The global economic downturn has affected nearly every industry, including advertising. While we think ad spending will remain weak in 2009, we anticipate a rebound in 2010. However, it may be too late for investors to play this rebound, as the stocks of most advertising-related companies have appreciated considerably since the market lows of the past year.
According to TNS Media Intelligence, after falling 4.1% in 2008, US advertising fell another 14.3% in the first half of 2009. With the exception of online advertising, every major category (television, newspapers, radio, magazines, outdoor) posted double-digit declines during this period. While media companies that depend on advertising revenue have taken a big hit during this recession, marketing services conglomerates Omnicom, Interpublic Group and WPP Group have been affected as well. During the first half of 2009, US internal revenue at Omnicom, Interpublic and WPP declined between 10.1% and 12.3% compared with the overall decline of 14.3% reported by TNS.
While their short-term results are discouraging, we like the marketing conglomerates' competitive positioning. Although most large corporations have internal marketing departments, they still outsource the majority of their marketing needs (ad creation, brand strategy, media buying, public relations, and so on) to specialised agencies because of the complexity and scale of their campaigns. As a result, the large global footprint and broad portfolio of services these firms can offer make it very difficult for smaller rivals to compete for large, integrated marketing campaigns. Additionally, the nature and variety of services performed leads to customer "stickiness," as building relationships with new service providers can be cumbersome. Combined with incremental acquisitions and international exposure, we think marketing services firms will enjoy steady revenue growth over the long run.
In the short term, we expect revenue growth to remain weak. However, despite significant revenue declines in the past two quarters, operating margins have held up fairly well, thanks to a business model with very few fixed costs. For example, Omnicom was able to reduce its operating expenses by 15% in the first half of 2009, nearly matching the 17% decline in revenue. Therefore, its operating margin was 12.1% compared with 13% in the prior-year period. We think the ability to adjust operating expenses as needed will lead to respectable profitability irrespective of the business cycle.
Although we think these conglomerates are well positioned for the future, an investment in any company comes with risk. For these conglomerates, the main risks are insourcing (corporations performing more of their marketing operations internally) and disintermediation over time as more advertising moves online. While we think we have appropriately taken these factors into account, there is a risk that these businesses will underperform our expectations. Therefore, as with all companies, we would recommend that investors buy shares only at an appropriate discount to our fair value estimate. For example, Omnicom, Interpublic, and WPP have all traded at a healthy discount to our fair value estimates in the past few quarters. At their lows, we believed the prices of these stocks presented an attractive risk/reward ratio.
Although it was (and still is) impossible to know the depth and length of the global economic downturn, we were comfortable recommending the stocks while the stock markets were testing their lows because of the firms' strong competitive positioning.
Considering the appreciation in the shares, we don't think an investor should consider buying the stocks of these companies at current prices, as the stocks are now trading close to our fair value estimates.
The experience of the marketing conglomerates provides a great investing lesson. If an investor had waited for the fundamentals of these companies (or the fundamentals of the overall economy) to actually improve, it would have been too late to reap a large chunk of the rewards for holding these stocks. For example, Omnicom still hasn't returned to revenue growth, but the stock is up 87% from its low in March. On the other hand, patient investors who are willing to invest in businesses with solid competitive advantages, even during periods of crisis, stand to benefit handsomely as the market catches on.
Omnicom
Omnicom generated $13.4 billion in sales in 2008 from a wide variety of services across the globe. The company's three global networks (BBDO, DDB, and TBWA) are very strong on their own, earning the lion's share of industry awards every year. While the individuals at these agencies deserve much of the credit for Omnicom's success, a great deal must also be attributed to its excellent management team, led by CEO John Wren. An accountant by training, his patience and business acumen have served the company well. Wren has been more selective in acquisitions over the years than his rivals, allowing the company to avoid the acquisition-related problems suffered by others. A broad service offering, global reach, creative excellence, and disciplined management have made Omnicom the de facto gold standard in the communications industry.
WPP Group
With the acquisition of TNS in 2008, WPP is now the largest marketing conglomerate in the world. We think the company benefits from many of the same traits as Omnicom: strong individual agencies, global reach, and diversified offerings. Additionally, WPP has been more aggressive expanding overseas and now receives about two thirds of revenue from outside the United States, compared with just under half for Omnicom and Interpublic. Therefore, we think WPP could have better growth prospects than its peers over the long run. On the other hand, WPP has admittedly overpaid for many acquisitions in the past, and we remain sceptical that management has the discipline to refrain from overpaying for future targets.
Interpublic Group
Though much smaller than Omnicom and WPP (about half the revenue), Interpublic similarly benefits from a global network of world-renowned agencies including Universal McCann, Lowe, Draftfcb, and Jack Morton. However, IPG is still in the midst of a lengthy turnaround, as the company basically imploded after buying hundreds of companies during the 1990s and lacked the proper financial controls to account for all the acquisitions. After taking half a decade and $2 billion (audit fees, impairment charges, and restructuring fees) to clean up this mess, IPG was recording steady improvements in its financial results until the recent economic downturn. We expect further improvements once the economy rebounds.
Larry Witt, CFA is a Morningstar stock analyst based in the United States.
