Growth Challenges Remain for Liberty Global

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Liberty Global (LBTYK) reported another quarter of mixed results.  Headline numbers continue to track to guidance that assumes acceleration in growth in the second half of 2018.  There is evidence in the first half results that the acceleration will occur.  However, there is still quality of earnings issues and the company’s overall growth profile beyond the expected second half improvement is questionable given tougher competitive conditions in the company’s major markets along with potential regulatory headwinds.  We have been very patient with LBTYK the last few years but we are leaning toward selling.  Don’t be surprised if you see a confirmation with a sale in the next week.

Like many traditional media stocks, LBTYK faces slowing growth yet the stock trades at historically cheap valuation on an absolute and relative basis.  Over the last few years, the market has strongly favored growth, while value stocks with decelerating growth have been pressured to previously absurd multiple of operating cash flow, free cash flow, and earnings.  A company like LBTYK historically grew organically at upper single digits supplemented by M&A and high free cash flow to provide leveraged returns for equity holders.  With growth slowing as media consumption fragments amid competition from new entrants like Netflix and Google’s YouTube, investors have begun to question terminal growth rates and values for companies like LBTYK.  Thus, even though the stock trades at 6X EBITDA adjusted for the pending sale of its German and certain Eastern European assets to Vodafone, there is little interest in the shares.

There is a path to upside as upon receipt of the sale proceeds with the stock at current prices, management is likely to aggressively buyback shares and would have the capacity to repurchase almost half of the stock over the next three to five years.

The problem is the growth profile.  Post the divestitures to Vodafone, LBTYK will operate in the UK, Belgium, Switzerland, Poland and a few small Central European countries.  UK is growing thanks to the company building out connectivity to millions of new homes.  The current cable network in the country is barely growing.  Switzerland is facing modest negative growth due to competition and stepped up sports rights costs.  Belgium is currently growing income thanks to synergies from a deal to buy a mobile operator, but growth is barely evident after excluding the synergies.

Unfortunately, the long delay until the receipt of Vodafone proceeds, with no guarantee regulators will allow the deal, offsets even a bullish view on the company’s growth profile.  A view which we no longer share.  Thus, we are likely moving on form LBTYK in search of a better investment opportunity.

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.

Nexstar Reaffirms Industry Leadership

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Nexstar Media Group (NXST) reported another solid quarter, further cementing the company as the most consistent, highest quality local TV broadcaster.  A boom in political TV advertising and excellent expense control led to the company beating expectations for EBITDA, the key valuation metric for the industry.  Critical to NXST and the industry is converting EBITDA to free cash flow.  Currently, NXST estimates $13 per share in average free cash flow in 2018 and 2019.  TV broadcasters use two year averages to smooth out the political cycles.

A couple of years ago, NXST grew to be the second largest owner of local TV stations when it purchased Media General in a highly accretive transaction.  Since that deal closed, NXST has used its free cash flow to pay down debt, repurchase shares, and pay a rising dividend.  By the end of this year, the balance sheet should be in good shape to pursue another accretive transaction.

With the FCC loosening ownership rules and several attractive broadcasters actually or theoretically for sale, the big question for NXST is what comes next?  Another highly accretive leverage acquisition?  A massive share buyback?  Going private as was rumored recently by Reuters?

We like all three options as each offers substantial upside to the current stock price.  We can easily construct a scenario under any option that lifts the stock to at least $90-$100 over the next year or two.

The NXST story is not without risk.  Cord cutting and the fragmentation of TV viewing hurts the company’s retransmission and advertising revenue.  The big four networks, of which most of NXST’s stations are affiliates, are demanding ever higher payments form the company for the right to maintain the affiliation.  The recent blocking of the Sinclair Broadcasting/Tribune merger by the DOJ and FCC has created uncertainty about the company’s freedom to pursue large scale M&A.  Finally, TV broadcasting is a cyclical business and any economic weakness would hurt results and pressure the stock’s valuation.

Every quarter that goes by where NXST shows good performance and industry leadership builds our confidence that the end game will balance out favorably.  We were especially pleased when management was very firm on the conference call that it would do what is best for shareholders, who include senior management.

We are not sure what the next big news is going to be but we expect to hear something from NXST before year end.  Northlake will happily stick around at least until then.

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.

Disney: Shift Towards DTC/OTT Comes Into Focus

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Disney reported mixed 3Q18 results with theme parks and broadcast TV excelling and cable networks, the film studio, and consumer products lagging.  Revenue and EPS were a little under consensus estimates leading the stock to decline 1-2%.  The shares have been quite strong since March, reaching their highest level since May 2017.  This may have contributed to small decline in the shares since the report as the expectations bar had risen with the stock price.

