Disney Quarter Shows Stability But No Improvement

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Disney’s (DIS) third-quarter 2009 report looked a lot like its second-quarter 2009 report. Trends remain weak but are not getting any worse. EPS beat by a penny while revenue fell slightly short of expectations. The revenue miss led to CNBC headlines and a post-report sell-off in the shares, but the miss appears to emanate from the impossible-to-model studio entertainment segment and greater-than-expected revenue deferrals at ESPN that will be recovered in the next two quarters.
Advertising at ESPN was down close to 10%, a little worse than expected and lagging the figures posted by Time Warner (TWX) and Viacom (VIA) . But this was not unexpected given ESPN’s greater exposure to auto advertising. A mid-single-digit decline at ABC and an upper 20% decline for the local TV stations were as expected and almost identical to advertising trends in the March quarter.
Theme parks offered a mixed picture. Good cost controls and promotions that drove attendance and helped cover high fixed costs allowed margin performance to improve sequentially. Bookings, however, weakened slightly with the December quarter looking down 7%.
Overall, Disney’s results are similar to those reported by Viacom and Time Warner earlier this week. Business trends are stabilizing but not improving and visibility remains low.
All three stocks have rallied sharply with the market and the rest of the media stocks. Like its two peers, I expect Disney shares will sell-off slightly in response to its earnings report. The problem is not with the quarter, which has no major issue. The problem is the stock’s rally reflects more than stabilization of weak trends. More signs of improvement are needed to drive the shares higher.
Unlike some others I am not willing to pay a big premium for Disney compared to the other big entertainment conglomerates. The company has unique assets and is well-managed, but the gap is closing as other companies, particularly Time Warner, improve their asset mix and operations. In addition, Disney remains more cyclical than its peers while business trends are doing nothing more than bumping along the bottom.
As with Viacom and Time Warner, I have no argument if you want to own Disney to play an improved economic outlook and operating leverage from cost-cutting. For now, though, the easy money has been made.

Good Quarter at Time Warner Goes Unrewarded

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Time Warner reported a good 3Q09, beating expectations on most key metrics. EPS of 45 cents exceeded the consensus estimate of 37 cents. Revenues of $6.81 billion fell slightly short of consensus for $6.97. EBITDA was down just 2%, far ahead of expectations for a drop of 11-14%.
The upside came in Networks and Filmed Entertainment which are the core businesses of the slimmed down Time Warner. Networks upside came in margins as EBITDA grew 14% against an as expected 5% gain in revenues. Tight expense management including only a modest increase in programming costs drove the EBITDA gain. Total advertising in Networks fell 3%, a little better than expected. TNT and TBS appear to have had positive advertising growth offset by negative growth at CNN which is lacking Presidential election related advertising this year.
Filmed Entertainment reported 34% EBITDA growth against expectations ranging to 20% declines once again revealing the hopeless nature of modeling film studio profitability. The upside came form the phenomenal success of The Hangover, lower than expected print and advertising expenses, a $40 million favorable reversal related to home video catalogue sales, and ongoing cost reduction initiatives. Warner Brothers seems to have taken major strides toward more consistent film profitability a la Disney and News Corporation.
Publishing and AOL were both down over 20% in revenues with EBITDA declines of 46% and 23%, respectively. About the only good thing that can be said regarding these segments is that year over year declines are stabilizing. AOL also had a better than expected margin performance.
Similar to Viacom yesterday, TWX shares initially bounced higher on the good results but then gave back the gains. The combination of these two reports suggests a stabilized but not yet improving ad environment. On 1Q calls, stating that the worst was over for advertising was good enough to power the stocks. Now that the stocks have rallied sharply, investors need improvement not stability. As a result, we are getting sellers even as numbers and commentary are good and constructive. Basically, as noted in the preview, the bar was set very high leaving near-term trading skewed toward sell the news.
Next up is Disney after the close on Thursday. I expect more of the same although investors tend to follow Disney’s lead more so than the other major entertainment companies.

