Activision Blizzard Shows Strong Momentum

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Activision Blizzard (ATVI) reported better than expected 2Q20 earnings, beating on both the top and bottom line.  EPS of 97 cents crushed the consensus of 69 cents.  Despite the 28 cent beat, management raised 2020 guidance by 45 cents to $3.05.  Management showed a high degree of confidence in trends for the rest of 2020 by passing through more than the quarterly EPS beat to guidance.  This is important because video games have been among the biggest COVID winners as people stayed at home and played video games in lieu of other entertainment options (e.g. concerts, movies, casino trips, eating out).

Most parts of ATVI performed well in the second quarter but the big driver of results and the stock story has been the launch of a free-to-play version of Call of Duty called Warzone.  The game has been very well received and extends and defends the CoD franchise into and from the Fortnite driven free-to-play universe.  The game quickly has grown to 75 million registered users driving overall ATVI monthly active users up 3X in the quarter.  Also supporting the strong results was World of Warcraft and King’s mobile games, most notably the Candy Crush franchise.

During the quarter, Northlake trimmed large client positions in ATVI as the stock crossed into the $80s reaching prior all-time highs and achieving a price target we had recalibrated over the past six months.  The shares now trade at 27X earnings, a lofty level historically.  However, the market’s P-E multiple has also expanded and on a relative basis the shares are not horribly expensive.  Northlake believes that the impact of the virus will be sustained well into 2021 or until a vaccine is both widely available and widely deployed.  We expect ATVI’s current momentum to slow but continue at least into 1Q21 before comparisons get more difficult.  We still see upside to 2020 estimates and more so in 2021.  Current consensus in 2021 calls for no growth against the pandemic boosted 2020.  We think ATVI can still grow and believe EPS of $3.50 is realistic.  Maintaining the current P-E of 27 leads to a target of $95 in the first half of 2020, enough to continue holding our now right-sized holdings in ATVI.

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.

Execution and Sentiment Improving at ViacomCBS

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ViacomCBS (VIAC) reported better than expected results in 2Q20.  Revenues were down -12% but good cost controls and some expense timing benefits led to adjusted EBITDA +8%.  Free cash flow was much better than expected even after the timing benefits.  Overall, the quarter showed progress for a company that has been viewed very negatively by investors.  In the last couple of months, we have noted improved tone in the research we read on VIAC.  This has translated into improved sentiment on the stock which has rallied to $26 from a March low of $10.  While Northlake continues to have concerns about VIAC’s long-term positioning in a world of cord cutting and sharply declining ratings for linear TV, we feel management has earned credibility and the shares can recover further.

VIAC gets most of its revenue and profits from broadcast and cable networks and the Paramount film and TV studio.  As Netflix led a global transition to internet-delivered TV, VIAC stumbled on many fronts both operational and financial.  New management was brought aboard and made some progress but the merger of CBS and Viacom got off to a slow start and accelerated concerns about long-term strategy.

A smart and timely acquisition of Pluto TV, successful negotiations for carriage of the company’s networks by cable, satellite, and OTT distributors, steady progress with the company’s own OTT services (CBS All Access and Showtime), and importantly, much improved free cash performance, have all helped improve sentiment toward VIAC stock.  In conjunction with its 2Q20 earnings, management announced the rollout of an international OTT service built around the company’s many brands including CBS, Showtime, Paramount, BET, MTV, Comedy Central, and Nickelodeon.  VIAC will also be bulking up its domestic CBS All Access service with many of these brands while relaunching the service in 2021. 

Subscriber growth to date for All Access and Showtime OTT has been steady and the services now reach a combined 16 million subscribers.  This pales in comparison to Netflix or Disney + but for the first time, it appears that VIAC has a strategy for digital delivery of content.  Disney has received a huge valuation for its streaming services.  VIAC has received little credit in our view.

We expect positive momentum in affiliate fees, streaming subscribers, and adjusted EBITDA and FCF growth to continue through 2020.  With the shares till trading at a depressed P-E of 6X, we think merely staying on track in 2H20 is enough of offer upside back to the low $30s.    This is enough for us to hold VIAC shares for now.

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. 

