SONY Corporation (SONY): SONY reported a good quarter with modest beats on operating income driven by profit margins.  The company passed through a portion of the beat to its full-year operating income forecast.  Often companies that only pass through a portion of an earnings beat are penalized, but that usually does not apply to SONY due to the very conservative corporate culture.  In fact, analyst estimates for the company’s FY22 (ends 3/31/23) were slightly above the revised guidance in anticipation of the management’s usual practice of guiding conservatively.  Upside in the quarter came from the all-important video games businesses along with financial services.  In the games segment, upside was driven by better-than-expected sales of PS5 gaming machines and first-party software sales.  PS5 has been in high demand and supply constrained since it was introduced over a year ago.  There is plenty of room left to fulfill demand.  The upside in sales of Sony’s own video games is especially encouraging given weakness in game sales at competitors Electronic Arts and Ubisoft.  Sony has a history of timely releases of critically acclaimed games.  The upside in financial services is less meaningful as investors value the segment at cheap multiple.  Nonetheless, the upside is real in earnings and cash.  The company’s other important divisions are Pictures, Music, and Image Sensors.  Pictures performed well even though results plunged over 80% comparing against the massive all-time top 3 Spiderman film a year ago.  Music continues to show consistent growth driven by expanding streaming services and new outlets like Tik Tok and Peloton that heavily incorporate music into their service offerings.  SONY shares have rebounded well, up 50% from the lows reached last October.  We are making minimal changes to our valuation model and continue to see the shares worth at least $120 based on the fact that the stock trades at a discounted valuation to standalone peers in Music, Pictures, and Gaming.

Meta Platforms (META): Including the 22% jump in response to the company’s 4Q22 earnings report, META shares have doubled in just three months.  The shares bottomed in early November following an awful 3Q22 earnings report that contained initial guidance for a $10 billion jump in each of operating expenses and capital spending.  These increases came against the backdrop of the company’s first-ever revenue declines and the name change accompanied by a commitment to spend tens of billions on the company’s metaverse strategy.  Like many investors, we were stunned and lost confidence in management.  In our last META commentary, we noted that the conference call was one of the worst we had ever heard and questions about the company’s long-term viability as a growth company were legitimate.  Fortunately, we noted “the company still maintains a massive and highly effective advertising reach.  Arguably, the best in the world besides Google search. We may admit defeat…we want to let the dust settle first and evaluate in a less emotional, lower volatility environment.”  Fortunately, we remained patient and the stock has recovered a substantial portion of the losses incurred in 2022.  To put the recent management guidance in perspective, in October, management provided a forecast for operating expenses and capital spending to each rise $10 billion in 2023 so the company could invest in artificial intelligence and the metaverse.  Later in the fourth quarter, management began to win back investor confidence when it lowered its forecasts for each area by $1-2 billion.  Along with its 4Q22 report, management again lowered guidance on these two items by another $5 billion and $4 billion.  Given history, the company is likely to end up at the lower end of the new guidance ranges.  Should that occur, the original operating expense increase of $10 billion will end up at less than $1 billion.  For Capital spending, the original increase of $10 billion will be closer to $3 billion.  The financial impact of the updated guidance is massive.  In October, we noted that earnings estimates would be almost cut in half and free cash flow would have dropped by one-third.  Now, it looks like earnings estimates are only down modestly from where they existed prior to the horrible October earnings report and guidance.  More importantly, the abrupt change to management’s approach to the business has restored confidence in the company’s long-term earnings and cash flow power.  With financial management discipline now a mantra from Mark Zuckerberg, the company’s strength as an advertiser in terms of reach and effectiveness can be more highly valued by investors.  Furthermore, the company faces easier comparisons by lapping privacy changes made by Apple at the same time that internal investments in artificial intelligence are restoring much of the lost signaling forced by Apple.  There is even good news on newer revenue drivers with Reels engagement and monetization improving and new services like click-to-message producing material revenues.  This is all a long way of saying that despite the huge rally in the shares since November including the recent massive gain, we still see upside for META as long as the economy avoids a more severe recession.  Based on P-E or EBITDA, we think the shares can push over $200 in the near term and if the improved trends are evident in coming quarters, much higher targets are achievable.

