Home Depot Still Building Value

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Home Depot (HD) shares are unchanged since August including a pullback of about 5% since reporting 3Q21 earnings in November.  Not much has really changed over this time frame.  The stock is just consolidating the huge move off the March COVID-driven low.  With the shares up from Northlake’s initial purchase at $190 to almost $300 prior to the recent pullback, expectations have moved higher.  This led to the shares pulling back despite reporting 23% comp store sales growth and 26% EPS growth in 3Q21.  Despite each of these metrics exceeding expectations, investors chose to focus on flat operating profit margins.  Comparable store sales growth over 20% should lead to higher margins but pandemic-related expense increases in labor, supply chain, and sanitation held back margins.  With the stock’s valuation having expanded significantly, a single disappointing metric led to the shares correcting.

Northlake chose to take advantage of the pullback and add to positions in Home Depot that were established in March.  We believe that the focus on the home will outlive the pandemic, supporting a higher level of sales growth over the next few years.  The company should be able to manage the higher cost structure with modest savings on the elevated expenses as the pandemic subsides.

We also look favorably on the announcement that HD is acquiring HD Supply Holdings (HDS), a leader in the maintenance, repair, and operations (MRO) distribution business.  Home Depot sold HDS to private equity as the company wanted to focus on its core retail business.  Over the last few years, HD has had great success expanding its total addressable market by focusing more on serving Pro customers like contractors.  Re-entering the MRO segment builds on the Pro focus and further expands the company’s long-term opportunity.  The acquisition provides small EPS accretion and leaves HD with plenty of cash to fuel dividends and share repurchases.

We view HD as a core holding for Northlake clients.  HD has the blue-chip characteristics of above GDP growth, financial strength, and strong senior management that we seek in most of our individual equity investments.  We see upside of over $300 in the next three to six months driven by sustained comparable sales growth and an easing of operating margin pressures.  At $300, the shares would be valued at 16 times 2021 estimated EBITDA, a modest and well-deserved premium to the S&P 500.  On forward 12-month EPS of $12.30, the shares would be valued $307.

HD 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

Adding to Home Depot

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Home Depot (HD) shares are unchanged since August including a pullback of about 5% since reporting 3Q21 earnings in November.  Not much has really changed over this time frame.  The stock is just consolidating the huge move off the March COVID-driven low.  With the shares up from Northlake’s initial purchase at $190 to almost $300 prior to the recent pullback, expectations have moved higher.  This led to the shares pulling back despite reporting 23% comp store sales growth and 26% EPS growth in 3Q21.  Despite each of these metrics exceeding expectations, investors chose to focus on flat operating profit margins.  Comparable store sales growth over 20% should lead to higher margins but pandemic related expense increases in labor, supply chain, and sanitation held back margins.  With the stock’s valuation having expanded significantly, a single disappointing metric led to the shares correcting.

Northlake chose to take advantage of the pullback and add to positions in Home Depot that were established in March.  We believe that the focus on the home will outlive the pandemic, supporting a higher level of sales growth over the next few years.  The company should be able to manage the higher cost structure with modest savings on the elevated expenses as the pandemic subsides.

We also look favorably on the HD’s announcement that it would be acquiring HD Supply Holdings, a leader in the MRO distribution business.  Home Depot sold HDS to private equity as the company wanted to focus on its core retail business.  Over the last few years, HD has had great success expanding its total addressable market by focusing more on serving Pro customers like contractors.  Re-entering the maintenance, repair, and operations segment build son the Pro focus and further expands the company’s long-term opportunity.  The acquisition provides small EPS accretion and leaves HD with plenty of cash to fuel dividends and share repurchases.

We view HD as a core holding for Northlake clients.  HD has the blue chip characteristics of above GDP growth, financial strength, and strong senior management that we seek in most of our individual equity investments.  We see upside to over $300 in over the next three to six months driven by sustained comparable sales growth and an easing of operating margin pressures.  At $300, the shares would be valued at 16 times 2021 estimated EBITDA, a modest and well-deserved premium to the S&P 500.  On forward 12-month EPS of $12.30, the shares would be valued $307.

HD 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

Ready for the Rotation Trade

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There are no changes to Northlake’s favored themes for December.  We remain neutral on growth versus value and continue to favor mid caps.  As a result, current client positions following the models in the Russell 1000 Growth (IWF), the Russell 1000 Value (IWD), and the S&P 400 Mid Cap (MDY) will be held for at least one more month.

