THE MARKET ENVIRONMENT
U.S. equity markets finished the second quarter higher, continuing the recovery for the year-to-date period following a difficult 2022. The Russell 1000 Growth Index gained 12.81% versus the Russell 1000 Value Index, which gained 4.07%, led by the technology, consumer discretionary and communication services sectors. Utilities, energy and consumer staples were the only sectors to decline during the quarter. Year to date, the Russell 1000 Growth Index has returned 29.02% and the Russell 1000 Value Index has returned 5.12%, a reversal of the value recovery that occurred last year.
During the quarter, the U.S. government announced an agreement to suspend the debt ceiling until January 2025 that includes nondefense discretionary spending to remain flat throughout the upcoming two fiscal years, which eased concerns about a potential default. The Federal Reserve increased its benchmark interest rate by 25 basis points in May before pausing at its June meeting. Comments from members of the Federal Open Market Committee pointed to further interest rate hikes in the future and rates remaining elevated for some time. The U.S. 10-year Treasury began the quarter yielding around 3.5% and ended the quarter near 4%.
Regardless of the economic backdrop and central bank activity, our disciplined investment process continues to revolve around bottom-up, fundamental research. As long-term investors, we value our companies through the economic cycle and focus portfolio construction on optimizing our best ideas. We attempt to identify growing businesses that are managed to benefit their shareholders and invest in those businesses only when priced substantially below our estimate of intrinsic value.
THE PORTFOLIO
Top Performers:
Thor Industries reported fiscal third-quarter earnings that showed margin improvement and management raised the low end of its full-year outlook to $5.80-6.50 from $5.50-6.50 previously. In Europe, pricing and operational initiatives combined with moderate improvements in chassis availability drove strong sequential and year-over-year growth. Demand in Europe remains resilient, and management expects to complete the restocking cycle for motorized products in the first half of fiscal year 2024 as chassis and other supply constraints ease further. In addition, a new manufacturing facility in Poland commenced operations which we believe will enable the company to expand the reach of its offerings in Europe as production scales up over the next 24-36 months. In our follow up call after the release, CEO Bob Martin said he “easily” sees sales above $3 billion in that segment, absent the supply chain constraints. In the U.S., the macro environment remains difficult compared to the strong backdrop the previous couple years, but we appreciate that results improved relative to its fiscal second quarter. Even after the share price increase following the release, we still believe Thor Industries is trading below our estimate of its intrinsic value.
Oracle’s fiscal fourth-quarter earnings and full-year 2024 outlook were strong, in our view. Total revenue grew 18% in constant currency and 5% ex-Cerner, which was ahead of consensus expectations. Applications cloud and support revenue grew 11% in constant currency ex-Cerner powered by the “strategic back office,” consisting of Fusion and Netsuite, which together now account for $6.6 billion in runrate revenue. The infrastructure ecosystem grew 15% in constant currency, powered by infrastructure cloud services. We see management’s announcement of $2 billion in new Oracle Cloud Infrastructure contracts with 33 AI companies and partnerships with Nvidia and Cohere as a sign that the company will be a leader in AI. Further, CEO Safra Catz guided to total revenue growth of 7-9% in the fiscal first quarter and approximately 30% cloud growth in constant currency in full-year 2024, both ahead of consensus expectations.
Alphabet’s first-quarter search revenue growth accelerated slightly sequentially, which management described as “resilient” against the backdrop of a pullback in advertising budgets. Travel and retail verticals were called out as performing well, offset by declines in finance and media and entertainment. Alphabet’s cloud business reached GAAP profitability this quarter, moving from a -12% margin a year ago to a 3% margin. On the AI front, Alphabet upgraded Bard to run on its more powerful PaLM language model, while also adding the ability to assist with coding and software development. CFO Ruth Porat revised 2023 capital expenditures guidance, driven by higher data center construction and server spending to support AI investments across consumer products, advertiser tools, and the cloud business. Porat reiterated that the company plans to hold expense growth below revenue growth and that it will begin to see the benefits of the company’s cost-reduction initiatives later this year and into 2024. Alphabet hosted its annual developer conference in May where it showcased what we view as an impressive array of new AI-powered consumer tools to be rolled out over the course of the year.
