2Q22 Earnings Updates: Part Two – ATVI, NXST, DIS, WMT, and HD

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Activision Blizzard (ATVI): ATVI and Microsoft (MSFT) continue to await a regulatory ruling on the proposed acquisition of ATVI for $95 per share.  The companies expect to close the deal in 2023, and Northlake continues to expect approval despite the large discount to the deal price at which ATVI trades.  Recently, the discount has narrowed with the shares trading at $80-$81 up from a range of $77-$78 from April through mid-July.  We think a couple of things are at work.  First, the companies have completed all regulatory filings and there hasn’t been much resistance from the government.  This may not mean anything, but controversial deals often hit a roadblock late in the filing process.  Second, government regulation of tech companies has been focused on privacy and self-dealing, neither of which are a factor in this acquisition.  It also helps that MSFT has not been a target of new regulation and congressional reviews focused on Apple, Amazon, Google, and Facebook.  Third, ATVI has been making progress on corporate governance and employee relations.  Fourth, ATVI is beginning to show improved earnings after a very tough stretch triggered by game release delays and weak performance of new games that were likely triggered by the distraction from the company’s governance and employee relations issues.  This factor was confirmed in ATVI’s 2Q earnings report that revealed better results and laid out a timeline for a series of new releases that renew earnings power in 2023 and 2024.  This is especially important as it raises the downside support level should the deal be blocked by regulators.  With a high likelihood of deal approval and improved earnings support, we like ATVI with 17% upside to the $95 acquisition price.  This upside is especially attractive in a tricky period for the stock market and economy.

Nexstar Media Group (NXST): NXST reported another healthy quarter as the company continues to outperform virtually all other legacy media companies.  The stock is up 29% this year against a 10%-20% decline for the major averages and worse declines for many other media stocks.  We still see another 10%-20% upside based on the company’s prodigious free cash flow generation and management’s shareholder friendly use of this cash.  NXST beat street expectations for EBITDA and all-important free cash flow in 2Q22.  Management guides on a two-year cycle to account for political advertising in even years, so with the current guidance time frame of 2022/2023, guidance was maintained since it is only the first quarter of the period.  NXST has three main revenue lines:  core advertising, political advertising, and retransmission fees paid by cable, satellite, and streaming services.  Political looks set for a record again this year as the battle for House and Senate control and governorships remains closely fought and intense.  We expect another record in 2024, a presidential election year when control of the House and Senate will again be up for grabs.  Retransmission fees should continue to grow even after NXST pays ABC, CBS, FOX, and NBC for programming rights.  This revenue line has long-term risk from cord cutting and mix shift from linear to streaming viewing.  We expect continued growth at least through 2025, but should cracks appear the multiple of cash flow on NXST shares will compress even if financial returns keep growing.  Core advertising was once 80% of local TV station revenue.  The rise of retransmission (now about 50% of revenue) and political (about 25% of revenue over the two-year cycle) leaves core ads at just 35% of revenue, greatly insulating NXST and local TV from a recession.  The less cyclical revenue streams support valuation for NXST shares.  We see 7X-7.5X EBITDA as appropriate, slightly below pre-pandemic levels.  This equates to a target of $215-$240 on what we expect are modestly conservative estimates. At $240, NXST shares would be 4X Northlake’s original purchase for clients five years ago, a remarkable performance for a traditional media company.

