Comcast Wins On Secular and Cyclical Aspects of the Pandemic

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Comcast (CMCSA) remains a unique investment, winning on all sides of the pandemic-impacted economy.  Broadband continues to have a tailwind as the value and necessity of a high-speed internet connection has been enhanced, likely permanently in our view.  NBC Universal is a cyclical business and just at the start of its recovery in theme parks, TV advertising, and movies.  Financial performance is strong with the balance sheet repaired after earlier acquisitions and focus shifting to share buybacks and continuing dividend growth.  With strong execution by a stable and experienced management team, CMCSA shares offer relatively low volatility and double-digit upside potential.  We maintain our target price of $64 based on slightly higher 2022 estimates.

The second quarter report offered a few fresh insights.  First, broadband demand remains good but the big upside in net adds is coming from lower churn this year.  We think this shows how the pandemic has raised the importance of a broadband connection.  It is possible that lower moves and government programs are providing a temporary boost.  Second, Peacock will be rolled out in Europe in the markets where Sky is active (UK, Germany, Italy).  Peacock sign-ups and usage are getting a boost in the U.S. from the Olympics.  Management has not committed for a massive investment cycle at Peacock.  This could be a risk given how much competitors like Netflix, Warner Brothers Discovery, Amazon and others are spending.  Comcast sees Peacock as complementary rather than a full substitute to its linear networks.  This means more focus on advertising and less on paid subscribers.  Third, Xfinity Mobile has achieved profitability sooner than expected.  The swing could be $500 million or more in the next few years, meaningful even at Comcast’s massive scale ($34 billion in EBITDA in 2021). Mobile may also be helping broadband thru double play bundles and lower churn.  Finally, theme parks are recovering ahead of schedule and are at 2019 profit levels despite attendance still barely over 70% of pre-pandemic levels.  The park in Beijing will open soon and at first that will pressure profits.  It adds a nice growth opportunity beginning in 2022.

Comcast’s balance sheet carries a lot less debt relative to cash flow than other cable and entertainment companies.  The company is now buying back stock but there will be tens of billions of excess capacity if the company maintains current leverage as EBITDA grows over the next several years.  The positive is a big boost in the buyback could be coming.  The negative is investors will still worry that Comcast is looking for a big acquisition to bolster Peacock and protect NBC and its cable networks.

We also are continuing to monitor increased competition in broadband from AT&T, T Mobile, and Verizon as they build out fiber and 5G fixed wireless.  The current administration also is likely to keep the regulatory pressure on.  Comcast shares have done well but always seem to have a series of risks that investors can’t let go.  At one time, we were worried these risks would derail the shares in 2021.  The timing has now shifted to 2022.  For the next few quarters, this leaves a window for continued gains in CMCSA shares, especially if the company provides a big boost to its buyback in 4Q21 when the next capital allocation update is due.

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 Secure Despite Slower Second Half Ahead

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Facebook (FB) shares are trading down about 4% following the company’s 2Q21 earnings report.  The report was good across the board.  Financial measures including EPS, revenue, operating income, and profit margins all exceeded Wall Street estimates.  Engagement metrics matched estimates even as reopening economies likely distracted user attention.  Management guidance for the balance of 2021 included cautious comments about a slowing rate of growth due to tougher comparisons against the growth spurt in the stay-at-home economy of 2H20.  Management also continued to express concern about the impact of Apple’s privacy initiatives.

Investors have been expecting a slowdown in growth in 2H21.  In fact, interpreting management’s commentary, most analysts actually raised revenue targets for 3Q21 and 4Q21.  Operating income and EPS rose as well although the timing of expense growth in 2021 (lower in 1H, higher in 2H but no change to overall dollars) means that there will be less operating leverage over the next few quarters.

None of this comes as a surprise and in Northlake’s opinion is not the cause for the decline in the shares today.  Rather, it is the fact that expectations soared for FB after huge beats by Google, Snap, and Twitter.  FB beat estimates but by a lesser degree. In reaction to earnings reports, Wall Street is often very short-term.  For long-term investors like Northlake that is just something we must live with.  Our focus is on changes to the long-term investment thesis and whether a stock has gotten too far ahead of our price targets to offer above-average long-term return. 

We do not believe this is the case at FB, but similar to our views on Apple and Alphabet, the upside to our targets has moderated.  We expect FB to continue to report positive surprises against cautious management guidance comments.  This should lead to estimates rising for 2022 and 2023 that in turn raises our target.  FB shares may pause to allow earnings to catch up to the stock price.  Investor’s may also need to see that the post-pandemic environment allows for sustained growth but now off a much higher 2021 base.

