Most value investors accept that they are often going to be buying into stocks that aren’t exactly the flavor of the month. And that’s definitely the case with the stocks for consideration here.
The near-term outlook isn’t great for paintings and coatings company PPG Industries (NYSE:PPG), machinery company Caterpillar (NYSE:CAT) or UPS (NYSE:UPS) and all three face near-term headwinds, but they all look like a good value for investors willing to take a long-term perspective and buy unfashionable stocks for their value.
Image source: Getty Images.
Industrial headwinds in 2020
It’s no secret that the industrial economy isn’t starting 2020 in great shape. Business survey data from the widely followed Institute for Supply Management purchasing managers index — in which a reading above 50 indicates expansion in the industrial economy — remains weak.
Meanwhile, light vehicle and heavy truck sales remain in decline, and the ongoing grounding of the Boeing 737 MAX is significantly affecting the industrial sector. Additionally, the trade conflict has influenced sentiment, Europe’s growth remains anemic, and China’s already slowing growth is being negatively affected by the coronavirus.
US ISM Manufacturing PMI data by YCharts
Why PPG is a good value
In this environment, it’s not surprising to see all three companies affected. PPG is a major coatings supplier to the automotive and aerospace industries, and the production halt on the 737 MAX caused management to lower its expectations for growth in 2020.
The case for buying PPG rests on the idea that 2020 will mark a trough in its fortunes, and the company’s long-term trend of improving profit margin and cash flow generation will mean it trades on a favorable valuation, even as profit growth slows this year.
PPG Operating Margin (TTM) data by YCharts
Meanwhile, the company has some potential upside prospects coming from a possible fall in raw material prices, a better economic outlook in the second half, and the possibility that ongoing consolidation in the paintings and coatings industry will lead to margin expansion over time.
Moreover, if the Boeing 737 MAX achieves a return to service in the summer, then PPG has some potential upside to earnings expectations, as Boeing should start to ramp up production in due course.
Caterpillar disappoints
Caterpillar recently gave disappointing full-year 2020 guidance, with management noting that all three of its segments (resource industries, construction industries, and energy and transportation) generated sales that were below internal expectations in the fourth quarter of 2019. Moreover, its three month rolling retail sales turned negative in December, and its dealers are set to significantly reduce their inventory in 2020 in response to weak sales.
Data source: Caterpillar. Chart by author.
Frankly, the company is heading for a tricky 2020 — management expects its end-user demand to decline by 4% to 9%, and investors should note that cyclical companies often overshoot estimates both on the way down and on the way up.
Why Caterpillar is a good value
That said, Caterpillar’s valuation looks attractive. After all, if it hits analyst expectations for $9.34 in earnings in 2020 — company guidance is for $8.50-$10 — then it will trade less than 15 times forward earnings. That’s not bad for a company expected to be at a cyclical trough in 2020.
A better way to look at it is through looking at enterprise value (market cap plus net debt), or EV, to earnings before, interest, tax, depreciation and taxation, or EBITDA multiples. The analyst consensus has Caterpillar generating $8.5 billion in EBITDA in 2020, putting it on a forward EV/EBITDA multiple of 12 times EBITDA.
As you can see below, Caterpillar has traded on far higher multiples during trough periods in the past. Throw in the improvements in underlying FCF generation in recent yields — meaning its dividend is sustainable — and a 3% dividend yield, and Caterpillar looks like a good value stock.
CAT EV to EBITDA data by YCharts
UPS hits a trade wall
UPS has also been hit by sluggish global trade growth and its impact on international trade. The company also disappointed the market recently by outlining plans to increase capital expenditures in its network and make a series of initiatives which will reduce EPS by $0.33 in 2019 — full-year guidance is for EPS of $7.76-$8.06.
Data source: UPS. YOY= year-over-year growth.
With the bad news out of the way, it’s time to turn to why the stocks are a good value.
Why UPS is a good value
Accepting that this is a period of heavy investment for UPS makes the stock look like a good value. For example, management expects adjusted free cash flow of $4.3 billion to $4.7 billion in 2020, equivalent to 5.1% of its market cap at the midpoint of guidance. In terms of earnings, UPS trades on just under 13 times its earnings estimate for 2020.
Those are decent enough valuations, but if you consider that the FCF and earnings are being constrained in 2020 in order to accelerate revenue growth in the future, then the stock looks cheap. Just bear in mind that the investments UPS is making in its network could take a while to come to fruition, and it may well be that servicing e-commerce will require a step-change in investing requirements for UPS.
Throw in the idea that the second half of 2020 will see a recovery in the industrial economy — even if it’s down to easier growth comparisons to the second half of 2019 — and UPS is a value stock worth buying. The icing on the cake would be an improvement in the global trade environment.