Sticking With Home Depot As Consumers Spruce Up The Homes They Are Stuck In

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Home Depot shares are up about 50% since Northlake purchased them for clients in March.  This is far beyond what we expected at the time.  This also explains why the stock has sold off about -4% since reporting fantastic 2Q20 earnings.  We have often discussed how in the short term stocks trade based on expectations.  We have also noted that stocks trade based on the future rather than the past or current situation.  For HD, expectations were elevated above even the consensus estimates and the stock had run up in the last month especially anticipating the exceptional results.  None of this really matters in the long term where Northlake concentrates its stock selection.  On that basis, we still see modest upside potential for HD shares. 

The highlight of 2Q20 results was comparable store sales growth of 23%.  This level of growth has continued through mid-August.  Given overall retail sales growth in the low to mid-single digits this is an extraordinary result.  Households have clearly reallocated spending toward the home rather than retrenched during the pandemic induced recession.  Vacations, out of home entertainment, and apparel are out of favor, and fixing up your home is in.  EPS came in at $4.02, +27% vs a year ago and ahead of the $3.70 consensus. 

If there was a blemish on the report, it was that margins did not expand despite the sales growth.  Normally, when retailers exceed expectations on sales, there is margin expansion as SG&A had been budgeted at the lower expected level of sales.  However, HD spent heavily on employee benefits/bonuses and COVID mitigation.  Some investors find this disappointing and believe the higher spending will have to be sustained even as sales fall back to more normal growth rates.  A more bullish view to which Northlake subscribes is that the company is executing extremely well against the unprecedented surge in demand by holding profitability against hard to predict and unusual expenses.

Northlake believes that the shift in consumer spending patterns is likely to hold well into 2021 if not longer.  EPS in 2021 could approach $12 (current consensus is $11.35).  A P-E of 25X provides upside to $300 above our prior target of $275.  Additional upside could come from P-E expansion relative to the market but we are less willing to count on this factor given P-E’s everywhere are elevated due to historically low risk-free interest rates.  Upside of 7% is not particularly exciting but with uncertainty remaining about the path of the virus, the upcoming election, tensions with China, and future stimulus, we are comfortable sticking with high quality stocks like HD that have the wind at the back of business fundamentals. 

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. 

Nexstar Reports Better than Expected Ahead of Political Tidal Wave

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Nexstar Media Group (NXST) reported better than expected results in 2Q20 across revenue, EBITDA, and FCF.  The stock initially rallied sharply as would be expected but other traditional media companies that reported over the past 24 hours had lesser results and that eventually caught up with NXST and the shares traded down -4% which amazingly was better than most media stocks on Wednesday.

NXST faced tough conditions due to the pandemic’s impact on the economy.  Advertisers are quick to cut back spending when recession hits and this was exacerbated by certain categories like hospitality, restaurants, and retail that had to shut down.  Sports are also important to TV advertising, so the lack of games in the second quarter meant lost advertising.  Advertising represents about 50% of NXST’s revenue and sports represents about 10% of advertising.  Core advertising at NXST fell -35% in the quarter with the rate of decline improving each month and through July.  Core advertising actually handily beat more bearish consensus estimates.  Political advertising was a bright spot and is expected to accelerate sharply starting in September.

The other half of NXST’s revenue is subscription fees paid by cable, satellite, and online services for the rights to show NXST’s TV stations in 114 cities across the country.  This revenue line grew 29% in the quarter and is running ahead of budget in 2020.  NXST has to pass through about half of these fees to the owners of the ABC, CBS, FOX, and NBC networks since they provide most of the valuable programming other than locally produced news.  On a net basis, these retransmission fess continue to grow steadily and should do so through at least 2022 based on multiyear contracts currently in place.

The growth in net retransmission fees that represent half of revenue is a key attraction to NXST as it drives steady growth in free cash flow that is used to pay down the debt used to acquire Tribune, increase dividends and buyback stock.  One risk to NXST and what tripped up the stock today is concern about cord cutting leading to fewer subscribers paying these fees.  While NXST’s subscriber counts were on budget in the June quarter, other large media companies saw worsening trends including Sinclair Broadcast Group and 21st Century Fox.

