Nexstar Media Group Reiterates Strong Free Cash Flow Guidance

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Nexstar Media Group reported inline but mixed results for 1Q18. Importantly, the company reiterated its 2018 guidance for $13.10 in average annual free cash flow per share in 2018 and 2019.  The political cycle leads investors in local TV broadcasters to look at valuation on a two year basis.  Normally, Northlake tries to avoid a lot of numbers in these quarterly earnings updates.  In the case of NXST, we point out the free cash flow because $13.10 represents 19% of the current stock price.  Given management’s track record at hitting or exceeding its guidance, raising the quarterly dividend, buying back shares, and accretively purchasing additional TV stations, we find this level of free cash flow extremely attractive.  We remain highly confident that one way or the other this cash flow will be put to use to enhance shareholder value driving NXST shares to at least $80 over the next year.

Free cash flow yields in local TV broadcasting stocks are among the highest of any industry we follow.  Most other industries have yields in the 3-10% range.  Investors appear to view stations as going the way of newspapers.  We agree the industry faces challenges but the bearishness implied by NXST’s valuation is far too steep.

NXST’s 1Q18 results offered mixed news on these challenges.  The disappointment was in core advertising growth, which fell 3%, well short of management’s guidance.  It is extremely rare for NXST to miss guidance on any metric but the company was not alone as ad trends throughout local TV were weak.  Good expense control, a hallmark of NXST, and strong political advertising made up for the core advertising shortfall.  Retransmission consent fees hit guidance and margins on this revenue held up well.  A big concern for investors is the increasing share of retrans that is being clawed back by the network owners (ABC, CBS, FOX, NBC).

Looking ahead to 2Q18, management expects little improvement in core advertising.  Auto advertising remains weak and the national ads that air on local stations generally are holding back growth.

Several catalysts lie ahead for the industry.  News on approval of the merger between Sinclair Broadcasting and Tribune Media is likely in the near-term.  A decision in a court case concerning the UHF discount could come this summer.  The FCC is likely to expand the national ownership cap this fall or winter.  NXST is well positioned regardless of the outcome of these decisions thanks to its free cash flow.  Volatility in the shares in both directions is likely as the news is released.  We are willing to absorb any downside in the shares as long our outlook for the U.S. economy is positive.

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.

Liberty Global Announces Accretive Deal with Vodafone

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Liberty Global (LBTYK) remains a very frustrating investment for Northlake.  1Q18 results were typical.  The company claimed growth in line with estimates with earnings and EBITDA up nearly 5%.  However, the results were boosted by a one-time catch up payment in Germany.  Excluding the payments, growth was around 3.5%.  This type of messaging has occurred over and over for LBTYK at the same time that the core growth rate for the business has been ratcheted down from high single digits to mid single digits to “around 5%.”  With cable and wireless growth rates throughout Europe declining amid increased competition, it is not surprising that LBTYK has lost the confidence of investors.

We have stuck with LBTYK because of our long history of success with the management team, even preceding the creation of Northlake in 2004.  We also think some of the criticism for the one-off items is unwarranted.  For example, when the catch up payments in Germany were withheld over the past year, Liberty was not adjusting its numbers upward, so it is arguably fair to include them now. Most significantly, we have stuck with LBTYK due to valuation.  The valuation argument is stronger today than ever following the announcement that LBTYK is selling operations in Germany, Romania, Hungary, and the Czech Republic to Vodafone for 11X EBITDA.  LBTYK is trading at 8X EBITDA making the sale highly accretive.  If you applied the proceeds of the sale to share buybacks (management said on its conference call that if they had the money today they would be buying back as much stock as they possibly could), the stub LBTYK is trading at just 6.5X EBITDA.  Growth may be slowing but that is a lower multiple than many European telcos that are lucky to grow even 1-2%.

