Sherwin Williams Reports Improved Outlook for 2018

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Sherwin Williams (SHW) reported strong 2Q18 results and increased guidance for the year, reversing the reduced guidance from last quarter. Initial EPS guidance for 2018 of $19.05 was previously reduced to $18.65 reflecting new investments in an expanded partnership with Lowe’s, but SHW now expects to earn $19.20 reflecting a strong start to paint season. Paint sales volumes are growing, and price increases are helping to offset higher raw material input prices. SHW also continues to benefit from the integration of Valspar, which has now been part of the combined company for over a year. Northlake expects SHW to climb toward $500 reflecting 20x 2020 EPS of $25.

SHW is experiencing broad-based volume growth across segments and geographies exceeding results of competitors in the industry, which implies market share gains and strong execution. Management noted that recent strength is continuing into 3Q18. Importantly, SHW has also been able to pass through higher raw material prices to customers with minimal pushback. While rising input costs remain a headwind, the increased guidance conservatively assumes these costs – epoxy, zinc, propylene, and titanium dioxide – will be at the high end of the expected range and will not stabilize until 4Q18 as opposed to the previous expectation for moderation starting in 3Q18. Further, SHW has demonstrated the ability to manage through this inflationary environment by taking pricing actions as necessary.

Now that Valspar has been part of SHW for over a year, 3Q18 will be the first quarter where results are directly comparable year-over-year. Management has consistently said that they run the combined business as a single entity instead of viewing each legacy unit separately. Investors may now come to share that view when SHW reports consolidated results, more clearly demonstrating the power of the combined business instead of providing opportunities to pick apart which legacy group is doing relatively better or worse. The combined supply chain for North America is nearly fully integrated; efforts to improve efficiency internationally are now underway. More than half of the expected synergy benefits were booked in the first half of 2018 leaving SHW ahead of schedule.

In summary, Northlake continues to expect SHW to move toward $500 as the long-term growth potential becomes more clearly understood. With the directly comparable 3Q18 report upcoming, the benefits of the Valspar acquisition should become more apparent in the consolidated financial results. Domestic housing and remodeling activity should continue to drive paint volumes higher. Price increases should be able to offset inflationary headwinds. The recently increased guidance and positive commentary give us greater confidence that SHW will continue to grow earnings to $25 by 2020.

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.

Facebook Outlines Decelerating Growth Outlook

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Facebook (FB) shares are down 18% this morning following slightly weaker than expected 2Q18 earnings and more significantly a dramatic and totally unexpected slashing of its revenue growth and profitability outlook over the next several years.  Northlake sees FB shares trading in a range of $160-$200 looking ahead to the rest of the year with risk to the downside in the near-term.  Despite the muted near-term outlook, we are holding FB shares as we suspect the new guidance is too conservative and ultimately by resetting expectations, FB will be able to better positon the company for the myriad challenges it faces due to privacy concerns, stagnating engagement, elevated investment, and a transition in usage of Facebook and Instagram toward stories and video and away from the news feed.

Management attributed the massive cut to revenue growth to a shift to Stories on Facebook and Instagram that monetize weakly at present, foreign exchange headwinds, and users opting out of sharing data with advertisers after GDPR.

With all this new information in hand, last night after listening to the company’s conference call, we built a simple spreadsheet to try to gauge the possible new earnings estimates for 2018, 2019, and 2020.  One issue in this exercise is that the company’s guidance commentary left a wide range of outcomes for revenue and expense growth and profit margins.  We settled on accepting management’s guidance that each of the next two quarters will show revenue growth “high single digits” lower than the prior quarter.  With revenues up 42% in 2Q18, we assumed a worst case scenario and decelerated revenue growth to 32% and 22%.

Guidance on margins was much less explicit beyond reiterating 50-60% operating expense growth in 2018 as investment in security and privacy and video content ramp. So far this year, expenses are up less than 40%, so we assumed 58% growth in each of the last two quarters to bring the full year into the guidance range.  All that management said about the future outlook was that margins would compress in 2019 and steady in the mid-30% in a few years.

