Comcast Set to Emerge Strongly from COVID

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Comcast remains a tale of COVID winners and COVID losers.  The cable/Xfinity business is performing great, driven by broadband.  Cord cutting has minimal impact given margin dynamics and the fact that you cannot really cut the TV cord without maintaining the broadband cord.  The NBCUniversal and traditional media side is still feeling pressure from COVID.  Cord cutting acceleration hurts NBC and the company’s cable networks.  These businesses also are hurt by weak advertising related to the recession and directly impacted advertisers in travel, hospitality, and services.  NBCU also is a major theme park operator.  This business is very slowly recovering and remains way down vs. 2019. Finally, NBCU is major film studio so the closure of theaters and limited attendance where they are open has been a big loss.  Comcast Sky business in Europe faces similar impacts from COVID on advertising and cord cutting without the benefit of a broadband business.

In 4Q20, cable saw customer relationships, revenue, adjusted EBITDA, and free cash flow rise 5.1%, 6.3%, 12.3%, and 26.1%, respectively.  NBC, on the other hand, saw revenue fall 18.1% and adjusted EBITDA decline 20.7%.

Northlake feels better about the outlook for Comcast shares coming off 4Q20 results.  First, we think the cable business will hold onto decent growth in 2021 despite tough comparisons to the work from home broadband boom.  Management guided 2021 to look similar to 2019, which was a very good year for Xfinity with adjusted EBITDA rising over 7% and a then best in a decade gain in broadband subs.  Second, NBCU should see much improved results as hopefully COVID impacts steadily fall through 2021 and into 2022.  Theme parks and movie theaters should fill up and advertisers will fully reengage as consumers emerge from their homes anxious to spend money.  Sky should benefit also benefit from improved advertising demand and also as pubs reopen and turn their TV subscriptions back on.  This scenario sets up Comcast as a long-term COVID winner thanks to broadband gaining permanent importance and COVID loser businesses enjoying a cyclical rebound.

As important as the fundamental business outlook, Comcast’s financial profile is improved.  The company has been paying down debt in lieu of buybacks since what we still view as the ill-advised acquisition of Sky.  Leverage is now below 3X EBITDA and should hit the long-term target of 2.5X in 2022.  CEO Brian Roberts indicated that Comcast would resume share buybacks in 2021.  Buybacks are a very shareholder friendly way for management to spend the company’s massive and growing free cash flow.  A return to buybacks also suggests Comcast is strategically complete and no major acquisitions are on the horizon.  Neither should there be a big investment to build out a wireless network or buy or spend heavily on steaming services.  Peacock is off to a good start as the company’s streaming effort and a restructuring that combines Peacock, NBC, and the cable networks should efficiently produce sufficient content to support all three businesses.

Using an average of 2021 and 2022 EBITDA to account for the recovery of the COVID loser businesses, we now see a price target of $58 for Comcast.  This could prove conservative as we are only giving Comcast credit for about 15% of the free cash flow it will generate over the next two years.  Risks include headlines around net neutrality, tough comparisons for broadband in 2021, increased broadband competition from telco 5G and fiber builds, and any decision to materially increase investment in streaming.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. 

Apple Fully Ripe After Exceptional Quarterly Results

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Apple reported an extremely good December quarter to open the company’s 2021 fiscal year.  Strength was across the board in all products, services, and geographies.  The results materially exceeded high expectations.  Northlake sees two key long-term takeaways from the results.  First, the iPhone remains healthy and is poised for several years of growth as 5G wireless networks roll out globally and a huge installed base of older iPhones upgrades to the iPhone 12 family and beyond.  Apple also continues to gain market share in mobile phones with a significant number of iPhone 12 buyers new to Apple.  Second, the flywheel of services, wearables, and accessories off the installed base offers a huge high-margin opportunity even as iPhone sales moderate beyond the 5G upgrade cycle.

Despite the great results, Apple shares are trading down over 2% the morning after the report in a strong tape.  There are a couple of things to consider.  Yesterday, when the market had its worst day in several months, Apple was unchanged.  In addition, since Thanksgiving, Apple shares had risen from $112 to new all-time highs over $140.  It is often said that the stock market discounts the future. For today, Apple’s great recent stock performance means that the market had already discounted the great results.

Apple shares now trade at 32 times 2021 estimated earnings and 29 times 2022 estimated earnings.  The stock market multiple is about 21 and 18 times 2021 and 2022, respectively.  Apple clearly deserves a premium given its historical track record, disciplined financial management, shareholder-friendly capital allocation, and long-term growth opportunity.  Long-term growth at Apple post the 5G upgrade cycle seems like it should be in the mid-single digits and above global GDP growth. 

Northlake sees Apple shares as fairly valued presently.  Given the company’s quality and the potential that (1) current estimates prove too low, and (2) opportunity exists in new areas such as automated vehicles, fairly valued is good enough.  The stock may consolidate recent gains, allowing valuation to catch up and the 5G cycle and flywheel to prove themselves.  A trading range of $120-150 for the next few months is our most likely scenario.

