Back to Mid Cap for Above Average 2022 Economic Growth

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We are moving back to mid cap after three months of our large cap recommendation, while sticking with our neutral view on growth vs. value. For clients using Northlake’s Market Cap and Style strategies, the shift from large cap to mid cap triggers the sale of the S&P 500 (SPY) with proceeds reinvested in the S&P 400 Mid Cap (MDY). The change is consistent with our view that the economy will sustain growth well above pre-pandemic levels throughout 2022. This should lead to rotation toward small and mid cap stocks, which are more sensitive to macroeconomic trends. The shift in the Market Cap strategy is consistent with current positioning overweighting small and mid cap for clients using thematic ETF strategies.

Recent concerns about peaking economic and earnings growth and the prospect of accelerated Fed tapering and tightening has caused small and mid cap to lag the gains in the large cap S&P 500.  This makes the timing of this swap attractive and produced a positive result for the prior large cap recommendation. While in place, the previous recommendation saw SPY rise just over 2.0%, while MDY gained just under 0.5% and the small cap Russell 2000 (IWM) fall 1.3%. This is exactly the type of incremental performance we are trying to achieve with the Market Cap and Style strategies.

MDY is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. SPY is held in select Northlake client accounts.  Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov.

Home Depot Story Continues to Build

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Home Depot (HD) reported excellent 3Q21 results with sales continuing to grow ahead of consensus expectations and surprisingly good gross and operating margins despite supply chain driven cost pressures. Northlake’s investment thesis on HD has been built around three ideas. First, we believe that the pandemic has created a secular increase in willingness of consumers to spend money on their homes. Second, management is best in class and executes on a day-to-day and strategic basis. Third, increased investment in ecommerce and Pro capabilities extend HD’s competitive moat.  3Q21 results support our investment thesis fully.

Stock Reaction: HD shares have soared nearly 7% since reporting results building on a strong run since the initial sell-off after reporting the prior quarter. The shares sit at all-time highs although valuation remains within historical bounds.  Investors in retail stocks have been very sensitive to trends in profit margins this quarter and HD easily satisfied concerns.

Earnings Analysis: Sales, operating income, and EPS all exceeded Wall Street consensus estimates. Strength was especially notable in big ticket items like appliances and power tools. Traffic remains down about 5%, but average ticket was up 12%. Management noted that HD’s labor expenses are most sensitive to traffic (staffing the store when it is crowded), so the combo of light traffic and large tickets contributed to the margin flow through. Gross margins were down just 5 basis points, a great performance compared to other retailers. Supply chain issues are easing a little but still remain.

Looking ahead, management spoke optimistically about a larger total addressable market consistent with Northlake’s view on the secular change in home-focused spending. On a near-term basis, the sharp rise in housing prices is providing further support to demand. Also helping 2022 is HD’s recent focus on the Pro customer. Much of the pandemic demand has been for DIY. Pro demand has a reopening aspect as many consumers are still just beginning to be comfortable with letting workers in their home. On margins, management seems confident they can continue to manage the supply chain issues.  In addition, a material portion of the excess costs related to COVID are beginning to fall away for a net benefit even after increasing employee pay.

Target Price: HD has exceeded our prior target price of $375. We still see upside as the company’s excellent performance in 3Q21 supports a higher P-E multiple. higher estimates, and willingness to base our target on 2023 earnings. Last quarter, we noted our $375 target was based on 25X 2022 estimates or 23X 2023. We now think the shares can support 25X our increased 2023 estimate of $17 for a target of $425. We would note that this is not big upside from current trading levels, but as with other blue chip growth stocks like Apple, we are comfortable holding shares and letting value build through continued earnings and cash flow growth and the passage of time.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

Disney Outlook Leads to Delayed Gratification for Shareholders

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Disney (DIS) reported slightly disappointing earnings for its 4Q21 with modest shortfalls across most business segments headlined by preannounced weak Disney+ streaming subscriber additions and poor operating margins at theme parks.  With a new fiscal year starting in October, management took the opportunity to reset expectations across most of its business lines. 

