Activision Blizzard Experiences Step Change in Shift to Digital

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Activision Blizzard (ATVI) reported better-than-expected top and bottom line 3Q17 results. The strong quarter flowed through to increases in 2017 sales and earnings guidance. Important game launches including Destiny 2 and Call of Duty:WWII appear to have gone well so far. Other key franchises such as Hearthstone, World of Warcraft, and Candy Crush continue to deliver for ATVI. Even the existing library of older titles is contributing to the strong results, with remastered versions of popular games driving renewed interest. Investors and gamers alike are excited for the inaugural regular season of the new competitive e-sports Overwatch League, which will begin on January 10th, 2018. In total, ATVI is firing on all cylinders across all three of the Activision, Blizzard, and King divisions.

ATVI released Destiny 2 during the third quarter, noting that the much-anticipated sequel to the 2014 smash hit was performing better than the original Destiny as measured by consumer spending and time spent per player. Notably, more than half of all Destiny 2 console copies sold were digital full-game downloads, representing a significant increase from the 30-40% of copies of the original Destiny. This industry-wide shift to digital full-game downloads has provided a strong benefit to ATVI and other video game producers, as they are able to collect nearly $10 in additional profit compared to physical game discs sold. Importantly, the trend seems to have accelerated beyond the estimated pace of 5% per year increases. Pre-orders for Call of Duty:WWII also consisted of a higher digital mix than prior years, although not to the same degree as Destiny 2.

During BlizzCon 2017, ATVI announced new expansions for World of Warcraft and Hearthstone. As gamers continue to spend more time playing each game, expansions and other add-on content have proven to be efficient in driving increased engagement and player spending for minimal development costs. Reflecting this successful strategy, Blizzard noted that they are investing more on World of Warcraft than ever before.

Similarly, ATVI has been releasing remastered versions of popular older titles, demonstrating the value of their massive library of intellectual property. Over time, ATVI will use these library titles to branch out into new mobile games as well. In the meantime, King Digital’s Candy Crush franchise is performing well. Tests around mobile game advertising are ongoing, with refinements being made to ad formats while ATVI builds out the necessary sales, servicing, and targeting support on the back end. Mobile ad inventory is expected to ramp up in 2018. Early success has led to growing traction among entertainment, technology, and banking advertisers in large markets such as the US and UK.

Excitement for the upcoming start of the first season of the e-sports Overwatch League is building. 12 teams, some owned by other professional sports team owners, will compete to win the fandom of the growing 35 million registered Overwatch player community. Two major sponsorships from HP and Intel represent initial success on the marketing front, with many more sponsors expected to support and benefit from the growing interest in e-sports.

In summary, ATVI’s ongoing stretch of strong execution against conservative guidance should lead to further success. With several key franchises that are just entering their prime earning periods, all three divisions of the company are poised for continued growth. Opportunities stemming from mobile advertising and e-sports initiatives will begin to be meaningful contributors in the near future. Further bolstered by a step change in the industry-wide shift to digital full-game downloads, Northlake believes ATVI can climb into the mid-$70’s as EPS grows toward $3 in the coming years.

ATVI 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. 

Sticking With Small Cap and Small Cap Growth To Yearend

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There are no changes to the recommendations from Northlake’s Market Cap and Style models for December.  The Market Cap model remains on a small cap signal for the second consecutive month and the Style model favors growth for the third consecutive month.  The signals from both models strengthened slightly for December.  Client positions following the models will remain invested in the Russell 2000 Small Cap (IWM) and the Russell 2000 Growth (IWO) for a least another month.

November was a good month for the stock market that on the surface featured the continued trend of low volatility.  However, the relative performance of small vs. large cap and growth vs. value was volatile within the month with a return to rapid rotation.  For example, small caps lagged to start the month, while growth took a big hit at the end of November.  Northlake’s models are composed mostly of longer term indicators but do include trend and technical factors that are designed to pick up short-term stock market gyrations.  Overall, the models are telling us that the economy and interest rates remain favorable for stocks, arguing for an aggressive posture that favors more volatile, higher beta assets like small cap and growth stocks.

