Buy Home Depot. Cheaper Than Buying A House.

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When Home Depot (HD) last reported earnings we noted that the company was performing extremely well, but investors were worried about the company’s ability to grow sales this year compared to the heavy spending on home upgrades during the peak of stay-at-home orders in 2020.  4Q20 also saw some pressure on margins from elevated expenses related to COVID.  Three months ago, these issues led the stock to react poorly to excellent earnings and provide an attractive buying opportunity in Northlake’s opinion.  The shares ultimately rebounded and reached new highs in early May, gaining almost 20% from the post-earnings low in February.

Earlier this week, HD reported 1Q21 results that easily exceeded expectations and answered some of the questions we addressed in our last blog post.  Sales soared around 30% and are now projected to rise in 2021 against the tough 2020 comparisons.  Margins bounced back thanks to the big sales gain providing leverage in operating expenses.  Gross margins did compress a little thanks mostly to soaring lumber prices and also to general stress on the supply chain.  Most importantly, unlike after the big earnings beat in the prior quarter, analyst estimates are moving up materially based on the 1Q21 results and management commentary about current and future trends. 

Management noted that sales strength in May matched March and April despite much tougher comparisons.  Investors now expect 2021 sales to grow in the mid-single-digit range vs. flat to slightly down expectations previously.  Northlake thinks new expectations may still prove conservative.  HD is well positioned with Pro customers that represent almost half of sales.  Many people are only now beginning to let contractors back in their homes, so strength in this area should sustain at least through 2021.  Northlake also believes that the pandemic has led to a secular shift in consumer preferences such that the balance between spending on experiences and things will shift modestly in favor of things over the next several years.  Homes are the most important “thing” for most people in the US.  Finally, it appears millennials are beginning to buy homes at a rate more consistent with prior generations.

Gross margins will continue to present a challenge as lumber and other commodity prices remain elevated and supply chains are still challenged especially in the ability to receive deliveries.  We noted in our last update that HD should begin to see leverage on operating expenses, especially as COVID-specific expenses begin to roll off.  1Q21 operating expenses far exceeded even our optimistic view and with higher sales ahead, this trend is sustainable.

As usual, management was still cautious about its financial outlook, falling back on the unprecedented impact of the COVID pandemic.  The company did not raise guidance although under questioning from analysts, management did seem to admit that the outlook was much improved.

The big run in HD shares from March through early May clearly had raised the expectation bar for 1Q21 and full year 2021 results.  The shares had pulled back ahead of the results due to investor positing and fell modestly after the report.  Northlake used this post-earnings pullback to add HD to the few accounts where it was not yet owned.

We are raising our target price from $308 to $375 based on a material upgrade to consensus earnings estimates that we still believe may prove low.  We had been assuming 22X estimated 2022 EPS of $14.  We now are using 25X 2022 estimated EPS of $15.  The think multiple expansion is warranted based on the company’s stronger growth profile and due to the fact that multiple for the market has risen over the past several months.

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 Traditional Businesses Provide Bridge to Renewed Streaming Growth

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Disney (DIS) shares are trading down about -3% on a big up day for the market after reporting 2Q21 results.  Despite reporting results ahead of expectations on financial metrics and seeing estimates for revenue, operating income, and EPS rise, the shares are falling due to a shortfall in growth for Disney+ subscribers and management guidance that subscriber growth will remain subdued through the second half of the company’s fiscal year.

About half of Northlake’s valuation target for DIS comes from the company’s DTC services which include Disney+, Hulu, and ESPN+.  Disney+ is by far the largest factor among the DTC services.  Thus, it is not surprising that a shortfall in subscriber additions is leading to selling of the shares.  Management noted that since its last subscriber update in early March, net adds have picked up.  Nonetheless, several issues are leading to the 2H21 slowdown.  First, the horrible COVID situation in India has led to the suspension of the largest annual cricket tournament.  Second, management has decided to delay the rollout of DTC services in Latin America by a few months in order to be able to use a huge lineup of sports rights to promote the service.  Finally, domestic subs have slowed due to a similar pull forward effect that impacted Netflix.  Management reaffirmed its 2024 Disney+ subscriber guidance and noted that churn is well below management expectations, indicating the service is being very well received.

