Sorting Out the Year Ahead

We’re at the beginning of another New Year, which is always an exciting time. The start of a year brings 12 brand-new months of opportunity, but it also comes with its own set of challenges. 2023 is no different, as I see a few challenges and plenty of opportunities for value investors.

First, one of the main challenges for investors this year will be the Federal Reserve. Our central bank seems determined to be aggressive in its fight against inflation, even as it is becoming increasingly obvious that inflation has slowed. Higher interest rates caused significant compression in valuation multiples last year. While we are closer to a peak in rates, a meaningful decline is not coming soon.

Another challenge facing investors is earnings. The Fed’s rate increases have slowed the housing market significantly. Other key industries like auto, where higher rates have made purchasing a new or used car more costly, are likely to soon follow suit. And we’ve seen major corporations announce massive layoffs, which will serve to further weaken the economy and pressure earnings.

So, as value investors, there are several challenges in the current environment, but there are also great opportunities in front of us in the New Year.

For starters, many stocks are much cheaper than where they were a year ago. While the S&P 500 overall may not look overly attractive at 17X this year’s EPS estimates, many stocks of high-quality companies are selling at much cheaper multiples, including ones in our Buy List. Most of our stocks also have very attractive dividend yields. Such opportunities were generally not available before the bear market started a year ago.

The other things value investors have on their side is time. It is unusual for bear markets to extend beyond 18 months, and we are a little more than 12 months into the current one. Remember, markets are always forward-looking. So, even if things look a little bleak for now, by the second half of this year, investors could be looking at an easier Fed and an earnings recovery sometime in 2024.

Overall, 2023 could be bumpy at times, but I expect it to be a good one for patient value investors.

PDCO: A Perfect Stock for the Current Market

In the January 6 Alert, we added Patterson Companies (PDCO) to the Buy List. To review, Patterson Companies primarily distributes of products and services to the animal health and dental industries. The company has been in business for more than 140 years, and it has animal health and dental locations throughout the U.S. and Canada.

The Animal Health segment operates from more than 80 locations and sells more than 140,000 products and services, including pharmaceuticals, vaccines and nutritional items. Over 50,000 customers, primarily animal companion veterinarians and equine veterinarians, rely on Patterson Companies’ products in order to deliver high-quality animal care. This division also sells to livestock producers. The Animal Health segment accounted for 61% of sales in the most-recent fiscal year.

Patterson Dental is the second-largest distributor of dental products in the U.S., only lagging Henry Schein (HSIC). This business segment sells to over 100,000 customers, and it derives 57% of its revenues from the sale of consumable products, including infection control products, restorative materials and instruments. The remainder of the sales come from larger equipment items, software and design services, and equipment financing. Patterson Dental accounted for the remaining 39% of sales in the latest fiscal year.

To differentiate themselves from the competition, PDCO provides a positive experience to its customers, which includes a multi-touchpoint shopping experience and online and in-print showcases of their merchandise, services and equipment offerings. PDCO can also fill orders rapidly and accurately using centralized fulfillment centers where orders for consumables are accepted.

PDCO will look to augment its growth through small acquisitions, with its most recent one in December. The company acquired Dairy Tech, which provides dairy equipment and single-use bags used in feeding newborn calves. Terms of the deal were not announced.

Financial Review

Patterson has been in a long-term recovery after a weak April 2018 fiscal year, when results were hurt by several factors: 1) the failed execution on a salesforce realignment, 2) the slow adoption of a product transition in dentistry, and 3) added costs related to an Enterprise Resource Planning (ERP) software implementation.

However, after only earning $1.68 a share in 2018, EPS improved to $2.27 in the April 2022 fiscal year, with an extra week in the fiscal year adding $0.04 a share to results. Strength in consumable products in Animal Health and CAD/CAM products in dentistry helped EPS improve from $1.91 in fiscal 2021.

Six months into the current fiscal year, PDCO projects flat to slightly higher EPS for fiscal 2023, expecting EPS in a range of $2.25 to $2.35 a share. So far this year, sales and profitability are slightly lower due to the strength of the dollar and the absence of an extra week. However, the dollar should be less of a headwind in the second half of the year, operating margins are firm, and management believes demand remains good. These factors should allow for improvement in the second half of the year and allow the company to meet their projections for the year.

I believe Patterson is a good choice at the current time where there is uncertainty about the economy and earnings. While there are execution and margin risks at distributors, demand for the company’s products should remain stable. The company has enjoyed good earnings growth since fiscal 2018, and at less than 12X a reasonable EPS estimate of $2.40 in the April 2024 fiscal year, valuation is reasonable for a company that should grow EPS at a mid-single-digit growth rate. The 3.7% dividend yield adds to the attraction of the shares.

PDCO is a buy below $29.50. My target is $33, which is where the stock traded at in April of last year.

