Selling Charter and Buying Disney

I just completed a swap of all Northlake client positions in Charter Communications (CHTR) into Walt Disney (DIS).

CHTR shares have been strong the last few days on takeover rumors. The stock had fallen sharply last week after Time Warner Cable (TWC) announced poor earnings and guidance. GHTR takeover rumors appeared before the Liberty Global (LBTYA/LBTYK) buyout of Virgin Media (VMED) but surely a big deal in cable, even if it was in Europe, helped the takeover rumor gain traction. The only article I found regarding the rumor was on deadline.com which referenced a freeze in expenses at CHTR in conjunction with a move of the company's headquarters to Connecticut, close to the new CEO, Tom Rutledge. I like Rutledge and think he has the chops to create a lot of value at CHTR. However, I think it is way too soon for him to consider selling the company. I know that is not totally in his control but it just seems an odd thing for the Board to consider after bringing him in and launching an aggressive growth strategy with higher investment in marketing to attack CHTR's underpenetrated markets in digital video and broadband.

Those expense increases is what worry me especially after TWC soured investor sentiment toward the group. CHTR's increased spending is to gain new subs. If it works, the payoff long-term is significant. TWC appears to be catching up the industry on programming expenses after a year where its increase in this category sharply trailed other cable companies. If CHTR is not bought out, I fear that guidance for 2013 could disappoint the street and send the shares down to the low $70s.

Cable stocks, including CHTR, did exceptionally well in 2012 as fears about over the top and cord cutting receded, investors ignored the margin pressure from rising programming expenses, and appreciation of cable's dominant position (and hedge) in broadband grew. In addition, cable's entry into in business services became a material driver of growth. The TWC guidance, the re-emergence of Netflix (NFLX), the rollout of Aereo, and more focus on programming expenses could leave the group vulnerable. CHTR might be especially vulnerable given it is in investment mode.

DIS is a new buy. The company is at the beginning of a ramp in growth driven by ESPN and theme parks. ESPN, the company's biggest single asset, is coming off a period of heavy sports rights inflation. Increased rights fees are being passed through to cable and satellite distributors via increased affiliate fees, alread negotiated with 7 of the top 10 cable and satellite companies. The benefit of the fees begins this quarter. Over the next few years, the rights fee increases will level off as the affiliate fees rise, setting up margin expansion. A new national sports networks competitor form News Corporation (NWSA) is a risk to sentiment but will not impact ESPN's ramping profitability for several years if ever.

In theme parks, DIS is coming off a period of heavy capital investment. Visitation and per capita spending should benefit from the investment leading to growth in revenues and margin expansion at the parks. California is already seeing this benefit. Spending will pick up in Shanghai but I believe investors will cut DIS slack given the opportunity in China at the new park and to build DIS's already strong brand in the country.

DIS also appears to be at a good spot at its film and TV studio. Film seems poised for a good run with its upcoming slate driven by the Marvel acquisition and then the Lucasfilm acquisition. TV production is in a bull market for all the major players as increased spending by cable and broadcast networks all over the world are driving business fundamentals. The value of TV in a digital world to both traditional and new broadband distributors is bullish for DIS.

Disney and Liberty Global 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. Regulatory filings can be found at www.sec.gov. Disney, News Corporation, Liberty Global, and Virgin Media are net long positions in the Entermedia Funds. Steve is sole portfolio manager of Entermedia, owns a controlling stake in Entermedia's investment management company, and has personal monies invested in the Funds. The Entermedia Funds are long long/short equity hedge funds focused on media, entertainment, communications, leisure, and related technologies.

Mixed Media Earnings Better Than Stock Reactions

Most major media companies reported earnings this week including those in Northlake’s portfolio of individual stocks. As has been the case with the broader market, earnings reports and guidance from Northlake’s portfolio was mixed. CBS was the clear winner with a solid quarter amid tough circumstances and a confident outlook for the December quarter and 2013. Liberty Global was as expected although the market greeted the results with a sell-off in the shares. Charter Communications and Discovery Communications were a little light on reported numbers and guidance but a lot of the issues were one-time or unsurprising. Liberty Media is an asset value play where earnings mean little.

Here’s a closer look at the results for each company with some thoughts about where the stocks go from here.

