Steady as She Goes at Google

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Google (GOOG/GOOGL) reported another solid quarter with 24% foreign exchange neutral revenue growth.  Revenue growth was driven by advertising, up 20% in constant currency terms.  Mobile is the driver with paid clicks rising 53%.  Mobile ads remain cheaper than desktop, so the shift to mobile leads to lower ad pricing (-19%) but the net growth indicates that GOOG continues to grow very rapidly despite its massive size and market share.

Perhaps equally importantly, operating margins rose for the 7th consecutive quarter.  This added financial discipline coincides with the addition of Ruth Porat as GOOG’s CFO in the summer of 2015.  Since Ms. Porat joined GOOG, the company restructured as Alphabet and isolated its Other Bets from the core search and YouTube businesses, has shown greater discipline at Other Bets, and initiated a share repurchase.

This added discipline and mostly good quarterly earnings over the past several quarters has led GOOG shares to trade at all-time highs, including an initial pop of about 4% on the 1Q17 earnings report.  However, GOOG has still severely lagged the stock performance of the other dominant megacap internet companies, Amazon (AMZN) and Facebook (FB).  Since 12/1/2015, GOOG shares are up 14%, while AMZN has risen 35% and FB is up 38%.

GOOG is not growing as fast as FB and does not have as large an addressable market as AMZN.  However, the search business arguably has the biggest competitive moat.  GOOG is more of a blue chip today than AMZN and FB and there are no other megacap blue chip companies trading near a market multiple while sustaining core organic growth around 20%.  GOOG is trading at around 22X 2018 estimated earnings, or a price-to-growth ratio of 1.0.  Most other blue chips trade at PEG ratios of at least 2.0.  GOOG is sitting on about $130 in cash.  Adjusting the P-E for cash brings the forward P-E multiple under 20X.  We expect tax reform to be signed into law by President Trump sometime in the next 18 months and it will likely allow GOOG to repatriate the overseas cash at a very low tax rate, providing another potential catalyst for the shares.

In the meantime, we expect the core organic growth at GOOG, driven by mobile, to maintain its recent pace.  This should be good enough for GOOG to gain more respect from investors, allowing the P-E multiple to expand.  We see GOOG moving up to 25X 2018 estimated earnings or $1,050.  This equates to 22X adjusting for cash on the balance sheet.

Beyond the usual analysis of business fundamentals, one risk to watch is the outcome of European regulators review of GOOG’s Android and Search businesses.  Recently, GOOG settled with Russia regarding Android, possibly setting a template for the European investigation.  The settlement may initially lead to a negative reaction in GOOG shares but we believe putting this issue behind the company will ultimately be viewed as a positive by investors.

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.

Back on Track at MGM Resorts

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As expected, MGM Resorts (MGM) bounced back with a strong quarter in 1Q17 after reporting disappointing 4Q16 results. As described in our 4Q16 update, the miss was largely driven by the shift in timing of Jewish holidays compounded by management’s miscommunication of the anticipated impact to their convention business. MGM’s management took responsibility for the error, and is clearly focused on delivering against reset expectations going forward. The fundamentals remain strong, as demonstrated by MGM’s better than expected sales and profits.

MGM bolstered our conviction in the long-term story by stating that they expect further upside in profit margins for the next few years. This is largely driven by the Profit Growth Plan, which outlines management’s cost cutting and profitability initiatives. Additional upside to profits should come as MGM’s Cotai project nears completion; the resort remains on track to open toward the end of 2017. The company is on the verge of significantly reducing capital expenditures related to new project developments, which will lead to substantial free cash flow generation. In turn, the increased free cash flow will most likely either be reinvested in a new resort in Japan or be returned to shareholders. Both outcomes would be great for MGM shareholders.

MGM’s Las Vegas properties each performed above expectations, even after adjusting for slightly elevated (i.e. lucky) hold. Hold is a term the casino industry uses to describe the profits they retain from their gambling operations. Hold typically falls within an expected range, but it is practically impossible to accurately predict the quarter-to-quarter variances within that range. Las Vegas as a whole continues to exhibit strong visitation trends, both from business groups attending conventions and individual leisure travelers. The high occupancy rates on the strip combined with rising room rates and increasing spending on food and beverages remain strong tailwinds. There is very limited supply of new rooms expected to be developed in the foreseeable future. Furthermore, Las Vegas will benefit from hosting its first two professional sports teams. The newest NHL franchise, the Vegas Golden Knights, will begin their inaugural season in the fall at the T Mobile Arena, which is partly owned by MGM and sits near several of MGM’s properties. The stadium for the Las Vegas Raiders will be built over the next few years. We expect the new teams and stadiums to disproportionately benefit MGM due to the proximity to several of MGM’s Las Vegas properties.

