Home Depot Story Continues to Build

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Home Depot (HD) reported excellent 3Q21 results with sales continuing to grow ahead of consensus expectations and surprisingly good gross and operating margins despite supply chain driven cost pressures. Northlake’s investment thesis on HD has been built around three ideas. First, we believe that the pandemic has created a secular increase in willingness of consumers to spend money on their homes. Second, management is best in class and executes on a day-to-day and strategic basis. Third, increased investment in ecommerce and Pro capabilities extend HD’s competitive moat.  3Q21 results support our investment thesis fully.

Stock Reaction: HD shares have soared nearly 7% since reporting results building on a strong run since the initial sell-off after reporting the prior quarter. The shares sit at all-time highs although valuation remains within historical bounds.  Investors in retail stocks have been very sensitive to trends in profit margins this quarter and HD easily satisfied concerns.

Earnings Analysis: Sales, operating income, and EPS all exceeded Wall Street consensus estimates. Strength was especially notable in big ticket items like appliances and power tools. Traffic remains down about 5%, but average ticket was up 12%. Management noted that HD’s labor expenses are most sensitive to traffic (staffing the store when it is crowded), so the combo of light traffic and large tickets contributed to the margin flow through. Gross margins were down just 5 basis points, a great performance compared to other retailers. Supply chain issues are easing a little but still remain.

Looking ahead, management spoke optimistically about a larger total addressable market consistent with Northlake’s view on the secular change in home-focused spending. On a near-term basis, the sharp rise in housing prices is providing further support to demand. Also helping 2022 is HD’s recent focus on the Pro customer. Much of the pandemic demand has been for DIY. Pro demand has a reopening aspect as many consumers are still just beginning to be comfortable with letting workers in their home. On margins, management seems confident they can continue to manage the supply chain issues.  In addition, a material portion of the excess costs related to COVID are beginning to fall away for a net benefit even after increasing employee pay.

Target Price: HD has exceeded our prior target price of $375. We still see upside as the company’s excellent performance in 3Q21 supports a higher P-E multiple. higher estimates, and willingness to base our target on 2023 earnings. Last quarter, we noted our $375 target was based on 25X 2022 estimates or 23X 2023. We now think the shares can support 25X our increased 2023 estimate of $17 for a target of $425. We would note that this is not big upside from current trading levels, but as with other blue chip growth stocks like Apple, we are comfortable holding shares and letting value build through continued earnings and cash flow growth and the passage of time.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 Outlook Leads to Delayed Gratification for Shareholders

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Disney (DIS) reported slightly disappointing earnings for its 4Q21 with modest shortfalls across most business segments headlined by preannounced weak Disney+ streaming subscriber additions and poor operating margins at theme parks.  With a new fiscal year starting in October, management took the opportunity to reset expectations across most of its business lines. 

Stock Reaction:  Since DIS last reported quarterly earnings in August, the company indicated that it was seeing a slowdown in subscriber growth for its Disney+ streaming service.  This news came as a surprise to Northlake.  We previously expected continued strength in streaming and a rebound in theme parks as they fully reopened to allow the stock to break out of out of the $170-$200 range it had been in since early in 2021.  After reporting quarterly earnings yesterday, the stock did break out.  Unfortunately, it moved lower into the $160s based on the new FY22 expectations and falling investor confidence that Disney+ will meet the company’s multiyear growth targets.

Earnings Analysis:  The only material concern arising from the slight shortfall in the 4Q21 earnings was the weak operating margin at the company’s theme parks.  The sharp drop in the stock has much more to do with the new FY22 outlook.  Investors place little value on DIS’s traditional media businesses including ESPN, ABC, and local television stations.  The focus is squarely on theme parks and streaming.  Despite the shortfall in theme parks margins, the news for that segment is generally good.  Demand trends are strong and set to accelerate as the U.S. allows vaccinated international travelers to return.  In-park spending is well above pre-pandemic levels.  New ticket plans are proving popular and financially accretive.  Unfortunately, permanent cost savings are being offset by inflation in wages and other inputs.  Nonetheless, we still expect a return to at least prior margins despite the 4Q21 shortfall.  Theme parks should provide incremental value to DIS shareholders as the parks fully ramp over 2022 and especially 2023.  We have less confidence in the outlook for Disney+ after the new guidance calling for continued subdued growth in new subscribers until the second half of FY22 and increased spending on content above prior expectations.  Management notes that the timing of new country rollouts and new content is heavily weighted to late 2022 and 2023.  Disney+ is currently in 60 countries and could reach 160 by the end of 2023.  Content production delayed by the pandemic shutdowns should reach the desired level of one new original per week in the fall of 2023 across key intellectual property including Marvel, Star Wars, Disney, Pixar, and National Geographic.  Furthermore, local language production will soar into the hundreds, which is crucial as geographic reach of the service expands.