Viacom’s Sequential Improvement in Advertising is Bullish

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Viacom reported mixed 2Q09 results with adjusted EPS of 49 cents matching expectations on $3.3 billion in revenues, which were $200 million light of expectations. The revenue shortfall came from the Paramount movie studio and Rock Band which are less important aspects of the Viacom story. The company’s cable TV networks performed well in the quarter, showing sequential improvement from 1Q on domestic ad trends and operating margins. Headline revenue of -14%, operating income of -22%, and EPS of -23% certainly remain weak but the sequential improvements at the cable nets will likely carry the day.
Domestic advertising was -6% in 2Q, better than expectations of -7% to -9%, and a 300 basis point improvement from 1Q09’s -9%. While previously declining ratings stabilized in 2Q, it is not clear if the sequential improvement in advertising was Viacom closing the gap with its peers or a general improvement in market conditions. Viacom had been underperforming peers by 300-900 basis points over the past several quarters.
Management stated that if Rock Band video game is backed out of Media Networks, the margin on the cable nets improved by 100 basis points sequentially. This is also a positive for Viacom as it has spend heavily to improve ratings at its cable networks.
Despite greater than expected weakness at Rock Band and Paramount, this quarter is a win for Viacom shares as trends in cable networks is what matters.
As far as read through to other cable networks, Viacom’s results are promising but we won’t really know for sure until we get Time Warner’s results on Wednesday morning. I suspect that we will learn that cable nets as a group held up better than expected in 2Q but that some of Viacom’s games were closing its underperformance gap. Management comments that it completed its upfront at acceptable pricing and volume and that the scatter ad market strengthened in June and into July are hopeful signs for cable network industry.
I have no issue with those who want to play an advertising recovery via Viacom. However, I prefer the greater operating leverage at CBS and the higher growth and superior, non-fiction focused business model of Discovery Communications.
Disclosure: CBS and Discovery Communications are widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg’s personal accounts.

Solid Results From AT&T Should Sustain Improved Investor Sentiment

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In response to solid 2Q09 earnings, AT&T shares are breaking out of a multi-month funk where they sharply lagged the market and peer Verizon. The results were at the high end of expectations and contained no major negative surprises. The stage is set for a better second half and 2010 as the economy stabilizes and improves and iPhone dilution wanes. The shares have been disappointing since I purchased them for Northlake clients late last year but I remain confident the stock can work its way to the low $30s in the next 6 to 9 months. Combine with a 6.7% dividend the total return potential is good. I also think this quarter provides a floor on the stock where it should hold up better than the market in the event recent market gains reverse.
The big news in the quarter was the continued positive impact of AT&T’s exclusive iPhone deal. Wireless subscriber growth exceeded expectations and despite the downward pressure this places on margins due to phone subsidies, profitability held up better than expected. Strong growth in data revenues and low churn strongly suggest that as iPhone activations plateau, AT&T’s profits in wireless will spike higher. This sets the stage for a resumption of earnings growth in 2010.
Another positive in the quarter was signs that the steady deterioration in consumer wireline was stabilizing. Make no mistake, this business is in a long-term state of decline but access line losses were not quite as bad as feared. Couple this with growth in U-Verse TV and broadband and the shrinking mix of consumer wireline and the drag on overall growth is lessening.
The one negative in the quarter was that Enterprise revenues dropped more than expected. Along with fears of iPhone dilution, Enterprise had been the big factor causing the stock to lag. There really is no good news here and won’t be until the economy picks up and corporate spending reins are loosened.
The balance sheet and cash flow look a bit better than expected as capital spending was light in the quarter. The first half spending pace is below guidance but that could be a timing difference.
Overall, AT&T reported a solid quarter that revealed better times ahead. The stock is bouncing off recently depressed levels. I think there is more upside to come as investor psychology on AT&T shifts to better growth in 2010 and beyond as wireless becomes the dominant factor and the economy improves.
The big risk in the stock is the cost of maintaining the exclusive iPhone relationship. Apple is in a very strong bargaining position given the huge popularity of the iPhone and ongoing complaints about AT&T’s network quality. I think this likely to be a 2010 worry more than 2009 but it definitely places downward pressure on AT&T’s valuation all else equal.
Disclosure: AT&T and Apple are widely held by clients of Northlake Capital Management, including in Steve Birenberg’s personal accounts.