A couple of things we are watching as we head toward yearend and into 2018 are Federal Reserve policy and earnings growth.  Led by the investor interpretation of future Fed actions, interest rates have risen modestly in the past month in anticipation of continuing increases in the Fed Funds rate through 2018.  Third quarter earnings showed nice growth and investors liked what was reported but the rate of earnings growth decelerated, albeit from elevated levels, and is projected to decelerate in the future (independent of corporate tax cuts).  Market history suggests that tighter monetary policy and peaking earnings growth are headwinds for stock prices.  Northlake does not see either of these issues as a big problem looking out the next six months but we are monitoring each closely.

Last month’s fresh signals in small cap and small cap growth performed in line with the benchmark S&P 500.

IWM and IWO 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.  IWM is used as a hedging vehicle in the Entermedia Fund.  Entermedia is along/short equity hedge fund managed and controlled by Steve Birenberg.

Liberty Media Third Quarter Review

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During November, Liberty Media reported third quarter earnings and hosted its annual analyst meeting.  A portion of the Northlake client base owns stock in companies controlled by Liberty Media including Formula One Group (FWONA/FOWNK) and Liberty Sirius (LSXMA/LSXMK).  Liberty regularly creates tracking stocks or spins off companies they control.  We have gradually sold off many client positions in these two stocks, usually when we need to rebuild cash reserves.  Both have good long-term potential but we see each as fully valued in the near-term.  FWON and LSXM trade at premium valuations reflecting their long-term growth.

The 2017 Formula One racing season ended this past weekend.  From the perspective of FWON shareholders it was a successful under the new ownership group led by Liberty Media.  TV ratings improved, a few new races or previous races were added to the schedule for next season, and initial changes to build out the management team and future strategies were implemented.  Formula One is a very popular sport pretty much everywhere in the world except for the United States.  The value of sports rights has grown massively in a fragmented world of TV and digital viewing.  Liberty Media sees an opportunity to dramatically improve the economics and value of Formula One.  Nothing that occurred in the first year of Liberty ownership changes that outlook.  Next year will be another transition year including the important need to negotiate a new deal with the racing teams.  The teams and Liberty share economics of the sport.  Liberty hopes to make changes that can grow the pie considerably but this would require the teams to agree to changes that could lead them to less guaranteed money.  We think Liberty can convince the teams and early moves by Liberty to add more races, staff up the sport’s infrastructure, and sign new, more lucrative TV deals are a good for the teams and for shareholders.  We like the long-term opportunity at FWON but feel the shares already reflect the upside given their premium valuation of 17X 2018 estimated EBITDA.  Northlake remains comfortable owning FWON shares but sees them a source of cash should that become necessary for individual clients.

Liberty Media owns 69% of Sirius XM Satellite Radio, a percentage that goes up as Sirius continues it large and steady repurchase of its own shares.  Eventually, Sirius XM (SIRI) and Liberty Sirius (LSXMA/LSXMK) will merge but that does not appear to be likely in the very near future.  Fortunately, for LSXM shareholders, business at SIRI continues quite strong.  The company beat Wall Street consensus in 3Q17 and raised most of its guidance metrics for 2017.  The story at SIRI is double digit annual growth in free cash flow per share.  While some investors worry about the shift to embedded modems in cars that open up more entertainment opportunities, we see the long implementation cycle for new automobile models providing protection for SIRI for at least several more years.  Additionally, SIRI management is not standing still.  It is upgrading the service to two way communication, aggressively attacking the used car opportunity, and building out its already large opportunity as a supplier and integrator of advanced solutions to automobile manufacturers.  We see few issues for SIRI over the next year or two but the good news is in the stock price that trades at a low teens EBITDA multiple.  Once again, we are comfortable owning LSXM shares but see them as a source of funds for clients that may need cash reserves.

FWONA, FWONK, LSXMA and LSXMK are 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.  FWONK is net long position in the Entermedia Funds.  LSXMK is held as an arbitraged long position against a short in SIRI 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.

MGM Resorts Overcoming Short Term Pain for Long Term Gain

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Third quarter results at MGM Resorts International (MGM) were above expectations, largely due to a boost from two massively popular boxing events during the prior three months. MGM also benefited from slightly above average luck on gaming profits. The strong results were offset by disappointing guidance for the fourth quarter after MGM experienced elevated reservation cancellations in the wake of the tragedy at Mandalay Bay on the first day of October. Importantly, MGM also noted that booking activity largely returned to normal once marketing efforts resumed in the following weeks. Still, MGM expects revenue per available room to decline 5-7% in the fourth quarter compared to the previous year. The stock rallied on the results as the strong third quarter and temporary nature of the fourth quarter headwinds allayed fears of prolonged weakness.

