Home Depot: Keeping Eggs in This Nest

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Home Depot (HD) reported strong 1Q20 earnings especially when compared to most other companies, including other retailers that were hurt badly by the economic shutdown.  HD stores were deemed essential and remained open, a huge advantage, but the big story in the quarter was digital sales up 79%, reaching 15% of sales.  Comparable store sales rose over 7% although profits were penalized by increased store level costs due to employee raises and bonuses and cleaning.  On the quarterly conference call, management noted sales trends had accelerated further in May with comparable store sales now up over 10%.  Nonetheless, due to volatile sales trends and uncertainty regarding elevated costs, guidance for 2020 was withdrawn.  Management emphasized that it was volatility in sales not concern about trends that led to withdrawing guidance.  This message was firmly reinforced when the company elected to continue to pay its dividend.

Northlake purchased HD in the first half of March when the economic shutdown first began.  To finance the purchase for clients, we sold holdings in MGM Resorts (MGM).  So far this trade has worked beautifully with HD up 23% and MGM up 4%.  Our thesis was to look for high quality, financially strong growth stocks that had fallen sharply but were likely in a position to emerge as a secular winner in world changed by the coronavirus experience.  HD fit the bill perfectly since the company had already emerged as a leader in ecommerce among store-based retailers and “nesting” at home seems likely to increase spending related to home improvement.  We overstayed our welcome in MGM but the company’s high balance sheet debt and COVID-19 risks surrounding live entertainment fit with our desire to reduce risk and upgrade quality in an unprecedented economic shutdown.

HD shares closed at an all-time high the night before 1Q20 earnings were released.  The positive quarterly report has been met by modest selling with the shares pulling back about -4%.  We believe the run up in the stock and all the talk about the nesting theme just set the bar too high for traders.  It is also fair to note that HD’s P-E multiple has expanded and now sits at a significant premium to its historical level.

Northlake believes HD’s position within the post-COVID nesting theme and enhanced ecommerce leadership justifies the premium valuation.  We believe HD shares can ultimately trade at 25 times next year’s consensus earnings of $11 for a target of $275, or 16% above current prices.  The pace of gains in HD will probably slow as the stock digests the move to all-time highs and investors possibly shift focus toward companies leveraged to reopening of the economy.  Northlake will happily remain patient with HD holdings and would look to add to positions on any meaningful weakness.

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. 

Activision Blizzard Delivers Early Restructuring Benefits

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Activision Blizzard (ATVI) beat expectations for 1Q20 earnings and raised guidance for the remainder of 2020 from $2.35 to $2.60. Last quarter, Northlake noted that ATVI 2020 EPS could climb into the $2.50-$2.70 range as benefits from the well-timed restructuring efforts begin to pay off. Consensus estimates for 2020 have now climbed to $2.74, with analysts expecting $3.01 and $3.49 in 2021 and 2022 respectively. While it is encouraging to see strong execution, especially while many other industries are struggling, ATVI has climbed into a range where upside to our target is becoming more limited. Using our prior methodology, 20-25x 2020 EPS of $2.60-$2.80 implies a target for ATVI of $52-$70. 25x 2021 and 2022 EPS implies targets of $75.25-$87.25, which equates to $65.23-$68.75 discounted back to today at 10% return per year. With strong execution and likely upside to typically conservative guidance offset by a more demanding valuation, Northlake is neutral on the outlook for ATVI shares in the short term.

The restructuring efforts at ATVI began before the COVID crisis stalled the global economy. Despite the headwinds facing companies around the world, ATVI has demonstrated the rationale for and ability to deliver on the goals of the restructure. Last quarter, the launch of Call of Duty: Mobile brought a large new audience into the popular franchise. This quarter, ATVI released free-to-play Call of Duty: Warzone on console and PC, and doubled the franchise audience and in-game spending levels. Successful expansions into new regions such as Brazil and India bode well for continued franchise momentum next fall.

World of Warcraft: Shadowland and Warcraft III: Reforged are expected to further demonstrate the benefits of reengaging lapsed players and expanding the global audience in 2H20. Last quarter, World of Warcraft: Classic doubled the active player base by bringing back gamers who used to play. New and remastered content should continue to drive increased engagement and in-game spending for all of ATVI’s major franchises in time.

