Improved Sentiment Emerging for Comcast

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Comcast reported another good quarter with growth in the dominant cable business sustaining in the high single digits with margins continuing to expand.  Encouragingly, the much smaller but still material media businesses at NBC Universal and Sky are showing clear signs of emerging from the severe impacts of the pandemic.  It seems like most every quarter we are happy with Comcast’s results, especially at the cable business.  This is a testament to the superior competitive position the company has in broadband services and an excellent job by management to support and exploit the company’s edge.  It also seems that most every quarter the company reports good results and the stock trades lower.  This changed last quarter after an earnings beat and it happened again this quarter.  We think this means the perception of the company is changing and the value we have felt could be created may be finally emerging. 

Comcast has been in the penalty box since its acquisition of Sky and aggressive battle with Disney for control of much of the Fox Corporation media empire.  Northlake agrees with many investors that Comcast should not be diluting the outstanding financial growth profile offered by the broadband business.  What is done is done, and over the next several quarters Sky and the legacy media businesses are poised for big cyclical upside.  In addition, the company is one quarter closer to reaching its deleveraging goals and turning toward share repurchases.  On the 1Q21 conference call, CEO Brian Roberts mentioned his excitement at getting close to the resumption of the buyback.  There is lingering concern that Roberts is an empire builder, so reiterating the promise made last quarter to return to buybacks in 2021 is a positive sign.  It is also another step toward rebuilding investor confidence in Comcast, which was harmed by management’s capital allocation decisions rather than the excellent operating execution the company consistently exhibits.

We are raising our target on Comcast to $64, up 14%, by rolling our calculation to using 2022 estimates and giving the company credit for 2021’s free cash flow.  Last quarter, our target was $58 based on an average of 2020 and 2021 EBITDA with no credit for free cash flow.  We are making these adjustments because we have more confidence in the company’s outlook.  A feared slowdown in broadband adds after the huge rush from new subscribers during the pandemic does not appear to be in the cards.  As noted above, we also see green shoots in the COVID-impacted NBCU and Sky businesses.

We continue to monitor several risks.  AT&T, Verizon and T Mobile are making big efforts to supply broadband through fiber buildouts and 5G fixed wireless.  More competition is never good, although it might keep the government from taking too tough action against the “cable monopoly” under a Democratic-led FCC.  The FCC and Congress could still hurt the cable business through regulations or legislation with the primary threat being price controls under the auspices of net neutrality. 

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. 

Facebook Growth Outlook Remains Strong

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Facebook (FB) reported another blowout quarter with growth accelerating.  Strength was across the board in all geographies.  Earnings estimates for 2021 thru 2023 are moving up substantially.  If this sounds like what we wrote for Alphabet and Apple that is a fact.  You can add Amazon to the mix with a similar report.  It is the return of FANG.  All but Alphabet have seen their shares lag since last summer following a huge run up in the initial stages of the market’s recovery from the pandemic.  In hindsight, the huge gains in these stocks in 2020 were spot on.  Earnings have massively beaten consensus expectations for the past three quarters. 

More evidence is developing that the upside is not just from pulling forward growth due to the impact the pandemic had on consumer and business behavior.  Instead, there appears to be a new higher base of revenue off of which FB and other digital economy companies can sustain above average growth.  Growth will slow, particularly after the upcoming quarter that compares to a period last year when the initial lockdowns severely depressed most advertising, including online.  eCommerce got a boost almost immediately as the pandemic started so tougher comparisons begin in the current quarter. 

For FB shares, we think the setup remains favorable.  Three consecutive big earnings beats, limited upside in the shares for six months, materially higher earnings estimates, and signs that the shift toward digital economic activity has a meaningful level of permanence combine to leave upside in the stock even after the recent run and big post-earnings bounce.  Northlake thinks FB deserves to trade at premium to the S&P 500 that now has a P-E of about 20 times 2022 estimates.  It looks like FB could earn at least $15 in 2022, up 15% against a gain of 30% in 2021.  Applying a P-E of 25 on 2022 earnings estimates leaves us with a target of $375, or additional upside of 15% by year end.

Beyond the earnings results, we were most interested in the company’s comments on future growth drivers.  New large markets were noted in virtual and augmented reality, shopping, and supporting content creators.  Management noted these are incremental opportunities, while growth in the core advertising businesses of Facebook and Instagram are still quite strong with engagement holding firm so far as economies reopen and ad pricing rises strongly. 

