Conservative Guidance Sets Up Nexstar to Outperform

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Nexstar Media Group (NXST) reported good 4Q17 earnings with strength in political and digital advertising offsetting slightly worse than expected growth in retransmission fees.  Guidance for 2018 and 2019 was limited to average annual free cash flow.  At $600 million per year, it was below street expectations.  The culprit appears to be timing of renewals on retransmission fees (paid to NXST by cable, satellite, and OTT operators for the right to carry their local TV station signals).  Retrans fees have been rising steadily as TV stations get paid more closely to the level of viewership they provide.  NXST had relatively few stations renew during 2017 and that occurs again in 2018 before 80% of their stations renew in 2019.  The level of retrans revenue expected in 2020 is unchanged, reinforcing the timing nature of the lower expectations.

Northlake remains highly confident in its long position in NXST.  The company produces prodigious free cash flow averaging over $13.00 per share the next years.  FCF represents 18% of the current stock price, a level 2-4 times that of most stocks.  Investors have little faith in the long-term outlook and financial forecasts for media companies, so NXST is not alone in looking cheap.  We believe (1) the company has among the best management teams we know, (2) the new guidance is conservative and likely to be exceeded, and (3) local TV is insulated from the challenges facing traditional media as local TV is about local news, where TV ratings are holding up well during a period when news has risen in importance in the national conscious.

NXST shares have pulled back about 5% since the earnings report and lack a near-term catalyst.  However, we expect increased visibility on 2018 advertising trends, further industry mergers and acquisitions following recent deregulation of the industry, and debt reduction will reignite interest in NXST shares.  Quickly forgotten was a recent 20% increase in NXST’s dividend, a clear signal of the confidence of the Board and management in the outlook for modest growth and incredibly strong cash generation.  We see upside in NXST shares to at least the mid-$80s and could easily construct a scenario where they approach $100 in the next year or two.

NXST 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.  NXST 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.

 

MGM Clears Hurdle to Resume Uptrend

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MGM Resorts (MGM) reported 4Q17 results in line with to slightly better than expectations.  Due to a variety of factors including poorly communicated guidance in 2016, a delayed opening for the company’s new casino in Macau, the tragic shooting at Mandalay Bay on October 1st, a shift in metrics away from industry standard revpar, and a few new hotel/casino project announcements by competitors, MGM shares have not fully participated in the stock market rally.  Investors were tense heading into the 4Q17 results and 2018 guidance with bulls and bears both on edge.

They key items in the report were a -4.9% decline in revpar, just slightly ahead of -5% to -7% guidance, 1Q18 guidance for revpar to fall -2% to -4%, and 2018 revpar to rise 2% to 4%.  Also, 1Q18 margins will soften by a higher than expected 250 basis points.  All this news kept the bull vs. bear battle intact but the company did well on its conference call explaining the guidance and especially stating the bull case for Las Vegas and the company.

Northlake’s updated view on MGM remains very positive and we think the shares can rise to the low $40s assuming guidance is reached and there are no unexpected macro pressures.

Rather than give clients the usual quarterly recap, we thought we would share the views of Kevin Fitzpatrick, a colleague who works at Gabelli & Company.  Kevin knows the MGM story well and talks to lots of different investors about the company.  He kindly shared the comments and allowed us to reproduce them.  Kevin’s thoughts capture Northlake’s thinking well after the least earnings report and conference call.

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The past two calls, ever since Murren (MGM CEO James Murren) miscommunicated the weakness of Q2’17, have been really good. Typically, any company I follow with an ex-Wall Street/ex sell side guy running the company knows what to say.

I liked a few things about the call:

1.)   MGM is focused on reasons to come to LV, rather than places to stay. Raiders Stadium (NFL, Bowl Games, World Cup)

2.)   Convention Center Expansion

3.)   MSG Sphere (could be cool)

4.)   T-Mobile Arena (Golden Knights are 1st place in their division, Basketball – NBA Summer League, Boxing)

5.)   Interstate 11 Project (AZ visitation)

As we know some new supply is coming to Las Vegas, but bringing something different to the market, which should help overall visitation

1.)   Resorts World LV (Asian visitors)

2.)   Wynn Paradise Park (big visitor draw)

All of this ties in nicely with our investment thesis which remains even more true after the past Q:

1.)   Profit focus: Improved analytics capabilities are enabling management to focus on maximizing total profit per occupied room rather than simply room rates (revpar).