Our recent monthly updates have discussed our view on what Wall Street is referring to as the “rotation trade.”  At Northlake, we believe the rotation trade has legs well into 2021 and our models have positioned clients to benefit by owning value and mid cap.  There are several aspects to the rotation.  First, large cap growth stocks have massively outperformed, while all value stocks have been left behind.  Relative performance between growth versus value and large versus small/mid cap is well above even past historical extremes.  Think about stocks like Apple, Facebook, and Alphabet as leading examples of large cap growth.  Second, the pandemic exacerbated the performance gap between large versus small and growth versus value by creating COVID winners and COVID losers.  Large cap growth companies are largely winners in a work from home environment.  COVID losers include many companies in cyclical industries such as hospitality and entertainment.  Losers also include naturally cyclical economic sectors such as finance, energy, and industrials.  A recession is bad news for companies in these sectors under almost any circumstance.

The rotation trade is a shift in leadership from large cap growth stocks to small and mid cap value and COVID losers.  The rotation started in late summer and accelerated when initial Phase 3 trial results for leading vaccines were encouraging.  Northlake expects pent up demand in cyclical industries and COVID loser businesses.  As long as vaccines can be widely distributed in 2021 and prove as effective as they have been in trials, we think the recent outperformance of value, small and mid cap, and COVID losers has a long way to go.  Just getting back to near historical relationships provides a long runway.

Northlake’s models picked up on the rotation trade.  In Market Cap, we have favored small or mid cap since late 2019.  Thanks to the large cap growth winners, this proved costly on a relative basis until August, but since then clients have regained a lot ground on a relative basis.  The extreme outperformance of large caps for the last five years driven by growth stocks tricked our models.  Now that a sustained shift has taken place, we believe it will have legs.  In Style, we captured most of the growth stock outperformance as we mostly favored large cap growth over the past five years.  At the start of October, we moved to neutral and sold half our large cap growth exposure and reinvested in large cap value.  So far, the timing has been excellent.

It is important to note that we are not bearish on growth stocks, large or small.  We just expect small and mid cap value stocks and COVID losers to lead the market higher in the months ahead. This is expressed in client portfolios though our ownership of individual stocks including Alphabet, Apple, Activison Blizzard, Facebook, and Home Depot.  We also have value and COVID loser exposure with Comcast, Disney, Nexstar Media Group, IBM, and ViacomCBS. Viacom and Nexstar have been huge winners over the last few months.

Overall, we like Northlake’s positioning in our equity portfolios.  Between our models and individual stocks we have a barbell of large cap growth/COVID winners and small and mid cap value/COVID losers.  The balance should work if the market can continue to move higher as we expect.

Many clients are still carrying above average cash balances despite reinvestment this summer into stocks including Home Depot, VICI Properties, and preferred stocks of CGI Liberty and Qurate Retail.  We are actively looking for new ideas at both ends of the barbell to further reduce cash reserves.

MDY, IWD, IWF, AAPL, ATVI, GOOG, GOOGL, DIS, NXST, HD, VIAC, CMCSA, FB, IBM, VICI, GLIBP, and QRTEP 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.

Streaming Subscriber Growth and Vaccines Bullish for Disney

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Disney (DIS) reported another quarter of massive subscriber gains for Disney+ and steady growth for the Hulu and ESPN streaming services.  Subscribers for Disney+ came in at almost 74mm vs expectations of 65mm, growth of about 16mm subscribers since the end of last quarter.  About half the gain came from India, where DIS charges less than $2 for the rebranded Disney+ Hotstar service DIS acquired in the acquisition of Fox’s entertainment assets.  Some investors discounted the subscriber gain due to India but Northlake is OK with these gains as DIS likely has modest pricing power and India has been a tough market to crack even for Netflix (NFLX).

Another issue that held back DIS post-earnings was strong comments from management indicating an increased content spending forecast could be announced at the upcoming analyst meeting.  There has been a long-running debate at NFLX over whether the company could ever produce significant free cash flow given a need to spend ever more on content or risk subscribers plateauing or even declining.  A similar debate is underway at DIS.

