Lower Rates Lead to Mixed Impact on High-Dividend Stocks

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Surprisingly to Northlake, intermediate and long-term interest rates have fallen slightly over the last several months.  We had been anticipating higher rates as the economy emerged from COVID impacts, inflation held at well-above pre-pandemic levels, the timing of the Federal Reserve’s monetary policy tightening grew closer.  Instead, for reasons that most on Wall Street still do not understand, rates have fallen slightly.  Northlake still expects higher intermeidate to long-term interest rates over the coming quarters along with a partial re-steepening of the yield curve.

If we had to point to one reason for the recent dip in interest rates, it would be a quicker than anticipated fall in economic data and activity from peak post-COVID growth rates.  Given the virtual complete shutdown of the economy in 2Q20 and 3Q20, peak growth due to easy comps was always set to occur this summer.  Concerns about the impact of a pullback in stimulus and the possibility that spending had been pulled forward have been a steady source of debate.  The delta variant added another wrinkle as real-time data like OpenTable reservations and air travel appear to show a reaction.  The bond market seemed to anticipate weaker data which coupled with technical trading factors led to the surprising drop in interest rates.

Falling rates due to economic concerns did not hurt the overall stock market but investors rotated away from small and mid cap stocks, value stocks, and stocks of companies sensitive to the reopening of the economy.  Bond investors cheered, however.  Returns on major bond indices like the Barclays Aggregate have been positive for the past four months and bonds overall have about recouped the losses from 1Q21.  Year-to-date, bonds have produced no return.  Lower rates have helped Northlake’s preferred stock investments in Qurate Retail (QRTEP) and Liberty Broadband (LBDRP) since preferred stocks share very similar characteristics to bonds despite having “stocks” attached to their name.

The impact of interest rates on high-yielding stocks is normally quite straightforward.  Lower rates make the high dividends more valuable, while the opposite is true when rates rise.  Over the past few months, the relationships have not held.  Many high-dividend stocks are considered value stocks, including many that are also sensitive to the economic reopening.  Thus, stocks that Northlake favors with high dividends such as VICI Properties (VICI) or the iShares Select Dividend ETF (DVY) have slipped slightly off their highs since they have been lumped into the rotation trade that strongly favored growth stocks.  Verizon Communications (VZ) has also slipped from its spring highs.  Our best performing dividend stock has been Lamar Advertising (LAMR).  LAMR sits very near its all-time high as strength in advertising across all media has led to exceptional financial results and higher forward estimates.

We added AT&T (T) to client portfolios in late July.  AT&T is a total return play.  The dividend yield is presently 7% and we think the stock is undervalued based on operating fundamentals as management has aggressively shifted strategy to focus on the core communication services.  AT&T shares are sensitive to trends impacting high-dividend stocks.

There was big news at VICI a few weeks ago.  The company announced a takeover of peer casino gaming REIT MGM Properties.  We think this is a great transaction for VICI shareholders.  It is accretive to earnings which means the dividend should be going up faster than expected.  In addition, VICI shares are likely to be added to many REIT-focused funds due to the massive scale of the newly enlarged company.

AGG, LBRDP, QRTEP, VICI, LAMR, T, VZ, and DVY are 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.

Home Depot Keeps Building on Recent Strength

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Home Depot (HD) reported solid 2Q21 results with same store sales growing in-line with expectations and earnings ahead of consensus estimates. HD chose not to provide guidance given uncertainty related to the ongoing pandemic. Management had a positive tone on the outlook for 2H21 and the long-term housing environment. HD noted that August has started out at a similar pace to 2Q21, implying growth will continue this coming quarter. Northlake believes that the fundamental elements for success remain in place for HD: strong housing demand with limited supply, consumers shifting spending from experiences to things such as home improvement, significant exposure to professional contractors with large and growing project backlogs, and reliable, consistent execution from management.  