Apple Scores Again with Big Quarter and Good Guidance

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Apple reported another great quarter with Mac and iPhone unit sales exceeding expectations and gross margins coming in well ahead of the most bullish estimate. The stock has come a long way and may stall after this morning’s pop but I think over the balance of this year the stock can move to $180 to $200 assuming the economy and market pose no major obstacles. Analysts are effusive in their praise today and most have raised earnings estimates and price targets. All good but keep in mind universal praise often means in the short-term the good news is priced in.
Last night a good friend and hedge manager who has made money shorting Apple in trades asked me why the stock was up 5% after hours and how the stock could go straight up this year without a 20% correction. I should point out my friend covered his latest short yesterday at a profit before the earnings report. Here was my reply:

Apple soared because of guidance on gross margins reported. Guidance was almost equal to current consensus. For Apple that is an upside surprise. I read today that one analyst calculated that over the last 12 quarters the average EPS guidance was 12% below then current consensus. Furthermore, I read that some people though they might guide as low $1.00 yet they guided to $1.20.
Also, inventories look low, very low, which means that predictability on the quarter is high as channels rebuild.
Finally, gross margin came in at 36.3% despite rising commodity costs. And guidance is for 34% despite even higher commodity costs. Commodity costs were a major worry.
Macs were firm and showed great elasticity to the price drops especially the laptops. That had been another worry.
But the iPhone is amazing. Revenues of $1.7 billion this quarter and clearly they are driving gross margins. That biz had just $400 million in revenue in the year ago quarter. Growth like that is impossible to come by and that is why the stock keeps going up. Plus Apple has absolutely superb operating execution every quarter.
Cash is now $34 per share and earning virtually nothing, less than 15 cents this year. EPS in 2010 are probably gonna be north of $7.00 so you got a $125 stock which is less than 20 times. Not cheap but not outrageous in a growth starved market.
Something new is going to have to pop up to trip it 20%. The economy has not hurt as badly as feared, the Jobs factor is less, Macs are still gaining share, and the iPhone is on fire. Besides another leg down in the economy or a market crash, tell me the new thing that is going to hit for 20%. I don’t see it at least for the next 3-6 months.

After the report and during the conference call, I provided live commentary of my thoughts via Twitter. Here is recap of my tweets:

Big gross margin drives AAPL well above consensus EPS. Guidance closer to analyst estimates than usual which should be a positive.
One question for APPL is Receivables, which are up a lot. Probably late in qtr iPhone 3Gs shipments but worth asking.
AAPL inventories look low which should create confidence in Sept qtr guidance/estimates and may explain stronger than usual guidance.
Product/Segment breakdown for AAPL has no surprises. Big units for laptops with $100 sequential decline in ASP means price cuts working.
No Steve Jobs on the AAPL call unless he makes an unannounced appearance.
Good question and better than usual guidance leads to routine conference call for AAPL so far. Now up $7 from NY close! IMO, well deserved.
Good question from AAPL analyst: Given locked in deferred revenue why isn’t sequential guidance stronger than usual? Answer: less Macs due to recent refresh.
Another good Q for AAPL: Mac elasticity? Answer: admit price cuts helped on MacBook Pro but no change to LT view of price/value for Macs.
iPhone boosting AAPL gross margin reversing gross margin worries from a year ago and cushioning currently rising commodity costs.

