Market Cap Model Shifts to Large Cap for December

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Northlake’s Market Cap model shifted to Large Cap from Mid Cap for the month of December. The current signal is just barely in large cap territory. The shift reflects the lessening impact of a cyclical bottom in the economy and financial market conditions. When the financial markets and economy quickly decelerated following the collapse of Lehman Brothers in September 2008, the Market Cap model began to strongly favor small caps. As the markets and economy have been in recovery mode since spring, the extreme readings seen in many of the underlying indicators have moderated.
One basic tenet of the model is that at extreme readings you should take the opposite trade. In other words when all the indicators were reflecting the disaster in the global economy and markets, the next move was likely to be up. Thus, it was time to favor small caps and bet on their higher volatility. Now that economic and market conditions have eased, there has been a gradually lessening in the desirability of the higher risk small and mid cap indices. This was first reflected in October when the Market model shifted from small cap to mid cap. After a two month run, the model took the next step in reducing portfolio risk by moving to lower volatility large cap.
As a result of the latest shift, all non-core client holdings in the S&P 400 Mid Cap (MDY) were sold and proceeds were reinvested in the S&P 500 (SPY).
There were actually few changes in the underlying indicators of the Market Cap model. Rather several indicators that were favoring small caps weakened. In particular, the indicators tied to interest rates, while still favoring small caps, are much weaker now than a month ago. On the other hand, technical indicators, which had already favored large caps, grew stronger in that view following a month when the S&P 500 produced a return far in excess of the Russell 2000 (IWM) and S&P 400 Mid Cap (MDY).
The Style model is unchanged for December and continues to flash a value signal. As a result, client positions in the Russell 1000 Value (IWD) will be maintained.
The models had a below average performance in November. The Style model’s recommendation of Value worked out OK as IWD rose 5.73% almost exactly matching the S&P 500 return of 5.74%.
The Market Cap model underperformed in November as MDY gained 4.20%, lagging the S&P 500 by about 1.5%. Not all was lost, however, as MDY still performed better than the small cap IWM, which gained 3.1% in November.
The current value signal has been in place since the beginning of July. During that time, the value signal has been pretty good with IWD up 10.3% against a gain of 18.4% for the comparable growth index. The S&P 500 is up 19.1% during the same period.
The expired Mid Cap signal had mixed results. For October and November, MDY produced a price only return of -0.50%. The S&P 500 easily beat this results as SPY gained 4.1%. Once again, not all was lost as the small cap IWM fell 3.6%. Thus, the model’s recommendation to move from small cap to mid cap at the start of October was accurate. It was not, however, as accurate as possible.
Disclosure: IWD and SPY are widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg’s personal accounts. MDY and IWM are held as core positions by selected clients of Northlake Capital Management, LLC.

