Stocks Hang Tough

For the market to take the disappointing news on the China trade talks relatively well shows that a strong underlying bid for stocks remains.

Why is this the case?

For starters, earnings may not have been great in the first quarter as relatively flat results were expected. However, they were good enough for investors to be hopeful they will improve in the coming quarters, especially with a sound economy.

While stocks are not cheap by historical standards as the S&P 500 is trading over 16X 2020 estimates, they are not expensive either, considering the low level of interest rates. We are, in fact, looking at the possibility that the federal funds rate may not go over 2.5% for a very long time, with reported inflation low and central bankers and politicians from both political parties now squarely behind easy money policies.

While the current trade disputes with China could cause some more volatility, I expect they will be settled sometime before the year’s end as both sides should be motivated to strike a deal. China would like to see fewer restrictions on its exports, as the country is now running a trade deficit and growth is slowing as it deals with the great debt burden that it used to finance its rapid economic expansion of recent decades.

President Trump is facing a reelection campaign next year and a fair deal for the United States would make him look like a strong and effective leader who is helping the economy. The tariffs, thus far, have not been disruptive to the economy or the stock market, so investors can be patient until something gets done.

We now are out of one of the seasonally strongest times for the market, so there could be some ups and downs in stock prices. This is fine for us though, as it should present opportunities to buy good companies at reasonable prices. Despite the expected higher volatility, I am confident that stock prices will be higher by the end of the year than they are now.

Moving Beyond the Tough Times

Bed Bath & Beyond (BBBY) is a retailer that specializes in high quality goods for the home and for heartfelt events. Most sales and operating income are generated by its namesake chain of home goods stores. However, the company also owns and operates other well-known nameplates, including buybuy  BABY, The Christmas Tree Stores, Harmon’s Face Value discount cosmetics stores and Cost Plus World Market home furniture and decor stores.

The company operates a total of 1,533 stores, including 994 Bed Bath & Beyond stores, in all 50 states. It also has websites covering each of its retail businesses that offer a wide range of products.

It has been a very rough five years for BBBY, which saw its stock peak at $80.18 in January 2014. What went wrong is not a mystery. The company enjoyed very high profit margins that were not sustainable in an age of increased competition from online retailing.

Annual revenues for the company stayed relatively stable at around $12 billion between the January 2015 and January 2019 fiscal years. However, the company was forced to increase the discounts that were available from the familiar Bed Bath & Beyond coupons to maintain this level of sales. Operating income fell from $1.5 billion to $422 million from the January 2015 to the January 2019 fiscal years, while earnings per share (EPS) fell from $5.07 to $2.05 over the same period.

These poor results, along with its plunging stock price, gave birth to a group of activist hedge funds seeking to make changes at the company, including the removal of CEO Steven Temares and several members of the Board of Directors by claiming that the company’s retail perspective had gone stale. In response, BBBY management has said that it is already implementing some of the changes that were proposed by the activists, including plans for margin improvement, which I will touch on below, and eventually, sales stability through an improved product assortment and better customer experience and engagement. While activists and company management remain at odds, BBBY did make a concession in late April by forcing five directors to step down. Their replacements were new independent directors. This was not good enough for the activists, who are still demanding Temares’ resignation.

There are signs of stability coming from the company. In the fourth quarter of the January 2019 fiscal year, the company’s EPS was $1.20 vs. $2.05 on an 11% decline in revenues. However, the company was hurt by the fact that the last quarter had one less week than the comparable fourth quarter of the January 2018 fiscal year.

There are signs of stability coming from the company. In the fourth quarter of the January 2019 fiscal year, EPS was $1.20 vs. $2.05 from the same quarter the prior year. Revenues declined 11%, reflecting the one less week in the quarter. On a comparable basis, revenues were down just 1.4%, aided by strong online sales. It is also significant that the $1.20 in EPS was $0.09 above expectations, as it was the first time in several years that the company beat analysts’ estimates. It is also significant that the company had forecast EPS to grow from $2.05 in the January 2019 fiscal year to $2.11 to $2.20 a share in the current year. While sales will likely decline a little more than 1%, the company believes that an improved product assortment, emphasizing more profitable products, will lift margins, and that advanced data analytics will make the use of coupons more effective.

The market is expressing some skepticism about this earnings recovery, with the shares selling for less than 8X the company’s guidance. However, even if the management’s guidance is too high, anything close to an EPS of $2.00 a share should encourage investors enough to drive the stock higher, given its very cheap valuation. Last year’s operating margin of 3.5% is a far cry from the over 12% that was earned just four years ago, so there should be room for improvement. Furthermore, it is hard to see price competition having a further negative impact with margins so low. BBBY also has a strong balance sheet, with interest expenses covered 6X by operating income and long-term debt just 28.5% of total capitalization. Finally, while I think the company will come close to achieving its goals for the year, any failure could force Mr. Temares to resign, which could be bullish for the stock as the activists may then seek a buyer.

Buy BBBY below $17.50. My target is $21. The close to 4% dividend yield should add to total returns.

