Weekly Issue: Standing in the thematic crosswinds of earnings season
In recent writings, we are once again contending with “earnings season” as we’ve seen the frequency of reports skyrocket. Investors go through this rapid fire period four times a year, and it equates to drinking from the fire hose as we look to dissect, parse, analyze and several other verbs that equate to scrutinizing corporate results. This time, we will be doing this for results for 3Q 2017, which will also offer more than a glimmer at what’s to come in the current quarter, the one that closes out 2017.
This frenetic period can be fabulous if the preponderance of companies, and your investments in particular, are delivering better than expected results and offering an upbeat outlook for what’s to come. It would be wonderful if that was always the case, but it’s not. What it means is assessing results relative to expectations and matching corporate guidance with consensus expectations. Beats can mean a stock pops, while misses can drag shares down as if they were outfitted with an anchor.
From an investor perspective, if a stock gets clobbered, we have to decide if we exit an existing position or use the weakness to scale into it further? Or, if it’s one we’ve had our eyes on for a while — a Tematica Contender as we call it — we have to assess if we should add it as a new one? The answer hinges on several factors, including the magnitude of the miss and the degree of the pullback — is it an over-reaction to something that is transitory in nature or is it a warning sign that more pain is to be had?
Earnings season also helps us to understand the landscape and if it is shifting in a favorable way or not. This means making sure that we don’t have blinders on and solely focus on our active positions, but rather examining the quarter’s results and outlook as well as color commentary from the customers, suppliers and competitors.
For example, given our position in Disruptive Technologies investment theme company Universal Display (OLED), it would behoove us to dig into quarterly results from Apple (AAPL), Alphabet (GOOGL), Samsung, HTC, Huawei and other smartphone companies to gauge demand for organic light emitting diode displays. In looking to get a better handle on smartphone demand, we would cross reference forecasts and commentary offered by those smartphone vendors with key smartphone semiconductor suppliers such as Qualcomm (QCOM), Broadcom (AVGO), Skyworks Solutions (SWKS) and Qorvo (QRVO). With organic light emitting diode displays set to take share from backlit liquid crystal displays, it would also be smart to see if light emitting diode (LED) manufacturers, like Cree (CREE) are seeing a crimp or something stronger in demand from the smartphone market.
That is but one example of how we are examining the various pieces of the puzzle this earning season for all the holdings on the Tematica Investing Select List. As we digest the holdings we have, we’re also looking for fundamental and thematic data points that tell us how strong both the tailwinds and headwinds behind our 17 themes are still blowing.
As we look to assess the strength of thematic tailwinds and headwinds, we have and will continue to sift through the litany of earnings reports and corresponding earnings conference calls looking for confirming data. Earlier this week, Netflix (NFLX) reported its quarterly results, which showed a big beat on subscriber growth while management also shared that it is upping its spending or original content and programming in 2018.
First, let’s look at the 3Q 2107 subscriber figures for Netflix. The total new subscribers came in at 5.3 million vs. expectations for 4.4 million, with the US clocking in at just 0.85 million new adds vs. the expected 0.75 million. The real standout was International subscriber growth, which rose by 4.45 million in 3Q 2017, smashing the expected 3.65 million number and further cementing the fact that Netflix subscriber base is now more international than domestic, a line that was crossed back in July in the company’s second quarter earnings report.
Are we surprised by Netflix’s continued subscriber growth? Given the continued shift toward digital content consumption on smartphones, tablets, laptops and even on devices like Apple TV that is part of our Connected Society investing theme, the short answer is no.
But that is only part of what’s going on when we look at the Netflix story.
The other part is Netflix’s content strategy, where it has been investing heavily to build proprietary content to woo subscribers and stand apart from iTunes, Amazons’ (AMZN) Prime Video as well as on-demand services from cable operators like Comcast (CMCSA) and Verizon (VZ). In short, Netflix has been embracing our Content is King theme, and based on what it shared on the earnings call, it intends to do even more of that.
On the call, Netflix shared it looks to spend $8 billion on content in 2018, more than a stone’s throw ahead of the $7 billion that was expected, and release 80 movies in 2018, up from 8 in 4Q 2017. We see this as further evidence of a looming content war between Netflix, Hulu, Amazon, YouTube, Facebook, and potentially Apple as they all look to bring proprietary content to market. As these new content players bid on and win programming, we are likely to see content costs rise meaningfully, which could pressure companies such as CBS (CBS) and Comcast (CMCSA).
