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.

Riding a New Horse in Wireless

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We are calling an audible on our 2021 purchase of AT&T (T).  We have sold the shares and reinvested the proceeds into T Mobile USA (TMUS).  We still see value in T shares.  However, we see more upside in TMUS.  Furthermore, we see the TMUS story playing out over a multiyear period vs. AT&T being a fixer upper over the next year.  Northlake has typically used a buy-and-hold approach with individual stocks, often holding investments for five years or more.  Finally, we think the positive fundamental investment thesis we see at TMUS has more visibility than the positive outlook we have for T.  The bottom line is we believe TMUS offers more upside at a higher degree of confidence.

Given our interest in cable and telecommunications, we have followed TMUS closely for many years.  The company’s rise as an insurgent from third or fourth in wireless to a market leader and full peer of AT&T and Verizon has been very impressive.  TMUS shares were trading at just $15 back in 2013 and are up 757% since then.  Verizon shares have a total return of 60% over the same period, while AT&T is up only 5%.  AT&T and Verizon have paid out healthy dividends, while TMUS does not pay a dividend but investors have clearly recognized the superior growth profile and operating execution at TMUS.

The next phase of the TMUS story is just getting started.  Following years of market share gains as the Uncarrier that made TMUS a strong #3 in wireless and produced superior earnings and free cash flow growth, the 2020 acquisition of Sprint made TMUS a full peer of AT&T and Verizon.  Subscriber counts and geographic coverage moved to parity and TMUS emerged with a stronger spectrum position concentrated in the most efficient mid-band range.  TMUS is able to offer 5G broadly today, while AT&T and especially Verizon had to spend heavily on new spectrum just last year.  The spectrum was extremely expensive and Verizon will not have it fully online for nationwide 5G for another year or two.

While TMUS’s improved and arguably superior competitive position has been evident for a couple of years, the real payoff is about to occur when earnings and free cash flow explode higher.  The integration of Sprint has been a massive job and not without hiccups.  When we bought T shares last July, TMUS was trading around $150 vs. our new purchase price of $121.  Much of that decline was due to higher-than-expected churn within the Sprint customer base.  In its 4Q21 earnings report issued in January, TMUS made clear that churn had peaked and what happened in 2021 was just an acceleration of their internal forecast.  With the combined subscriber base now well established (and still dominating industry growth), attention turns to the final step of the billing integration that should be completed in mid-2022.  At that point, free cash flow will flow as massive cost synergies exceed their hefty cost to capture.  Consensus forecasts call for TMUS free cash flow to rise from $5.6 billion in 2021 to $13.5 billion in 2023.  Management has long promised a huge stock buyback program in 2023.  The confident tone from management on the 4Q21 conference call about churn and net synergies give us confidence that the buyback will arrive ahead of schedule later this year. 

We think the buyback announcement will be a big positive catalyst for TMUS shares.  In addition, with the Sprint integration almost complete, we expect the next couple of quarterly reports to mimic the positive results seen in the 4Q21 numbers.  The earnings reports should improve sentiment toward the shares with the buyback still to come. 

We believe TMUS shares have upside to $150 this year, a gain of 25%, based on 8X EBITDA and recognition of the 2023 free cash flow.  Once initiated, the buyback should be large and ongoing.  TMUS could easily buy back half or more of the stock float (Deutsche Telecom owns over 40% and is not a seller) from 2023 through 2025 while maintaining a healthy balance sheet.  We have four decades of experience investing in stocks that offer above average organic growth, large and growing free cash flow, and material share buybacks.  The payoff has always been superior.  Perhaps this time is different, but we think the recent collapse in the stock of unprofitable growth stocks suggests this tried-and-true approach to creating shareholder will once again be in vogue.

TMUS 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. 

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.

Explaining Income Equities

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Beginning this quarter, we are adding a new blog post to cover the income-oriented stock and ETF ideas we have been increasingly using in client portfolios.  Not all clients use these investments, but we have broadened their use, so we thought it would be useful to produce summary commentary each quarter.

