Wall Street US stocks
US entertainment stocks have outperformed other sectors so far this year. And they seem ready to take on industry-wide challenges too. Image Credit: Reuters

Among the 11 sectors making up the US equity market, only one has seen its earnings growth upgraded by analysts since the start of the year - communication services. This sector comprises more than the historical telecommunication sector dominated by telephone companies.

Today, only 10 per cent of the sector is made up of telecommunication services (including mobile-phone service providers) and 90 per cent is media and entertainment companies, which includes interactive media, social networks, movies, TV shows, advertising and broadcasting. The advertising market accounts for a sizeable part of the sector’s revenues.

Having the best earnings momentum has propelled communication services to become one of the top performing US equities sectors this year, delivering 32 per cent return until the end of May. We believe there is more to come – we expect this sector to outperform the broader US equity market over the next 6-12 months.

Best earnings momentum

Except for communication services, every other US equity sector has seen their 2023 earnings growth estimates downgraded this year as economic growth slowed on the back of rising interest rates. Today, the sector’s earnings are estimated to grow by 17 per cent for the full year, compared with 7 per cent expected at the start of the year, according to consensus estimates compiled by Refinitiv.

Cost-cutting and optimisation measures, besides a resilient advertising market, have driven the earnings outperformance. For years, the sector had seen strong revenue expansion, driven by the structural growth of digital advertising and the explosion in digital media services. Of course, the cost structure grew in tandem, assuming the good times would last.

A growth slowdown in 2022 led to a series of profit warnings from the sector. Eventually, the sector’s earnings fell 22 per cent last year.

Companies in the sector reacted with cost-cutting measures this year, cheering investors. This prudence has enabled the sector to continue generating strong cashflow, which are used to fund share buybacks. According to Bloomberg data, share buybacks in the communication services sector amounted to 1.1 per cent of the sector’s market capitalisation in Q1-2023, double the pace for the broader market.

A likely US recession over the next 12 months could impact advertising spending, potentially hurting the sector’s earnings. However, the sector has already shown its ability to reduce costs in the face of revenue headwinds. We expect it to be more adept than other sectors in adjusting costs further to mitigate a growth slowdown.

AI opportunity

AI is set to affect the sector. There is a fear AI could eat into advertising revenues driving the sector. We should not overlook the opportunities that AI brings. It can enhance services, which drives new revenue potential while delivering productivity improvements.

The internet, media, and entertainment services are likely to evolve with the application of various AI tools. Periods of great technological change may introduce new forces upending the existing competitive landscape. We see companies in the sector adapting to the change and finding opportunities to monetise AI.

We do not expect AI to significantly disrupt the sector’s advertising business model in the near term.

Reversal of 2022 underperformance

The communication sector has outperformed the broader US equity market by over 20 per cent this year, but this is only a partial reversal of the underperformance seen stretching back to Q4-2021. Regulatory uncertainties over the use of personal data and alleged anti-competitive behaviour have weighed on the sector.

Then there was the string of profit warnings last year. As a result, the sector underperformed the broader US market by 30 per cent from Q4-2021 until the end of 2022. This year’s outperformance means it has retraced just over a third of its peak-to-trough underperformance versus the broader US market since 2021.

We expect the sector to make up from the past year’s underperformance in the coming quarters as its returns catch up to reflect its stronger earnings momentum.