Aside from the boost generated by the two major boxing events, third quarter results also benefited from ongoing efforts to enhance profitability. MGM has been investing in technology to assist with data analytics with the goal of maximizing revenue from every occupied hotel room. This focus on revenue per occupied room is a departure from the industry standard focus on maximizing revenue per available room. In some cases, MGM can steer customers away from rooms that might charge a higher daily rate to less expensive rooms with 25-50% higher profitability. MGM noted that oftentimes these customers are non-gaming visitors who are instead spending more on sports and nightlife entertainment options as well as food and beverage options. The new NHL team, the Vegas Golden Knights, has helped MGM attract even more of these visitors now that the inaugural season is underway.

As expected, ongoing disruption from the renovation of the Monte Carlo detracted from third quarter performance. The resort is being rebranded as the Park MGM and NoMad Las Vegas Hotel. Although the project is anticipated to negatively impact results into the middle of next year, it should be a positive contributor by the end of 2018. Early signs of success in the few restaurants and room products that are already completed provide confidence that the full project will earn nice returns for shareholders. MGM foreshadowed that these low-risk Las Vegas renovation projects should be expected in future years.

Outside of Las Vegas, MGM is nearing completion of two new resorts; MGM Cotai in Macau will open in January 2018 and MGM Springfield in Massachusetts is slated to open in September 2018. Once completed, these construction projects will free up substantial amounts of free cash flow which can then be used to increase shareholder returns. Relatedly, MGM Macau has continued to perform well and the recently opened MGM National Harbor in Maryland has gotten off to a strong start. We expect all four resorts to be important upside catalysts for MGM in the intermediate term.

In summary, Northlake believes MGM can push into the upper-$30’s based upon a sum of the parts valuation analysis breaking down the company’s domestic operations and the public equity values of its majority owned holdings, MGM Macau and MGM Properties. The completion of new construction and renovation projects will add to the already strong collection of assets and drive revenue growth. The ongoing efforts to drive profit margins higher will also be an important contributor. As each project wraps up and profitability continues to improve, more free cash flow can be returned to shareholders.

MGM 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.  MGM 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.

Facebook Demonstrates Continued Expense Discipline and Rapid Growth

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Facebook (FB) reported very strong 3Q17 results with both sales and earnings substantially better than expected, largely driven by lower than expected expenses for the second straight quarter. The company has now spent less than their initial annual expense guidance for the past two years, demonstrating operational discipline even while investing for growth. FB noted that 2018 would be another year of substantial investments in growth initiatives including premium video content, artificial intelligence and machine learning, virtual and augmented reality, and global internet connectivity. FB also announced plans for new investments in security related to increased scrutiny around the 2016 election. In total, FB expects expenses to grow between 45-60% in 2018 compared to expense growth of 35-40% in 2017 and initial 2017 guidance for expense growth of 40-50%. We believe FB wanted to create some flexibility due to the ongoing uncertainty around security expenses, but will remain disciplined and expense growth will end 2018 toward the bottom end of the new target range.

FB year-over-year sales growth accelerated from the previous quarter, up 47% compared to 45% in 2Q17. Analysts currently expect sales growth to gradually slow toward 20% over the next several years. Slowing sales growth combined with rising costs could create a headwind to FB shares. However, Northlake believes that disciplined investments in growth initiatives such as premium video content and new computing platforms can allow FB to grow faster than currently expected. Additionally, FB has opportunities to increase monetization on all of their existing applications. The primary Facebook platform should be able to support increased ad prices due to the company’s dominant competitive position and unmatched ad measurement capabilities based on customer data. Instagram is still early on in the effort to maximize advertising contributions by increasing price and volume of ads. Untapped potential in Facebook Messenger and WhatsApp also should also lead to upside revisions to earnings estimates.

Northlake expects FB to push above $200, roughly equivalent to 25x 2019 EPS of $8.13 with potential upside to earnings estimates as growth initiatives start to meaningfully contribute. Slowing revenue and earnings growth combined with increasing expenses could pose a challenge in the near term, but we believe the recently demonstrated expense discipline will continue to provide another source of upside surprises for investors. FB has a dominant competitive position and several untapped opportunities. A relatively undemanding valuation given the company’s growth prospects  should prove rewarding for investors.