Up until 2020, most of the high-dividend paying stocks and equity ETFs had been purchased as bond substitutes.  Even prior to COVID, interest rates were at historically low levels that we found unattractive for long-term investment.  Northlake used stocks like Verizon (VZ), MGM Growth Properties (MGP), and Lamar Advertising (LAMR), and ETFs such as iShares Select Dividend (DVY).  These stocks and others served clients very well for many years.

Post the market collapse in March due to COVID, interest rates on money market funds have remained near 0% and the Ten Year US Treasury bond yield fell well below 1%.  Northlake made the decision to invest conservatively in 2020 due to the unusual risk surrounding COVID and the election.  We sold a lot of securities, and when we decided to begin reinvesting we saw high-dividend paying stocks and ETFs as a conservative alternative given our continuing concerns about the market.

Aside from credit quality, the primary risk for these investments is a sharp rise in interest rates.  Given the Federal Reserve and other global central banks clear guidance that they will keep interest rates low until the economy has moved well beyond the pandemic, we see little risk of significantly higher interest rates in the next few years.  A spike in inflation caused by excess monetary and fiscal stimulus could push rates higher, but we feel disinflationary trends from technology and the maturity of the U.S., Japan, and European economies makes sustained higher inflation unlikely.

Since the March stock market low, we have added to client holdings in DVY and Verizon and continue to own Lamar Advertising.  We substituted VICI Properties (VICI) for MGP and other high-dividend payers that we sold in March.  VICI was also added for a broader group of clients.  We also added two preferred stocks to our high-dividend portfolio, GCI Liberty (GLIBP) and Qurate Retail (QRTEP).  Each of these preferred stocks is part of Liberty Media, which we know well and have followed closely for 30 years.

VICI is a real estate investment trust closely tied to Caesars Entertainment.  The company acts as Caesars financing arm when real estate is sold but Caesars continue to manage and operate the property.  For example, VICI owns Caesars Palace, and Caesars Entertainment pays VICI under a long-term lease for the right to operate and manage the property.  VICI owns around 30 different casino gaming properties around the country.  Most are operated by Caesars Entertainment, but several other casino operators also have leases with VICI. There are two key aspects to our investment thesis on VICI.  First, despite the COVID lockdowns last spring, VICI received 100% of the rent payments it was due across its entire portfolio.  This speaks to the quality of the company’s cash flow used to pay dividends.  If COVID could not hurt VICI, it is hard to see a scenario that would impact the dividend.  Second, there remain many quality gaming properties throughout the United States still owned by the operators.  VICI has more opportunities with Caesars and we expect continued diversification to other operators.  VICI shares yield 5% and we think the company can sustain mid-single digit growth in dividends through rent escalators and more property acquisitions.  Northlake expects an attractive total return of 10% annually in a low interest rate environment with many unusual economic and market risks.

GLIBP and QRTEP are more like bonds given the fixed nature of their payments and maturity dates.  We see both stocks as a way for client accounts with a need for conservative investments to earn current yields well above money market and bond interest rates.

GLIBP is tied closely to Liberty Broadband (LDRDA) and Charter Communications (CHTR).  The primary support for GLIBP’s dividend payment is the GCI Liberty and LBRDA ownership of Charter Communications ownership of about 30% of CHTR.  CHTR is the second largest cable broadband company in the US and produces growing and stable free cash flow.  GLIBP pays an annual dividend of $1.75 for a current dividend yield of 6%.  The preferred matures in 2038.  Shares were purchased around $25 and now trade at $28.

QRTEP pays an $8.00 annual dividend which equates to a current yield over 8%.  The preferred matures in 2031.  Qurate Retail owns and operates QVC, HSN, and Zulily.  QVC and HSN have morphed from pure home shopping TV networks to ecommerce retailers with over half of current business done online.  We believe the 8% yield outweighs the risk of competition from Amazon and other ecommerce giants.  Qurate is growing, and the business produces very high free cash flow to support the QRTEP dividend.  Shares were purchased in the low-to-mid $90s and now trade at $99.

GLIBP, QRTEP, VICI, LAMR, 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.