The bottom line is we still see reasons to hang onto LBTYK with the shares trading at the bottom of the recent range.  Approval for the VOD sale could take a year but taking steps through the regulatory process could provide trading catalysts.  LBTYK is likely to close its prior sale of its Austrian business at an accretive multiple soon.  Growth in the all-important UK market has picked up the last few quarters and post the German sale it is the dominant business at the company.  A transaction in Switzerland to better position the company’s cable-only operations seems likely this year.  These catalysts plus the prospect for a cleaner quarter of growth near the 5% level make LBTYK worth holding.  If everything comes together at LBTYK we see the shares in upper $30s over the next 12 months.

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.

Super Hero Fight at Disney as Films and Parks Battle Networks

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Disney (DIS) shares remain at a very challenging juncture at the company’s spends heavily on its primary strategic priority, shifting its media networks business to a direct to consumer model.  A key part of this strategy is the acquisition of most of 21st Century Fox’s entertainment assets. In DIS’s latest earnings report, the company indicated spending at BAMTech (key to the DTC strategy) would lead to losses $100 million higher than previously projected.  The quarter also saw sharp deterioration in Media Networks profits margins from 37% a year ago to 34% this year.  Two years ago, Media Networks margins were 39%.  Furthermore, Comcast continues to pursue the Fox assets leading to the possibility that DIS would have to increase its offer, adding to the heavy investment in the DTC strategy.  Overall, Media Networks struggled and the core trends in subscribers and advertising continue to decelerate and paint a mixed picture at best long time.

In the meantime, the two other roads at the junction, Parks and Resorts and the Film Studio are booming.  Led by an unprecedented run at the box office, most recently, Black Panther and Avengers: Infinity War, the studio is growing rapidly.  The studio saw 20% revenue growth and 29% operating profit growth last quarter.  Parks and Resorts grew revenue 13% and operating profits gained grew 27%.  Operating margins in the segment were the highest we have in our spreadsheet for any second quarter.

Put it all together and DIS shares are difficult to forecast.  The stock trades at 14X projected earnings, below the market multiple by a significant amount for the nearly the first time ever.  It is hard to argue that DIS does not deserve at least an average multiple given its brand strength the deep interaction between its operating divisions.  However, CBS trades at less than 10X.  Time Warner is being out for 13X.  Discovery trades at 8X.  These companies may not be as strong as DIS but they all face similar secular challenges in subscriber growth, TV ratings, and sing growth and the expensive investments required to thrive in a new world of internet delivered TV; a world where success is not guaranteed.

Northlake is willing to give DIS the benefit of the doubt as the power of the company’s family friendly brands suggest success in an OTT world is possible.  While we wait to find out, Parks and Resorts the Film Studio can support the stock.

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. 

 

Activision Blizzard Starts 2018 with a ‘Beat and Raise’ Quarter

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Activision Blizzard (ATVI) reported 1Q18 results above expectations, but provided underwhelming guidance for 2Q18. The full year outlook for 2018 was increased slightly, but still remains below street expectations. ATVI is typically quite conservative with guidance, and combined with the back-half weighted content slate compared to 2017, we expect results to surpass guidance for the full year.

Strength in the quarter was driven by in-game content sales which grew over 10% in all three segments. Both the Blizzard and King segments had strong sales, although profitability for Blizzard was limited by investments in growing the new Overwatch League (OWL). The Activision segment, especially Call of Duty: WWII, was negatively impacted by competition from Fortnite. ATVI also noted a slight benefit from earlier timing of sales compared to expectations.

Digging further into the Activision segment, excitement is building for Call of Duty: Black Ops 4. The Black Ops sub-franchise has been the most popular variant of the game to date; the expected inclusion of a “battle royale” game mode – similar to Fortnite – should alleviate some competitive concerns. Destiny 2 will launch the Warmind expansion this quarter, with a larger expansion planned for the fall. Both expansions have received praise from the Destiny community. Following up on the successful launch of a remastered version of Crash Bandicoot last year, ATVI will relaunch Spyro the Dragon this year. The ability to continue to monetize older games demonstrates the lasting value of the company’s game library and intellectual property.