We are very confident in NXST’s outlook for cash flow due to the contracts in place, upcoming political advertising, and what believe is the best management team in the TV station business.  We expect NXST to be able to begin repurchasing stock in September as debt levels come down to target.  The company has little else to do with its free cash flow which equals about 25% of the stock’s capitalization.  Current regulations rule out further acquisitions.  Thus, even if the risk from subscriber declines and cyclical core advertising stay elevated, the share price is easily supported by buybacks and dividends.  Using a below average EBITDA multiple, we see NXST as conservatively valued at $100, about 16% above the current stock price.  Should the economic recovery proceed and investor confidence improves, NXST can return to its historical multiple which offers upside to $125. 

We understand the risks in a cyclical and secularly challenged industry but that also offers upside.  Northlake owns a lot of growth stocks including Apple, Alphabet, Facebook, and Home Depot.  Having some exposure to a value stock like NXST is a nice diversification strategy with downside protected by free cash flow.

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.

Disney Pivot to Digital Accelerates

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Disney had a truly awful quarter.  But the stock is up 10% today!  Investors have chosen to look past the pandemic’s devastating impact on theme parks, ESPN (no live sports last quarter), and inability to release blockbuster films.  Instead, the focus is on the continuing massive success (as measured by subscribers) of Disney+ and newly announced plans to launch another direct-to-consumer (DTC) service and lean in with further investment as the company goes all in on its pivot from linear to digital delivery of its content.

June quarter results were actually better than expected even as the company reported a loss.  Advertising was not quite as bad as feared, and cost savings due to management actions and delays in paying for sport rights and producing TV and films also helped.  These factors will likely reverse in the current quarter and looking further ahead as hopefully the world returns to normal or a new normal.  The devastation caused by COVID is revealed in the -42% and -72% decline in revenues and segment operating income, respectively, in the quarter.  Theme Parks were closed almost the entire quarter and saw revenues drop by -85% or $5.6 billion.  Revenues at the film and TV studio fell by -55%.  Theme Parks lost $3.7 billion in the quarter.

It is somewhat amazing that Disney investors are ignoring these results even if they were widely expected and understood.  The timing, pace, and size of the recovery in theme parks, film, TV, and ESPN remains highly uncertain.  Furthermore, it is plausible that the pandemic brings about permanent damage to travel, tourism, and entertainment that has driven Disney’s growth historically.

The uncertain future for the traditional business segments is why the company’s pivot to DTC is so important to investors.  To some degree, every traditional media company is pivoting to DTC as cord cutting is eroding the value of linear cable and satellite TV.  Disney’s unrivaled content brands position it best for the transition.  However, what really appeals to investors is that the company is all in and seems willing to risk its traditional profit lines. 

In conjunction with its earnings, Disney made several announcements that emphasized it was all in. First, the company announced it would more or less complete its rollout of Disney+ to all major economies except China by the end of 2020.  Second, the company announced a new general entertainment DTC product under the Star brand that is very successful and well known in India and APAC. Hulu will remain primarily a U.S. service. Third, Mulan will launch as a $30 digital purchase option in lieu of theatrical distribution anywhere that Disney+ exists.  This means no theatrical release in the U.S., U.K.. and ,most of Western Europe.  Fourth, the company announced it was using the extra revenue from the faster than expected start to Disney+ (subscribers already have reached the low end of the company’s 2024 target) to invest further in content to drive the DTC services.  This means profits from DTC will not come sooner than expected but as Netflix has proven, investors are willing to put value on revenue and subscriber growth and wait for profits as the addressable market seems to grow ever larger.

Disney has historically traded based on a P-E multiple.  With COVID massively reducing profits in at least 2020 and 2021, P-E valuation is no longer valid.  Our recent blog posts on Disney had already transitioned to a sum of the parts valuation methodology.  Disney closed yesterday with an enterprise value of about $270 billion against $240 billion for Netflix.  Netflix has 192 million subs around the world paying more than twice the price Disney charges its 100 million subs.  Netflix is profitable today, producing hundreds of millions of dollars in EBITDA while Disney will lose a few billion dollars on its DTC businesses in 2020.  Despite these comparisons it is plausible that Disney’s DTC business can be valued at least half of Netflix given the power of the company’s brand and the pace and ease with which it has gained subscribers.  If this were the case, the rest of Disney’s businesses would be reasonably valued at 10X 2019 EBITDA, a sharp discount to the 15X it traded at pre-COVID. 

