Sticking with CBS as Long-Term Growth Confidence Improves

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CBS reported better than expected results for 2Q16, beating consensus estimates on both revenue and EPS.  The upside came from the sales of owned content, especially the Star Trek to Netflix.  Advertising growth at the CBS TV Network grew 2%, slightly below expectations for 3% growth.  Wall Street is focusing on the advertising shortfall and the shares are about 3% lower as we write this update.  Media shares have rallied this year on the back of a surprisingly strong advertising market for national TV.  Recently, concern has arisen that the second half of the year would see decelerating growth despite a strong upfront for the fall TV season.  Continued ratings erosion for most major TV networks is exacerbating the worry about advertising.  CBS shares seem to be taking a hit as renewed worries arise about the long-term health of the TV network business model.

Northlake shares the secular concerns but believes they will play out slower than bearish investors anticipate. CBS remains the best positioned TV network company for the more challenging environment given that it has only one major network that will be included in all bundles, whether they skinny and offered by cable and satellite companies or new OTT providers.  In addition, CBS appears to have a good start on its own OTT services.  With the earnings report, the company announced it had about 1 million subscribers for each of its Showtime and CBS All Access services.  This gives confidence to management’s long-term view that these businesses can produce $800 million in high margin revenue.

Future growth will also be driven by continued gains in retransmission fees earned from cable, satellite, telco, other non-CBS OTT services, and local affiliates.  This revenue is very predictable and does not face risk similar to those of cable TV networks owned by most of CBS’s peers.

If retrans grows from $1B in 2016 to $2.5B in 2020 and the new OTT services reach $800 million in the same years, CBS can still grow operating income even if advertising flat lines.  Share buybacks will leverage the operating income growth into faster EPS growth.  Divestiture of the radio business later this year will also enable a large share buyback.  Management showed its confidence in the outlook by announcing a 20% dividend increase a new $6 billion share buyback.

In our view, today’s decline in the shares is not warranted.  We think CBS can trade into the low to mid $60s based on 15X 2017 estimated EPS.

One thing to keep an eye on is whether CBS is merged with Viacom.  This possibility exists because Sumner Redstone controls both companies and is involved in several lawsuits as he attempts to exert his control over a very weakly performing Viacom.  We have mixed feelings on the advisability of CBS taking over Viacom.

CBS 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.  CBS is a net long position in the Entermedia Funds.  Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.

 

Catch up Move Coming in Google After Good Quarter

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Google (GOOG/GOOGL) reported better than expected 2Q16 results.  Revenues grew 2% on a currency neutral basis, the best in four years, and several hundred basis points ahead of Wall Street expectations.  EPS also surprised to the upside at $8.42 against expectations for $8.09 as tighter cost controls continue to be evident since the arrival of the CFO about a year ago.  Mobile now represents over half of revenue and it appears that the shift to mobile maybe poised to accelerate financial results much as it has for Facebook over the past year.  This should prove satisfying to investors and sets up GOOG/GOOGL to play some catch up after the shares were down a few percent so far this year heading into the earnings print.

Mobile has had a mixed impact on Google’s financials so far.  In the core search business, mobile has kept searches or paid clicks growing at a very high rate.  However, pricing for mobile search ads has been well below desktop liming the upside from growth in searches.  It appears that mobile pricing may be improving.  If so, Google should be able to sustain its overall growth rate even as comparisons stiffen as benefits form adding a fourth paid search link to mobile searches is lapped.

Google is not sitting still and is always tweaking its search business to sustain growth.  There has been some movement to add new types of text ads or additional ad links in certain verticals recently.  These changes are likely to help sustain momentum beyond improved mobile ad pricing.

Besides tougher comps, other investor worries at Google include higher traffic acquisition costs and continued losses at its Other Bets.  We like it when good stocks face some concerns as it keeps in place the proverbial wall of worry that leaves expectations in check.  In turn, that keeps the stock price at a reasonable valuation.

Strong fundamentals and the wall of worry are in place for GOOG/GOOGL and the stock remains very attractive.  2Q16 results increase confidence that 2017 EPS can grow nearly 20% to over $40.00.  GOOG/GOOGL today trades at only 20 times earnings giving no benefit to nearly $100 in cash on the balance sheet net of debt.  The company just completed a meaningful share buyback and additional return of cash to shareholders should be announced later this year.  When companies spend cash to benefit shareholders at least some credit for balance sheet cash should be given.  We think the shares can reach $850 this year based on 20 times next year’s earnings plus credit for half the cash.  If growth holds in 2017 as we expect, the stock can move even higher by this time next year.  We are sticking with GOOG/GOOGL for Northlake clients.

GOOG and GOOGL 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.  GOOG and GOOGL are net long positions in the Entermedia Funds.  Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.