When we discussed FB’s 1Q21 results three months ago, we established a price target of $375.  The shares closed at $373 yesterday before the 2Q21 report.  After today’s pullback, the shares trade at about 20 times 2022 estimated EPS.  This is a reasonable price to pay for what Northlake believes can be sustainable 15-20% long-term growth.  We see upside to $400 over the balance of 2021 with much higher targets as investor confidence about 2022 and beyond improves and matches Northlake’s view.

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.

Another Blowout, Another Cautious Guide For Apple

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Once again Apple (AAPL) reported an outstanding quarter, easily beating consensus estimates that were modestly above the guidance provided three months ago.  When we last wrote about Apple, we noted how consistent the company’s financial performance was and how we could almost just repost the prior quarter’s blog.  Well, how about this:

“In 2Q21 3Q21, 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 which Apple can sell new products and services.  Services are now 19% 21% of revenue, and Wearables have grown to 9% 11% 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 3Q21 saw the highest gross margin in nine years and the highest operating margin in five years.”

Apple even cautioned again on revenue growth noting that it expected “very strong double-digit growth” but less than the 36% rate in 2Q21 due foreign exchange, a return to 20% normal growth in services, and greater supply chain constraints for iPhone.  If you are wondering why Apple shares are down today after another massive across the board earnings beat, it is due to the fact that supply chain issues (e.g. component shortages) might now be impacting Apple’s most important product line.

Northlake has little concern about a possible modest shortfall in iPhone sales in the September quarter.  As we noted last quarter, we expect the current iPhone cycle to extend for several years as current iPhone users upgrade to 5G phones.  We also expect the company to continue gain switchers from Android.  The installed base of phones, iPads, and Macs running common iOS-based software will continue to grow, in turn driving more sales of high-margin services and wearables.

Apple shares have lagged the market this year but did catch up a little since the 2Q21 earnings report in April.  Company fundamentals remain outstanding, arguably as good as they have even been.  The stock’s valuation has mostly reflected the good news in 2021 with the P-E being elevated in the upper-20s to begin the year.  With back-to-back blow out quarters, earnings estimates have gone up materially and the shares now trade at 24 times 2022 consensus estimates.  We still do not see that as cheap, but upside to $155-160 now seems achievable.  We may trim massively overweight positions in Apple in client accounts (while keeping a close eye on capital gains taxes) but we are comfortable continuing to hold the shares.

The most important thing we are keeping our eye on is the growth rate in 2022 and 2023.  While we see the extended 5G cycle and flywheel off the installed base as driving earnings growth, the rate of gains should slow considerably.  Comparisons get much tougher and Apple has probably had some one-time benefits from the pandemic-driven acceleration in the digital economy.  As long as we do not see a secular challenge to the growth thesis, we will sit tight as owners of Apple for Northlake clients.

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. 

ABC to XYZ as Alphabet Continues Shine

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Alphabet (GOOG/GOOGL) reported a second consecutive quarter of blowout earnings, smashing consensus estimates on all line items.  Most impressive to us was 38% operating margin, about 700 basis points ahead of expectations.  It was only a year or two ago that investors were very concerned about GOOG/L profitability as the company invested aggressively across each of its major business lines and its other bets. 

Management has cautioned for a few quarters that profit margins are getting a boost from less marketing spend during the pandemic – digital traffic is so high that there is little need to spend money to attract pageviews.  We expect margins to settle back somewhat beginning in 2H21 as comparisons toughen.  However, we believe that GOOG/L has moved the margin bar permanently higher due to a combination of factors. The impact of CFO Ruth Porat who was hired six years continues to be felt.  She has brought much greater discipline to operating expense control.  GOOG/L also is benefitting from its large and ongoing investments in AI and machine learning that are making it easier for Search and YouTube advertisers to execute advertising plans.  This provides operating leverage to GOOG/L as it increased advertising budgets at lower cost for the company to deliver.

The story at GOOG/L is far from just profit margins.  Revenue continues to grow very rapidly against 2019 levels (comps vs 2020 are distorted by the initial economic shutdown) at a pace ahead of pre-pandemic growth.  The pandemic clearly has boosted the digital economy.  There is a question of how much of the incremental growth is pull forward vs. a new higher base.  Northlake’s opinion is that the digital economy is taking share at a more rapid pace.  Revenue growth in Search, YouTube and Google Cloud will inevitably slow, but we believe it will settle at rate at least as high as the pre-pandemic level of 15-20% off a materially higher 2021 base than was expected two years ago.

Northlake is very comfortable continuing to hold GOOG/L shares.  However, after a gain of 57% so far in 2021, the upside to our target is only about 10%.  The exceptionally strong 2Q21 results combined with the signal they send about sustainable revenue growth and profit margins leads us to increase the estimates we use for the purpose valuing GOOG/L shares.  Notably, our estimates continue to include multibillion-dollar losses for Google Cloud, Waymo, and Verily.  Our target increases from $2,900 to $3,000 and includes a conservative valuation for the money losing businesses.  The shares currently trade a reasonable 23X 2022 estimates and would be at 25X at our target, a reasonable valuation with the S&P 500 trading at 20X.

