Messy Quarter But Core Growth At Discovery Warrants Patience

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Discovery Communications (DISCK) shares have traded off 5% since reporting June quarter earnings. The underlying organic growth rates were largely in line with estimates but accounting adjustments related to the company’s acquisitions in Europe earlier this year led to a reduction in net income guidance for the year and miss on reported EPS for the quarter. It is too soon to get a read on how the acquisitions will work out. They are designed to sustain the company’s growth as it enters new territories and expands the programming and channel genres it offers. The stock sold off mostly because expectations were so high. DISCK shares trade at the highest valuation among its cable TV network peers leaving little room for error. I think it makes sense to show a little patience as ultimately investors should re-focus on the company’s superior near-term and long-term growth.
This growth was evident in the just reported quarter. Adjusting for acquisitions, advertising grew 10% domestically and 21% abroad. Affiliate fees grew 5% domestically and 14% in international markets. Management suggested domestic ad growth could strengthen in the current quarter and surprisingly offered positive comments on fourth quarter ad growth. Strong ratings are a key driver of management confidence. Affiliate fee growth should pick up a little after decelerating slightly. Timing and phasing of renewals makes this line item a little trick to predict but there is little doubt growth will pick up as ratings and additional TV Everywhere rights support higher fees.
The 20% growth abroad even before the acquisitions in Europe is what really sets DISCK apart from its peers. Other network companies have similar growth but DISCK is getting almost half its revenue and 40% of its EBITDA from high growth international markets.
DISCK also has more upside from upgrading its domestic networks. The Oprah Winfrey Network is finally turning into a contributor after years of losses. Other networks like Investigation Discovery have moved from small or mid-tier contributors to full-fledged, large growth drivers.
After the pullback, DISCK shares trade about 19 times 2014 estimates. Most peers trade more like 15 times. DISCK’s growth drivers, including very aggressive share buybacks, should drive 20-30% EPS growth for the next several years, well ahead of the peers so the premium makes sense. 2015 EPS could easily exceed $5 so if the multiple just holds, which it should given the growth rate, the shares can work to $100. Those numbers explain my call for patience.
DISCK is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. DISCK is a net long position in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, consumer retail, communications, and related technologies. Steve is portfolio manager of Entermedia, owns a controlling stake in Entermedia’s investment management company, and has personal monies invested in the funds.

Qualcomm Fights Offs Bears

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After a lot of worry on the part of investors, Qualcomm (QCOM) reported solid June quarter results and provided guidance for more the same. QCOM shares have lagged in 2013 due to investor fears about a slowdown in high end smartphone demand. Despite signs of slower growth (offset by a positive surprise in iPhone volumes last quarter), QCOM hit its numbers. QCOM also is buying back its stock aggressively showing confidence in its outlook. The shares trade at just 12 times EPS estimates unadjusted for $15 per share in cash. With revenue, operating income, and EPS all set to grow at least double digits even in a tougher competitive environment, the shares look inexpensive. Apple’s next iPhone introduction could serve as a positive catalyst and allow the stock to catch up to the market’s big gains this year. A a target in the mid $70s, providing 20% upside remains realistic.
Besides just hitting numbers and guidance, upside in the quarter was driven by good pricing. With average selling prices for smartphones falling as mix shifts to low and mid-end phones in emerging markets, there is fear that QCOM’s margins will come under pressure. If this sounds familiar, it is because you hear the same thing about Apple.
I think these fears are overdone as QCOM and AAPL both showed this quarter that they can navigate moderately falling average selling prices and maintain decent margins. The next quarter or two should provide insight into whether my thesis makes proves correct. If so, upside in QCOM is substantial as the multiple expands and earnings estimates rise slightly. As with AAPL, a large share buyback, incredible financial strength, and cheap valuation provide support and set up an attractive near-term risk-reward tradeoff into new smartphone introductions this fall from Motorola (Google), Apple, and Samsung.
Qualcomm and Apple are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. Qualcomm and Apple are net long positions in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, consumer retail, communications, and related technologies. Steve is portfolio manager of Entermedia, owns a controlling stake in Entermedia’s investment management company, and has personal monies invested in the funds.

