Will Apple’s Lost Sales Stay Fresh or Turn Rotten?

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When Apple (AAPL) reported its June quarter results, management hinted at supply chain issues beginning to impact the company’s ability to meet demand.  During the quarter, at a conference presentation, the company updated its guidance to note that about $3 billion in sales would be lost in the September quarter.  When the company reported September quarter earnings this week, the actual lost revenue amounted to $6 billion.  Guidance commentary indicated that at least another $6 billion in revenue would be lost in the December quarter.  Despite the sales shortfall that was primarily evident in iPhones, Apple still managed to match consensus estimates for EPS.

Stock Reaction:  After initially falling about 5% in response to the earnings, by the end of the next day’s trading Apple was only down about 2%.  The recovery makes sense to us as the details of the earnings report and management’s conference call commentary painted a clear picture of strong demand across the entire portfolio of products and services and execution on margins and cash flows remains best in class.

Earnings Analysis:  The supply chain issues have been in two buckets:  COVID related and semiconductor shortages.  Management noted that COVID issues had eased but low-tech semiconductors continue to be a problem.  Beyond supply chain, the results were quite good.  All products and services in all geographies grew well and management indicated that demand trends support more of the same.  We were especially impressed by 26% growth in services at a record gross margin.  Product gross margins held nicely despite pressures from the supply chain such as elevated freight.  Guidance calls for less than 10% revenue growth and a modest sequential decline in margins.  This is manageable in our view and we see only small changes in estimates that are not material to the long-term investment thesis.

Target Price:  The big questions for Apple investors are (1) how long will the supply chain issues last, and (2) are the lost sales deferred or destroyed.  Most observers see supply chain issues lasting until mid-2022 although Apple’s massive scale and importance to its suppliers should allow the company to be among the first to see better supplier deliveries.  There clearly will be some lost sales this quarter given that the holiday season brings gifts of Apple products.  We still expect the overwhelming majority of lost sales to be deferred.  Lost sales moving forward seem concentrated in iPhones.  Given already long upgrade cycles, we anticipate that most buyers will wait a few months for their new phone rather than permanently keep their current phone or switch away from Apple to Android.  Apple continues to have a high level of switchers in current sales supporting this outlook.  We also are encouraged by comments about demand which are consistent with the very strong reviews for all of Apple’s current generation product and services.  Macs and iPads especially seem to have taken a step forward while iPhones are benefitting from a backlog of phones 3-5 years old.  Services and wearables continue to grow rapidly off the flywheel of the ever-expanding installed base of iPhone users.

Despite our positive view of the company’s current performance and the likely recouping of most of the lost sales, we still see Apple shares as somewhat expensive and are sticking with our price target of $150.  At $150, the shares trade at 25 times 2022 expected earnings.  This is moderate but deserved premium to the S&P 500’s multiple of 20.
The shares currently are trading at $150 but we see no reason to sell or aggressively reduce positions given the overall quality of the company and at least several more years of solid growth. 

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. 

Comcast Questions Starting Sooner

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Comcast (CMCSA) reported another good set of quarterly financial results.  Revenues, EBITDA, and free cash flow all at least met Wall Street estimates in 3Q even as the company had preannounced a slowdown in growth of new broadband subscribers.  From a financial perspective, the huge increase in broadband subs during the peak of the pandemic provides much greater financial reward than the small shortfall in broadband subscriber growth.  3Q21 marked the point at which Comcast had reduced debt to the level before the acquisition of Sky.  This is an important milestone as management has been promising to accelerate stock buybacks once financial leverage targets were achieved.

Stock Reaction:  Immediately following the report but before the conference call, CMCSA shares were trading up about 3%.  During the call, when management discussed broadband trends in 4Q21 and beyond, the shares dropped sharply to a loss of as much as 4%.  Now, two days later, the stock is off about 2% from the close before earnings were released.  In our last update, we mentioned that there were likely two issues related to broadband subs but not until 2022.  Management guided 4Q21 subs below the level that had already been reduced in September.  The company also refused to comment on 2022 expectations noting lack of visibility.  The latest commentary has moved the concerns we expected to emerge next year forward.