CBS reported a slightly disappointing 2% rise in revenue but this was more than offset by a better than expected 7% increase in operating cash flow. Margins expanded again, a hallmark of CBS financial performance the last few years. The biggest takeaway though is the confidence management showed in future performance despite poor ratings so far this fall at the CBS Network. I think the long-term setup remain good and the shares can reach the low $40s but not until confidence in the economic outlook returns and ratings improve.

Liberty Global began to show the acceleration in revenue and cash flow that was predicted by rapid growth in subscribers over the past year. Honestly, I am not sure why the stock sold off 5% on this news. This acceleration is just beginning and 2013 is set up well. Another positive is that the company promised to pick up the pace of its share buyback in the fourth quarter. It seems farfetched but I can easily compile a target for LBTYK shares north of $100 in a few years given the pickup in growth, massive free cash flow that will follow as the cost of obtaining the new subscribers subsides, and the company continues to very aggressively buyback shares.

Charter Communications shares have been selling off for a few weeks as the company has announced its intention to accelerate capital investment and promotions in order to gain new subscribers. Charter has a real opportunity given that its penetration of homes passed severely trials its cable company peers. The new management team at Charter has instituted this strategy successfully before. The story is not unlike Liberty Global – subs first, financial payoff later – and the upside is similar. Charter is a few years behind, however. I think the shares may have a hard time regaining lost ground in the near-term but valuation at current levels provides support. Charter is on the watch list.

Discovery Communications reported a little worse than expected results for revenue and EPS but better than expected gains in operating income. This set up often suggests one-time items and that was the case. Advertising growth of 8% was a good print given Olympic competition. Guidance was the biggest issue for the stock, which sold off several percent on the report. Management forecast December quarter ad growth of 8%, no sequential improvement despite extremely strong ratings and positive seasonality. Discovery remains superbly positioned given its strong ratings, emerging networks (OWN and ID), and especially the growth opportunities abroad for its low cost, non-fiction programing. Discovery remains one of the few real growth stories in media.

Liberty Media is a collection of assets dominated by a t 49% stake in Sirius XM Satellite Radio. The second largest asset is the Starz Encore suite of pay TV channels. Liberty trades at 20% discount to the value of its assets. Those assets also have excellent growth prospects. This quarter management did indicate that Starz, due to be spun off before year end, would have a little less growth in 2013 as contracts with cable and satellite companies are renegotiated. The bigger question though is how the company will close the discount to its asset value while monetizing a portion of its ownership in Sirius. The conference call offered little fresh insight. John Malone, Liberty’s controlling shareholder, has a superb track record of realizing value form his investments. In Malone we trust. I see the shares between $130 and $150 in 2013 as long as business trends at Sirius remain firm. Fortunately, Sirius has been steadily adding more subscribers than expected in 2012, setting 2013 up favorably.

CBS, Charter Communications, Discovery Communications, Liberty Global, and Liberty Media are widely held by Northlake Capital Management LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, a long only registered investment adviser. CBS, Charter Communications, Discovery Communications, Liberty Global, and Liberty Media are net long positions in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, communications and related technologies. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in the funds' investment management company and has personal monies invested in the funds

Liberties Still Shining and Charter Plots Growth

Last week saw the final three holdings in Northlake's individual stock portfolio report their latest quarterly earnings. The news was good across the board, rounding out an excellent earnings season for Northlake's portfolio that has been well received by investors.

Liberty Global continues to grow its subscriber base in Europe at a rapid clip. Good cost management is allowing modest growth in operating cash flow despite the added expense of bringing new subscribers aboard. Importantly, several quarters of better than expected sub growth means that financial results will accelerate later this year and in 2013 as the new subs begin paying for their services and subscriber acquisition costs decrease. Just as in the U.S., cable TV, broadband, and telephony services in Europe are proving resilient to economic pressures. This is especially the case in Germany where Liberty Global made timely acquisitions right as German households were finally beginning to spend significant money for cable TV and broadband. It is an odd quirk but Germany has always significantly trailed other wealthy nations in the use of higher end cable TV packages and high speed broadband. Liberty Global is riding the wave now as household penetration accelerates. I see upside to $65-70 for the shares in the next 12 months.