The OWL continues to gain traction for the Blizzard segment. ATVI plans to add a handful of teams to the existing group of 12 by the end of the year. Interest from viewers and sponsors has been strong to date. ATVI expects to leverage the new capabilities and infrastructure built for OWL on other franchises in the near future, notably including Call of Duty. Blizzard recently launched a popular expansion to Hearthstone, with more in-game content and game modes still under development. World of Warcraft (WoW) has seen strong pre-sales for the expansion that will launch in August.

The King segment reached an important milestone in the quarter: the nascent digital advertising business reached profitability. Ad profits will ramp throughout the year before becoming a more meaningful contribution to ATVI in 2019. Key hires were made to bolster product development, marketing, and measurement capabilities. King is taking a creative approach to ads that drive engagement and monetization without negative impacts to the player experience. Ad formats that are supportive of gameplay (as opposed to disruptive) benefit gamers and advertisers alike. The two most popular versions of the crucial Candy Crush franchise remain at the top of the various app store game charts thanks to strong in-game content spending. King plans to launch new games in 2018 and beyond.

In summary, 1Q18 results demonstrated the durability of critical franchises owned by ATVI. Call of Duty struggled in 2016 only to rebound in 2017; 2018’s Black Ops 4 is expected to be even stronger and more innovative. Destiny 2 was initially plagued by gameplay issues voiced in the gaming community, but ongoing expansion content is addressing these issues and driving further engagement. WoW, Hearthstone, and Candy Crush are on a roll, and older games from the ATVI library remain in demand. Northlake sees ATVI as near fair value based on 25x 2018 EPS of $3, with upside to $80 as we move closer to 2019 EPS of $3.20.

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.

Light at the End of the CBS Tunnel

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CBS has been the most frustrating stock in the Northlake portfolio.  The company has consistently met or exceeded earnings estimates, steadily increased its dividend and share buyback, pruned its portfolio wisely to reduce advertising exposure and cyclicality, and is the clear leader among broadcast and TV network companies with its OTT strategy.  However, none of this has mattered.  CBS shares have declined steadily since last August from a high of $68 to last night’s closing price of $49.

Despite doing almost everything right, CBS has been tarnished by legitimate secular concerns facing traditional media:  cord cutting/subscriber loss, declining TV ratings, and weak or declining advertising trends.  Those are fair reasons to sell or short the stock and we have explained numerous times the errors we have made with our media stock investments by emphasizing value vs. investor sentiment about the long-term secular issues.

The second culprit has been the ongoing saga about CBS and Viacom merging.  CBS investors hate the idea given that Viacom’s business has performed abysmally over the last three years and the two company’s common controlling shareholder appears ready to force the merger on CBS, even if it means the CBS management team that has steered the company so well through stormy waters is pushed out.

Thankfully, last night’s 1Q18 earnings report has provided relief for CBS shareholders.  The stock is trading up over 5% in response to a very strong report pretty much across the board.  EPS and revenue produced material upside surprises driven by both advertising and content businesses.  Equally important, CBS announced that its two OTT services, Showtime and CBS All Access have a combined five million subscribers.  CBS stands out from its peers in having successfully launched direct-to-consumer services.  CBS is also included on all but one of the rapidly growing cable substitute OTT services.  This strategy has real economic benefits since it means CBS subscribers are growing (while other TV networks are declining) and the new subs pay a higher fee to CBS directly than what the company earns from its traditional cable and satellite customers.

If today’s big up move is going to mark the bottom for CBS shares, the next step has to be a satisfactory resolution of the Viacom merger discussions.  We see a lot of potential value creation in the merger for CBS shareholders as long as the purchase price is fair and CBS management initially is in control.

On a standalone basis, we thing CBS can trade back to the low $60s based on a P-E of 12 times 2018 consensus earnings estimates.  This is a premium to other TV-centric media stocks but CBS has earned a premium.  With a well-structured Viacom deal completed, we think the shares can reach $70 in 2019 based on significant EPS accretion to current CBS earnings estimates near $6.  It has been a long painful stretch for CBS shareholders.  We believe the end has just begun.

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.

