The title of this note might be, “What to expect when you’re expecting … earnings.” As companies in the Cabot Undervalued Stocks Advisor portfolio start reporting earnings this week, let’s look into what is behind the results and estimates.
Earnings reports usually lead with the headline earnings per share number, which is usually the profits on a GAAP basis (generally accepted accounting principles). Regulators require companies to report on a GAAP basis, which are audited, to minimize management’s ability to manipulate them. Investors usually ignore these numbers.
Nearly every company reports “adjusted earnings,” which have a variety of one-time and other costs removed. This format provides the basis for determining whether a company “beat,” “missed” or “met” consensus expectations in media reports. These adjustments are opinions, and whether these adjustments are warranted is a subject of a lot of debate.
Let’s look into what is behind these consensus estimates.
Wall Street brokerage analysts generate their own estimate of what a company can earn each quarter and year. These are aggregated and averaged to provide the consensus estimate. However, there are at least four different aggregators – FactSet, CapitalIQ, Bloomberg and Zacks – with slight differences in the pool of analysts they include and in how the estimates are combined. This means there are at least four consensus estimates for many companies, which may be 1-3 cents apart. In some cases, a company may beat one aggregator’s consensus, but miss someone else’s.
In producing their earnings estimates, brokerage analysts try to be as accurate as possible. In the early days of Wall Street brokerage research, starting after Donaldson, Lufkin & Jenrette launched arguably the first high-quality sell-side research effort in 1959, being accurate was a high-risk game. Each analyst did their own work, with little input from companies. Large gaps between their estimate and the actual results were common.
Over time, as more firms joined the research ranks, portfolio managers found the range of estimates to be too wide and inaccurate to be useful. The arrival of the aggregators and consensus estimates helped simplify their efforts.
As a result, analysts gradually shifted their approach, from arriving at their own estimates to comparing their estimates to the consensus. The arrival of Regulation FD in August 2000, which prevented companies from selectively disclosing information to one party but not another, led to companies providing earnings guidance for what future earnings might look like. This greatly reduced the range of Street estimates and the risk of analysts being wildly wrong.
With the value of individual earnings estimates largely diluted, professional investors have shifted to other forms of analysis, including small group meetings with company managements.
Behind the earnings consensus creation curtain is the interplay between the analyst and the company’s primary contact with Wall Street – the investor relations (IR) executive. This game has become a critical component of setting investor expectations.
In most cases, the best result for a company is the “beat and raise,” where the earnings are ahead of consensus estimates and the company raises its forward earnings guidance. This suggests to the market that the company is doing a lot better than expected, implying that the shares are undervalued.
These expectations aren’t set by accident. Analysts and IR executives can do a bit of a dance during the quarter to help make this happen. If analysts are over-estimating what the company can do, the IR executive can tactfully help rein in their optimism. In many cases, the analysts will almost magically be a penny too low, leading to a “beat.” Even if consensus estimates have been tamped down by, say, 10% or more from their original level, a company often gets credit for a “beat” if actual earnings are ahead of the final estimate. This game is called “managing the Street.”
Some companies can overplay this game. Not that long ago, Apple (AAPL) would report “blowout” (well ahead of estimates) earnings, then provide guidance that called for dismal earnings growth in the following quarter. Clearly, they were low-balling their guidance, leading to rising estimates during the quarter and another “beat.” Fortunately for Apple, their business was so strong that they had no trouble beating estimates of any kind.
The IR executive’s skill is critical to this game. They need to be effective in communicating with analysts. A company’s credibility can be crippled if the IR executive conveys too much or too little optimism, or doesn’t keep the CEO and CFO and their guidance on-message. This can lead to a lower multiple.
Investors put a lot of weight on companies meeting estimates, because there is an assumption that the IR person is on their game and playing properly. If a company actually misses estimates, investors will assume that if the results were too weak for management to “find” a few cents, the shares should be sold.
So, for this quarter’s earnings, let’s watch the game being played.
Share prices in the table reflect Tuesday (July 21) closing prices. Send questions and comments to Bruce@CabotWealth.com.
TODAY’S PORTFOLIO CHANGES
Netflix (NFLX) – Moves from Hold to Retired.