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.

Is the Bottom In for TV Stocks?

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TV stocks have had a good rally in the past week for the first time since May.  Among Northlake positions, this includes Disney (DIS), CBS Corporation (CBS), and Nexstar Media Group (NXST).  Each has rallied between 5-10% off of at or near 2017 lows.  The challenges facing TV have metastasized this year.  The issues are cord cutting, cord shaving, weak TV ratings, and poor advertising trends.  All the major media companies reported earnings the past two weeks and for TV stocks there were a few signs of improvement.  When combined with horrific sentiment among investors and extremely bearish positioning in the stocks, this has a triggered a rally.

Northlake has a lot of domestic media exposure including cable operator Comcast (CMCSA). It has been a rough ride of late but we reaffirm that we own the very best positioned companies given the secular headwinds.  This was evident in recent earnings reports from all four companies.  Our recent report on CMCSA can be found here (http://northlakecapital.com/2017/10/27/comcast-posts-solid-results-despite-increased-competition/).  Below are comments related to recent results from DIS, CBS, and NXST:

Three items are supporting the recent rally in TV related stocks.  First, there appears to be material uptake of OTT services providing a boost to subscriber counts for networks and stations that are included in the new packages.  DIS, CBS, 21st Century Fox (FOXA), and AMC Networks (AMCX) each indicated that affiliate and/or retransmission fees were beginning to see some benefit from OTT subs.  These subs act to offset losses due to cord cutting when a customer switches from traditional cable or satellite subscriptions to an OTT service.  Second, the outlook for fourth quarter advertising growth has improved.  Ratings remain weak but October was strong, lapping political displacement a year ago, and early pacing for November and December are positive on a year-over-year basis.

The third positive relates to investor sentiment and positioning.  We cannot emphasize enough how bearish the outlook has been for traditional media stocks.  Analysts have downgraded many stocks and reduced estimates and price targets.  The valuations on the stocks against earnings and cash flow are at levels not seen since the 2007-2009 Great Recession.  One analyst we respect noted that NXST was trading as though its prodigious free cash flow would disappear in six to eight years.  The TV industry may be in tumult but that is an awfully pessimistic view.  The bearish sentiment was so overwhelming that when fundamentals did not deteriorate and the stocks went up on weak earnings, a countertrend rally developed.  We think the rally will have legs, especially in our portfolio names given they have the best competitive positioning versus the secular challenges.

DIS reported worse than expected and laid out further detail on its 2018 outlook.  The stock initially traded down 3-4% but reversed ruing the company’s conference call and is up 2% now on the morning after they reported.  One positive was a lower rate of sub losses for ESPN, down -3% versus a recent accelerating trend that saw the prior quarter fall by -3.5%.  Management also laid out further detail on expenses related to its recent BAMtech acquisition and the rollout of its direct-to-consumer services for ESPN and Disney.  The upfront losses in 2018 appear less than many investors anticipated.  DIS also faces a slower rate of programming expense growth at ESPN as the huge step up in NBA rights fees occurred in the past year.  All of this clears the deck for what should be a huge year for DIS’s studio with two Star Wars, three Marvel, and two Pixar films hitting theaters.  These films should support continued solid trends at the company’s theme parks and acceleration in the consumer products business.  Northlake does not see a ton of upside for DIS in the next year or two during the transition phase from traditional distribution via cable and satellite to OTT but in the near-term the relief rally could build.  If that happens, it will be time to make a tough call on holding DIS shares.

CBS remains much less exposed to secular headwinds than other TV network companies as it owns no cable networks and has a head start with early success from its own OTT services CBS All Access and Showtime.  In addition, broadcast networks like CBS remain sharply undervalued as far as retransmission fees compare to their popularity with viewers.  CBS will double its retransmission fees in the next three years which not only can drive operating income growth but also reduces the company’s exposure to secular and cyclical challenges for advertising.  Among the large traditional media companies, we find CBS the most attractive given its assets, strategy, execution risks, and management.