2.)   Cotai: We do not believe that the property is fully reflected in MGM China’s valuation.

3.)   Free Cash Flow: We expect free cash flow generation to accelerate dramatically heading into 2019.

4.)   Undervalued: Core MGM valuation remains discounted relative to peers and historical transaction multiples.

5.)   Strip Renovation Opportunities: we see opportunity for high-ROI capital investment into MGM’s south-Strip.

I think this is the year for MGM to really outperform.

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Thanks, Kevin!  Here at Northlake, we could not agree more!

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.

 

Expectations Closer to Reality at Liberty Global

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Liberty Global (LBTYK) reported a mixed quarter to end 2017.  Rebased revenue grew 3%, a nice acceleration, albeit to a still low level of growth.  Rebased operating cash flow grew just shy of 5%, basically meeting guidance for “around 5%.”  Northlake has been waiting a couple of years for LBTYK to show growth acceleration on the back of its strategy to add wireless to its cable triple play bundles and to build out millions of new homes to which it could offer service.  Unfortunately, at one time we expected revenue growth to accelerate to mid single digits and operating cash flow growth to ramp to high single digits.  Our view was based on management guidance and our analysis of the company’s historical growth rates and prospects.

What went wrong?  First, competition of cable TV, broadband, wireline phone, and wireless phone in the company’s European markets was tougher than we expected.  Second, management executed poorly, especially on its new build project in the UK.  Finally, the strategic rationale of a broad European footprint expansion and focus on the quad play may have been mistaken, at least relative to the option of having a little less debt and buying back a lot more stock.  Of course, there is no denying that this is all easy to say with the benefit of hindsight.

If you have read this far, you are probably expecting the punch line to be that Northlake is selling all shares of LBTYK.  We plan on it, but not quite yet.  Two catalysts exist that we think can get the stock to work materially higher over the next six months.  First, while at a lower rate than we ever expected, expectations for 2018 operating cash flow growth should finally be reset to a level the company can meet or slightly exceed.  Improved execution on the UK new build project, tight cost controls, and the synergies from the wireless acquisition in Belgium should provide a good base to meet growth expectations.  Second, and more importantly, on again, off again M&A discussions between LBTYK and Vodafone are back underway.  It appears that Vodafone may purchase assets from LBTYK in German and Eastern Europe.  Based on recent transaction multiples for similar assets, these sales would be at prices accretive to the valuation the market currently places on LBTYK.  We think a deal will happen this time and that should pop LBTYK shares higher.  An even better scenario would be if the two companies would complete a full blown merger or an asset swap, either of which would be even more accretive for LBTYK shareholders.

LBTYK has been a disappointing investment over the last few years.  One way or another the end is sight.  We want to get our exit right rather than give up at a discounted valuation when potential catalysts are in reach.  So, for now, Northlake remains long LBTYK.

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.

CBS Successfully Navigating Challenging Environment

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CBS reported better than expected 4Q17 results but in what has been a consistent pattern for several years, the shares did not respond favorably.  There has been a long list of issues for CBS shares mostly focused on the changing consumption of television as viewers migrate to services like Netflix and Hulu and younger viewers eschew traditional network programming all together.  A new issue for CBS is that its controlling shareholder, National Amusement, seems determined to force a merger with Viacom (also controlled by National Amusement).  Recent reporting on the matter appears to favor Viacom shareholders and management relative to CBS, which leaves CBS shares under pressure.  The Viacom merger discussions should reach a conclusion within the next few months.

At this point, although we have reservations about the long-term strategic value of the merger, we believe the announcement will be met with relief and should spark a rally in deeply oversold and undervalued CBS shares.  The primary risk in the merger for CBS shareholders is that CBS is forced to pay a premium for Viacom shares – something we see as undeserved – and that National Amusement is willing to sacrifice CBS’s highly regarded management to force a merger.  At just over 10X confidently provided 2018 guidance, we feel these risks are already heavily discounted in CBS shares.  Thus, we plan to let the CBS-Viacom merger discussions play out and revisit our investment thesis on CBS shares once we know the details.

