Stock Strategist Industry Reports

The Advertising Message Is Clear: Buy WPP and IPG

Ali Mogharabi

We believe the sell-off of advertising holding companies’ shares has created an attractive entry point for investors. All four of the narrow-moat advertising names we cover-- WPP (WPP),  Interpublic Group of Companies (IPG),  Omnicom (OMC), and  Publicis--are trading at 4-star prices, but we think WPP and IPG have the best prospects.

In our view, the macro environment points to growth in advertising spending during the next few years, which bodes well for WPP and IPG. We expect a turnaround in ad spending, which experienced a slowdown in the second half of 2016 that continued through 2017, driven mainly by geopolitical uncertainties that may have discounted the expectation of enduring moderate economic growth.

Ad holding firms such as WPP, IPG, Omnicom, and Publicis have acquired a variety of agencies to offer their clients a one-stop shop. Their portfolios of agencies represent nearly everything necessary to provide an entire solution to their clients, the advertisers. They have long had creative and media agencies, all of which also have digital capabilities, including real-time data analytics and programmatic ad buying.

Based on company revenue and estimated ad spending worldwide, we think the four largest ad holding firms together hold approximately a 10% share of what appears to be a fragmented market. Further, based on industry studies, we think global advertising spending is likely to grow at a 4.3% annual average rate through 2021, slightly below the 4.8% we’ve seen over the past five years. During the same period, global advertising spending has grown at around 1.4 times real GDP growth.

WPP is the largest player in the advertising space, operating in more than 110 countries. We expect the firm to maintain its market-leading position as it generates competitive organic growth, continues to make acquisitions, and increases focus on the faster-growing emerging and the overall digital ad markets.

IPG is the fourth-largest player in the advertising space. Similar to WPP, we expect IPG to maintain its market position. The firm has demonstrated consistent operating margin expansion through cost controls during the past three years, which we expect to continue through the next few years, highlighting the success of IPG’s turnaround, which began 10 years ago.

Omnicom is the second-largest player (based on revenue) in the advertising space. Compared with its peers, the firm has attained that position less through acquisitions and more through organic growth. While Omnicom also appears cheap to us, we prefer WPP and IPG for the reasons mentioned above.

Publicis is the third-largest player in the advertising space (based on revenue), operating in more than 100 countries. We believe the firm’s restructuring, as it molds its creativity and technology offerings into one, is likely to help it generate competitive organic growth, increase focus on the faster-growing emerging and the overall digital ad markets, and maintain margins at levels above its peers.

Brand Recognition Will Help to Differentiate
We view the big four ad holding companies as having narrow economic moats. They hold valuable intangible assets, in our view, around the equity of their brands and the strong reputations of their different advertising agencies around the world. We also think the firms’ continuing investments in consumer data accumulation and analysis give them a sustainable competitive advantage. To a lesser extent, we think the ad holding firms benefit from customer switching costs associated with further integration of their resources with their clients’ marketing departments. We believe the utilization of these moat sources and overall execution will result in the companies earning excess returns on capital for at least the next 10 years.

While a lot of consolidation has taken place, WPP and IPG have operated and will continue to operate as holding companies, allowing the acquired agencies to maintain their reputations under their existing brands and strengthen their relationships with clients, all of which, by winning larger accounts, helps the firms increase the value of their own brand. In addition, we think it is the firms’ reputations and brands that allow them to compete mainly with other ad holding companies for larger accounts. When seeking ad agencies to create and manage large campaigns, Fortune 500 companies allow only a few ad companies to pitch their ideas. This is where the reputation and brands of a holding firm come into play, as usually the known agencies associated it are asked to make the pitches and compete for the account or a campaign of the account.

The ad industry is ever changing, but we view these intangible assets as a source of sustainable competitive advantage for the four firms under coverage through these various transitions. We note that the continuing double-digit growth we’re seeing in digital advertising has brought about disruption in the overall advertising space. Digital advertising has driven prices lower and introduced more widely adopted and easily implemented programmatic advertising, which may remove the digital media buying responsibilities from ad firms.

In our view, such disruption is also creating opportunities for the ad holding companies. Within digital, the emergence and accelerating growth of online long-form video content distribution is accommodated by growth in digital video advertising, which we think is a favorable trend. In our view, such a trend is likely to increase demand of differentiated ad content and effective messaging via more creativity for which the holding firms and their agencies are known, possibly easing pricing pressure.