Better Apple Results and Guidance Amid Cautious Sentiment

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There is no super cycle at Apple but business fundamentals at Apple still look solid.  Apple reported earnings in line with Wall Street estimates but ahead of fears.  Guidance for the next quarter was ahead of recently lowered investor expectations.  The key takeaways from Apple’s quarter are:

  • iPhone units volumes are not collapsing, growing 3% year over year in the March quarter with implied guidance for flat sales in the June quarter.
  • The iPhone X strategy is having important positive effects. It was the best-selling phone during the quarter, the first time since Apple split the iPhone line into a regular phone and plus phone that the high end phone was the best seller.  This drove ASPs up 11%, leading to a 14% revenue increase for iPhones.
  • China revenues grew 21%, the highest growth rate in several years. The iPhone X did particularly well in China as despite overall weakness in the country’s smartphone market, the high end remains solid.
  • Services and wearables grew very strongly, north of 30%. These business lines are up to 13% of total Apple revenues and getting large enough to help overall revenue growth and profit margins.
  • Within Services, Apple claims to have 270 million paying subscribers, up 100 million year over year. Apple Music and iCloud are the bulk of these subscribers.  Subscribers offer predictable high margin revenue that Wall Street loves.  See Netflix, Amazon Prime, and Spotify.
  • Recent pressure on gross margins should begin to ease as 2018 progresses. With the rising contribution of high margin services and wearables, 2019 could see positive operating leverage.  Several analysts pressed this point and while management would not confirm they did not push back very hard.
  • Inventories of iPhones are in good shape, within their normal range of 5 to 7 weeks. This suggests sell though of phones in the March quarter was up mid single digits.  More importantly, it sets up the June quarter to have unit volumes north of 40 million, well ahead of recently lowered estimates centered around 39 million.
  • Apple still believes smartphones are a growth market based on the fact that 500 million feature phones are still sold every year and eventually every phone sold will be a smartphone.
  • The company raised the dividend by 16% and initiated an additional $100 billion buyback. We would prefer a larger dividend but approve overall of the capital allocation strategy.  We expect another large buyback announcement and dividend increase next year at this time.

Overall, we feel better about Apple than we have in several quarters.  Investor sentiment and expectations have cooled yet the business is still on solid footing.  2019 could set up well if the new phones announced this fall sell well; a fair assumption as the lack of a super cycle on the iPhone 8/X leaves a huge base of 2-4 year old phones that could be upgraded.  There is some evidence among the latest U.S. wireless carrier reports than upgrade rates could be bottoming.  Continued growth in high margin services and easing margin pressures as the iPhone X matures and component inflation eases could be evident by later this year.

Northlake still sees upside in Apple to around $200 based on 15X 2019 consensus earnings estimates.

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. Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.

Sticking With Large Cap and Growth

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There are no changes to the recommendations from Northlake’s Market Cap and Style models for May.  The Market Cap model is signaling large cap for the second consecutive month, while the Style model remains on a growth signal for the third straight month.  As a result of the latest signals, Northlake client accounts following the models will continue to own the S&P 500 (SPY) and the Russell 1000 Growth (IWF).

Last month we noted that the large cap signal was one of the strongest on record.  This remains the case again for May.  As would be expected given a repeat of the exceptionally strong growth signal, there was little change in the underlying indicators in the Market Cap model.  Again this month, seven of the eight internal and external indicators are flashing large cap.

This is not the case in the Style model where five of the fourteen indicators shifted from growth to value.  The single month reading puts the Style model at neutral but to dampen volatility and false signals, our model uses two month smoothing where growth is still favored. We are not surprised that there was a move back toward value given all the issues that have popped up with growth stocks (FB privacy issues, GOOG earnings) and the volatile daily trading of growth stocks.  In addition, there has been an increasing focus on higher interest rates and higher inflation.  Each are late cycle phenomenon, which is often a time that value stocks outperform.

A typical day in Northlake email contains at least one report discussing whether the growth stock trend is rolling over in favor of value.  This is why we use models.  We want to base our decisions on facts and proven reasoning that has worked historically.  Providing added comfort is the heavy use of technical and trend indicators in Northlake’s models that are designed to make sure major trends are captured fairly early as they are established and take hold.  We may be at an inflection point in the long running growth over value theme.  Timing will not be perfect but if we can capture most of multiyear shift in themes, the value added exists for clients.