LAST WEEK’S PORTFOLIO CHANGES (July 15 update)
Adding Chart Industries (GTLS) as a new Buy
Adobe (ADBE) is being Retired on valuation
VanEck Vectors Oil Refiners ETF (CRAK) moves from Hold to Retired.
GROWTH PORTFOLIO
Chart Industries (GTLS) is a leading global manufacturer of highly-engineered equipment used in the production, transportation, storage and end-use of liquid gases (primarily atmospheric, natural gas, industrial and life sciences gases). Its equipment cools these gases, often to cryogenic temperatures that approach absolute zero. Chart has no direct peers, offering turnkey solutions with a much broader set of products than other industry participants. The company was featured in Cabot’s 10 Best Stocks to Buy and Hold for 2020.
The company generates positive free cash flow and is prioritizing reducing its modestly elevated debt from its 2019 cash acquisition of Harsco’s Industrial Air-X-Changers business, as well as continuing its sizeable cost-savings program. Chart reported strong first quarter results in April, delivering earnings considerably ahead of year-ago results and consensus estimates. The company’s June mid-second quarter update provided encouraging news on both of these initiatives.
Chart should report earnings tomorrow (July 23). The consensus estimate has ticked upward in recent weeks, to $0.42/share.
GTLS shares have risen about 5% in the past week. The valuation remains reasonable at 17.3x estimated 2021 earnings of $3.10/share and 10.4x estimated 2021 cash operating profits. Earnings for 2021 are estimated to be about 27% higher than estimated 2020 earnings. The shares look poised to continue their recovery. Buy.
MKS Instruments (MKSI) generates about 49% of its revenues from producing critical components that become part of equipment used to make semiconductors. MKS’ products are generally in the stronger segments of this currently healthy market. While MKSI shares closely track the broad semiconductor indices, the expansion of its Advanced Markets segment, including its 2016 acquisition of Newport Corporation, as well as its 2019 acquisition of semiconductor-related Electro Scientific Industries, may allow its shares to break out. The company recently promoted 13-year company veteran Dr. John T.C. Lee to CEO. The $850 million in debt is modest relative to its earnings and is mostly offset by $500 million in cash balances. MKS Instruments was featured in the February 19 issue of Cabot Undervalued Stocks Advisor.
Analysts’ consensus estimates continue to point toward EPS growth of 12% and 37% in 2020 and 2021, respectively. With the shares up 6% since a week ago, above 120 and near the all-time high set in early 2018, we suggest traders take their profits.
For longer-term holders of MKSI, the shares continue to track the Philadelphia Semiconductor Index (SOX), and a strong earnings report would provide encouraging evidence that its ESI acquisition is boosting its prospects. At 17.3x estimated 2021 earnings of $6.94, we consider the shares reasonably undervalued. MKS reports earnings next Thursday, July 30. Hold.
Quanta Services (PWR) is a leading specialty infrastructure solutions provider serving the utility, energy and communication industries. Their infrastructure projects have meaningful exposure to highly predictable, largely non-discretionary spending across multiple end-markets, with 65% of revenues coming from regulated electric, gas and other utility companies. Quanta achieved record annual revenues, operating income and backlog in 2019, and is pursuing a multi-year goal of increasing margins. Dividend payouts and share repurchase activity have continued uninterrupted during the pandemic.
We view this company as high quality, well run and resilient. The market views PWR shares as a safe haven in an unpredictable market and economy, helping the shares to fully recover from their March 2020 lows. The new 15-year contract to operate and modernize Puerto Rico’s energy grid is an encouraging positive as the company is seeking to shift toward a capital-light, recurring profit model. Quanta Services was featured in the July monthly issue of Cabot Undervalued Stocks Advisor.
Quanta is expected to report earnings on Monday, August 2. The consensus estimate is $0.47/share. For the full year, analysts estimate that Quanta’s earnings per share will dip about 5% in 2020 to $3.16, due to disruption costs related to the pandemic, then rebound over 22% to $3.86 in 2021.
PWR shares continue to tick upwards. On 2021 estimated earnings, the P/E is a reasonable 10.4x. Traders may consider exiting near 43. For long-term holders, Quanta stock looks well-positioned to continue to prosper. New investors should establish a starter position now and look to add on weakness. Buy.