Disney (DIS): DIS reported better than expected 3Q22 earnings driven mostly by outstanding performance at the company’s theme parks.  Consumer Products, Content Licensing, and Linear TV also helped on operating income.  Streaming losses were worse than forecast but offset by better-than-expected subscriber growth.  Theme parks look solid – even in the event of a recession – and linear is declining, but not terribly so.  Avatar and Black Panther lie ahead to boost film studio profits and drive streaming subs.  These non-streaming businesses produce a good level of base profits and underpins a big chunk of the current price.  We suggested last quarter that everything besides streaming is worth $100 per share.  The tricky part is valuing streaming, and 3Q22 offered a lot of interesting new information.  Management revised long-term subscriber targets downward, but most of the decline was in India where monthly subscriptions are just $1.  For the first time, subscriber guidance breaks out Hotstar, which covers India and other low-value SE Asia and Africa markets.  The new sub guidance in developed markets is only a bit less than before and better than investors feared.  Management also outlined price increases for the streaming services in the U.S. with the intent to eventually roll them out to Europe and developed Asia.  The price increases on Disney+, Hulu, and ESPN+ are substantial amid concerns about consumer spending and inflation.  As offsets, the company formally outlined the plans for a lower-cost advertising-supported version of Disney+ and offered new bundles with and without ads that provide dramatic savings vs. buying the services individually.  The idea appears to be to force people into bundles, which helps sub counts at Hulu and ESPN+ and lowers churn, thus offsetting the risk that the big price increases boost churn as they appear to do whenever Netflix raises prices.  Management reiterated that streaming losses would peak this year, but losses in 2022 and 2023 are higher than previously expected.  The company is sticking by its goal to show streaming profits in 2024, although this is unlikely on a full-year basis until 2025.  One helpful new data point is that content spending will plateau near the current $30 billion annual level.  This mirrors plans by Netflix and Warner Brothers Discovery and reinforces the idea that streaming can be a profitable business within a few years.  After the material subscriber and profit reset at Netflix and drop in Netflix shares from $700 to $200, this is welcome news.  An improved outlook on streaming and ongoing great performance at theme parks justifies the 5% rally in DIS shares following the earnings report.  It allows a modestly higher target price for DIS of $145, up from $130 after last quarter’s weak earnings report.  Should the 2024/25 profit outlook firm up, multiple expansion can push DIS shares far beyond our current target.

Walmart (WMT): WMT reported 2Q22 earnings on August 16th after preannouncing a significant disappointment last month and lowering its EPS forecast for the year by about 10%.  As we noted in our prior writeup recapping the preannouncement, WMT shares needed a signal that consumer spending in its stores had firmed up in order for the stock to work again.  2Q22 results came in better than lowered expectations on sales and earnings, and management noted a pickup in late July and early August.  This is the news we were hoping for even if it arrived ahead of schedule.  WMT shares have fully recovered the losses following the preannouncement.  Management also noted that inventory clearance in general merchandise, the primary cause of the guidance cut, is on or ahead of schedule.  A final significant item from the earnings call is that the company is seeing higher income shoppers trade down to shop at WMT instead of other more expensive stores, which is offsetting weakness from heavily inflation-impacted lower income consumers in the company’s base.  Interestingly, this trade-down sustained in the initial stages of the decline in gas prices.  WMT shares are not out of the woods given the tricky macro environment but we continue to like the combination of offense and defense from the more aggressive management of the base business, market share gains in weak economic environments, and early success for Walmart+.

Home Depot (HD): Despite higher mortgage rates and a major slowing of the housing market, HD reported better-than-expected revenues and earnings in 2Q22.  Comparable store sales grew 5%, in line with Wall Street expectations, with transactions down and ticket size up.  Gross margins held steady – an important factor given investors often worry about this datapoint.  HD indicated that supply chain pressures are easing, and it has been able to raise prices to offset higher costs.  Management maintained 2022 guidance, which Northlake finds prudent given uncertainty in the macroeconomic outlook.  Northlake’s investment thesis for HD is built on consistent execution by a best-in-class management team.  One particularly helpful aspect of the corporate strategy is the focus on the pro customer/contractor.  As COVID impacts have eased, homeowners are allowing contractors in their home to fulfill a backlog of projects.  This has more than offset any softening in the do-it-yourself market that boomed during COVID stay-at-home restrictions.  The combination of higher ticket and lower transactions likely reflects the company’s focus on the pro customer.  Northlake has been patient with HD even as worries about the housing market have dominated headlines and driven the stock lower.  We believe there is a secular shift to spending on homes as individual priorities have changed post COVID.  This factor may be less than we first expected as spending has shifted back to the decade-long emphasis on services (travel, entertainment, dining, etc.).  However, a small incremental gain along with the exposure to pro spending should allow HD to continue to thrive even if discretionary purchases are pressured by inflation.  It is also important to remember that HD is not very sensitive to new home construction.  Rather, it is remodeling that drives the business.  Slower housing turnover of existing homes is a risk we are monitoring.  We also are watching the high growth in inventories even as management explained that it was purposeful to keep shelves stocked.  Other retailers including Target and Walmart have been forced to cut guidance to clear elevated inventories.  We believe the company’s product selection is less exposed to inventory obsolescence. HD shares are valued at less than 20 times earnings, a level we do not think adequately reflects the company’s growth prospects, financial strength, and management quality.  A return to a low 20s P-E multiple can push the shares into the upper $300s as the Wall Street calendar turns toward 2023 and beyond.