Better Quarter Clears Deck for Apple New Products

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Apple (AAPL) reported a better quarter although earnings are still down year-over-year. I expect that earnigns will turn positive again in the Decemebr quarter and growth will pick up as next year moves along, partially due to very easy comparisons beginning next spring. Renewal of earnings and product momentum is critical to get AAPL shares moving again.
The most recent quarter cleared the decks ahead of this fall’s new product launches and also contained a few pieces of good news. The summer and early fall can now play out bullish for the stock as investors can look ahead to new product introductions. Of course, those products will have to capture investor and consumer imagination. The stock has rebound over 10% in July and I think it has more upside heading into the product announcements. But I think $500 will be a topping area until we see the new products. In particular, we want to see the new high end iPhone and whether or not the the company introduces a lowe-end or mid-range smartphone for emerging markets.
In the June quarter, AAPL reported 1% revenue growth but EPS fell 20% as margins fell. One of the issues troubling AAPL shares is declining margins and fear that they could decline further if demand wanes for high end phones, pricing comes down, and the company introduces a lower margin, lower-priced phone. I have noted in the past that AAPL margins spiked way higher on introduction of the iPhone 4s. If you look at a trendline of margins it is clear that this period was unique. Margins have come down sharply since then (47% peak to 35% current). However, takeaway a couple of 4s quarters and margins have settled from the very low 40% range to the mid 30% area. The big question is what happens next. It is a tough call but I believe the street is too pessimistic. In fact, the caution now almost mirrors the optimism when the 4s performance and excitement over the iPhone 5 introduction drove the stock over $700.
Positives in the quarter included: (1) iPhone demand was well ahead of expectations at 31 million units vs. 26 million expectations, (2) margins came in at the high end of management guidance and ahead of street expectations despite lower average selling prices for iPhones as iPhone 4 and 4s drove upside in emerging markets, (3) software and services is becoming a big business, and (4) the company is very aggressively repurchasing its shares.
The big negative in the quarter was a material miss in iPad shipments. Management indicated that the comparison was tough vs. the iPad mini introduction a year ago but acceleration is necessary as iPhones alone are not enough to drive sustained long-term EPS growth.
Current consensus calls for AAPL to earn $39 in fiscal year 2013. Next year, the consensus calls for 9% growth to $42.50. Cash net of debt is $140 per share. This cash figure is unadjusted for taxes that would need to be paid on overseas repatriation. Adjusting for 100% of the cash, the shares trading are at less than 10 times for forward earnings estimates. Many hardware companies trade for similar multiples but I do not believe they have AAPL’s growth potential or financial power.
I can see the shares trading to over $600 on a little multiple expansion if AAPL gets back on an earnings growth track. Downside protection is offered by the aggressive share buyback that has shrunk shares outstanding by 3% in just six months. If Apple can just sustain 2014 projected earnings levels and uses its free cash flow to buy back stock, the company could reduce shares outstanding by 10% per year. Take into account the $140 in cash and the company could buy back all its shares just over 6 years.
The risk is that new products don’t sell well enough to drive revenue and competition drives margins significantly lower. With support from cheap valuation that seems to imply future growth will disappoint and the large share buyback, I think the current set up for the shares is favorable. Longer term the upcoming slate of products will tell the story and we will not see those for a couple of months.
Apple is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. Apple is a net long position in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, consumer retail, communications, and related technologies. Steve is portfolio manager of Entermedia, owns a controlling stake in Entermedia’s investment management company, and has personal monies invested in the funds.

Google Core Trends Intact Despite Noisy Quarter

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Google (GOOG) reported slightly disappointing second quarter earnings. Revenue of $11.1 billion was slightly less than estimates of $11.4 billion. EPS of $9.54 were materially below consensus expectations of $10.81. Given these headline numbers, GOOG shares initially traded down about 5%. However, they were down less than 2% when trading closed the day after the report and have since recovered all the lost ground.
The margin contraction was a little worse than the headlines suggested as GOOG accelerated deprecation that may have cost the company close to 50 cents a share. Other key items below the headlines include still very strong growth in searches (clicks up 23%) and ongoing pressure on search prices as more searches are on lower priced mobile platforms or in emerging markets. There is great hope that pricing improves as GOOG continues to rollout its “enhanced campaigns” that combine a mobile and desktop ad buy. Motorola continues to perform horribly and lose money but a high end phone is due to be introduced in October.
I don’t see anything that changes the core fundamental story at GOOG. Revenues continue to grow about 20% with EPS growing slightly slower as GOOG spends to defend its core search business and expand into new areas. Profit margins are the primary risk for the shares as management is content to focus on absolute profit dollars rather than margins. Given that search is always going to be the company’s highest most profitable business, margins will come down. I believe that this expectation is built into the stock which trades at a reasonable 15 times 2013 earnings adjusting for over $130 in cash on the balance sheet. In a market where most companies are growth-challenged, GOOG seems like a logical place for investors to allocate money. In fact, I think this is largely why the stock bounced back after the disappointing earnings. The reality is that GOOG still offers attractive growth at a reasonable price.
I have long held to a $925 target on GOOG based on 2013 estimates. As we look forward to 2014 and EPS over $50, I think the shares can work to over $1,000. This is not huge upside, just 10-15%. But with the market at all-time highs and most companies struggling to generate even mid-single digit revenue growth, I think GOOG’s relative attractiveness remains high. After the move up from the mid-$600s, GOOG shares are no longer a screaming buy but offer enough upside to warrant maintaining as a core position in Northlake client portfolios.
Google is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. Google is a net long positions in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, consumer retail, communications, and related technologies. Steve is portfolio manager of Entermedia, owns a controlling stake in Entermedia’s investment management company, and has personal monies invested in the funds.