Apple Quarterly Earnings Preview

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My friend and RealMoney.com colleague, Jordan Kahn, wrote the following preview of Apple’s June quarter earnings which are due to be reported after the close tonight. Please check out Jordan’s blog “In The Money” for more of his always excellent commentary.
I’d preface Jordan’s comments by noting that the estimates and stock price targets for Apple have been rising along with the stock for the past month. This has raised the expectations bar as far as the immediate reaction in the stock after earnings are reported. As Jordan notes, guidance commentary is key, especially in lieu of the weak economy and premium price points on Apple products. In the long run, I think Apple still has substantial upside as there is plenty of market share still to be gained in Macs and iPhones and I expect both product lines to be expanded/refreshed regularly along with an eventual move into something akin to the currently popular netbooks. Adjusted for $32 cash on the balance sheet (producing just 20 cents if EPS), the stock is reasonably priced at 19 times 2010 consensus estimates which are probably conservative. Enough of me, here is Jordan’s very well informed and insightful preview:
Apple (AAPL) will report earnings after the close on Tuesday. Consensus estimates are for EPS of $1.18 on revenue of $8.25 billion (according to Reuters). Apple has a long, long history of topping consensus estimates, so that is not really the question here. Whisper numbers are already in the low $1.20s. The key to the stock in the days ahead is guidance — namely, how conservative management is with September guidance.
Piper Jaffray looked at the last 12 quarters and calculated that Apple management has, on average, guided forward EPS estimates 12% below Street expectations. Right now, the Street has next quarter’s EPS number at $1.29, and many analysts think guidance could come in the range of $1.00 to $1.10. So watch this number as a key driver (I know it’s a silly game of underpromising and overdelivering, but I don’t get to make the rules.)
The company launched its third generation iPhone 3GS in June, which was met with very strong demand. Apple also cut the price of the old 3G iPhone to $99, which likely spurred demand for folks who have been waiting for a better price entry into the smartphone market. The company also lowered prices on refreshed Mac laptops. So unit sales for these categories should be good, and we will have to see if the company had to sacrifice margins. Gross-margin guidance from last quarter was 33%.
Other keys to the call will include the following:
* can iPhone units sold top the 5 million whisper number?
* can Mac shipments hit the high end of 2.3 million to 2.5 million units?
* update on iPhone release in China (and other foreign markets);
* comments on any upcoming iPod line-up refresh;
* comments on rumors of an upcoming “tablet” launch;
* update on Steve Jobs’ status (will he get on the conference call?); and
* again, guidance — how conservative will management be ahead of the back-to-school period?
Although most of the hype surrounds the iPhone, don’t forget that the biggest driver of earnings is still Mac sales. There has been chatter that the shipping delays on the online store for Macs augurs well for demand currently outstripping supply, but expect Apple to ramp-up its builds over the next quarter.

Barron’s Boosts Media Stocks Ahead of Earnings

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Earnings season for media stocks begins in earnest next week but there is still news flow that is impacting the stocks.
Media stocks soared on Monday after leading last week’s rally. Monday’s move was the result of a bullish cover story (subscription required) on the sector in Barron’s. The author, Michael Santoli, essentially reiterated my view that TV and movie related media stocks are too cheap given that changes in the TV business are happening more gradually than conventional wisdom. Investors are extrapolating cyclical issues to an accelerated secular decline in industry profitability. I do not deny that secular challenges exist but TV and movies are not the same as newspapers, radio and music it is the implosion of those businesses that have investors on edge toward all media. Major media companies will grow again with significant earnings and cash flow upside in the early part of the economic cycle thanks to material and permanent cost cuts in response to the current crisis. Stock prices assume no or negative growth creating an opportunity for investors in media stocks.
After it appeared that the upfront might break, it appears that negotiations have again stalled. The broadcast networks continue to hold for flat to low single digit pricing declines, while media buyers want upper single digit declines. The bid-ask spread has narrowed but no meaningful business is being written by broadcasters. There are some signs of thaw in the cable network upfront but not enough to gauge pricing and volume trends. The longer the upfront drags on, the more pressure on media stocks as estimate risk for 4Q09 and 1H10 rises. The stalled upfront becomes a problem for the stocks if investor sentiment toward the economy sours again.
I have been a little surprised that cable stocks have not performed better since Cablevision’s early July win at the Supreme Court in the Network DVR case. This is a clear positive for the group as it should lead to lower capital expenditures, fewer truck rolls and operating expense savings, and higher free cash flow. Investors appear worried about weak 2Q subscriber trends as little help is expected from the digital transition. In addition, over the top video and cord cutting remain a big concern.
Finally, news broke last week that Disney had reached agreement on expansion of Hong Kong Disneyland. Three new gates accompanying 30 attractions are on the way and should help to better position the park which many have felt was too small. Disney will invest $465 million and convert its current debt in the park to equity. While this news could be a financial positive for Disney in several years if park attendance and spending climb, I think the better news is that it clears the way for a deal on a park in mainland China near Shanghai. A Shanghai park would probably not make the same mistakes as Hong Kong and could be a real boon to Disney directly and its attempts to more broadly build its brands and characters in China. I remain on the sidelines in Disney, especially not that I have added cyclical media exposure though CBS. I can see a bullish opportunity coming for Disney, however, as 2010 should see a return of the content generation engine led by the return of Toy Story. A cyclical improvement in advertising and theme parks would also help.

