Apple Risk Reward Balanced Amid Strong Fundamentals

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Apple reported a strong 1Q20 and guided the current quarter nicely ahead of estimates on all key financial metrics.  This is clearly a positive for Apple shares.  However, the stock has soared recently, up 21% since Thanksgiving.  Northlake sees the latest good news as largely reflected in the current price of Apple shares.  Fundamentals are good and after a stretch of subdued growth Apple should have a couple good years ahead thanks to the upcoming 5G cycle in iPhones and continued growth in wearables and services.  We are comfortable continuing to own Apple shares but we see the risk-reward tradeoff as balanced.  Northlake emphasizes company fundamentals over any other factor impacting stock prices, so despite what we see as limited upside for Apple in the near-term we plan to sit tight with current client positions.  It is possible that some overweighted client positions could be cut back modestly.  We do want to note that we made similar comments after Apple’s earnings report in October.  The shares are now about 23X times 2020 earnings estimates nearly 59% above the average multiple the shares have traded at in the past 5 to 10 years.

The positive surprise in the December quarter mostly came from iPhones with revenue growth of 8% the best since the September quarter of 2018.  Analysts had expected a flat quarter for iPhones.  Clearly indications and reports that the iPhone 11 family was selling well turned out accurate.  Strength was primarily in the U.S. and Europe. China returned to growth for the first time in 18 months.  Wearables grew 37% led by AirPods.  Services grew 17%, perhaps a little short of steep estimates but a still healthy growth rate.  In services, management called out iCloud, Apple Music, Apple Pay, and advertising.

Combined Services and Wearables are up to 28% of trailing twelve months revenues.  This has significant implications for the other major positive in Apple’s latest report.  Gross margins surprised to the upside and moved to the top end of the tight range they have been in for several years.  Services has a higher gross margin of 64% vs. Products (phones and wearables) at 34%.  We believe that Wearables have an above average gross margin compared to the larger family of products that includes Phones, Macs, and iPads.  Management noted that iPhone gross margins improved due to lower input prices.  Guidance for upcoming gross margins suggest a new higher gross margin level could be sustainable.

The bull case for Apple that has driven the shares up since the middle of 2019 is that (1) the upcoming 5G wireless cycle will improve iPhone demand, (2) Services and Wearables are becoming large enough to drive overall company revenue growth, and (2) gross margins benefit from increased Services and Wearables revenue as a percent of overall revenue.  The 1Q20 report and 2Q20 guidance support this thesis.  As long as Apple is tracking to this investment thesis we see it as a core holding for Northlake clients.

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 Broadband Strength Offset by TV Headwinds

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Comcast reported solid 4Q19 results with strength in the cable business offset by a modest shortfall at NBC Universal’s broadcast and cable TV networks, theme parks, and film studio.  As often seems to be the case over the past year, Comcast’s conference call snatched defeat from the jaws of victory when the company discussed specific details of the quarter and provided guidance commentary looking ahead.  This quarter investor worries center on weaker than expected guidance for cable margin expansion in 2020, lack of affiliate growth for cable networks due to cord cutting, and investment spending at Sky.

At Northlake, we are not traders.  Instead we look at the big picture of company fundamentals against current valuation for the shares.  We have held steady at Comcast since our initial purchases in mid-2013 and been nicely rewarded with the shares up 140% since then.  The S&P 500 is up about 100% in the same time frame.  Presently, Comcast’s investment thesis is complex.  On the one hand, the cable business is in excellent shape.  Led by still robust growth in broadband subscribers (up 5% from a year ago), margins are expanding, capital spending is falling, and free cash flow is rising.  The company is losing cable TV subscribers (down over 3% in the past year) but still gaining customers overall thanks to broadband.  Furthermore, so far cord cutters tend be less profitable customers and when they do cut the cord they usually keep broadband and pay a higher price for it.  The tradeoff works for Comcast financially speaking.  Northlake remains bullish on Comcast’s cable business.

Where we have concern is on the future of the company’s cable and broadcast TV networks businesses and the recently acquired Sky.  Cable and broadcast TV make up about 20% of Comcast on a consolidated basis.  Sky represents another 17%.  TV networks are a loser from the cord cutting that is positive for Comcast Cable.  Comcast is addressing the transition to streaming by launching Peacock, an ad supported streaming service featuring the company’s massive trove of content generated by NBC and the Universal film and TV studio.  Northlake has a favorable view of Peacock though we question whether it can scale to offset cord cutting.  Sky has performed pretty well since Comcast acquired it a year ago.  The strategic thinking is that to compete successful in TV requites global scale.  Sky’s satellite TV subscribers in the UK, Italy, Germany, and other European markets give Comcast an easy entry to take its NBC Universal and Sky content businesses global.  Peacock seems built to take advantage of Sky’s international reach.  However, Sky itself has parallels to the rapidly declining satellite TV businesses at Dish and DirecTV.  Northlake sees Sky in a better light than most investors but concerns about Sky’s future and the large, debt financed investment Comcast made to purchase it are a headwind for the shares.