Tyson Foods (TSN) is one of the world’s largest food companies, with over $42 billion in revenues last year. Beef products generate about 36% of total revenues, while chicken (31%), pork (10%), and prepared/other contribute the remaining revenues. It has the #1 domestic position in beef and chicken with roughly 21% market share in each. Its well-known brands include Tyson, Jimmy Dean, Hillshire Farms, Ball Park, Wright and Aidells. As only 13% of its sales come from outside the United States, Tyson’s long-term growth strategy is to participate in the growing global demand for protein. Tyson Foods was featured in the June issue of Cabot Undervalued Stocks Advisor.
Unlike many of its food company peers whose shares have fully recovered this year, or more, Tyson’s shares remain 32% below their year-end price and are seemingly stuck in a 58-65 range, although they ticked upward from the low-end of this range in the past week.
Much of this underperformance is due to absentee issues surrounding its processing facilities (there is no evidence that the virus is transmissible to meat products), oversupply conditions in the poultry industry and import restrictions by China. Also, Tyson is more of a commodity company than a diversified branded food company, so its exposure to weaker commodity prices and its much lower profit margins make it a less-defensive stock than its peers.
Tyson reports earnings on August 3. Its profits are expected to fall 17% in 2020 due to pandemic business disruptions, then rise 29% in 2021. The 2020 P/E is 13.2x. The shares produce a 2.8% dividend yield. The company’s business is starting to improve, particularly from its food service segment that suffered from stay-at-home restrictions, as well as from its emerging and higher-margin prepared foods business. Buy.
Universal Electronics (UEIC) is a dominant producer of universal remote controls that subscription broadcasters (cable and satellite), TV/set top box/audio manufacturers and others provide to their customers. The company pioneered the universal remote, named the ‘One for All’, which was quickly adopted by consumers after its launch in 1986. Since then, the company has expanded into a range of remote control devices for smart homes, safety and security and other residential and commercial applications, driven by its extensive and valuable proprietary technology. Clients include every major cable and satellite company: AT&T, Cox, Dish, Comcast, Samsung, LG, Sony, Liberty, Daikin, Sky and more. Universal Electronics was featured in the February monthly issue of Cabot Undervalued Stocks Advisor.
Strong and steady revenue and earnings growth drove the shares to over 80 by mid-2016, from only about 12 in mid-2012. However, the shares have stumbled and remain down about 45% from their peak. UEIC is a volatile, undervalued, micro-cap growth stock, appropriate for risk-tolerant investors and traders. Over the short-term, its shares generally correlate with overall market and economic re-opening sentiment. The company reports earnings on August 6.
UEIC shares ticked upward in the past week, and trade at 13.0x estimated 2020 earnings of $3.71, and 10.6x estimated 2021 earnings of $4.52. Attractive buying opportunities are appearing as the shares remain near the midpoint of their recent range. Strong Buy.
Voya Financial (VOYA) is a U.S. retirement, investment and insurance company serving 13.8 million individual and institutional customers. Voya has $603 billion in total assets under management and administration. The company previously was the U.S. arm of Dutch financial conglomerate ING Group, from which it was spun off in 2013. Voya has several appealing traits. Even though it is well-capitalized, it is migrating toward a capital-light model, taking a major step in this direction by selling its life insurance business, which should close in the third quarter. Some of the released capital could be used to repurchase shares. Also, it won’t be a cash tax payer for as many as five years due to its deferred tax assets. Voya is generating considerable free cash flow. And, its diversified and highly-regarded product base offers steady long-term revenue strength.
Near-term issues for Voya are its COVID-related claims (readily manageable but not likely accurately modeled into estimates), the size of the positive impact of rising equity markets and the potential markdowns on its other investment assets. Voya will provide more color on these, along with an update on its life insurance exit, when it reports earnings on August 5.
The shares trade at an attractive 8.1x estimated 2021 earnings and 0.8x book value. Per share earnings in 2021 are expected to jump 42% compared to 2020. VOYA is a mid-cap stock, appropriate for growth and value investors and traders. The shares’ daily trading range appears to be ticking slightly upward. Strong Buy.