ATVI, NXST, DIS, WMT, and HD 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. 

1Q22 Earnings Update: Part One – IBM, GOOG, SONY, ATVI, TMUS

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Due to Steve’s travel schedule, we are going to try something new this quarter with our quarterly blog updates on individual stocks held widely in Northlake accounts.  Rather than publish a separate commentary on each stock, we are going to produce two or three updates with each containing comments on several stocks.  This will result in less detailed written analysis, so we request that you pass along feedback on the format for this quarter’s updates.  We always aim to please clients and are fully flexible and happy to adjust our various communications.

So far, we have had earnings reports from IBM (IBM), Alphabet (GOOG/GOOGL), Sony (SONY), and T Mobile USA (TMUS).  Before we provide commentary on these reports, we want to discuss the current market environment and its impact on the reactions to the current round of reports and long-term price targets.

The market has been in a corrective phase that has accelerated in the past week.  Major stock market averages are down between 10% and 20% so far this year.  Looking at our screens every day, we can state confidently that the averages understate the damage. Breadth has been terrible and outside of energy, commodities, and some consumer staples, we are in a bear market.  Many widely held stocks are down between 30% and 70% over the past six months.

Our initial 2022 stock market outlook stated that we expected a below average year, and thought there was greater chance for a significant decline than material upside.  Unfortunately, so far, the downside has developed.  We correctly anticipated the market would struggle with the shift in monetary policy at the Federal Reserve and global central banks.  Even before the war in Ukraine, the Fed appeared to be tightening policy faster than expected creating negative sentiment among investors.  The war accelerated inflation and in response the Fed is now tightening aggressively.  On a big picture basis, this has led to a compression in the overall stock market multiple from about 21 times to 19 times 2022 estimated earnings.  Future earnings are less valuable when discounted at higher current and projected interest rates.  Investors also have less confidence in economic growth and earnings projections as they are beginning to fear a recession.  These factors lead to lower P-E ratios or other valuation metrics and can also lead to lower earnings estimates.

Alphabet (GOOG) shares peaked around $3,000 and the company is expected to have earnings of $125 per share in 2022.  A 2 multiple point drop in GOOG’s P-E ratio is worth $250.  The shares are down about $700.  What accounts for the other $450 decline?  It is not lower earnings as GOOG estimates have barely changed even with the negative reaction to yesterday’s earnings reports discussed more below.  Instead, higher interest rates heavily impact growth stocks where future earnings are discounted many years ahead.

Facebook (FB) shares are down about 50% from 2021 all-time highs, much worse than GOOG.  The same factors hurting GOOG shares flow directly to FB – market and growth stock multiple compression.  FB also has hit a tough patch in growth with earnings estimates for 2022 falling about 30% due to lower projected revenues and higher costs.  FB shares not only saw multiple compression, but the lower multiple is on a much smaller level of earnings.

With this as background let’s look at the companies that have reported thus far.