Apple (AAPL): AAPL reported weaker than expected results for the company’s 1Q23.  Investors were not particularly concerned since (1) most of the weakness was related to COVID shutdowns at the company’s Chinese iPhone supplier, and (2) comments from management suggested demand remained strong.  Management indicated iPhone revenues would have been up year over year if they had been able to meet demand.  Furthermore, despite a shortfall in revenues, gross margins were at least as good as expected.  Looking ahead, management indicated that some of the lost sales should be regained in the March quarter with gross margins holding at elevated levels ahead of street expectations.  Beyond iPhones, iPads had their highest revenue quarter in since the December quarter of 2013 and services sustained positive growth despite the lost iPhone unit sales.  For now, macro weakness seems to be impacting Apple less than most other technology companies providing hope that if a deeper recession occurs, the company’s financial results can hold up relatively well.  Apple has emerged as a defensive stock thanks to strong business fundamentals, market share gains, high free cash flow, a stellar balance sheet, and shareholder friendly capital allocation (buybacks and dividends).  While the shares look expensive at over 20X earnings for moderate growth, the valuation seems likely to stay elevated, similar to other defensive stocks such as consumer staples.  In past quarterly updates, we have noted that we do not see a lot of upside for Apple shares.  We still think that is the case but are willing to hold the stock due to the all-around quality of the company.

Alphabet (GOOG/GOOGL): GOOG reported a rare across-the-board miss in 4Q22.  Led by YouTube, revenues fell short across the board, although Search did hold up better than digital advertising peers.  Profit margins fell short as well, as the company has been less aggressive than other tech companies about layoffs and other cost saving actions.  As with Apple, most of challenges the company is facing are macro-oriented representing economic weakness and digestion of the excessive surge in revenues during COVID.  GOOG is facing a secular challenge from artificial intelligence, specifically ChatGPT’s ability to effectively answer many search inquiries.  Despite the earnings shortfall and AI challenges, management was upbeat on the conference call.  Management discussed a company-wide efficiency initiative that, while lacking in specifics, was a change in tone from a company noted for its high spending ways.  This discussion was led by CFO Ruth Porat, who made a big difference improving the consistency of the company’s financial performance when she was hired in 2015.  The goal is to get revenues growing consistently faster than expenses with 2024 targeted as first evidence.  On AI and ChatGPT, management noted that they are already the leader and AI is used throughout the company to help clients and improve service offerings.  Also noted was that the company has a direct competitor to ChatGPT that will roll out later this year and be integrated into the core Search offering.  ChatGPT poses a threat to Google Search since any market share gain takes away Google’s highest-margin and steadiest growth revenue.  For now, investors are penalizing GOOG by lowering the forward multiple of earnings.  We are hopeful the company is up to the challenge but it likely will be several quarters before the company can show investors and clients the effectiveness of its AI products and services.  The next few quarters are also likely to show continued pressures on growth in the core digital advertising services due to macro pressures and the COVID reset.  Northlake takes long-term view of its investment strategies and individual investments.  GOOG remains attractive on a multiyear basis assuming the AI challenge is met effectively.  The shares are inexpensive, trading about 20% below their historical valuation.  We are holding GOOG but for the first time in years have a few questions.

