Activision Blizzard Announces Disappointing 2019 Guidance and Restructuring Plan

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Activision Blizzard (ATVI) reported record 4Q18 earnings in line with expectations despite sales coming in weaker than hoped. Guidance for 2019 was poor, with sales now expected to be 13% below previous consensus estimates and earnings of $2.10 coming in 16% below consensus. Along with the disappointing guidance, ATVI announced a layoff of 8% of employees as part of a restructuring plan aimed at improving overall efficiency and increasing the pace of content releases for crucial franchises. The stock had fallen over 40% in the months before this report due to several issues including increased competition, a rapidly evolving industry, and the unexpected news of ATVI parting ways with Bungie and the Destiny franchise intellectual property rights. Shares of ATVI staged a relief rally upon learning the latest updates, signaling that investors likely expected the news to be worse than it was.

The sales shortfall in the quarter was primarily attributed to a lack of in-game spending on Call of Duty: Black Ops 4 (CoD), Overwatch, and Hearthstone. ATVI noted that in-game spending on CoD improved with a new content launch late in the quarter, while the weakness from the Blizzard segment was expected to take longer to improve. The Blizzard segment also faces a tough comparison in 2019, with no major frontline releases planned to build on the strong performance of last year’s World of Warcraft (WoW) expansion. The ongoing weakness at Blizzard is the primary cause of the sales guidance shortfall. On an encouraging note, player engagement remains high for Blizzard’s franchises despite the current lack of in-game spending.

The King segment stood out as a positive among the many concerns in the quarter, with the slowly ramping mobile advertising business finally starting to contribute meaningful results. Ad bookings grew compared to both 4Q17 and 3Q18. King launched an updated version of the popular Candy Crush franchise that has gotten off to a fast start, leading monthly active users to grow sequentially from last quarter for the first time since ATVI acquired King.

Northlake believes ATVI is making the right changes with the restructuring plan. Removing redundancies in back office and consumer marketing positions while hiring more game development talent will help reduce costs and allow ATVI to create more expansion/add-on content for existing franchises. In turn, the increased pace of content releases should drive higher engagement and in-game spending. Gamers are playing fewer games, and spending more time and money with each game. The restructuring plan allows ATVI to benefit from this industry-wide trend. An additional benefit of hiring more developers is the ability to make quicker fixes to games in the event that the gaming community dislikes aspects of new launches, as exemplified by the initial problems surrounding Destiny 2 at launch that took a long time to correct and partially led to the split between ATVI and Bungie.

ATVI is working through several challenges amid increased competition and a quickly changing industry. Free-to-play games with in-game spending such as Fortnite have become much more popular. Competitors are evaluating new business models and delivery technologies around streaming and subscriptions, such as Electronic Arts’ EA Origin plan. Gamers are playing fewer games, and playing them longer, which benefits deeply engaging franchises such as Take Two’s Grand Theft Auto and Red Dead Redemption. Mobile game developer Zynga has demonstrated the strength of a business model focused almost exclusively on adding live services to existing franchises instead of constantly launching new titles. At the same time, gamers have become more influential in causing changes to games when they don’t like particular aspects, forcing game companies to be nimble in responding.

Northlake expects ATVI to improve in all these areas as part of the restructuring plan. ATVI should continue to lead the industry in developing esports, with the popular Overwatch League beginning its second season and CoD expected to develop a new league soon. Thanks to King, ATVI should also continue to lead on developing a strong mobile advertising business. While 2019 appears to be a difficult year, Northlake doesn’t believe it makes sense to sell ATVI at current depressed levels. Looking ahead, if ATVI struggles to get back on track, Northlake could consider selling shares as they approach $50. However, Northlake expects ATVI to climb back above $50 in the medium-term reflecting roughly 19x 2020 EPS of $2.59, with longer-term upside potential to get back into the $60-$80 range as 2021 and 2022 EPS expectations of $3.00 and $3.68 respectively begin to appear more achievable.

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

Bullish Outlook Affirmed at Nexstar Media Group

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Nexstar Media Group (NXST) reported strong 4Q18 results and issued positive initial guidance for 2019 and 2020 on a standalone basis.  NXST should complete its acquisition of Tribune Media in 3Q18 and reiterated initial guidance that the combined company will earn at least $900 million in average free cash flow in the 2019/2020 cycle.  Local TV station owners are analyzed based on two year averages due to the large influx of political advertising in election years.

