De-Risked For Now Apple Worth Holding

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Apple shares are responding well to a mixed earnings report and guidance update. The earnings for the December quarter were largely in line with the dramatically lower guidance the company issued earlier this month.  News headlines discuss the revenue guidance for the March quarter as below consensus.  However, it is clear that investors feared even worse which is why the stock is reacting well.  Also favorably received is the new breakdown for revenue and gross profit between the hardware businesses and services businesses.  In particular, the gross margin of almost 63% for services, up 450 basis points from a year ago, was better than many investors anticipated.

Northlake sees three key issues for Apple. First, excluding China, Apple actually grew revenues last quarter versus the reported -4.5% decline.  Thus, a key question is when China can improve.  We have a nard tome forecasting improvement given limited information and what seems like more than just a trade war driven setback.  Second, how fast can services can grow and at what gross margin level?  The services business composes many different items including Apple Pay, the App Store, subscriptions, iCloud, and Music.  It is not clear what the margin structure is for these businesses individually so the mix of revenue in future time periods could matter.  Services revenue growth decelerated to 19% in the December quarter but we are not concerned as Apple services are still not well penetrated into a device base of around 900 million units worldwide.  Services is still not quite 10% of the business but when adding in wearables, home and accessories (also fast growing and high margin), the total is over 20%.  This is enough to support the stock, particularly at a P-E ratio of just 12X.  Third, iPhones still dominate at 62% of revenue.  Beyond China, the big question is surrounds upgrade rates or how long people keep their phones.  Ever lower upgrade rates have hurt iPhone sale badly.  5G is the next major driver of upgrades but that is probably late 2020 or 2021.  Nonetheless, we see deterioration in upgrade rates decelerating and think the street may be too pessimistic.  Even a small improvement in upgrade rates versus bearish consensus would help the shares.

Following today’s 7% gain in Apple shares, we think the stock could move sideways into the next earnings report in three months.  We see enough positives along with a still low P-E to take the bear case off the table for now.  A big dividend increase and boost to the share buyback is coming April.  At less than 13X earnings and giving nor credit to about $30 in cash on the balance sheet, we think the shares are worth holding.  If the services and upgrade stories develop positively, we think the stock can move towards $200 later in 2019 as the earnings multiple expands.  As noted, we think the latest news takes away downside risk for now, so Northlake plan to hold Apple.

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. 

 

Comcast Reality Outweighs Risks For Now

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Northlake has been patient with Comcast over the past year as we disliked both the ultimately futile pursuit of 21st Century Fox assets and the ultimately successful purchase of Sky.  We have stuck with Comcast due to management’s consistent execution in its operating businesses and our view that cord cutting concerns are overdone.  Comcast’s 4Q18 earnings support our patience as the company showed in line to better than expected results in each of its business units with accelerating growth in its cable business.  You read that correctly.  Revenue and EBITDA growth in 4Q18, at 5.2% and 7.3%, respectively, accelerated and is at its fastest rate in six years.

How is it possible that Comcast can be growing its cable business at a decent rate amid cord cutting?  First, the cord cutting phenomenon is much more severe for satellite TV (DirecTV and Dish) than for cable.  Over the past several quarters, total pay TV subscribers have consistently fallen almost -4% on a year over year basis.  However, as in 4Q18, Comcast subscriber losses have been at just under -2%.  Comcast’s X1 strategy is allowing the company’s pay TV business to outperform peers and manage for profitability as it focuses on controlling expenses.  This allows the company’s fast growing broadband business to drive the cable business – subscribers up 5% year over year, revenue up 10% as customers pay for speed.  Broadband is much higher margin, so overall Comcast’s cable business is able to grow moderately and expand margins – up 80 basis points in 2018 with a forecast for another 50 basis point improvement in 2019.  Northlake is not arguing with the threat to the pay TV business.  However, investor sentiment and the torrent of cord cutting articles paint a picture much bleaker than the financial reality.  We also believe the threat from wireless substitution or 5G Fixed Wireless Broadband are overdone as data caps on traditional wireless places are a fraction of consumption of Comcast’s broadband subscribers and 5G Fixed Wireless is an unproven technology at scale.