Recent strength in King Digital mobile ads took a step back in the first quarter, partially due to less time spent commuting as many people continue to work from home for the foreseeable future. Year over year growth only increased 20% over the prior April compared to 75% growth in 1Q20 overall. Monetization for Overwatch and Hearthstone also appear to be slowing. This trend could change when ATVI releases Overwatch 2 in an attempt to drive engagement similar to the recent success seen in the Warcraft franchise. Diablo Immortal is still being tested for a mobile release, and Diablo 4 is also in the pipeline. These upcoming game launches should help refresh a few more franchises, and the new console cycle should also be a nice tailwind for the video game industry as a whole.

In conclusion, Northlake appreciates the early success demonstrated by ATVI on recent restructuring efforts and the approach to creating more value from existing franchises. Given the ongoing momentum and typically conservative guidance provided by ATVI, we expect upside to consensus estimates can drive the stock higher. Our optimism for the strength of ATVI’s underlying business is becoming mirrored in the more challenging valuation of the stock. Northlake may consider trimming or selling ATVI if it continues to rally above $80 in the near term, but we remain patient to let our winners run in the meantime.

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.

ViacomCBS: Still Too Cheap

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Shares of ViacomCBS (VIAC) performed poorly prior to the economic shutdown and COVID-19 crisis and have fallen further.  The stock is now about 50% lower than its mid-February level even after rallying 70% from its March low.  Of all the investments Northlake has owned over the past couple of years, VIAC has performed the worst and flummoxed us the most.  Wall Street views the company as subscale and unable to invest enough to transition its business from traditional media to streaming media.  We think this argument has merit but we have continually thought it was reflected in the company’s valuation.  Today, VIAC shares trade a price-earnings ratio of less than 5X.  To put that in perspective, the average stock trades around 18X earnings assuming pre-COVID levels.  To us, VIAC has been and remains too cheap.

The company’s 1Q20 earnings report showed initial impacts of the economic shutdown.  Advertising in the U.S. and abroad fell sharply at the end of March, stabilized in April, and is showing a slight improvement in May.  The other main revenue line is affiliate fees.  This is a tale of two businesses.  Local CBS stations are driving 20% growth in affiliate fees as the per subscriber fee catches up to the still leading nightly viewership of broadcast television.  On the other hand, Viacom’s cable networks including MTV and Nickelodeon are under pressure from cord cutting and probably at best producing flat revenue.  The story on affiliate fees received a boost recently as VIAC was able to gain carriage for all of its leading broadcast and cable networks on YouTube TV.  This should lead to better overall subscription growth over the next twelve months and also is the first sign that the merger of CBS and Viacom is paying dividends.  Another potential positive is coronavirus driven boost to local TV news ratings on CBS stations.  We believe this could pay off later this year and in 2021 when negotiations for carriage renewal on these stations comes up with other cable, satellite, and streaming services and the local network affiliates.

The biggest controversy at VIAC is how the company is positioned for the transition to streaming TV.  The company has mid-size entrants with Showtime, CBS All Access, and Pluto TV.  However, the reach of these services pales in comparison to Netflix, Hulu, or Disney+.  Those companies have committed to massive investments in new content to fuel their growth and create a competitive moat.  This is where VIAC bears argue that the company is subscale such that to increase the content investment to compete will overwhelm the company’s financial resources.

As noted above, we believe there is merit to the bear case for VIAC.  Yet with the stock trading at 5X earnings, we believe the shares have been penalized too deeply.  Initial green shoots from the merger of Viacom and CBS give us confidence management is taking the right steps near-term and long-term.  The valuation argument for VIAC has not worked for several years but we are sticking with VIAC shares for a further significant bounce.

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. 

Disney Worth Waiting For

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Few companies are more directly impacted by the economic shutdown related to the COVID-19 crisis than Disney (DIS).  The company’s theme parks are closed.  Movies theaters are shut denying Disney the ability to launch the massive blockbusters from its Marvel, Pixar, Disney, and Star Wars franchises.  Sports are not being played, crippling viewership and ad revenue at ESPN.   The company has laid off and furloughed workers, eliminated its dividend, and announced deep cost cuts.  While still financially strong, Disney has more debt than usual due its acquisition of the film and TV studio and entertainment cable networks from Fox last year.