In the meantime, the latest quarterly results and the accompanying management commentary give us confidence in the near-term and long-term outlook for CBS.  Earnings results at the operating level met expectations in what continues to be a challenging environment for traditional TV networks.  Growth is modest against tough comparisons to 2016 when CBS aired the Super Bowl and enjoyed heavy political ad spending.  Underlying drivers are clearly positive, however.  Political spending is poised for a huge year with recent special elections indicating heavy TV spending will again be the norm after the Trump campaign managed to get by on free and social media.  More importantly, CBS’s initiatives in direct to consumer digital streaming are running ahead of schedule and lead its traditional media peers by a big margin.  CBS now has 5 million combined subscribers for its CBS All Access and Showtime OTT products, which combined are tracking to generate over $500 million in revenue in 2018.  CBS is managing this transition well as it continues to monetize its large programming library and production by selling some rights to Netflix and other third parties primarily in international markets.  Finally, CBS continues to increase the predictability of its revenue and profit stream through growing retransmission fees paid by cable and satellite operators and local TV station affiliates.  This revenue stream grew 31% in the quarter and is locked in at a high growth rate for at least 3 to 5 years.  There is also a built in hedge as a cable or satellite subscriber lost to All Access or one of the new cable-like OTT services pays CBS a greater monthly subscription fee.

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.

Activision Blizzard Resets the Bar Lower for 2018

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Activision Blizzard (ATVI) once again beat expectations upon announcing 4Q17 and 2017 results. However, guidance for 1Q18 and 2018 were mixed, with full year guidance generally in line with expectations while 1Q18 guidance appeared a bit light. ATVI has demonstrated a consistent pattern of issuing conservative guidance and then outperforming each quarter. Northlake believes ATVI has followed this approach again for 1Q18, setting up another beat-and-raise opportunity assuming execution remains strong. All three operating segments – Activision, Blizzard, and King – are on strong growth trajectories and industry tailwinds remain intact.

Call of Duty: WWII, the newest installment of the key CoD franchise, has been the best-selling version on the current generation of game consoles since CoD: Black Ops III two years ago. This encouraging news helps to ease fears that gamers were becoming fatigued with the series after lackluster sales of previous versions. Destiny 2 has also performed well, even as news of mild frustration with changes from the original Destiny game mechanics have been reported. These two franchises are expected to drive growth for the Activision segment via constant additions of downloadable add-on content and in-game transactions. The shift to digital full-game downloads has also been a major benefit to the industry, including ATVI, and appears to have room to run as internet speeds and console storage space improve.

The Blizzard segment celebrated a successful launch of the Overwatch League (OWL) in the last quarter. Twelve professional e-sports teams have been sold, and are now competing in the inaugural season. Viewership of OWL started strong, but has tapered off in the subsequent weeks. In comparison to the viewership of the most popular e-sports such as League of Legends, OWL has a long growth opportunity ahead if they can execute on their vision. New league and team sponsors continue to be added, further bolstering the financial performance of OWL. Blizzard is also developing new expansions for Hearthstone and World of Warcraft that should drive ongoing engagement and contribute to profitability.

King Digital has been developing a mobile advertising business since ATVI acquired the company a little over two years ago. Recent developments include further investments in personnel with a focus on building out engineering, sales, and analytics teams. Other investments are being made to improve advertising technology infrastructure. King continues to test various ad formats with a keen eye on the impact to player engagement while still delivering value for advertisers. Although much progress has been made on this front, advertising will only be a modest contributor to profitability in 2018. In the long-term, the investments made to build a durable mobile ad business should substantially reward ATVI shareholders.

Despite Northlake’s confidence in ATVI’s execution and outlook, concerns surrounding valuation leave us considering a sale of some or all ATVI client holdings. The stock has moved close to our mid-$70’s price target, reflecting 25x 2018 EPS of $3. Any further upside will likely be driven by multiple expansion or estimate increases, both of which are possible. Given 25x 2019 EPS of $3.20 only implies upside to $80, the risk-reward balance could be shifting to the downside.