Stock Reaction:  Since DIS last reported quarterly earnings in August, the company indicated that it was seeing a slowdown in subscriber growth for its Disney+ streaming service.  This news came as a surprise to Northlake.  We previously expected continued strength in streaming and a rebound in theme parks as they fully reopened to allow the stock to break out of out of the $170-$200 range it had been in since early in 2021.  After reporting quarterly earnings yesterday, the stock did break out.  Unfortunately, it moved lower into the $160s based on the new FY22 expectations and falling investor confidence that Disney+ will meet the company’s multiyear growth targets.

Earnings Analysis:  The only material concern arising from the slight shortfall in the 4Q21 earnings was the weak operating margin at the company’s theme parks.  The sharp drop in the stock has much more to do with the new FY22 outlook.  Investors place little value on DIS’s traditional media businesses including ESPN, ABC, and local television stations.  The focus is squarely on theme parks and streaming.  Despite the shortfall in theme parks margins, the news for that segment is generally good.  Demand trends are strong and set to accelerate as the U.S. allows vaccinated international travelers to return.  In-park spending is well above pre-pandemic levels.  New ticket plans are proving popular and financially accretive.  Unfortunately, permanent cost savings are being offset by inflation in wages and other inputs.  Nonetheless, we still expect a return to at least prior margins despite the 4Q21 shortfall.  Theme parks should provide incremental value to DIS shareholders as the parks fully ramp over 2022 and especially 2023.  We have less confidence in the outlook for Disney+ after the new guidance calling for continued subdued growth in new subscribers until the second half of FY22 and increased spending on content above prior expectations.  Management notes that the timing of new country rollouts and new content is heavily weighted to late 2022 and 2023.  Disney+ is currently in 60 countries and could reach 160 by the end of 2023.  Content production delayed by the pandemic shutdowns should reach the desired level of one new original per week in the fall of 2023 across key intellectual property including Marvel, Star Wars, Disney, Pixar, and National Geographic.  Furthermore, local language production will soar into the hundreds, which is crucial as geographic reach of the service expands.

Target Price: We still expect Disney+ and the company’s other streaming services – especially Hulu – to be successful and drive value.  However, due to lower visibility of profits and delayed timing at Disney+, we are lowering the value we place on the company’s streaming services.  This reduces our target price from $225 to $205.  Following the sharp drop in the stock today, this still equates to upside of 25%.  The shares are unlikely to reach this level until there is renewed momentum for Disney+ subscriber growth and clear signs of the timing for theme parks to reach peak profit margins.  One near-term catalyst could be stronger subscriber growth in response to Disney+ Day taking place on November 12 when the company is offering a surge of new content.  It is also possible that DIS has reset expectations, giving investors all the bad news.  Often this type of kitchen-sink guidance sets up a bottom for a stock.  DIS has a great track record and arguably the best content in the world, so while frustrated by the loss of 2021 and much of 2022 for our investment thesis, we are willing to sit tight. 

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. 

Activision Headwinds Strengthen

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Last quarter we noted that ATVI has been managing the headwinds coming from the employee discrimination lawsuits well.  Looking solely at the results of 3Q21, one would conclude the same thing.  However, the other shoe dropped when the company delayed the release of two important games from 2022/2023 to 2023/2024.  The issues are a loss of key personnel and loss of productivity as a result of the lawsuits.

Stock Reaction:  ATVI traded down another 12% after dropping 20% from 2021 highs due to the lawsuits.  The stock now trades at less than 20 times projected 2021 estimates and the same on 2022 that is now assumed flat year-over-year due to the delayed game releases.

Earnings Analysis:  3Q21 earnings were good with Activison in line, Blizzard underperforming (Blizzard is where the discrimination impacts are being felt), and King’s mobile games outperforming.  Management slightly raised 2021 guidance, passing through some of the upside from the latest quarter.  Guidance could have gone higher, but it appears management wants to play it safe given the imminent launch of the next Call of Duty game.  Performance of this game is critical to the 2022 outlook and is the next big catalyst for the shares.  If Call of Duty meets high expectations from investors, it will make it easier to look at the delayed games as just deferring future profits.  Any shortfall would create an even higher hill to climb to regain investor confidence and shift the focus to 2023.

Target Price:  Last quarter, we reduced our target on ATVI from $115 to $90 because we expected investors to mark down valuation until the headwinds passed.  We did note that $115 was ultimately achievable as earnings power was unchanged and eventually the company would regain the street’s confidence.  It now appears unrealistic to achieve a recovery to $90 in the near future.  We expect the shares to stay range bound +/- 10% against current levels until (1) Call of Duty acts as a catalyst, and (2) management signals progress on now delayed games.

