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 16^th 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.