Given the $212 billion market cap on NFLX against $255 billion for DIS, at Northlake we are not very concerned about the subscriber mix or content spending.  As we noted in last quarter’s DIS update, if you value the streaming services at 50% of NFLX, you get DIS theme parks, cable and broadcast networks, and film studio at just 10X EBITDA, a discount of roughly 1/3rd to historical valuations.  While COVID has accelerated long-term challenges for cable and broadcast TV and created new challenges for theme parks and the film studio, we feel this discount is too large.  Furthermore, we think DIS streaming services have a chance to become more valuable than 50% of NFLX.  It is important to note that despite missing the huge NFLX stock gains, we do not think the stock is currently overvalued.

Independent of the earnings report, DIS is a big beneficiary of the positive vaccine news from Pfizer and Moderna.  This news takes on added importance given that DIS cut theme park losses by almost half in the latest quarter with the California park still closed and other parks operating at severely limited capacity.  Demand has been surprisingly strong even amid higher COVID case counts.  Perhaps theme parks can return to normal in 2022, providing valuation support to DIS.  EPSN also benefits from a vaccine as it insures that sports are back to normal which could boost recently weak sports ratings.  Finally, getting films back in theaters is important for DIS given the massive financial success for films from Marvel, Disney, Star Wars, and Pixar that benefit from a theatrical window.

Northlake continues to see DIS worth $150+ in the near-term with much more potential as the COVID skies clear and if a path to profitability in streaming becomes clear.  We should learn more about streaming at the upcoming analyst day in December.  There is some short-term risk to DIS if content spending is above current expectations, but we think investors will underwrite the spending given the rapid subscriber growth at Disney+ and the potential for the Star-branded general entertainment service yet to be unveiled.

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.  DIS 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.

Explaining Income Equities

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Beginning this quarter, we are adding a new blog post to cover the income-oriented stock and ETF ideas we have been increasingly using in client portfolios.  Not all clients use these investments, but we have broadened their use, so we thought it would be useful to produce summary commentary each quarter.

Up until 2020, most of the high-dividend paying stocks and equity ETFs had been purchased as bond substitutes.  Even prior to COVID, interest rates were at historically low levels that we found unattractive for long-term investment.  Northlake used stocks like Verizon (VZ), MGM Growth Properties (MGP), and Lamar Advertising (LAMR), and ETFs such as iShares Select Dividend (DVY).  These stocks and others served clients very well for many years.

Post the market collapse in March due to COVID, interest rates on money market funds have remained near 0% and the Ten Year US Treasury bond yield fell well below 1%.  Northlake made the decision to invest conservatively in 2020 due to the unusual risk surrounding COVID and the election.  We sold a lot of securities, and when we decided to begin reinvesting we saw high-dividend paying stocks and ETFs as a conservative alternative given our continuing concerns about the market.

Aside from credit quality, the primary risk for these investments is a sharp rise in interest rates.  Given the Federal Reserve and other global central banks clear guidance that they will keep interest rates low until the economy has moved well beyond the pandemic, we see little risk of significantly higher interest rates in the next few years.  A spike in inflation caused by excess monetary and fiscal stimulus could push rates higher, but we feel disinflationary trends from technology and the maturity of the U.S., Japan, and European economies makes sustained higher inflation unlikely.

Since the March stock market low, we have added to client holdings in DVY and Verizon and continue to own Lamar Advertising.  We substituted VICI Properties (VICI) for MGP and other high-dividend payers that we sold in March.  VICI was also added for a broader group of clients.  We also added two preferred stocks to our high-dividend portfolio, GCI Liberty (GLIBP) and Qurate Retail (QRTEP).  Each of these preferred stocks is part of Liberty Media, which we know well and have followed closely for 30 years.

VICI is a real estate investment trust closely tied to Caesars Entertainment.  The company acts as Caesars financing arm when real estate is sold but Caesars continue to manage and operate the property.  For example, VICI owns Caesars Palace, and Caesars Entertainment pays VICI under a long-term lease for the right to operate and manage the property.  VICI owns around 30 different casino gaming properties around the country.  Most are operated by Caesars Entertainment, but several other casino operators also have leases with VICI. There are two key aspects to our investment thesis on VICI.  First, despite the COVID lockdowns last spring, VICI received 100% of the rent payments it was due across its entire portfolio.  This speaks to the quality of the company’s cash flow used to pay dividends.  If COVID could not hurt VICI, it is hard to see a scenario that would impact the dividend.  Second, there remain many quality gaming properties throughout the United States still owned by the operators.  VICI has more opportunities with Caesars and we expect continued diversification to other operators.  VICI shares yield 5% and we think the company can sustain mid-single digit growth in dividends through rent escalators and more property acquisitions.  Northlake expects an attractive total return of 10% annually in a low interest rate environment with many unusual economic and market risks.