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. 

Adding AT&T to Northlake Portfolio

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We added AT&T (T) to Northlake’s portfolio of individual stocks.  Not all clients use individual stocks as part of their strategy, and a few that do may not have purchased T due to unique client constraints.  In most cases, the purchase was financed by cash reserves in client accounts. 

T is a low-risk, moderate-reward way to earn a solid return over the next 12-18 months which makes it especially attractive against cash reserves that most likely will continue to earn well under 1%.  The current yield from AT&T’s dividend is over 7%.  We expect this dividend to be paid three more times at 52 cents per quarter before the company closes the merger of its Warner Media segment into Discovery Communications.  The new dividend will be 29 cents per quarter.  Based on our analysis, the implied yield post the Warner Media merger is a still very healthy 5.5%.

What has Changed at AT&T?

For many years, Northlake has had a negative opinion toward T as the company made a series of acquisitions outside of its core wireless and broadband connectivity businesses.  The largest acquisitions were DirecTV and Time Warner.  The idea behind the acquisition strategy was to increase the attractiveness of wireless and broadband services by adding content that could be packaged into attractive bundles.  We disliked the acquisitions from their announcement given (1) T’s poor history of diversification, (2) the timing of the acquisitions against secular challenges to the video business, and (3) the massive debt that was issued to finance the purchases.

So, what has changed that shifted our opinion on T from sell to buy?  New management took over in April 2020 and immediately looked to sell assets and pay down debt.  DirecTV was first to go along with many smaller businesses including international and advertising.  These were good first steps, but we were still not enamored of the Time Warner acquisition (subsequently renamed Warner Media).  When T and Discovery surprised virtually everyone in May with the merger announcement, our view of T began to shift.  Time Warner had been acquired just a few years ago in a massive, company-defining acquisition.  The willingness of new T management to realize its error and act aggressively to shift course is a major feather in their cap.  We have been managing money since 1982 and can think of few strategy changes of this magnitude coming so quickly after they were initiated. 

Thoughts About the Merger

We also were intrigued by the structure of the merger of Warner Media into Discovery (Discovery’s current stock reflects the post-merger company).  We have long held a favorable view of Discovery and once owned it for several years across the Northlake client base.  The company has had a unique strategy of focusing on non-fiction programming including the Discovery Channel, TLC, Animal Planet, HGTV, and the Food Network.  Non-fiction programming has been insulated from the secular changes in TV caused by streaming.  Discovery is backed by John Malone, one of our favorite billionaire investors.  Malone has a fantastic record of creating value in cable, media, and entertainment businesses.  In the current deal, he is giving up his voting and control shares at no premium, a huge endorsement of the deal by one of the world’s best investors.

The merger should close by the middle of 2022 after a regulatory review.  At that time, T shareholders will receive 70% ownership of the newly created Warner Brothers Discovery.  Discovery’s excellent management team will be in complete control, led by long-time media executive David Zaslav.  The idea behind the merger is to create a streaming giant that can rival Netflix and Disney by combining Discovery’s non-fiction content with Warner’s  HBO, HBO Max, and Turner networks (TNT, TBS, CNN, Cartoon).  Warner also brings the world’s #2 movie studio and #1 TV studio as content creation engines.  Put together, the two companies can better soften the decline in linear television and more effectively compete in streaming television.

Success in streaming is critical for traditional media. It has become clear that global scale is required.  Warner Brothers Discovery has the global reach and broad content to be a winner.  The new company also offers significant free cash flow to pay down debt incurred in the acquisition and finance the heavy content spending required to compete against Netflix and Disney as well as Amazon, Apple, Facebook, and Google.

Initially, T and Discovery shares rose sharply on the merger announcement.  However, both stocks have drifted lower and sit 15-20% below their pre-merger levels.  Investors are concerned about initial elevated debt levels, the risks of a one-year delay due to regulatory approval in a rapidly shifting media landscape, the possibility that T shareholders will sell the Discovery shares they receive, and the cut in T’s dividend after the merger closes.  We believe all these factors are well understood and implied in the stock prices of T and Discovery.

Target Price and Sum of the Parts

T currently trades around $28.  We see upside to $36 over the next 12-18 months.  In addition, we expect T shareholders to receive $2.43 in dividends over the next six quarters.  The total return potential is 37% composed of new T shares, Warner Brothers Discovery shares, and dividends.