IBM (IBM):  IBM reported a second consecutive strong quarter, once again surprising on the upside for revenue growth.  As recently as Thanksgiving, IBM shares traded at just 11 times 2022 estimated earnings, barely half of the average stock’s multiple.  The depressed valuation was due to years, even decades, where the company barely grew and lost market share as it missed the technology transitions underway.  We identified IBM as undervalued following the company’s acquisition of Red Hat which we thought would serve as the foundation for the company to start growing again within markets for cloud computing, consulting, and software.  IBM continues to maintain a large installed base of corporate clients.  Now, rather than lose market share, the company can offer its own products and services that not only replace lost legacy revenues but create new growth potential.  A new CEO who was the main proponent of the Red Hat acquisition and the spin off of a declining business unit adds to the IBM story.  The company is just beginning to build investor confidence in forecasted mid-single-digit revenue growth.  The company exceeded this level in 1Q22 and raised revenue guidance for 2022 to the top end of its prior range.  Margins and free cash flow are still seeing a little pressure but should follow if revenue trends are sustained.  If investors gain confidence in these measures, IBM’s multiple can expand.  It already has with the shares up over 20% from Thanksgiving and up about 2% this year against significant declines for the market and many other technology stocks.  We still think the shares can reach $160 based on a P-E of just 15 times 2023 earnings estimates.  Keep in mind the stock has a dividend yield of 5% and Northlake clients received a special dividend worth over $5 per share in the spin off completed earlier this year.

Alphabet (GOOG/GOOGL):  GOOG shares are down another 3% after reporting 1Q22 results but have rebounded from a decline of about 6%.  The earnings report was fairly good.  Revenues, operating income, and EPS all at least matched estimates adjusted for unusual or one-time factors like a write-off in the company’s investment portfolio.  The company’s largest business in Search grew 27%, a remarkable rate for a business so big.  Factors troubling other digital adverting companies like Apple’s privacy changes and macroeconomics have had little impact on Search so far.  YouTube has struggled and fell short of estimates for the second straight quarter.  It is not clear what is causing the slowdown at YouTube, with growth having declined from the upper 20% range to the mid-teens.  Investors are very concerned by the YouTube shortfall, and this is the primary reason for the stock’s decline in response to the earnings.  Two other factors are hurting the shares.  First, expense growth is set to accelerate as the company begins to invest in growth opportunities.  COVID held back these investment initiatives.  Second, revenue growth faces its most difficult comparison in 2Q22 vs a gain of 62% in 2021.  Overall growth at GOOG will be in the mid-teens next quarter.  Growth stocks always struggle when revenue decelerates. Despite the near-term investor concerns, Northlake remains bullish on GOOG.  The stock trades at a P-E of 19, about equal to the market but even mid-teens growth is two to three times the average stock.  We value GOOG shares on EBITDA.  Previously, we used a multiple of 15X.  If we lower that to 12X in light of the overall market multiple compression and the added pressure applied to growth stocks, we get a target of $2,925, up 25% from current levels.  GOOG remains one of our favorite stocks.

Sony (SONY):  SONY reported good results but has since seen its shares crushed from around $120 to $85.  Two factors are at work.  First, the yen has collapsed vs the dollar, declining by almost 20%.  This pressures SONY’s yen-reported results and dollar-equivalent trading price in Tokyo.  Second, Microsoft’s pending acquisition of Activison Blizzard is perceived as a threat to Sony’s industry-leading PlayStation video game platform and tightly integrated PlayStation network and first party published games.  We recently added SONY shares to build larger positions in many client accounts.  We see little threat to PlayStation given Microsoft’s incentives and likely regulatory concessions to get the deal approved.  SONY’s other business units including filmed entertainment, image sensors, and music are all performing well.  The yen-based dislocation in the shares has created exceptional long-term value.  Our previous target was $155.  We have barely touched our yen-based estimates but the weakness vs the dollar lowers our target to $127, up almost 50%.  Ultimately, we expect the yen to strengthen, providing further upside.

Activision Blizzard (ATVI):  We are holding ATVI shares anticipating that Microsoft’s acquisition of the shares at $95 will be approved in 2023.  ATVI’s earnings are really struggling with a sharp slowing in growth for its Call of Duty and World of Warcraft franchises.  King mobile games continue to exceed expectations.  Earnings estimates have fallen sharply and the shares would probably trade in the $40 to $50 range vs current levels in the upper $70s without the Microsoft takeover.  One positive is that current game development is back on track with major games in both key franchises coming later this year and throughout 2023.  Despite the poor results and weak 2022 earnings expectations, we are holding ATVI shares due to our view the acquisition will be approved.