Interestingly, almost the entire conference call was focused on the company’s launched and upcoming direct to consumer/over the top products (DTC/OTT).  These products include the recently launched ESPN+, the soon to be majority owned Hulu (after the purchase of Fox assets closes), and the late 2019 launch of a Disney-branded service somewhat similar to Netflix and Hulu but focused on Disney’s power brands:  Disney, Marvel, Pixar, and Star Wars.  These power brands will be enhanced by the Fox acquisition when intellectual property like Planet of the Apes, Deadpool, and Kingsman come into the Disney family.

Northlake has been surprised at the strength in DIS shares of late.  The upside accelerated after Comcast backed off bidding for the Fox assets.  However, DIS is still paying a high multiple, above its own, making the deal financially dilutive in the early years.  Investors have looked beyond that to the promise of the company’s DTC products.  Given the rich valuation ascribed to Netflix shares and the brand strength of DIS, the assumption is that success is assured for the Disney OTT service.  This may be the case but it ignores the fact that DIS will not fully control all the historical films and TV shows related to its intellectual property for several years.  Furthermore, while management believes the brands are so strong that the OTT service can thrive with limited content, the success of Netflix and to a certain extent Hulu is based on the very broad something-for-everyone content libraries.  In other words, it is possible that DIS is underestimating the amount of money it must invest in programming.

All this may sound negative but Northlake sees DIS and its brands as having unique value.  The stock has gone nowhere since August 2015 when the company first admitted that ESPN, previously a major driver of the company’s growth, hit headwinds due to cord cutting and subscriber losses.  From that day forward, a pivot to a Netflix-like DTC service seemed inevitable.  Now that DIS is adding Fox film and TV production and intellectual property, it is easier to see a path to success despite the challenges we just outlined.

DIS shares are inexpensive compared to their history trading at 15 times 2019 estimated earnings.  Other media companies less well positioned for a DTC TV world trade at 10 times earnings or less.  DIS has always earned a premium, and the runaway success of the film studio and theme parks and the unique way the brands help all of the businesses deserves a premium.  Northlake sees the current valuation as fair.  A good content lineup from the film studio is coming in 2019, which along with a reduced pace of sub losses at ESPN as vMVPDs grow should support the shares.  Thus, although we see limited upside and perhaps 10-15% downside in the next year, we currently plan to hold the shares.

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. 

MGM Reduces Outlook for 2018

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MGM Resorts (MGM) reported decent results for 2Q18 albeit against expectations that were lowered just 90 days ago.  When management lowered guidance dramatically for the rest of 2018, investors were very disappointed, sending the shares down 10% over a two day period.  The only real good news here is that by almost any measure the guidance appears conservative such that a weaker than expected 2018 on the Las Vegas Strip is now fully reflected in the numbers.

Northlake has been bullish on Las Vegas for several years given solid economic growth and consumer spending, low unemployment, and a slight uptick in wage growth.  This backdrop is usually good for Las Vegas visitation from leisure travelers along with a strong convention calendar from businesses.  It is now fair to reassess a bullish Las Vegas outlook especially against new casino and hotel openings scheduled for 2020 and 2021 that will add supply to the market.  MGM management along with the other major operator on the Strip, Caesar’s Entertainment, noted that the convention and event calendar is unusually light in 3Q18 versus last year.  One fewer prize fight, less concerts, and a normal summer lull in conventions that was not evident in 2017 make an argument for not reading too much into the 2018 shortfall.  Furthermore, the set up for a return to growth in 4Q18 is strong, especially for MGM, as it (1) laps the 10.1.17 shooting at its large Mandalay Bay property, and (2) finishes construction on the renovation of the Monte Carlo to Park MGM.  Caesars forecast a return to double digit growth in 4Q18, while the implied growth in MGM’s 2H18 forecast for 4Q18 seems to be around flat.

The investment theses is the near-term for MGM now revolves around the idea that the company has lowered the bar to a level that de-risks the outlook right as the company gets easier comparisons in Las Vegas, wraps up large capital expenditures in Las Vegas, Springfield, MA, and Macau.  Free cash flow is poised to surge and after the shares have pulled back over 20% from 2018 highs, the stock is trading at a historically inexpensive multiple of operating and free cash flow.

Finally, after a series of missteps, we believe that MGM is vulnerable to an activist investor.  One firm recently filed on MGM indicating it had moved its ownership position over 5%.  We see quite a bit of asset value at MGM including the real estate at its premier Bellagio and MGM Grand Las Vegas properties.  MGM also has a complex corporate structure with majority ownership of its publicly traded subsidiary in Macau and its REIT in the U.S.  There is value to be had in a breakup scenario and with sports betting and Japanese casinos as a catalyst, MGM has a theoretical growth profile and asset value that could attract an activist investor.