Earnings Analysis:  Short of the broadband subscriber outlook, Comcast had good results across the board.  Cable is still growing over 10% thanks to the much larger broadband base, a shift to profits in Xfinity Mobile, and continued steady growth in connectivity services to businesses.  The company’s media and entertainment businesses at NBC Universal continue to recover strongly after being crushed during the pandemic.  Advertising, theme park attendance, and Sky’s UK and European TV operations all grew very strongly.  Comcast is continuing to invest heavily in its Peacock streaming services which reduces headline growth at NBC Universal and obscures the underlying organic recovery.

Target Price:  We are sticking with our target price in the low-$60s for Comcast but expect it to take a few quarters before investor sentiment improves and the shares resume an upward trend.  Financial results will remain quite strong and the stock buyback should accelerate sharply to about 10% of the shares outstanding per year.  Unfortunately, the unclear outlook for broadband subscriber growth is dominating the investment narrative.  The big fear is that now much higher penetration of broadband households and increasing fiber-to-the-home investments by telcos means that Comcast’s growth will slow dramatically.  Management notes (we believe correctly) that thus far the slowdown is merely due to COVID impacts on increased penetration and lower churn from less housing moves.  Currently slower growth is coming ahead of a pickup in fiber passings by telcos over the next few years.  Investor fear is driving the terminal value placed on Comcast lower even as financial results continue to grow with almost no impact.  Northlake believes that over the next few quarters, Comcast will prove to investors that broadband remains a growth business.  Greenfield builds and a pickup in housing formation should provide enough room for cable and telcos to co-exist with modest growth.  Comcast will also enjoy continued growth at NBC Universal and Xfinity Mobile.  Today, Comcast shares assume close to no growth.  This is a dire view given the dominant competitive position cable broadband will maintain in most of the country even as telco fiber penetration grows. 

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. 

The Wait is Ending at Sony

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Sony (SONY) reported a second consecutive beat and raise quarter. Even after the previous quarterly report, we still thought that guidance was conservative, so we are pleased but not surprised with another step forward confirming our investment thesis.  We could almost republish our last quarterly update and just add today’s date.  Three months ago, we wrote, “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 businesses 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.” 

Stock Reaction:  One thing that has changed is SONY shares are beginning to reflect the good results.  The stock is trading up over 4% to an all-time high in U.S. trading following the report.  SONY recently received a buy rating from a U.S-based analyst that covers media, entertainment, and video game stocks.  Most Japanese analysts that cover SONY are focused on electronics and technology based on the company’s tradition.  We believe this has held back the stock.  Hopefully, another beat and raise quarter will improve sentiment in Japan and encourage more U.S. analysts to follow the shares.

Earnings Analysis:  While earnings were good relative to expectations in most segments, the most encouraging aspect of the 2Q21 report was the broad-based increase in guidance.  Revenues were increased in Music, Pictures, and Financial Services and lowered only in Electronics Products.  Operating income was boosted in Music, Pictures, Electronics Products, and Imaging and maintained in Games and Financial Services.  We are especially encouraged by the outlook for Music and Pictures and eventually a resumption of upside in Games after that business shifts back from money-losing sales of PS5 game machines to high-margin video games and network services.

Target Price:  We are raising our target on SONY to $155 based mostly on rolling over to 2022 estimates.  Our new estimates are slightly higher reflecting the second consecutive beat and raise quarter.  However, we did slightly lower our EBITDA multiple to reflect the multiple compression in video game publishing stocks such as Activision Blizzard and Electronic Arts.  This is a conservative approach as the valuation of music labels has expanded materially since the highly successful IPO of industry leader Universal Music Group in September.  SONY is #2 in music and is enjoying the same strong financial performance as UMG.  The bottom line is SONY shares still look undervalued at 11X EBITDA when peers in music, video games, entertainment, and imaging sensors (semiconductors) trade at higher multiples.  Those businesses account for over 80% of SONY’s operating income.  As analysts and investors in the U.S. and Japan gain appreciation for SONY’s transformation and consistent superior execution, we believe valuation will expand with a further boost for the shares coming from additional upside on still conservative guidance.

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. 