We have a few other takeaways from the quarter and conference call.  On the downside, management was reluctant to affirm guidance beyond the Disney+ 2024 subcriber figure.  An update could be coming, especially after much time on the call was devoted to discussing new sports rights at ESPN and ESPN+.  Perhaps the company is investing in sports rights in order to drive ESPN+ subscribers above prior guidance and also support Hulu and LatAm where sports are integrated into the entertainment service unlike Disney+ in the US.  Also interesting was the disclosure that Hulu is much more profitable than previously thought.  This cuts both ways since it establishes a much higher valuation for Hulu but also suggests profitability for Disney+ and ESPN+ could be further off than we previously expected.  On the positive side, the domestic theme parks are finally open and demand has been fantastic against capacity restrictions that are being steadily relaxed.

We suspect DIS shares will continue to consolidate until the subscriber outlook at Disney+ in FY22 is positive.  Beyond net additions, ARPU trends need to improve as India comes back from COVID and price increases in the US and Europe take place.  Fortunately for DIS, the company’s traditional businesses are poised for a huge rebound over the next several quarters as the global economy fully reopens.  Theme parks, movies, and advertising-supported networks are already showing green shoots and should accelerate dramatically.  These businesses provide a bridge to the other side of the (hopefully) temporary slowdown in Disney+ subcriber growth.  Northlake believes this is the scenario that will play out and is sticking with a $225 target for DIS shares.

DIS is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.  DIS is a net long position in the Entermedia Funds. 

A Step Closer to Rewarding Patience at Activision

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When Activison Blizzard (ATVI) last reported, we noted that the stock looked fully valued but the company’s excellent track record, recent business strategy enhancements, and potential for positive surprises left us willing to wait out a period of lesser stock performance.  1Q21 was a big step in the right direction with ATVI easily beating Wall Street estimates and increasing 2021 guidance.  The stock is initially responding positively, something that has not always been the case when growth companies report earnings this quarter.  We still think ATVI shares need some time before the next leg higher, but 1Q21 results increase our confidence that material share gains from current levels will occur within the next twelve months.

Key to ATVI’s current and future success is the strategy to narrow its focus on its most successful game franchises. Call of Duty is proving the strategy with great success in mobile and synergy between mobile, console, and online game play.  ATVI will follow a similar strategy at its other key franchise including World of Warcraft (WoW), Diablo, and Overwatch.  WoW is already benefitting from increased focus and investment, growing solidly despite the lack of major new gameplay.  Diablo remains on track to launch on mobile, console, and online in the second half of 2021. Success at Diablo should fully validate ATVI’s strategic pivot and we are optimistic after reading positive commentary concerning alpha and beta versions of the games.  Overwatch remains a question as news flow has been sparse and the lead manager of the franchise recently left the company.  Overwatch becomes more important in 2022 and 2023.  Management remains publicly confident in the franchise despite investor concern.

ATVI also has a huge mobile gaming winner in Candy Crush.  The King acquisition was completed in 2016 and has proven to be smart.  Candy Crush has sustained its spot at the top of mobile game rankings, and mobile gaming has grown steadily around the world.  When King was purchased, there was great optimism about advertising within the game.  This revenue stream finally appears to be a reality, setting up Candy Crush and ATVI’s other mobile gaming activities for accelerating growth in a very high margin revenue stream.

While there are clear signs of fundamental momentum across ATVI, uncertainty about tough comparisons to 2020’s shelter-in-place boom is holding back the stock.  1Q21 results and management commentary give us confidence that the company will be able to grow over the balance of 2021.  In a show of confidence, management passed through a material portion of the 1Q21 earnings beat to full-year guidance.  ATVI has a history of beating in 1Q but not raising guidance.  Furthermore, ATVI announced an acceleration in hiring of game developers to reinforce its strategy of focusing on key franchises.  New employees come at a cost but the company still felt confident to raise full year guidance.

ATVI shares currently trade at a P-E multiple that is inline with S&P 500.  Historically, the shares trade at premium.  Increased guidance still implies a sharp slowdown in growth in 2H21, so investors are not yet willing to pay a premium for ATVI’s currently elevated financial performance.  The latest earnings report gives us confidence that later this year investor confidence will grow and ATVI will return to its premium valuation on 2022 earnings estimates.  At 25 times next year’s expected earnings, we see upside to $115 for a gain of 25%. We are happy to wait.