The bottom line is MGM has probably kitchen-sinked its outlook right as its free cash flow is about to inflect positively.  This should provide support for the shares as we await a resumption of growth or decisive action to realize value from either current management or an outsider.  We see MGM shares worth at least mid-$30s, lower than our prior hopes for 2018 but still offering enough upside to warrant holding.

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.

CBS: Strong Fundamentals Overshadowed by Embattled Management

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CBS is performing well compared to other TV centric media companies.  Smart management decisions have the company building a successful presence in in OTT video with Showtime and CBS All Access.  A strong lineup of sports and marquee entertainment event programming like the Grammy’s is keeping advertising to low single digit declines even as prime time TV ratings fall double digits.  More importantly, the must-have programming allows CBS to gets its network on all new OTT services and charge higher prices to cable and satellite companies and its own affiliates for access to its programming.

Operating income is poised to grow 7% this year, and 10% next year.  EPS, fueled by aggressive share buybacks, will grow 19% in 2018 and 14% in each of the next two years.  The balance sheet is in good shape with debt leverage a manageable 3X EBITDA.  The latest quarterly earnings report was a little better than Wall Street expectations and management raised guidance for subscriber growth at its OTT business.  The stock trades at just 10X 2018 estimated earnings and less than 9X 2019 consensus estimates.

So what’s not to like?  The highly regarded CEO, Leslie Moonves, is subject to a sexual harassment investigation after a damning report in the New Yorker by the same journalist that broke the Harvey Weinstein story.  At the same time, led by the CEO, the Board is suing the company’s controlling shareholder that has overwhelming voting control in an attempt to invalidate the super voting stock.  This move is related to the Board’s view that the National Amusement, the Redstone family holding company, is attempting to force CBS into an unwelcome and value destroying merger with the family’s other controlled media company, Viacom.  These two intertwined issues leave massive uncertainty as to the future management, strategic, and financial direction of CBS.  The timeline for resolution of the CEO investigation and courtroom fight could extend until late fall.

So where does that leave CBS stock?  Probably in purgatory with a bias lower in the near-term.  No doubt there is value in the shares and as long as the stock market holds up and earnings meet expectations we see limited down from current prices, maybe 10%.  Favorable resolution of the issues leaves 30% upside, perhaps more if the easiest way out for the Redstone family to sell CBS and Viacom to the highest bidder.

For right now, Northlake is holding CBS but our bias is to look for a better opportunity pending further developments.  One harsh lesson for Northlake over the last few years is that cheap valuations, even remarkably cheap valuations, do not provide upside for media stocks short of unpredictable mergers and acquisitions.  CBS is a particularly difficult case given the conflict between relatively strong fundamentals and the Boardroom drama.

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. 

Activision Blizzard Reports Strong 2Q18 Results and Typically Conservative Guidance

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Activision Blizzard (ATVI) beat estimates for 2Q18 sales and earnings, but provided mixed guidance commentary for the back half of the year. Guidance for the third quarter was well below expectations, partially due to increased marketing expenses ahead of a busy and highly competitive holiday season launch slate. Full year guidance was increased but remains slightly below street expectations. The typically conservative guidance from ATVI helps keep street expectations in check and sets ATVI up to outperform in the coming quarters. The stock reacted negatively to the underwhelming guidance, but Northlake remains positive on ATVI with upside to $80 as investors begin to focus on 2019 EPS of $3.20. Our confidence is bolstered by the vast and growing library of successful franchises, each of which appears to be executing at a high level quarter after quarter.

ATVI has several major upcoming game launches throughout the rest of 2018, including large expansions for Hearthstone, World of Warcraft (WoW), and Destiny 2 (D2), the next iteration of Call of Duty (CoD), and a to-be-announced new mobile game from King based on an existing popular franchise. Consistently strong engagement across ATVI’s portfolio of lasting franchises demonstrates the value of the company’s intellectual property and the ability to please each community of gamers year after year. For context, the original version of CoD launched in 2003, WoW launched in 2004, and Hearthstone and Destiny were both launched in 2014.

CoD: Black Ops 4 will be released on October 12th, kicking off three weeks of highly anticipated game launches including Battlefield V from Electronic Arts on October 19th and Red Dead Redemption 2 from Take-Two Interactive on October 26th. Expectations are justifiably high for CoD into a competitive environment, since the Black Ops variant has been the most popular version to date and pre-orders have reportedly been strong. Despite CoD: Black Ops 3 being released in 2015, management noted that monthly active users grew from last quarter in anticipation of the next version. Northlake believes CoD will exceed elevated expectations, especially given the new “battle royale” mode which should help attract new younger players to the franchise, since recently popularized “battle royale” games like Fortnite and PlayerUnknown’s Battlegrounds have been popular among gaming neophytes. As a final note on the bright future for the CoD franchise, ATVI and Tencent announced they would be developing and launching a mobile version of the game in China.