Alphabet Shines Amid Digital Ad Industry Challenges

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Alphabet (GOOG/GOOGL) reported better than expected earnings with revenues, expenses, and EPS all coming in ahead of expectations.  The revenue upside was especially impressive given the turmoil in internet and mobile advertising caused by Apple’s privacy initiatives.  Google did not escape completely unscathed as YouTube ad growth was a few percent less than expected (although still more than 40%).  Google Search was exceptionally strong and more than made up for YouTube and a slight deceleration in growth at the company’s Cloud segment.  Google is less impacted by Apple’s privacy changes since Search provides more first-party data the company’s advertisers can use to still reach consumers on a user basis.  Search also is benefitting from a rebound in verticals sensitive to COVID reopening such as travel and hospitality.  Retail is also holding up well and is probably Google’s largest category.  Facebook and Snap also have big retail presence but the ads they sell go purely to ecommerce.  Google is an omnichannel ad buy for retailers that are now seeing renewed strength in store level sales.

Stock Reaction: GOOG/GOOGL shares are up 6% and hitting new all-time highs today following last night’s earnings report and conference call.  This is in stark contrast to Facebook, Snap, and other digital advertising stocks that traded down sharply after reporting and sit 15-20% or more below their all-time highs reached as recently as two months ago.  Alphabet was already the best performing internet stock in 2021, up 60% prior to today’s gain.  The 3Q21 report is a clear endorsement of the 2021 stock performance.

Earnings Analysis: Search led the way, more than making up for slight shortfalls relative to expectations at YouTube and Cloud.  YouTube took a small hit in its direct response ad sales due to Apple’s privacy changes.  Cloud decelerated slightly to mid-40% growth but management noted continued strength in the most important large enterprise portion of the business.  Perhaps most impressive in the quarter was the company’s operating profit margin.  Management has been showing much improved cost controls since the arrival of CFO Ruth Porat in 2015.  Alphabet operating margins are higher now than pre-pandemic.  Management suggested continued investment was coming to support revenue growth but given multiple chances to push back on the idea that margins had reached a new higher level, Ms. Porat deferred.

Target Price: After slightly tweaking our valuation assumptions and rolling forward to 2022 estimates, our new target for GOOG/GOOGL shares is $3,200, up $200 from prior levels based on 2021 estimates.  This leaves about 12% upside after today’s big gains.  Management did caution that comparisons really begin to toughen in 4Q21 and that will continue through 1H22.  Furthermore, despite the confidence expressed on profit margins, management noted there is some spending that was eliminated during the pandemic that will come back onstream over the next few quarters.  These factors contribute to our decision to keep the valuation multiple in check despite Alphabet appearing to distance itself from peers on multiple financial and operating metrics.  Should the next couple quarters go smoothly, we can switch our focus to 2023 and targets in the range of $3,5000 to $4,000.

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.  DIS is a net long position in the Entermedia Funds. 

Facebook Reset Delays Reward

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Facebook (FB) has had a rough go lately.  News stories have occurred almost daily criticizing the company.  Politicians and regulators are looking for a way to punish the company and limit its influence.  Apple’s changes to enable greater privacy for iOS users is limiting FB’s ability to measure and target its users on behalf of advertisers.  The company is also not immune to macro factors such as supply chain issues, pull forward of digital economies, and tough comparisons.  Against this backdrop and a stock price that had declined about 15% since its all-time high in early September, FB reported 3Q21 results.  The results and guidance were disappointing by the company’s extremely high historical standards but not as bad as feared.  Management addressed the many issues swirling around the company proactively, and in Northlake’s opinion, effectively.  Overall, the quarterly report and conference call raised new questions for FB shares but also set the stage for improved performance in the quarters ahead.  The big question for Northlake is how much time it takes for the financial results to stabilize and re-accelerate.  We intend to wait.

Stock Reaction: The initial after-hours reaction to the results was positive and the shares opened higher.  This reaction was based on the results and guidance being no worse than already lowered expectations.  The stock quickly turned negative in morning trading and was down about 5% in the afternoon.  The shift in tone is most likely based on the materially lower estimates for 2022 and the realization that it could be several quarters before results stabilize and improve.