Upfront Trying to Break Which Would Help Media Stocks

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The following commentary first appeared in the “Dow of Steve” blog on SNL Kagan’s subscription website on July 1, 2009.
There were signs in last that the upfront market was finally beginning to move although few if any deals have been struck between broadcast networks and advertisers. Experienced observers can point to only one other instance of the market breaking so late and rumblings about a haphazard, last minute ad marketplace that serves advertisers and networks poorly are growing. [UPDATE: The upfront stalled again after the July 4th holiday though the bid-ask spread on advertising has narrowed]
The stand-off appears to relate primarily to advertiser demands for double digit cuts in ad pricing based on CPMs. The news last week was that broadcast networks were close to deals ranging from upper single digit CPM declines for NBC, the weakest network, to low single digit declines for industry leader CBS.
If this pricing holds the upfront could prove better than expected for broadcast and cable networks but pricing is only part of the equation. Broadcast networks will also take a hit from lower rating guarantees and are almost certain to sell less inventory than they did a year ago. With so many prognosticators believing the economy will begin to recover and grow again this summer and fall, networks seem willing to gamble that scatter pricing during the TV season will be far better than what can be negotiated now in the upfront.
Overall, if last week’s reports are accurate broadcast networks may be able to exceed the -15% overall upfront decline that many Wall Street analysts have been expecting. This would be good news for the stocks of the network owners including CBS, Disney (ABC), News Corporation (FOX), and General Electric (NBC).
The cable network upfront usually breaks after the broadcast networks so if broadcast networks can limit the decline, it is likely that cable nets, which generally enjoy stronger ratings, will be able to limit year-over-year declines to low to mid-single digits. This would be a win for cable networks stocks including Discovery Communications and Scripps Interactive, whose networks should be among the best performers. The big conglomerates also will have pockets of strength including Fox News for News Corporation.
While the latest news makes sense, the late breaking upfront still leaves the risk that that a scramble to sell most of the ad inventory right before the new TV season starts is going to create inventory management problems for networks and advertisers.
It is funny but with all the talk of eliminating the upfront it just might be the current economic crisis that kills it or alters it significantly. After all, the upfront is based on analog TV economics that is still being used in a digital world. NBC already claims to have opted of the upfront with the changes it made last year. Could it be that a very late breaking market in 2009 effectively ends the upfront as we know it?
Should the theme that 2009 represents the end of the upfront as we know it, it would be a negative for TV network offsetting the possibility that the upfront itself is not as bad a as feared. I suspect that networks and advertisers can make the transition but Wall Street abhors uncertainty. For the networks the uncertainty is heightened because even though cancellation options exist, selling much of your inventory up to a year in advance provides a degree of predictability in financial results and business operations.
Disclosure: Discovery Communications is widely held by clients of Northlake Capital Management including in Steve Birenberg’s personal accounts. A handful of clients of Northlake Capital Management hold positions in General Electric.