Plus, while some advertisers have brought the programmatic media buying in-house, given that ad purchases cannot be based only on pricing, others own the technology (or partner with other vendors) and allow the ad agencies to make various decisions regarding programmatic purchases. In addition, other clients continue to give the agencies and their technologies complete control.

Within digital, the ad holding firms are forced to go head-to-head with more dominant players in the space, such as Facebook, Amazon, and Alphabet’s Google, which are the major ad inventory providers from whom agencies purchase ads. While those three companies also provide a platform for advertisers to directly purchase the ads, they are designed mostly for small and medium-size businesses, which the ad agencies of the holding companies do not chase aggressively.

We Expect Less Uncertainty, Higher Ad Spending to Aid Recovery
After a strong 2016 ad spending year, uncertainties surrounding the Trump administration, which may have also brought on doubts about the economy, have slowed ad spending in 2017. During the first three quarters of 2017, ad holding firms reported weak organic revenue growth in the United States. Cost-cutting measures implemented by many clients also resulted in ad holding companies’ clients asking for lower prices. Such factors plus ongoing fear of competition from consulting firms have been responsible for the underperformance of WPP and IPG.

We believe uncertainties surrounding the macroeconomic environment will soon clear up, minimizing advertisers’ hesitancy to market products and services more aggressively, likely beginning in the second half of 2018. The 2018 Winter Olympics and the World Cup are also likely to yield organic and total revenue growth for the companies. We expect over 2% organic revenue growth for WPP in 2018, given the firm’s wins in 2017 and the completed cycle of lost accounts in late 2016 and early 2017, providing easier comps for 2018. We also think the companies’ increasing focus on efficiency and consolidation of agencies under their umbrellas likely will minimize impact of lower prices and help maintain or possibly widen margins. In addition, we think WPP and IPG will continue to benefit from the double-digit growing digital ad space dominated by their frenemies: Google, Facebook, and soon Amazon. Last, we do not foresee any substantial threat from consultancies.

Behind Geopolitical Confusion Is a Growing Macroeconomic State
In our view, the macro environment points to growth in advertising spending during the next few years, which bodes well for advertising holding companies. We think a slowdown in ad spending in the second half of 2016, which continued through 2017, has been driven mainly by geopolitical uncertainties that may have discounted the expectation of enduring moderate economic growth. Real GDP growth around the world, in our view, has historically been closely paired with higher ad spending and, in turn, revenue growth for ad holding companies. We believe that GDP growth, along with growth in disposable income, is more likely to push further consumption, which influences businesses’ decisions regarding the size of their ad and marketing budgets. Plus, while the management of ad agency operations may require further improvement in efficiencies by the ad holding firms, we think the presence of the agencies globally and their focus on brand messaging in line with local cultures will benefit the holding firms over some of their competitors, such as consulting firms, in the long run.

The large ad holding firms have increased their exposure in the developing economies and the emerging markets to further tap into the faster-growing regions. Since 2006, as a percentage of total revenue, the revenue from non-U.S. and non-Europe regions increased from 17% in 2006 to 22% by 2016. Based on the International Monetary Fund’s real GDP growth projections for Latin America, Asia-Pacific, and other regions (which include Africa and the Middle East), we have estimated an average five-year revenue compound annual growth rate of only 0.2% for the largest four ad holding firms we cover. Such low growth is mainly due to the ongoing weakness that Omnicom, which generates the second-most non-U.S. and non-Europe revenue, has experienced in Brazil. We expect WPP and IPG to post 2.6% and 2.2% top-line CAGRs in those regions through 2021, respectively. Those rates remain below the expected real GDP growth rates of the regions, as the economies of those regions have not yet become primarily consumer-driven. Based on IMF estimates, real GDP in those emerging markets and developing economies is expected to grow at 4.9% per year through 2021.

We believe consumer confidence and disposable income point to further consumption. Both indicators have been growing steadily in the U.S. The passage of President Donald Trump’s individual and corporate tax reform by Congress may accelerate growth in disposable income. Plus, the upward trend for both bodes well for consumption in the future, which more than likely will convince companies to increase their ad spending.