While we continue to view Disney as THE Content is King company, given its several means of monetizing its character and content library, these developments from Netflix and other content providers could add another challenge for it to face even as it begins to flirt with its own streaming services in 2018 and 2019. When Disney does report its quarterly earnings, we’ll be curious to see if it steps up its movie calendar to compete with these new content providers. Clearly, Disney is viewing Netflix as a competitor as was evidenced by Disney’s August announcement it will pull Disney, Pixar, Star Wars and Marvel content from Netflix in the coming months. Now we’ll have to look to see if Disney looks to do the same with other streaming services, like Hulu and Amazon Prime Video.
As it relates to Netflix stock, we have stood on the sidelines with this company and its shares, given concerns over the mounting liabilities on the balance sheet. We’re referring to its escalating debt and ballooning content liabilities, as well as the increasingly competitive streaming landscape. At 93x expected 2018 earnings, the shares are super expensive, but we’ll roll up our sleeves to examine other valuation metrics and potential entry points given the expectation for strong EPS growth that delivers EPS of $2.14 in 2018, up from $0.43 in 2016.
These are some examples and we could shed more light as they pertain to our various investing themes, but given one of the key backdrops of those themes is the shifting economic landscape we are also looking for “real deal” data points on the economy. These data points help us frame and put the various monthly economic indicators into perspective the same way industry statistics, like weekly railcar loading and truck tonnage, do. That has us pouring over results and guidance from companies like CSX (CSX) to determine how much stuff (autos, metals, agricultural products, wood, coal, chemicals and other liquids and so on) is moving in and out of manufacturing plants to distribution sites and other locations.
On its earnings call this week, CSX shared its total volume for the quarter rose 1% year over year, which is in tune with an economy growing at or near 2%, with revenue per unit flat vs. year ago levels. With this conference call, CSX management set the table for a more in-depth look at its business during its October 30 analyst meeting. Given the pace of weekly railcar loading that has been losing steam since the summer, we’re inclined to pass on this company as part of our Economic Acceleration/Deceleration theme until we see a firming in that weekly traffic data.
Interestingly enough, comments made by WW Grainger (GWW), a distributor of maintenance, repair and operating (MRO) supplies during its earnings call point to signs of a pick up in the economy. The company shared its spot buy and large non-contract business volume growth turned positive during the quarter. The question we are pondering is how much of this is due to the true speed of the economy vs. August-September hurricane fallout related demand? The answer will help stage our next move with LSI Industries (LYTS), which should benefit from both hurricane rebuilding and the adoption of light emitting diodes in the general illumination and signage markets.
Reading over the above paragraphs, you may be wondering how we managed to listen to all of these earnings conference calls or how we plan on doing so as the number of reports quadruples next week?
The answer to both is the same – while we do listen to a good number of them first hand, we also use the time-tested approach of reading the follow-up conference call transcripts. Much like skipping the kickoff returns in a football game, this allows us to get to the meat of the earnings call material. In some instances, we even search through them for certain key words thanks to the joys and efficiency afforded to use by search tools and PDF copies.
There is another benefit to using the transcripts and that is the ability to compare the latest transcript with the prior one also. This allows us to gauge if a management team is adopting a more bullish or more cautious tone with its business and monitor progress on recent struggles and opportunities. We utilize this approach when the Federal Reserve publishes its FOMC meeting minutes and policy statements. In both instances, the perspective it offers is rather insightful.
That clearly falls into the camp of work smarter, not harder, which is something we are definitely all about as we look to take advantage of opportunities in the market as they present themselves. As we look to determine potential opportunities, we’ll also be revisiting earnings expectations for the S&P 500 group of companies to determine if 2017 EPS expectations are tracking or if a meaningful revision will be necessary. Should a step down in expectations be required, it would mean the market is that much more expensive than the current 19.6 multiple using consensus 2017 EPS expectations for the S&P 500. That could lead to some pullback in the market as investors question potential upside and strategically lock in profits for the year. The silver lining is if that comes to pass, we could see opportunities to scoop up well-positioned companies at better prices, and that has us once again building our stock shopping list.