With the acquisition of Sky, Comcast now gets about half of its revenue away from cable.  NBC, film and TV production, cable networks, theme parks, Sky satellite in Europe each face their own threats from changing consumer TV habits.  For now, excellent day-to-day management is allowing these businesses to continue to produce steady growth.  We actually see greater risks here than cable, especially Sky, but once again the financial reality for the next few years is far better than investor sentiment.

The bottom line is we see Comcast executing well and continuing to offer above average growth in key financial measures of revenue, earnings and free cash flow.  Management showed its confidence in the outlook by raising the dividend 10%.  We are also confident and look for Comcast shares to grind higher over the next year.  In the low $40s, we would reconsider our bullish stance but that represents 15% upside from current trading levels.  With well below average financial variability, 15% is plenty when there are so many macro issues troubling the market.

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 Sold

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Northlake has sold client positions in Sherwin Williams (SHW) following the company’s disappointing update on 4Q18 earnings.  SHW preannounced a large miss versus consensus expectations driven by weakness in its North American stores, Chinese markets, and wholesale business at Lowe’s.  Demand in the U.S. was unexpectedly weak in October and November and management was at a loss to fully explain the shortfall.  Weather does seem like it was a major factor but management admitted they were unclear on the cause of the sales shortfall.  Weaker sales trends led to an inventory adjustment that further impacted sales.

Management noted that demand picked up to expected levels in December and strengthened further in January.  This news helped the stock to come off its lows versus Northlake’s sale price.  Overall, SHW was sold at a small profit versus initial purchases for clients in the fall of 2017.

We have always liked management at SHW.  They are honest and the long-term track record on operating and M&A execution speaks for itself.  Our concern now is that the stock lacks significant upside over the next year or two.  With 2019 estimates coming down a bit, the shares trade at 18X earnings at Northlake’s sale price.  SHW historically sustains a premium a multiple but with slow housing and the prospect for higher interest rates it seems like a stretch to expect multiple expansion in the near-term.  Also concerning to us is that management preannounced a material shortfall and failed to comment on 2019 guidance even though the company is scheduled to report in just two weeks.  Budgets for 2019 must be completed by now.  The company was honest about not being sure what led to the unexpected revenue weakness in October and November.  Thus, management is probably not yet confident about using the December and January as indicative of 2019 trends.  Nonetheless, we think there is risk of conservative 2019 guidance below the slightly lower estimates that have been issued in the last few days.

Shifting to Growth from Neutral to Begin 2019

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Effective 1/1/19, Northlake’s Style model moved back to Growth after four months at neutral.  The Market Cap model remains on a large cap signal for the fifth consecutive month.  Client positions in the Russell 1000 Value (IWD) or S&P 500 500 Value (SPYV) have been sold with proceeds reinvested into the Russell 1000 Growth (IWF) or S&P 500 Growth (SPYG), respectively.  Current client holdings in the S&P 500 (SPY) or Russell 1000 (IWB) providing exposure to the Market Cap model will be maintained for at least one more month.

The shift from neutral to growth occurred after three indicators previously favoring value flipped to growth.  Taken as a group, the three indicators show that growth stocks are gaining relative strength compared to value stocks at the same time that growth stocks momentum has turned up following several months of very weak price performance.  Given the recent high profile declines in Facebook, Apple, and other high profile large cap growth stocks, it is important to remember that these indicators look at the Russell 3000 Index, essentially the 3000 largest cap stocks trading in the United States.  Furthermore, while the decline in growth stocks has received a lot of attention, the latest stock market declines are centered on fears of a U.S. recession beginning in 2019.  This has led to even sharper declines among cyclical value stocks in industries such as banking and energy.  The models are designed for relative performance.  In this case, we want to be in the best performing group of stocks, either growth or value.

Briefly looking back at 2018, the models performed pretty well.  The Market Cap model closely tracked the S&P 500, which would be expected given the model recommended large cap for eight of the last nine months of the year.  While the S&P 500 was down in 2018, on a relative basis it outperformed small and mid cap, so the Market Cap model did its job.

Results were even better in the Style model, where an emphasis on growth through August allowed the model to capture the upside in growth relative to value before the trend reversed in the final months of the year.  The Style model spent the last four months of 2018 in neutral mode.

More analysis of the model’s 2018 performance can be found in yearend client letters that will go out next week.

SPY, IWF, and SPYG 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