GLIBP and QRTEP are more like bonds given the fixed nature of their payments and maturity dates.  We see both stocks as a way for client accounts with a need for conservative investments to earn current yields well above money market and bond interest rates.

GLIBP is tied closely to Liberty Broadband (LDRDA) and Charter Communications (CHTR).  The primary support for GLIBP’s dividend payment is the GCI Liberty and LBRDA ownership of Charter Communications ownership of about 30% of CHTR.  CHTR is the second largest cable broadband company in the US and produces growing and stable free cash flow.  GLIBP pays an annual dividend of $1.75 for a current dividend yield of 6%.  The preferred matures in 2038.  Shares were purchased around $25 and now trade at $28.

QRTEP pays an $8.00 annual dividend which equates to a current yield over 8%.  The preferred matures in 2031.  Qurate Retail owns and operates QVC, HSN, and Zulily.  QVC and HSN have morphed from pure home shopping TV networks to ecommerce retailers with over half of current business done online.  We believe the 8% yield outweighs the risk of competition from Amazon and other ecommerce giants.  Qurate is growing, and the business produces very high free cash flow to support the QRTEP dividend.  Shares were purchased in the low-to-mid $90s and now trade at $99.

GLIBP, QRTEP, VICI, LAMR, VZ, and DVY are 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. 

Is ViacomCBS Pivot to DTC Too Late?

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ViacomCBS (VIAC) reported slightly better than expected earnings for 3Q20.  The good news was both advertising and cable affiliate fees came in above Wall Street expectations.  Advertising was still down versus last year due to COVID impacts but -9% is a vast improvement from 2Q20 even with a boost from political spending.  More impressively, cable affiliate fees returned to positive growth for the first time in two years.  It appears that VIAC has cycled through the negative impact of negotiations with its cable and satellite distributors in which the company exchanged lower first year pricing for continued carriage.

While the results were good with some interesting underlying factors, the bigger news from the earnings report and conference call is that VIAC appears to be pivoting harder toward its direct-to-consumer (DTC) platforms including Paramount+, Showtime, and Pluto TV.  Paramount+ is the new branding coming in early 2021 for the current CBS All Access service.  Management indicated on the conference call that it would be upping its content investment for these services in 2021 and also may be less aggressive in licensing current TV and film production to other DTC services such as Netflix.

VIAC is doing well with its DTC services so far with subscriber counts ahead of expectations.  However, we struggle with how much credit to give VIAC shares for these efforts.  Viacom, CBS, Paramount, MTV, and Nickelodeon have a lot of valuable franchises.  This is seemingly enough to have a popular service.  Yet, VIAC is late to the game in launching its service against DTC competitors Netflix, Amazon, Disney, Comcast (Peacock), and AT&T (HBOMax).  Each of these competitors is owned by a company much larger than VIAC, and several have investor bases much less concerned about free cash flow and profits.

While VIAC was early on the AVOD trend with its purchase of PlutoTV, it is arguably late is completing a larger pivot with Paramount+ and Showtime.  Will there be enough demand for all of the competing services to be successful?  Can VIAC sustain the necessary content investment to compete given it smaller scale?

VIAC shares have rebounded nicely from the March COVID lows.  This has been well deserved as management has done a good job with the merger integration of Viacom and CBS, answering questions about cable affiliate fees, and executing well so far on its DTC strategy.  Now that the stock has rebounded, it is the forward outlook that we are struggling to understand.  The pivot toward DTC has a steep financial penalty as seen in meaningfully lower 2021 earnings estimates since the company reported.  Estimates still will come down when the company pays up for renewing its NFL rights later this year. 

Our concerns about the long-term success of the DTC strategy are offset by low valuation on the shares and excellent execution by management over the past year.  Fortunately, as we mull whether to continue holding VIAC we are backstopped by the good recent momentum financially and strategically.  VIAC is approaching our recent price target in the low $30s.  Decision time is near.

VIAC 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. 

Election May Be Over But Nexstar Remains A Winner

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Nexstar Media Group (NXST) reported another great quarter driven by political advertising and tight management of operating expenses.  Results easily exceeded recently raised consensus estimates.  Throughout 2020, this has been a consistent pattern for NXST, a testament to the strength of the management team and the strategic and financial success of the acquisition of Tribune Media.

