Looking Past the Clouds

March turned out to be a stormy month for the stock market. In fact, two days after we published the Value Authority issue for March, Silicon Valley Bancorp announced it needed to raise capital. The announcement spooked a lot of people and triggered a quick withdrawal of deposits, which led to the eventual failure of the bank. And SVB’s failure created a mini-panic, as many thought we were about to see another 2008-style crisis.

Thankfully, cooler heads eventually prevailed, and a major banking crisis was largely averted.

The fact is the problems at Silicon Valley Bank were very company specific. The bank primarily relied on uninsured deposits from start-up tech corporations that it had helped fund, and it experienced losses from a fixed income portfolio whose average maturities were too high in a time of sharply higher interest rates. Still, the majority of financial stocks were caught in the cross hairs in March, and most financial stocks remain well below their prices prior to the failure of the Silicon Valley Bank.

Interestingly, the Russell 1000 Value Index was virtually unchanged over the same period. Other sectors, primarily defensively oriented sectors like utilities, picked up the slack as financials faded. This enabled us to realize a quick gain in WEC Energy (WEC), our pick from last month.

Now that the financial storm clouds have parted, what can we expect in April? Well, that largely depends on what happens during the first-quarter earnings season. The season officially gets underway later this week, with Delta Airlines (DAL) reporting on Thursday and major banks like JP Morgan (JPM) reporting on Friday.

With banks, I expect to see positive results and, in turn, a generally positive reaction from bank stocks in the near-term. However, there are still a few issues that will likely remain unresolved. The big question is how long can banks keep paying close to 0% interest on savings deposits without seeing their deposit base erode and interest margins squeezed? Commercial real estate is also an issue at many banks, with vacancy rates still high due to more people working at home, and loans that need to be refinanced at higher interest levels. These issues will take a few quarters to play out.

Aside from banks, earnings at most companies should be good for now. Still, there are concerns that tighter credit conditions as a result of the Federal Reserve raising short-term rates and the fallout from Silicon Valley Bank could slow loan growth and perhaps cause a recession. So, some uncertainty remains in April.

Some near-term weakness in our stocks is possible if the market retreats again, but I do not think any additional unrealized losses will be significant. The companies in our buy list are attractively valued, with many having attractive dividend yields as well. So, once we clear the current uncertainties, there is significant appreciation potential in our stocks.

USB: No Crisis Here

Given that March was a tough month for most financial stocks, there are a lot of bargains out there right now. But I don’t want us to pick up shares of just any financial stock; we’re going back to the well for more profits in a regional bank that’s well-positioned for the challenging environment for financials.

We had great success with U.S. Bancorp (USB) last year, achieving a 13% gain in just over two months and easily outpacing the 9% gain in the Russell 1000 Value Index over the same period. The stock has fallen approximately 25% since then, given the recent concerns in the banking industry following the failure of Silicon Valley Bank.

This selloff has left the stock selling at its lowest level in approximately 10 years, excluding the height of the pandemic, when it traded at $28.36 in May 2020. While there may be some broader implications from the Silicon Valley Bank failure still to come, the stock has overreacted, and I look for the shares to do very well from current prices.

Let’s quickly review USB’s operations. The company is a “super regional” bank holding company with $674.8 billion in assets, which makes it the fifth-largest bank in the U.S. in terms of asset size. The majority of its more than 3,100 branches are located in 25 states in the Midwest and West and operate under the name U.S. Bank. USB has several diversified lines of business:

  • Consumer and Business Banking (31.6% of net income in 2021): Accepts deposits and provides loans and other banking services to individuals and small businesses.
  • Corporate and Commercial banking (31%): Offers lending, leasing and Treasury services to mid-market companies and large corporations.
  • Payment Services (22.7%): Provides credit and debit cards to individuals and businesses, as well as Treasury services to larger businesses.
  • Wealth Management and Investment Services (22.7%): Offers investment advisory and retail brokerage services, and private banking services to wealthy individuals.
  • Treasury and Corporate Support (-7.9%): Focuses on incomes from the company’s investment portfolios, interest rate management activities and tax advantaged projects.

Late last year, USB completed its acquisition of the core banking assets of Mitsubishi UFJ financial group (MUFG) for $8 billion.  The acquisition greatly enhanced USB’s position in California, moving USB up to the fifth-largest bank in the state from its previous position as the 15th-largest bank in California.

So, what makes USB the best bank to buy right now? In addition to the washed-out stock price described above, the company should do well with the two major issues negatively impacting the group at the present.

First, in regard to commercial real estate loans, I believe USB’s position is relatively manageable. The company’s commercial real estate loan book totals $55 billion and yet it only accounts for 14.2% of total loans. If 10% of this amount were written off in a dire scenario, the loss would be approximately $3.00 a share. While this would be painful, it would not be catastrophic and does not justify the steep decline in the share price.

The second issue impacting banks stocks, declining interest margins, is a little more difficult to project. However, the company earned $4.45 a share last year with a net interest margin of 2.72%, which was not that far above the 2.48% margin in 2021 when the Federal Reserve was still keeping short-term rates at 0%. Now, some margin compression is likely as consumers will eventually return more interest on the deposits. That does not seem to be the case right now, though, as USB still offers very low interest on deposits. I believe lower margins would cost USB no more than $0.75 a share over the next 12 months, which would be painful but already priced into the stock at the current time.

Current analysts’ estimates call for USB’s EPS to increase to $4.78 this year, up from $4.45 last year. I believe the company may play it conservative with loss reserves given the weakening economy. So, this factor, along with the potential for margin compression, likely means estimates for this year are too high. However, this has largely been discounted by the market, and my $42 target is just over 10X the $4.00 a share I believe is realistic with normal levels of interest margins and credit costs.

