The Apple Needs Time to Ripen Again

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Apple reported strong 4Q20 earnings with headline numbers for revenue and EPS ahead of Wall Street estimates.  The stock responded by trading down -6%, however, due to the composition of revenue and a refusal to provide detailed top line guidance for the December quarter.  Revenue was up 1% vs a year ago and about 2% above consensus.  The better than expected revenue was driven by all the business lines other than iPhones.  iPhone revenues fell -21% and came in about 5% below expectations.  iPhones still dominate Apple at over 50% of trailing 12 months revenue. 

Analyzing iPhone trends during 2020 is very challenging.  COVID has impacted demand and supply.  The new iPhone 12 series that has been very well received by critics and seen high initial demand is rolling out 4 to 7 weeks later than 2019’s iPhone 11 family.  The lack of specific guidance for revenue is understandable given all the uncertainty created by COVID.  Will stores be open?  Will consumers continue to spend as virus cases escalate in the U.S. and Europe?  Demand is very strong to start.  Will Apple’s supply chain be able to meet demand?  Investors became more worried about the near-term outlook when management only gave broad comments about revenue for the December quarter.  Northlake takes solace in the fact that management still guided iPhone revenues to be up this holiday quarter even though there is substantially less selling time.  In addition, management noted that everything besides iPhones would grow at least at a double digit rate.

The problem with Apple stock since it hit an all-time high of $137 at the start of September is that it is just very expensive.  Apple just completed its 2020 fiscal year.  Earnings were $3.28 per share, up from $2.97 in FY19 but clearly depressed by COVID in FY20.  Analysts expect growth to $3.90 in FY21, a gain of 19%.  FY21 growth is juiced by expected strong demand for the new 5G-enabled iPhones, continued growth in high-margin services, share buybacks, and easy comparisons.  Based on trailing earnings, Apple shares trade at 33X earnings.  Looking ahead, the P-E ratio on FY21 estimates is 28X. 

Northlake finds these multiples high by historical measures or against long-term growth that is likely under 10% annually.  The average stock is presently trading about 22X FY21.  Apple clearly deserves a premium.  However, we see the current valuation providing a warranted premium.  A few months ago we trimmed client holdings of Apple at $126 based on valuation concerns.  The current pullback has corrected excessive valuation but leaves little room for upside.

We plan to hold current positions in Apple and continue to manage positions on a client-by-client basis.  We like the growth potential in iPhones over the next few years as 5G rolls out, finally giving people a reason to upgrade to a new phone.  Services and Wearables should continue to grow at double digit rates and have margins well above iPhones.  Apple is still a great company.  The stock just needs a rest to let the earnings catch up with the massive move up in the stock price this year.

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. 

Alphabet Learning Investors’ ABCs

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Alphabet returned to nearly pre-pandemic growth in 3Q20 led by Cloud and YouTube.  Advertising revenues grew 15% adjusted for foreign currency, just below the high-teens level of late 2019.  Revenues, margins, and operating profits all surprised materially to the upside, with the overall results relative to consensus estimates the biggest positive surprise in many years.

Strength in advertising is even more impressive given that 15-20% of Google advertising is related to travel and hospitality, where spending is still down over 80%.  Coupled with a slight acceleration in Google Cloud Platform revenue growth to 45%, estimates for 2020 and 2021 revenues are moving higher.  Perhaps more importantly for the stock price, Alphabet reported its highest operating margins in two years.  Better than expected revenue helped produced operating leverage.  However, good expense control, hardly a hallmark of Alphabet management, was also evident.  Operating expenses grew in the mid-single digits, leading to an operating margin of over 24%, a full 3% above analyst estimates.  Alphabet has improved its expense control since Ruth Porat was hired as CFO five years ago.  Nonetheless, steadily lower operating margins as Alphabet pursued its many initiatives from health care to cloud to self-driving cars has been a point of frustration for investors and held back valuation for Alphabet shares.

Another frustration for investors has been poor transparency into the company’s financial results including the results in the various segments.  Similar to expense control, there has been some progress over the last five years.  Most recently, the company began breaking out YouTube revenues.  In conjunction with the 3Q20 report, Alphabet announced they would be breaking out Google Cloud Platform into its own segment.  This should serve to highlight an important growth business that is reaching material scale in revenue.  In addition, it is likely that GCP has been operating at a loss or very low margin. If this is the case, the new reporting structure could also highlight better operating margins for the core advertising driven businesses.  At a minimum, another step toward improved disclosure and transparency should help build investor confidence.  The parallel may not be perfect but Amazon shares benefited greatly when the company began to break out the financial performance of its industry leading cloud platform, Amazon Web Services.

Northlake believes that 3Q20 will be seen as critical quarter for Alphabet shares.  GOOG shares are up nicely in 2020 but have lagged far behind other COVID winner tech giants like Amazon, Facebook, Microsoft, and Apple.  GOOG is up over 4% today while the other stocks are down 4% plus on average.  We think a catch up move for GOOG is coming.  Our revised target is 15 times 2021 projected EBITDA plus a portion of the hidden value for other bets like Waymo and Verily, equating to $1,900 or 17% upside.  It will take a couple more positive quarters to provide the catalyst for these gains but our confidence is improved off the stellar 3Q20 results.

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.

Comcast: A Tale of Three Cities

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Comcast remains a tale of three cities: cable, NBC Universal (NBCU), and Sky.  Fortunately for investors, the dominant business – cable – is a clear COVID winner with attractive secular prospects.  On the other hand, NBCU and Sky are COVID losers facing secular challenges.  Results in 3Q20 were very strong in cable led by broadband.  NBCU and Sky had better results than expected but both saw sharp declines in operating cash flows thanks to the impact of COVID on movie releases, advertising, and theme parks. 