Earnings Analysis: Revenue fell slightly short of estimates but grew 35%.  Operating income was also a little shy of estimates as margins fell due to higher expenses to both combat the near-term issues and support the company’s investments for the long-term.  Guidance calls for a continued deceleration of revenue growth due to Apple privacy, tougher comparisons for ecommerce and digital ad comparisons, and an assumed slowing in advertising as supply chain challenges leave many businesses without enough inventory to meet demand.  Encouragingly, management noted that it was about hallway done with changes meant to bring measurement and targeting back to previous levels.  Facebook seems well ahead of peers in this area, but it remains unclear how much “signaling” will be permanently lost for advertisers.  Apple’s changes effectively require a shift for advertisers from targeting individual users to similar groups.  For now, advertisers are not able to target potential customers as specifically or measure the effectiveness of the ads.  Eventually, Northlake believes FB will be able to mostly solve these problems even if not achieve earlier return on investment for its advertisers.  One thing working in the company’s favor is that all digital advertisers face the same issues and FB should emerge maintaining its status as the best place and highest return for advertisers.  We all hate advertisements but the reality is they work and competition means businesses will spend to maintain and grow market share.

Target Price: We believe investors should be patient with FB shares, even if it takes several quarters to resume the uptrend.  Looking out into mid-2022, we have established a target price of $365.  This is only down slightly from our prior target of $375.  However, we have lost a year of time value.  We are using materially lower estimates for 2022, while 2023 comes down as well but to a much lesser extent.  Given the uncertainties and bad publicity we have also lowered the multiple of earnings and/or EBITDA we use to value the shares.  We strongly suspect our new estimates and target price will prove conservative.  The shares will start moving upward again when it becomes clear that growth will again accelerate and estimates for out years rise.  This could take several quarters or maybe less if the mitigation efforts on privacy start showing results.

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.  DIS is a net long position in the Entermedia Funds. 

AT&T Fundamentals Continue to Improve

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AT&T (T) reported its first quarterly results since Northlake took a long position in client accounts in July.  Virtually across the board, the results slightly exceeded estimates leading the company to modestly increase its 2021 guidance for financial results and subscriber counts.  Our thesis is built upon a hated company that is showing improved execution on financial and operating fundamentals, while also making smart strategic divestitures to focus on its connectivity business.  3Q21 results fully support our outlook for T shares.

Stock Reaction: Investors are not yet embracing the turnaround at T.  The shares initially traded up, building on gains from the prior day when Verizon also reported confidence-building results.  However, the shares reversed to close slightly lower along with Verizon and T Mobile.  There remains skepticism about recent industry growth in mobile phones given penetration rates over 100% and intense competition between the big three telcos and cable companies now offering wireless services.  Investors have a little more faith in T’s aggressive buildout of its fiber network to provide broadband for consumers and small businesses.  Finally, there is a general lack of interest in T due to the still complicated financial reporting and uncertainty about how the merger of T’s Warner Media segment with Discovery Communications will work.

Earnings Analysis: T has three major segments – wireless, consumer wireline, and Warner Media.  Each segment reported slightly better than expected 3Q21 results for revenue, EBITDA, and subscribers.  T has now strung several good reports as new senior management builds credibility.  In wireless, T is growing subscribers at industry-leading rates, matching long-time growth leader T Mobile. T is using promotions more like T Mobile’s Uncarrier branding approach.  So far, it is paying off with improved financial performance.  T is also benefitting from its FirstNet network for police, fire, EMT’s and other emergency responders.  In consumer wireline, T is now an insurgent as its fiber network is passing 30 million homes with many millions more to come.  This is showing up in upper single-digit revenue growth and a turn to positive EBITDA as the subscriber count scales.  Better gross adds are occurring although the Street needs to see more on this front since so many subs are converting from T’s slower DSL broadband services.  Warner Media seems clearly established as a top three player in streaming with HBO Max.  Management has simplified the services to focus solely on HBO Max which is helping the approach to distribution.  Despite taking HBO Max off distribution on Amazon Prime Video (cost 3-4 million customers), subscriber additions still exceeded estimates.  Management raised subscriber guidance for yearend 2021.  EBITDA is coming under pressure as the ramp in content spend continues.  This spending should peak next year.  All in, Warner Media is at least on track pending its merger into Discovery Communications in mid-2022.

Target Price: When we purchased AT&T in July, we established a $36 target based on the sum of the company’s 71% share of new Discovery Communications and the new connectivity-focused AT&T that will emerge post the merger closing.  We still see this upside but point out that even a target of $30 provides a 25% total return from current prices, supported by a hefty dividend of 8% until the merger closes and nearly 6% after.  Management must continue to build credibility with continuing stronger financial and operating results.  Most analysts are cautious on T but there is clear improvement in sentiment (albeit grudgingly) as we read the research reports.  The combination of skepticism, improving investor sentiment, and steady strength in financial and subscriber metrics is what attracts us to T.  While we wait, we get paid a very healthy dividend when money markets still pay almost nothing and 10-year Treasury notes have an annual yield of 1.6%, which is the yield T pays each quarter.