ATVI just wrapped up the inaugural season for the Overwatch League (OWL) with the broadcast of the grand finals on ESPN. The first season was a success for the 12 teams and several sponsors including Toyota. ATVI announced two new teams – Atlanta and Guangzhou – would be joining OWL with more teams to be announced later this year. While esports are still growing in popularity and may take time to become more mainstream, ATVI has now built the framework to develop more leagues for other successful franchises including CoD.

With practically every aspect of ATVI’s business seemingly firing on all cylinders, Northlake remains excited about the bright future ahead for shareholders. All three segments – Activision, Blizzard, and King Digital – boast many franchises that continue to build strong player communities year after year. Underappreciated opportunities in areas including esports and mobile advertising are just beginning to be tapped. Northlake continues to expect ATVI to move to $80 as 2019 EPS estimates to increase toward $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.

Shift to Mid Cap and Growth for August

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Both of Northlake’s thematic models sent new signals for August.  The Market Cap model shifted from large cap to mid cap, while the Style model moved from neutral back to growth.  As a result of the new signals, client positions in the S&P 500 (SPY) and Russell 1000 Value (IWD) were sold and proceeds reinvested into the S&P 400 Mid Cap (MDY) and the Russell 1000 Growth (IWF), respectively.  The new mid cap signal replaces a four month run for large caps.  The new growth signal comes after two months at neutral for Style.

This month’s changes are driven mostly by model mechanics as opposed to underlying factors.  The signals are based on a two month average to smooth volatility.  This month there were minimal changes in underlying factors but dropping an old reading and adding a fresh one was enough to take each model just over its trigger level for change.

We had noted in previous updates that the large cap signal beginning in April was among the strongest the model had recorded since our data began in 1979.  The underlying model factors had gradually been pulling off the extreme reading and it was just enough in August to trigger a shift to mid cap.  With concerns rampant on trade, small and mid cap could benefit as investors seek out companies with less international exposure.  The shift back to growth could be timely following a large pullback in the FANG and related stocks following disappointing results from Netflix, Facebook, and Twitter.  Neither of these items has a specific model factor but the gist of the models is for a combination of factors to pick up on shifting market themes and trends.

MDY 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

Apple Issues Guidance Above Expectations

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Apple (AAPL) reported solid 3Q18 results and issued slightly better than expected guidance for the September quarter.  The stock should be in good shape heading into this fall’s new iPhone launch.  Northlake intends to hold AAPL shares in client accounts but some small sales could occur due to position size management.   A move up to $220+ seems plausible based on an elongated iPhone cycle, continued growth in services and wearables, and buyback driven EPS growth.  We arrive at our price target based on 15 times what we expect to be $14 in EPS in 2019 plus modest credit for almost $30 in net cash per share still on the company’s balance sheet.  Upside could exist if AAPL’s multiple expands as service and wearables continue to grow rapidly or if the large installed base of older iPhones begins to upgrade a little more rapidly once the entire lineup shifts to the X form factor with a greater array of screen sizes and price points.  Northlake sees both outcomes as highly plausible.

In the most recent quarter, iPhone unit sales were a little light though inventories were drawn down more than normal such that underlying demand was likely in line with street expectations.  iPhone revenues grew 20% despite just a 1% gain in units shipped as the higher priced iPhone X has lifted average selling prices.  Eventually, the large installed base of older phones will have to upgrade to sustain iPhone revenue growth.  We are hopeful that a full lineup of X form factors including a normally priced LCD screen and a plus size OLED screen will boost upgrades.  Northlake and many other investors had hoped for a super cycle based on the iPhone X.  This did not occur as consumers have shown a willingness to use their phones much longer – after all, functionality is quite good even on three year old phones – and balked at the $1,000 price tag on the only option to upgrade.  An elongated cycle could now happen given a broader area of form factors and price points.

The installed base of iPhones users may only be growing slowly but iPhone owners are spending more and more money on Apples services and wearables.  Services grew 29% adjusted for a one-time benefit, continuing a string of high growth quarters.  Apple Music, iCloud storage, Apple Pay, and the App Store are driving this growth.  Penetration of many of these services is still low, so growth should continue even as comparisons stiffen in calendar 2019.  Wearables are also benefiting from the installed base.  Apple Watch got off to a slower than expected start but is now growing rapidly since the watch added cellular connectivity and focused its marketing on health and fitness.  AirPods have been a big hit right from the start.  Services plus wearables are over 20% of revenue on an annualized basis.  These businesses are accretive to gross margins and drive mid-single digit revenue growth for the entire company even if iPhone revenue decelerates and eventually flattens out.

Finally, AAPL is executing as promised on its massive share buyback.  The company still has $27 in net cash on its balance sheet and free cash flow is high, sustaining balance sheet cash even as billions of dollars are spent on share buybacks and dividends each quarter.

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.