While various indicators demonstrate the higher likelihood of moderate economic growth in developed and emerging markets, we are aware of geopolitical factors that might discount this likelihood slightly. They include the multiple questions surrounding the current U.S. administration, which may have created some instability and increased the employee turnover rate at the White House and the State Department. In addition, talks regarding Brexit, which is scheduled to take place in 2019, continue. Since the United Kingdom voted to exit the European Union, the U.K. economy has continued to grow between 1% and 2%. In addition, the U.K. and the EU continue to negotiate the Brexit process and have recently made progress.

Uncertainties brought about by other elections in Europe, along with the 2016 U.S. presidential election, may have also increased risks associated with many companies’ globalization strategies. Questions surrounding nationalism and globalism in developed countries may force advertising holding companies and their agencies to help advertisers focus more on local cultures when designing campaigns. If true, we view this as positive for ad holding companies, as historically they have acquired local agencies when attempting to expand their reach in new markets. For this reason, ad holding companies may be well situated as opposed to competitors like consultancies, which pitch more cost-cutting measures and efficiency that bring about more standardization, not necessarily benefiting big brands in the time of possibly growing patriotism in developed economies.

For example, in France, while globalist Emmanuel Macron won the presidential election, the runoff brought forth by nationalist candidate Marine Le Pen surprised many as she was pushing for France to exit the EU. Results of Germany’s parliamentary election in 2017 also indicate the rise of nationalism as nationalist party Alternative for Germany won seats in the Parliament for the first time. Increasing devotion to nationalism was also apparent in Austria’s election of Sebastian Kurz, leader of the right-leaning People’s Party, to be the next chancellor.

Agencies Benefit From Digital Advertising’s Ups and Downs
Digital marketing has brought forth opportunities for advertisers to more precisely target current or potential customers. Ad spending on digital media in the U.S. has overtaken traditional media such as television, and according to eMarketer, by 2021 digital ad spending will represent around 50% of total ad spending, up from 37% in 2016. Plus, various industry studies indicate that while overall ad spending is projected to grow at a 3% CAGR through 2021, growth of digital media, which is driven mainly by below-the-line or more targeted marketing and advertising, is expected to push digital ad spending higher at a 12% CAGR.

As the transition toward the lower-cost, more standardized, and more easily measurable digital ad space continues, we believe WPP, IPG, and their peers are facing some pricing pressure by their clients. Such pressure has been heightened by more frequent than normal account reviews and implementation of more cost-cutting and operational efficiencies by clients in their marketing departments. In addition, programmatic advertising has created more pressure, as these ads are lower-priced and can be more easily implemented because they remove the digital media buying responsibilities from ad firms.

In our view, such disruption is also creating opportunities for the ad holding companies. In digital, the emergence and accelerating growth of online video advertising is a favorable trend, as we think it is likely to increase demand for differentiated content and effective messaging via more creativity. We think ad holding firms like WPP and IPG have an abundance of talent in this area, which may provide them some leverage for slightly more favorable pricing.

Video ad spending is expected to be the fastest-growing part of overall digital ad spending, growing at roughly a 15% CAGR through 2021. We expect creativity, which was pushed to the background during the peak of cheaper and high-volume display online advertising, is more likely to be pushed to the forefront, from which ad holding firms will benefit.

Further, most of the ad holding firms’ clients, which consist of Fortune 500 companies, aim not only for below-the-line, or more targeted and direct, campaign launches but also above the line in order to more effectively maintain and/or increase their products’ brand equity. We believe this is especially true for consumer packaged goods firms, which are now further fearing the continuing growth of Amazon’s marketplace, where over time, pricing may become the only differentiator. While such a strategy drives growth in online video ads, we believe it will also push up demand for longer and more creative and imaginative video ads, which are more likely to garner interest from or generate engagement with viewers, possibly resulting in higher ROI. In our opinion, demand for creativity may also increase thanks to the shorter digital video ads, such as the bumper ads (6 seconds) seen on Google’s YouTube. We think innovation will help create short videos with the necessary effective, attention-grabbing messages.

Automation Still Needs Hand-Holding by Agencies
The continuing evolution in digital advertising has also brought forth programmatic ad buying. Initially, many advertisers handed over such responsibility to ad agencies, which began creating their own ad trading platforms. Some of those agencies, including WPP’s Xaxis (part of GroupM), would actually take inventory of the ads bought and resell them to their clients. In other words, instead of being just buying agents, they became principal buyers of the ads. Such a model at times helps increase the inventory arbitraging opportunity for the agency. However, at the same time, it may create a conflict of interest when it comes to the agency’s responsibility for its clients versus maximizing the arbitrage opportunity.

