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Media Talk

3Q23 Earnings Updates: Part One – GOOG/GOOGL, TMUS, META, IBM, and VICI

Alphabet (GOOG/GOOGL): GOOGL reported mixed results for 3Q23.  The two dominant businesses, Search and YouTube, had better-than-expected revenue growth as advertising accelerated ahead of high expectations.  On the downside, Cloud revenue grew more slowly than expected, up 22%, with management alluding to cloud spending optimization that has previously tripped up Microsoft Azure and Amazon AWS, the two leading cloud players. Upside in Search and YouTube revenue more than offset the shortfall at Cloud, but higher than expected growth in operating expenses led to a small miss vs. consensus operating income.  GOOGL shares are down 9% following the earnings report.  Despite the sharp negative reaction, Northlake does not see the quarter as having structural implications to a positive long-term investment thesis.  However, the shares may struggle to regain momentum in the near-term.  GOOGL shares have long been highly sensitive to trends in operating expenses and operating profit margins.  With concerns industrywide about elevated operating expenses and capital spending necessary to activate AI upside, the timing of a margin and operating income miss is poor.  Investors had been anticipating upside to 2024 EPS at GOOGL.  Despite higher revenue estimates at Search and YouTube after the strong 3Q23, the combo of lower Cloud revenue forecasts and slightly lower profit margins has taken upside to 2024 estimates off the table for now.  We think upside is still possible but the shares will be in “prove it” mode for the time being.  Importantly, management remains committed to operating margin expansion (revenue grows faster than expenses), headcount growth is moderate, and a reimagining of the company’s cost structure for efficiency remains in place.  GOOGL profit margins have expanded greatly since 2019 when investor concerns about expense growth were also high.  The management team has credibility on profit margins and should be able to balance the added investment related to AI thanks to better-than-expected growth in Search and YouTube, which together generate 70% of company revenues.  The shares remain reasonably valued at 11X 2024 slightly lower 2024 EBITDA estimates and trade at a small discount to their historical multiple with sustained growth ahead in key businesses and the potential of AI to open large, new revenue opportunities.

T Mobile USA (TMUS): TMUS reported solid 3Q23 results and modestly raised guidance for subscribers, EBITDA, and free cash flow.  The shares are holding up well on a tough day for the market after rallying sharply over the past week following good earnings reports from peers AT&T and Verizon.  Importantly, despite intense competition in wireless – including cable companies – and seemingly full penetration of the population, industry growth remains positive and the promotional environment is tough but stable.  The Sprint acquisition is now fully integrated with cost synergies achieved ahead of projections.  The network now reaches 300 million people, a goal that has been achieved a year ahead of schedule.  Excess capacity acquired thru Sprint has allowed TMUS to build a large wireless broadband business that competes effectively with cable broadband.  Wireless broadband appears to be an enduring business despite initial skepticism it was a temporary, low-capability, low-priced solution similar to DSL.  Wireless broadband is also bringing many new customers to TMUS that can be upsold wireless phone plans.  TMUS is now every bit a peer of AT&T and Verizon in terms of subscribers and churn.  The TMUS network is fully 5G and the best in the industry.  One area where TMUS lags its peers is in operating profit margin.  TMUS margin has steadily improved to 50% but remains below the 55% level at AT&T and Verizon.  As the company closes the gap, revenue growth in the low to mid-single-digits will translate into high single-digit growth in EBITDA.  Free cash flow will rise faster as capital spending on integrating and building out the networks peaks this year.  In contrast, AT&T and Verizon are barley growing each of these financial measures.  Following the completion of cost synergies, a surge in subscribers and market share, TMUS fundamentals reflect industry leading growth in subscribers, financials, and capital return (dividends and share buybacks).  The next few years should see TMUS maintain leadership.  We expect an upward trend in the shares to resume and still see potential above $180 as the company continues its superior execution.