Review of Remaining Positions:

If you not have done so already, please check the Hotlines/Flash Alert section of the website for a review of earnings for our companies that have recently reported results.

Big Lots (BIG) will report fiscal first-quarter results sometime before our next issue. Expectations are for an EPS of $0.70 for the first quarter of the new fiscal year vs. $0.95 for the first quarter of the previous fiscal year. The company also reported a 2.5% increase in revenues to $1.3 billion, with higher freight costs and accelerated investments in the company’s “store of the future” holding back the top line. However, I do believe there is room for upside in the quarter, as I believe that new CEO Bruce Thorn wanted to keep expectations in check after the company reported a much-better-than-expected fourth quarter. Comparable store sales were up over 3% the last two quarters, and another good report from BIG should help the stock continue its comeback. BIG is a buy below $34. My price target is $42.

I am slightly raising my price target on Chubb (CB) to $147.50. While first quarter earnings were not overwhelming, they were solid, and 3% to 4% premium growth and good non-catastrophic loss ratios should continue for the remainder of the year. We are approaching hurricane season, which is a wild card for the stock. But as long as CB just realizes average or lower catastrophic losses, book value per share by the year’s end should exceed $120, which would support my new price target. CB is well above my $132 buy under price, so hold to my $147.50 target.

There are three things to keep in mind following last week’s very disappointing results from Cognizant Technology Solutions. First, the company is continuing to grow, with revenues expected to be up 3.6% to 5.1% this year in constant currency. Second, the stock is very attractively valued at just over 15X this year’s revenue guidance of $3.87 to $3.95 a share. Finally, new CEO Brian Humphries appears determined to get growth back to mid-to-high single-digit rates and will start spending 25% of the company’s free cash flow to make acquisitions that will fill the company’s strategic needs. So, while I hate to see the stock drop so much in price, I believe the chances are good it will outperform meaningfully over the next year, as it represents value in a somewhat pricey market. Buy CTSH under $62. My target is $75.

F5 Networks (FFIV) has been an uneven performer since my Feb. 8 recommendation. However, we got the stock at a good price, and I like the progress the company is making as it transitions into a software-oriented company that helps enterprises launch applications across multiple cloud platforms. Software revenue was up 30% last quarter, and now accounts for 19% of total product revenue. Customer support and services will provide a steady stream of income as the transition continues. The stock is a great opportunity at 14.5X EPS estimates for the September 2019 fiscal year, and I continue to recommend FFIV under $155. My price target is $170.

First Hawaiian Inc. (FHB) has participated nicely in the recent rally in bank stocks. The company is also performing soundly, with slow but steady growth. The company earned $0.54 last quarter, and from this run rate, an EPS of $2.30 is 2020 is likely, given a decent economy. This level of earnings should support my $30 target, with a 4% yield adding to total returns. Buy FHB, if a market correction takes it below $26.

I continue to believe that the selling in Ingredion (INGR) shares since last Thursday’s earnings report is overdone. Most of the earnings miss was related to factors that should reverse or stabilize over time, such as currency translation and corn prices. Meanwhile, the company is continuing with its cost-cutting efforts and in building its specialized product portfolio. Trading at 12.5X the midpoint of management’s new EPS guidance for 2019 of $6.80 to $7.20 a share, the stock offers exceptional value in the current market environment. Buy INGR under $90. My target is $105.

Shares of Morgan Stanley (MS) have performed well this year, and still have some value to them at 1.25X tangible book value a share, which should increase to $40 by year end. The dividend remains above average at 2.5%. While I will be watching for a potential sharp market sell-off that could drive the stock lower, there is enough upside to make the stock a worthwhile holding. Buy MS below $46. My target is $53.

I am hopeful that the first-quarter earnings report of Party City (PRTY), which has been scheduled for release before the market opens on Thursday, will bring stability to its beleaguered stock price. The market is concerned that bloated inventories, the ongoing helium shortage and increased online competition will lead to a severe shortfall in earnings and perhaps force the company to raise equity with the stock trading at very low levels. This would severely dilute this year’s expected EPS of $1.65.

However, while some of PRTY’s recent results have not been inspiring, they have shown stability, and I look for the results on Thursday to be reasonably close to the expected breakeven EPS. Keep in mind that the private equity funds that brought the company public still own close to 50% of the shares, so they are highly motivated to take whatever action is necessary to prevent the stock from falling further. Continue to buy PRTY. My new buy under is $8 and my target is $12.

Valley National Bancorp (VLY) has seen its stock bounce back nicely after selling off following its first-quarter earnings report due to concerns about its narrowing net interest margins. However, the company is experiencing good loan growth, is executing well on its cost reduction plan and credit losses remain mild. These factors should offset continued margin contraction and allow EPS to increase to $0.93 this year to increase from $0.81 in 2018. Valuation remains reasonable at 11.5X this estimates, and the 4.2% dividend yield is very attractive. Buy VLY when it trades below $10.50. My target is $12.50.

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