CBS: New Buy For Cyclical Upturn as Balance Sheet Concerns Ease

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I purchased CBS for most Northlake clients on July 7th. The stock has pulled back by 33% off its recovery high leaving it at a point where I think the risk-reward tradeoff is favorable. I can easily construct a scenario where the stock moves from $6 to $9 assuming that advertising trends begin to improve and turn positive late this year or early in 2010. If I am wrong and advertising trends remain negative, I think downside is contained at $4.50 setting up $3 of upside against $1.50 of downside.
CBS is highly leveraged to the economy due to the fact that 70% of its revenue comes from advertising. TV is the largest business segment along with significant exposure to Radio and Outdoor Advertising. The purchase of CBS is consistent with my view that the economy has bottomed and will show sustained improvement later this year.
Obviously, the cyclical exposure adds risk to CBS. Other media conglomerates such as Time Warner, which I recently sold, receive 20-30% of their revenue from advertising. The reason why I am willing to take the added risk in CBS is that the company has effectively used the easing of credit conditions to refinance the balance sheet and eliminate near-term maturities. This should prevent the stock from revisiting its lows even if the economy and advertising fail to recover.
The upside in CBS comes from the fact that a recovery in revenues and operating margins creates substantial earnings power. Even if margins recover to a level well below the 2007/2008 peak, the stock will be trading at one of the lowest P-E multiples among major media stocks.
A final point in favor of CBS is that the CBS TV Network is coming off a very good season. CBS was the only broadcast network to maintain ratings. This leaves the company is good position for the late-breaking upfront ad sales market. I suspect that CBS may be able to limit its upfront price decline to low single digits, far better than ABC, NBC, or FOX. If ratings hold early next TV season, overall ad sales could end up flat or even up slightly once the balance of inventory is sold in the scatter market. This outlook is contingent on decent ratings and a better economy and advertising environment but that is the reason to own CBS.
Beyond the cyclical risks, CBS faces two other unique challenges. First, Sumner Redstone’s control of the company creates corporate governance issues which are exacerbated by pressure on his personal finances. Second, the company has made a few expensive acquisitions to expand its online presence. I think CBS overpaid for CNET and LastFM but the problem is more investor perception than financial. CBS CEO Leslie Moonves is widely respected as perhaps the top executive in Hollywood providing comfort that the acquisitions are either going to work out better than expected or are just a misstep that will not be repeated.

July 2009 Model Signals: A Shift to Value

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For the first time since February, there has been a change on Northlake’s Core and Explore ETF models. The Style model has moved to Value after spending 5 months at Growth. The new Value signal is weak, just barley in Value territory on Northlake’s 0 to 100 scale. However, five of the nine underlying indicators now favor value and a sixth is rated neutral. The trend toward value has been in place for several months so this move comes as little surprise.
As a result of the new signal, all client positions in the Russell 1000 Growth (IWF) were swapped into the Russell 1000 Value (IWD). The effect on client portfolios is to shift exposure from technology, health care and consumer sectors to financial services, utility, and energy sectors. The shift is anticipating a second half recovery in the economy that favorably impacts the more cyclical parts of the economy.
The Growth signal since the beginning of February was very accurate and contributed favorably to client portfolio performance. While clients owned IWF, it gained almost 19% against an increase of less than 12% for the IWD. This is exactly how the model is supposed to function – capturing incremental performance in a major trend.
There was no change to the signal from Northlake’s Market Cap model. It remains firmly in small cap territory although the signal has weakened slightly for two consecutive months. The small cap signal also anticipates better times ahead for the economy and continued improvement in credit market conditions.
Small caps, as represented by client exposure to the Russell 2000 (IWM) outperformed the S&P 500 in June for the second consecutive month. SO far in 2009, the Russell 2000 is up 3.6% vs. a gain of 2.5% for the S&P 500. Thus, the Market Cap model has done its job this year. The small cap signal has been in place since September 2008. During that time, small caps have lagged large caps by a little less than 2%. The small cap signal was early in anticipating an improved economic and stock market environment. Performance especially suffered during the initial portion of the market crash in the final quarter of 2008.
Disclosure: IWD and IWM are widely held by clients of Northlake Capital Management including in Steve Birenberg’s personal accounts.