Liberty Media Entertainment Merger with DirecTV Closes

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Last Thursday, shareholders of Liberty Media Entertainment (LMDIA) and DirecTV (DTV) formally approved the merger between the two companies. The merger closed Thursday night. Many Northlake clients owned shares in LMDIA. Each share of LMDIA is now one share of DTV. In addition, for every ten shares of LMDIA, shareholders received one share of Liberty Starz (LSTZA).
For example, if a Northlake client owned 500 shares of LMDIA they would now own 500 shares of DTV and 50 shares of LSTZA. Any fractional shares of LSTZA will be paid in cash.
As of early Monday morning, Schwab Institutional shows the new holding of LSTZA but has not yet converted the LMDIA to DTV. This means that account values are understated by the value of client DTV holdings. Schwab has assured me the DTV shares will be credited to accounts very soon.
I plan to hold both DTV and LSTZA for the time being. DTV is growing around 10% a year and producing lots of free cash flow which is being used to aggressively repurchase shares. In my opinion, the growth profile of the company, cash flow, and balance sheet strength are about 20% undervalued at the current DTV price of $31. DTV has further upside in the event that the long rumored takeover of the company by a major telecom company comes to fruition. Just last week, John Malone, the controlling shareholder of LMDIA and now the largest shareholder of DTV, indicated that he is willing to sell the company. In a takeover, DTV could be sold for a price of $40-50. I am less optimistic about a takeover but the ongoing speculation provides excellent support for the stock as do the aggressive share repurchases.
LSTZA operates the Starz and Encore movie channels that are available on a subscription basis via cable and satellite services. The company’s revenues come from splitting the subscription fee with the cable and satellite companies. Expenses are dominated by the fees paid to the movie studios for the rights to show the movies exclusively on Starz and Encore for a period of time. Revenue growth has been slow but the movie rights expenses have been falling driving good growth in profits the last few years. The outlook for growth is more mixed as online video rights complicate negotiations between the studios and LSTZA. Fortunately, the company’s current rights deals are good through 2012 and 2015. In the meantime, LSTZA produces significant free cash flow which I expect to be used to aggressively buyback shares. Current Northlake client holdings of LSTZA are small due to the 1:10 ratio. I suspect that will eventually lead me to sell the shares but for now I think they could rise another 20% to around $60.
If Media Talk readers have any questions about the LMDIA-DTV-LSTZA transaction, please do not hesitate to contact me or just leave your thoughts in the comments section below.
Disclosure: LMDIA and now DTV are widely held by clients of Northlake Capital Managemet, LLC including in Steve Birenberg’s personal accounts.

Steve Birenberg to Co-Manage Entermedia Growth Partners Hedge Fund

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I am pleased to announce that beginning January 1, 2010, I will be co-managing Entermedia Growth Partners. Entermedia is a 16 year old hedge fund focused on media, communications, entertainment, and communications technology. Entermedia will be a separate business from Northlake but is highly complementary. The Entermedia investment portfolio contains long and short investments in many of the stocks that Northlake clients currently own or have owned in the past. The universe from which investments are drawn at Entermedia is virtually identical to the universe I research on behalf of Northlake clients.
Northlake clients will benefit in several ways from my involvement with Entermedia. First, Entermedia may be a good investment option for some Northlake clients. The fund is managed more aggressively than the typical Northlake portfolio but Entermedia also uses lots of hedging strategies. This has allowed the fund to perform well in both rising and falling markets. In fact, one of Entermedia’s best years was 2008 when the fund fell just 8% despite a 40% decline for many major market averages. Second, the larger combined asset base of Northlake and Entermedia will allow greater access to research services, company management teams, and Wall Street analysts. More resources will be available to Northlake as I strive to continue the fine record of investment performance created over the past five years.
Entermedia is currently managed by Ken Goldman, one of my best friends and my primary confidante on media and telecom stocks. Ken is several years older than me and is retiring so he and his wife can spend time in China where Ken’s wife was born and raised and her family still lives. Another of my best friends, Tom Curran, will be my partner at Entermedia. Tom and I have been friends since our kids were in the same classes in grade school. Amazingly both of us have a child about to graduate from college! Tom has prior experience managing his own hedge fund and will handle all operational aspects of Entermedia in addition to bringing his expertise at analyzing balance sheets and corporate credit quality. Northlake clients can also gain comfort in that Tom will be sharing my office space and available to cover for me when I am out of the office during market hours.
I am very excited to be expanding my own money management activities and thrilled that Entermedia is such a complementary business that will bring many advantages and opportunities to my Northlake clients. I look forward speaking with each Northlake client about Entermedia as we discuss year end planning. In the meantime, have a great Thanksgiving holiday!