Stock Reaction:

HD shares fell 4.3% following 2Q21 earnings, likely due to elevated expectations since 1Q21 results alleviated investor fears about tough comparisons to strong 2020 growth. Last March, investors feared HD would not be able to grow in 2021 and 2022 due to tough comparisons driven by the heavy investments people made in their homes during the pandemic. Through the first half of the year, HD has proven that it can continue to grow, perhaps signaling strong repeat spending by newer customers. Overall, after 2Q21, analysts and investors should have more confidence in HD’s ability to grow earnings this year and next.

Earnings Analysis:

HD grew same store sales 4.5% even while lapping the incredible growth from 2020. This compares favorably to fears that sales would decline this year that were held as recently as last quarter. The rapidly falling cost of lumber since May along with inflated transportation costs negatively impacted gross margins more than expected, but HD was still able to beat earnings expectations thanks to leverage in operating expenses. The negative surprise on gross margins is expected to be contained to 2Q21 since the price of lumber should stabilize instead of continuing to rapidly fall. Transportation costs will remain elevated given ongoing supply chain struggles, as heavy pent-up demand has outpaced the ability to ramp up supply in most industries. HD is trying to offset high transportation costs with creative solutions such as exclusive use of their own ocean vessels for shipping containers. As long as sales continue to grow, volatile gross margins are a manageable headwind that should not prevent HD from achieving earnings growth for the next few years. HD will also benefit as certain costs related to the pandemic are no longer necessary, which could lead to higher operating margins and earnings.

Target Price:

Northlake is sticking with a $375 target based on 25X 2021 EPS or 23X 2022 EPS. HD has a long runway to keep growing from an enlarged base thanks to the pandemic-driven boost in 2020. The underpinnings for success are in place, but we are watching for signs of weakness in the housing market, changing consumer spending habits, or a slowdown in HD’s ability to keep efficiently expanding their store footprint that could undermine the long-term thesis.

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 Letting the Genie Out of the Bottle

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Disney (DIS) reported FY 3Q21 results that were better than expected for both financial metrics and subscriber additions. Long-term guidance was not updated since DIS is in the process of creating the operating plan for FY22. Given ongoing strength in DTC services – Disney+, ESPN+, and the recently profitable Hulu – and the ramping recovery at theme parks, live sports, and movie theaters, Northlake expects guidance and estimates to increase when the FY22 operating plan is announced.

Stock Reaction: DIS investors were pleased with the positive results; shares were up almost 5% during the day following earnings, and closed up 1%. The stock may be close to breaking out of the downtrend since March with the outlook improving for both traditional and streaming businesses. DIS may soon increase long-term guidance which could push the stock to new all-time highs.

Earnings Analysis: DIS parks returned to profitability sooner than expected thanks to exceptionally strong spending by visitors, even as slowly rising capacity limits are constraining attendance. The company announced an upcoming service called Disney Genie that will allow visitors to customize their experience using their smartphones and discover new attractions like the Star Wars Galactic Starcruiser hotel or Avengers Campus. Northlake expects FY22 results for parks will likely be better than FY19. On the DTC side, Hulu surprised positively by growing profitability more than expected thanks to very strong ad sales, boosting expectations for the outlook of the transition from linear cable and broadcast TV to streaming. Subscriber additions were strong across all digital services, and linear subscribers only fell 3% from 3Q20 which is an improvement from the -4% pace reported last quarter. DTC pricing grew while churn improved, implying that customers are happy with the value of the service and DIS has a long runway to increase prices. Last quarter, investors feared that 2H21 subscriber additions would be slower than 1H21, but results signal that DIS guidance was likely very conservative. The growth is impressive amid a period of intense competition for streaming services when peers have been underperforming estimates. DIS will expand DTC services to Latin America, Asia Pacific, and Eastern Europe regions over the next year. The return of live sports is helping drive subscription and advertising dollars across traditional and digital services, offset by rising sports rights expenses and marketing costs. For films, DIS plans to retain flexibility to use shortened exclusive theatrical windows, direct-to-DTC releases, and a hybrid approach as long as uncertainty from the pandemic remains. Green shoots at the reopening segments remain encouraging.

