MGM Resorts Working Through Headwinds

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MGM Resorts (MGM) reported pretty good 1Q18 earnings but lowered its outlook for the rest of the year based primarily on company specific factors.  The business environment in Las Vegas and Macau remains favorable and should stay that way short of a global growth slowdown or recession.  MGM’s problems are partially due to poor communication of their outlook.  This is the second time this happened in the past year, adding to our frustration.  The stock reacted sharply lower in the two days following the earnings.  We believe it now incorporates the lower outlook and a penalty for lower confidence in management.  An upcoming analyst meeting in May should allow management to restate the bull case and rebuild confidence.  We also see the company as vulnerable to an activist investor given heightened M&A activity in the gaming industry.  Thus, while we are disappointed and frustrated, we are sticking with MGM for now.

MGM’s 1Q18 results were pretty good at the property level, coming in ahead of expectations.  Corporate expenses were elevated and appear likely to stay that way.  The critical RevPAR metric fell over -4% but that was actually at the top end of guidance.  MGM is more focused on Las Vegas than other casino operators. Those operators raised expectations for MGM with strong results and commentary in the days just prior to MGM’s report.  This made MGM’s disappointing guidance especially surprising and triggered a big sell-off in the shares.

Management attributed the lowered outlook mostly to a slower than expected rebound at Mandalay Bay after the tragic shooting in October and greater and longer than expected disruption at Monte Carlo which is being completely renovated and rebranded.  The company also had some bad luck with the cancellation of a major prize fight and unusually low hold so far in April.  We can forgive these items but still call out management for poorly communicating expectations surrounding Mandalay Bay and Monte Carlo.  Unfortunately, this is the second time in the past year where management failed to communicate clearly and accurately when discussing guidance.  We are much less forgiving on this matter.

We believe that MGM has reset the bar and should achieve its new guidance.  In addition, the company has the opportunity to execute better and explain itself at its upcoming analyst meeting.  There is a great value in MGM shares which are trading at just 8X the lowered EBITDA projections when backing out the publicly traded values of MGM China and MGM Properties.  Global peers trade at 11-12X EBITDA and regional casino companies in the US trade at 8-9X.  There is an ongoing wave of M&A activity in the U.S casino industry and we see MGM as vulnerable.

The basic story of peaking capital spending and an inflection to material free cash flow is still in place.  Management was extremely chastened and apologetic on the call.  We felt they were sincere.  They are highly motivated for multiple reasons to hit their new guidance, improve communication, follow through on returning capital to shareholders, and produce positive earnings surprises.

The recovery in the shares could take time as MGM is now a “show me” story.  The first opportunity comes on May 11th at the analyst meeting.  We are sticking with MGM at least until then.  If the story gets back on track as we expect, a return to the uppers $30s provides almost a 30% return.

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.

Comcast Posts Solid Performance Amid Strategic Concerns

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Comcast (CMCSA) has become a difficult company and stock to analyze.  The latest quarterly earnings report indicates 2018 is off to a decent start but not without significant challenges that reinforce the long-term concerns about video subscriber losses and broadband competition.  Complicating matters further is the company’s offer to buy Sky, the dominant satellite TV company in the U.K and Europe.  There is also still well reported speculation that Comcast is interested acquiring most of 21st Century Fox that Disney has agreed to buy.

There is plenty to like about Comcast.  Despite the well-publicized subscriber losses in cable TV, broadband subscribers and ARPU are still growing and growth in business customers remains at double digit levels.  In 1Q18, cable revenue grew 3.6% and cable EBITDA grew 4.7%.  Cable faces challenges but the sky is not falling yet.  Programming expenses grew only 3%, the first sign of a long awaited slowdown that should remind investors that moderate subscriber losses in cable TV are not the end of the world.

Leaving aside the Olympics, NBCU grew revenues nicely and had a 13.1% increase in EBITDA.  NBCU’s continued strong growth is important given that its historical success is being offered by management as a blueprint for why Sky and possibly Fox assets are the correct strategy.