 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 Cash Flow Harvest Just Beginning

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Nexstar Media Group (NXST) reported strong 1Q21 earnings highlighted by a faster than expected improvement in core advertising, continued upside in profit margins, and a big beat on EBITDA.  Management reaffirmed its key guidance metric based on the average of 2021 and 2022 free cash flow.  The cyclical nature of political spending requires use of a two-year average when analyzing local TV broadcasters.  In 2020, NXST earned over $500 million in revenue from political ads and should be near the same in 2022.  In 2021, political ads will be 90% or more below these figures. 

NXST guides to an absolute dollar amount of average free cash flow.  The current guidance calls for $1.3 billion per year.  As we noted in our last company update, NXST has successfully completed its strategic transformation and is now in position to use its massive free cash flow to directly support shareholder value through dividends and share buybacks.  The company is executing quickly on the buyback announced just a few months ago.  On today’s conference call, management indicated that a total of $500 million in shares could be purchased this year.  Repurchases so far total over $100 million and are being made at current prices despite a gain of over 30% for the shares already in 2021.  At current prices, the $500 million buyback would retire about 7% of the current shares outstanding.  We expect a larger buyback in 2022 and 2023 after the boost in free cash flow from political spending occurs next year.  Debt leverage will remain under 4X, and unless buybacks remain elevated, debt will move much lower over the next few years.

NXST shares trade at a 20% free cash flow yield.  As a comparison, leading blue chip growth companies often trade at a yield of just 3-5%.  Investors do not value NXST free cash flow highly because of the threat to the company’s financial profile from streaming and fragmentation of TV viewership.  We remain vigilant on these factors but do not believe they are likely a factor before late in 2022 when NXST will be negotiating its carriage agreements with TV networks and cable, satellite, and streaming services.

We think this window will provide at least one more move materially higher in NXST shares.  We maintain our target price of $180, up 20% from current levels.  We believe this is a conservative target based on just 7.5X 2021/2022 EBITDA.  The key metrics to watch over the next few quarters will be the strength of the recovery in advertising and trends in cord cutting.  Advertising holds potential to surprise to the upside and we are wary but expect cord cutting to be stable. Today’s action in NXST shares, up slightly after trading several percent lower on a bad market day, is encouraging and supports 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. 

Sticking with Mid Cap and Value into the Recovery

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There are no changes to the recommendations from Northlake’s Market Cap and Style modes for May.  We are sticking with Mid Cap and Value for another month.  Current client positions following the models in the S&P 400 Mid Cap (MDY) and Russell 1000 Value (IWD) will be held for at least another month.  Clients also gain exposure to these themes from investment in ETFs focused on financials, industrials, and small cap value ETFs.  International ETFs are also a path to value exposure especially in developed markets like Europe where the COVID recovery is lagging the United States.

The key takeaway from our latest model update is that the value signal is the strongest it has been in 20 years and was also near this level in 2010.  The models have been tweaked multiple times over these time frames, so the comparison is not perfect but clearly something unusual is happening in the growth vs. value debate.

Recently, we have discussed “rotation” a lot.  To recap, the market has been moving regularly between growth and value, large cap and small cap, COVID winners and COVID losers, and cyclical and defensive.  The changes have been choppy the last few months after a six month stretch ending in mid-February where small caps, value, COVID losers, and cyclicals performed very well.

Northlake currently recommends mid cap and value.  Taken together these areas capture most of the stocks that were market leaders from late last August through mid-February.  We have been firmly of the opinion that these themes would reestablish and sustain leadership over the balance of 2021.  A simple way to look at rotation and why we like our current positioning is this chart:

Graphical user interface Description automatically generated with medium confidence

We are in the Recovery stage of the cycle now.  The current recovery is likely to be turbo-charged by a combination of massive pent-up demand, extreme fiscal stimulus, and sustained highly accommodative monetary policy. 

It is no coincidence that our Style model is flashing a similarly strong value reading as in 2010.  In 2021 as in 2010, the economy is emerging from an unusually steep economic crisis.  We have data on our models going back to 1979.  There is a clear trend that the strongest value signals have occurred when the economy is exiting recession and is in the recovery phase.

We think the outlook is strongly in favor of small (and mid) cap and value stocks.  These areas have struggled for ten years as the digital economy steadily gained coming out of the Great Recession and accelerated due to the unusual impact of COVID.  The recent six month stretch of improved stock market performance for small and mid cap and value provided a nice catch-up move after a historic stretch of underperformance.  Northlake believes there is plenty more to go even after adjusting for the changes in economic activity triggered by digital technologies.

MDY and IWD 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.