MGM National Harbor, the new resort in Maryland near Washington, D.C., has performed reasonably well as it ramps up operations. Further upside is expected as MGM leverages its M Life rewards program to drive consumer awareness in the surrounding areas and provide incentives for increased visitation and spending.

MGM stated that MGM Growth Properties (MGP) is looking to grow via acquisitions to diversify their revenue streams to properties not operated by MGM. MGM owns a substantial amount of MGP after splitting into two separate companies; any growth at MGP will directly benefit MGM via increased dividend payments and equity appreciation.

In total, we believe that MGM is back on track to continue producing strong results. As profitability increases and new projects come online to drive revenue growth, we expect that the stock can push back into at least the mid-$30’s.

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.

To Xfinity and Beyond

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Comcast reported another good quarter and the shares are moving up to another all-time high.  CMCSA shares are befitting from two factors.  First, the company continues to execute almost perfectly on all financial and operational metrics.  Second, the threat of onerous cable regulation has fallen sharply under the Trump Administration.  Putting the long history of excellent quarterly results together with the reduced regulatory threat and a very strong balance sheet and Comcast has emerged as a blue chip stock.  We see further upside as the valuation of the shares expands to reflect its blue chip status and financial results stay consistent at mid to upper single digit growth in revenue and operating cash flow.

In 1Q17, Comcast grew revenue by 8.9%, adjusted EBITDA by 10.4%, and earnings per share by 26.2%.  The cable business saw 5.8% revenue growth and 6.3% adjusted EBITDA growth.  Margins expanded as all operating expenses except programming expense (fees paid to TV stations and networks for the right to transmit their programming) grew at a rate below revenues.  Programming expenses are up double digits again this year but should normalize in 2018 and grow around the rate of revenue.  This sets up nice margin expansion potential in 2018 and beyond.

Supporting the long-term outlook at Comcast is the fact that cable subscribers are actually growing.  Yes, you read that correctly.  Despite all the talk about cord cutting, Comcast actually has about 1% more video subscribers now than a year ago.  This is a testament to the excellent management and smart and effective investment in its X1 platform.  Cord cutting is real.  Total cable and satellite subscribers in the U.S. are down about -2% from a year ago.  Risk remains but Comcast deserves credit for its management decisions and execution.  With video stable, Comcast continues to benefit from growth in broadband subscribers and business customers.

Not to be overlooked is excellent performance at NBC Universal.  The entire division grew revenue 14.7% and Adjusted EBITDA by 24.4% in 1Q17.  All four segments – Cable Networks, Broadcast Television, Filmed Entertainment, and Theme Parks – grew revenues and all but Theme Parks saw improved profit margins.  Theme Parks had an unfavorable comparison on spring break timing.  Comcast bought NBC Universal in 2011 and the acquisition has turned out even better than ever could have been expected.  Once again, management decision-making and execution has been consistently on target. Furthermore, restrictions placed on Comcast to complete the acquisition of NBC Universal expire in 2018, creating options for leveraging NBC Universal’s content such as launching a standalone internet TV package.

Comcast shares closed at $30.76 the night before the election.  Trading today at $40, the stock is up 30% since then.  We see upside to $45-50 over the next year as the EBITDA multiple expands reflecting the company’s blue chip status, reduced regulatory risk, and continued consistent growth.

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.

Deregulation to Drive Sinclair Broadcasting

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Sinclair Broadcasting (SBGI) has been added to Northlake’s individual stock portfolio.  We expect transformational acquisitions to increase the company’s free cash flow by 25-50% over the next two years.  Free cash flow per share could average $6-7 on a pro forma basis for the 2017/2018 TV station cycle.  We believe this will drive the shares into the $50s, up at least 25%.

SBGI is one the largest owners and operators of local TV stations in the US.  The company presently owns 173 stations in 81 different markets.  Most of these stations are affiliates of the big four networks: ABC, CBS, FOX, and NBC.  SBGI also owns the Tennis Channel and is developing a sports network and news network for distribution via cable and online.  Tennis and the developing networks should provide a small boost to long-term growth but the local TV station business remains dominant.