T Mobile USA (TMUS):  TMUS 1Q22 results and outlook were a bright spot in a thus far bleak reporting season for telecom, media, and technology.  Results exceeded expectations for subscriber, revenue, and income growth.  Free cash flow matched investor estimates.  Management raised guidance for all important financial and subscriber estimates.  The integration of Sprint is just about complete and, as promised, results are accelerating. Concerns remain about the potential for slowing growth in wireless telephony, but TMUS is well insulated in that it happens to be a share gainer vs. AT&T and Verizon.  A major catalyst lies ahead when the company announces the start of a massive, multiyear stock buyback program.  We are maintaining our $150 target for TMUS, based on 2023 estimates that represent full realization of Sprint synergies.  The share buyback adds a lot of upside leverage to the stock price as we look long-term to 2024 and beyond.

IBM, GOOG/GOOGL, ATVI, TMUS, and SONY 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.

Activison Buyout Bails Out Weak Near-Term Fundamentals

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Since we last published on Activision Blizzard (ATVI), the company agreed to be purchased by Microsoft for $95 per share in cash.  The deal is expected to receive heavy scrutiny by regulators and Microsoft has suggested a deal close in mid-2023.  The $95 buyout price is above our target of $90, which we had lowered from $115 following the problems ATVI ran into involving personnel and human resources issues.  We had also suggested that achieving the new target would take time as ATVI worked though its issues, so a $95 deal price in 2023 is not too far off the reality if regulators approve the deal.

ATVI shares are trading just above $80 after rallying slightly in the last few days.  The discount to the $95 buyout price is significant and suggests investors are concerned that the deal could be blocked.  Depending on what price you assume ATVI would trade at without a deal, the current price indicates only about a 50/50 chance of regulatory approval.  We think that is too pessimistic.  Regulators will look at this deal from a horizontal and vertical perspective.  Horizontally means analyzing Microsoft’s market share when combining its own video game publishing efforts with those of ATVI.  Given many very large competitors including Sony, Take Two Interactive, Ubisoft, Tencent, and Electronic Arts, we see little to worry about from this perspective.  Vertical integration is where the deal could get tripped up as Microsoft controls one of the two major online platforms outside of China for distributing and playing traditional published video games.  Sony owns the other platform.  The concern would be that Microsoft could restrict competition by limiting the new games it is acquiring from ATVI to its own platform.

ATVI owns just a few massive games including its Call of Duty and World of Warcraft franchises.  Each franchise is among the most popular games in the world.  Call of Duty is particularly popular on Sony’s Playstation platform.  In Northlake’s opinion, it would be idiotic for Microsoft to restrict Call of Duty to its own platform and walk away from over half of the current revenue the game provides.  Microsoft will surely offer assurances to regulators that it will not restrict distribution of its newly acquired games for a period of at least several years.  Whether this will be good enough for the new regulators at the FTC that were recently appointed by President Biden is where the questions lie.  The Biden administration is clearly looking to regulate major tech companies much more and it is politically popular to do so.  The new regulators have been vocal in their desire to crackdown on major tech mergers and have indicated less interest in approvals with conditions such as an agreement by Microsoft to not restrict distribution.  Microsoft would likely go to court if regulators block the deal and the court rulings allowing the merger of AT&T and Time Warner set a very favorable precedent for Microsoft to win.

ATVI reported weak 4Q21 results with terrible performance from the new Call of Duty game and weakness at World of Warcraft.  There had been fears that the controversies enveloping ATVI would hurt game development and lead gamers to punish the company by avoiding its games.  These fears appear to have been well placed.  The outlook for ATVI’s earnings over 2022 and 2023 fell by about 10% although the company did outline an ambitious plan to reinvigorate growth. 

The downside in the shares without the deal might be around $60 against upside to the $95 deal price.  With the stock at $80 this presents a mixed risk-reward tradeoff.  Thus, we will hold ATVI shares now as there is virtually zero initial downside since regulatory review has not even begun.  Should we find a new idea to add to client portfolios, it would have a better risk-reward tradeoff, so ATVI is a likely source of funds over the next few months.

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.