New T will be a pureplay on connectivity with a leading wireless business and smaller — but fast growing — broadband business.  T has shown improved performance in both these business segments over the past several quarters.  We believe execution has improved thanks to the focus management can now bring to the business post the divestitures and debt paydown.  Given its recent history of strategic errors, we believe new T will start off trading at a discount to its closest peer, Verizon.  Verizon trades at a dividend yield of about 4.5%.  We believe new T shares should start trading at 5.5% yield.  This equates to about $21 per share.  We expect several more quarters of improved execution from T will allow the stock to move closer to Verizon’s valuation.  At a 5% yield, T shares would trade at $23.  If T can ultimately achieve valuation parity with Verizon, a reasonable possibility in our opinion, T shares would trade to $25. 

Our target for Warner Brothers Discovery is $40 vs. a current Discovery price of just under $28.  We base our Warner Brothers Discovery (the current Discovery stock represents the soon to be merged company) target on the valuation of the company’s traditional media businesses and a per-subscriber value for its streaming business.  T shareholders will own 70% of Warner Brothers Discovery, which works out to about $11 per share at our target.  At Discovery’s current price, T shareholders have $7 in value.

Thus, we see a range for T from the current $28 to as much as $36 at our targets for both stocks.  The $2.43 in dividends to be paid over the next 6 quarters adds material incremental value and provides downside protection if the stock market or company fundamentals falter.  The risk-reward profile skews favorably and is the key reason T is now part of the Northlake’s individual stock portfolio.

T 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.

Another Confidence Building Quarter for IBM

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IBM reported another quarter of encouraging results against our investment thesis highlighted by a return to revenue growth at the best level in three years.  Growth came from the right places driven by Red Hat and consulting services related to cloud initiatives.  Revenue growth of 3% pales in comparison to the cloud leaders including Amazon, Microsoft, and Alphabet.  However, IBM trades at just 11 times 2021 estimated earnings versus the S&P 500 at nearly 20 times.  We have seen dramatic multiple expansion at other legacy tech stocks including Cisco Systems and Oracle as growth showed acceleration.  Northlake believes IBM has returned to growth, albeit modest, and catalysts are ahead to drive multiple expansion and produce above-average returns for shareholders.

While just the first quarter of renewed revenue growth, this is the second consecutive quarter where IBM slightly exceeded Wall Street estimates.  Guidance and management commentary support positive revenue growth in the next few quarters ahead of the planned spinoff of the company’s declining business units.  The new IBM should be able to sustain low to mid-single-digit revenue growth driven by cloud transformation at the many enterprises and governments that still rely on the company.  Management indicated that the transition from legacy hardware and software at long-time customers to cloud-based services is now a net positive for revenue and margins.  Key to the improved outlook is the success of the Red Hat acquisition as indicated by a quadrupling of customers using various IBM hybrid cloud solutions since the deal closed. 

The IBM story has been slower to develop than we expected but recently improved quarterly financial results and the upcoming spinoff should be the start of better shareholder returns.  While we wait, IBM pays a hefty dividend providing an annual return of nearly 5%.  Our target of $160 remains intact with a higher degree of confidence following the good 2Q21 results.  Including the dividend, IBM at $160 would provide a 20% total return at relatively low risk.

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.

Expecting Mid Cap and Value to Resume Leadership

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Despite a tough June and second quarter for our Mid Cap and Value recommendations, we are sticking with these themes.  Client positions in the S&P Mid Cap 400 (MDY) and Russell 1000 Value (IWD) that are linked to our Market Cap and Style models will be maintained.  For clients not invested in our models but using our favored themes, we plan to stick with investments in value sectors like Financials (XLF) and Industrials (XLI).  We also continue to favor investments in non-U.S. stocks in both developed (EFA/VEA) and emerging markets (EEM/VWO, XSOE).

Two factors have driven the latest rotation among market cap and style themes.  First, the prospect that the Federal Reserve has moved a step closer to beginning to remove monetary accommodation and raising interest rates has led to a rotation in favor of large cap growth stocks.  Second, investors are focused on inflation, and have recently accepted the Fed’s view that current trends are transitory.  This has led to a decline in market-based interest rates which is a powerful tailwind for large cap growth stocks. 

We see the latest rotation as temporary given continued strength in the economic recovery as COVID fears and restrictions recede.  Tighter monetary policy is a headwind for small cap, mid cap, and value stocks.  However, we still see monetary policy remaining highly accommodative well into 2022 and believe that there is another move higher in our favored themes which remain inexpensive against still rising earnings expectations.

Our Market Cap and Style models also support our recommendations.  In Style, the latest readings reveal movement toward growth, but the model reading remains firmly in value territory.  The movement reflects a shift in technical and trend factors given the recent good performance for growth stocks.  External factors continue to strongly favor value.  There were no changes to any factors in the Market Cap model.  The model remains solidly in mid cap.

While the second quarter performance of our models and themes lagged the market, on a year-to-date basis performance remains positive on an absolute and relative basis.

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