Less Than Meets the Eye at Disney

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Disney reported better than expected fourth quarter 2009 financial results. Benefiting from an extra week, the company reported adjusted EPS of 46 cents, easily beating consensus of 40 cents. Revenues also beat expectations handily, coming in at $9.69 billion against a consensus estimate of $9.26 billion.
Although it got little direct questioning on the call, I think a material portion of the upside came from the extra week. My initial back of the envelope calculations still show some upside but not enough to justify the initial 3.8% pop in the stock. I’ll be surprised if the stock is up that much when it opens in NT on Friday.
Highlights of the quarter include -3% ad sales at ESPN, weak them park revenues and margins, and the expected poor performance of operating profits at the movie studio. On the upside, there was improvement at ABC and the local TV stations and affiliate fees at the cable nets continue to show steady gains.
Like other media companies that reported last week, Disney indicated ad trends are improving. Ad sales are getting an added boost from good ratings at ESPN and a decent start to the new TV season at ABC including a couple of new shows turning into hits. The company mentioned that scatter pricing is running up 20% and that option pickups for the March quarter are the best in ten years. Trends at the local TV stations improved to -15% in the September quarter. Management was less optimistic about December quarter trends than other TV station owners who reported last week.
Disney’s theme parks set the company apart from the rest of the media companies. I find trends here to be a bit worse, especially adjusting for the extra week. Attendance is holding up well but the cost is high with revenues down more than 10% adjusting for the extra week and also an unspecified amount of sales of Vacation Club properties. Reported results in 4Q09 showed revenue -4% and operating income -17%. This is another indication of pressure on the business as margins are declining.
To me the most interesting comments on the call came from Bob Iger as he explained that the secular changes in DVD consumption are driving the management changes and organizational restructuring at the movie studio. Iger stuck a tone that was much more concerned than other studio owners about permanent changes to the DVD market relative to cyclical impacts.
As the call wraps up, the stock has given up about half of its initial after hours gains. Overall, I find management to be balanced in its view of the future and less hopeful than other media companies. However, at least part of this can be chalked up to the fact that Disney is normally not very promotional. Analyst questions are not particularly tough suggesting that estimates will be stable despite my initially more pessimistic view of the numbers than the street.

Disney to Finish Off Media Earnings Season

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Disney wraps up September quarter earnings for media and communications companies when it reports after the close on Thursday. Analyst estimates call for EPs of 40 cents on revenue of $92.6 billion. If estimates are hit, revenues will be down about 2%, operating income will fall 15-20% and EPS will be down 4%.
At the segment level, Media Networks should hold up the best while Studio Entertainment operating profits will plunge. Media Networks includes ABC and local TV stations, ESPN, the Disney Channel, and other cable nets. Growing affiliate fees and a rebound in advertising growth, though still negative, should be the drivers at Media Networks. Studio Entertainment faces challenging comparisons and is coming off generally poorly performing movies at the global box office.
Investors will be looking for insight into several issues on the conference call. ESPN ad sales have been lagging the industry due to high auto exposure. Is the company seeing a recovery in auto that is apparent at other networks? ESPN’s ratings have been good, as have sports ratings in general. IS the company able to translate ratings into ad sales?
Disney’s Theme Parks remain under pressure as consumer watch their pocketbooks. The company has kept hotel occupancy at surprisingly high levels but the cost has been very aggressive pricing and depressed profit margins. Has the pricing environment improved or have promotions eased? How do advance bookings look into the holiday season and spring break 2010?
There are also lots of questions about the movie business. DVD sales remain under pressure and one could infer from sales of Dreamworks Animation’s Monsters vs. Aliens initially poor DVD sales that animated titles may finally be succumbing to DVD weakness. In addition, Disney has announced has several very senior executive changes at its movie studio. When combined with the Marvel Entertainment acquisition and the deal to distribute movies for Steven Spielberg, Disney seems to taking a new approach to the movie business. The model now seems to be purely distribution with ownership or larger budget films restricted to Pixar and possibly the long-term relationship with Jerry Bruckheimer form Pirates of the Caribbean sprouted. The astute blogger and critic David Poland of The Hot Blog and Movie City News noted that the new Disney model looks an awful lot like the failed Paramount model if Pixar is excluded. I wonder if any analyst will have the guts to ask that question!