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Comcast Attractive While The Rest of Cable Engulfed in Merger Rumors

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Despite merger and acquisition rumors popping up all around the cable and satellite industry, Comcast CMCSK) shares have not moved higher. This makes sense since Comcast is by far the biggest company in U.S. pay TV industry with 25 million subscribers. Charter Communications, now 25% owned by cable industry pioneer John Malone’s Liberty Media (LMCA) has just 4 million subscribers. Charter is hoping to buy Time Warner Cable, the second largest cable company, with 10 million subscribers. The combination of Malone’s return and his bullish outlook for cable broadband and the possibility of acquisitions at premium prices suggest the value of a cable subscriber has moved up considerably. While Comcast will not be sold and is unlikely to buy other cable systems, all the activity in the industry does give a boost to the value of its subscribers and, in turn, its stock price. Add in early signs of turnaround at Comcast-owned NBC, steady growth in NBC Universal cable networks and theme parks, continued mid-single digit growth in Comcast’s core cable TV and broadband business and Comcast shares look like they have at least 20% upside.
Comcast generates about 80% of its operating cash flow from cable and 20% from NBC Universal. Other pure play cable stocks are trading at 8-9 times EBITDA in the current rumor-friendly environment. Assets similar to NBC Universal’s stable of cable TV networks and theme parks trade at more than 10 times EBITDA. However, at $38, Comcast shares trade at less than 6.5 times EBITDA. Again, Comcast assets should not be valued at acquisition inflated premiums but somewhat higher valuations seem warranted. At a blended multiple of 8 times 2014 EBITDA, Comcast would trade at $60, a full 50% above the price Northlake clients bought in June. At 7 times EBITDA, Comcast would trade just over $50, still 30% above Northlake’s recent purchase.
One final support for higher prices for Comcast shares is the company’s excellent balance sheet and free cash flow. Comcast is projected to end 2013 with debt at just a little over 2 times EBITDA. This is a very healthy balance sheet indicative of investment grade ratings. Free cash flow should be comfortably over $3 per share in 2013, giving the shares a free cash flow yield of over 8%. Comcast is using its free cash flow to aggressive buy its own shares and pay a healthy dividend. Shares outstanding are falling by over 2% per year providing further support for forward valuation of Comcast shares. Modest dividend increases can also be expected each year on top of the present current yield of almost 2%.
CMCSK is widely owned by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Regulatory filings can be found at www.sec.gov. CMCSK is a net long position in the Entermedia Funds. Entermedia is a long/short equity hedge fund focusing on media, entertainment, leisure, communications, and related technologies. Steve is portfolio manager of Entermedia, owns a controlling stake in Entermedia’s investment management company, and has personal monies invested in the Entermedia Funds.

Mid Cap and Value Remain the Favored Themes for July

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There were no changes to Northlake’s Market Cap and Style model for July. The Market Cap model continues to recommend Mid Cap (MDY) and the Style model still favors Value (IWD). As a result of the new signals, client assets invested with the models will continue to maintain holdings in MDY and IWD.
The indicators underlying the Market Cap model were pretty stable for July. Only trend and technical indicators had new signals including Advisory Service Sentiment, NYSE Breadth, and the momentum indicators.
Advisory Service Sentiment moved from a neutral reading to favoring large cap as the percentage of bulls declined sharply. This indicator is designed to capture trend changes. The recent drop in bulls from an extreme triggered a shift toward the presumably safer large caps.
Another trend indicator, NYSE Breadth also moved in favor large caps. This indicator measures advancing vs. declining issues based on monthly averages. The decline in the market since the mid-May all-time high indicates a degree of caution is warranted. As a result, the less volatile large caps are now favored.
The momentum indicators use shorter time horizons with emphasis on the last six months. Since small caps did pretty well in this period this indicator actually moved in favor of small caps, somewhat balancing out the other trend and technical indicators and leaving the Market Cap signal unchanged at Mid Cap.
There was minimal movement in the Style indicators wit the only change being a shift in the insider activity from value to neutral. This indicator measures insider trading activity among company management and Board of Directors. The value signal that has been in place now for five months has weakened a little but barring a major change I anticipate it holds for at least another month.
With another quarter in the books, it is time to look at the latest quarter and year-to-date performance of the models. Overall, the results are mixed to slightly negative with good results in the Style model unable to overcome poor performance by the Market Cap model.
In the latest quarter, the Style model gained over 3.2% vs. a gain of 2.3% for the S&P 500. The model spent the entire quarter on a value signal, which proved accurate. Year-to-date, the Style model is up over 15.3%, compared 12.6% for the S&P 500. The model has been in value all year except for February when it shifted to growth.
Unfortunately, the Market Cap model was well off target in the second quarter producing a loss of approximately -1.2%. The model favored small cap in April and mid cap in May and June. In each month, the signal was incorrect, favoring the weakest of the three options (small, mid, large). Adding this poor performance to an average result for the Market Cap model in the first, quarter, on a year-to-date basis, the model is lagging the S&P 500, gaining just under 9% vs. the 12.3% gain for the benchmark.
The unusually high volatility in signals emanating from the Market Cap model vs. the stability in the Style model might be instructive. I believe the Market Cap volatility shows confusion in an environment where markets are volatile and economic data are mixed. Both models are constructed using the same theory, so I have every reason to believe that the Market Cap model will prove accurate once again, especially if the slowly improving U.S economy can be maintained as the Federal Reserve begins to back off its most aggressive monetary policy.
MDY and IWD are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Regulatory filings can be found at www.sec.gov.