Disciplined Growth Continues at Alphabet

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Alphabet (GOOGL) reported good fourth quarter and full year results to close out 2016. GOOGL beat sales estimates, but missed EPS targets due to a one-time equipment write-off and a higher than expected tax rate. The core Search business continued to perform well, with paid clicks growing 36% year-over-year compared to estimates of 27% growth. The strong ad volume growth was offset by costs per click falling 15% year-over-year, worse than the estimated 11% decline. Like Facebook (FB), GOOGL has masterfully maneuvered the shift from desktop to mobile.

GOOGL’s critical verticals such as YouTube, Google Cloud Platform and G Suite, AI and machine learning initiatives, new Pixel and Home hardware, and updated operating system software for Android, Chrome, and Daydream VR all appear on track to deliver continued growth with disciplined investment. Meanwhile, “other bets” such as Fiber, Nest, Calico, Verily, and Google Ventures are being prudently managed to provide unrivaled optionality while minimizing the negative impact to current operating results.

The recent launch of YouTube Red, a subscription video service, compliments YouTube Music and the Google Play store by offering ad-free premium content. GOOGL hinted at plans to expand their premium content offerings while simultaneously streamlining or consolidating their media products over the next year. GOOGL believes that both Google Cloud Platform and G Suite now offer differentiated cloud services compared to competitors like Microsoft (MSFT) and Amazon (AMZN), allowing the company to focus on growing sales in areas that benefit from that new expertise. AI and machine learning initiatives drive GOOGL’s product and service ecosystem, allowing the company to quickly iterate developments that improve the consistency of the user experience whether typing a search on a Chromebook or using voice search via Google Assistant on a new Pixel phone, Google Home, or Android-connected car.

In summary, GOOGL remains on track to deliver outstanding sales and profit growth for the foreseeable future driven by the core Search business and critical verticals of YouTube, Cloud, AI, hardware, and software. The ongoing secular shift from traditional to digital advertising should continue to be a long-term tailwind. Further optionality is provided by disciplined investments in “other bets.” We expect over 16% upside at GOOGL with an increased target price of $952 based on 23x 2017 EPS of $41.39.

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.

Selling ClubCorp as it Explores Stategic Alternatives

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In Northlake’s yearend letter, we stated “Admittedly, we have been too patient with ClubCorp.  However, with oil prices rebounding and golf rounds played rising for the first time in several years, we feel if the stock is going to work it should do so as we approach the 2017 golf season.”  Lo and behold, it appears that the Board of Directors and management of ClubCorp (MYCC) lost patience.  This week the company announced it was exploring strategic alternatives to enhance shareholder value.  The stock moved up from $15 to over $17.  Northlake sold all positions at around $17.24.

We think that private equity is the most likely buyer of MYCC if the company is sold.  Perhaps an Asian buyer emerges given the popularity of golf across the Pacific and a desire by many companies and investors in those areas to put money into U.S. dollars and U.S. dollar investments.  There is also the possibility that MYCC again explores turnings into a REIT with operating company/property company structure.  This is a complex undertaking for MYCC given the nature of its revenue streams (high food and beverage revenue).

In a sale or REIT conversion, Northlake believes that MYCC could reach either wide of $20.  However, a sale or REIT conversion is not guaranteed at $20 or at any price.  At $20, upside is 16%, a good but not great return.  We think we can reallocate the capital into a better idea, consistent with our yearend letter to find something consistent with the “Trump Trade” based on reflation and value.

In the end, MYCC was a disappointing investment for Northlake’s clients.  We did get a nice pop to start 2017 and now have added liquidity and flexibility in client portfolios as we navigate the major changes underway in Washington.

Disclosure:  Northlake Capital Management, LLC and Steven Birenberg’s personal accounts no longer have any positions in MYCC.  Entermedia Growth Partners, LP and Entermedia Tax-Exempt Partners, LP, long/short equity hedge funds managed by Steve Birenberg in a separate investment management company maintain a small long position in MYCC.

Change to Begin 2017 for Northlake’s Models

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Both of Northlake’s models changed signals to begin 2017.  The Market Cap model is now recommending small cap after spending eight months at mid cap. The Style model is still recommending value but as a result of the new small cap signal, value exposure will shift from large cap value to small cap value.  The trades initiated by these changes are: (1) sell holdings in S&P 400 Mid Cap (MDY) and reinvest proceeds into Russell 2000 (IWM), and (2) sell holdings in the Russell 1000 Value and reinvest proceeds into Russell 2000 Value (IWN).  All of these trades were executed on January 3rd.

The shift to small cap was driven mostly by the Market Cap model’s internal indicators that measure stock market technical and trend trading patterns.  Three of these indicators shifted to small cap for January.  A majority of the external indicators that measure economic and interest rate factors were already in small cap mode, so with the internal and external indicators in agreement, the overall model shifted to small cap.

The Style model actually saw very little movement in its underlying indicators for January, registering a second consecutive month with the overwhelming majority of indicators on a value signal.  The two month smoothing measurement for the Style model is now deeply in value territory.  The shift to small cap value is the direct result of the new small cap signal from the Market Cap model.  Back in late 2014 when we updated the models, we did a lot of testing to determine how best, if at all, to link the Market Cap and Style models.  We determined that anytime the Market Cap model recommended small cap that we should use a small cap version of growth or value for the Style model.  A mid cap signal from the Market Cap model worked best with large cap growth or value.  This month marks the first small cap signal since we updated the models (mostly the Market Cap model has been in mid cap mode the past two years) and thus the first use of small cap growth or value.

Small and mid cap stocks performed well in 2016, something that was captured by the Market Cap model which gained 14% in 2016.  Wall Street favored small caps as the dollar strengthened and in anticipation of normalization of monetary policy.  Over the course of 2016, the Style model moved gradually from growth to value mode.  This allowed the Style model to keep up with the market’s gains in 2016.

Northlake follows the model signals whether we fully agree with them or not.  The models are back-tested, have a long history of success, and are regularly monitored for possible updates.  There are occasions when the model signals do not match our personal opinions.  This is not one of those times.  The concept of value and small cap stocks is consistent with reflation of the global and U.S. economies.  Our yearend letter discusses the massive shift in investor expectations from those based on easy monetary policy and low inflation to tighter monetary policy and fiscal stimulus.  We also discuss the shift away from decades of globalization and increasing international trade.  This changing investment landscape supports value and small cap stocks just as the models are now recommending.

IWM and IWN 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.