Target Price: We still expect Disney+ and the company’s other streaming services – especially Hulu – to be successful and drive value.  However, due to lower visibility of profits and delayed timing at Disney+, we are lowering the value we place on the company’s streaming services.  This reduces our target price from $225 to $205.  Following the sharp drop in the stock today, this still equates to upside of 25%.  The shares are unlikely to reach this level until there is renewed momentum for Disney+ subscriber growth and clear signs of the timing for theme parks to reach peak profit margins.  One near-term catalyst could be stronger subscriber growth in response to Disney+ Day taking place on November 12 when the company is offering a surge of new content.  It is also possible that DIS has reset expectations, giving investors all the bad news.  Often this type of kitchen-sink guidance sets up a bottom for a stock.  DIS has a great track record and arguably the best content in the world, so while frustrated by the loss of 2021 and much of 2022 for our investment thesis, we are willing to sit tight. 

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. 

Activision Headwinds Strengthen

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Last quarter we noted that ATVI has been managing the headwinds coming from the employee discrimination lawsuits well.  Looking solely at the results of 3Q21, one would conclude the same thing.  However, the other shoe dropped when the company delayed the release of two important games from 2022/2023 to 2023/2024.  The issues are a loss of key personnel and loss of productivity as a result of the lawsuits.

Stock Reaction:  ATVI traded down another 12% after dropping 20% from 2021 highs due to the lawsuits.  The stock now trades at less than 20 times projected 2021 estimates and the same on 2022 that is now assumed flat year-over-year due to the delayed game releases.

Earnings Analysis:  3Q21 earnings were good with Activison in line, Blizzard underperforming (Blizzard is where the discrimination impacts are being felt), and King’s mobile games outperforming.  Management slightly raised 2021 guidance, passing through some of the upside from the latest quarter.  Guidance could have gone higher, but it appears management wants to play it safe given the imminent launch of the next Call of Duty game.  Performance of this game is critical to the 2022 outlook and is the next big catalyst for the shares.  If Call of Duty meets high expectations from investors, it will make it easier to look at the delayed games as just deferring future profits.  Any shortfall would create an even higher hill to climb to regain investor confidence and shift the focus to 2023.

Target Price:  Last quarter, we reduced our target on ATVI from $115 to $90 because we expected investors to mark down valuation until the headwinds passed.  We did note that $115 was ultimately achievable as earnings power was unchanged and eventually the company would regain the street’s confidence.  It now appears unrealistic to achieve a recovery to $90 in the near future.  We expect the shares to stay range bound +/- 10% against current levels until (1) Call of Duty acts as a catalyst, and (2) management signals progress on now delayed games.

The latest issues may or may not impact long-term earnings power.  At a minimum, the delayed game releases push realization of earnings power out to 2023.  ATVI has encountered and overcome major challenges before.  In fact, that has been the case for peers Electronic Arts and Take Two Interactive as well.  This history makes us willing to hold for now and hope for better news starting with the new Call of Duty game.  A P-E under 20X on base level earnings is historically very cheap for ATVI.  This should limit downside while we wait for a recovery and further datapoints to evaluate the shares.

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 Still Shining

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The title of this blog post is similar to when we last discussed Nexstar Media Group (NXST).  This is no coincidence as the company’s 3Q21 earnings report was more of the same good news.  NXST has built nationwide scale of local TV stations, a business than has always generated large free cash flow (TV stations require very little capital spending and operate at high margins).  The company’s scale is currently allowing it to fully participate in above average economic growth and use its free cash flow in multiple ways to support shareholder value.  NXST, like other local media stocks, has always been volatile, but we expect the slow grind higher that has the stock up from $58 in 2017 when we first purchased it to $160 (up 175%) to continue.