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. 

Is Bull Thesis Still Intact at IBM?

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IBM reported disappointing 4Q20 earnings although there were positives that support Northlake’s investment thesis.  EPS exceeded expectations, but the upside was due to below-the-line or non-operating items.  The culprit in the quarter was revenue weakness.  We are not surprised by a revenue shortfall given IBM has a lot of exposure to on-premises enterprise spending in its hardware, software, and consulting businesses.  However, weakness was broader and deeper than we expected in these business lines.  Unfortunately, management indicated 4Q20 trends were likely to continue through the first half 2021. 

The revenue miss in IBM’s historical business lines overshadowed better than expected growth of 17% in the company’s Red Hat segment.  On a sequential basis, Red Hat showed an accelerating growth rate against expectations for a slight deceleration.  Red Hat is central to Northlake’s bull case IBM.  Red Hat accelerates IBM’s shift to offering cloud services to its large installed base and provides an entrance to many new customers that look to cutting-edge technology providers.

Prior to reporting its previous quarter, IBM announced a major corporate restructuring that will split the company by spinning out much of its most growth-challenged businesses comprising the Global Technology Services segment.  GTS has had declining revenue for years and earns below corporate-average margins.  Spinning it off to shareholders will leave core IBM much more heavily focused on cloud services and artificial intelligence.  While IBM trails Microsoft Azure, Amazon AWS, and Google Cloud, the cloud businesses now being driven by Red Hat offer solid double-digit growth potential. 

With GTS gone, new IBM can offer mid-single-digit growth, rising margins, and significant free cash flow.  The stock trades at just 10X earnings.  A successful transition to a moderate growth profile would allow the multiple to expand, potential to 12-15 times earnings.  The upside is thus significant.

Unfortunately, our bull thesis is taking longer to develop than we hoped.  Partially, this is due to the impact of the COVID-19 pandemic on IBM’s large exposure to on-premise energy spending.  This is certainly not the company’s fault.  However, it is fair to wonder whether the shift to a digital economy has long-term ramifications that will keep pressure on IBM’s non-cloud and AI businesses and offset the growth they offer.

The next few quarters seem likely to look like 4Q20.  This will make for tough going for the stock.  Investors are aware of the near-term challenges after the difficult finish to 2020, which should protect downside in the shares.  IBM also has a secure dividend that provides a current yield of over 5%.  Business trends should improve in 2H21 and in 3Q21, the company should provide full details of its spinoff and restructuring. 

We are not sure if it is worth waiting another six months or more for our bull thesis to begin playing out.  Results in 2020 were impacted by the pandemic but it is fair to suggest they also push back against the timing and probability of the bull case.  Right now, we are sitting tight as we reevaluate our IBM investment thesis.  The bad news is out.  The valuation is low.  The current yield is high.  We believe these factors give us time for further analysis.

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.

Adding Growth and Value with Sony

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We recently added Sony (SNE) to Northlake client accounts.  In many cases, we partially paid for the investment in SNE by selling shares of ViacomCBS (VIAC).

SNE is well-known for its consumer electronics products, but this is just a small part of the company.  The key growth drivers are video games, music, TV and film production, and imaging sensors.  These segments make up about 80% of SNE profits, and each has excellent secular growth prospects.

SNE trades at 11X 2021 EBITDA, while pure-play peers in each of the company’s growth businesses trade at 15-20X EBITDA.  Video game publisher Activision Blizzard, which Northlake clients own, trades at 19X.  Vivendi recently sold a 10% stake in its Universal music label (#1 market share to #2 for SNE) for over 20X.  Lionsgate, a comparable independent producer of film and TV, trades at 11X but is not considered a major studio like Sony, Disney, or Warner Brothers.  Sony’s image-sensing semiconductors are widely used in high-end smartphone cameras from Apple and Samsung and are used extensively in automated vehicles.  Stocks with exposure to automated vehicles are speculatively valued. We think conservatively that SNE can enjoy multiple expansion to 13X, closing less than half the gap to peer pure-play stocks.  This provides over 20% upside. 

Importantly, SNE has no debt.  New senior management is pursuing shareholder-friendly capital allocation policies, something new to SNE and other leading Japanese companies.  SNE has refocused on driving growth over the past ten years and current leadership was central to the decision-making.  We suspect the stock will always trade at a discount to pure-play peers since it is a conglomerate and based in Japan.  However, we see plenty of upside and love the conservative financial profile that is reinforced by Japanese culture.