Liberty Media (LMCA), unrelated to Liberty Global, except for having John Malone as its controlling shareholder, also continues to make good progress. LMCA is an asset value story composed of three big pieces. Sirius XM Satellite Radio represents over half of the asset value. The Starz Encore pay TV business is about 25% and the balance is a portfolio of publicly traded securities, a few private investments, and cash reserves. LMCA trades at a 20% discount to its asset value which has been growing steadily thanks mostly to Sirius. Over the past six months, LMCA has taken increasing steps to unlock and increase the value. When it reported earnings, LMCA announced it would spin-off Starz, further simplifying the remaining LMCA and setting up an end game for its investment in Sirius. Subsequently, LMCA has increased its stake in Sirius and now has a direct path to taking control. It is not clear exactly what the next steps will be but driving the value of Sirius higher, closing the gap to net asset value, and massively buying back its own stock could create value of $150 or more in LMCA.

Charter Communications reported very slightly weaker than expected results but the big news was the decision by its new, highly regarded CEO to accelerate the company's transition to an all-digital network. This will lift capital spending for the next six to eighteen months but seems certain to accelerate growth as Charter's penetration of its more rural and mid-size markets is quite low. The opportunity is especially large in high speed internet. The shares initially traded lower as the story for cable companies is falling capital spending, growing free cash flow, and rising share repurchases and dividends. Confidence in the CEO and the realization that Charter is merely delaying the inevitable explosion in free cash flow and likely increasing the free cash flow capability turned the shares around quickly. I think another 20% upside remains with share repurchases and dividends kicking in during 2014 making Charter shares a solid long-term holding.

Disclosure: Liberty Global, Liberty Media, and Charter Communications are widely held by Northlake Capital Management LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, a long only registered investment adviser. Regulatory filings can be found at SEC.gov. Liberty Global, Liberty Media, and Charter Communications are net long positions in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, communications and related technologies. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in the funds' investment management company and has personal monies invested in the funds.

Media Earnings - Good Numbers, Bad Stocks

The final batch of earnings this quarter for Northlake holdings comes from the media stocks. Much like with the earlier reports from the technology stocks, the results and guidance were good but the stocks went lower. The stock reactions are mostly a function of the market correction underway so far in May, a decline of 3-4% on top of a loss of 1-2% in April. In the short-term, market trend is a controlling factor. In the long run, the good results and positive outlooks will win out.

Let's take a quick look at the recent reports:

CBS continued its string of great earnings. Results exceeded expectations with operating margins expanding to all-time records yet again. Top line growth reflects a rebound in advertising growth at the CBS Network, slow and steady recovery in the local TV, radio, and outdoor segments. Cost controls have been excellent and programming expenses are under control thanks to many years of steady ratings at the CBS Network. Margins are also benefiting from sales of content to digital distributors like Netflix and Amazon. Retransmission fees paid by cable and satellite companies for the rights to carry the TV network are also growing quickly and highly profitable. Key for CBS shares is that the new, high margin revenue streams are very stable and predictable. This should allow the multiple investors pay for CBS shares to continue to rise. It remains below other entertainment stocks.

Discovery Communications reported better than expected results and increased guidance. The stock fell 6%. DISCK shares have been among the best performers in media as everyone has seen the great ratings for the US networks (Discovery, TLC, Animal Planet, ID) and continued expansion of the international reach with 20% advertising gains. The company forecast moderating advertising growth in the current quarter but still at industry leading levels. Management also reminded investors that timing of expenses meant that the next two quarters would see slower profit growth followed by a big spurt at year end. The only problem with DISCK is that expectations were so high. If ratings and ad growth hold, a period of pause should give way to continued gains in the stock to the upper $50s.

Charter Communications reported a surprising increase in cable TV subscribers. Since AT&T and Verizon launched TV and housing went into a severe recession, cable TV companies have been slowly losing customers. Investors worry that the losses are cord cutting as viewers give up cable to watch TV via Netflix or on the web. The trend across the industry over the past year has been for fewer lost subs. Charter turned the corner this quarter. This is not a big deal as Charter and other cable companies are driven now by high speed data and small and mid-size business accounts but it does relieve big picture worries which is good for the stocks. Charter also reported better than expected high speed data subscribers. The cost of signing up these new subs pressured margins but new subs lock in future growth. Charter shares are also benefiting as the company uses free cash flow to pay down debt, effectively transferring value from bondholders to stockholders. I think the stock can reach the mid to upper $70s.