With revenue growth exiting 2018 in the low-to-mid 20% range, we decided to assume 28% growth in 2019 and further slowing to 23% in 2020.  In order to create a path to margin compression in 2019 and mid-30% margins in a few years, grew expenses by 40% in 2019 and 30% in 2020.  This seems fair given that the security and privacy issues have continued with new revelations since the initial Cambridge Analytica scandal, and video spending is exploding at all conceivable FB competitors.

Our inputs gave us 2018 EPS of $6.94 and 2019 EPS of $7.73.  To get a sense of the magnitude of the change, consensus for 18/19 hearing into the earnings report was $7.63/$9.16.  This type of reset for a heretofore never missed earnings, high growth company is unheard of.  There is little wonder that the stock is down 18% this morning.  In fact, we are somewhat surprised it is not a little worse but the perception that management has guided conservatively and thrown out the proverbial “kitchen sink” is prevalent this morning.

The reason we expect the shares to be in the lower end of new valuation range for the time being is that a review of sell side analyst reports this morning shows a very wide range of new earnings estimates.  Our estimate came out on the low end of revised street expectations.  There are a few close to us at $7/$8 in 18/19.  But we see estimates as high $8.60 in 2019 and $9.60 in 2020.  This range of 10% is unusual for a widely followed stock with a fairly predictable financial model.  An old saying on Wall Street is that investors do not like uncertainty.  So while we expect ultimately that FB will materially exceed our estimates and its own guidance, it is likely to take some time for investors to get comfortable with this concept.

In the meantime, we hope we are wrong and note that even on our worst case estimates, the shares trade a low 20s P-E multiple of 2019 earnings, a reasonable valuation for a company that despite facing headwinds is still growing its top line in excess of 20% in a world where even mid-single digit growth is considered decent.

Whether FB gets back to being a superior growth stock will be determined by if this reset is setting up a new leg of growth or the beginning of a steady deceleration in growth as social media matures.  With Instagram still booming, Messenger and WhatsApp barely being monetized, and Facebook having unprecedented global reach and return on investment for advertisers, we think the most likely future is steady, above average, high margin growth and superior stock returns.

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

Comcast Strength Driven by Broadband

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If I told you Comcast had more almost 3% more subscribers today than a year ago, I bet you would think I was crazy.  Well, that is the truth.  Yes, the company is losing video subscribers to cord cutting in favor of Netflix, Hulu or skinny streaming cable-like channel bundles.  But broadband is still growing – 260,000 new subscribers in 2Q18 – and the company is still adding commercial/business customers from small to mid to enterprise.  The bottom line is despite the dire headlines, Comcast’s broadband business is still strong.  Even better, the cable business is becoming more profitable and less capital intensive as the mix shifts from low margin, capital intense video – think set top boxes – to high margin broadband connectivity.  These trends look set to continue.  On its conference call this morning, Comcast noted that a typical household uses over 150GB of data and has 11 devices attached to the Wi-Fi router.  Unlimited wireless data plans and 5g can take some customers who would otherwise use cable broadband but the wireless networks are just not robust enough for the current data use case and the data usage continues to grow rapidly.  Furthermore, cable broadband capacity and speed can scale much more easily than wireless.

Comcast stock has underperformed this year for several reasons including skepticism on the long-term growth of the core cable business.  2Q18 results should provide relief on this front.  However, Comcast is still not in the clear with investors due to its now abandoned pursuit of assets being sold by 21st Century Fox and its ongoing and likely successful attempt to purchase Sky.  We understand the strategic rationale for both these transactions.  We just do not see either of them as the best course of action for Comcast shareholders over the next year or two. This is especially the case when the core cable business is trading at all-time low valuations and the company’s balance sheet and free cash flow are extremely strong.  The best thing for current Comcast shareholders is for the company to buy back its stock and raises it dividend.  Again, we understand that management thinks years ahead, while we send monthly updates and quarterly letters to clients.