Here is a brief look at the company’s leading segments.  Sony’s PlayStation video game console is the world leader.  PlayStation also operates a leading gaming network (similar economics to the AppStore) and publishes many of its own popular video games.  Sony Music and EMI Publishing are industry leaders.  Music is booming thanks to the transition to a digital economy.  Beyond Spotify or Apple Music, music is also popular on YouTube, Peloton, and social media.  TikTok has built a business of around 700 million monthly users based off licensed music.  Sony’s film and TV studio controls valuable intellectual property like Spiderman, Karate Kid, Ghostbusters, Hotel Transylvania, The Smurfs and Japanese properties like Fate/Grand Order and the recently released all-time Japanese box office champ, Demon Slayer.  SNE has no streaming service of its own which allows it to develop these franchises and sell to the highest bidder among Netflix, Amazon, Hulu, HBOMax and others as they all race to build and retain massive subscriber bases.  Image sensors are just one of many technologies developed out of the company’s historical focus on consumer electronics that now can be exploited in new digital products and services.

VIAC is a traditional media company trying to transition to internet-delivered entertainment.  As a film and TV producer through Paramount and CBS, the company competes directly with SNE.  The recent merger of CBS and Viacom offers upside.  We have been impressed with new management’s ability to achieve merger synergies and build streaming businesses.  However, we believe the company will have a hard time competing with much larger peers like Netflix and Disney.  The scale of content investment required will limit financial returns for the company’s steaming efforts and not produce enough profits to offset the slow but steady decline in Viacom and CBS cable and broadcast networks.  

We did not view this trade as a direct swap from VIAC to SNE.  However, we do think there is some similarity and SNE has a better growth profile with a much stronger financial profile.  Furthermore, we have very similar industry and sector exposure to VIAC from other Northlake client holdings such as Comcast and Disney, allowing the sale of VIAC and purchase of SNE to diversify Northlake’s individual stock portfolio.

Sony, Disney, and Comcast 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. 

Moving to Small Caps to Begin 2021

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There are no changes to Northlake’s favored themes for December.  We remain neutral on growth versus value and continue to favor mid caps.  As a result, current client positions following the models in the Russell 1000 Growth (IWF), the Russell 1000 Value (IWD), and the S&P 400 Mid Cap (MDY) will be held for at least one more month.

Our recent monthly updates have discussed our view on what Wall Street is referring to as the “rotation trade.”  At Northlake, we believe the rotation trade has legs well into 2021 and our models have positioned clients to benefit by owning value and mid cap.  There are several aspects to the rotation.  First, large cap growth stocks have massively outperformed, while all value stocks have been left behind.  Relative performance between growth versus value and large versus small/mid cap is well above even past historical extremes.  Think about stocks like Apple, Facebook, and Alphabet as leading examples of large cap growth.  Second, the pandemic exacerbated the performance gap between large versus small and growth versus value by creating COVID winners and COVID losers.  Large cap growth companies are largely winners in a work from home environment.  COVID losers include many companies in cyclical industries such as hospitality and entertainment.  Losers also include naturally cyclical economic sectors such as finance, energy, and industrials.  A recession is bad news for companies in these sectors under almost any circumstance.

The rotation trade is a shift in leadership from large cap growth stocks to small and mid cap value and COVID losers.  The rotation started in late summer and accelerated when initial Phase 3 trial results for leading vaccines were encouraging.  Northlake expects pent up demand in cyclical industries and COVID loser businesses.  As long as vaccines can be widely distributed in 2021 and prove as effective as they have been in trials, we think the recent outperformance of value, small and mid cap, and COVID losers has a long way to go.  Just getting back to near historical relationships provides a long runway.

Northlake’s models picked up on the rotation trade.  In Market Cap, we have favored small or mid cap since late 2019.  Thanks to the large cap growth winners, this proved costly on a relative basis until August, but since then clients have regained a lot ground on a relative basis.  The extreme outperformance of large caps for the last five years driven by growth stocks tricked our models.  Now that a sustained shift has taken place, we believe it will have legs.  In Style, we captured most of the growth stock outperformance as we mostly favored large cap growth over the past five years.  At the start of October, we moved to neutral and sold half our large cap growth exposure and reinvested in large cap value.  So far, the timing has been excellent.

It is important to note that we are not bearish on growth stocks, large or small.  We just expect small and mid cap value stocks and COVID losers to lead the market higher in the months ahead. This is expressed in client portfolios though our ownership of individual stocks including Alphabet, Apple, Activison Blizzard, Facebook, and Home Depot.  We also have value and COVID loser exposure with Comcast, Disney, Nexstar Media Group, IBM, and ViacomCBS. Viacom and Nexstar have been huge winners over the last few months.

Overall, we like Northlake’s positioning in our equity portfolios.  Between our models and individual stocks we have a barbell of large cap growth/COVID winners and small and mid cap value/COVID losers.  The balance should work if the market can continue to move higher as we expect.

Many clients are still carrying above average cash balances despite reinvestment this summer into stocks including Home Depot, VICI Properties, and preferred stocks of CGI Liberty and Qurate Retail.  We are actively looking for new ideas at both ends of the barbell to further reduce cash reserves.

MDY, IWD, IWF, AAPL, ATVI, GOOG, GOOGL, DIS, NXST, HD, VIAC, CMCSA, FB, IBM, VICI, GLIBP, and QRTEP 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.