Apple SEes A Surge Ahead of 5G Cycle

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Apple reported a surprisingly robust quarter, beating expectations across the board.  Revenues grew 11% vs a year ago, the best growth rate in almost two years.  Margins rose modestly, which accompanied by continued share buybacks, allowed EPS to grow by 18%.  The source of strength was broad.  The small form factor, lower price iPhone SE drove iPhone sales even with stores closed around the world for much of the quarter.  Work From Home trends led to a surge in sales of Macs and iPads.  Mac revenue grew 22%, the best since 2017. iPad revenue grew 31%, the best since 2013!  Wearables and services sustained mid-to-upper teens growth as Apple continues to offer more services to a growing installed base of devices.

Management withheld formal guidance once again due to the uncertainty created by the various impacts of the COVID-19 epidemic.  Commentary provided in place of formal guidance suggests management is confident these trends will sustain through the current quarter, providing a bridge to highly anticipated 5G iPhones due to debut in October.

The next leg for Apple shares is expected to come from a super cycle for iPhones as 5G rolls out around the world supported by wireless service providers and app developers.  The average age of iPhones currently in use is several years old with a large number of users still on IPhone 6, 7, and 8.  Added speed from 5G and possible new applications is expected to be the first “must have” upgrade for iPhones in many years.  A surge in iPhone sales would support Watch and Air Pod wearables and services such as Apple Pay, Apple Store, warranties, and content subscriptions.

Investor anticipation of this cycle has driven Apple shares to all-time highs even amid a global recession.  This has been caused mostly by an expansion in the stock’s P-E multiple.  Apple shares now trade at 27 times 2021 estimated earnings.  This is really the only flaw Northlake sees in the Apple investment thesis as this multiple is the largest premium that Apple has traded at for years.  The company is executing at a high level and financial strength is unrivaled.  Share buybacks and dividend increases will continue.  We are having trouble justifying a target price any higher than current levels but on the theory that 2021/22/23 earnings estimates could move higher on the benefits of the super cycle and a long-term mix shift in favor of high-margin services, we are willing to hold Apple shares.  Given the outstanding performance, we do see it as prudent to manage position sizes so small sales of partial positions in Apple as client accounts are managed and rebalanced are likely.

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. 

Broadband Continues to Drive and Save Comcast

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“Comcast’s 1Q20 2Q20 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.”

If that looks and sounds familiar it is because this was the lead paragraph in last quarter’s review of Comcast.  We did strike 1Q20 and replaced it with 2Q20 as there really is little change in Comcast’s fundamentals from three months ago.  That said, we feel a bit better abut Comcast stock as the strength in the company’s cable business, built on broadband connectivity is better than we hoped and is looking more sustainable.  Cable margins have kicked up a level as broadband continues to rise while low margin cable TV subscribers cut the cord.  Cable TV still matters but Comcast will not defend margin-detracting subscribers.  Also helping margins is improvement in wireless where Comcast continues to grow subscribers and is gaining economies of scale.  The wireless business is closing in on breakeven after losses had been running over $100 million per quarter.

Unfortunately, NBC Universal and Sky continue to be severely impact by COVID while also facing secular challenges.  Both segments were not as bad as expected in 2Q but results were still poor.  NBCU saw revenues -25% and EBITDA -30%.  Sky saw revenue -13% and flat EBITDA.  Sky EBITDA benefited from lack of sports rights payments and that benefit will reverse throughout 2H20.  In contrast, Cable saw revenues rise slightly and EBITDA grow 6%.  There is some hope for NBCU and Sky in 2H20 as sports return to the air (and hopefully stay there!) and theme parks have reopened everywhere but California.  However, cost savings from sports rights, lack of film and TV production, and elimination of Film marketing will reverse.

Comcast shares have moved back to their level from February as investors value the cash flow and consistency of the cable business. A reasonably successful launch of Peacock, Comcast’s ad-supported streaming service has also helped sentiment.  Thanks to its broadband business, Comcast has a shot at a successful transition to streaming with the ability to help Peacock get subs and the need for all households to have broadband if they want to stream.  Finally, the strong free cash flow is repairing the balance sheet that was stressed after the acquisition of Sky.  This moves share buybacks closer.  We think the shares can grind higher and still reach the $50 level.  Not huge upside but enough given the defensive characteristics of the broadband connectivity business.

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. 

Green Shoots for IBM Amid Legacy and Pandemic Challenges

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IBM reported modestly better than expected earnings against lowered, pandemic-impacted expectations.  Revenue and EPS both fell year-over-year as growth in cloud-related business lines (including Red Hat) could not overcome secular decline in legacy software and hardware business and cyclical impacts from the pandemic.  Importantly, we continue to see green shoots in IBM’s transition toward cloud computing and improved profitability.  At just 11X next 12 months earnings and sporting a 5% dividend yield and new CEO, we like the risk-reward in IBM.