The balance sheet and cash flow remain in great condition.  Debt to EBITDA is an industry low 2.2X, firmly in investment grade territory.  Capital spending has peaked in absolute dollars and relative to revenue, powering free cash flow.

Presently, an investment in Comcast comes down to balancing solid near-term financial performance against long-term secular challenges and the company’s M&A strategy.  Northlake thinks the company and the cable industry can perform better than the consensus expectation as video subscribers fall, leaving our primary concern around M&A.  Management rightly points out that the NBCU deal has been a home run.  Furthermore, the attempt to buy Time Warner Cable that was blocked by the FCC and DOJ was clearly a smart move.  Looking further back, Comcast was built by acquisitions and has created a lot of shareholder value.  Our concern is that the acquisition history is not indicative of success for the current Sky and Fox strategy.  The cable and TV network industry has changed.  Subscribers, ratings, and advertising are falling and the well-established trends of OTT viewing, driven by Netflix, are firmly in place.  We understand that Comcast believes M&A is the right strategy to fight back against these trends.  The DNA of large corporations is to grow. Northlake would prefer the company to use its balance sheet and free cash flow strength to buy back stock and raise the dividend.  This is the clearest and safest path to enhance shareholder value in the challenging and still rapidly evolving media landscape.

CMCSA shares are trading at under 8X EBITDA.  Backing out NBCU, whose peers trade at a premium, leaves the cable business valued at near 7X.  Even with the secular challenges and lingering questions about acquisition strategy, this valuation incorporates a lot of negativity.  Northlake has more concerns about CMCSA than it has had in some time but based on our long, successful association with the management team, we are sitting tight pending the outcome of the Sky and possibly Fox transactions.  We think the shares belong in the low $40s and would be sellers near those prices.

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.

Sherwin Williams: Betting On The Long-Term Amid Short-Term Headwinds

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Sherwin Williams (SHW) beat 1Q18 sales and profit expectations, but unexpectedly reduced 2018 consolidated earnings guidance from $19.05 to $18.65 reflecting new investments in an expanded partnership with Lowe’s. SHW expects to recoup the entire $0.40 2018 EPS impact in 2019, noting that the incremental investment would be accretive to sales and profits next year. Excluding the new investment, SHW effectively reiterated 2018 guidance and noted the potential to increase guidance later this year depending on how paint season shapes up. The first quarter is generally a smaller quarter seasonally and SHW typically prefers to wait until mid-year before adjusting guidance. SHW has made substantial progress on integrating the Valspar acquisition and remains on track to create substantial shareholder value with meaningful long-term growth prospects. Northlake continues to expect SHW to move toward $450-$500 in the coming years as earnings per share climb toward $25 by 2020.

SHW is increasingly confident in the ability to capture $385-$415 million in annual cost savings related to the Valspar acquisition, while most of the one-time costs to achieve these ongoing savings will be booked in 2018. Further, SHW noted the potential for incremental revenue synergies. June 2018 will mark the anniversary of the Valspar acquisition, potentially allowing SHW to begin simplifying the consolidated financial results and paint a cleaner picture of the long-term growth potential.

Both the Americas and Consumer Brands segments performed well in 1Q18. The Americas segment benefitted from strong sales volumes driven by an ongoing shift from “do it yourself” to “do it for me” paint jobs. The Consumer Brands segment benefitted from price increases that offset rising costs in raw materials SHW uses to create paint products. The Performance Coatings segment underperformed, as this segment is furthest behind on Valspar integration and faces the highest raw material inflation due to more complex material inputs. Notably, Valspar was one price hike cycle behind SHW when acquired, and SHW intends to close this price gap throughout 2018. Raw material inflation headwinds are expected to ease in the second half of 2018 as comparisons to the prior year normalize.

In summary, Northlake continues to expect SHW will climb toward $450-$500 as investors become more confident in the long-term growth potential. SHW will continue to benefit from the still strong housing and remodeling environment while it completes the integration of Valspar. As we approach the anniversary of this acquisition in June, the benefits should start to become more apparent in the consolidated financial results. By the end of 2018, SHW will have substantially reduced debt, allowing a renewed focus on investing in growth and 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.