NXST is the second largest owner of local TV stations in the United States serving mostly small and mid-size cities.  We have a long history with NXST at the Entermedia hedge fund and find their management team to be the best in the business.  Even in a cheap group of local broadcasting stocks, NXST stands out as a great value.  Free cash flow per share is about 20% of the current stock price even after a 10%+ rally in the shares.  Local TV faces many of the same issues as other traditional media with the added challenge of rapidly rising payments to the big four networks (ABC, CBS, FOX, and NBC) for the right to maintain their affiliations.  Nonetheless, many positives exist including the ability to create shareholder value from the massive free cash flow by paying down debt, increasing dividends and share buybacks, and buying more stations in highly accretive transactions.  Each of these positives should become more evident in the year ahead when the FCC loosens local station ownership rules (expected later this month) and political advertising drives the biennial boost to revenues an cash flow.

CBS, DIS, NXST, and CMCSA 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.  CBS, DIS, NXST, and CMCSA 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.

Further Improvement at Liberty Global

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We have been wrong on Liberty Global (LBTYK) for more than two years.  The shares peaked at over $50 in 2015 and now sit at $30.  The $50 price was fed by takeover speculation but even so the shares have vastly underperformed a bull market.  The shares have still returned over 50% from our original purchase, which partly explains why we have been so patient:  we know this management team and have had great success with them for a couple of decades.  Unfortunately, a series of operational missteps and perhaps strategic errors have hurt management credibility and led to a couple of years of slow and much slower than expected growth.  Management has repeatedly promised acceleration in revenue and cash flow only to push out the timeline.

2017 has brought a pickup in growth.  Recently reported third quarter earnings show rebased revenue and operating cash flow grow by 2.5% and 3.9%, respectively.  These growth rates are higher than the first half of 2017 and much of 2016.  However, they are a far cry from the high single digit growth promised just a few years ago.  Management reiterated guidance for 5% operating cash flow growth for 2017, implying growth of 6% in the fourth quarter.  Acceleration accomplished.  For 2018, management has not yet specifically commented but growth above 5% is expected by still bullish investors.

Part of Liberty’s problem is that European cable markets have become more competitive than management and Northlake anticipated.  This is likely to continue and has made some the moves to acquire even more assets in certain countries questionable, with the benefit of hindsight, of course.

We sound like a broken record but with some modest improvement in growth and a lot of financial leverage working in our favor if growth accelerates and management credibility is restored, now is not the time to throw in the towel on LBTYK.  Other catalysts included the pending spin-off of the company’s Latin American assets and the possibility that highly accretive M&A activity takes place in Germany, Switzerland, or the United Kingdom.  Next quarter is probably the last one we can give LBTYK but if our bull case does emerge the upside is substantial: 20-30% within a year.

LBTYK 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.  LBTYK 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.

Accelerating Growth at Apple

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Apple (AAPL) reported good September quarter earnings driven by better than expected revenue everywhere but iPhones.  Profit margins were a little light driven by the mix shift away from iPhones.  A lower tax rate assisted the revenue upside to produce EPS about 10% ahead of consensus estimates.  The critically important guidance for the holiday quarter was good with revenue and gross margins matching analyst estimates.  Apple is known for guiding the quarter ahead below estimates, so this outlook is a positive surprise.  Since this holiday quarter sales are complicated by the never before seen three new iPhone models (8, 8 Plus, and X) and uncertainty about production quantities of the iPhone X, the guidance appears to be quite good relative to expectations.  Apple shares have responded, moving up another 5% to all-time highs.

The September quarter marked the fourth consecutive quarter of accelerating year-over-year revenue growth for Apple following three quarters of negative growth during the first nine months of 2016.  Revenue growth reached double digits for the first time since the September quarter of 2015.  The fact that growth was led by Services, Macs, and iPads is reassuring as despite what looks to be a strong launch for iPhone X it is hard to argue that iPhones are a high growth business.  Upside in Services, even after adjusting for a one-time benefit, is good news as margins in this segment rival those of the iPhone.

Revenue guidance suggests 9% growth for the December quarter. If achieved or exceeded, this should support investment sentiment that Apple is growing again.  The high growth days are behind the company but a consistent mid-single digit growth rate in revenues drives a powerful financial profile and double digit growth in cash flow and earnings per share.  In a growth starved world, especially among large blue chip companies, investors should remain bullish on Apple.  Like most analysts, we see the shares headed still higher; perhaps north of $200 as the stock earns a market P-E multiple on what could be a conservative consensus estimate for 2018 of $11.38.  If iPhone X turns out to be a brisk seller that ushers in a new platform for smartphones, Apple shares offer even more upside.