With the all in strategy and continued much faster than expected subscriber growth, Northlake now sees a path back to all-time highs in the $150s for Disney.  The next catalyst will be an analyst meeting in a few months that updates investors on the DTC strategy and financial profile.  Disney remains a core holding for Northlake and we would be buyers on a modest give back of today’s large gains.

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.

Still Expecting Rotation Toward Small Caps

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There are no changes to the signals from Northlake’s Market Cap and Style models for August.  Last month, we shifted to small caps and small cap growth and these signals remain in place.  Client positions following the models will remain invested in the Russell 2000 (IWM) and the Russell 1000 Growth (IWO) for at least one more month.

The Style model is stronger for growth this month, which is no surprise given the continued leadership of the major tech stocks.  This supports trend and technical indicators.  One area where value has gained is the improvement in many commodity prices.  Commodity prices including gold, lumber, and copper have moved up in recent weeks.  This is usually taken as a sign that inflation could turn higher and the economy could strengthen.  Value indices contain cyclical stocks that perform better when inflation and commodities are higher.

This could be important as it also syncs with the small cap recommendation from the Market Cap model.  While there are many growth stocks in the Russell 2000, there has been a firm trend for several years, accelerated by the pandemic, for investors to prefer to large cap growth stocks.  A lot of trading takes place driven by algorithms that trade big baskets of stocks.  One such trade is to buy large cap growth and sell small cap.  Northlake believes that the relative performance of large cap vs small cap has reached an unsustainable extreme.  A trigger such as rising commodity prices or higher inflation expectations is what is needed to shift the algorithms.  Another trigger would be a flattening and decline in COVID case curves.  While the headlines remain quite negative on the latest surge in COVID, the curves have flattened and 7 day moving averages of cases are off their highs from a week to ten days ago nationally and in the large Sun Belt states including Arizona, California, Florida, and Texas.  Should this continue, small cap stocks are poised to outperform.  Small cap stocks would also do better on positive vaccine news.  August is scheduled to see data released on a number of vaccines.

In July, small cap and small cap growth performed well on an absolute basis but still trailed large cap due to the concentration of gains in stocks like Amazon, Apple, and Facebook.  We are encouraged by the positive returns in small caps and think the setup is improving for a rotation toward small caps.

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.

Facebook Boosted By Increased Engagement

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Facebook (FB) reported a stronger than expected 2Q20 driven by large increases in engagement across its family of properties.  Social apps like Facebook and Instagram have seen a huge boost in usage during the pandemic as people stuck at home looked for social interaction.  Higher engagement led to more ads being delivered, which overcame a sharp decline in ad prices as advertisers initially pulled back when the economy shutdown.  These trends were consistent across Facebook’s global reach.

FB also benefited due to the company’s importance to direct response and e-commerce advertisers.  FB advertising has a well-accepted high return on investment for this group of advertisers that largely have been beneficiaries of stay at home and work from home trends.  Think of sellers with mostly an e-commerce reach or sellers of apps such as video games.  FB has never had a huge presence in brand advertising that is dominated by the giant corporations you see on TV such as Procter and Gamble and Coca Cola.  Management noted in this quarter’s conference call that the top 100 advertisers represent just 16% of total advertising revenue.  This share has fallen steadily as the other 9 million advertisers on FB continue to grow.  This data is the reason why the widely publicized boycott of FB among large brand advertisers is not expected to have much impact on the company’s revenue growth.

FB exited the third quarter with advertising revenues growing about 10% and management forecasted this level of growth for the third quarter.  Overall advertising is still declining due to the global recession putting FB’s growth in a very favorable light.  The company is continuing to invest in what it views as a still very large total addressable market, so costs grew faster than expenses and margins contracted.  However, better than expected revenue growth allowed earnings to beat expectations.