GROWTH & INCOME PORTFOLIO
Bristol-Myers Squibb Company (BMY) is a global biopharmaceutical company. Following its controversial acquisition of Celgene for $74 billion in November 2019, the merged company markets a long list of pharmaceuticals, including Revlimid, Eliquis and Opdivo, which treat cardiovascular, oncology and immunological diseases. The company expects revenue and profit growth to come from four areas: sales volume increases from current products, development and launch of new medicines, life cycle management and synergies from the Celgene acquisition. Bristol-Myers’ financial priorities include debt repayment, investment in innovation, share repurchases and annual dividend increases. Investors will want to be aware that the Celgene deal raised Bristol-Myers’ debt to over $46 billion – a manageable sum yet elevated compared to peers. Bristol-Myers was featured in the April issue of Cabot Undervalued Stocks Advisor.
The company reports earnings on August 6, with the consensus estimates sitting at $1.48/share. Full year earnings are expected to increase by 32% and 20% in 2020 and 2021, respectively, in large part due to the benefits from the Celgene deal. Its 2020 P/E is a modest 9.6x, and 8.0x on next year’s estimate. BMY shares provide a generous 3% yield, well-covered by its enormous $13.5 billion in free cash flow this year.
The shares have price and valuation support at around 55-56, and offer defensive traits during “risk-off” trading days, as well as the potential to ride some sentiment tailwinds surrounding the pharmaceutical sector in general. Strong Buy.
Broadcom (AVGO) is a global technology leader that designs, develops and supplies semiconductor and infrastructure software solutions that serve the world’s most successful companies. CFO Tom Krause expects to continue paying the dividend and paying down debt in 2020 (none of which is maturing this year), even under poor economic conditions. Share buybacks and M&A activity are on the back burner for now. Broadcom was featured in the December 17 and January issues of Cabot Undervalued Stocks Advisor.
The company’s current quarter ends in July so it won’t likely report earnings until September. Broadcom is an undervalued growth and income stock as well as a useful trading stock. Despite its shares losing half their value in the market selloff, Broadcom’s stock price has fully recovered. Other than the sell-down, the stock has remained in a range of roughly 270-320 for over a year, and is just below its all-time high of 331. Full-year profits are expected to grow 1% and 12% in 2020 and 2021, respectively, and the 2020 P/E is 14.6x. Hold.
Dow Inc. (DOW) is a commodity chemicals company with manufacturing facilities in 31 countries. In 2017, Dow merged with DuPont to temporarily create DowDuPont, then split into three parts in 2019 based on the combined product lines. Today, Dow is the world’s largest producer of ethylene/polyethylene, which are the world’s most widely-used plastics. Dow is primarily a cash-flow story driven by petrochemical prices, which often are correlated with oil prices and global growth, along with competitors’ production volumes. Dow was featured in our July edition of the Cabot Undervalued Stocks Advisor.
Dow announced on July 6th that it is selling railroad infrastructure assets for $310 million. Proceeds will go toward debt reduction. This transaction is part of its strategy to sell assets not directly related to producing its products.
The company reports earnings tomorrow, July 23, with consensus estimates sitting at a loss of $(0.25)/share, reflecting a likely short-term trough in the commodity cycle. We’ll be watching for commodity pricing and volumes, as well as the size and outlook for cost-cutting measures.
Analysts expect full-year EPS of $1.04 and $2.33 in 2020 and 2021, respectively. Valuation at 18.2x depressed 2021 estimates remains acceptable as long as the cycle appears to be improving. The high 6.6% dividend yield is particularly appealing to income-oriented investors, but has a small risk of a cut if the cycle remains subdued, but management makes a convincing case that the dividend will be sustained.
After a healthy surge from the market’s lows in March, Dow shares reached 44.40 in early June on optimism about the economic re-opening. Since then, they have pulled back on rising numbers of Covid-19 cases, which suggest a slower re-opening and thus slower demand for plastic-based products. We like its reasonable valuation and appealing yield. Buy.
Total S.A. (TOT) based in France, is among the world’s largest integrated energy companies, with a global oil and natural gas production business, one of Europe’s largest oil refining/petrochemical operations, and a sizeable gasoline retail presence. The company is also expanding somewhat aggressively into renewable and power generation business lines, which may either be highly profitable or value-destructive. While low energy prices have hurt Total like all integrated producers, the company’s low production costs (management claims its costs are below $30/barrel), efficient operations and sturdy balance sheet position it well relative to its peers. Also, the company’s production growth profile may still be among the best in the industry despite sharp capital spending reductions.
