The power lower interest rates have had on stocks this year is exhibited by the nearly 20% increase in the S&P 500 this year, despite the fact we are about to have our second consecutive earnings season where profits have declined year over year.
However, the decline in the 10-year Treasury rate from 3.2% from November to close to 2.0% currently has been a major boost for stocks, as it has left investors more comfortable buying and holding at higher multiples. This is especially true considering we have seen a similar decline in yields of corporate securities, with the average yield on BBB rated bonds declining from 4.8% to 3.5%.
Thus, with no signs that credit spreads, the difference between government and corporate security yields are widening, it is likely inaccurate to say that the decline in Treasury yields is a sign that a recession is coming, as we often hear on financial media.
If bond investors really thought a recession was imminent, we would have seen credit spreads widen significantly from their current low levels. In the short term, bonds may have gotten a little ahead of themselves, and the higher-than-expected number of new jobs announced by the U.S. government last Friday could have started a bit of a corrective phase. This, in turn, could take stocks lower as well in the near term.
However, make no mistake about the fact that we could be in for a new era for rates, where the 10-year Treasury rarely goes above 3%. Central banks simply will not be able to raise short-term rates significantly, given the sharp global increases in corporate and government debt we have seen since the financial increases. At some point, this will lead to an expansion of U.S. Price to Earnings (P/E) beyond historical norms of 14X to 16X.
A multiple of 20X, formerly considered a top for stocks, could be more like an average P/E going forward. This will not happen overnight, but as rates stay lower for longer, stocks will be bid up as investors gain confidence that a historical 10-year note yield of 4% is a thing of the past.
I believe my Value Authority recommended stocks stand to benefit from the higher P/Es we are likely to see in the future. There are some near-term concerns about the economy holding back our financial stocks, and economic, tariff and competitive concerns are hurting our retail holdings. However, I believe these issues will be resolved in our favor and I look for these depressed shares to start to do well. So, despite the potential of some near-term weakness in the overall market, I believe our stocks will do very well through year-end.
Packaging Corp. Wrapping up Profits
Packaging Corporation of American (PKG) was formed from the merger of several companies in 1959, including some of which began operations in the 1800s. PKG has two divisions. Its Packaging Products division is the third-largest producer of packaging products in North America. The division produces linerboard and corrugated packaging products, including shipping containers, protective packaging, food packaging and colorful boxes used in retail displays. The company manufacturers linerboard from 6 mills and produces packaging products from 95 facilities.
The Paper division is the third-largest producer of uncoated freesheet in North America. PKG manufactures and sells both standard white papers used in printing and other communications applications, and specialty products that come in different colors, brightness and textures. The product is produced from two white paper mills in the United States.
The Packaging segment is the much larger of the two, contributing 84% of total sales in 2016. PKG has made several acquisitions over the course of the decade that I believe have changed the nature of the company for the better. In 2013, the company acquired Boise Corporation for $2 billion, including assumed debt. The acquisition greatly improved PKG’s scale in containerboard, increasing capacity by 41%.
From 2016 through 2018, PKG spent an additional $815 million in acquisitions. These acquisitions included the 2016 purchase of TimBar Corporation for $386 million. The acquisition allowed PKG to further optimize its containerboard capacity and gave the company a greater presence in value-added specialty products. In 2017, PKG purchased Sacramento Container Corp for $265 million. The acquisition improved PKG’s strategic and operational position in California.
The combination of the acquisitions, a strong economy, as well as improved volume and pricing, led to strong financial performance of the company from 2014 through 2018. In this period, revenues increased from $5.8 billion to $7.0 billion and earnings per share (EPS) grew from $4.66 to $8.03. Cash flow in this period was very strong and, despite the acquisitions, the company reduced its net debt from $2.2 billion to $2.1 billion while increasing its dividend every year.
PKG also enjoyed strong results in the first quarter of 2019, with revenues up 2.5% and EPS improving to $1.98 from $1.45 a share. However, containerboard prices have declined in recent months, which will lead to lower earnings comparisons for the remainder of the year. EPS is expected to end the year essentially flat at $8.00 a share.
However, I believe the decline in earnings is now well discounted in the price of the stock, which traded at over $130 in February of last year. Provided the economy remains healthy, EPS should remain above $7 a share even if container prices fall more, and the stock should do well at this level of earnings. The 3.24% dividend yield will enhance total returns. Continue to buy PKG under $100. My target is $115.
Position Review
Big Lots (BIG) continues to be held down by a toxic environment for many retail shares, despite signs the company’s turnaround is starting to take hold, with solid comparable store sales gains and stabilizing operating margins. However, fears of a slowdown in consumer spending and the potential impact on tariffs are currently driving the bad stock performance. Trading at only 7X expected EPS with a dividend yield of 4.4%, the stock is currently discounting a lot of bad news and any clarity on tariffs or increased confidence in consumer spending should be a major positive catalyst, as could fiscal second-quarter earnings, which will be reported in early September. Buy BIG below $32. My target is $40.
Cognizant Technology Services (CTSH) will report second-quarter earnings sometime in the first week of August. Expectations are for EPS of $0.92 vs. $1.11 on a 3.3% increase in revenues, as slower-than-expected growth in the company’s financial services and health care businesses will negatively impact margins. However, the company is currently seeking to get costs in line with the reduced revenue expectations, and digital offering continues to grow at a double-digit-percentage pace. These factors will soon allow the company to return to earnings growth. The recent improved performance of the stock show the market is getting comfortable with the prospects of a turnaround. Buy CTSH under $62. My target is $75.