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.

Facebook Delivers Strong Results Despite Data Privacy Concerns

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Facebook (FB) has recently been the focus of media scrutiny surrounding the company’s role in Russian interference in the US presidential election, the Cambridge Analytica data leak, and the Eurozone’s upcoming General Data Protection Regulations (GDPR). Despite the concerns caused by these issues, FB reported impressive 1Q18 sales and earnings results. The outlook for 2018 year-over-year expense growth was narrowed from a range of 45-60% to 50-60% growth, signaling that FB has likely already accounted for most or all of the near-term expenses required to address data security. There was no discernable impact to user engagement metrics during the quarter. Northlake continues to expect FB to move toward $250 reflecting 25x 2019 EPS of $10.

Total advertising revenue grew 50% year-over-year, with mobile ad revenue growing an even more impressive 60%. The average price per ad increased 39% from 1Q17, slightly slower than the 43% growth in the previous quarter. Ad unit growth accelerated to 8% compared to 4% growth last quarter. The increase in ad volumes was partially due to the continued decrease in desktop usage; desktop users see more ads per page than mobile users, creating an easing headwind as the decline of desktop usage nears completion. The decline of desktop usage effectively masked the ad volume growth of mobile until now, but that impact is dissipating. Ad volumes also benefitted from strong growth in Instagram.

As noted earlier, FB narrowed 2018 expense guidance to a range of 50-60% growth compared to 2017. FB explained that the majority of the expenses driving the low end of guidance from 45% to 50% was related to security and safety, with other expense growth tied to video content and investments in technologies such as artificial intelligence (AI), augmented reality (AR), and virtual reality (VR). Ultimately, investments in AI should allow FB to scale back spending on employees to review safety and security issues but until AI is able to reliably handle such critical tasks, FB will continue to hire more employees.

FB’s daily and monthly active user metrics were not impacted in any noticeable way during the quarter. Given the fact that the Cambridge Analytica news broke near the end of 1Q18, investors would justifiably like to see another quarter with strong engagement metrics before concluding that the negative headlines had no impact on users. FB chose not to disclose changes to time spent on Facebook after noting it was down 5% last quarter amid changes to the newsfeed emphasizing friends and family over other content. FB is choosing to optimize the service based on quality of time spent on the platform rather than the time spent per user. CEO Mark Zuckerberg commented that FB conducted wellbeing research which demonstrated that meaningful digital interactions with family and friends have a positive effect compared to passive consumption of content. This should increase the value of the platform to advertisers.

Looking ahead, investors remain concerned about the upcoming implementation of GDPR and how it may affect FB ad targeting and measuring. If the vast majority of users elect not to share any data with FB, the company may be much less effective at matching advertisers with targeted customer groups and measuring the return on investment for advertisers. Targeting and measuring are two major advantages FB has over most advertising competitors. FB expects most people to continue to share data as the data is also used to improve the user experience in many ways. However, if GDPR does lead to consumers tightly protecting their data, the effects will be felt across the entire digital advertiser landscape. As long as FB is able to target and measure advertising relatively well compared to peers, the company should continue to take advertising market share.

In summary, Northlake sees a long runway for ad growth at FB. Only 7.5% of the 80 million businesses on Facebook advertise, and only 8% of the 25 million businesses on Instagram advertise. Messenger already has 18 million businesses on the platform and FB has moved slowly to monetize the app. Whatsapp remains a largely untapped opportunity. The number of businesses on each platform as well as the percent choosing to advertise should continue to grow rapidly. Further, as the transition from desktop to mobile nears completion, it is providing an unexpected further boost to ad unit growth. While expenses are growing rapidly, FB appears to have a handle on what is required for the short-term and long-term health of the business. We expect expense growth will peak in 2018 allowing the company’s margin profile to stabilize at still very healthy levels. Northlake expects FB shares to move towards $250 as visibility for $10 EPS in 2019 becomes clear.

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.