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. 

Sherwin Williams Successfully Integrating Valspar Acquisition

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Sherwin Williams (SHW) reported solid 4Q17 results slightly above consensus sales and earnings estimates. Heading into 2018, SHW expects earnings per share between $18.80 and $19.30 excluding Valspar acquisition-related expenses of $3.45. Importantly, SHW noted that most of the remaining costs to achieve the estimated $385-$415 million of annual acquisition synergies will be booked in 2018. The integration of Valspar appears to be going well, with both the overall size of expected synergies and the estimated time to achieve those benefits better than initially planned. Northlake continues to expect SHW to move toward $450-$500 in the coming years as earnings per share climb toward $25 by 2020.

From a business segment perspective, retail sales to “do it yourself” customers remain slower than hoped, offset by strong demand from contract painters. The strong housing cycle has been a nice tailwind for SHW, but there is a risk that rising mortgage rates will begin to offset that benefit as fewer consumers are able to afford home loans. Industrial markets also remain strong for SHW and Valspar. The primary challenge for the industrial segment in 2018 will be inflation in raw material prices, which will limit profitability to the extent that SHW is unable to pass through price increases to customers. Specifically, SHW expects an average increase of 4-6% in 2018 for key raw material inputs such as crude oil, propylene, and Titanium Dioxide (TiO2). SHW has historically demonstrated the ability to manage inflation risk by effectively implementing price increases as needed while maintaining strong customer relationships and delivering valuable products.

SHW currently has substantial debt on the balance sheet, partly due to financing for the Valspar acquisition. The company plans to use free cash flow to pay down excess debt in 2018. Once SHW reduces debt to normalized levels, free cash flow will likely be shifted towards other beneficial uses such as further investments in growing the business organically or via acquisition, or returning excess capital to shareholders through share buybacks.

In summary, Northlake expects SHW will move toward $450-$500, equating to roughly 20x 2018 to 2020 EPS. A backdrop of strong overall demand from contract painters and industrial customers should continue for the foreseeable future. While there are inflationary risks to the long-term outlook, they appear to be manageable. Once SHW has completed the Valspar integration and reaped the benefits, the combined company will be in a strong position to continue consolidating the industry while returning capital to shareholders.

SHW 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.  SHW 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.

Parks and Resorts Strong at Disney

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Disney (DIS) reported mixed results with the headline EPS number getting a big boost from a tax rate well below estimates.  Parks and Resorts was the positive standout with 13% revenue growth accompanied by operating leverage that boosted operating income growth to 21%.  The rest of the company’s divisions all reported flat to lower year over year revenue and operating income.  This has been a persistent pattern for Media Networks and Consumer Products for the last two years.  The Studio results are volatile due to the timing of film releases and there is no concern for this segment beyond the tough comparisons given the unrivaled intellectual property lineup of Star Wars, Pixar, and Marvel.

The investor debate surrounding DIS has calmed considerably over the past few quarters, allowing the shares to recover some of the losses that began in the summer of 2015 when the company first announced subscriber losses at ESPN.  Nonetheless, the shares have been a long-term laggard amid growing concern about the company’s ability to sustain growth given the potentially declining fortunes of its Media Networks in a world of cord cutting and cord shaving.

This provides a good lead into Northlake’s main takeaway from the quarter:  the investor debate has shifted to the company’s strategies for dealing with a world where TV is on demand and delivered direct to the consumer over the internet rather than through a cable or satellite company.  The company’s strategy is to gradually shift toward a direct to consumer strategy supported by the acquisitions of BAMTech and the Fox entertainment assets. BAMTech is providing the technology to deliver apps and over the top TV services built upon the bulked up intellectual property that now adds Fox.

While there has been some improvement in ESPN subscriber losses and a new cycle of affiliate fee negotiations with cable and satellite companies can improve results of the Media Networks segment over the next year or two, the long-term outlook remains quite challenging for these businesses.  Investors are still worried but seem to be giving the company the benefit of the doubt as it develops its direct to consumer strategies.  This is a big positive change for the prospect of DIS shares.