CBS Shows Upside But Maintains Guidance

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CBS reported modest upside to estimates in 3Q09 with most of the excess coming from the syndication business. However, it was still a strong quarter of improvement with the CBS Network returning to positive ad growth, dramatically lower ad revenue declines at the local TV stations, and modest improvement but still deeply negative ad sales at the radio stations and outdoor properties. Furthermore, on the conference call, management noted that Oct and November trends have continued to improve, particularly at the local TV stations which are showing positive growth excluding the huge political spending during 2008’s Presidential election.
Management reaffirmed 2009 guidance despite the upside in the third quarter. This disappointed some investors who saw it as a lack of confidence in 4Q ad spending at the TV network. If you add current 4Q EBITDA estimates to year-to-date reported EBITDA you get exactly to the mid point of management’s guidance. What the street would have liked was an increase in the low end of guidance to suggest that results would ultimately settle in the top half. I understand that reading but I think it is overly bearish and that the company will reach the high end of its guidance.
For 3Q, CBS reported adjusted EPS of 25 cents against the consensus estimate of 25 cents. Revenues of $3.55 billion exceeded consensus of $3.2 billion. EBITDA of $597 million was ahead of the $538 million consensus. As noted, most of the upside was in syndicated TV sales.
Away from TV, radio showed margin stability which could be a good sign for 2010 if ad revenue declines slow. Outdoor showed little improvement. It was in line with estimates at 20% ad declines but following a better than expected report form competitor Lamar (LAMR), the segment’s performance was viewed as disappointing. Interactive lagged at both the revenue and EBITDA lines but you would not know that form listening to the company which remains confident in its web strategy.
I remain bullish on CBS as a pure play on a cyclical ad recovery. The asset base ratings leading competitive positions, which means if a recovery occurs upside could be substantial. I think the shares could reach $15 in 2010 assuming estimates rise modestly toward the high end of current range. Obviously, that is my expectation of what will happen.
Disclosure: CBS is widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg’s personal accounts.

Discovery Leading the Advertising Recovery

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Discovery Communications (DISCA) reported another good quarter, making it five in a row since the company went public in September 2009. The upside was not as big this quarter than prior quarters but that is due to factors beyond management control: higher expectations and analyst estimates and a still tough environment for advertising sales. What is in management’s control continues to perform as well or better than any peer media company. Ratings are good, channel upgrades are on target and creating value, and cost controls remain strict.
DISCA shares are up 90% since Northlake’s initial purchase in mid-September 2008 on the first day of the market crash. I still think upside remains but it will take more help from an economic and advertising recovery to drive future gains. I expect continued strong operating performance and support from merger activity at other cable networks to combine with an ad rebound and take the shares to the mid-$30s in 2010.
In 3Q09, DSICA reported revenues of $854 million, EBITDA of $364 million, and EPS of 22 cents. Revenues were slightly ahead of estimates and EBITDA was a significant positive surprise. The upside did not flow through to EPS, which fell short of the 27 cent estimate solely do a large non-cash charge related to stock-based compensation.
DISCA’s fundamental drivers are advertising sales and affiliate fees. Domestic ad sales rose an industry leading 5%, better than expectations for a 1% gain. DISCA is converting outstanding ratings into ad sales. International ad sales were up 9% in local currency, at the high end of guidance, although foreign currency translation led to a reported figure of -22%.
The news on affiliate fees was equally positive with domestic fees rising 10% after adjusting for the deconsolidation of Discovery Kids (now part of a joint venture with Hasbro)). International fees rose 5%, again pressured by currency translation.
The company raised its EBITDA guidance but was only cautiously optimistic about 4Q and early 2010 ad sales. I think management is playing it safe due to the uncertain economy and the high amount ad sales taking place very close to airing. This theme was repeated throughout 3Q media conference calls. The trend of improving ad sales is obvious and established but like much in the economy the situation is fragile. I think DISCA management captured it well when they said “difficult pricing prevents full monetization of ratings” and “the environment is “improving but challenging.” I suspect that when DISCA reports 4Q in early February it will be another positive quarter.
For 2010, I think revenue growth can be in the high single digits with slightly more margin expansion leading to low double digit EBITDA growth. The company does face two headwinds in 2010. The rebranding of Discovery Health to the Oprah Winfrey Network will cost $20 million in EBITDA and the sale of Travel Channel will cost DISCA an attractive ad sales contract that proves 1-2% of EBITDA. Nevertheless, as noted, I think another good year of industry leading financial and operational performance is on tap.
Disclosure: DISCA is widely owned by clients of Northlake Capital Management, LLC including in Steve Birenberg’s personal accounts.