Stock Reaction:  NXST shares initially traded down 1-2% following the company’s conference call to discuss the 3Q21 results but as the day wore on the tide turned leaving the stocks up 3-4% and close to its all-time high set earlier this year.  The shares have moved sideways since July even after the company raised guidance for its 2021/2022 cycle after the 2Q21 report.  Whether or not another solid quarter is enough to allow a breakout from the trading range in either direction, we still see the next big move higher barring a macroeconomic setback.

Earnings Analysis:  3Q21 earnings were good, led by a rebound in core advertising excluding the auto category.  Auto remains a top 5 category and it has not rebounded yet from pandemic lows due to supply constraints.  Dealers do not have enough cars to sell, so they limit their advertising spending.  All other top 10 ad categories are growing, with sports betting continuing to develop into a new top 3 vertical.  Excluding auto, core advertising was up double digits vs. 2019, a result that will likely surprise many investors who ignore local TV and believe it is a dying category.  NXST’s other big revenue stream is retransmission fees that it receives from cable, satellite, and streaming services that offer its TV station feeds to subscribers.  Visibility here remains good with most contracts locked in through 2022.  The next cycle will begin in 2023 where we still expect moderate growth despite lower sub counts due to the continued importance of local TV news and smaller but still leading TV ratings for broadcast entertainment programming.  NXST has been bulking ups its digital revenue through acquisitions of content that is complimentary to its news operations.

Target Price:  NXST is valued on two-year average earnings due to the massive swings in political spending between even and odd years.  The latest report suggests that the company could exceed its current guidance for free cash flow.  Management was confident in near-term trends and another political cycle kicks in next year.  There was even a mention of further growth in 2023, an unusual utterance for a management team that very carefully and effectively manages street expectations. 

NXST is a relative thinly traded stock in an industry that investors view skeptically on a secular basis.  This leads to volatility in the shares as today’s post earnings trading indicates.  NXST has one of the best management teams among all stocks we follow, and we remain highly confident that operational, financial, and strategic success will continue, so we are comfortable riding out volatility in the share price.

We are sticking with our $180 target price built on what we believe to conservative assumptions.  We continue to see an easy path to $200 or more if the company successfully answers investor concerns about advertising and retransmission growth as streaming continues to gain share of TV viewing.  Further clarity on the balance of capital allocation between acquisitions and share buybacks is also important.  Given the company’s history, we expect the answers to be satisfactory supporting 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. 

Models Stable Ahead of Fed Taper Decision

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We are sticking with our current positioning for at least another month after reviewing the latest updates from our Market Cap and Style models. We will continue to hold current positions following the models including the S&P 500 (SPY), Russell 1000 Growth (IWF) and Russell 1000 Value (IWD).  We will also stick with our preferences for clients investing in thematic ETFs.  This includes holdings in the sector funds for financial (XLF) and industrial (XLI), small cap value (IWN), and exposure to developed economy international (EFA/VEA) and emerging markets (EEM/VWO).

The message from our models and our review of recent economic data and stock and bond market trading trends is that the rally has the potential to continue and to broaden.  We see concerns about the slowing economy, higher inflation, and monetary policy as misplaced.  The economy is slowing but the outlook for the next year at least remains for GDP growth well above pre-pandemic levels.  Supply chain issues are a headwind, but we see them eventually being resolved with deferral rather than destruction in demand except for pure holiday-related spending. Inflation has also moved higher, but we accept the transitory argument put forth by the Fed due to secular factors like demographics and technology leading to maturation of the major Western economies (and maybe even China).  The Fed is tapering and may begin raising the Federal Funds rate in 2022.  Tapering is surely less accommodative, but we do not see it as having the same impact as tightening policy.  In fact, for most of the next six to nine months, the Fed will still be a new buyer of bonds and beyond this frame will just step away from the market rather than selling its large portfolio of bonds.  Higher rates present a challenge whether market-driven or triggered by the Fed.  Rates are likely to remain quite low by historical standards, returning policy to a normal economic environment.  Investors may like normal after a decade plus of unusual investing environments.

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