The company provided some datapoints to support the large potential of the new initiatives.  After a slow start, the Oculus artificial and virtual reality headsets are gaining traction.  Quarterly revenue is nearing $1 billion and notably there was little sequential slowdown off the holiday quarter.  The development of an app store for AR and VR offers potential for high-margin revenue growth.  In shopping, management noted that there are over 1 billion users of the company’s Marketplace and that only 5% of the businesses that are on Facebook either pay for advertising or use the ecommerce tools.  Similarly, Facebook Watch has a huge audience but is not used by content creators in the way that YouTube monetizes.  Beyond these growth opportunities, WhatsApp and Messenger remain unmonetized despite massive usage and reach.  The importance of these early-stage growth initiatives is magnified as comparisons in the core advertising business get tougher in the remainder of 2021 and 2022.  Most importantly for FB shares, these longer-term opportunities support the growth outlook which in turn supports a premium multiple for the shares.

Beyond the coming tougher comparisons, there are a few things to keep on eye.  First, management indicated that operating expense growth in 2021 would be at the upper end of the guided range.  This is unusual as FB normally guides operating expenses and then comes in at much lower growth.  For now, investors are OK with elevated expenses as revenue growth can easily absorb the spending and investing in new growth opportunities is deemed wise.  Should growth decelerate more and sooner than expected this could still be an issue.  Regulatory changes from governments around the world as they investigate FB and other major platform companies are worth watching but are difficult to predict.  More news coming on this front in 2021.  Finally, unrelated to business fundamentals, FB shares remain in the center of the frequent rotation between growth and value stocks or COVID loser and COVID winner stocks.

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.

Apple Branches in Full Bloom

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While reviewing Apple’s (AAPL) 2Q21 earnings report, I mentioned to Tim that I could almost just repost the blog reviewing 1Q21 earnings.  Just change the date and tweak it here and there.  Tim astutely pointed out that consistency is a sign of a great company; it is also especially valuable in an era when tweets or comments by management change investor perceptions and cause historically unusual stock volatility.

In 2Q21, AAPL once again easily exceeded estimates with strength across all products and geographies.  The quarter reinforces our belief that the 5G iPhone cycle will play out over several years even as much of Wall Street is still thinking about a 2021 super cycle.  Also reinforced is the idea that the iPhone has become a flywheel off of which Apple can sell new products and services.  Services are now 19% of revenue, and Wearables have grown to 9% even in a quarter where the dominant iPhone segment is producing huge results at the start of a product cycle.  The flywheel is providing another boost as Services offer superior margins.  Although not detailed, Wearables likely provide above average margins as well.  2Q21 saw the highest gross margin in nine years and the highest operating margin in five years.

If we had to point to one new takeaway, it would be the idea that the new post-pandemic normal might place a premium on high-performance devices (phones, laptops, PCs, tablets) as new digital habits have formed and a hybrid workplace including “work-from-home” emerges.  This concept would play to AAPL’s strengths as a premium products company.  A great response to new Macs and iPads that contain the company’s internally designed high-end processor is one sign that a new normal could be developing to AAPL’s advantage.  A shift toward premium devices could also be evident in the mix shift in favor of the iPhone12 Pro.  Mix shifts up the product chain further support margin expansion.

Beyond AAPL’s current business momentum, the company’s financial strength remains outstanding.  To the Board’s great credit, capital allocation remains very shareholder friendly as evidenced by another dividend increase and new $90B share buyback program.  In the past nine years, AAPL has reduced its shares outstanding from about 6.6 billion to 4.2 billion.  Even so, the company still has about $90 billion in cash net of debt and free cash flow nearing $100 billion a year and remains committed to moving to net cash and debt of zero.

As we noted last quarter, we find AAPL shares fairly valued.  The stock has moved sideways so far in 2021 and lagged the market despite announcing two outstanding earnings reports.  Earnings estimates are rising again, which along with the lack of movement in the stock has compressed the P-E ratio.  The shares now trade at 23X 2022 earnings down from 29 times at our last update three months ago.  Given current market multiples, we think AAPL shares should trade at least at 25X 2022 earnings estimates.  This would target a stock in the low $140s, providing only modest upside. 

