4 More Undervalued Stocks to Buy After Earnings

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday morning I sit down with Morningstar’s chief U.S. market strategist, Dave Sekera to discuss one thing that’s on his radar this week, one new piece of Morningstar research and a few stock picks or pans for the week ahead. Dave, you have quite a few things on your radar this week. Let’s start out with the Federal Reserve meeting. Is the market expecting a rate hike? And if yes, how much?

Dave Sekera: The market’s definitely expecting a rate hike. When we look at the probability in the futures market, we are seeing almost a guarantee that they’re going to hike by 25 basis points. However, at that point, we think the Fed is going to be done and is probably going to pause. And if you look at the futures market at this point, I think it’s only about a 25% probability of a potential hike after that.

Dziubinski: Also earnings season continues this week, and you have your eye on a combination of both tech companies and real economy stocks. So let’s talk about tech first, Apple AAPL reports this week, what other tech earnings reports are you watching for?

Sekera: Well, starting off the week we have [NXP Semiconductors] NXPI, one of the semiconductor companies that we follow. Now, NXPI is a 4-star-rated stock. We rate the company with a narrow economic moat, and it trades at about a 27% discount to our fair value. I suspect earnings should probably be OK. Now, there has been a glut and commodity oriented semiconductors, which is working its way through the sector, but NXPI makes much more specialty type of semiconductors where we’ve seen demand and supply much more in balance. The one thing I really like about NXPI from a long-term perspective, that we do think it’s a good play on the transition to EVs over the next decade, or electric vehicles.

Now on Tuesday we follow that up with [Advanced Micro Devices] AMD. AMD, also a 4-star-rated stock, narrow economic moat, and trades at about a 22% discount. Now we’ve seen AMD just has had a huge rally thus far this year. The stock is a play on artificial intelligence, but really I think even more importantly, AMD has been able to take advantage by missteps from Intel INTC. And longer term, we do think the AMD is going to be pretty well positioned for growth in data centers, specifically as we see more companies move into the cloud from their own on-premise computing.

And then, as you mentioned, on Thursday we’re going to see Apple. So, Apple’s a 3-star-rated stock, it puts it in that fair value territory. We do rate Apple with a wide economic moat, and if you remember, we did actually raise that moat to wide from narrow earlier this year, but the stock does trade at a 13% premium. So, while Apple we do think has long-term and durable competitive advantages, here in the short term, I think investors should be relatively cautious. What we’re hearing from some of the other people in the industry is that many customers have been holding on to their phones longer, so there may not be as much turnover here over the past quarter.

Dziubinski: Let’s pivot and talk a little bit about some of those real economy stacks you’re waiting to hear from and why.

Sekera: Well, really, my concern here is that the first-quarter GDP report only came in at 1.1%. Now granted that 1.1% is better than what we had expected at the beginning of the year for the quarter, but throughout the quarter we actually were seeing a good economic momentum. We actually thought that GDP was going to come in well over 2.0%. So, generally what we’ve seen this earning season, Big Tech and banks have both been in line to better than expected. And in fact, I’d say the guidance that most management companies generally has been much better than what investors feared. I want to hear if this positive tone is really carrying over into the real economy or not. And when I say real economy, these are those companies that actually make physical products, conduct in-person services, and so forth.

Generally industrials sector overall is pretty close to our fair value estimate at this point. So, from a sector play, we don’t necessarily see a lot of upside, but there are several different stocks I’m going to be focused on this week. On Tuesday we’ve got Eaton ETN. It’s a 3-star-rated stock, pretty much trades close to fair value. But then we’ve also got Illinois Tool Works ITW. That’s actually a 2-star-rated stock, we think that one’s trading well above our fair value. In fact, it’s about a 19% premium to fair value, and that’s a 2-star-rated stock. Middle of the week we’ve got Emerson EMR, a 4-star-rated stock, a wide economic moat, trades at a 19% discount. And then we’ll close out the week with Johnson Controls JCI, another 4-star-rated stock with the narrow economic moat. That one trades at about a 15% discount to our fair value.

Dziubinski: And then the last thing on your radar this week, Dave, will be the ongoing saga among regional banks. As of Monday morning, JPMorgan Chase JPM had taken over First Republic Bank after First Republic was seized by regulators, which marks the third bank failure this year. So, explain what’s happening.