Looking ahead, the 10% growth forecast appears conservative.  Management is assuming that pandemic driven engagement and daily active users flatten out as economies around the world are now more open.  In addition, Apple is implementing more restrictive data sharing that could reduce return on investment for advertisers that rely on the data for targeting.  Investors generally believe FB can navigate these issues.  It seems too soon for engagement to flatten given a renewed rise in virus cases in much of the world and prior tightening of privacy restrictions have actually served to help the internet giants including Facebook and Google.

Analysts expect FB to earn $8 per share in 2020, up from $6.43 in 2019.  In 2021, the current consensus estimate is just over $10 with 2022 currently estimated at $12.65. From 2019 to 2022, growth is estimated to compound at 25%.  This is rapid growth for a company the size of Facebook in a growth starved world economy further pressured by ongoing impacts from the pandemic.  FB has a long history of exceeding analyst estimates. 

After a big post-earnings pop, FB shares trade at 25 times 2021 earnings.  Northlake believes this is a fairly full valuation.  Looking further ahead, as investors will do, the P-E is 20 times 2022 earnings.  On the assumption that current estimates will prove low, we could shares the move modestly higher over the balance of 2020.  Thus, we expect to hold core positions for Northlake clients, understanding that the rich valuation leaves room for a sharp correction should large cap growth stocks lose favor.  We are also wary of the possibility of new government regulation attempts that seem likely before the election. As we did recently with Activison Blizzard, we may make marginal sales of Facebook in coming months to manage position size and risk.

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.

Alphabet Solid Q But Less Upside Than Peer Megacap Tech

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Alphabet (GOOG/GOOGL) reported a good quarter relative to expectations but saw more mixed fundamental trends than the other tech giants including its closest peer, Facebook.  There was nothing wrong with GOOG’s quarter but it paled in comparison to blowouts reported by Amazon, Apple, and Facebook and this led to a modest sell off of about 3% in GOOG/GOOGL shares on the day following the earnings report.

Facebook reported positive revenue growth and an exit growth rate of 10% for the quarter.  Google Search had -10% growth and exited the quarter at flat year-over-year growth.  Search is Alphabet’s largest business by far.  The second largest business is YouTube which enjoyed 6% revenue growth although this was a slower level than the upper-single-digit growth back in March and April.  Search and YouTube are much more exposed to brand advertising than direct response advertising.  Equally important, travel and tourism may be as much as 15% of Search and remains at a minimal activity level with air travel still down 80% in many regions of the world and hotel occupancy between 30% and 40% in major global urban centers.

Overall, Alphabet managed flat revenues adjusted for foreign exchange thanks to continued growth of over 40% at Google Cloud and 26% growth for Other businesses driven by the Google Play Store (the equivalent of Apple’s App Store for Android devices) and YouTube subscription businesses.

Alphabet has been doing a better job on cost controls over the past year and operating margins are under less pressure than Facebook or Amazon, other companies that are continuing to invest aggressively right through the recession.  One reason these stocks have done so well is the willingness to invest to sustain superior revenue growth against large and still growing total addressable markets.  Search is perhaps more mature than social media or e-commerce or streaming video but Google continues to develop its shopping/e-commerce business.  Furthermore, general growth in digital business and commerce largely begins with search where Google’s position is dominant.

Alphabet has enjoyed modestly decelerating revenue growth over the last few years as Search has matured but prior to the pandemic was still growing in upper teens.  As Cloud continues to grow rapidly and when brand advertising and travel and tourism return, Northlake believes Alphabet can return to pre-pandemic growth. Improved cost controls, more disclosure on operations, and a big boost to shareholder friendly actions such as the new $28 billion buyback announced in conjunction with second quarter earnings are also positives.  At 13X 2021 EBITDA giving no credit non-EBITDA producing assets including Google Cloud, Self-driving leader Waymo, and health care company Verily, we find Alphabet shares attractive as a core holding.  We think the shares can trade at 15X EBITDA.  Adding conservative values on Cloud, Waymo, and Verily, we can get to a target of $1,650 to $1,700 looking out to the end of 2020, unchanged from our view after our last update in April.

We do expect the government to take regulatory action against Alphabet within the next few months.  We believe this is widely anticipated and thus at least partially reflected in the current stock price.  Given the deep discount at which Alphabet shares trade on a sum of the parts basis, we see downside supported even with aggressive regulatory actions.

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.