A Tale of Three Segments at Comcast

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Comcast’s 1Q20 earnings report and conference call exposed sharp differences of how the COVID crisis is impacting the company’s three business segments.  Already positive trends in the core cable business are getting a boost.  NBC Universal and Sky, however, are in the direct path of the virus with little visibility for the pace or timing of a recovery.  All three of Comcast’s businesses were already facing secular challenges that may now accelerate as the economic shutdown seems likely to create long-term impacts even assuming things get back to normal over the next six-to-twelve months.

All of this makes Comcast a difficult stock to analyze.  We have stuck with Comcast thanks to a strong management team and excellent free cash flow.  Since we expect the virus and economic shutdown to ease over time, we are sticking with the stock.  The story has become more complicated, more so than many other Northlake favorites.  Previously, we thought Comcast shares could trade to the low $50s late in 2020.  Like all of Northlake’s individual stock holdings, the payoff has also been pushed out.  Unlike some other stocks, we think our target needs to be lowered as secular challenges at NBC Universal and Sky like have accelerated more than the upside in the cable business thanks to the transition from cable to broadband.

A quick look at the company’s business in the time of COVID:

Comcast Cable is benefitting from a surge in broadband subscribers and more people paying for faster speeds.  Cord cutting is accelerating on the TV side but this helps profit margins as delivering cable TV is not very profitable due to high customer service costs and programming expenses.  Profit margins are rising as Comcast Cable becomes Comcast Broadband.  Free cash flow is improving as spending on customer premise equipment is falling and the network is proving extremely robust.

NBC Universal is in the direct path of COVID and the economic shutdown.  Theme parks are closed.  Movie theaters are closed.  TV advertising is very weak as consumers are not out spending money.  There was already a shift underway toward streaming that was a headwind for the company’s cable and broadcast TV networks.  Stay at home seems likely to accelerate the transition toward streaming hurting advertising and affiliate fees.

Sky is sort of like DirecTV with its main operations in the UK.  Over the years, Sky has led is customer acquisition and retention strategy with sports.  With major UK and European sports shut down, the company is in a difficult spot.  We expect sports to return but Sky faces similar secular headwinds from streaming that produces a leveraged economic impact as subscriber number decline.

Until we get a better feel for the rebound potential at NBC Universal’s theme parks, film and TV studio, cable and broadcast networks, and Sky’s sports-driven satellite TV subscriber base, we are unable to precisely calculate a price target.  We do think it is at least 20% above current trading levels, which thanks to the company’s strong management and financial profile, is enough for Northlake to continue holding Comcast.

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.

Facebook Remains a Long-Term Winner

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Facebook (FB) reported 1Q20 sales slightly better than recently reduced expectations, and earnings in line with lowered estimates. Sales and earnings estimates fell roughly 6% and 11% respectively throughout March as analysts grappled with quantifying the challenges FB faced from the COVID crisis. Advertisers pulled back sharply in the final three weeks of March, but FB noted that ad sales growth in the first three weeks of April had recovered to a flat pace compared to last year. Investors reacted positively to the faster than expected bounce in growth in April, given 2Q20 is generally expected to bear the brunt of the damage from COVID for most companies and economies across the globe. Diversified ad verticals and strong engagement metrics were the primary drivers enabling FB to quickly return toward growth. The resiliency of the business through this challenging stretch demonstrates why FB remains a long-term winner. Northlake continues to see a near-term range of $200-$250, based upon 20x-25x $10 EPS, as a reasonable price for a high-quality growth business.

Digging into the details of the March slowdown and April recovery illustrate several important points about FB’s ad business. During the slowdown, FB still saw strong demand from video game and ecommerce advertisers, albeit at lower prices due to less participants overall in ad auctions. The relative stability of these ad verticals helped limit the damage during the slowdown and lead to a faster than expected initial recovery. The widely diversified exposure to small and medium businesses also proved beneficial, as these companies tend to focus more on direct response and ecommerce campaigns that are holding up better than large brand awareness campaigns common to TV and larger advertisers. FB remains a leader in ad product innovation, allowing advertisers to reach highly targeted audiences and directly measure the impact ads have on purchasing behavior. This encourages even the most cautious advertisers to spend at the right price given the visibility into the returns on ad investments. These characteristics allow FB to weather the storm better than most other businesses with cyclical economic exposure to areas like advertising, and will drive the return to prior levels of revenue growth when the economy begins to recover more broadly.