Liberty Media's earnings don't matter as the company is effectively an investment vehicle for John Malone. The only meaningful operating business is Starz Encore. The numbers there were decent but don't drive the stock. Instead, management comments about what it will do with its 40% stake in Sirius XM is what investors hope to hear. This quarter there was big news on that front as Liberty indicated it would be increasing its stake in SIRI to 45.2% via purchase of a forward contract to buy 302 million shares of SIRI at $2.15. This is positive news for LMCA as the stock trades at a 25-30% discount to the value of its assets. The purchase or more SIRI indicates LMCA is working towards monetizing the SIRI stake sooner rather than later. The sooner the long-term relationship between the two companies is determined the lower the discount at which LMCA should trade. LMCA has multiple options for resolving the SIRI stake. Given value created in the past when LMCA faced a similar situation with big stakes in Discovery Communications, Liberty Global, and DirecTV, there is every reason to have confidence that management will do whatever makes the most money for LMCA shareholders. It is no coincidence that John Malone is LMCA's biggest shareholder and the management team is compensated mostly with LMCA stock. I think the stock would be trading at $110 today with no discount and if SIRI rises to $2.50-3.00 as I expect, LMCA would be worth closer to $125.

Disclosure: CBS, DISCK, CHTR and LMCA are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Northlake is a registered investment advisor. Filings can be found at www.sec.gov. CBS, DISCK, CHTR, and LMCA are net long positions in the Entermedia Funds. Steve is co-portfolio manager of Entermedia, owns a stake in Entermedia's investment management company, and has personal monies invested in the Funds.

A Holiday Gift for Charter Communications. And Northlake Clients.

Just before Christmas Santa delivered gold for shareholders of Charter Communications (CHTR). Santa made a first stop at Cablevision (CVC) headquarters, leavng coal, when it was announced that Tom Rutledge was abruptly leaving his role as #1 operating executive at CVC. Rutledge is the most highly regarded executive in the cable industry, a role that was magnified at CVC due to the volatile decision-making of the controlling shareholders, the Dolan family. In addition, CVC arguably faces the toughest competitive environment among major cable companies as it goes head-to-head with Verizon's FiOS in its NYC metropolitan area markets. CVC fought off Verizon successfully for many years despite street fears and the company produced industry leading financial and subscriber results cementing Rutledge's stellar reputation.

The specific reason behind Rutledge's abrupt departure from CVC remains a mystery but that does not matter to CHTR. CHTR is a good landing spot for Rutledge as its current CEO was already planning to leave in February. CHTR has recently largely completed its capital spending program to upgrade its infrastructure. Major products like broadband, phone, and digital cable are underpenetrated in CHTR's systems. CHTR faces less competition with barely any FiOS overlap and AT&T's U-Verse at 30% of subs. Satellite is CHTR's primary competitor but service providers lack a broadband offering, which is increasingly the premier product in cable's bundle.

CHTR shares trade at a slight premium to its cable peers. However, the company has the potential to produce the fastest organic growth in cable in revenue, EBITDA, and free cash flow. Overall, CHTR's investment profile is excellent. The primary risk is that the new CEO brings expectations down to lower his own bar and/or pursues acquistions rather than using free cash flow to deleverage, buy back shares, or pay dividends. CHTR is also heavily leveraged but free cash flow should handle the debt load comfortably over the next several years.

I like the CHTR story. If CHTR is able to hit current 2012 estimates, I think the shares can trade to $65-70 in 2012, up 20-30% from current prices. In the short-term, I think the shares can continue to rise as sentiment and sponsorship among analysts and investors toward the shares improves thanks to the arrival of Rutledge.

Disclosure: CHTR is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor. CVC and CHTR are net long positions in the Entermedia Funds. The Entermedia Funds are long/short equity hedge funds focused on media, entertainment, communications, and related technologies. Steve is co-portfolio manager of Entermedia, owns a stake in Entermedia’s investment management company, and has personal monies invested in the Funds.