Total remains attractive to income investors with its high 7.9% dividend yield that is likely to be maintained at least this year. Management has chosen to maintain their dividend of 68 euros, even if they need to raise debt or trim assets to do so. Total SA was featured in the May issue of Cabot Undervalued Stocks Advisor.
Total reports earnings on July 30. In its “Main Indicators” release last week, the company said that its price realizations (industry term for average price received) for its oil and gas, and its refining margins, remained weak. The most recent consensus estimates indicate full-year EPS of $1.24 and $2.77 in 2020 and 2021, respectively. The P/E multiple of 13.7x estimated 2021 earnings reflects only partial recovery toward normalized earnings of around $4.00. The shares remain rangebound. Growth and income investors should add to positions below 38. Hold.
BUY LOW OPPORTUNITIES PORTFOLIO
Columbia Sportswear (COLM) produces the highly-recognizable Columbia brand outdoor and active lifestyle apparel and accessories, as well as SOREL, Mountain Hardware, and prAna products. For decades, the company was successfully led by the one-of-a-kind Gert Boyle, who passed away late last year. The Boyle family retains a 36% ownership stake and Gert’s son Timothy Boyle remains at the helm.
First-quarter sales fell 13% from a year ago, as 64% of sales are produced in the U.S., where its reliance on wholesale distribution, and the longer lockdown periods relative to other countries, hurt results. However, the company is rapidly improving its online operations, both through its own websites and through third-party online retailers, which combined generate over 20% of sales. Columbia’s balance sheet remains solid, with $707 million in cash and only $174 million in debt. The company is likely to remain healthy as consumers seek its highly relevant products.
Columbia’s shares have ticked up in recent days yet trade at the same price as they did in early 2018.
The company reports on July 30, with analysts expecting an $(0.88)/share loss as the quarter includes the full effect of the stay-at-home orders. Full year estimates are $2.23 and $4.04 for 2020 and 2021, respectively. For comparison, the company earned $4.83/share in 2019. On next year’s estimates, the shares trade at a P/E of 19.2x. The stock has appeal for value investors and for growth investors with patience for what might be a slower recovery than other growth stocks. Traders will find COLM shares appealing given their sensitivity to consumer and economic re-opening trends. Buy.
General Motors (GM) under CEO Mary Barra (since 2014) has transformed from a lumbering giant to a well-run and (almost) respected auto maker. The company has smartly exited many chronically unprofitable geographies (notably Europe) and trimmed its passenger car roster while boosting its North American market share with increasingly competitive vehicles, particularly light trucks. We consider its electric and autonomous vehicle efforts to be near industry-leading. GM’s much-improved North America cost structure allows it to remain profitable at perhaps an 11 million vehicle industry volume. Its GM Credit operations are well-capitalized but will likely be tested in the pandemic. The shares will remain volatile based on the pace of the economic re-opening, U.S.-China relations, its successes in improving its relevance to Chinese consumers, and the size of credit losses in its GM Financial unit. GM was featured in the December 31, 2019 issue and the February issue of Cabot Undervalued Stocks Advisor.
GM’s second quarter vehicle sales fell 34% from a year ago, but showed improving results as the quarter progressed. The company said that demand surpassed supply later in the quarter. Full-sized pickup truck sales were particularly sturdy. Sales in China fell a more modest 5% in the quarter. GM reports on Wednesday, July 29.
Wall Street is projecting EPS of $1.16 and $4.06 in 2020 and 2021, respectively. GM remains an attractive cyclical stock for investors and traders. Strong Buy.
SPECIAL SITUATION AND MOVIE STAR PORTFOLIO
Amazon.com (AMZN) remains nearly perfectly positioned for a pandemic world. Its to-your-doorstep shopping marketplace allows consumers to safely shop for just about anything without leaving their homes. As the world accelerates its transition to the digital world, the Amazon Web Services (AWS) cloud business will continue to produce vast and growing profits ($20 billion in operating profits next year, up 20% from the prior year and comprising nearly 65% of total company operating profits). Also, Amazon’s innovations and forays into new industries are disrupting established global businesses, including freight companies, retailers, entertainment and technology companies. Amazon.com was featured in the April issue of Cabot Undervalued Stocks Advisor.