Sekera: Sure. So the FDIC put the bank actually what’s called under receivership, and in doing so, they then immediately sold the assets to JPMorgan. And JPMorgan actually then also assumed all the deposits of First Republic. So there shouldn’t be any impact to the depositors. They will be made whole, and they’re not going to end up having to take any losses specifically for the depositors.

This really isn’t all that surprising to us. Our equity analyst had lowered our fair value estimate back in March down to $3 a share. And, in fact, after this most recent earnings report, he lowered the fair value down to zero. Looking forward, what did this really mean? Again, I would reiterate, we just don’t think that this is the beginning of a financial crisis, this is really going to be much more idiosyncratic to a handful of banks. It’s just a much different setup than what we saw in 2008 and 2009. I would just note we do cover most of the larger regional banks, so there may be some other bank failures on the horizon, but of those that we cover, we don’t see any others that we really have a legitimate concern like we did with First Republic, that it just may not survive as an ongoing entity.

Dziubinski: Got it. Let’s pivot over to some new pieces of research from Morningstar, specifically this week we’re looking at three notable fair value estimate changes that our analysts made after earnings last week. First we shaved 3M’s MMM fair value estimate to $127 from $131. Why is that? And what do we think of the stock today?

Sekera: We still think the stock is undervalued. So 3M is a 4-star-rated stock, trades with about a 16% discount to our fair value, and we do rate the company with a wide economic moat. Another positive factor here is 3M pays a very high dividend yield, about 5.65%, and I’d note that fair value estimate reduction really wasn’t all that much of a decrease, it’s only about a 3% cut. And I think the thing here was that our analyst thinks that management guidance here is probably a little on the aggressive side, so I know he lowered his revenue and earnings forecast slightly here for the short term. But I’d say long-term our outlook remains pretty much the same. And what we’re looking for here is going to be a pullback this year followed by low-single-digit revenue growth thereafter, and we do think that the margins will end up recovering over time and start moving back up toward historical averages.

Dziubinski: So then we lifted our fair value estimate at McDonald’s MCD by $20 to $260 per share. Now what drove that increase, and do we think the stock is a buy today?

Sekera: I think really most of that increase was just really driven by higher than expected increases in comparable store sales. And those comparable store sales were driven by a combination of two things. One, higher guest count as well as then higher prices. And to some degree, I think McDonald’s is probably benefiting from trade down from higher-price-point restaurants as inflation kind of works its way through the system. A lot of people that might have been going to other restaurants are seeing the pain of what they have to pay at those restaurants and looking for cheaper alternatives. But even after raising our fair value on McDonald’s, it’s still a 2-star-rated stock. Now granted, it does have a wide economic moat, but right now it’s still trading at a 14% premium even to that higher fair value.

Dziubinski: And then the last fair value increase we’ll talk about this week is Microsoft MSFT. Now you’ll actually be talking with Morningstar’s Microsoft analyst during our YouTube show next week, so don’t give too much away now, but tell the audience what our new fair value estimate is for Microsoft and why we increased it.

Sekera: Sure. So, Microsoft, we increased to $325 a share and as a combination of a number of different factors that we listened to and heard about this past quarter. So, first its cloud business, Azure, was better than expected, but then also Microsoft 365 had better-than-expected renewals. And I think when we listened to management guidance, I think the comment from our analyst here was that while macroeconomic pressures persist, they don’t appear to be worsening at this point.

Now as you mentioned, we will be hosting Dan Romanoff next week, he’s the equity analyst that covers Microsoft. And I’m going to have him walk us through his investment thesis as well as his valuation for Amazon AMZN, but I’m also going to have him do the same—I’m sorry, for Microsoft, and then I gave it away there, we’re also going to have him do it for Amazon, so we’re going to get a twofer out of Dan next week. But in addition to Dan, we’re also going to host Ali Mogharabi, and he’s the analyst that covers both Alphabet GOOG and Meta META. And I’m going to have him do the same thing, to talk about his investment thesis and his valuation on those two companies following their earnings reports.

Dziubinski: Great. Let’s move on to the stock picks portion of our program. Last week we talked about five undervalued stocks you liked after earnings, and this week you’ve brought along four more ideas for us. Your first pick this week is ServiceNow NOW. Now our analyst reiterated after earnings that Morningstar really feels like ServiceNow is one of our top picks in the tech sector, why is that?