This math plus some cautious comments about revenue in the current quarter due to component shortages and timing of the iPhone12 cycle is causing the shares to trade flat despite the latest big earnings beat.  We still believe a trading range of $120-150 is likely but are very happy to continue to hold AAPL shares given the company’s overall quality and long-term growth opportunities.

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. 

Sony Investing for Growth

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When Sony reported 3Q20 results three months ago, the company sharply raised guidance for the fiscal year that ended in March.  4Q20 results met or slightly exceeded the new higher guidance.  In conjunction with the latest report, Sony established a new three-year financial and strategic plan including guidance for the current quarter and fiscal year.  The new plan is heavy on investment in operating expense, capital spending, and possible M&A.  These investments lead to modest near-term pressure on estimates and perhaps a slower growth rate in EBITDA over the next three years.  However, the plans should lead to more sustainable long-term growth and higher growth looking beyond the three-year time horizon.  Given that Northlake’s investment thesis for Sony is built on a materially discounted valuation, we like the plan to invest in growth as it supports an expansion in the stock’s valuation multiple toward its peers in music, video games, entertainment, and semiconductors.  The modest pullback in the shares in response to earnings is of little concern to us and we reiterate our target of $145, nearly 40% above current trading levels.

As a blue-chip Japanese company, it is no surprise that Sony thinks long-term and usually guides conservatively.  Even so, there has been a big change at the company in the past ten years that crystalized during the just completed three-year plan.  In the earnings presentation, Sony noted, “In previous Mid-Range Plans, we have prioritized improvement and enhancement of the profitability of each business, but in the Fourth Mid-Range Plan, we aim to grow both sales and profit.”  The company is indicating that the restructuring of its asset base, including asset sales, cost savings, and productivity enhancements is complete and the time to invest for growth is at hand.

This does not mean that Sony will forego continued M&A or stop trying to improve margins.  Rather, the current business segments of Music, Video Games, Entertainment, Imaging Sensors, Electronics, and Financial Services have been restructured with growth opportunities identified.  Music and Video Games should receive the most investment through both acquisitions and capital spending to build the businesses.  Entertainment is sitting out the streaming wars beyond its dominant position in anime, and instead will seek to create content and exploit it in the best distribution channel whether that be theaters or selling it to the highest and best entertainment company that is looking to pivot from linear to streaming.  Imaging Sensors offers both further restructuring as it recovers from the loss of Huawei as a customers and growth given increasing use of cameras in premium smartphones and new areas such as automated vehicles.  Electronics remains a restructuring story but also has opportunities for growth as the mix of TVs and video production equipment improves.  Financial Services serves as a supplier of excess capital and offers modest growth. 

The financial forecasts in the new three-year plan will probably be conservative if recent history is a guide.  Northlake expects higher results to be achieved but it may not be evident until the transition from the pandemic economy to whatever the new normal economy looks like is complete.  We believe that the shift in behaviors that has benefitted the company’s music and video games business will contain a significant element of permanence.  Not only is the increased digitization of life beneficial to consumers but management has smartly focused its business mix to take advantage of the post-pandemic economy.

An indication of the payoff from both past actions and the new plan is the announcement of a new 200 Trillion yen buyback program.  The company did not buy back any stock in the past year.  This buyback is just a taste of what is to come and we have seen the results of growth company buybacks at Apple and more recently Alphabet.

Recently, Sony shares have been caught up in the rotation trade between growth and value.  Many growth stocks have moved sideways for months after huge runs in 2019 and 2020.  We are not sure when the shares will make their next move higher but we remain confident and patient.  The company’s financial strength, improved asset mix and performance, and general conservatism provide protection while we wait for multiple to expand from the current 11X EBITDA to more closely match its peers that trade at 15-20X EBITDA.

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. 

Easy as ABC at Alphabet

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Alphabet (GOOG/GOOGL) reported another outstanding quarter with growth in revenues, operating income, and EPS easily beating elevated Wall Street estimates.  This is the third straight quarter where GOOG has beaten Wall Street estimates.  Importantly, overall revenue growth accelerated to 32% on a constant-currency basis from the impressive 23% growth rate in 4Q20.  The string of better-than-expected reports suggests that the surge in digital commerce during the pandemic has at least an element of permanence rather than just a pull forward of previously expected demand.  In addition, March was just the beginning of a rebound in travel and hospitality advertising spending as the pandemic begins to wane.  Earnings estimates for 2021 thru 2023 are rising 10-15%.  Higher estimates plus greater confidence in the sustainability of growth boosts our target for GOOG/GOOGL shares to $2,900 as we look ahead to yearend and expected 2022 results.