NXST has been a great stock, up 50% since May 2019 and at a new all-time high after gaining over 4% in initial response to its earnings report and guidance.  We have long felt that NXST offered exceptional upside as the company produces massive free cash flow relative to its market capitalization.  Northlake is highly confident that the Tribune merger will close and thus values NXST on the company’s pro forma guidance.  Even after rising nearly 20% just in February, the shares offer a free cash flow yield north of 20% based on 2019/2020 free cash flow per share of $19.73.  We see that guidance as potentially conservative given management’s track record of beating operating and synergy guidance.  As a comparison, other secularly challenged media stocks such as cable and cable TV networks trade at free cash flow yields of 5% to 15%.  Regional casinos, which have a similar growth and financial profile to local TV broadcasters trade at free cash flow yields of 10-15%.

In its 4Q18 earnings report, NXST noted that local and national advertising fell a little less than -2%.  Given that political spending was an all-time record and displaced traditional advertising for October, this suggests that November and December could have shown positive advertising growth.  Management also guided 2019 core advertising (non-political) to be positive. With growth in retransmission fees up double digits for the next several years, any stability in advertising should allay secular fears about the future of local TV stations as TV consumption continues to fragment toward digital distribution such as Netflix and Hulu.

Increased investor confidence in local TV’s long-term outlook should allow the free cash flow produced by NXST to be more highly valued.  Northlake sees NXST shares offering upside from $111 to $133 over the next twelve months assuming that economy holds to recent slow levels of GDP growth in the 2% plus range.  We know NXST management well and find them to be among the best in any industry and plan to remain confidently long as they navigate through the Tribune merger and the secular challenges.

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.

 

CBS Pivots Toward Investing For Growth

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CBS reported slightly disappointing 4Q18 earnings although the shortfalls were small, just a few percent, and most were explained by the always tricky timing of content sales.  The bigger news from the quarter was management pivoting from a financial engineering driven corporate strategy toward an “invest to grow” strategy.  Given the changes in TV consumption habits driven by Netflix, major media companies have been under severe pressure to clearly define corporate strategy.  In some cases, significant companies have chosen to sell – Time Warner and 21st Century Fox.  Disney has been moving toward a Netflix-like direct-to-consumer strategy for some time.  CBS is attempting a hybrid approach, continuing to invest in and develop its Showtime and CBS All Access OTT services while also being willing to sell content to third parties, including competitors like Netflix and Hulu and Amazon Prime Video.

The big change we learned about with earnings is that CBS is all-in on a growth strategy.  The company announced it will be suspending its share buyback for at least six months and divert the cash to up its programming spend.  The goal is to drive Showtime and All Access from 8 million current digital subscribers to 25 million by the end of 2022.  Previously, these services were targeting 16 million subscribers in this time frame.  Management also guided to high single digit revenue growth and low double digit earnings per share growth in this time frame.

Northlake is skeptical of that CBS can meet these new targets.  However, CBS shares already reflect a healthy dose of skepticism, trading at less than 9 times 2019 estimated earnings and less than 8 times 202 estimate earnings.  These P-E ratios are about one half of the market multiple.

Issues depressing CBS’s multiple for the past few years remain in place:  a possible merger with Viacom, lack of a permanent CEO, risk of losing rights to Sunday afternoon NFL games, and competitive pressures from changing TV viewing habits.  Our sense is that investors want to own CBS as these issues clear up.  We find it encouraging that the shares traded lower after hours on the earnings miss but quickly reversed in regular trading and moved up 2-3% from the pre-earnings close.  Investors appear to be rewarding the company for its strategic pivot.  The strategy faces many challenges but providing clarity on a path forward is being rewarded.

We think the same thing can happen once a final decision is made on a permanent and CEO and the Viacom merger.  Both of these issues should be resolved in the next six months.  Consequently, Northlake is sticking with CBS for now, expecting a rally in the shares toward the upper $50s or low $60s.

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. 