Sekera: It is. ServiceNow is rated 4 stars, and we rate the company at a wide economic moat, and it trades at about a 23% discount to our fair value. For first quarter, both revenue and profitability were better than what we expected, and I think we were even on the high side of expectations as compared to the Street. And the company then still provided very solid guidance. And, in fact, I think they raised their full-year outlook. And the outperformance here is driven by both robust demand as well as just tightly focused operations. Across our coverage in the tech sector, I believe that our analysts there believe it just has the best combination of both top-line growth characteristics coupled with already some of the highest margins in the industry.

Dziubinski: Your second pick this week is Discover Financial DFS. And this is a stock we’ve talked a little bit about in a previous show. It was one of your financial stock picks after the banking crisis hit in March. How are things looking today?

Sekera: They’re looking pretty good as far as I’m concerned. It’s a 4-star-rated stock, the company’s rated with a narrow economic moat, and it trades at a 29% discount to our fair value. So, listening to our analyst here, earnings were pretty much largely in line with what we expected and there’s just really no change to our investment thesis here. Now, yes, we do expect defaults will increase, but we’ve already boosted our charge-off rate here. And I think the big difference between our forecasts and where the stock is currently trading in the market is that I think a lot of investors are assuming a higher for longer charge-off cycle. Whereas when we think about the economy, we do expect the economy is going to stagnate this summer, potentially even contract this fall, but then by fourth quarter should bottom out and then start improving throughout 2024.

Dziubinski: Your third pick this week is Verizon VZ. That stock has an especially attractive yield, what else is there to like here?

Sekera: It does. It’s yielding about 6.7% right now. It’s a 5-star-rated stock, narrow economic moat, trades at a 32% discount to our fair value. Now listening to Michael Hodel, he’s our analyst that covers there, I think, just notably, he thought the results this past quarter were generally underwhelming, but he did maintain his fair value estimate of $57 a share. And I think, listening to him, he thinks at this point management is still placing too much emphasis on customer growth and really they should be focusing more on driving margins at that company.

Part of the investment thesis here though is there’s really only three major players left in the cellphone industry right now. So longer term, we do think that the industry will start becoming more focused on what he calls rational competition over time. And that the company, and specifically all the companies in the industry, will focus less on what we’ve seen in the past, unprofitable growth just for the sake of growth. I think that’s going to be a benefit for really all the companies within that sector, but specifically we do think that Verizon is very, very undervalued here.

Dziubinski: And then your last peak pick this week is Illumina ILMN. Now this stock has been in the news lately. Activist investor Carl Icahn has launched a proxy fight over the company’s Grail acquisition. Walk viewers through what’s going on there and why you like the stock.

Sekera: Well, and I should caution the investor, it is a little bit of a complicated story at this point, but we do think this stock does have some pretty significant upside over the long term. It’s currently rated 4 stars, and we do rate the company with a narrow economic moat, and it trades at a 24% at discount.

Illumina acquired another company by the name of Grail in 2021. However, both the U.S. and EU regulators are now trying to force the company in order to have to divest Grail. Grail itself makes a liquid biopsy product that’s currently in testing, and what this product can do is it can test for up to 50 different types of cancer using just one blood draw. And if that product gets approved, we think it has just a very, very large total addressable market. In fact, we would actually look at that product as being a game changer in healthcare as far as when cancer can be detected and treated. And of course the earlier treatment also then provides usually greater successful outcomes.

In our view, if Illumina is forced to divest Grail, we assume that if that does happen, we do think that they would look at doing a spinoff so that the existing shareholders would still own the stock in Grail. And so once you still own both those companies’ shares, you still have the upside and the economic value whether or not it’s actually owned by Illumina or if it’s spun off as a separate company.

Dziubinski: Got it. Well, thanks for your time this morning, Dave. Be sure to join Dave and I next week for a special edition of our weekly Monday morning show. Dave will be talking with our lead analysts on Microsoft, Meta, Amazon, and Alphabet. Tune in to hear what they have to say about the prospects for each company and what they think of the stocks today. See you next Monday morning at 9 a.m. Eastern, 8 a.m. Central. Have a great week.