Merger activity is being driven by deregulation of broadcast TV ownership rules at the Federal Communications Commission (FCC).  Just last week, the FCC reinstated the discount for UHF stations that was put in place last fall by the Obama Administration’s FCC.  We expect the FCC to lead further deregulation of TV broadcast ownership over the balance of 2017 including elimination of the restriction on owning two of the top four stations in a single market, dropping the eight voices rule, and either increasing the ownership cap from the current 39% of US households or leading Congress to increase the cap.  For now, elimination of the UHF discount is good enough to trigger industry consolidation.  The company has been operating at the cap, restricting highly accretive station acquisitions.  With the UHF discount reestablished, SBGI sits with upper 20% household reach, allowing for transformational acquisitions for SBGI and the industry.

We recently returned from meetings with broadcasting companies, regulatory experts, and industry analysts at the National Association of Broadcasters (NAB) annual convention.  Our meetings included a group meeting with SBGI and a chance one-on-one meeting with the company’s CEO.  SBGI is incredibly bullish on the new regulatory environment and sees the company heading toward close to national reach for its TV stations.  Management sees national reach as a game changer for advertising sales and the company’s negotiating position with cable, satellite, and OTT service providers and the big four networks.  In addition, national reach creates a blue sky opportunity to use spectrum under the new ASTC 3.0 broadcasting standard to develop new revenue streams.

SBGI and Nexstar Media Group (NXST) are likely to pursue transformative acquisitions to achieve close to national scale.  Both companies will also aggressively pursue acquisitions in existing markets should the FCC allow.  At NAB, it was apparent from many broadcasters that operating multiple stations in a single market offers the highest synergies.  Presently, speculation surrounds SBGI attempting to purchase Tribune Media (TRCO).  TRCO owns TV stations in very large markets, while SBGI is primarily in small and midsize markets.  We expect SBGI to announce a deal to purchase TRCO within the next month.  TRCO will give SBGI the national scale it seeks.  Even with the reinstated UHF discount, SBGI/TRCO would be over the current cap at 44% reach.  We expect the FCC would give the company a waiver pending a complete review of all TV station ownership rules. SBGI could also divest certain stations as part of the deal to remain below the current 39% cap.

SBGI and the local TV station business do face secular challenges.  TV ratings are under consistent pressure, which impacts advertising sales.  Competition for ad dollars from online businesses, especially Facebook and Google, is fierce and local TV is losing market share.  The industry also faces cost pressures as the big four networks charge their affiliates more and more for the rights to broadcast their programming.  This pressures margins and slows the growth in net retransmission revenue, the biggest driver of growth for the industry over the past five years.  Relaxation of ownership rules that set up SBGI, NXST, and other industry participants to grow via transformative and accretive acquisitions is the antidote to the slow or non-existent organic growth of the TV station business.

As mergers occur and the industry consolidates, we expect investors to revalue upward the very high free cash flow per share produced by TV station owners.  Many media companies trade at free cash flow yields of 5-10%, while a pro forma SBGI/TRCO would be trading at a yield of 15-20%.  Should investors value SBGI at a 12% free cash flow yield, the shares could rise to $54.

SBGI 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.  SBGI 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.

No Changes to Market Cap and Style Models

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Despite a lot of underlying movement in the indicators, there are no changes to the recommendations from Northlake’s Market Cap and Style models.  The Market Cap model remains on a small cap signal and the Style model still reads neutral on growth vs. value.  With no changes to the signals, client positons in the Russell 2000 (IWD), the Russell 2000 Value (IWN), and the Russell 2000 Growth (IWO) will be held at least one more month.

Both models saw substantial movement in their internal indicator readings.  Internal indicators measure stock market technical and trends, so given the large variation between small and large cap stocks and growth and value stocks so far this year, the internal indicator readings changed.  Recently small caps have lagged and growth has led, so the internal indicators shifted from small to large cap and value to growth.  The external indicators, purposefully designed to be less volatile and focused primarily on economic data, remain solidly recommending small caps and value.  The message from the external data is that the economy is in good shape.  This usually leads to good performance for small caps and value.  The actual daily trading action recently might be sending a signal that the external data is going to change.  The models are purposefully designed to work this way with internal indicators providing timeliness and external indicators focusing on the longer term big picture themes.

So far this year, the models have been off target due to the small cap signal form the Market Cap model.  Small caps have given up some of their strong relative performance at the end of 2016.  So far, Northlake sees that as a normal relative correction rather than the end of the Trump Trade that favors small caps.  The small cap signal has led to poor relative performance from the Market Cap model in 2017.  Growth and value have been fairly even this year but the small cap signal has investment focused on small cap growth and value, contributing to underperformance for the Style model as well.  Thankfully, individual stock performance has been excellent this year offsetting the performance of the models.

IWM, IWN, 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.