The latest issues may or may not impact long-term earnings power.  At a minimum, the delayed game releases push realization of earnings power out to 2023.  ATVI has encountered and overcome major challenges before.  In fact, that has been the case for peers Electronic Arts and Take Two Interactive as well.  This history makes us willing to hold for now and hope for better news starting with the new Call of Duty game.  A P-E under 20X on base level earnings is historically very cheap for ATVI.  This should limit downside while we wait for a recovery and further datapoints to evaluate the shares.

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. 

Nexstar Still Shining

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The title of this blog post is similar to when we last discussed Nexstar Media Group (NXST).  This is no coincidence as the company’s 3Q21 earnings report was more of the same good news.  NXST has built nationwide scale of local TV stations, a business than has always generated large free cash flow (TV stations require very little capital spending and operate at high margins).  The company’s scale is currently allowing it to fully participate in above average economic growth and use its free cash flow in multiple ways to support shareholder value.  NXST, like other local media stocks, has always been volatile, but we expect the slow grind higher that has the stock up from $58 in 2017 when we first purchased it to $160 (up 175%) to continue.

Stock Reaction:  NXST shares initially traded down 1-2% following the company’s conference call to discuss the 3Q21 results but as the day wore on the tide turned leaving the stocks up 3-4% and close to its all-time high set earlier this year.  The shares have moved sideways since July even after the company raised guidance for its 2021/2022 cycle after the 2Q21 report.  Whether or not another solid quarter is enough to allow a breakout from the trading range in either direction, we still see the next big move higher barring a macroeconomic setback.

Earnings Analysis:  3Q21 earnings were good, led by a rebound in core advertising excluding the auto category.  Auto remains a top 5 category and it has not rebounded yet from pandemic lows due to supply constraints.  Dealers do not have enough cars to sell, so they limit their advertising spending.  All other top 10 ad categories are growing, with sports betting continuing to develop into a new top 3 vertical.  Excluding auto, core advertising was up double digits vs. 2019, a result that will likely surprise many investors who ignore local TV and believe it is a dying category.  NXST’s other big revenue stream is retransmission fees that it receives from cable, satellite, and streaming services that offer its TV station feeds to subscribers.  Visibility here remains good with most contracts locked in through 2022.  The next cycle will begin in 2023 where we still expect moderate growth despite lower sub counts due to the continued importance of local TV news and smaller but still leading TV ratings for broadcast entertainment programming.  NXST has been bulking ups its digital revenue through acquisitions of content that is complimentary to its news operations.

Target Price:  NXST is valued on two-year average earnings due to the massive swings in political spending between even and odd years.  The latest report suggests that the company could exceed its current guidance for free cash flow.  Management was confident in near-term trends and another political cycle kicks in next year.  There was even a mention of further growth in 2023, an unusual utterance for a management team that very carefully and effectively manages street expectations. 

NXST is a relative thinly traded stock in an industry that investors view skeptically on a secular basis.  This leads to volatility in the shares as today’s post earnings trading indicates.  NXST has one of the best management teams among all stocks we follow, and we remain highly confident that operational, financial, and strategic success will continue, so we are comfortable riding out volatility in the share price.

We are sticking with our $180 target price built on what we believe to conservative assumptions.  We continue to see an easy path to $200 or more if the company successfully answers investor concerns about advertising and retransmission growth as streaming continues to gain share of TV viewing.  Further clarity on the balance of capital allocation between acquisitions and share buybacks is also important.  Given the company’s history, we expect the answers to be satisfactory supporting our bullish outlook.

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. 

Models Stable Ahead of Fed Taper Decision

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We are sticking with our current positioning for at least another month after reviewing the latest updates from our Market Cap and Style models. We will continue to hold current positions following the models including the S&P 500 (SPY), Russell 1000 Growth (IWF) and Russell 1000 Value (IWD).  We will also stick with our preferences for clients investing in thematic ETFs.  This includes holdings in the sector funds for financial (XLF) and industrial (XLI), small cap value (IWN), and exposure to developed economy international (EFA/VEA) and emerging markets (EEM/VWO).

