives and tapes, abrasives, closure and masking systems, electrical markets, automotive aftermarket and roofing granules. This segment accounted for 33% of 2019 sales.
Transportation and Electronics Business — This business segment consists of electronics, including display materials and systems and electronic materials solutions, automotive and aerospace, commercial solutions, advanced materials and transportation safety. This segment accounted for 27% of 2019 sales.
Healthcare Business — Products and services provided to these and other markets include medical and surgical supplies, skin health and infection prevention products, oral care solutions, separation and purification sciences, health information systems, inhalation and transdermal drug delivery systems and food safety products. This segment accounted for 25% of 2019 sales.
Consumer Business — This business serves global consumers and consists of home improvement, stationery and office supplies, home care and consumer healthcare home care. This segment accounted for 15% of 2019 sales.
By reviewing the company’s difficult 2019 period, one can see that 3M’s sales declined by 1.5% on a constant currency basis. The weakness was primarily due to soft electronic display and automotive markets, along with weakness in parts of the aerospace business. EPS, on an ongoing basis, declined to $8.89 from $9.96 a share as lower gross margins on a decline in sales volume offset the benefits of lower operating expenses and a decrease in the number of outstanding shares. These outstanding shares had helped increase EPS by over $0.20 a share.
3M’s management was looking for a bounce back in 2020 with easy sales comparisons and the absence of inventory liquidations, which had hurt gross margins in 2019. Guidance was for organic sales to be anywhere from flat to up 2% and for EPS to improve to $9.30 to $9.75 a share.
Considering the potential coronavirus impact, this guidance is now likely too high. However, 3M has held its own since I recommended the stock, and I believe the risks to the estimates are well understood by the market. In this era of very low interest rates where a company of 3M’s financial strength could be selling for multiples much higher than historical averages, it is a very undervalued company with a dividend yield of around 4%. Buy 3M under $150. My target is $180.
Carnival Corp. (CCL) has come under heavy selling after it was apparent that there was a risk that the coronavirus could spread beyond Asia. While this year’s earnings will be disrupted, I remain confident that the disease will eventually be controlled, and the company will have a chance to earn at least $4.00 a share in 2021. My new buy under price for CCL is $30. My target remains $50.
It is not a surprise that the stock price of Chevron (CVX) would take a hit with the price of oil collapsing. However, CVX has the financial strength to easily make it through the current crisis. The weakness in oil prices will eventually self-correct, as the very low price of oil will discourage investment in drilling. This will cause the price to rise again eventually. Furthermore, the company is executing well in terms of its operations, and the stock should recover over time. I am lowering my buy under price to $90 and my target to $115, but I really like CVX at its current price.
Cognizant Technology Services (CTSH) is being impacted by the coronavirus as the company has restricted all non-essential travel outside of India, and the market fears the company will suffer at some point if direct contact with clients remains restricted. I do believe that these fears are highly exaggerated, and although we could see some disruption in the better-than-expected results the company has been realizing in recent quarters, I do expect the stock to continue its strong performance once the coronavirus fears passes. CTSH remains a buy below $66.50. My target is $79.
General Mills (GIS) will report fiscal third-quarter earnings on March 17, with expectations for EPS of $0.76 vs. $0.83. Sales are expected to increase to $4.3 billion from $4.2 billion. Estimates have been under some pressure, as sales from China are 4% of the company’s total. Furthermore, 40% of GIS’s sales in China come from Häagen-Dazs stores, half of which have been closed due to the coronavirus.
Despite the pressure on Chinese operations, the company has been benefiting from the “safety trade” in stocks with lower economic exposure. GIS should grow EPS in the mid-to-upper-single-digit percentages as the number of units continues to increase. Good value remains in the stock because it is selling for 16.2X EPS estimates with a 3.6% dividend yield. GIS is a buy under $54. My target is $60.
The sharp decline in the price of Genuine Parts (GPC) since the company reported strong fourth-quarter earnings on Feb. 19 is, in my opinion, unwarranted. While the company’s supply chain has exposure to the coronavirus, their imports from impacted regions in China are only 17% of total Chinese imports. While the company’s industrial sector could also feel pressure from a weakening economy, I believe that GPC will still come relatively close to its EPS guidance of $5.80 to $5.90 this year. The stock is a good value at 14X these estimates. GPC is a buy under $100. My target is $110.
While Ingredion (INGR) does have exposure to China in its production and sales, I do not believe that the company faces a significant direct risk from the coronavirus. The recent decline in the dollar will be a boost to earnings. Therefore, I believe the recent decline in the stock is unwarranted, and I believe that the stock will be awarded a higher multiple than it has obtained in the past. This will make its multiple similar to that of other consumer product companies. INGR is a buy below $90. My target is $105.
MSC Industrial Direct (MSM) will report fiscal second-quarter earnings on April 8. Expectations are for EPS of $1.00 vs. $1.24 on a 4.3% decline in revenue to $791 million, as softness in the global industrial economy will weigh on results. While the coronavirus could add to the weakness in the short term, MSM remains a quality company with a strong returns on assets and a high free cash flow, which has earnings power in a good economy in excess of $5.00 a share. My new buy under price for MSM is $60. My target is $75.
Financials have been among the worst performing sectors, and Valley National (VLY) has seen its share price decline rapidly as the yield curve has inverted. I do feel the selling is overdone. The interest rate on the company’s liabilities will probably initially decline faster than the rate on the company’s assets, so earnings will not be impacted negatively in the near-term. Also, the company’s strong credit culture should help VLY withstand the risk of increased loan losses, should the economy weaken. The company’s $0.44 quarterly dividend and 5.9% yield remains secure. My new buy under price for VLY is $10 and my target is now $12.
I really do not think Valvoline’s (VVV) operations will be impacted by the coronavirus in a meaningful way, although some international lubricant volumes could be impacted if people drive less. However, even if EPS estimates dropped from $1.48 to $1.35, the stock is very cheap at 13X forward earnings. This is especially true when considering the good growth that the company is realizing from Quick Lube operations. VVV is a buy below $22.50. My target is $26.