Northlake maintains its concern about the success of Disney’s direct to consumer strategies, especially the cost to build the subscriber base via marketing and programming investment.  However, these concerns are offset by an underappreciated bull case in theme parks.  Parks and Resorts steady growth as the rest of the company has stagnated leaves this division at 1/3rd of profits, its highest level ever.  This provides great support for the stock because other theme park and live entertainment stocks trade at significant premium valuations compared to DIS.

The bottom line is we continue to give DIS shares the benefit of the doubt trading at just 14X next year’s earnings, a cheap level on a historic or relative basis for a company of Disney’s quality.  Upside may be limited for now but a lift to a still inexpensive 16X would bring the stock up $120, a 15% gain from current levels.

DIS 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.

Market and Strategy Update

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What began as a normal correction related to a quicker than expected increase in market interest rates (the 10 year Treasury rose from 2.5% to 2.8%) accelerated on Monday afternoon due to trading related to volatility strategies.  These strategies helped the market on the upside over the past year but are largely unrelated to economic and corporate fundamentals.  While extreme downside market volatility can impact the economy as consumers and businesses lose confidence and hunker down their spending, Northlake sees current economic fundamentals in good shape and disconnected from the market downside over the past few days.  There is a lot of money invested in these complex strategies that needs to be unwound.  This is leading to further downside this morning and the days ahead are hard to predict.

Our strategy always looks at crisis periods first through the lens of whether it will impact the economy and corporate earnings and lead to a recession.  Our second viewpoint is the impact on the valuation we place on economic activity and earnings.  We do not presently see an economic or earnings problem.  The extreme volatility could impact the multiple paid for earnings as investors are reminded of risk after a prolonged period where it was ignored.  The bottom line is for the very short-term we are going to sit tight because we see investment fundamentals in good shape – economic growth, corporate earnings growth, corporate cash flows are all in good shape and poised to strengthen in 2018.

Below is a good explanation of what happened on Monday afternoon.  Most clients won’t understand what JP Morgan’s Technical Market strategist is talking about.  That is actually the point.  The trading is disconnected from economic fundamentals that drive long-term value and that is why we think the best course of action is to stay the course.

In last week’s note, we noted that volatility, at the time, was not sufficient to trigger systematic strategy de-risking. On Friday, the market dropped ~2% on a day when bonds were down ~40bps. The move on Friday was helped by market makers’ hedging of option positions (as gamma positions turned from long to short midday). Friday’s move, on its own, was significant as it pushed realized volatility higher, which is a signal for many volatility targeting strategies to de-risk. Anecdotally, broad knowledge about the risk of systematic selling kept many investors fearful and waiting on the sidelines (both in equity and volatility markets). Midday today, short-term momentum turned negative (1M S&P 500 price return), resulting in selling from trend-following strategies. Further outflows resulted from index option gamma hedging, covering of short volatility trades, and volatility targeting strategies. These technical flows, in the absence of fundamental buyers, resulted in a flash crash at ~3:10pm today. At one point, the Dow was down more than 6%, and later partially recovered. After-hours, the VIX reached 38 and futures more than doubled—it is not clear at this point how this will reflect on various short volatility products (e.g., some volatility ETPs traded down over 50% after hours).  Today’s large increase of market volatility will clearly contribute to further outflows from systematic strategies in the days ahead (volatility targeting, risk parity, CTAs, short volatility).

No Apple Super Cycle But Super Financial Strength

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Apple (AAPL) reported strong growth but mixed results relative to expectations for its 1Q18 ending December 31st.  iPhone unit sales fell short of still high expectations but higher than expected average selling prices allowed revenue growth to match or exceed Wall Street estimates.  Specifically, iPhone unit sales fell a little short of the 80 million estimate but ASP of $796 easily beat the consensus of $755 as the mix of iPhone X in the quarter was stronger than expected.  Receiving less attention but of growing importance to the long-term attractiveness of AAPL shares was another quarter of very strong growth for the company’s services and other products business segments.  App Store revenue, Apple Music, Apple Watch, and AirPods all are growing rapidly giving these combined segments another quarter of greater than 20% revenue growth at extremely high and accretive margins.

