Agency Transparency Issue Not Going Away -- Pivotal Research

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We are updating price targets on agency holding companies ahead of 3Q16 earnings, featuring new YE2017 price targets and updates to our company models. As Publicis has fallen off since our recent downgrade to Hold, but our price target is now slightly higher, we are now upgrading Publicis back to Buy. However, IPG offers more upside potential and remains our preferred stock among the group. Omnicom and WPP remain Hold-rated, as our new price targets remain sufficiently close (+/- 15%) to current trading levels. WPP remains the best-in-class holding company in the long run, although OMC is poised to remain very strong in the near term.

Agency holding companies appeared relatively quiet during the third quarter, with seemingly less news related to transparency, account reviews and profit pressure than we saw earlier in the year. However, the importance of each of these topics remains undiminished.

The "rebate"/transparency issue isn’t going away any time soon.Marketers have taken the recent K2 report on transparency very seriously, with most we have spoken to looking to ensure that their contracts account for the issues referred to within the report. The impact of the report will likely take years to play out, as marketers become newly aware of different ways that agencies transparently or otherwise generate revenues. Marketers are also learning of the need to become increasingly vigilant in approving costs associated with the technology vendors their agencies recommend. As illustrated by the recent over-billing episode with Dentsu in Japan, they will also likely place additional scrutiny on media plans as well. However, we also think that many marketers 'happily' accept the trade-off between low fees and an agency's ability to generate revenues from principal trading activities to make up the difference. Although marketers who dislike these practices or the potential biases they introduce into holding companies, those marketers have relatively few alternatives outside of the holding companies to practically consider given holding companies’ advantages of experience, cost and geographic span.

Account reviews have shown Omnicom to be on a hot streak this year.While new business is only one factor supporting the health of a holding company, the degree to which Omnicom has outperformed this year is significant, with recent account wins for McDonald's, AT&T and Volkswagen among others. However, from the outside it is difficult to know how much of the new business performance was due to better strategic offerings vs. re-imagined workflows vs. better pricing. And where better pricing is at play, we’re mindful that Omnicom has expanded its principal trading operations significantly in recent years (illustrated well, we think, by the gap in revenue per employee at Omnicom which is around 30% higher than for Interpublic). Whatever the source, Omnicom is well positioned to grow faster than peers in 2017 because of this year’s activity.

Cost pressures are ever-present, and cause holding companies to manage differently. Marketers are constantly looking to squeeze like-for-like fees, and where they have the ability to do so, the margins that agencies generate. Individual business units, in turn, have to find new ways to manage their operations to meet goals promised to investors, such as a given number of basis points of margin improvement each year. We remain relatively optimistic that agencies can continue to find new ways to squeeze efficiencies out of their operations, above and beyond what marketers would try to claim for themselves. For example, we note that centralization efforts are ongoing at many sub-holding companies, as illustrated by Publicis’ creation of many single country P&Ls for its major creative agencies. Similarly, Publicis' efforts to place all agencies in markets outside of the top 20 under one P&L (dubbed Publicis One) probably balances global marketers needs with cost efficiencies, if possibly at the risk of limiting revenue growth from single country clients inside of those markets. But these efforts are not limited to Publicis. We noted that IPG' McCann Worldgroup recently sold off its Nordic units to an entity that will maintain an affiliate status with McCann. Such moves, while relatively small, are likely illustrations of ways in which holding companies can continue to manage their enterprises towards the margin goals they have set.

VALUATION. We value companies on a DCF basis. Key variables driving valuations across the agencies include long-term costs of capital ranging from 10.9% to 11.4% (IPG, OMC and WPP and the low end and PUB on the high end) and long-term growth rates ranging from 4.0% (for IPG and OMC) to 5.0% (for WPP and PUB).

RISKS. Agency risks relate to squeezing fees from clients, competition from adjacent industries, reduced competition between marketers and demand for advertising services.


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