DirecTV Comes Through with Free Cash Flow as Prior Worries Recede

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When I first read the DirecTV press release I was worried the stock would trade down. I saw the results as mixed with a few negatives offsetting plenty of positives. I sure was wrong. As the conference call concludes, the stock is up 6.1%.
I think part of the gains relate to ongoing takeover speculation as DTV approaches the closing of its merger with Liberty Media Entertainment (LMDIA). LMDIA owns 54% of DTV. The deal dramatically reduces LMDIA’s John Malone’s influence and simplifies the corporate structure. It also sets up a spin-off of the rapidly growing DirecTV Latin America unit. That step is widely expected and makes DTV an easier and more attractive merger candidate for AT&T. AT&T exclusively sells DirecTV service in the telco channel and is already accounting for the bulk of DTV’s new subscribers. With telco TV subscriber additions slowing but telcos still needing TV as part of the bundle in the battle with cable, DTV looks like a better and better acquisition candidate.
Getting back to the earnings report, the negatives were a slight miss in net subscribers on higher monthly churn, and modest shortfall in EPS and EBITDA. Upside came from a rebound in ARPU growth and higher than expected share buybacks and free cash flow. EPS of 37% were two cents short of estimates. The ARPU improvement was important as a weak 2Q09 ARPU had made investors skittish.
The misses were minor and besides takeover speculation, it seems that investors are taking away the fact the DTV still grew revenues and EBITDA by 10% and 8%, respectively. The EBITDA number is depressed by charges from repatriating money from Venezuela and foreign exchange. In the US, revenues grew 9% and EBITDA was up 11%. Compare that to flat to low single growth at cable and telco competitors and you have to be impressed.
Even better, DTV is providing the street with the capital allocation strategy it desires: heavy share repurchase. Share buybacks are now suspended until the closing of the LMDIA merger (shortly after 11/19). But expect a big announcement by the end of the month on a repurchase for 2010 likely to be 10% or more of the shares outstanding.
Net debt stands at $3.9 billion against EBITDA of over $5 billion in 2009 and estimates for greater than $6 billion in 2010. Even with new debt coming on board when the merger closes, the balance sheet is in superb shape and free cash flow continues to grow as subscriber growth moderates.
I still like the DTV story but prefer to play it through LMDIA which will create a stub of Starz Entertainment that I Think remains undervalued by about 30%. Via LMDIA I get that upside plus the good DTV story.
Disclosure: LMDIA is widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg’s personal accounts.