While WPP does principal-based ad buying, IPG does only agent buying. WPP’s strategy gives the firm an inventory arbitraging opportunity, which could help the top and bottom lines. However, such a method lacks transparency, which the firm’s clients may demand. For this reason, one of WPP’s most well-known clients, Unilever, has its own programmatic ad buying system, Ultra, which is managed by GroupM. While IPG’s agent-based buying minimizes the risk of negative reactions from clients, it also comes at an opportunity cost presented by the lack of inventory arbitraging.

While the real-time measurability of campaign results and dynamic adjustments to those campaigns helped attract many advertisers to the digital platform, we believe the lower cost of online campaigns has been the main attraction. In our view, the main low-cost driver has been the growing capabilities of programmatic advertising where media buys are automated, and the most heavily weighted factor in the purchasing model is usually the ad price. Advertisers began to recognize that instead of allowing the principal-based ad buyers to arbitrage the ad inventory, they could lower the cost of the ads they purchase by installing a programmatic ad buying platform in-house.

However, more advertisers are now realizing that ad purchases cannot be based only on pricing, and other factors such as campaign objectives, ROI goals, ad placement, overall strategic and creative thinking, and more must also be taken into account. For this reason, we believe ad agencies of ad holding firms will continue to play a role even within the growing programmatic ad buying.

Currently, while some advertisers have ad buying platforms all in-house, others continue to give ad agencies and their technologies complete control, and some own the technology (or partner with other vendors) and allow ad agencies to make various decisions affecting how and when purchases are made programmatically.

Agencies Benefit From Behemoths’ Good and Bad
While ad holding firms and their agencies have benefited from growth in digital advertising, they have also been forced to go head-to-head with more dominant players in the space, such as Facebook and Google.

In our view, Google, Facebook, and soon Amazon are the major ad inventory providers for advertisers and their agencies. Ad holding firms mostly purchase digital ads from the three companies for their clients, the advertisers. While those three behemoths also provide a platform for advertisers to directly purchase the ads, they are designed mostly for small and medium-size businesses, which the ad agencies of the holding companies do not chase aggressively. In addition, companies such as Google and Amazon continue to use ad holding firms to market their own offerings. For example, while Google is one of the largest ad buy-side and sell-side platform providers, it actually uses WPP’s Essence to handle its own programmatic ad buys. Another example is Amazon, which recently decided to use IPG for media buying.

Some negative events surrounding Google and Facebook may have also increased dependency of advertisers on agencies, in our view. Earlier in 2017, many brands’ ads were placed next to extremist and racist content on YouTube. In reaction to this and the fear of negative impact on brands, advertisers such as Verizon, Pepsi, and Johnson & Johnson pulled their ads temporarily. More recently, we saw a recurrence of bad ad placement as many brands were placed among disturbing content aimed at children. In response, Google has decided to increase its head count to monitor content placed on YouTube. On the data front, multiple times in late 2016 and in 2017, Facebook has admitted to mistakenly inflating ad-related metrics, which probably affected advertisers’ or their programmatic systems’ ad purchasing decisions. Facebook is also trying to avoid unknowingly placing Russian ads in user’s feeds, which some believe may have affected the 2016 U.S. presidential election.

We believe these occurrences have demonstrated the risk of programmatic media buying and ad placement, plus the overall value of an ad agency’s participation in an entire ad campaign--from creation to media buying and ad placement--which may have been overlooked by some.

Consultancies Still Chasing Agencies After Nearly a Decade
In our view, consulting firms currently are not the primary competitors nor the disruptive players in the space, as many had expected. IT and strategic consulting firms began dabbling in advertising and marketing about eight years ago. What they lacked--which we believe is still true today--is clients’ product knowledge, studies of customer behavior, and creativity. While the large four consulting firms—Accenture (ACN) , Deloitte, IBM (IBM), and PwC--have enhanced their creative offerings slightly, we believe they often find themselves in a dilemma where their strategic pitches to clients are based mainly on implementing various cost-cutting measures and increasing efficiency, while at the same time, they come at the cost of capping or minimizing marketing expenses, which could limit or slow revenue growth for the clients. Efficiency, or cost-cutting measures requiring different procurement--which is basically what we think consulting firms pitch to CEOs, CFOs, and CIOs of many companies--focuses mainly on price while marketing should be focused more on creativity and innovation.