The message from our models and our review of recent economic data and stock and bond market trading trends is that the rally has the potential to continue and to broaden.  We see concerns about the slowing economy, higher inflation, and monetary policy as misplaced.  The economy is slowing but the outlook for the next year at least remains for GDP growth well above pre-pandemic levels.  Supply chain issues are a headwind, but we see them eventually being resolved with deferral rather than destruction in demand except for pure holiday-related spending. Inflation has also moved higher, but we accept the transitory argument put forth by the Fed due to secular factors like demographics and technology leading to maturation of the major Western economies (and maybe even China).  The Fed is tapering and may begin raising the Federal Funds rate in 2022.  Tapering is surely less accommodative, but we do not see it as having the same impact as tightening policy.  In fact, for most of the next six to nine months, the Fed will still be a new buyer of bonds and beyond this frame will just step away from the market rather than selling its large portfolio of bonds.  Higher rates present a challenge whether market-driven or triggered by the Fed.  Rates are likely to remain quite low by historical standards, returning policy to a normal economic environment.  Investors may like normal after a decade plus of unusual investing environments.

SPY, IWF, and IWD are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  XLF, XLI, IWN, EFA, VEA, EEM and VWO are held is select Northlake client accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.

Will Apple’s Lost Sales Stay Fresh or Turn Rotten?

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When Apple (AAPL) reported its June quarter results, management hinted at supply chain issues beginning to impact the company’s ability to meet demand.  During the quarter, at a conference presentation, the company updated its guidance to note that about $3 billion in sales would be lost in the September quarter.  When the company reported September quarter earnings this week, the actual lost revenue amounted to $6 billion.  Guidance commentary indicated that at least another $6 billion in revenue would be lost in the December quarter.  Despite the sales shortfall that was primarily evident in iPhones, Apple still managed to match consensus estimates for EPS.

Stock Reaction:  After initially falling about 5% in response to the earnings, by the end of the next day’s trading Apple was only down about 2%.  The recovery makes sense to us as the details of the earnings report and management’s conference call commentary painted a clear picture of strong demand across the entire portfolio of products and services and execution on margins and cash flows remains best in class.

Earnings Analysis:  The supply chain issues have been in two buckets:  COVID related and semiconductor shortages.  Management noted that COVID issues had eased but low-tech semiconductors continue to be a problem.  Beyond supply chain, the results were quite good.  All products and services in all geographies grew well and management indicated that demand trends support more of the same.  We were especially impressed by 26% growth in services at a record gross margin.  Product gross margins held nicely despite pressures from the supply chain such as elevated freight.  Guidance calls for less than 10% revenue growth and a modest sequential decline in margins.  This is manageable in our view and we see only small changes in estimates that are not material to the long-term investment thesis.

Target Price:  The big questions for Apple investors are (1) how long will the supply chain issues last, and (2) are the lost sales deferred or destroyed.  Most observers see supply chain issues lasting until mid-2022 although Apple’s massive scale and importance to its suppliers should allow the company to be among the first to see better supplier deliveries.  There clearly will be some lost sales this quarter given that the holiday season brings gifts of Apple products.  We still expect the overwhelming majority of lost sales to be deferred.  Lost sales moving forward seem concentrated in iPhones.  Given already long upgrade cycles, we anticipate that most buyers will wait a few months for their new phone rather than permanently keep their current phone or switch away from Apple to Android.  Apple continues to have a high level of switchers in current sales supporting this outlook.  We also are encouraged by comments about demand which are consistent with the very strong reviews for all of Apple’s current generation product and services.  Macs and iPads especially seem to have taken a step forward while iPhones are benefitting from a backlog of phones 3-5 years old.  Services and wearables continue to grow rapidly off the flywheel of the ever-expanding installed base of iPhone users.

Despite our positive view of the company’s current performance and the likely recouping of most of the lost sales, we still see Apple shares as somewhat expensive and are sticking with our price target of $150.  At $150, the shares trade at 25 times 2022 expected earnings.  This is moderate but deserved premium to the S&P 500’s multiple of 20.
The shares currently are trading at $150 but we see no reason to sell or aggressively reduce positions given the overall quality of the company and at least several more years of solid growth. 

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. 