Given these headwinds, it is no surprise that DIS shares have fallen from $150 to less $90 at the March lows.  Since then the stock has recovered to $110 amid hopeful signs that theme parks and movie theaters can begin to reopen.  More importantly, the company has seen massive growth in subscribers at Disney+.  Current subscriber levels are nearing the low end of the 60-90 million target the company set for 2024.  Clearly, Disney+ has received a boost from stay-at-home orders around the world as households look for entertainment options.  A similar dynamic has played out at Netflix where the shares are trading at all-time highs.

Valuing Disney+ subscribers similarly to the implied value of Netflix subscribers suggests about half of the current DIS stock price is being attributed to the company’s streaming services.  The outlook for the company’s theme parks, films, and ESPN is highly uncertain until the timing and effectiveness of reopening the global economy can be ascertained.  This is obviously contingent on containing COVID-19 and minimizing any second wave of infections.

We always viewed DIS shares as a quality growth holding similar to other Northlake stocks like Alphabet, Apple, and Facebook.  Today, DIS is more cyclical.  We are OK with that as we believe it makes sense to own stocks at both ends of a barbell composed of quality, financially strong growth companies and cyclical, financially leveraged companies.  Northlake is willing to believe that one way or the other the world will get to the other side of the COVID-19 crisis.  When it does, there will have been a rare opportunity to own one of the world’s great companies and participate in the recovery in its stock price.  Patience is the word for a company as good as Disney.

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.

Less Cyclical Nexstar Sustaining Free Cash Flow

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Nexstar Media Group (NXST) shares responded well to the company’s 1Q20 earnings report as investors gained a better understanding of the stability of the company’s free cash flow.  Shares in NXST were pummeled in the initial stages of the COVID-19 crisis despite a much less cyclical financial profile than the company had in Great Financial Crisis.  Since then, NXST has gone from almost 100% advertising revenue to receiving over 50% of revenue from subscription fees paid by cable, satellite, and steaming providers.  There is no doubt that core, non-political advertising is suffering deep declines since Mid-March; perhaps on the order of -40%.  However, subscription revenue is growing around 15% this year and next as the company has been able to reprice recently expired deals more in line with the value provided by still heavily watched local news.  This value may be getting enhanced during the current crisis with local news viewership up 30-60% as homebound individuals seek information about the spread of the disease and the economic shutdown in their cities and towns.

The decline in core advertising has begun to lessen and should rebound further as economies around the country begin to reopen.  Nonetheless, our expectation is that NXST will see 2020 operating cash flow decline materially from our prior expectations.  However, lower interest rates, tax breaks in the CARES Act, cost cutting, and lower capital spending is allowing the decline in free cash flow to be much more modest.

Free cash flow is the crucial financial metric at NXST since the company’s debt level is elevated after its purchase of Tribune in 2019.  Based on guidance provided by the company with 1Q20 earnings, NXST’s balance sheet should still improve greatly in 2020, especially given the big boost from political advertising that will come starting around Labor Day.  Once debt is reduced, NXST should resume share repurchases and dividend increases in 2021.  In a positive sign, NXST is maintaining its dividend during 2020.

NXST clearly faces risks should the reopening of the economy go poorly and/or a significant second wave of COVID-19 emerge.  In addition, the company faces secular pressure on subscriber counts as households cut the cord.  The valuation of NXST shares already discounts these risks.  The stock has rebounded from the upper $40s at its March low to the upper $70s.  Pre-COVID, we thought NXST shares could reach $130-150 in 2020.  We now project upside to $90-100 with our prior targets coming into play during 2021.  NXST is one of the most sensitive stocks among Northlake’s portfolio to the economy and COVID-19 crisis.  We believe portfolios should be structured as a barbell between less cyclical and more cyclical stocks.  NXST’s history and strong management make it an ideal piece at the cyclical end of the barbell.

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.