Bottom Performers:
Warner Bros. Discovery’s first-quarter results revealed overall revenue that was hurt by ongoing advertising pressure in the networks segment and timing-related impacts to studios. Despite this, overall profitability continues to improve with adjusted earnings growing 12% year-over-year due to continued execution on cost synergies and an inflection in the direct-to-consumer segment. We found the improvement in direct-to-consumer to be particularly noteworthy, as churn hit a record low, subscribers grew by 1.6 million, and synergy realization drove operating expenses down $760 million year-over-year. The combination pushed direct-to-consumer adjusted earnings into positive territory for the first time, and management said it now expects the segment to be profitable for the full-year 2023, a year ahead of previous guidance. In addition, management reiterated guidance for full year adjusted earnings, free cash flow, and leverage targets. We believe the company is performing well given the current backdrop, and that profitable growth in the direct-to-consumer business should help ease investor concern around the long-term viability of the business.
Warner Music Group reported fiscal second-quarter earnings in May that were largely in line with consensus expectations, as revenue headwinds from foreign currency impacts, digital advertising weakness, and a lighter release slate all weighed on results. CEO Robert Kyncl remains confident that revenue will reaccelerate over the next two quarters, aided by a stronger release slate and easier advertising comps. On the cost front, we believe the company demonstrated strong discipline, which led to better margins and a 4% reduction in headcount. Kyncl plans to reinvest savings into growth initiatives, and despite this reinvestment, we believe the long-term outlook for around 100 basis points of annual margin expansion remains intact. AI has been a recent topic of conversation in the music industry, and while we believe it is too early to know AI’s ultimate impact on music, we are confident that Warner Music’s deep back catalog will stand the test of time. In our view, music intellectual property is irreplaceable and under-monetized relative to history, time spent, and other forms of media. We believe Warner can close this monetization gap as more people pay for streaming subscriptions, distributors raise prices, and new use cases license the existing catalog.
Walt Disney’s second-quarter results were pressured by a shortfall in the media business. Despite this, the parks business continues to perform well with revenue growing 5% year-over-year and earnings up 23% year-over-year. This was mainly driven by a recovery at the international parks, especially Shanghai and Hong Kong, which helped offset labor cost headwinds at the domestic parks. Disney+ subscriptions in the U.S. and Canada declined by 300,000 quarter-over-quarter and international subscriptions grew by 900,000, finishing at 46.3 million and 58.6 million, respectively. The North American decrease in subscriptions can partly be attributed to the increase in pricing in the U.S. as the average revenue per user grew 20% sequentially. Streaming losses improved by $400 million quarter-over-quarter but remain at -$650 million. Further, the linear business remains under pressure with an expected high-teens earnings decline in 2023, partly driven by a weak advertising market and a decrease in Pay TV subscribers. Walt Disney’s CEO Bob Iger communicated plans to integrate Hulu content onto Disney+ for bundled subscribers if it acquires Comcast’s 33% stake, which he expects will improve customer churn, engagement and expense synergies. Disney+ also plans to further increase the price of its ad-free tier to drive more subscribers to the ad-supported tier.
During the quarter, we initiated positions in Baxter, Celanese, First Citizens Bcshs CI A, IQVIA Holdings and State Street. We eliminated Adobe, Berkshire Hathaway CI B, Masterbrand and Mastercard CI A from the portfolio.
Past performance is no guarantee of future results.
The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. It is a widely recognized index of broad, U.S. equity market performance. Returns reflect the reinvestment of dividends. This index is unmanaged and investors cannot invest directly in this index.
The Russell 1000® Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000® companies with lower price-to-book ratios and lower expected growth values. This index is unmanaged and investors cannot invest directly in this index.
The specific securities identified and described in this report do not represent all the securities purchased, sold, or recommended to advisory clients. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time one receives this report or that securities sold have not been repurchased. It should not be assumed that any of the securities, transactions, or holdings discussed herein were or will prove to be profitable. Holdings are representative of Harris Associates L.P.’s U.S. Equity composite as of 06/30/2023.
Certain comments herein are based on current expectations and are considered “forward-looking statements”. These forward looking statements reflect assumptions and analyses made by the portfolio managers and Harris Associates L.P. based on their experience and perception of historical trends, current conditions, expected future developments, and other factors they believe are relevant. Actual future results are subject to a number of investment and other risks and may prove to be different from expectations. Readers are cautioned not to place undue reliance on the forward-looking statements.
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