Activision Blizzard (ATVI): ATVI reported a very good 4Q22 exceeding analyst estimates comfortably.  AVTI was the only major video game publisher to produce a strong 4Q22 report.  Closest peers Take Two Interactive, Ubisoft, and Electronic Arts each reported disappointing results.  Amid weak earnings reports from competitors, only ATVI is seeing 2023 estimates move higher, while the others face estimate cuts.  For ATVI, this is a huge turnaround.  In September 2019, ATVI shares plunged after the company was accused of serious mistreatment of employees.  The publicity led to a backlash by gamers and company employees, including those developing ATVI’s games.  Lost sales on current games and delayed and potentially imperfect future game releases became important risks to the stock.  Thanks to the surge in gaming during the stay-at-home period of the pandemic, ATVI shares recovered until the summer of 2021 when the employee issues again grabbed investor attention and fears grew about the all-important upcoming holiday release of Call of Duty, ATVI’s most important franchise.  Those fears proved true a couple months later when the company slashed earnings estimates on weak performance of 2021’s Call of Duty game.  The decline in the stock was short-lived, however. In January 2022, Microsoft announced an acquisition of ATVI for $95 per share, well above the $60 low the shares had recently reached.  From the moment the acquisition was announced, there was a high level of skepticism about gaining regulatory approval.  Since then, ATVI shares have mostly traded in the $70s, a big discount to the acquisition price.  The U.S. recently sued to block the merger and it is expected the U.K. will soon announce its opposition.  Analysts think there is about a 50/50 chance that Microsoft can fight the regulators in court or make enough concessions and gain approval.  Investors appear to believe the acquisition is doomed as ATVI shares are trading only modestly above their likely level if the deal were scrapped.  Importantly for ATVI, the company will receive a $3 billion breakup fee ($4 per share) from Microsoft in the event the deal does not go through.  This history is important now that ATVI’s earnings power and growth outlook is back on track.  With 2023 EPS projected at $4, ATVI shares trade at about 18X earnings.  Closest peer Electronic Arts trades at about 17X earnings.  We think ATVI deserves a premium multiple to EA due to the strength of its key console and mobile franchises, but in a deal break scenario if ATVI shares traded to EA’s valuation the downside is in the mid-to-upper $60s.  Against even a slim possibility the deal is approved at $95, this creates a nice risk-reward tradeoff for ATVI shares — $8-10 downside vs. $20 upside.  ATVI management operated with less scrutiny in the last year while the acquisition has been pending.  The time was well spent as the company settled the employee issues, focused on its most important franchises (Call of Duty, World of Warcraft, Overwatch, Candy Crush, and Diablo) and released critically acclaimed games that have sold very well.  Historically, when business fundamentals were on track, ATVI and other video game company shares traded above 20X projected earnings.  If ATVI reached 20X current 2024 earnings estimates, the shares have upside to around $90, almost reaching the acquisition price and further supporting the attractive risk-reward tradeoff in the shares.  Northlake plans to hold ATVI in client accounts.

Walt Disney Company (DIS): DIS reported better than expected 1Q23 results.  This was a welcome relief after last quarter’s terrible results, but is less important toward the long-term attractiveness of DIS shares than the new corporate strategy outlined by Bob Iger in his return to the CEO spot.  Iger referred to the new strategy as a “transformation.” The key components were (1) a new organization structure that puts content distribution decisions back on the people who created the work, (2) an incremental $1.5B in cost cutting partially enabled by the new organization structure, (3) a renewed focus at Disney+ on the company’s major franchises leading to a $3 billion reduction of projected general entertainment content spend beginning in 2024, (4) moving ESPN to its own reporting segment and committing to owning it for the foreseeable future, and (5) reinstatement of a modest dividend intended to grow over time as the new strategy drives future profitability and cash flow. Like Netflix, Disney is moving away from providing subscriber guidance.  The focus for streaming is on reaching the previous goal of profits by the end of 2024 and profitable growth thereafter.  It appears that management believes that Disney+ already has sufficient subscriber scale and global reach such that it can forgo general entertainment content and focus on the key franchises including Marvel, Star Wars, and Disney/Pixar animation.  A recent price increase at Disney+ led to minimal churn, likely enforcing the idea that company could stay focused and spend less on content and marketing ultimately driving profitable growth.  Like any major corporate strategy shift, risks exist.  Iger’s history and well-earned reputation allows the company to handle any pushback regarding costs cutting and the announced 7,000 job losses.  Theme Parks are booming and show no signs of slowing, providing a profit push for the corporation while 2023 and 2024 allow the corporate transformation.  There has been a little pushback on the strategy regarding how much of cost savings are incremental and drive future earnings power above previously existing earnings estimates.  It is true that many of the costs saves are at streaming yet the company did not update its forecast for streaming to show profits late in 2024.  We have little concern on this front as the stock is already attractive on EPS estimates of over $5 in 2024 and over $6 in 2025.  In Northlake’s opinion, the issue had been a low confidence level in reaching those figures.  We think the new strategy likely improves earnings power beginning in 2024 but improved investor confidence should lead to a higher multiple in the near term.  Looking out, we see DIS shares returning to at least the $130s although timing is tricky given 2023’s transition to the new strategy and the uncertain economic outlook.  We strongly believe the company and stock are back on track, investor sentiment has turned, and the bottom is in short of a more severe recession.

SONY, META, AAPL, GOOG/GOOGL, ATVI and DIS 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.