NXST shares have rallied well off the March pandemic lows but we are frustrated that the stock is not much higher.  We think the shares are easily worth over $100 and without heroic assumptions our target is $120 or 7 times the average of 2020 and 2021 EBITDA with credit for free cash flow to be earned from now through the end of 2021.  Advertising is recovering steadily and almost half of revenue and EBITDA is locked in through affiliate fees and programming expenses.  Local TV broadcasting is naturally a high free cash flow business and the boom in political spending this year is allowing NXST to pay down a lot of the debt used to by Tribune.  Leverage should be under 4X, below historical levels by the end of 2020.

We believe that lower leverage, a continued cyclical improvement in advertising, and a recognition that political advertising is a growth category can support a 7X EBITDA multiple.  Gray Television, a smaller but still significant TV broadcasters, noted that on the 2016, 2018, 2020 election cycles political spending at their stations went from $118 million to $234 million to $380 million.  President Trump will soon be gone but we have a hard time believing that politics will become any less heated.  NXST will get another boost to free cash flow in 2022.  In 2021 and 2022, the company will earn over $2 billion in free cash flow against a market cap of under $4 billion. 

With leverage below 4X, the company will be able to continue raising its dividend by 20% a year and buy back 20% or more its shares in the next 24 months.  Short of another sharp downturn in the economy, something we do not project, it seems the shares have limited downside and considerable upside.  Finally, investors remain focused on the growth vs. value theme.  Northlake has plenty of growth exposure in the individual stock portfolio with Apple, Alphabet, Facebook, Activision, and Home Depot.  NXST provides high quality exposure to value should a sustained rotation toward value stocks come into play. 

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.

Activision Blizzard to Resume Uptrend in 2021

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Activision Blizzard (ATVI) reported strong 3Q20 earnings driven by its Call of Duty franchise.  Revenues and earnings were above management guidance and the even higher analyst estimates.  Management raised the 2020 outlook, and initial comments on 2021 suggest management believes earnings can grow against the tough 2020 COVID-boosted results.

Over the summer, we made sales in ATVI across the Northlake client base to right size the position.  ATVI shares reached an all-time high in the fall of 2018 and then lost about half their value as growth forecasts slowed.  ATVI management addressed the growth challenges by focusing game development efforts on key franchises including Call of Duty, World of Warcraft, and Candy Crush. These efforts paid off handsomely in 2020, especially at Call of Duty, where expansion of the franchise into the battle royale mode – popularized by Fortnite – and a mobile game version proved very popular and profitable.

ATVI shares held up relatively well during the bear market in 1Q20 and then steadily recovered as investors focused on industries that would benefit from stay-at-home orders.  ATVI results did surge in 2Q20 and the stock returned to 2018 highs in July.  At that time, we felt the valuation was stretched and with position sizes above our targeted levels, we made small sales across the Northlake client base.

Four months later, the company has reported two consecutive quarters above analyst estimates and raised guidance considerably.  Despite the good news, ATVI shares remain about 5% below our sale price.  We feel good about our decision to right size the position and we are now more optimistic that ATVI can push to meaningful new highs in 2021. 

Historically, ATVI shares often have a lull during the holiday season until the company provides detailed guidance for the year ahead when it reports 4Q results at the end of January.  On the 3Q20 call, management took the opportunity to note that they anticipated growth in 2021.  This is important as ATVI faces very challenging comparisons in 2021.  In addition, there remains uncertainty about the ability to deliver the next release in the important Overwatch franchise due to COVID delays in game development.  Fortunately, the Call of Duty franchise is stronger than ever with its successful expansion into battle royale and mobile.  Furthermore, King’s Candy Crush games continue to sustain top 10 performances.  World of Warcraft also has sustained the revitalization seen over the last few years.  Overall, ATVI’s decision to exit the Destiny franchise and focus its resource on the company’s most important games appears to be paying off.

ATVI more than passed though the 3Q20 EPS beat to full year guidance.  The street still expects a beat vs. guidance and EPS near $3.50 in 2020.  If there is growth in 2021, ATVI shares are trading at just a little over 20 times earnings, only a modest premium to the S&P 500.  Growth in 2021 against the tough comparison should reassure investors about ATVI’s long-term strategy and opportunity.  In addition, a good 2021 will show that the COVID boost to 2020 results supports a larger long-term opportunity rather than a pull forward of growth.  This is Northlake’s expectation and if it occurs ATVI shares can move into the $90s, providing upside of 20% over the next twelve months.

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.