DirecTV 3Q Earnings Preview

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Northlake clients own DirecTV (DTV) through their position in Liberty Media Entertainment (LMDIA). LMDIA owns 54% of DTV. DTV will acquire LMDIA prior to year end in a transaction that has already received all necessary government approvals. LMDIA shares will convert into DTV shares. LMDIA shareholders will also receive shares in a new company called Starz Entertainment. I am bullish on both DTV and Starz.
DirecTV (DTV) is expected to report 3Q09 EPS of 39 cents on revenues of $5.42 billion. EBITDA is projected at $1.39 billion. One of the most impressive things about DTV is that the company is continuing to grow right through the recession. On a year-over-year basis, revenue is projected to be up 8.7%, EBITDA up 11.2%, and EPS up 21.2%. EPS gets an extra boost form very aggressive share buybacks that have been in place for several years.
Growth remains because DTV remains a share gainer in multichannel TV. Gross adds this quarter should again be over 1 million subscribers. Churn may tick up a few basis points but net subscriber additions will still be up by 140,000. This compares to flat to lower net adds for cable and is not far off the gains already reported by AT&T (T) and Verizon (VZ). Keep in mind that Telco TV subs number in the millions while DTV has over 18 million subscribers.
Besides the headline financial and subscriber numbers, I think the focus of the call will be on ARPU. Last quarter, DTV guided 2009 ARPU growth lower by 100 basis points (note that ARPU in 2009 is still projected to be up about 2%) and the stock traded poorly despite an otherwise good quarter. The culprit was cautious spending on extras like pay per view and premium tiers. Analysts indicate that ARPU trends have stabilized.
There will also likely be some discussion of use of free cash flow once the Liberty Media Entertainment (LMDIA) merger closes later this year. Presently, DTV is unable to buyback shares. I have every expectation that share repurchases will resume at their prior level.
A final topic that could come up on the call is DirecTV Latin America. There is speculation that the company may spin-off the fast growing division. Analysts may also question the intensifying competitive environment in Mexican multichannel TV with cable companies and Telmex battling for market share.
Disclosure: T and LMDIA are widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg’s personal accounts.

November Model Update: Mid Cap and Value Still Favored

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There are no changes to Northlake’s Market Cap and Style models for November. The Market Cap model is sending a Mid Cap signal for the second consecutive week. The Style model has a Value reading for the fifth consecutive month.
Underlying trends in the Market Cap model show a continued shift toward large cap and away from small cap. However, while leaning toward large cap, the indicators remain mixed, so the signal remains on mid cap. Two indicators moved in favor of large caps this month. Both were technical/trend indicators, reflecting the weak performance of small cap stocks last month. More detail can be found be below.
The Style model also saw two changes to underlying indicators this month, one in each direction. The valuation indicator switched from growth to value as value stock relative P-E ratios are now below average compared to growth stocks. This reflects the economic recovery and the positive impact it has on value companies that tend to be more sensitive to economic growth.
The trend indicators moved from value to growth last month. This reflects a good month for growth stocks in October. More details below on this as well.
Overall, the Market Cap ad Style models still reflect an improving economy and better investor confidence that the recovery will take hold. The models are no longer at the extreme readings from earlier this year when investor sentiment was very sour and the economy was at the depths of the recession. The result is that the models are sending somewhat mixed readings that no longer advocate for the most aggressive positioning. Client positions in the S&P 400 Mid Cap (MDY) and Russell 1000 Value (IWD) are being maintained and reflect the mixed readings.
Northlake’s models were off target in October but not all was lost. The Market Cap model moved from small cap in September to mid cap for October. This proved to be a mixed signal as the Russell 2000 (IWM) fell by 6.5% against a decline of 4.5% for the S&P 400 Mid Cap (MDY). However, mid caps still underperformed the large cap S&P 500 (SPY) in October. SPY fell just 2.0%. The Market Cap model correctly called moving away from small caps after a 13 month run but incorrectly shifted only to mid cap.
The Style model’s four month run on value still looks good. Value, as measured by the Russell 1000 Value index (IWD) has outperformed growth, as measured by the Russell 100 Growth index (IWF), by more than 1%. However, in October growth was the winner, limiting its loss to -1.3% vs. -3.2% for the S&P 500.
Mid caps and value lagged in October due to souring investor sentiment toward the economic recovery. Both strategies work better in a bullish stock market environment. The S&P 400 Mid Cap benefits from greater volatility relative to large caps and also has more exposure to economically sensitive industries like materials and energy. The Russell 1000 Value has a similarly greater exposure to economic trends with the addition of many more financial companies. Financial companies are the fulcrum of investor sentiment this market cycle due to their central role in the economic crisis.
Disclosure: MDY and IWD are widely held by clients of Northlake Capital Management, LLC. IWM and SPY are held by certain clients of Northlake as core positions. In his personal accounts, Steve Birenberg holds MDY, IWD, and SPY.