All that said, we are sticking with Comcast as a long in the Northlake portfolio.  We think investors have come to grips with the ill-advised likely acquisition of Sky.  Improved sentiment toward the cable business should allow the shares to recover to around $40 over the balance of the 2018, still 5-10% below where the shares peaked prior to the Fox and Sky news.  Should our forecast prove accurate, we will reevaluate our long-standing bullish outlook for Comcast shares with more insight into trends in the core cable business, the Sky transaction, and competitive challenges at NBC Universal’s cable and broadcast TV businesses.

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.

Alphabet: Strong Growth Continues as Expenses Moderate

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Alphabet (GOOG/GOOGL) reported good second quarter earnings and the stock is reacting well, up 4.6% to start the day.  GOOG earnings are often hard to understand given the company’s complex corporate structure and strategy.  For 2Q18, the results were relatively straightforward if you ignore the cost of the latest fine paid to the European Union.  The big picture showed another quarter of strong revenue growth, improved costs controls, and continued heavy investments for future growth.  Remarkably for a company of its size, GOOG continues to grow the top line over 20%.  Investors have been concerned over the past few years about heavy spending on operating expenses and capital expenditures, but it seems clear by now that these investments are sustaining growth and perhaps opening up new opportunities.  We are especially pleased that core advertising is continuing to grow and heavy investments in machine learning and artificial intelligence are allowing the advertising businesses in Search, YouTube, and programmatic to grow rapidly despite very high market shares in a global ex-China ad business that only grows low to mid-single digits.  Investment is also high in the company’s cloud computing and self-driving car businesses.  Google Cloud and Waymo are losing money today but clearly offer the potential for massive value creation over the next few years that is not reflected in the traditional valuation measures for the stock based on EPS and EBITDA.

Credit Suisse has a good summary of the bull case for GOOG shares that closely parallels our own view:

“…we maintain our Outperform rating as our thesis based on the following factors remains unchanged: 1) monetization improvements in Search through ongoing product updates, 2) larger-than-expected contribution from Google’s larger non-Search businesses, namely YouTube, Play and Cloud, 3) optionality for value creation from new monetization initiatives such as Maps as well as the eventual commercialization of Google’s Other Bets (Waymo).”

We would also add that it appears operating expense growth and traffic acquisition cost headwinds have peaked.  GOOG margins should remain under pressure due to ongoing investments but management expects the rate at which margins contract should be slowing.  2Q18 results support this view.

We see GOOG as a “new media” stock as it takes share of advertising and content spend from traditional media like TV, radio, newspapers, magazine, direct mail, and promotions.  The better positioned stocks in those industries trade at 8-10X EBITDA and offer low single digit growth at best.  GOOG trades around 12X forward EBITDA and is sustaining 20% growth.  We see GOOG’s valuation as a bargain and see the stock rising another 10-20% over the next year as investors look forward to continued growth in 2019 and 2020.  Should Waymo and Google Cloud gain credence in the valuation, the shares could move much higher than $1,400.

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.

Still Prefer Large Caps and Neutral on Growth vs. Value

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There are no changes to the recommendations from Northlake’s thematic models for July.  The Market Cap model is recommending large cap for the fourth consecutive month and the Style model has a neutral reading for the second consecutive month.  With no changes, Northlake client assets following the Market Cap model will remain invested in the S&P 500 (SPY).  Style model assets will continue to be split evenly between the Russell 1000 Growth (IWF) and the Russell 1000 Value (IWD).

There was underlying movement in the models that could lead to changes in the recommendations over the next few months.  The historically strong large cap readings from April through June have moderated.  This is due to the relative strength of small caps so far this year moving several of the technical and trend internal indicators from large cap to small cap.  The Style model is on neutral but close to reverting back to growth.  Growth has been the dominant theme since May of 2017.  There remains a split in the Style model where the technical and trend internal indicators favor growth but the economic-driven external indicators recommend value.  This is due to the fact that economic data shows strength in the U.S. economy but investors continue to favor mega cap growth stocks.

Quarterly client letters going out this week discuss recent performance of the models in detail.  The Style model has done quite well in 2018 since it has favored growth for three of the past six months.  The Market Cap model is also ahead of the benchmark in 2018 but less so.  It benefited primarily from capturing early 2018 relative strength in mid caps before the model moved to a large cap reading in April.

SPY, IWD,  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