Disney in Transition

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Disney (DIS) reported solid 1Q19 earnings with Theme Parks doing very well, Studio Entertainment struggling as expected against a tough comparison, and Media Networks showing improvement against strong secular headwinds related to cord cutting and on demand viewing.  EPS surprised to the upside although management cautioned that much of the upside was timing related such that full year expectations should largely be maintained.

The reality is that none of this really matters.  DIS’s future outlook is about to change dramatically as it closes on its acquisitions of assets from 21st Century Fox and embarks of the launch of its Disney+ direct to consumer (DTC) product.  Current EPS projections for DIS call for $7+ in 2019 and further growth in 2020.  However, these estimates are mostly based on DIS before the DTC transition.

Late last year, DIS issued three years of restated financial statements based on the company’s new reporting structure that is aligned with the DTC transition.  Segment data was provided that is helpful to assess the future outlook.  The big challenge DIS faces is that historically a material part of its business model for Media Networks and Studio Entertainment has been based on creating content, TV shows and movies, and licensing the properties to third parties.  Looking ahead, DIS will forego the licensing revenue and use the content in its own DTC services.  The properties are enormously valuable and include Marvel, Pixar, Star Wars, Disney, and ABC Network TV shows.  Furthermore, beyond passing on the very high profit margin licensing revenue,  For Disney to fill out a competitive DTC offering at Disney+ and its soon to be majority owned Hulu, likely requires a large increase in its own programming expense.  DIS+ and Hulu do not need as much as content as Netflix to be successful but they do need a much broader array of programming than DIS and new Fox assets have historically produced.

DIS is hosting an analyst meeting in April to more fully address its plans for its DTC businesses.  We have spent a lot of time reviewing Wall Street analysis of the possible EPS outcomes for DIS under its new strategy.  There is no doubt that over 2019 to 2021 time frame that earnings will be heavily pressured, perhaps bottoming close to $6.00.  From there, the growth profile is highly contingent on how many subscribers Disney and Hulu can attract.

Northlake is taking a wait and see attitude DIS.  The company owns many premium brands and has an amazing track record of success.  This suggests the shares should sustain an average to average P-E ratio on trough earnings.  Call it 15-18 times or $90-108.  We suspect that investors will initially give some credit to subscribers to be attained over the next few years and assume successful launch of Disney+.  This could push the multiple up to 20 times or higher and get the stock to $120 at least.  DIS shares presently trade near $100 or right in the middle of our range.  Northlake thinks the odds of DIS completing a successful transition are good, so we are comfortable holding the shares even as we expect little movement in the near-term.

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

 

We Are OK as Alphabet Invests to Create Value

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Alphabet (GOOG/GOOGL) reported a mixed quarter relative to very high Wall Street expectations but a good quarter looking to long-term value creation.  Revenue and EPS came in ahead of expectations although the EPS beat was a one-time item.  Operating Income disappointed as expenses were well above expectations, an ongoing issue for Alphabet over the past several years.  Management does not provide guidance but did note that headcount growth would slow and capital expenditures would be significantly less in 2019.

Alphabet again reported north of 20% revenue growth in its advertising business as it has every quarter for the last several years.  Advertising is now a at a run rate of more than $120 billion annually which makes this growth rate exceptional and rare among large American companies.  The cost of sustaining this growth is what worries Wall Street as the law of large numbers suggests that eventually the growth rate must slow.  After all, there is only so much money spent on advertising and promotion globally and that pot of dollars is only growing in line with global GDP growth or around 3%.

Like many investors, we are frustrated by the heavy level of ongoing investment at Alphabet.  However, it is clearly the correct strategy to position the company for sustained, well above average long-term growth.  The stock is reasonably valued on P-E to Enterprise Value to EBITDA (our preferred metric), trading at just a small premium to the average company.  IT is quite clear to us that Alphabet is well above average.

Beyond sustaining growth in the advertising business by supporting the search business and YouTube, Alphabet’s investments are creating value in health care at Verily, self-driving cars at Waymo, and cloud services at Google Cloud.  We see little evidence these opportunities are being incorporated into the valuation of Alphabet shares even as similar growth opportunities at companies like Amazon, Netflix, and Microsoft receive premium valuations.

Northlake continues to favor investment in Alphabet and sees the potential for 20% upside in the shares over the next year driven by continued revenue growth and some moderation in expense growth and capital spending.  Management comments about expense growth moderating are consistent with those made about Traffic Acquisition Costs and improvement in TAC occurred as promised giving us confidence the moderation will in fact occur.