We will have a better feel for the situation at USB when the company reports earnings on April 19, but I am very confident no negative surprises are coming. USB is a buy under $37. My target is $42. The 5.4% dividend yield looks secure and adds to the attraction of the shares.

Position Review: Attractively Valued and Due for a Bounce

Brady Corporation (BRC) has come under pressure with other industrial names since the beginning of March. However, I believe there is good technical support for the shares at $50, and the company’s growth should continue over the next few quarters. Even if the economy were to slip, BRC is a strong company that will come out of the bad times well. Valuation is attractive at 14.5X this year’s earnings. BRC is a buy below $50. My target is $62.

Fidelity National Information Services (FIS) will report first-quarter earnings in the first week of May, with expectations for EPS of $1.20, vs. $1.47 last year, on a 2.5% decline in revenues. The company continues to face pricing pressure and weakness in its soon-to-be-spun-out merchant services business. The stock also experienced another leg down on concerns the banking crisis will hurt its core banking services business. However, I think it is becoming clear that we are not going to see mass banking closures. Longer-term cost cuts should give EPS a major lift next year. FIS is a buy below $60. My $72 target is only 11.1X next year’s EPS estimate of $6.45.

First Busey (BUSE) will report earnings in the last week of April, with expectations for EPS of $0.64, vs. $0.53 last year, on a 13.6% gain in revenues. However, the recent interest margin and loan loss issues put these numbers in some doubt. The company’s non-interest checking deposits are 40% of the total, so I believe BUSE should not see any significant interest margin pressure this quarter. The company is not as favorably positioned on commercial real estate loans as U.S. Bancorp, as these loans account for 42% of BUSE’s total loan portfolio. However, the stock is now very cheap at 8X this year’s EPS estimates, and it has a 4.9% dividend yield. So, I think it is best to be patient and hear what the company has to say about its loan book before giving up at depressed levels. Near-term downside is very limited. BUSE is now a buy below $21, and my new target is $26.

Lowe’s (LOW) has been doing better as the recent decline in interest rates is raising hopes that the worst may soon be over for the housing market. Considering the difficult environment, Lowe’s is doing well, and the company is in good shape to take advantage of the inevitable recovery. At just over 14X this year’s EPS estimate, there’s still a good margin of safety in LOW shares. Buy LOW under $215. My target is $260.

Newell Brands (NWL) will report first-quarter earnings in late April, with expectations for an earnings loss of $0.04 per share, versus EPS of $0.35 last year, as inventories continue to be reduced. The key to the stock’s reaction to results will be guidance, with the market expecting this quarter to be the low point for NWL. Worries about a potential recession and reduced discretionary spending continue to weigh on NWL shares. However, I still expect NWL to be solidly profitable this year, even if there is a recession. Although it may require some patience, the stock will eventually recover. Buy NWL under $13.50. My $17.50 target is less than 15X next year’s EPS of $1.20.

Old Republic (ORI) has declined amidst the financial concerns, although the decline has not nearly been as dramatic as for bank stocks since interest margins and commercial real estate loans are not a concern. The company will report first-quarter earnings in the first week of May, with expectations for EPS of $0.53, vs. $0.63 last year, on about a 14% decline in revenues, which reflects continuing softness in the company’s title insurance business. However, the period of tough comparisons in title insurance is ending, and ORI should report stable results in the second half of the year. ORI is very attractively valued at 10.5X depressed earnings this year, with general insurance results likely to remain solid. Old Republic is a buy below $24. My target is $27. The 3.93% dividend yield will add to total returns.

Shares of Patterson Companies (PDCO) have been range-bound for the past few weeks. While the stock is cheap, investors may be waiting for an improvement in the dental market before taking the stock higher. I believe that as difficult COVID comparisons end (extra spending for infection control products is now gone), dental results will improve. PDCO is attractively valued at 12X this year’s EPS estimate with a 3.9% dividend yield. PDCO is a buy below $29.50. My target is $33.

Phibro Animal Health (PAHC) will report fiscal third-quarter results in the first week of May, with expectations for flat EPS of $0.33 on a 3% increase in revenues. I am a little surprised Phibro has not done better after reporting better-than-expected fiscal second-quarter results in February, but it has been a tough market for microcap (Phibro’s market capitalization in only $600 million) stocks like PAHC. However, at just over 11X this year’s EPS estimate, with a 3.18% dividend yield, the stock is very cheap and continued consistent results this year with the potential improvement next year should push the shares higher. PAHC is a buy below $16. My target is $20.

Sonoco Products (SON) will report first-quarter earnings on May 1. The company already pre-announced expected EPS of $1.30 to $1.40 a share, compared to guidance for $1.15 to $1.25 following the release of fourth-quarter earnings. Results will still be lower than $1.85 last year, although this was an extremely difficult comparison with prices for packaging spiking a year ago. Improved productivity and lower-than-expected costs were the chief drivers of the favorable guidance.

The stock still has difficulty sustaining rallies, with fears that a recession is inevitable at some point. However, the stock remains attractively valued, even if EPS fall as much as 20% from the $5.85 expected this year in 2025. So, while it is frustrating that SON has not done much for us even though earnings have been very good since my November 2021 recommendation, I remain confident that we will be rewarded eventually. Buy SON below $65. My target is $75.

Sysco (SYY) will report fiscal third-quarter earnings in early May, with expectations for EPS of $0.92, vs. $0.71 last year, on a 9.6% increase in revenues, with price increases and the introduction of new products driving the favorable results. The bottom line will also be aided by cost control efforts.

The stock has been range bound since my recommendation in February. However, there is good value in a steady grower at 17X next year’s EPS estimates. If the company shows progress in costs, which disappointed last quarter, SYY is poised to do very well.  Sysco is a buy under $80. My target is $92.