We have always felt that Comcast has done a good job managing the NBCU assets from a financial perspective.  Unfortunately, the changing nature of TV and video consumption has led NBC and cable networks like USA and Bravo to be in long-term decline.  Comcast was slow to change direction strategically, but the combination of its flex box for broadband only households and the launch of Peacock offer some hope for positive offsets.  We like the Universal theme parks, but this business will remain under pressure until there is a widely distributed vaccine.  We also like the Universal film and TV studio, but it also must wait for a recovery until COVID is in the rear view mirror.

We never liked the Sky acquisition as we felt Comcast paid way too much and the strategic rational was weak.  As with the rest of Comcast, Sky is a well-run business, but it faces similar challenges to U.S. cable and satellite businesses from cord cutting, lost advertising market share, and high content costs, especially for sports rights.

Given Comcast’s leadership position in cable broadband and the valuations accorded other pure-play cable stocks like Charter Communications and Cable One, an argument can be made that Comcast shareholders would be better off if NBCU and Sky were sold or spun off.  However, this seems highly unlikely given that Comcast’s CEO Brian Roberts drove the acquisitions of these businesses and he has voting control of the company.  Not all is lost though.  When COVID subsides and a proven vaccine is available, there will be a big cyclical turn in the troubled businesses.  This will build on already strong free cash flow driven by the cable business and move Comcast’s balance sheet from a position of strength to excess capital.  We believe this story will develop over the next several quarters after which stock buybacks will resume.  A sign of what is to come on shareholder value initiatives is the company’s 10% dividend hike this year even as COVID severely penalized the company’s finances.  Comcast has now raised its dividend for 12 consecutive years.

We still feel the shares can grind higher to low-$50s based on the depressed valuation.  Comcast has aspects of COVID winners and COVID losers.  We think the broadband business is not only a COVID winner but also has good long-term growth prospects.  The COVID loser businesses should inflect sometime in 2021.  This combination of secular and cyclical growth is a good set up for investors over the next year. 

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. 

IBM Moving in the Right Direction. Slowly.

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IBM reported 3Q20 earnings last week that were largely in line with expectations and consistent with trends over the past few quarters.  The report came on the heels of a major announcement from the company that it will be spinning a big piece of its slow-growing business to increase concertation on its cloud and artificial intelligence businesses.  The stock has been under a lot of pressure since it initially popped 10% on the spin-off announcement and now sits at its spring and summer lows.

Immediately after the spin announcement, the shares shot up from $120 to $140.  We believe this supports our thesis that as IBM returns to modest growth there is a lot of upside in the shares.  Unfortunately, details of the spin-off indicate that the reward will be delayed.  First, the spin is unlikely to occur until the second half of 2021.  Second, the costs to separate the businesses are high on a cash basis.  As these facts were digested, IBM shares gave up most of the spin announcement gains.

The stock has taken another hard hit since reporting earnings.  Our review of the report and analyst estimates indicates little variance in the results relative to expectations.  Research has pointed to a slowdown in growth of Red Hat.  Red Hat drives the cloud transformation that makes us bullish on IBM, so this is a concern.  However, a slowdown was expected and growth remains in the mid-teens.  We think another factor at work is that several peers who are also focused on large enterprise spending, such as Cisco Systems, have seen a sharp slowdown in revenue growth.  This was not evident at IBM, but investors have soured on companies supplying technology products and services to large enterprises.  Finally, there has recently been a rotation away from high-growth winners in areas like cloud services.  Many stocks in these high-growth industries have pulled back 10% or more.  This has likely bled over to IBM given the importance of Red Hat and the cloud to returning the company to growth.

Fortunately, IBM pays a very healthy dividend while we wait for our bullish thesis to play out.  Currently, the dividend equates to an annual yield of nearly 6%.  We are disappointed with the pace at which our thesis is developing at IBM.  We never expected the stock to work right away and we certainly did not expect a pandemic to hurt traditional core business lines.  The spin-off of legacy businesses to focus on growth areas fits our thesis perfectly, so we plan to remain patient.  At just 10 times 2021 consensus earnings estimates with a 6% dividend yield, it takes little upside in the shares to produce a good total return from current levels.  We think expectations and sentiment are low, and the prospects of a slimmer, more focused, and growing new IBM can produce significant upside in the shares as we move into 2021.  We hope to see more progress soon.

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. 

Neutral on Style for Further Risk Reduction

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The October model update results in moving to neutral on the growth vs value theme in the Style model.  As a result, we have completed the sale of one half of client positions in the Russell 1000 Growth (IWF) and reinvested the proceeds into the Russell 1000 Value (IWD).  We are sticking with the S&P 500 Mid Cap for a second consecutive month after moving from small cap to mid cap at the start of September.

Last month we expressed some near-term caution about the stock market outlook that reinforced the changes we made by swapping small cap and small cap growth exposure to mid cap and large cap growth exposure.  The market did correct in September with most major indices and sectors declining by a mid-single digit percent.  The latest trade to neutralize our bet on growth vs. value further reinforces our strategy to reduce risk heading into the election.  In this case, the risk reduction is achieved through diversification.

The factors driving the shift from growth to neutral were actually in place last month but we look at our models using two month averages to reduce volatility of the signals.  The key factors that drove the switch in October are improved relative performance of value stocks over the past few months and continued improvement in economic data as the economy has reopened.

MDY, IWD, and IWF 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.