Apple Fundamentals and Stock Price Fairly Balanced

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Apple reported better than expected 2Q20 earnings albeit after the company announced new guidance as COVID disruption closed the company’s stores in China, the U.S. and the rest of the world.  The company did not provide its usual detailed guidance for the quarter ahead but did provide some big picture comments.  iPhones and wearables will continue to face pressure as stores are mostly closed outside of China.  The company continues to sell online and the recent introduction of a smaller iPhone SE appears to be selling well.  iPads and Macs have had a sales boost driven by stay at home and work from home.  The company’s installed base of devices continues to grow, supporting Services revenues.  In the trailing twelve months, Apple’s Services business represented almost 17% of company revenues.  Services gross margins are around 65% vs the company average of 38%.  Services have also received a boost from work and stay at home thanks to Apple Arcade, Apple TV+, and Apple Music subscriptions.

As it does each April, Apple provided an update on its capital allocation plan.  The company announced a dividend increase and a $50 billion boost to its share repurchase authorization.  The company’s plan continues to be to reduce the excess cash on its balance sheet and use free cash flow to pay higher dividends and repurchase additional shares.

When we wrote our last update on Apple three months ago, the stock was trading at $324, very close to its all-time high.  At that time, we noted that we thought the risk-reward profile on the shares was balanced.  We also noted that the company’s financial strength and long-term potential from services and a 5G iPhone cycle supported continuing to hold Apple shares.

These same factors have allowed Apple shares to hold up fairly well in the last six weeks, down only about -10%.  The outlook is very muddled at the moment with no clear plans on when stores will reopen and if the holiday season will see normal demand.  Most importantly is whether there will be any delay to the highly anticipated new 5G iPhones.  The company normally introduces its new phones in September and starts shipping by early October.  Press and analyst reports suggest that a one month delay is possible.  A longer delay or reduced demand related to recessionary conditions is a definite risk for Apple shares over the next few months.

The risk to the 2020 iPhone cycle is balanced by Apple’s financial strength, the company’s growing Services business, and the work and at stay at home boost for iPads and Macs.  Northlake still thinks Apple shares are worth holding for the long-term but there is little change to our view that the risk-reward is balanced in the short-term.  From the current stock price around $290, we see up or down 10% as a trading range until more clarity exists for store reopenings, timing of the 5G iPhone cycle, and the impact of the recession on consumer demand.

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. 

Taking Time To Consider Shift to Mid Cap

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Northlake’s Market Cap model shifted from large cap to a weak mid cap signal for May.  We are using discretion and waiting to make the change in client portfolios given the ongoing market volatility and uncertainty about progress of reopening the economy while containing the pandemic.  Moving to mid cap adds a higher risk, higher reward investment.  While we have shared with clients that we see the market outlook as more balanced, we still think it is best to play it safe overall and manage client accounts with extra caution.  We expect to complete the swap from large cap to mid cap (S&P 500/SPY to S&P 400/MDY) but prefer to use our discretion on timing.

The Style model continues to recommend growth.  We are comfortable with that recommendation given growth companies are better positioned when the economy is under such unusual stresses.  As a result, client positions currently invested in the Russell 1000 Growth (IWF) and S&P 500 Growth (SPYG) will be held another month.

Looking at the detail on the shift to mid cap in the Market Cap model, we see a split between internal technical/trend indicators and external economic indicators.  Historically, the best time to buy small and mid cap stocks is in the depth of a recession.  These stocks typically have suffered the most by that point and then lead the way higher as the market looks toward economic recovery.  The model’s external indicators are at this point.  The internal indicators are not confirming the signal as investors continue a multiyear theme of favoring large companies.  With the growing dominance of giant technology companies like Apple, Amazon, Microsoft, Google, and Facebook, the focus on large cap makes sense.  Keep in mind these stocks represent about 20% of the S&P 500 presently.  Complicating the current signaling of the models is that these same large companies plus others like Walmart or Home Depot stand to emerge from the economic shutdown and pandemic in even a stronger competitive position.

In the end, we are applying to Northlake the same advice that we have shared with our clients: the pandemic and economic shutdown impacts each of us individually, so showing flexibility in investment decision-making independent of rigid approaches is acceptable.

IWF, SPYG, 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