2020 could be a transitional year for Comcast as the story at cable is well understood and faces a slightly lower growth rate as the company absorbs a new round of programming cost inflation.  Nonetheless, we think very highly of Comcast management.  The company has had good success on an operational level and balances its capital allocation (dividends and buybacks) carefully with its investments to sustain growth.  In conjunction with the 4Q19 earnings release, Comcast raised its dividend by 10%.

Ultimately, we think the success in Comcast’s cable business wins out.  If we value Comcast between pure play cable and entertainment companies, the stock offers upside into the low $50s.  Along with a 2% dividend yield, the shares have upside of 15% looking out a year.  By the end of 2020, Comcast will have paid off the debt incurred to acquire Sky and share repurchases should resume.  This also supports our valuation calculation and provides a catalyst for the shares later in 2020.

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.

Green Shoots Sprouting at IBM

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IBM’s 4Q19 earnings report was a big step in the right direction for Northlake’s bullish thesis on IBM shares.  As a reminder, we see the potential for an expansion in the company’s depressed P-E multiple if the company can return to modest revenue growth due to improvement in the company’s growth businesses – hybrid cloud, artificial intelligence, consulting, and software and services.  The combination of many years of internal restructuring and investment and the acquisition of Red Hat as an accelerant have the potential to move the company back to low to mid single digit revenue growth.  A similar transition was made at Cisco Systems beginning in 2017 and that stock’s P-E multiple expanded from 10X to 15X allowing the shares to climb more about 70%.  We see IBM’s 4Q results as the first step toward following a similar path.  IBM still has much more to prove but at less than 11X newly issued 2020 EPS guidance the shares offer considerable upside.  At 13X 2020 guidance, the shares would trade at $173, up 25% from the close immediately prior to the 4Q earnings report.

In 4Q19, IBM produced 3% overall revenue growth, a nice acceleration from recent quarters.  Key growth initiatives came through and the challenging businesses lines in the company’s legacy hardware businesses stabilized their rate of decline.  Importantly, the acquisition of Red Hat is working form a strategic and financial standpoint.  Strategically, Red Hat’s open source platform is being sold into IBM’s large installed base, while the platform also pulls legacy IBM customers into the company’s hybrid cloud products and services.  Management noted 50 new engagements thanks to Red Hat.  Financially, Red Hat’s internal growth has accelerated, which along with the new revenue being generated by IBM’s legacy enterprise customer base has led to a pickup in overall corporate revenue growth.

The quarter was not perfect and the guidance assumes a lower tax rate and back-half weighted 2020 financial performance.  IBM needs to build upon the 4Q19 report with several more quarters similar to 4Q19.  Greens shoots are evident.  Time will tell if they bloom into flowers but so far so good.

IBM 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 Stick with Mid Caps and Neutral on Growth vs. Value to Begin 2020

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Northlake’s Market Cap and Style models begin 2020 as they ended 2019, favoring mid caps and neutral on growth vs. value.  This means that client positions following the models will stay invested in the S&P 400 Mid Cap (MDY), the Russell 1000 Growth (IWF), the S&P 500 Growth (SPYG), and Russell 1000 Value (IWD) for at least one more month.  These recommendations have been in place since the start of October.

There was underlying movement in both models that could indicate a change is coming in February.  The Market Cap model saw three indicators shift towards large cap, while the Style model saw three indicators move towards growth.  The specific indicator changes do not send a clear message.  One common thread is from the technical and trend indicators which are picking up growth stocks reestablishing their uptrend relative to value after a choppy stretch since August.  The economic and interest rate indicators are mixed.  There is some movement related to slightly improving economic growth prospects, something we have picked up in our daily tracking of economic data releases.  Changing earnings estimates are also a factor.  The models do not always send perfectly clear signals but following them with discipline is critical to their long run success within Northlake’s investment strategy.

Our yearend client letters should go out next week.  Those will contain a full update on the performance of the Market Cap and Style models.  2019 saw a split decision with material outperformance by the Style model and significant underperformance by the Market Cap model.

MDY, IWD, 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