F5 Networks (FFIV) will report fiscal third-quarter earnings after the market closes on July 24. Expectations are for EPS of $2.55 vs. $2.45 on a 2.4% gain in revenues. However, these estimates are based on the company’s guidance prior to any impact on the recent acquisition of NGINX, which closed with seven weeks to go in the quarter. Therefore, I would expect revenues to be higher. Because the acquisition is initially dilutive, EPS will fall below this guidance. However, the acquisition will enhance growth in the long run, as it improves F5’s capabilities to help customers launch applications across different cloud platforms. The stock has done better recently, and this is an important quarter for the company, as investors will get an early read on NGINX’s impact on the company. If the market gains confidence that EPS can approach $11 a share in the September 2020 fiscal year, up from $10.60 this year, my $170 target is easily achievable. FFIV is a buy below $155.
First Hawaiian Inc. (FHB) will report earnings after the close on July 25, with expectations for EPS of $0.53 vs. $0.50 on a 5.6% increase in revenues. Moderate loan growth and well-controlled expenses following the investments of last year will be the main drivers of the EPS growth. Loan losses also will stay modest. FHB has lagged the recent rally in financials, but I believe performance will improve once results are released and show that conditions at the bank remain stable. Buy FHB below $26. My target is $30.
Ingredion (INGR) will report second-quarter earnings sometime in the first week of August, with expectations for EPS of $1.65 vs. $1.66 on flat revenues. This is the quarter when earnings comparisons become easier for the company, since it ends higher commodity price comparisons and unfavorable currency issues. However, persistently higher corn prices may cause the company once again to lower guidance for the year, although this will be offset in part by higher prices and a better revenue mix as the company’s specialty products segment continues to grow. However, I do expect guidance to be revised to no lower than $6.50 from the current $6.80 to $7.20 a share and around 13X this potential lower estimate, since there is great value in the stock. With results likely to be much better in 2020 as corn prices moderate, continue to buy INGR below $90. My target is $105.
Morgan Stanley (MS) will report earnings on July 18, with expectations of EPS of $1.22 vs. $1.30, on a 3% decline in revenue. At an investor conference in June, the company disclosed that trading revenues will fall short of the strong results of the first quarter of this year, which results in estimates for the current quarter going down by approximately $0.05. Although the quarter is expected to be lackluster, Morgan Stanley keeps growing its book value and should continue to do so provided markets and the economy avoid a severe macroeconomic shock. Trading close to book value of $42.83 a share, and with a dividend yield of 2.74%, the stock remains attractively valued. MS is a buy below $46. My target remains $53, which represents 1.1X year-end 2020 book value.
Although it does not have a definitive date for its earnings release, Party City (PRTY) will report earnings sometime before our next issue is published. Expectations are for EPS of $0.37 vs. $0.40 on a 2.4% gain in revenues, as the ongoing helium shortage will reduce sales of balloons, which are a higher-margin product. The company in its last earnings report indicated it had reached an agreement with an exploration company that could be a source of additional helium, and investors will be interested in any progress made from this pact.
PRTY has been a victim of the merciless selling in small retailers. While there is limited downside in the stock, the shares may not make a big higher move until Halloween sales are completed. However, as its current valuation of less than 5X this year’s EPS guidance, the bar has been set very low, and the stock should do very well on any results reasonably close to expectations. PRTY is a buy below $8. My target is $12.
Universal Health Services (UHS) will report second-quarter earnings sometime in the fourth week of July. Expectations are for EPS of $2.50 vs. $2.47 on a 5.8% increase in revenues. I believe analysts are modeling the quarter cautiously in light of recent patterns of unfavorable revenue mix from fewer surgeries in the acute care business and shorter stays in the behavioral health business. I believe with these trends now incorporated in estimates, there is room for potential upside.
The stock has performed well since my May 24 recommendation. The current market environment shows companies with relatively stable earnings seeing expanding valuation multiples due to a surprisingly large decline in interest rates. The stock is above my $125 buy under price, so hold to my $140 target in front of earnings.
Valley National (VLY) made an acquisition late last month, announcing their intention to purchase Oritani Financial (ORIT) in a stock-for-stock transaction valued at $740 million. The deal will strengthen Valley’s presence in Union County New Jersey, which is adjacent to Valley’s core North Jersey business. Valley National management announced the transaction will be slightly accretive to EPS, and the company paid an attractive multiple of a little less than 10X earnings once synergies are realized.
Valley will report earnings on July 25, with expectations of EPS of $0.23 vs. $0.22 on a 2.3% increase in revenues, aided by the company’s ongoing cost reduction efforts. I will be interested in the company’s comments regarding the North Jersey real estate market, and I will also be interested to see the amount of loan growth coming from Florida.
Valley’s stock has done surprisingly well recently, given the inversion in parts of the yield curve. This likely will not impact margins in the short-term. In fact, they could improve initially as the company lowers deposit rates while longer-term mortgage loans will take a while to reprice. However, this could be a long-term issue as, at some point, the company’s yields on long-term loans will decline. Given this potential long-term drag, I am lowering my price target to $12 and my buy under to $10. Hold VLY into earnings.