Models Stable Ahead of Election

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There are no changes to the recommendations from Northlake’s Market Cap and Style models for November.  For our Market Cap theme, we continue to favor mid cap.  In our Style theme, we remain neutral between growth and value.  There will be no changes to client positions in the S&P 400 Mid Cap (MDY) or the Russell 1000 Growth (IWF) and Russell 1000 Value (IWD).  Our neutral stance on growth vs value means that we own exposure to both growth and value.

During October, the market declined for a second consecutive month with growth stocks being the weakest performers.  Our shift to neutral on Style at the start of September has been timely so far. The improved performance for value began in September.  There was little change in the path of the economic recovery over the past month, as economic data continues to be solid despite the rise in COVID cases in the U.S. and Europe.  Overall stability in market trends and economic data from September to October explains why there are no changes to our recommendations in our thematic strategies.

The Presidential election could lead to changes in our recommendations.  In general, a Biden victory and Democrats taking over the Senate is likely good for value and small and mid cap stocks.  The idea is that with full Democratic control a much larger stimulus than currently being discussed will happen.  The market impact of a Trump victory is less clear.  Wall Street has usually liked it when one party does not fully control the executive and legislative branches.  There are real issues to address but the old adage that investors hate uncertainty receives a boost when the getting anything done in Washington is difficult. 

Wall Street is most concerned about a bitter and divisive aftermath to the election.  This is best reflected in current elevated readings of stock market volatility.  We anticipate that lower volatility lies ahead in all but the worst case post-election scenario.  Back in 2000, when the election was not decided until early December when the Supreme Court ruled on the Florida recount, the market fell about 5% during the period of uncertainty.  Given all the concern about the post-election situation this year, we believe the market has at least partially discounted a negative scenario.  Back-to-back monthly market declines would support this view. 

MDY, 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.

Facebook Performing Well Amid Pandemic

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Facebook continues to perform well despite the economic impact of the pandemic and negative publicity surrounding privacy and political issues.  Ad revenue grew 22% during 3Q20, powering a better than expected earnings report.  This is the second consecutive quarter that Facebook had better than expected advertising growth, supporting the idea that it is a COVID winner.  Revenue accelerated through the quarter as July was up 10%.  Management guided 4Q20 ad revenue to be ahead of the 3Q20 growth rate.  Strong revenue growth was accompanied by expanding operating margins, a good sign given that expense growth has been an issue for Facebook since the Cambridge Analytica scandal forced the company to spend a lot more on privacy.  With revenues and profit margins coming in better than expected, EPS easily exceeded analyst estimates.

Usually, an earnings report this solid would lead to a nice pop in the share price.  However, management spoiled the party by giving guidance for 2021 operating expense to be well above Wall Street expectations.  The company has usually easily spent toward the low end or under its preliminary guidance for operating expenses.  Thus, it is probably safe to assume this will be a conservative forecast.  It does still raise some concerns, however, due to management continuing to point out that 2021 revenue growth could face some unusual headwinds.  Management has mentioned changes to Apple’s privacy rules, European regulation, and the possibility that 2020 COVID driven growth is pulling forward ecommerce growth.  Most likely, management just wants to keep 2021 top line estimates under control given the impressive growth in 2020 during the pandemic.

Northlake continues to look favorably on Facebook shares.  Compared to other large internet companies, we think Facebook has a very large revenue opportunity on compared to its current scale.  The powerful family of apps includes Facebook, Instagram, Messenger, and WhatsApp.  The last two are barely monetized today despite having massive global scale.  Instagram remains early in its growth curve and, along with Facebook, increasingly targets ecommerce and the benefit that ecommerce has on core advertising revenue.  Despite its massive size today, Facebook still has a large growth opportunity and the ability to sustain 20%+ top line growth for years to come.  Furthermore, after several years of elevated operating expense growth, beyond 2021 margins should stabilize or expand. 

For a company the size of Facebook, the ability to drive 20% growth in revenue and earnings is rare.  At 25 times 2021 consensus EPS estimates, Facebook shares trade at only a small premium to the market. We think continued positive earnings surprises can push the stock back to new highs above $300 in the months ahead.  As we move deeper into 2021 and investors begin to value the shares on 2022 earnings, a move to $325 is reasonable providing upside of over 20% in the year ahead.  This is a more optimistic outlook than we had for FB shares following 2Q results.  Our improved outlook has been well earned given the great performance of the company through the COVID crisis.

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.