The media sector was a steady, if unspectacular, performer in 2010, with share prices advancing an average of +13 per cent compared with a virtually flat market. This performance in 2010 over 2009 was almost identical to that of 2004 over 2003 when the sector rallied dramatically in March 2003 after the tanks rolled into Baghdad and then trod water in 2004 as share prices waited for earnings growth to catch up and justify the previous year's strong rally.
Similarly, the sector performed robustly once Barclays had passed its stress test in March 2009, going up 100 per cent, and then ticked along in 2010 while the market waited for the upgrades to come through in 2011 and beyond. Given the globally synchronised cost-cutting post the collapse of Lehman in September 2008, followed by the globally co-ordinated reduction in interest rates to the lowest level in human history by March 2009, we have witnessed a faster rebound than either of the previous two recoveries of the early 90s and early noughties. Since that time, we have witnessed the impact of the beginning of globalisation and the coming of the digital age.
Keeping in mind the previous cycle, we expect the next three years to 2013 to mirror the three years up to 2007 when the sector grew and diversified - B2B away from print and advertising into online and events and agencies from traditional media in developed markets to digital media and emerging markets. Indeed, outperformance in 2010 was driven by the quality cyclicals in the agencies and B2B sub-sectors, which exhibited these trends and which were our preferred plays. However, we believe that the sector has made more operational progress in the downturn than has been reflected by share prices and, in the absence of a double-dip, continue to view the sector as undervalued.
We do not see a double-dip as the main threat, especially while interest rates stay low, but expect anaemic growth in the UK and other developed countries that are burdened with heavy debt and ageing populations to be offset by robust growth in emerging markets with cash surpluses and growing, youthful populations. In addition, we view unfettered inflation as the big risk on the horizon rather than deflation as witnessed in the rising cost of all commodities, both hard and soft, from gold to cotton. We believe that the greatest risk to recovery is high debt and the greatest risk to growth is inflation, but the former (debt) is reduced by the latter (inflation) and therefore governments on both sides of the Atlantic are likely to keep interest rates too low for too long in their attempts to cure public and consumer debt.
However, equities and especially media stocks, which give exposure to strong corporate balance sheets and rising dividend streams and which act as an excellent hedge to inflation, look cheap in absolute terms. And very cheap in relative terms given the inexorable rise of all other asset classes from property to bonds to commodities.
This view is supported by our peak earnings analysis where, compared with the previous cyclical peak, we believe that sector earnings will benefit from three key factors. First, many groups (particularly in B2B) have improved their business mix towards structurally more profitable areas. Second, a number of companies entered the downturn with excess leverage, which, in the absence of further M&A and on current dividend and capital expenditure policies, we expect to reduce significantly through cash generation. And third, overseas earners will benefit from the depreciation of sterling compared with the peak of 2007: $1.60/£1 compared with $2.00/£1 and EUR1.20/£1 against EUR1.50/£1 - a fillip of 20 per cent.
In addition to room for earnings recovery, the animal spirits have started to stir, and we see scope for considerable M&A activity over the next 12 to 24 months. This is particularly the case as many larger groups have extended and diversified their funding over the past year, and are now locked into expensive long-term debt while accumulating significant cash balances on which they are generating next to no return. Also, we are aware of the sheer concentration of ownership in smaller media companies, with typically half of a small-cap's shares controlled by just five shareholders, thereby creating a ready platform for a bid. Finally, on our forecasts, a number of groups will have cash balances of around half of their current market caps by 2013, the next likely peak, which we believe can be deployed for acquisitions and/or buybacks.
In summary, we remain positive on the media sector as we pass the middle of the cycle and begin the inexorable climb towards the next peak and our preference continues to be for the quality cyclicals. In large-/mid-cap, our top picks are Aegis, DMGT, Informa and WPP. In small-cap, we highlight Euromoney, ITE, Mecom and Rightmove. We have constructed peak earnings models on a bottom-up divisional basis, assuming 2013 is the peak. We believe earnings per share can exceed the last peak due to an improved business mix; deleveraging and positive FX impact, as highlighted above. We see scope for EPS to be materially higher than the last peak at BSkyB, DMGT, Euromoney and Rightmove in the large-/mid-cap space and at Ebiquity and ToLuna in small-cap.
We calculate that the large-/mid-cap stocks are trading on eight times peak earnings, falling to five times for the small-caps. We have seen an increase in bid activity, from the largest (NewsCorp for BSkyB) to small-cap (Time Warner for Shed Media). We view Aegis, Euromoney, ITE and Rightmove as the most attractive in large/mid-cap, and Chime, Huntsworth, Motivcom and YouGov in small-cap. On our forecasts, Bloomsbury, M&C Saatchi and YouGov will have cash balances equal to half their current market caps by 2013, while this will be around a quarter for Chime, ITE, Rightmove and ToLuna. We therefore see significant scope for enhancement through acquisitions and/or buybacks.
Lastly, distribution via tablets and mobile internet along with data-rich content that provides accountability and ROI will dominate City investment thinking in 2011 - and even a game-changer like the mighty iPad is but an empty vessel without quality content. Having been through a tough three years of retrenchment and regrouping, our time has come again - don't be short of media stocks.
Lorna Tilbian is the executive director and head of media research at Numis.