Target Price: DIS is on track with Northlake expectations and we are sticking with a $225 price target for upside of 25%. Both segments reported surprisingly positive results after a recent stretch of concern about subscriber growth and lingering pandemic impacts. If DIS announces updated long-term guidance for DTC, and parks and experiences continue to ramp quickly, Northlake could see upside beyond our target.

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. 

Sony Performing Well and Will Be Worth the Wait

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Sony (SONY) reported better than expected 1Q22 earnings and raised full-year guidance.  We had thought that guidance was conservative, both short-term and long-term, so the news was not surprising.  It is welcome news in support of the long-term investment thesis that SONY’s individual business are deeply undervalued compared to peers with a management team that has executed well strategically, operationally, and financially to remake the company over the past five years.  Northlake continues to see SONY shares as deeply undervalued and is willing to exercise patience given the high-quality assets on the balance sheet and conservative corporate culture.

Stock Reaction:  SONY shares had a minimal reaction to the good news.  The stock has moved mostly sideways in a wide band since we purchased it for client accounts earlier this year.  SONY has significant exposure to video games; stocks in that sector had a tough week when SONY reported.  We believe that limited the upside in SONY shares despite the “beat and raise” quarter.  Beat and raise usually gets a positive reaction from traders.

Earnings Analysis:  SONY reported its highest ever operating income in 1Q22 led by Music, Electronic Products, and Image Sensors.  Games were down against the tough COVID-boosted year-ago quarter but operating income at this segment was the second-highest ever, trailing only the June quarter of 2020.  Sony Music is the second-largest music label in the world and continues to leverage growth in music streaming and the expansion of music licensing to services like Facebook and Peloton.  Electronic Products is mostly a margin story as management has narrowed the product focus to premium TVs and cameras and worked hard to reduce costs.  Image Sensors are used in high-end mobile phones where demand for 5G is driving a replacement cycle offset by loss of sales of Huawei, China’s largest cellphone manufacturer, due to government boycotts.  SONY’s film business is still recovering from COVID-driven theater shutdowns.  The guidance increase after just one quarter of a new fiscal year is unusual for SONY.  Most of the upside is coming from Music and Electronic Products.  We next see upside at Games where comparisons are easing and thus far engagement trends are holding up better than feared against 2020’s stay-at-home environment.

Target Price:  We continue to have a $145 target price on SONY.  The company is focused on music, video games, image sensors (semiconductors), and film and TV production.  Many peers focused solely on any of these businesses trade at multiples well above where SONY trades.  We understand the need to apply a conglomerate discount and a further discount that accounts for the conservative culture of Japanese corporations.  However, we believe the current discounted valuation is too steep and fails to reward the current management team for its superior execution and its successful efforts to change the culture of the company toward a more Western style.  For the shares to work, there must be improved sentiment toward video games and film and TV and improved comparisons in image sensors.  We see each of these things developing over the coming six to twelve months and are willing to be patient given SONY’s severely discounted valuation, financial strength, and superior management team.

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. 

Nexstar Continues to Shine Brightly

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Nexstar Media Group (NXST) reported another in a string of excellent quarterly earnings reports.  Revenue and EBITDA exceeded management guidance and the company raised the all-important annual free cash flow guidance.  NXST has always benefitted from having one of the best management teams across all the industries we follow in terms of operating execution and corporate strategy.  Currently, the company is getting a boost from a surging advertising market as companies try to capture sales and market share during the domestic economy’s reopening phase.  We still see upside for NXST shares and can easily justify much higher target prices than we currently calculate.  We plan to continue to hold NXST shares for Northlake clients investing in our individual stock portfolio strategy.