Analysts expect per-share earnings to fall from $23.01 in 2019 to $20.32 in 2020, then rise 93% to $39.16 in 2021. The decline in 2020 profits results from Amazon’s plans to spend much of its profits (essentially all of its second-quarter profits) on COVID-related expenses, including new hires and wage increases. AMZN shares trade surged past 3,100 and have gained over 70% this year. This stock is clearly the iconic stock of its era. How long this will last is hard to say. Hold.
Equitable Holdings (EQH) owns two principal businesses: Equitable Financial Life Insurance Co. and a majority (65%) stake in AllianceBernstein Holdings L.P. (AB), a highly respected investment management and research firm.
Equitable, with a 161-year history, was acquired by French insurer AXA in 1992. Starting in 2018, AXA began to spin off Equitable with an initial public offering of part of its ownership. Part of the motivation behind the spinoff was to fund AXA’s $15 billion acquisition of insurer XL Group Ltd. Through subsequent stock sales, AXA currently owns less than 10% of Equitable. With its newfound independence, Equitable is free to pursue opportunities that it was unable to as a subsidiary of AXA.
The company is well-capitalized and has significant liquidity. Its diverse, high-quality investment portfolio is hedged against adverse changes in interest rates and equity markets. AllianceBernstein’s assets under management (AUM) as of June was $600 billion. While this year’s profits will decline about 13% due to higher mortality costs, they will like recover next year. Equitable expects to continue delivering a 50-60% payout ratio through dividends and share repurchases. The shares offer a 3.4% dividend yield.
Equitable reports earnings on August 6. EQH shares are undervalued, with a 2020 P/E of 4.7x. Like many insurance companies, investors also value Equitable on a book value basis. With its $37.78 in per-share book value, EQH trades at 53% of book value, a significant discount. EQH shares also trade just below their 20 IPO price, which was a disappointment at the time relative to the 24-27 price range that bankers had targeted. Since then Equitable has arguably become a better company and any sale of AllianceBernstein is likely to unlock further value. EHQ shares are appropriate for dividend investors, growth investors and traders. While the shares may trade in sync with the overall stock market, given its investment-driven operations, we see more upside than downside. Strong Buy.
Marathon Petroleum (MPC) is a leading integrated downstream energy company and the nation’s largest energy refiner, with 16 refineries, a majority interest in midstream company MPLX LP, 10,000 miles of oil pipelines, and product sales in 11,700 retail stores.
As noted last week, Marathon may sell its Speedway retail gas station chain. Thus, the market is increasingly valuing Marathon’s shares as if this deal will be completed. Since neither a deal nor a price is a guaranteed outcome, the shares will sell at a discount to this value but higher than if there was no chance of a deal.
Using very rough numbers, we think the Speedway business might be worth $24/share and the rest of Marathon worth perhaps $17/share, for a total value to MPC shareholders of perhaps $41/share. There are many assumptions that could change these numbers. With MPC shares trading at about $38, this implies about 8% upside. While interesting and appealing, it is not enough to warrant a return to a Buy rating. Meanwhile, Marathon produces a reasonably sustainable 6.3% dividend yield.
The shares will trade near-term around the pace of the re-opening of the economy, on overall oil prices and the currently wide refiner margins.
Wall Street analysts are now forecasting a 2020 full-year loss of $(2.47)/share, continuing a trend downwards. Estimates for 2021 earnings also weakened modestly to $2.14/share. The company will report second-quarter results on the morning of August 3.
Like most energy stocks, MPC offers a useful vehicle for traders: its economics are closely tied to oil prices yet the company has a more stable business, with its refining, MPLX midstream, and retail operations that dampen its volatility and provide more downside protection relative to pure exploration or energy service companies. Hold.
Netflix (NFLX) is the world’s leading streaming entertainment service with 193 million paid subscribers in over 190 countries. Viewers can enjoy unlimited access to TV series, documentaries and feature films across a wide variety of genres and languages, all without commercial interruptions. The company is experiencing rapid international subscription growth and creating original foreign language content for international markets. Netflix was featured in the January 22 issue of Cabot Undervalued Stocks Advisor.