During the 1Q20 conference call, FB noted that voice and video calling doubled on Messenger and WhatsApp and message volume increased by 50%.  This higher engagement comes as everyone is practicing physical social distancing and finding new ways to digitally stay in touch with friends and family. Around 2.3 billion people used a FB product daily during the quarter, and 3 billion people used FB apps on a monthly basis. Broad reach and strong engagement are key drivers of success for FB by generating a massive supply of potential ad impressions for advertisers to buy.  As advertising demand normalizes over the coming quarters, elevated engagement with company’s family of apps should drive financial returns back to pre-COVID levels. Northlake believes it is likely that the increased engagement seen during the COVID crisis will become part of the new normal, expanding FB’s addressable audience and leading to even greater growth prospects.

FB is continuing to invest in innovation and community support throughout the crisis by developing new products and directly donating money to small businesses in need of assistance. Examples of product innovation include Messenger Rooms, company fundraisers, and gift cards. Messenger Rooms is a new way for friends to host video chats and stay in touch. Fundraisers and gift cards allow the community to support the businesses they care about to help get them to the other side of this crisis. FB sees direct donations to struggling small businesses as a way to ensure their diversified advertiser base remains intact. Even while continuing to invest, FB announced that they planned to reduce expenses overall in 2020 compared to previous expectations. Some of the expenses will return to normal in 2021, but FB remains focused on maintaining high profit margins over time to ensure the company can sustain its competitive position.

Longer term growth opportunities are also easy to see at FB. The core Facebook app, along with Messenger and Instagram, has a long runway toward maximizing revenue. Whatsapp remains an untapped opportunity, and the building blocks and engagement are coming into place for monetization to begin sooner than later. FB also recently announced a partnership with Jio Platforms in India, which will take advantage of the ecommerce and payment technologies FB has recently been developing. Each of these opportunities will come into play longer term, while FB should return to growth over the coming quarters as the COVID crisis eases. Furthermore, 2Q21 will likely be an extremely easy comparison, which will make growth look incredibly strong a year from now.

Put simply, FB has again demonstrated why it remains a long-term winner. Strong user engagement, a diversified advertiser base, and ongoing investments in product innovation are a recipe for continued success even in a challenging economic environment. While the stock is hovering near the lower end of our current price target range of $200-$250, Northlake expects the higher end of that range to come into play toward the end of 2020 as investors look to easy growth comparisons in 2021 and ongoing above average growth beyond that.

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.

IBM Cloud is Clearing The Way to Higher Stock Price

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Northlake’s investment thesis on IBM centers upon the gradual transition to faster revenue growth as cloud services become a greater part of IBM’s revenue mix. Prior to the COVID crisis, we got an unexpected boost from a CEO transition that elevated the head of company’s cloud efforts.  The economic shutdown clearly will impact IBM as the large enterprises it serves will delay and cancel technology spending.  There is little IBM can do about it and we just have to accept that impact on our investment thesis.  However, we see the crisis as delaying rather than averting our thesis.  In fact, the importance of cloud services has been elevated by the crisis, enlarging the addressable market and speeding the transition.  IBM faces fierce and larger competitors in cloud including industry leaders Amazon and Microsoft.  A larger and faster growing market is good for all cloud providers and IBM’s 1Q20 results suggest its transition is on track.

The key to IBM’s move to hybrid cloud services is the company’s 2019 acquisition of Red Hat.  Red Hat allows IBM to go to its large enterprise clientele with proven, industry leading solutions.  IBM has a niche to fill as many large enterprises are not comfortable moving to the public cloud solutions offered by Amazon, Microsoft and new entrant Google.  Large enterprises, particularly in health care, government, and financial verticals want to build a hybrid cloud where data is stored both publicly and privately.  This enables greater security of sensitive data and reliable back up of all data.

1Q20 results showed Red Hat business lines growing a better than expected 20%.  The line is getting blurry as Red Hat is integrated but IBM’s overall cloud services growth enabled the company’s key growth segment to grow at better than expected low-to-mid single digits despite initial COVID pressures in March.

The company’s 1Q20 conference call went well and featured the first appearance by the company’s new CEO, Arvind Krishna.  Mr. Krishna had been leading IBM’s cloud services division and spearheaded the acquisition of Red Hat.  At the same time he was promoted, IBM named Red Hat’s founder and CEO as President or the company’s #2 executive.  Mr. Krishna made a good impression on his first earnings call. Importantly, he indicated he would be on every call going forward, which is a positive change from the prior CEO who rarely appeared on calls.  Several analysts asked if more M&A including possible divestitures of legacy businesses was possible.  Mr. Krishna indicated this was possible.  Northlake believes any future M&A that increases exposure to growth businesses like cloud and software would be well received by investors.