Comcast Questions Starting Sooner

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Comcast (CMCSA) reported another good set of quarterly financial results.  Revenues, EBITDA, and free cash flow all at least met Wall Street estimates in 3Q even as the company had preannounced a slowdown in growth of new broadband subscribers.  From a financial perspective, the huge increase in broadband subs during the peak of the pandemic provides much greater financial reward than the small shortfall in broadband subscriber growth.  3Q21 marked the point at which Comcast had reduced debt to the level before the acquisition of Sky.  This is an important milestone as management has been promising to accelerate stock buybacks once financial leverage targets were achieved.

Stock Reaction:  Immediately following the report but before the conference call, CMCSA shares were trading up about 3%.  During the call, when management discussed broadband trends in 4Q21 and beyond, the shares dropped sharply to a loss of as much as 4%.  Now, two days later, the stock is off about 2% from the close before earnings were released.  In our last update, we mentioned that there were likely two issues related to broadband subs but not until 2022.  Management guided 4Q21 subs below the level that had already been reduced in September.  The company also refused to comment on 2022 expectations noting lack of visibility.  The latest commentary has moved the concerns we expected to emerge next year forward.

Earnings Analysis:  Short of the broadband subscriber outlook, Comcast had good results across the board.  Cable is still growing over 10% thanks to the much larger broadband base, a shift to profits in Xfinity Mobile, and continued steady growth in connectivity services to businesses.  The company’s media and entertainment businesses at NBC Universal continue to recover strongly after being crushed during the pandemic.  Advertising, theme park attendance, and Sky’s UK and European TV operations all grew very strongly.  Comcast is continuing to invest heavily in its Peacock streaming services which reduces headline growth at NBC Universal and obscures the underlying organic recovery.

Target Price:  We are sticking with our target price in the low-$60s for Comcast but expect it to take a few quarters before investor sentiment improves and the shares resume an upward trend.  Financial results will remain quite strong and the stock buyback should accelerate sharply to about 10% of the shares outstanding per year.  Unfortunately, the unclear outlook for broadband subscriber growth is dominating the investment narrative.  The big fear is that now much higher penetration of broadband households and increasing fiber-to-the-home investments by telcos means that Comcast’s growth will slow dramatically.  Management notes (we believe correctly) that thus far the slowdown is merely due to COVID impacts on increased penetration and lower churn from less housing moves.  Currently slower growth is coming ahead of a pickup in fiber passings by telcos over the next few years.  Investor fear is driving the terminal value placed on Comcast lower even as financial results continue to grow with almost no impact.  Northlake believes that over the next few quarters, Comcast will prove to investors that broadband remains a growth business.  Greenfield builds and a pickup in housing formation should provide enough room for cable and telcos to co-exist with modest growth.  Comcast will also enjoy continued growth at NBC Universal and Xfinity Mobile.  Today, Comcast shares assume close to no growth.  This is a dire view given the dominant competitive position cable broadband will maintain in most of the country even as telco fiber penetration grows. 

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. 

The Wait is Ending at Sony

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Sony (SONY) reported a second consecutive beat and raise quarter. Even after the previous quarterly report, we still thought that guidance was conservative, so we are pleased but not surprised with another step forward confirming our investment thesis.  We could almost republish our last quarterly update and just add today’s date.  Three months ago, we wrote, “Sony (SONY) reported better than expected 1Q22 earnings and raised full-year guidance.  We had thought that guidance was conservative, both short-term and long-term, so the news was not surprising.  It is welcome news in support of the long-term investment thesis that SONY’s individual businesses are deeply undervalued compared to peers with a management team that has executed well strategically, operationally, and financially to remake the company over the past five years.” 

Stock Reaction:  One thing that has changed is SONY shares are beginning to reflect the good results.  The stock is trading up over 4% to an all-time high in U.S. trading following the report.  SONY recently received a buy rating from a U.S-based analyst that covers media, entertainment, and video game stocks.  Most Japanese analysts that cover SONY are focused on electronics and technology based on the company’s tradition.  We believe this has held back the stock.  Hopefully, another beat and raise quarter will improve sentiment in Japan and encourage more U.S. analysts to follow the shares.