During 1Q21, GOOG saw accelerating growth in the core Search business and Google Play on Android (the equivalent of Apple’s App Store).  Search only benefitted for one easy month of comparisons to the start of the pandemic in March 2020.  Strength at Play even as consumers in many parts of the world began to resume normal activity is a good sign that the shift to a digital-centric lifestyle is permanent.  Alphabet’s fastest growing businesses are YouTube and Cloud.  Both reported growth in the upper 40% range consistent with 4Q20.  YouTube is especially impressive and appears to have moved to higher growth profile as advertisers seek to reach its massive audience of the prized 18-49 year-old demographic.  Management seems very confident that YouTube can sustain growth by gaining market share thanks to investments in AI and machine learning that are raising the ROI for advertisers.

1Q21 was not just a big quarter for the top line.  Margins expanded sharply led by the advertising businesses.  Google Cloud also cut its losses almost in half, benefiting partially from a new lower rate of depreciation for servers.  The company has a mixed record on profit margins but recently there is steady improvement.  On the conference call following the earnings report, management expressed confidence that operating expenses would remain controlled in 2021 even as revenue accelerated against easy comparisons and certain expense lines that benefitted from the pandemic begin to return to normal.

Capital allocation has been another area where Alphabet has often been criticized.  However, capital spending has recently been steadier and the company has begun large share buybacks.  The company has well over $100 billion in net cash on the balance sheet and will produce free cash flow north of $70 billion this year.  Along with earnings, a new $50 billion buyback program was announced.  Shares outstanding declined year-over-year again this quarter. A hallmark of Apple’s historic stock market run has been steady and large return of capital to shareholders.  Alphabet seems to be moving in this direction even as it continues to invest heavily in growth.

Prior to the quarterly report, our valuation analysis suggested that GOOG/GOOGL shares were nearing full value on 2021 estimates and had limited upside on 2022 estimates.  We were comfortable with the shares still due to what we believe are conservative assumptions in our valuation framework.  We also thought there was upside to results over the next few years.  We continue to use what we believe to be conservative assumptions in calculating our target price and the magnitude of the estimate increases easily exceed what we thought was likely. 

Our new $2,900 target is based on 2022 estimates and looks out 9 to 12 months.  We continue to assume conservative valuations on Waymo and Verily, the largest of the company’s Other Bets.  We also note that Google Cloud, now nearing a $20 billion revenue run rate, is still producing losses and thus penalizes our EBITDA based valuation approach.  We compensate to a limited extent by upping our overall EBITDA multiple assumption, but the Cloud business could easily provide another $100 billion, or $150 per share, in hidden value. 

GOOG/GOOGL shares have bucked the trend for large cap growth stocks to lag the market in 2021.  The already large advance plus another 5% pop on the latest earnings report could lead to some consolidation in the share price.  This is about the only cautionary statement we can make beyond continued challenges from regulatory authorities and the usual concerns about sustaining growth in revenues and profits.

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. 

Confidence Building Quarter at IBM But Key Catalysts Still to Come in 2021

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IBM reported a positive surprise in revenue and earnings per share for its 1Q21, an unusual occurrence over the last several years.  Revenue of $17.7 billion was about $300 million ahead of consensus and guidance, the first beat on this metric since 2018.  Gross margins, another trouble spot of late, also came in ahead of expectations. Management reiterated guidance for free cash flow and positive revenue growth for the full year.  At the segment level, these was positive news with improved results across several divisions including continued mid-teens growth at Red Hat, a return to growth for consulting, a gain of over 30% for cloud revenue, and improved but still declining results for transactional software. 

Overall, IBM’s 1Q21 results are a nice confidence boost for Northlake’s investment thesis but the key time frame will be the second half of 2021 when growth should pick up and be more consistent and the company completes its restructuring and the spinoff of a significant portion of its declining legacy revenue base.

We were also encouraged by the company’s conference call following the results.  Given the company’s history over the past decade, the analyst community has a high degree of skepticism.  This often manifests itself in questions that seek to undercut the narrative that IBM is offering with the results.  During this quarter’s call, there were several “gotcha” questions that sought to undercut the good news in the reported results.  Management handled the questions well which has not always been the case in recent quarters.  Encouragingly, the shares traded up after the report but prior to the call, held the gain during the call, and rose further in today’s trading despite a weak market.  The stock price action supports our view that the quarter was a confidence builder.

