TFI Television Francaise TF1

European media stocks outperformed the broader market by around 16% last year, and analysts are expecting continued outperformance from the sector in 2011, driven by an ongoing cyclical upswing in advertising and corporate spending.

Last week saw shares in Comcast Corp. (CMCSA, CMCSK), CBS Corp. (CBS), Lagardere S.C.A. (MMB.FR), WPP PLC (WPP.LN), Vivendi S.A. (VIV.FR), Television Francaise 1 SA (TFI.FR), and Axel Springer AG (SPR.XE) all hit 12-month relative highs.

The sector is trading at a 30% price-earnings premium to the market, according to Credit Suisse media analysts, which is low compared with its long-term upside of around 50%. That suggests the sector should see multiple expansion at this point in the cycle.

Despite the good performance in 2010 though, it should be noted that the media sector did underperform the wider market by 12%, if the timeframe is widened to 2009 and 2010.

Underlying the expected sector's strong stock market performance is the idea that corporate free cash flow is at a high level while investment levels are low so there is money available for a potential major uptick in spending.

Credit Suisse strategists recently noted that free cash flow is running at around 4.3% of GDP in the G4 economies, up from just 1% 10 years ago. At the same time, investment is approximately 16% of GDP in the major economies, down from around 20% of GDP in 2001.

So this year is seen as a return to business-as-usual for advertising with JP Morgan penciling in a continued rebound in spend, with their analysts expecting U.K. revenues up 2.4% this year compared with a bounce of 6.7% in 2010, with a greater uplift in 2012 of 4.2%.

The focus is therefore on late-cyclical stocks with analysts suggesting ITV PLC (ITV.LN), which Credit Suisse upgraded Monday to Outperform from Neutral, Reed Elsevier PLC (REL.LN, REN.AE), ProSiebenSat.1 Media AG (PSM.XE) and WPP as key longs, with Mediaset S.p.A. (MS.MI), Wolters Kluwer N.V. (WKL.AE) and yellow-pages companies as shorts.

Moving swiftly onto M&A, the general prognosis is for a range of smaller incremental deals, driven in the main by cheap cash. While this trend for smaller deals was already in place last year, there were also several larger transactions, such as Disney/Marvel, Comcast/NBCU, Bertelsmann/KKR digital music rights and Apax/Bankrate. But there are no houses willing to suggest major transactions, at least in public, at this stage of the year.

While the guessing game of large-scale M&A is normally left to risk arbitrage funds, the key consensus call for the first half of the year is Vivendi buying Vodafone Group PLC's (VOD.LN) 44% of French mobile operator, SFR. But much of the potential upside for that deal is probably baked into the Vodafone price already.

(Paul Sharma is a columnist for Dow Jones Investment Banker on the telecommunications, media and technology sectors. He has 20 years of telecoms industry experience, working as an analyst and in industry. He can be reached at +44 20 7842 9463 or by email: paul.sharma@dowjones.com)

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