Earnings Analysis:  While earnings were good relative to expectations in most segments, the most encouraging aspect of the 2Q21 report was the broad-based increase in guidance.  Revenues were increased in Music, Pictures, and Financial Services and lowered only in Electronics Products.  Operating income was boosted in Music, Pictures, Electronics Products, and Imaging and maintained in Games and Financial Services.  We are especially encouraged by the outlook for Music and Pictures and eventually a resumption of upside in Games after that business shifts back from money-losing sales of PS5 game machines to high-margin video games and network services.

Target Price:  We are raising our target on SONY to $155 based mostly on rolling over to 2022 estimates.  Our new estimates are slightly higher reflecting the second consecutive beat and raise quarter.  However, we did slightly lower our EBITDA multiple to reflect the multiple compression in video game publishing stocks such as Activision Blizzard and Electronic Arts.  This is a conservative approach as the valuation of music labels has expanded materially since the highly successful IPO of industry leader Universal Music Group in September.  SONY is #2 in music and is enjoying the same strong financial performance as UMG.  The bottom line is SONY shares still look undervalued at 11X EBITDA when peers in music, video games, entertainment, and imaging sensors (semiconductors) trade at higher multiples.  Those businesses account for over 80% of SONY’s operating income.  As analysts and investors in the U.S. and Japan gain appreciation for SONY’s transformation and consistent superior execution, we believe valuation will expand with a further boost for the shares coming from additional upside on still conservative guidance.

SONY 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 Shines Amid Digital Ad Industry Challenges

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Alphabet (GOOG/GOOGL) reported better than expected earnings with revenues, expenses, and EPS all coming in ahead of expectations.  The revenue upside was especially impressive given the turmoil in internet and mobile advertising caused by Apple’s privacy initiatives.  Google did not escape completely unscathed as YouTube ad growth was a few percent less than expected (although still more than 40%).  Google Search was exceptionally strong and more than made up for YouTube and a slight deceleration in growth at the company’s Cloud segment.  Google is less impacted by Apple’s privacy changes since Search provides more first-party data the company’s advertisers can use to still reach consumers on a user basis.  Search also is benefitting from a rebound in verticals sensitive to COVID reopening such as travel and hospitality.  Retail is also holding up well and is probably Google’s largest category.  Facebook and Snap also have big retail presence but the ads they sell go purely to ecommerce.  Google is an omnichannel ad buy for retailers that are now seeing renewed strength in store level sales.

Stock Reaction: GOOG/GOOGL shares are up 6% and hitting new all-time highs today following last night’s earnings report and conference call.  This is in stark contrast to Facebook, Snap, and other digital advertising stocks that traded down sharply after reporting and sit 15-20% or more below their all-time highs reached as recently as two months ago.  Alphabet was already the best performing internet stock in 2021, up 60% prior to today’s gain.  The 3Q21 report is a clear endorsement of the 2021 stock performance.

Earnings Analysis: Search led the way, more than making up for slight shortfalls relative to expectations at YouTube and Cloud.  YouTube took a small hit in its direct response ad sales due to Apple’s privacy changes.  Cloud decelerated slightly to mid-40% growth but management noted continued strength in the most important large enterprise portion of the business.  Perhaps most impressive in the quarter was the company’s operating profit margin.  Management has been showing much improved cost controls since the arrival of CFO Ruth Porat in 2015.  Alphabet operating margins are higher now than pre-pandemic.  Management suggested continued investment was coming to support revenue growth but given multiple chances to push back on the idea that margins had reached a new higher level, Ms. Porat deferred.

Target Price: After slightly tweaking our valuation assumptions and rolling forward to 2022 estimates, our new target for GOOG/GOOGL shares is $3,200, up $200 from prior levels based on 2021 estimates.  This leaves about 12% upside after today’s big gains.  Management did caution that comparisons really begin to toughen in 4Q21 and that will continue through 1H22.  Furthermore, despite the confidence expressed on profit margins, management noted there is some spending that was eliminated during the pandemic that will come back onstream over the next few quarters.  These factors contribute to our decision to keep the valuation multiple in check despite Alphabet appearing to distance itself from peers on multiple financial and operating metrics.  Should the next couple quarters go smoothly, we can switch our focus to 2023 and targets in the range of $3,5000 to $4,000.

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.  DIS is a net long position in the Entermedia Funds.