Earnings Reaction:  NXST shares responded positively to the earnings report and guidance increase, moving up about 5%.  This is encouraging after several months of sideways action even as evidence mounted that business fundamentals were very strong.  Normally, “beat and raise” quarters are rewarded but recently that has not been the case for many companies that are heavily exposed to the reopening of the economy.

Earnings Analysis:  NXST’s strong quarter was built upon surging advertising spending and the national footprint of local TV stations the company has built.  Core advertising is almost back to 2019 levels even as auto advertising, the largest category pre-pandemic, lags amid shortages of new cars for sale.  Services have stepped up with sports betting becoming a new top-five category that should be here to stay as more states approve and competition among service providers remains intense.  Local advertising has lagged national advertising, but NXST’s national reach allows it to participate to a limited extent in national.

The other big piece of NXST’s profit is the net retransmission fees it receives.  NXST is paid by cable, satellite, and OTT companies for the right to provide its TV station feeds.  In turn, NXST pays ABC, NBC, CBS, and FOX for the rights to national network feeds. Net retrans has been a steady growth engine for the local TV industry.  NXST has outperformed its peers thanks to its national scale giving it leverage in negotiations with networks.  Along with the entire industry, NXST has also gained from increased viewership of local TV news during the pandemic.  The big risk to this profit line is from cord cutting.  Cord cutting has slowed of late but remains near 5%.  NXST is able to get annual price increases in excess of the rate of cord cutting as local TV remains underpriced relative to its level of viewership.

Comparisons stiffen over 2H21 against massive political ad spending during last year’s election cycle.  This does not concern us as we look ahead to what should be an equally strong election cycle in 2022 with both the House and Senate up for grabs.

Target Price:  Using a conservative multiple on average 2021/2022 EBITDA, we maintain our target of $180, up 16% from current trading levels.  We can easily justify a target of $200.  Management is buying back shares steadily now that the balance sheet has been repaired after the acquisition of Tribune.  We see balance sheet capacity for much higher share buybacks over the next few years as a key catalyst toward achieving higher target prices.

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. 

ATVI Managing Turmoil Amid Strong Fundamentals

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Activision Blizzard (ATVI) reported a much-needed beat-and-raise quarter.  Strength was broad-based with Call of Duty, Candy Crush, and World of Warcraft all exceeding expectations.  Management raised 2021 guidance to reflect the results, with a portion of the upside held back due to the shift of Diablo Immortal from 2021 to 2022.  Given current strength across the portfolio, delaying the game to 2022 is a positive as it adds more content to sustain growth beyond 2021 and grants the game’s developers more time to add all the features expected.

Stock Reaction: ATVI shares are rallying 2-3% in response to the earnings.  The stock has been very weak lately due to a lawsuit filed by the State of California concerning the company’s labor practices.  In addition, video game stocks have pulled back as engagement has softened with people spending more time out and about in a largely reopened economy.  The rise in the shares could prove to be a “dead cat bounce” but we think valuation, an improvement in management response to the issues raised by the lawsuit, and signals that the game development pipeline is intact should allow the shares to continue to recover.

Earnings Analysis:  The main discussion on the conference call related to the California lawsuit accusing ATVI of discrimination against certain classes of employees, especially women.  The suit was filed a few weeks ago and management’s initial response created a firestorm when they denied the allegations.  Employees revolted and staged a walk out.  Over the past week, management has adopted a much-improved tone and seems to be sincere in the changes they are undertaking.  Importantly, there have been senior management changes at Blizzard, where the issues are concentrated.  Thus far, management indicated they have seen no decline in game play at Blizzard titles and development of future Blizzard games remains on track.  The biggest risk related to the lawsuit and its aftermath is that Blizzard game titles to be released in 2021 and 2022 are delayed.

Positively, financial results were strong and management expressed confidence with the increase to 2021 guidance.  We were most impressed by the strength at Candy Crush.  ATVI made a great acquisition of King several years ago to establish its leadership in mobile gaming.  Mobile games have since become the driver of the video game industry.  Management also made a smart move recently to accelerate investment at King to ensure that fresh content is available monthly.  Mobile games are all about recurring spending, so an increased content cadence is smart.