NFLX is a widely popular, aggressive growth/momentum stock. The shares have surged to 50x their year-end 2011 price of 9.90 – producing a 59% annualized rate of return – a stunning rate that reflects the power of an innovative idea launched at the right time.
The company reported a huge 27% surge in paid subscribers in the second quarter, in what they described as a “pull-forward of our underlying adoption.” Revenue growth of 25%, combined with a smaller 14% expense increase, drove operating profits up 92% from a year ago. This surge in growth can’t be fully extrapolated, as we find the pull-forward logic compelling given that the global stay-at-home orders motivated a lot of bored consumers to sign up to find something to watch. However, the surge will likely be followed by subdued growth in future quarters until the pull-forward effect has faded. Also, the jump in free cash flow will be offset and weakened as it ramps up production (and production costs) in the next 4-6 quarters.
We believe the appointment of company veteran Ted Sarandos as co-CEO carries limited near-term risk given what we know today, but co-CEO roles rarely are successful (Oracle’s co-CEO arrangement worked but was overseen by a dominant chairman). Netflix may become an exception, but the cost of failure – departure of either a key founder or a critical operations leader – could meaningfully hobble the company.
More difficult is assessing Netflix’ long-term growth and the impact on the share price. While the shares fell about 9% on the quarterly results, they remain only 13% below their all-time high and unchanged from their price (at the time an all-time high) from early July. The shares imply essentially no long-term change in its revenue growth trajectory – we find this unlikely given the rising amount of competition, limited chances of another price increase (they are already exploring lower-priced options), and the difficulties of maintaining their 20-22% membership growth rate on top of their 193 million subscriber base.
We appreciate Netflix’ strong (enormous) lead in subscriber numbers over its growing roster of competitors. We also recognize the immense advantage it has built up and continues to generate by understanding what its subscribers watch – to an extent that no other firm can match. This advantage translates into its ability to determine the types of movies and shows that will boost loyalty, then successfully produce that content. We recently watched its new movie “Extraction”, which has become another successful movie, and whose plot, music, cast, sub-plot and other aspects were no doubt carefully engineered to maximize its appeal.
Its 41.4x P/E on estimated 2022 earnings (more than 2 years away, and which assume a tripling of profits to $12.11/share compared to 2019 profits) as well as its 6.8x multiple of estimated 2022 revenues, implies that it is only in the early stages of its profit and cash flow growth – a view we don’t entirely agree with.
While the shares may resume their upward march, and we aren’t worried about any serious issues that suggest it should be sold immediately, NFLX shares are no longer undervalued nor undiscovered. We are moving Netflix to Retired.
NVIDIA (NVDA) is the pioneer and leading designer of graphics processing unit (GPU) chips, which initially were built into computers to improve video gaming quality. However, they were discovered to be nearly ideal for other uses that required immense and accelerated processing power, including data centers and artificial intelligence applications such as professional visualization, robotics and self-driving cars. In April, NVIDIA completed the $6.9 billion acquisition of Mellanox Technologies, an innovator in high-performance interconnect technology routinely used in supercomputers and hyperscale data centers. NVIDIA’s data center business now represents about 50% of total revenues. NVIDIA was featured in the March and May issues of Cabot Undervalued Stocks Advisor.
NVIDIA is a high-P/E, aggressive growth/momentum stock. Its shares have increased 17x since the start of 2015 and now trade essentially at their all-time high. The pullback earlier this week still leaves the stock above where it was trading only 4 sessions ago. Yet, part of the reason behind the gains is that cloud-based computing is the biggest secular trend in technology, and the most powerful. No one knows how large the industry will ultimately become, but “larger than it is today” seems like the correct answer for many days and years into the future. Until this open-ended growth appears to peak, it would be difficult to bet against it. The only question for momentum investors is when to stop betting on it. The valuation of 42.6x estimated fiscal year 2022 earnings is high and on the edge of astronomical, particularly for a company its size.
Wall Street now expects EPS to grow 21% in fiscal 2022 (January year-end) compared to fiscal 2021. The company reports its earnings in September. For now, we’re staying with our Strong Buy recommendation.