Over the past month, there has been a steady of drumbeat of signals that the iPhone super cycle was not living up to expectations.  Dramatic production cuts for March quarter iPhone units seemed clear from leaks in the supply chain.  Expectations of Apple’s iPhone, revenue, and EPS had all fallen significantly heading into the quarterly report.  Guidance for the March quarter ultimately came in at the low end of recent estimates, driving Apple shares lower on Friday in an awful market environment.

The debate on iPhone now shifts to whether this will be an elongated cycle driven by more gradual replacement of the massive installed base with FaceID based phones or whether smartphones have peaked and offer little or no growth with the risk of price cutting to drive units that undermines margins.  In other words, will smartphones face the same down cycle seen after PCs peaked?

We side with the elongated cycle and are comfortable that if we are wrong that the installed base can drives services and other product revenues and sustain organic growth in Apple revenue and EPS. Furthermore, the company’s massive financial strength is supportive of at least the current stock price and likely can drive the shares higher even if organic growth flattens (which we are not predicting).

Besides discussion of operating trends, the other highlight of the conference was the company stating that it intended to operate with zero net debt.  This means that the new tax law rules on repatriation will free up about $169 billion for the company to use for share buybacks, dividend increases, and acquisitions.  Given the largest acquisition Apple has ever made cost $3 billion, massive share repurchase is coming.

We are comfortable with consensus EPS estimates of $11.45 and $12.95 for this year and next year.  We also believe Apple can achieve those numbers before the benefit of incremental share buybacks.  The shares are not expensive relative to the market at less than 15 times 2018 earnings and the balance sheet provides strong downside support.  Thus, we feel we can remain patient with Apple even though we see less upside in the next few quarters.  Many Northlake clients have overweighted positions in Apple so if you see some partial sales, it is position management rather than a shift in our still modestly bullish view.

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.

Google Margins Concerns Emerge Again But We Are Not Very Worried

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Google (GOOG/GOOGL) shares fell after reporting 4Q17 earnings.  Revenue growth remained remarkably strong, rising 24% year over year, but Traffic Acquisition Costs (TAC) and other operating expenses rose even faster leading to margin compression and EPS below expectations.

The debate for Google investors has long been focused on (1) the sustainability of revenue growth, and (2) the cost of sustaining growth.  There has been long-term concern that revenue would decelerate due to competition or the just the maturity of the search business. Prior to the arrival of CFO Ruth Porat a couple of years ago, the company had a habit of missing operating margin expectations and appearing to have poor cost controls or return on investment discipline.  While revenue growth no longer seems a concern – it has actually accelerated in the past year – 4Q17 marked the first time in a couple years where expenses were well above expectations.

Northlake is forgiving of the expense growth given that it appears focused on driving big initiatives and signs of success are abundant.  MoffettNathanson Research captured it succinctly:

“As Google enters its 20th year, it’s remarkably still posting revenue growth above 20%.  We are hard pressed to find another company outside of Amazon that has ever achieved this rate of growth this late in its lifecycle.  Obviously, this track record speaks to the greatness of search as a business, but it also talks to the company’s continuing focus on finding and investing in future areas of growth.”

The investment continues in search and YouTube but is also focused on Google Cloud, YouTube TV, Waymo (self driving cars), and Nest.  Cloud and YouTube TV look very promising and are already scaling revenue and subscribers.  Waymo will be launching a full scale driverless ride sharing service in Phoenix this year.  As a money manager focused on long-term growth in quality companies for our clients, Northlake is tolerant of periods of heavy investment as long as the money seems to be spent wisely.  A single quarter acceleration that pressures margins is not very worrisome, especially when it comes during the holiday season where support for new products is naturally heaviest.

Management explained the elevated spending well on its 4Q17 conference call and noted the long running pressure from TAC should begin to ease later in 2018.  We see Google headed for around $50 in 2019 EPS, enough to justify a stock price above $1,250.  The renewed concern about operating margins could linger but we feel patience is warranted.

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.