Position Review: Attractively Valued

Brady Corp (BRC) has been rangebound since my recommendation last month. Macroeconomic concerns could prevent the stock from moving considerably higher in the short term. However, BRC’s valuation is very attractive, and the company’s financial strength and operational consistency should allow for solid gains when the economic concerns inevitably clear. BRC is a buy under $50. My $67 target is $17.5X EPS estimates for the fiscal year ending July 2024.

Cognizant Technology Solutions (CTSH) will report fourth-quarter earnings in early February, with expectations for EPS of $1.06, vs. $1.10 last year, on a 1% decline in revenues. The earnings and revenues declines reflect the staffing shortages that the company discussed in last quarter’s earnings conference call. Management, though, also expressed confidence that the issue will be resolved sometime in the first quarter. The stock is cheap, trading at less than 13X a conservative EPS estimate for this year of $4.70, and the stock should perform very well once the company demonstrates it is back on a growth track. CTSH is a buy below $60. My target is $70.

Fidelity National Information Systems (FIS) will report fourth-quarter earnings in the middle of February, and I will have a preview in next month’s issue. While concerns over market share losses and margin compression have weighed on the stock, the stock is very cheap at just 10X this year’s EPS estimates. Any signs of margin stabilization should result in an excellent 2023 for the shares. FIS is a buy below $80. My target is $100.

First Busey (BUSE) will report fourth-quarter earnings in late January, with expectations for EPS of $0.73 versus $0.53 last year. Higher short-term interest rates and recent loan growth should give a lift to results. Credit will be foremost in investors’ minds, and there is a chance that results could come short of expectations if the company lifts it loan loss provision in anticipation of a weaker economy. However, this risk is understood and priced into the shares at the current price, so I do not think the stock will sell off meaningfully should the company increase its provision.  BUSE is a buy below $24. My $29 target is 10.5X 2023 EPS estimates of $2.70.

Lowe’s Companies (LOW) has performed in line with the market since my September 12 recommendation. I am hopeful that the recent decline in long-term interest rates and an eventual Fed easing will rekindle interest in housing stocks. LOW will be a natural beneficiary, with its solid franchise at the consumer level and its growing efforts with professionals likely to produce solid long-term earnings gains. Management’s aggressive share buybacks will also grow earnings per share.  Buy LOW below $215. My target is $260.

Newell Brands (NWL) will likely report fourth-quarter earnings before our next issue, with expected EPS of $0.11, vs. $0.42 last year, on a 20% decline in revenues. Results are expected to be hurt by retailers’ attempts to lower their inventories. Once the inventory reductions are complete, there should be some normalization of earnings in 2023, and the company could earn $1.30 a share for the year. The stock is very cheap at this estimate. NWL is now a buy below $15. My target is $20.

Old Republic (ORI) will report earnings in the last week of January, with expectations for EPS of $0.56 vs. $0.88 last year. Earnings comparisons remain very difficult in the company’s title insurance business, with real estate transactions and refinancings slowing dramatically. Higher costs of insurance claims due to higher inflation could also hurt results. Despite these challenges, the shares have done well, with ORI and other insurance names considered a haven with the economic environment turning more difficult. The stock is not as cheap as when we bought it, but at 11X a conservative estimate for this year, it still has some upside. ORI is a buy below $24. My target is $27.

Phibro Animal Health (PAHC) will report fiscal second-quarter earnings in the first week of February, with expectations for EPS of $0.30, vs. $0.37 last year, on a 3.7% revenue gain. Higher costs and investments for future growth are anticipated to limit profitability. After some selling, which I feel was very excessive, PAHC has done better recently. And with the stock selling under 12X this year’s EPS estimate, more upside is possible. Remember, Phibro provides critical products for livestock health, and demand should show little sensitivity to economic activity. This should help the performance of the shares even if economic concerns grow. PAHC is a buy below $16. My target is $20.

Sonoco Products (SON) will report fourth-quarter results close to the time of our next issue. Expectations are for EPS of $1.21, vs. $0.90 last year, on a 21% increase in revenues. For all of 2022, EPS should rise to $6.41 from $3.55 in 2021, as the company benefited from higher prices for its packaging products and the Ball Metalpack acquisition. While some retracement on earnings is expected in 2023 with the economy slowing, I believe SON can earn at least $5.00 a share this year.  Valuation remains attractive at 12X this estimate. Buy SON below $65. My target is $75. The 3.3% dividend yield will add to the attraction of the shares.

U.S. Bancorp (USB) will report fourth-quarter earnings on January 25, with expectations for EPS of $1.18, vs. $1.07 last year, with the company benefitting from higher interest rates and loan growth. Credit results will be a crucial factor for investors’ reaction, but with the unemployment rate still low at 3.5%, I do not see USB adding dramatically to reserves. The stock is off to a strong start this year, and with EPS likely coming in at $4.80 a share this year, my current target is achievable. USB is a buy below $44. My target is $49.