Similarly, Call of Duty is also performing well thanks to a change in management strategy and increased investment.  All formats of Call of Duty including mobile, online, and packaged are benefiting from changes made by management.  The different game formats complement one another and drive monetization through synergy.

The execution by management at King and Call of Duty increase confidence that potential issues at Blizzard will handled well and the Blizzard game pipeline stays intact.  Blizzard is a key component of growth, especially in 2022 and beyond.

Also addressed on the conference call was player engagement now that global economies have largely reopened.  As expected, engagement is down sequentially.  However, thus far, the declines are less than expected by management and analysts.  This is an important factor to monitor and if current trends hold, there is further upside to 2021 earnings estimates.

Target Price:  We previously held a $115 target price for ATVI shares based on 25 times 2022 earnings estimates.  The shares currently trade at 18 times 2022 estimates, a discount on an absolute and relative basis to the stock’s history.  Coming out of this quarter, estimates for next year are flat to slightly higher.  The fallout from the California lawsuit has lowered confidence in management generally and presents challenges for the game pipeline, especially at Blizzard.  We expect ATVI to ultimately get past the current issues and achieve our $115 target.  In the near-term, it is more realistic to expect a return to the mid-$90s, which still equates to 15% plus upside. 

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.

Shifting to Neutral on Growth vs. Value

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Northlake’s Style model shifted from Value to Neutral.  For clients with allocations to the model, we are selling one half of the holding in the Russell 1000 Value (IWD) and reinvesting the proceeds into the Russell 1000 Growth (IWF).  There is no change to the recommendation of Mid Cap from the Market Cap model.  Client positions in the S&P 400 Mid Cap (MDY) following the model will be held at least one more month.  For clients using our thematic approach but not invested directly in the models, we may shift a portion of current value investments to growth.

The shift in the Style model reflects two factors.  First, even though the economy is growing at well-above pre-pandemic rates and is likely to sustain that well into 2022, the economic data has decelerated.  Second, value stocks have performed relatively poorly over the past few months as the peak economy thesis has led investors back to less cyclical growth stocks.

Northlake feels good about moving to neutral as we believe the drop from peak growth to above-average growth will lead to a balanced advance in the market where growth and value stocks can perform well.

MDY. IWF, 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.

Explaining Earnings Reactions

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With another set of quarterly earnings being reported, clients probably notice a lot of large stock moves in reaction to the news.  Often the stock moves seem unrelated to the earnings news.  Why did Apple and Facebook trade down after easily beating Wall Street estimates?  Why did Alphabet trade up and Comcast trade up when they also beat estimates?

Beyond the old adage that “traders got to trade”, there are three things happening.  First, investors adjust expectations right up until earnings are reported.  The “whisper” estimate can often be far ahead of analyst estimates.  This was the case for Facebook where blow out results from Alphabet, Snap, and Twitter had raised expectations such that the earnings beat the company reported was not a surprise and actually fell a little short of the whisper.  Second, Wall Street is more concerned with the future than the past.  This may be especially the case currently given the reopening of the economy seems to obviously suggest high earnings gains that will dissipate as time passes and pandemic’s economic impact recedes.  Investors look to “guidance” provided by management about future quarters.  Apple was an example this quarter as the company unexpectedly suggested that supply chain issues will slow the growth of iPhone sales over the balance of 2021.  Apple had avoided the supply chain issues plaguing so many other companies.  Third, how investors, especially traders are positioned heading into the earnings report impacts initial trading reactions.  This aspect is a combination of the first two points.  Traders can easily get caught too bullish or too bearish and be forced to quickly adjust positions.

The earnings reaction game is summarized well by our friend and fellow money manager, Todd Harrison:

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We agree with Todd and extend his timeline to 156 earnings cycles or 29 years!!!