Earlier this week, IBM announced a tiny increase in its dividend of less than 1%.  With many companies announcing dividend cuts or suspensions due to the COVID crisis, the announcement serves to reinforce IBM’s strong financial position, a clear positive in the uncertain economic environment likely to remain in place for at least a couple of quarters.  IBM shares have a dividend yield of 5%, another attraction for Northlake and enough to allow time for our investment thesis to develop.

Prior to the economic shutdown, Northlake’s target for IBM was $173 based upon modest expansion in the company’s P-E multiple as revenue growth accelerated.  Earnings in 2020 are going to be lower than previously expected with 2021 possibly matching our original hope for 2020.  This serves to delay the timing to achieve our target but not alter it.

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. 

Long Term Intact at Alphabet With Delayed Gratification

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Alphabet (GOOG/GOOGL) reported 1Q20 earnings that indicated better than expected results in January and February before the economic shutdown, offset by a sharp but not quite as bad as expected slowdown in March.  The company commented that advertising trends at Search and YouTube have stabilized in April with signs of green shoots.  Emerging businesses like Cloud and the Google Play Store each stayed on track at high levels of growth.  Management noted that it plans no change in its recently elevated level of stock buybacks.  Finally, management has been quick to announce cost and capital spending controls since the crisis began.  This continues a pattern of tighter corporate management and greater transparency since Sundar Pichai was elevated to CEO.  Alphabet has long been criticized for its loose management style.  Improvement on this front, even if spurred partially by a crisis, is a positive for the valuation of GOOG/GOOGL shares.

The earnings and conference call could be classified as “not as bad as expected.”  With optimism about health care solutions for the coronavirus and reopening of the economy picking up, investors bid GOOG/GOOGL shares up 9%.  The shares are now unchanged since December 31st.

Usually, our quarterly recaps focus a lot on the reported results but Alphabet’s report and conference call are likely to be the pattern as the rest of Northlake’s individual stock holdings report in the next two weeks. Investors will largely ignore 1Q20 and focus instead on how April developed relative to the initial shutdown impact in the second half of March.

In the case of Alphabet, the Google search business went from up 18-20% to down 15-18% and YouTube went from up 20% to up “high single digits.”  These two businesses are the key drivers of Alphabet revenue and earnings.  In both cases, investors were expecting much larger declines in growth. Management noted that the outlook in 2Q20 and beyond is extremely uncertain but they had recently seen a small pickup in activity on the part of large advertisers.  Things to watch going forward are resiliency the company has seen in direct response and ecommerce advertising and the unusually large exposure to travel, tourism, and consumer services advertisers.

Northlake’s view of GOOG/GOOGL shares on a long-term basis is mostly unchanged despite the coronavirus crisis.  It is more difficult to calculate a target price now as the variability in estimates for earnings and cash flows in 2020 and 2021 is very high.  We do believe that the company’s competitive position and opportunity set will be larger exiting the crisis whenever that may be.  The importance of the company’s businesses to users has never been clearer.  The coronavirus crisis is likely accelerating trends toward online services and ecommerce on a secular basis.

Previous to the crisis, we thought GOOG/GOOGL shares could reach $1,525 in 2020 and $1,700 looking into 2021.  We still believe these targets are achievable but the time horizon and path to reach them are more uncertain.  We are willing to take the uncertainty with the upside especially now that Alphabet has potentially enhanced its long-term opportunity.

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.

Large Cap And Growth To Ride Out Storm With Less Risk

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Northlake’s Market Cap model shifted from mid cap to large cap, primarily reflecting the history of large caps holding up better during bear markets.  The Style model is sticking with growth which makes sense given growth companies are less sensitive to the cyclical impact of recessions.

We swapped remaining client positions in mid cap to large cap.  Sales were made in the S&P 400 Mid Cap (MDY) and Russell Mid Cap (IJH), and proceeds were reinvested in the S&P 500 (SPY).  Client positions in growth indices including the Russell 100 Growth (IWF) and S&P 500 Growth (SPYG) are being held for now.

Many client positions following the models were sold during March when we began to raise cash reserves on March 9th.  Follow-up sales were conducted later in March.  We decided that raising cash was more efficient using model positions invested in ETFs.  Efficiency came from both having large investments in the models due to Northlake’s strategy and the ability for taxable accounts to book valuable tax losses.

Over the next few days, we plan to look at each client account and rebalance where necessary within the models and overall.  We do not intend to invest cash reserves as we remain of the belief that it is better to protect against further downside than try to time a bottom.  This is consistent with our U-shaped view of the market outlook.  A good way to think about it is that we are willing to be the tortoise rather than the hare and try to win back portfolio values in a slower, lower risk fashion.

IWF and SPY 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