Alphabet: Expense Growth Overshadows Revenue Upside But It Is Money Well Spent

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Alphabet (GOOG/GOOGL) reported mixed results relative to consensus expectations for 1Q18.  The results also contained a lot of noise due to accounting requirements.  The key takeaways for Northlake are that the company is still growing quite rapidly given its size, while the cost of sustaining the growth is rising.  We emphasize the long-term opportunity over the short-term costs especially since (1) revenue growth in core search remains strong, and (2) opportunities in self-driving cars, cloud, and YouTube are large.  The bottom line is we think GOOG is correct to invest for the future and that sustaining 20% revenue growth will eventually be rewarded by investors as expense growth moderates.

2019 and 2020 estimates for EPS are coming down slightly with operating expense and capital expenditure growth exceeding still vibrant revenue growth.  With Wall Street nervous about large cap technology stocks for the first time in a while due to the privacy issues and a possible investment landscape shift to late economic cycle concerns (interest rates and inflation), GOOG shares are trading down almost -4% in response to the earnings.  We expect to see a better balance between revenue and expense growth beginning in 2Q18, which should limit downside.

GOOG shares trade at around 21 times slightly lower 2019 estimates.  This is an attractive level for a large cap company that continues to post 20% growth.  The P-E ratio looks even more attractive when considering the company has over $100 per share in net cash on its balance sheet and several high growth businesses such as Waymo (self-driving car technologies) and cloud that are losing money or under earning relative to their large potential.  We also see YouTube as undervalued within the GOOG market capitalization when comparing it to Netflix and other video centric companies.

If we have one significant complaint, it is that GOOG provides limited information about the company’s different businesses.  This has become a widely held complaint on Wall Street.  We see upside of 20% in the shares but we suspect investors will want to see signs of improved balance between revenue and expense growth and/or better disclosure before the shares begin another move higher.  Northlake is willing to wait.

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.

An Unusually Strong Growth While Growth Leads A Correction

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Northlake’s Market Cap model moved from mid cap to large cap for April.  This is the first large cap reading since September 2017.  The Market Cap model often moves in stair step fashion from small to mid large and large to mid to small.  For December 2017, the signal was small cap, so the new large cap reading could be seen as completion of the current step function.  Interestingly, the current Market Cap reading of 12.5 is in the top 5% for large cap strength of all model readings since we started testing the data in March 1979 (on a scale of 1 to 100 where 1 would be the strongest possible large cap reading)!

Each of the internal and external components of the Market Cap model has eight indicators. Presently seven of the eight indicators (14 of the 16 total) favor large cap.  Simply put, both the stock market action and economic data are in sync in recommending large caps.  It is hard to read too much into this but it does coincide with investors expressing growing concern over the future path of the economy given news and headlines about trade wars, higher interest rates and inflation, and a more activist executive branch when it comes to oversight of major sectors of the U.S. economy.  One read could be that large caps are safer than small caps and the exceptionally strong model reading is signaling a slowdown in the economy and weaker stock market performance.  We plan to back test our model readings in the near future to test this theory.

The Style model remained at growth for a second consecutive month.  The overall reading is quite strongly in favor of growth though not at the extreme level of the Market Cap model.  Internal Style indicators are unanimous favoring growth in recognition of the strong performance of growth stocks, led by the big internet platforms until the very recent Facebook led decline.  The external indicators are split equally between growth and value indicating that economic factors are more mixed in their impact.

We never outguess our models but we do try to see if they offer insights and match our thinking.  Northlake feels comfortable with large growth stocks despite their recent sharp declines.  This is especially the case with Google and Facebook, where we could always make a valuation case as opposed to some other growth stocks. If the underperformance of growth stocks continues, it will prove the current internal indicators wrong.  In that case, we hope the short-term technical indicators, designed to pick up turning points, flip quickly and shift the model to value.

With the shift to large cap in the Market Cap model, client positions following the model that had been in the S&P 400 Mid Cap (MDY) have been sold and proceeds reinvested into the S&P 500 (SPY).  Positions in the Russell 1000 Growth will be held at least one more month.

SPY and IWF are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.