IBM shares rose from $100 to $130 into the 4Q20 results reported late January only to sink to below $120 when those disappointing results were reported.  The shares had rallied back to $130-$135 into this quarter’s results partially due to the rotation toward value stocks and reopening plays.  At just 12 times 2021 estimated earnings even after the recent run and with exposure to a bounce back in enterprise IT spending as workers return to workplaces, IBM has exposure to both investment themes.

Northlake sees further upside with $160 easily achievable if the company continues to progress on its turnaround plan and returns to the targeted mid-single digit growth target.  Investors are gaining confidence in the company under its still new CEO and results have the potential to build upon the good first quarter.  During the fourth quarter, the company should complete the spin-off of its weakest business units providing another catalyst.  In the meantime, investors are paid to wait by the healthy 4.7% dividend yield.  Management reiterated its support for the dividend and outlined the ease with which it can pay it out of free cash flow.

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.

Going All In on Value

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We are moving from neutral on growth vs. value to all-in on value effective today.  We are sticking with mid cap.  As a result, for clients using Northlake’s thematic models, we have sold all client positions in the Russell 1000 Growth (IWF) and reinvested the proceeds into the Russell 1000 Value (IWD).  There will be no change to client positions in the S&P 400 Mid Cap (MDY) that were purchased at the start of March when we closed our position in small cap to move to mid cap.

Value has performed much better of late.  The improvement began last September when the megacap tech stocks commonly referred to as FANG began a sideways correction that has continued through 2021 thus far.  Speculative tech stocks in areas including software, green energy, electric vehicles, and special purpose acquisition companies (SPACs) continued rising until mid-February but have since corrected 20% to 50%.  Northlake rarely invest in speculative tech stocks.

Value began performing better when megacap tech gave up market leadership, and value performance accelerated in November when the first vaccines were approved.  Value stocks include many cyclical areas that were impacted by the short but deep COVID recession.  The value thesis thus got a boost from the natural cyclical benefit of exiting a recession and a play on the US and global economies reopening.

The outperformance of value stocks over the last six months is the first sustained period where value assumed market leadership in more than five years.  Looking back further, growth has been the winner on a relative basis since 2011.  The shift toward growth is directly related to the Global Financial Crisis or Great Recession that took place from 2007 thru 2009.  By late 2011, the economy had emerged from recession and the stock market had recovered the massive losses from the peak in the fall of 2007 to the low in the spring of 2009.  From then, the economy enjoyed its longest period of uninterrupted growth in many decades until the COVID recession hit.  However, the rate of growth was consistently well below historic levels with notable developments in income inequality and weak job and wage growth. 

The sluggish and unequal economic growth favored growth stocks that do not rely as much on economic growth to drive profits.  The shift in favor of growth accelerated at the onset of the pandemic as an already strong trend toward a digital economy driven by the internet was given a giant boost from stay-at-home policies.  This led to massive outperformance for growth stocks beginning in March 2020.  The combination of almost a decade of growth leadership followed by the pandemic created extreme historical valuation disparities between growth and value stocks.

Northlake believes that a shift to value now will prove beneficial to client portfolios as the reopening of the US and global economies picks up steam with vaccinations becoming widespread.  There is a strong possibility that economic growth has a boom due to pent-up demand that lasts well into 2022 or even 2023.  There is also a possibility that after such a prolonged, extreme, and historic run in favor of growth stocks that the emergence from the pandemic leads to a lengthy period favoring value stocks that brings the extreme value discrepancy back to a more normal range.  At a minimum, Northlake expects the next few years to offer a more balanced return profile between growth and value stocks.

Northlake clients are well positioned should this occur as our Style model should pick up both near-term reopening-driven and long-term secular movements that could favor value.  At the same time, within our individual stock portfolios, we strongly favor large cap, blue-chip growth companies such as current holdings in Apple, Disney, Facebook, Google, and Home Depot.  Northlake’s strategy thus enables a balanced approach that can generate above-average returns but also uses diversification to dampen the volatility of portfolio returns.

MDY, IWD, AAPL, DIS, FB, GOOG/ GOOGL and HD 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.