META Platforms (META): META reported good 3Q23 results.  However, following the mixed report from Alphabet, investors were in no mood for any controversy.  Guidance and the commentary surrounding it provided the controversy and the shares pulled back sharply.  We think this is mostly manufactured controversy in a bearish tape and remain very positive on the outlook for META shares over the next year.  As noted, 3Q23 was clean beat on revenue and profits.  Furthermore, guidance for 2024 operating expenses and capital spending was a positive surprise.  Both will return to growth but well below the bearish fears heading into the report and a clear sign that management’s 2023 Year of Efficiency is becoming part of the corporate DNA.  This is extremely bullish on a long-term basis.  The controversy surrounded a wider range for 4Q23 revenue growth and the potential implications for 2024.  The wider range came about due to a drop in the lower end of the growth rate.  Management noted there was some volatility at the outset of the war between Israel and Hamas although the choppiness has since stabilized.  Management also called out the recent large contribution to advertising growth from Chinese ecommerce retailers, Shein and Temu.  Most of this strength is outside the U.S., especially LatAm, but investors are worried it creates a tough comp in 2024 amid the deteriorating relationship between U.S. and China.  Concern about the top line in a confusing macro environment has taken away the upside to 2024 that many investors previously expected. EPS estimates are pretty stable at $17-18 for 2024 but there had been hope $20 could be achieved.  Northlake still thinks $20 is possible next year and even at $17 the shares are inexpensive at a P-E of 17X.  Most importantly, the new culture at META focusing on efficiency protects EPS if the macro environment proves a headwind and warrants a higher P-E on a long-term basis.

International Business Machines (IBM): IBM reported better-than-expected 3Q23 results.  Revenue, EPS, and free cash flow each were better than consensus expectations.  Free cash flow is especially important as it is an important metric that investors are focused on for IBM, as it reveals the quality of the company’s renewed earnings growth.  The shares responded very positively in a lousy market.  We have three takeaways from IBM’s latest results.  First, management is building credibility by adding another positive quarter.  Second, the company is a real player in AI as it builds on its early entrance in AI via the well-known Watson.  Management noted IBM has booked hundreds of millions of dollars in AI revenue.  Third, despite a shortfall in revenue growth for the Red Hat software business that has been largely responsible for the company’s turnaround, investors still bid up the shares aggressively.  IBM shares are getting more notice with multiple new buy recommendations from analysts who previously did not follow the stock.  IBM has made good acquisitions, including Red Hat, and divested its slow-growth businesses.  Red Hat remains a growth driver with a good explanation for the slower growth in 3Q.  Watson looks like it can drive a second new growth angle in AI.  The shares remain inexpensive at 14X 2024 earnings and 4.7% dividend yield.  We have waited awhile for the turnaround at IBM to be rewarded by investors.  The high dividend and a one-time spinoff we monetized has provided return while we have been patient.  If the company keeps stacking good quarters driven by growth in software and AI, it is only a matter of time until a bigger reward is achieved as the P-E multiple expands to reflect the company’s renewed growth.

VICI Properties (VICI): VICI had another quarter of good execution in the extremely predictable business of owning casino real estate and receiving inflation-adjusted rent payments from leading casino operators like Caesars Entertainment and MGM Properties.  Revenue and Adjusted Funds from Operations (AFFO) both came in slightly higher than expectations.  AFFO is the metric REITs focus on in lieu of EPS.  It represents cash that must be mostly paid out as dividends.  VICI has been built through large acquisitions of casino properties like Caesars Palace, Bellagio, and many regional casinos in states all over the country.  Recently, the company has been entering new real estate markets in what it refers to as “experiential real estate.”  In the third quarter, the company announced several transactions in this area including acquiring a chain of bowling alleys (yes, bowling remains popular and is attracting capital from large businesses) and wellness centers as it expands its relationship with Canyon ranch.  VICI also continues to acquire more casino properties but most recent transactions have been small.  One criticism of VICI’s prospects could be that fewer large transactions are available that can drive the outsized growth the company has enjoyed in the last ten years.  This might be fair but ignores management’s effectiveness at combining many small deals equivalent to a larger deal and the fact there is less risk in smaller deals.  VICI shares have been under pressure as REITs trade mostly on dividend yield and the sharp rise in interest rates makes REITs less attractive.  We are happy to wait for the next leg up in VICI that will be driven by stable or lower interest rates and continued superior execution driving growth in AFFO and dividends.  We see the shares returning to at least the mid-$30s over the next couple of years, providing a low-risk, double digit annual return.

GOOGL, TMUS, META, IBM, and VICI 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.

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