While consulting firms are using their expertise in technology to offer data analytics possibly for better understanding of consumer behavior, in our view they lack the creativity that better utilizes data analytics as it helps marketing departments and agencies design and implement more effective campaigns.

We believe the latest more aggressive agency acquisitions by the consultancies back up our perception that they lack creativity. Accenture made 10 acquisitions in 2017, with the average purchase price estimated at more than $70 million. Of these, the main acquisition was Australian creative agency The Monkeys. The firm’s first major creative acquisition was in 2016, when it bought U.K. ad agency Karmarama, with clients like Unilever and Honda. According to R3, Deloitte made four acquisitions for a total of $144 million in the first three quarters of 2017. In early 2016, IBM bought German digital ad agency Aperto, with clients including Airbus and Volkswagen. While such acquisitions have helped consultancies make their marketing and advertising revenue more comparable to the big four ad holding companies, we believe they still trail the holding firms in talent.

We expect the brand equity moat source of ad holding firms to provide leverage when seeking additional talent and to maintain their lead over the consulting companies when it comes to creativity. Plus, we think IPG, WPP, and their peers have made headway in increasing their assets in digital marketing, which is where most of the consulting firms are focusing.

Consulting firms have been successful in convincing their clients to upgrade and integrate their systems corporatewide, implement cost-reduction strategies, and operate more efficiently, which has also led to less marketing and more pricing pressure on agencies. In our view, the overall marketing cost-reduction steps taken by larger clients have forced WPP, IPG, and their peers to further consolidate to create cost efficiencies over smaller ad agencies and minimize the impact of lower prices offered by the clients. While most Fortune 500 companies continue to demand creative and effective ad campaigns, they would also like to simplify the process of campaign design and launch by possibly reducing the number of agencies with whom they work for various components of their campaigns, which may include not only ad creation and media buying but also public relations. As a result, continuing consolidation has helped ad holding firms provide the complete advertising solution to clients around the world and benefit from growing digital ad platforms such as social media, mobile, and video. In our view, it will be difficult for consultancies to provide such one-stop-shop offerings.

While a lot of consolidation has taken place, WPP and IPG have operated and will continue to operate as holding companies, allowing the acquired agencies to maintain their reputation under their brands and strengthen their relationships with clients, all of which by winning larger accounts helps the firms increase the value of their own brand. In addition, we think it is the firms’ reputations and brands that allow them to compete mainly with other ad holding companies for the larger accounts. When seeking ad agencies to create and manage large campaigns, the Fortune 500 companies allow only a few ad companies to pitch their ideas. This is where the reputations and brands of the holding firms come into play, as usually the known agencies associated with them are asked to make the pitches and compete for the account or a campaign of the account. In our view, such recognition, which can be interpreted as high brand value, is shared by the holding firms, including WPP and IPG, and is what the consultancies have been lacking.

Accenture and other consulting firms are appearing a bit more often at pitches, but their hit rate has been disappointing. For example, in the third quarter of 2017, Accenture Interactive went head-to-head with IPG’s Huge for McDonald’s digital design account and lost. Earlier, Accenture failed to grab another McDonald’s account for digital innovation when it went up against Publicis.

On the basis of WPP’s details regarding the outcomes of the firm and consulting companies going head-to-head for various accounts during the first three quarters of 2017, we don’t think WPP and its peers will be significantly affected by consulting companies’ more aggressive strategies to enter and expand in the advertising and marketing space. WPP’s list of account wins and losses showed the firm won nearly twice as many accounts as consulting firms. Plus, those wins represented more than 3 times the revenue of those won by consultants. In addition, out of the 11 pitches for accounts representing potential revenue of more than $2.5 million, WPP’s agencies won nine while going up against Accenture, Deloitte, IBM, and PwC. Accenture and Deloitte split the other two.

Last, similar to Google and Amazon, while the consulting firms compete with ad agencies, they also depend on their services. In 2017, Accenture chose IPG’s UM as its media agency. IPG appears to be attracting more consulting firms, as PwC also chose to work with IPG’s R/GA agency. However, by winning the account, R/GA displaced only its fellow IPG agency, Deutsch.

Ali Mogharabi does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.