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.