 

 

 

Another Blowout Quarter for Facebook

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Facebook (FB) reported another strong quarter with EPS reaching 97 cents against estimates of 81 cents.  Revenue surprised to the upside by over $400mm, driving operating leverage as margins expanded by more almost 500 basis points.  User metrics were a little better than expected with daily and monthly active users still growing.  Given that 1.7 billion people are using FB at some point each month, maintaining user growth is impressive.  Ad revenue grew 63%, and acceleration from the last couple of quarter’s incredibly high rates. The big beat on EPS flows through to 2016 and 2017 estimates.  Next year should be comfortably north of $5.00, which leaves FB shares at a reasonable P-E of less than 25X even if growth slows to a range of 30-40%.  Northlake is sticking with its long positions in FB and looking for the shares to trade north of $150, maybe well north, in the next 12-18 months.

FB and GOOG are dominating internet advertising with about the only proven advertising models as far as return on investment for advertisers.  These two companies are akin to ABC, CBS, and NBC back before FOX and cable TV.  Massive reach and arguably the only way to reach a certain audiences gives them unusual power to drive ad revenues.  FB’s competitive position is further enhanced by its ability to narrowly target ads to specific demographics.  The recent shift toward video on FB should also drive growth as a new area for volume and at the typical higher CPMs for video ads.  Put it all together and you have user growth, new advertisers, larger ad budgets form existing advertisers, and rising CPMs.   Instagram is still ramping and while not yet being monetized What’s App and Messenger are massing user growth.

One area we think the street may be under appreciating is the potential for margin expansion.  58% operating margins are already quite high but given economies of scale and expense growth related to businesses that are not yet being monetized, further operating leverage could be material.

Put it all together and FB should sustain 40% growth in 2017 making the P-E of less than 25X quite attractive.

Areas of risk to watch include slowing engagement with the core platform among millennials given the rise of Snapchat, flattening ad loads as the company works to keep the services clean and not alienating users, and the inevitable tough comps especially as 4Q approaches when growth in 2015 picked up to 55-60%.

Concerns about FB being in a period of “peak growth” caused the stock to give up its initial gains as Wall Street is all about momentum these days.  Northlake is wary of slowing growth as we have seen that stall performance of other stocks but out time horizon is more than a days or weeks and FB remains in a dominant position.

FB 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.  FB is a net long position in the Entermedia Funds.  Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.

 

About The Death of Cable…Comcast Proving Otherwise

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It seems like everywhere you turn there is talk about cord cutting and cable losing subscribers.  Well, guess what?  For now at least, the narrative is false, especially at Comcast.  Comcast lost just 4,000 video subs in the seasonally weak second quarter against expectations for a loss of 31,000.  This was the best second quarter subscriber performance in 10 years.  In the last 12 months, Comcast has GAINED 90,000 video subscribers.  What the press and many industry commentators are missing is that the cable industry, led by Comcast, is gaining market share in video from satellite and telco competitors.  Furthermore, recently, it appears the two major OTT competitors, Netflix and Sling TV, are seeing much slower subscriber growth.  Finally, the overall rate of decline for video subscribers is not accelerating over the past few quarters.  This leaves cable in much better shape than generally perceived, something evident in Comcast shares trading at all-time highs, up 20% this year.  Long-term risks exist but for now, Comcast, leading with its best in class X1 set top box software, is growing revenue and cash flow from video.  The company is also investing heavily in customer service and reports that all key customer service metrics regarding incoming calls are improving.

With video growing slowly, Comcast is able to grow the overall cable business at mid to upper single digit rates.  Broadband subscribers grew by over 200,000 in the second quarter, ahead of expectations and the highest growth rate in 8 years.  Commercial revenues from sales to small and mid-size businesses grew 17% in the second quarter and now represent more than 10% of cable segment sales.  At that size and growth rate, the supposedly endangered cable industry starts with 1.7% positive growth before the residential business is even considered.

Comcast’s other large business is NBC Universal.  Results there were mixed in the quarter.  The NBC broadcast network performed well as did theme parks.  Cable networks were mixed and filmed entertainment took a big step lower against impossible comparisons from last year’s release of Jurassic World and Furious 7.  Theme parks are undoubtedly a growth business and NBC is enjoying a turnaround.

There are long-term challenges to TV networks so when valuing Comcast, we place a conservative valuation on NBC Universal and back into the implied valuation of the cable business.  Presently, that suggests, cable is being valued at about 7X EBITDA.  This strikes us as inexpensive for mid to uppers single digit growth in a 100% domestic business.  Furthermore, Comcast remains very strongly financially with debt to EBITDA at just 2X, well below peers.  This leaves the company well positioned to invest in its business, exactly what it has done to enable its current leadership position.