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.

Shifting to Small Cap for November

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Northlake’s Market Cap shifted to small cap for November.  The Style model still recommends growth.  Given these fresh signals, client positions following the Market Cap model will sell holdings in the S&P 400 Mid Cap (MDY) and purchase the Russell 2000 (IWM).  Although the growth signal is unchanged, the shift to small cap in the Market Cap model triggers a move from large cap growth to small cap growth.  As a result, client positions in the Russell 1000 Growth (IWF) will be sold and proceeds reinvested into the Russell 2000 Growth (IWO).

The shift to small cap is driven by internal indicators in the Market Cap model.  All eight internal indicators now favor small cap after three changed from large to small for November.  This change is primarily driven by better performance for small cap stocks over the last three to six months shifting the trend and technical indicators in their favor.  The external indicators offer a mixed picture with one change in favor of small cap this month.  Generally, the external indicators are picking up steady improvement in economic growth and continued strength in corporate earnings.  These factors usually favor small caps.

The Style model remains pretty firmly on growth.  One indicator in each of the internal and external groupings moved from value to growth for November.  Growth stocks have been performing very well with occasional one or two day swoons since summer.  The latest earnings reports form Amazon, Google, and Microsoft led to a surge in growth stocks in late October pushing the trend and technical indicators further in favor of growth.  The external indicators remain mixed as better economic and rising commodity prices favor value, while earnings growth and a weaker dollar support growth.

Last month the models did a pretty good job.  The growth signal was excellent as IWF rose about 4% versus a gain of 2% for the S&P 500.  The mid cap signal matched the benchmark S&P 500 with MDY up 2%.

IWM and IWO 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.  IWM is used as a hedging vehicle in the Entermedia Fund.  Entermedia is along/short equity hedge fund managed and controlled by Steve Birenberg

 

Alphabet Delivers Accelerating Growth

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Alphabet (GOOG/GOOGL) reported better than expected 3Q17 results. Sales were up 24% compared to 3Q16, accelerating from 21% year-over-year growth last quarter. Earnings per share were almost 15% above expectations, partially boosted by a favorable tax rate. Mobile search advertising, YouTube, and cloud computing each contributed to the strong results.

GOOG grew advertising revenue by 21% demonstrating continued success on the shift from desktop to mobile search as the primary platform. The cost per click (the price an advertiser pays for a search ad) for mobile ads is substantially lower than the cost for desktop ads, which has been a headwind for GOOG throughout this transition. However, that headwind may be nearing an inflection point as the overall cost per click increased from last quarter after a sustained period of decline.

YouTube remains a strong driver of growth at GOOG, with over 1.5 billion users watching an average of 60 minutes per day on mobile alone. Aside from desktop and mobile viewers, watch time in the living room is now over 100 million hours per day, up 70% compared to last year. These staggering figures help explain why even successful streaming companies such as Netflix (NFLX) have self-described “YouTube envy.”

Cloud computing is another area of focus and investment for growth at GOOG. The company noted that a substantial portion of recent hires were joining their cloud division. As GOOG continues to invest in improving cloud products and services, Northlake expects market share gains to follow. Progress is already becoming apparent as GOOG highlighted new deals with large companies such as Cisco (CSCO).

Artificial intelligence and machine learning are important building blocks of every aspect of future plans at GOOG. The company is working diligently to incorporate these technologies into everything they do to continuously improve the user experience. While these investments in new technology are not cheap, Northlake believes they provide a substantial competitive advantage.

One concern from the quarter is that GOOG increased the costs they paid to acquire search traffic. When asked about the increase, the company noted that they have been making similar deals for decades, and that it was simply a cost of doing business. Management also noted they will sacrifice margin for operating profit growth in dollars. It is clear that the first priority for allocating capital at GOOG is investing in sustained growth, as evidenced by the continued 20%+ growth over recent years. Investments in Other Bets such as self-driving cars at Waymo are also an important part of the long term growth strategy at GOOG.

Given the consistency and recent acceleration of growth at GOOG, Northlake believes the stock is fairly priced around 22x next year’s earnings after adjusting for net cash per share. As investors begin to look toward 2018 and beyond, Northlake believes GOOG can move toward and beyond $1,100.

GOOG/GOOGL 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.  GOOG/GOOGL 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.