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.

Facebook Almost In the Clear

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Facebook (FB) reported a better than expected quarter across its financial and engagement metrics providing investors with a large dose of relief.  The shares extended the recent rally off the December lows and now sit 13% above the pre-earnings close, 35% above the Christmas Eve low, but remain 23% above the July all-time high.  It was in July that the company shocked Wall Street by sharply lowering its revenue growth and profit margin forecast.  Also leading to investor angst was weaker engagement (daily and monthly active users, time spent) coming while the company faced nearly daily negative headlines related to its data privacy practices.

Looking ahead, the street has accepted management’s guidance for a sharp slowdown in revenue growth and still elevated expense growth for 2019.  Following 4Q18’s better than expected results, revenue estimates for 2019 and 2020 moved up slightly, now at 25% and 20%, respectively.  This is against 37% growth in 2019 which decelerated form several quarters at or above 50% in 2018 and early 2018.  2019 will be a second consecutive year of significant margin contraction as the company spends heavily to fix its data privacy issues.  Operating expenses are again rising more than 40% this year.

The outlook for FB shares revolves around a few key issues.  First, will engagement levels hold in core Facebook as they did in 4Q18?  Second, will margins stabilize in 2020?  Many other issues are at play for FB including the core Facebook transition to Stories, Instagram’s ongoing growth, and monetization of WhatsApp and Messenger.  In addition, negative press is likely to continue and increased regulation remains a possibility.  Nonetheless, the two big questions will determine what P-E ratio the stock trades at and what EPS will be in 2020.

Both of these items could vary widely and street estimates already have above average variance.  Is FB a 20% plus growth company, so rare today among large cap stocks, and thus worth a premium multiple of 22-25 earnings like other growth blue chips?  Consensus EPS estimates call for $8.77 in 2020 yet Northlake’s spreadsheet can easily get to a range from $8.00 to $10.00.  A 20 P-E at $8.00 is a $160 stock.  A $25 P-E at $10 is a $250 stock.  At its low in December, FB trade at near 16 times 2019.  A 16 P-E on consensus 2019 estimates is $140.

Northlake thinks the worst is over for FB and the stock can head back toward $200 this year.  Thus, despite some ongoing concern about engagement and the Stories transition, we are sticking with FB positions for our clients.

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. 

Sticking with Large Cap and Growth

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There are no changes to the signals from Northlake’s Market Cap and Style models.  Large Cap and Growth remain the favored themes.  This is the 6th straight month for large cap and the 2nd straight month for growth.  Client positions in the S&P 500 (SPY) and Russell 1000 (IWB) and the Russell 1000 Growth (IWF) and S&P 500 500 Growth (SPYG) will be maintained for at least another month.  Both models had some significant underlying movement in their indicators though neither appears set to flash a new signal next month.

The Market Cap model moved modestly toward mid cap from the very strong large cap signal that has been in pace for most of the past year.  This is the result of improvement for small cap stocks in the internal indicators that mostly measure technical trends and momentum.  After very weak performance relative to large caps through October 2018, small caps have firmed up and outperformed sharply in January’s strong market rally.    The internal indicators are designed to improve timing of the model and thus are purposefully sensitive to recent market action.  Stock prices are leading indicators so you want to have an early influence of potential changes in macro indicators for the economy and interest rates.  As of now, the external indicators in the Market Cap model still strongly favor large caps.  This can be interpreted as consistent with slower economic growth prospects in 2019.

The Style model saw its external indicators move from favoring growth to favoring value.  This indicates that economic growth may be slowing but it is stabilizing at lower rates.  The impact of a weaker dollar due to the Federal Reserve backing off its tightening policy is a benefit to value sectors like industrials and energy.  The internal indicators still strongly favor growth as the poor performance in growth stocks in late 2018 quickly reversed in January.

The models got off to a good start in January.  With the Market Cap model invested in the S&P 500, clients kept up with the big January rally.  A small or mid cap signal would have been even better but it is hard to complain with matching a 7% gain.  Growth was in the lead in January allowing the Style model to return almost 10% with its ownership of large cap growth ETFs.

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