The one thing we worry most about at Comcast is that someday, maybe with the advent of 5G wireless, the network advantage that is driving much of cable’s resiliency and growth will dissipate.  We already hear noise on this front but do not think ti will have a meaningful impact for another several years.  While the window is open for Comcast to continue its steady growth, we see CMCSA shares as a core holding.

CMCSA 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.  CMCSA is a net long position in the Entermedia Funds.  Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.

Stabilization at Apple Good Enough For Now

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Apple (AAPL) reported mostly inline results for its 3Q16 report.  Slight upside existed across most key financial and unit volume metrics.  Guidance for the current quarter ending 9/30/16 was similar.  Given recent sentiment surrounding AAPL, this was good enough to allow the shares to rebound in their initial response to the report, up 7-8%.  AAPL remains down -1% YTD, still lagging the market’s gains.

The rally in the shares reflects stabilization in the company’s fundamentals.  This suggests that the bear case built on declining iPhone sales ultimately leading to collapsing profitability is less likely.  However, it is worth noting that revenues were -15%, EPS were -23%, gross margins fell almost 200 basis points, and operating margins declined from 28.4% to 23.9%.  iPhone unit sales fell -15%, and due to lower average selling prices as a result of the new iPhone SE, iPhone revenues were -23%.  Macs and iPads also saw declines in unit volumes and revenues, although iPads surprised to the upside on units and average selling prices as the new Pro model seems to be gaining traction.

We mention this negative growth because for AAPL shares to extend today’s rally significantly requires a return to growth.  We believe that will happen, possibly as soon as the December quarter but almost certainly in CY2017 when a bigger upgrade to the iPhone is coming and the high margin services businesses (App Store, Apple Music, Apple Pay, licensing, and possibly AppleTV) becomes a larger part of the overall business (we expect services to represents more than 12% of FY2017 revenue).

We are willing to wait for growth to return because AAPL shares remain very inexpensive, especially when adjusted for the company’s incredible financial strength.  AAPL trades at just 11.7X 2017 consensus EPS estimates, a significant discount to its peers and the broader market.  Giving credit for net cash, the multiple is less than 9X.  The company is about 75% of the way through a $250B capital allocation plan, returning cash to shareholders through dividends and share repurchases.  Even though most of the cash is overseas and would be taxed upon repatriation, the aggressive return of cash to shareholders suggests credit should be given  for the $27 per share in cash.  AAPL may no longer have massive upside but we see a path for better than market performance over the next 12-18 months.  Northlake clients should be aware that we may look to trim over weighted AAPL positions but this should not be viewed as a sign we are bearish on AAPL overall.

We hope and expect that the worst has passed for AAPL shares and better performance lies ahead.  The next big data point will be the reception to the iPhone launch in late September or early October.

AAPL 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.  AAPL is a net long position in the Entermedia Funds.  Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.

 

From Video to Casino Games

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Northlake is taking partial profits in Activision Blizzard (ATVI) after the shares have doubled since the initial purchase in November 2014.  The outstanding performance of ATVI against minimal change in the broader market led to position sizes up to 2X what Northlake usually targets.  Northlake still likes ATVI and sees upside to the upper $40s based on fundamental momentum in its video game publishing business.  As a result, the sales of ATVI were partial and client accounts still own a normal size position.  ATVI shares can move higher based on: (1) better than expected performance from last year’s acquisition of mobile gaming giant King, (2) continuing strong sales of the Call of Duty franchise, (3) the success of the new game, Overwatch, and (4) ongoing revenue and profit margin benefit from the transition to digital gaming revenue from packaged goods.

We are reinvesting the proceeds of the ATVI sale into MGM Resorts (MGM).  MGM is an industry leader in casino resorts with leading positons in Las Vegas, Macau, and regional markets throughout the United States.  The company is undergoing a successful restructuring that includes: (1) spinning off its real estate in a publicly traded REIT, (2) an efficiency plan that is reducing expenses throughout the enterprise, and (3) the opening of new casino resorts in Macau and Washington DC.  The benefits of each these initiatives are hitting simultaneously over the balance of 2016 and 2017 creating a series of timely catalysts to lift the shares toward our $30 target.  In addition, MGM properties in Las Vegas, by far the largest part of the company, have been performing very well.  Las Vegas is operating strongly for most casino operators with limited new hotel and casino growth and steady individual and group travel trends.  We have been following each of the major U.S. gaming companies closely for several years and are particularly impressed by MGM’s management team.

Looking ahead, the opening of the new casinos in Macau and Washington DC will allow the company to rapidly earn a payback on these very large, debt financed investments.  Improving balance sheet metrics should lead to more investors discovering the overall growth story at MGM and reduce the risk profile of the company.

