In October 2007, we published Lessons from the Last Downturn which detailed the cyclical, structural, financial and valuation risks facing the media sector should the global economy slow down significantly, and fall into recession in the UK and US.
We viewed the professional/educational publishers as the safe haven in the sector, while we saw the greatest downside from free-to-air broadcasters. We thought large agencies could surprise with their resilience, while business-to-consumer would continue to suffer in terms of valuation due to structural as well as cyclical issues.
Although we have been taken aback by the sheer scale, severity and speed of the downturn, our analysis has proven broadly correct in the year or so since publication. We continue to view the near-term economic outlook as bleak, with steep interest-rate cuts and falling oil and commodity prices offset by high debt and negative wealth effects as house prices continue to correct and unemployment rises.
In this uncertain and recessionary environment, we are wary of the broadcasters, which have high advertising exposure and operational gearing, particularly as these factors are exacerbated by structural challenges and (still) high near-term multiples. By contrast, we are attracted by the breadth and resilience of revenue streams, variable cost bases and robust cash flow of the large agencies and professional/educational publishers, where multiples are well below those last reached in the depths of the 2001-03 downturn and even below those of the full-blown 1990-92 recession.
Elsewhere in the sector, we see long-term value in smaller agencies, B2B groups and some B2C publishers, though near-term share price movements remain difficult to predict with any degree of confidence as extreme volatility has become the norm. Finally, as the credit crunch eventually eases, we see scope for value in the sector to be unlocked through corporate activity as larger groups with strong balance sheets take advantage of the significant reduction in asset values and we also expect share prices to be supported, though on a selective basis, by increased dividends.
This month, we will be publishing Lessons from the Last Upturn where we will argue the case for the recovery. The stock market will begin to discount the pick-up a good year before we see any tangible signs of it. Indeed, the bottom of the market will come at the time of unmitigated gloom and despair when management will speak only of perpetual decline. That will be capitulation. Historic patterns imply the current correction is worse than 1974 and indeed as severe as 1929. Investor behaviour and psychology suggest a near bottom as unbridled greed has given way to frozen fear.
Valuations are the cheapest we have seen in 25 years and the stimulus thrown at the economy the greatest any of us has ever seen. The co-ordinated global policy response under way could see monetary policy go to zero - the lowest in 5,000 years of human history - while fiscal measures in the US, still the economic powerhouse of the world, will be unprecedented following the inauguration of the new president.
And all the while oil and commodity prices have been falling, building the foundations for the next recovery. With the banks largely recapitalised, Libor (London Interbank Offered Rate) will eventually fall and the early- cycle, sensitive media sector will lead the recovery, just as it led the way down - the canary in the mineshaft!
The best times to have bought media stocks in the past 25 years would have been in the darkest hour in October 1992 or March 2003 and the greatest returns were made in the early part of the cycle. For example, if you had bought Granada on 10 March 2003, you would have paid 52p for a stock trading on a price to earnings ratio of 13x. By 19 January 2004, ITV was trading at 145p and on a PE of 33x. Similarly, if you had bought Reuters on the same day, you would have paid 109p for a stock trading on a PE of 7x, which nine months later was trading at 317p and on a PE 21x. This dramatic re-rating occurred just as the tanks were rolling into Baghdad and as the collective wisdom of the market concluded that the worst was behind us and that the string of downgrades had come to an end. As the economic backdrop gets worse over the course of the next year and as unemployment rises, profit warnings will accelerate and earnings will compress from their 2007 highs - while multiples expand just as happened in 2003 and 2004.
The first stage of recovery is driven by re-rating, once the cycle of downgrades is over, and runs for about a year from when the market has turned. In 2003, the first year of recovery in the previous upturn, the sector PE multiple doubled from 13x to 22x. Within this, the average PE for agencies expanded from 9x to 18x, B2B groups from 11x to 22x and broadcasters from 13x to 26x. By contrast, the B2C groups which had held up well during the downturn - when the UK was perceived to be the strongest of the G8 economies as consumers withdrew equity from their homes and spent it on the high street - PE multiples "only" expanded from 11x to 15x.
The second phase of recovery is driven by the delivery of higher earnings. Between 2003 and 2007, EPS rose +47 per cent for the agencies, +85 per cent for B2B groups and superficially by +58 per cent for the B2C groups and broadcasters, the latter driven by BSkyB's move into substantial profitability and ITV's merger benefits and extensive cost-cutting; excluding these factors, EPS rose by just +36 per cent.
Finally, it's worth noting that peak earnings for B2C groups and broadcasters were achieved in 2005 as broader structural issues started to weigh in and curtail growth.
Every cycle is different and the combination of an acute financial crisis and a long-overdue economic downturn has made this one the worst in living memory, but we believe the lessons from the last upturn provide a valuable guide for when the media sector eventually turns. This, too, will pass!
- Lorna Tilbian is an executive director and head of media research at Numis.