AT&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.  DIS is a net long position in the Entermedia Funds. 

Setback for IBM Ahead of Positive Catalyst

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After two consecutive quarters of improved results and a positive analyst meeting earlier this month, IBM’s 3Q21 earnings were disappointing.  Revenues fell slightly short of estimates, and after adjusting for a favorable tax rate, EPS did as well.  Key growth areas like consulting and hybrid cloud performed well, but software, mainframe systems, and soon-to-be spun off Kyndryl businesses all fell short.  Management admitted that the company fell short of its own expectations but noted that the spin of Kyndryl was a meaningful factor that should go away after the spin coming on November 3rd.  We also believe the shortfall in systems is nothing to worry about as it is related to the usual mainframe cycle.

Stock Reaction: Investors punished IBM with the shares trading down about 9% following the report.  Given the recently improved results had raised expectations, the quarter came as a big negative surprise.  IBM has a poor history of earnings growth in the past decade, so traders are showing little tolerance for the shortfall and assuming the better results in 1H21 were an aberration.

Earnings Analysis: Revenue fell about 1% short of estimates.  The systems and Kyndryl shortfalls explained much of the miss, but the return of software to negative year-over-year growth was a big disappointment.  Hybrid cloud is the key to IBM’s future and Northlake’s positive investment thesis.  Fortunately, this segment continues to perform well, growing at 17%, consistent with recent trends.  Reported EPS looked a few pennies ahead of estimates but were boosted by non-operating items such as the low tax rate noted previously.  Gross margins were light, especially in the faster growing consulting business.  This raises fears that growth is coming from discounted pricing rather than competitive positioning.

Target Price: Despite the disappointment, Northlake is sticking with its bullish view of IBM and $160 target price.  The upcoming spin of Kyndryl will highlight IBM’s well-positioned hybrid cloud business.  With the shares at a P-E of just 10X – half of the average stock – expectations are low.  IBM shares are back in “show me” mode.  We are hopeful that the Kyndryl spin will improve management focus and execution.  The 9% drop looks like an overreaction and we are willing to wait given the upcoming spin and 5% dividend yield.

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.  DIS is a net long position in the Entermedia Funds. 

No Changes to Models or Strategies

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There are no changes to the recommendations from Northlake’s Market Cap and Style models for October.  The models continue to favor large cap and remain neutral on growth vs. value.  For clients with assets invested in Northlake’s models, positions in the S&P 500 (SPY), Russell 1000 Growth (IWF), and Russell 1000 Value (IWD) will be held at least another month.  Within our ETF-only thematic strategies, we continue to overweight small caps and value beyond investments in Core Index ETFs.  Northlake believes that economic growth will sustain above pre-pandemic levels at least through 2022 despite recent slowing and less accommodative fiscal and monetary policy.  This is slightly at odds with our models but not so far as to trigger a cutback in small cap and value exposure.

The models had very little change this month.  The large cap recommendation strengthened, as did the neutral call on Style.  Among the underlying indicators, the most interesting change is related to the recent strengthening of the dollar.  Dollar strength has been triggered by the recent increase in intermediate and long-term interest rates and steepening of the yield curve.  The dollar, interest rates, and the yield curve have been in focus for traders recently.  The latest moves all support value over growth and small cap over large cap, and are supportive of our stance to stick with those overweights for our ETF-only thematic strategies.

One other point worth highlighting is the recent improvement in COVID data.  Case counts have rolled over even as testing has risen with positivity rates falling.  More importantly, hospitalizations have rolled over.  Today’s news that Merck is seeking emergency authorization for a pill that has cut hospitalizations by 50% among infected individuals with a co-morbidity adds to the good news on COVID.  There are no guarantees, and winter has shown a tendency to worsen COVID as people spend more time indoors.  We are hopeful that much higher vaccination rates will soften the COVID uptick this winter.  For the market, the better news on COVID is positive for small and mid cap, value, reopening, and international stocks.

SPY, 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.