We value MGM on a sum of the parts basis.  The company’s Macau business has long been publicly traded in Hong Kong.  MGM recently did an IPO of if most of its real estate into a publicly traded REIT called MGM Growth Properties (MGP).  MGP can assist MGM in certain transactions such as MGM’s recent purchase of the 50% interest in Atlantic City’s Borgata casino it did not already own.  MGP also has an excellent opportunity to pursue accretive acquisitions of casino real estate unaffiliated with MGM.  Subtracting the public value of MGM’s 76% stake in MGP and 51% stake in MGM Macau, leaves MGM’s core operations in Las Vegas and regional gaming markets around the U.S. trading at less than 8X next year’s EBITA.  We view this as compelling versus other regional casino companies and other domestic focused leisure and entertainment companies with similar or lesser growth prospects over the next several years.

ATVI and MGM 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.  ATVI and MGM are net long positions in the Entermedia Funds.  Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.

 

Thoughts on Brexit

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EMAILED: 6/24/2016 11:20AM Central:

Recognizing markets move quickly and that can make opinions change, here are some of Northlake’s thoughts this morning after Leave wins the UK referendum:

Uncertainty.  It is an old adage but the fact is that Wall Street dislikes it.  Brexit creates a lot of uncertainty as there really has never been anything like it.  Thus, the bias for now in terms of investment strategy should be increased caution.  However, panic is probably not the way to act as Brexit is a long process with the possibility that it will not impact the economy and the stability of the global financial system nearly as much as the bearish view predicts.

Brexit is not even effective yet.  All of the legal and technical rules that govern the EU and the UK’s interaction with the EU (and the rest of the world) remain in place.  This gives time for negotiations to smooth what will be a tricky transition.  Global central banks and governments also have some capability to keep the financial system stable.  The UK also has the ability to act since it has its own currency and independent central bank. These things suggest panic is not required.

Nevertheless, the uncertainties are enormous.  The EU is likely to drive a hard bargain when it negotiates with the UK if for no other reason that it does not want to reward the UK for leaving by letting things continue largely as is.  Anti-EU sentiment is high in many European countries and political parties that dislike the EU have been gaining power in recent elections.  If the EU goes easy on the UK, then maybe Finland, the Netherlands, or even France may have a referendum on leaving.  And leaving for any country that uses the euro is a lot more complicated than for the UK.  There is no longer a French franc, for example.

Uncertainty also can cause businesses and consumers around the globe to slow their plans to spend and invest.  An obvious response to Brexit is a rally in the dollar.  That hurts US exporters and multinationals.  It also pressures energy and commodity prices and emerging market currencies.  Those are the issues that caused the market to get off to a horrible start in January and February.

We are mostly trying to help you understand what the market is thinking and what we are thinking as we consider investment strategy after what is almost certainly a very important event.  The bottom line for Northlake from a strategy standpoint is that we do not want to panic but we do want take a little more cautious approach looking out over the next several months.  The global and U.S. economies and markets were in decent but not great shape going into the Brexit vote.  We can’t deny that more uncertainty and risk exists today.  That spells more caution as it relates to investment strategy.

We will end with another adage.  Time heals all.  On Wall Street that is because time reduces risk.  Most clients and investors have time horizons that mitigate short-term risk.  If your time horizon is beyond days, weeks, or months, it could be painful at times but as is usually the case when Wall Street hits a rough patch, it makes sense to wait it out and stay the course.

 

No Changes for July : Mid Cap and Neutral on Growth/Value Still In Play

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There were no changes to the recommendations from Northlake’s models for July.  The Market Cap model still favors Mid Cap and the Style model remains in neutral mode.  As a result, there will be no changes to the ETF holdings in client portfolios.  The Market Cap model will continue to be represented by the S&P 400 Mid Cap (MDY), while the Style model investments will remain split equally between the Russell 100 Growth (IWF) and Russell 1000 Value Value).

The Market Cap model moved slightly in favor of large cap with two internal/technical indicators shifting from small cap to large cap.  The indicators that shifted measure stocks vs. their 200 day moving average and the number of stocks making new 52 week highs.  The Style model moved toward value reflecting better recent performance for value stocks.  While the Style model remains solidly in value mode, a move away from the neutral reading to value is possible next month.

The Market Cap model performed well in the second quarter and so far in 2016.  The shift from large cap to mid cap beginning in May was timely.  For the quarter as a whole, the Market Cap model returned 1% more than the benchmark S&P 500.  Year-to-date, the Market Cap model is about one half of one percent ahead of the benchmark.  The Style model matched the S&P 500 in the second quarter and has also done the same so far in 2016.  The Style model has been sending a neutral signal since April 1st.  Performance would have been better with a pure value signal but the benefit to client portfolios would have been marginal.

MDY, IWD, and IWF 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.