Northlake’s investment thesis on IBM is that the company can return to growth driven by a mix shift in favor of cloud-based business lines.  IBM is far behind cloud leaders Amazon and Microsoft, but the Red Hat acquisition completed in 2019 is providing a growth engine on its own and especially by complimenting and tying together IBMs other cloud businesses.  IBM remains an important supplier to many large enterprises and with Red Hat is now able to lead the transition to hybrid cloud environments.  Management is firm in its belief that the just reported 34% growth in cloud-related revenues is not just moving current clients from one business line to another.  Rather the company is gaining incremental revenues.

The IBM story is not without challenges (as reflected in the depressed P-E multiple).  Unlike peers such as Oracle, IBM did not reinstate 2020 guidance.  Investors take this as a signal that management confidence is low.  Structurally, IBM still has material revenues, perhaps 40% that are in secular decline and are unlikely to ever resume growth.  Profitability has been continually challenged as leverage works against the declining businesses and thus far the successful Red Hat and cloud initiatives drive revenues but not profits.  IBM is using the pandemic to drive costs out of the business and this should become evident over the next twelve months.

Investors favor growth stocks at the moment and IBM is a value stock.  We like the set up though as should the company’s growth profile improve, the potential for multiple expansion is high.  Cisco Systems faced a similar transition a few years ago albeit with a better legacy business in networking.  Once the company returned to modest growth the P-E went from 10 to 15.  At 15X the 2021 consensus estimate, IBM would trade at $180, up 40% from current levels.  This is plenty of upside even if it only gets part of the way there and the low P-E and 5% dividend yield reduces the risk profile.  The next couple of quarters will be key to our IBM thesis.  We are happy to wait especially since Northlake has plenty of exposure to high growth darlings including Alphabet, Facebook, and Activison Blizzard.

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. 

Market Cap Model Favors Small Cap for First Time Since 2017

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Northlake’s Market model shifted to small cap for the first time since 2017.  This is the culmination of a gradual move in the model in favor small cap over the last four months.  Client positions following the model will sell holdings in the S&P 400 Mid Cap (MDY) and reinvest the proceeds in the Russell 2000 (IWM).  The Style model continues to recommend growth.  This makes the sixth consecutive month for growth.  Growth has been favored for 16 of the past 19 months with the only the final three months of 2019 maintaining a neutral reading.   The Style model shifts from large cap to small cap exposure only when the Market Cap model is registering small cap.  As a result, clients positions in the Russell 1000 Growth (IWF) and the S&P 500 Growth (SPYG) will be sold and reinvested and in the Russell 2000 Growth (IWO).

Northlake uses a disciplined approach to its models except in extreme market environments.  Thus, even if the model recommendations are inconsistent with other aspects of our market outlook, we complete the recommended trades.  In this case, the shift to small cap in both models aligns well with our views and our desired portfolio structure. 

The market’s advance over the past several years and especially since the February/March 2020 plunge has been driven by a small group of large cap growth stocks.  Apple, Alphabet, and Facebook are Northlake holdings that have pushed the major averages higher.  Microsoft, Netflix, and Amazon are the other large cap growth leaders.  Of course, other stocks have moved up, but these six stocks now compose about 25% of the S&P 500, the most extreme concentration among the largest companies ever.  Correspondingly, the disparity in returns between large cap and small cap stocks has reached historical extremes.  It is Northlake’s view that a period of improved relative performance lies ahead for small caps.  In fact, our Market Cap model shifted from large to mid cap in May and performance has favored mid cap since then by over 2%.

Beyond the extreme historical difference in small vs large cap performance, Northlake’s sees the better than expected economic activity since the economy reopened as favoring small caps.  Small cap stocks usually do best in the early stages of an economic recovery.  The future path for the economy is far from certain due to the recent surge in COVID cases and potentially lingering effects from the economic shutdown.  However, as long as the economy does not turn significantly lower, the set up for small cap stocks is good.

We are pleased to have small cap exposure via our models as we prefer a barbell structure in the current market environment.  On one end of the barbell are large cap growth stocks.  We will still have this exposure through Apple, Alphabet, Facebook, Activision Blizzard and Home Depot.  In addition, small cap growth stocks are well correlated with large cap growth.  The other end of the barbell is small cap value cyclical companies.  The Russell 2000 gives Northlake clients material exposure to this theme.  Nexstar Media Group and ViacomCBS fit in this bucket. In addition, Disney and Comcast have cyclical business segments including theme parks and TV networks.

Small cap stocks typically have a greater risk-reward profile than large cap stocks.  However, at this point in the economic cycle, we believe investors should have diversified exposure across many stock market themes.  This month’s model changes combined with current individual stock holdings leave Northlake client portfolios well diversified and positioned consistently with our broader market and economic views.

IWM and IWO 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.