Omnicom (OMC, Financial) is a holding company of advertising, marketing and corporate communication agencies. The industry is dominated by four players: WPP PLC (LSE:WPP, Financial) is based in the U.K., Publicis (XPAR:PUB, Financial) is based in France, Omnicom is based in New York City, and Interpublic Group (IPG, Financial) is also based in New York City.
They are all under the same holding company model in which the agencies are operated independently.
Omnicom provides services in four disciplines: advertising, customer relationship management (CRM), public relations and specialty services. Essentially, Omnicom helps its clients manage things like media planning, marketing and brand building.
Omnicom was founded in 1986 by a three-way merger between BBDO, Doyle Dane Bernbach and Needham Harper Worldwide. It holds five major agency networks: BBDO, DAS, DDB Worldwide, Omnicom Media Group and TBWA Worldwide. The U.S. accounts for about 56% of the revenue. The top 100 clients represent a bit over 50% of revenue with the largest account less than 3%.
Omnicom has been run by CEO John Wren since 1997; Wren has been with the company since 1981. A New Yorker, Wren started as an entrepreneur of a T-shirt manufacturer.
Financial profile
Revenue growth
The advertising industry is growing along with nominal gross domestic product (GDP). According to Staistitica.com, the revenue of the U.S. advertising industry was about 5.4% on an annual basis from 2004 to 2014. During the same period, Omnicom grew its U.S. revenue by 4.6% CAGR from $5.2 billion to $8.2 billion (source: company 10-K). In 2009 revenue was down 8.9% excluding 3.4% currency effect with no material positive contributions from acquisitions (re: 10-K).
Omnicom’s competitor in the U.S., Interpublic Group, had 10.8% revenue decline excluding currency with no material positive contribution from major acquisitions either. Therefore, although the advertising industry is commonly viewed as a cyclical industry, the numbers did not show a cyclical nature. In recent years, Omnicom’s growth has been dragged down by a strong U.S. dollar. This is likely a negative trend in the short term as the Federal Reserve has raised the interest rate, and the U.S. dollar appreciates.
Margins
Omnicom has stable margin with a net margin ranging between 6% and 8%. Even in 2009 the margin did not drop significantly. Omnicom is organized as a holding company, and its own agencies can compete with each other in the same market. As a result, I don’t see significant margin expansion with increasing scale. In fact, at the end of 1990s, the company grew through acquisitions, and revenue growth has been in double digits, but the margin has been stable.
Source: data from gurufocus.com
Cash flow
Omnicom has very strong cash flow. Over the last two decades, the cash flow at Omnicom has been greater than the net income as the company consistently exercised working capital improvement.
Debt maturity
Omnicom has about $4.6 billion in debt. Debt convenants require 3x net debt to EBITDA. The company constantly maintains above $2 billion cash on the balance sheet. Annual free cash flow generation is above $1 billion. EBITDA is $2 billion-plus. Going back to 2009, the company’s revenue dropped 10%, and net income dropped 17%. Barring a black swan event, the company’s debt repayment capability seems solid.
Return on invested capital
Omnicom has delivered 20%-plus ROIC consistently through Wren’s tenure. If using cash returns, the ROIC is even higher.
So Omnicom has about nominal GDP growth with some cyclical nature but not much operating leverage. You might ask, why invest in something like this with primarily single-digit organic growth that is already one of the biggest players in an industry of oligopoly? The answer lies in its cash flow and the company’s use of free cash flow.
From the above, we have seen that Omnicom generated strong cash flows consistently. The cash flow generated has been used in repurchasing stocks and giving dividends. Over the last four years, free cash flow averaged about $1.5 billion per year, of which over $800 million was used in share repurchases and $500 million was used in paying dividends.
Since 2007, Omnicom has reduced its share count by about 30%. Using the last four years of repurchase in stocks of $800 million-plus per year, assuming the Omnicom stock price stays at about $90, the company can retire about 3.8% of shares on an annual basis. EPS growth from share repurchase alone would be about 4%. Therefore if global nominal GDP maintains at a low 4% to 5% growth, Omnicom could have about 10% growth in EPS. Including dividend yield of 2.4%, the stock could be returning 12% to 13% on a consistent basis. Ironically, the lower the share price, the higher the growth.
Risks
Facebook (FB, Financial) and Google have changed the landscape of advertising. There are worries that, with the vast amount of data and analytics, some clients may be able to move all or part of advertising in house, skipping the agencies. This could be a long-term trend, but managing brands is not an easy task and requires special expertise that may not be supported sufficiently in house.
Valuation
At the price of $86, Omnicom is more attractive relative to the Standard & Poor's 500 but not with enough margin of safety. The excellent return profile is somewhat offset by the lower growth profile and negative currency headwinds.
The stock is currently at 17x 2017 forward earnings with revenue growth forecast at less than 4% and EPS growth at less than 6% for 2017. The EPS growth does not factor in share repurchases. By comparason, the S&P 500 is forecast to have 12% EPS growth. Price-earnings (P/E) for the S&P 500 on 2017 earnings is also 17x.
Note that Omnicom does not use non-GAAP EPS as a lot of other S&P 500 companies do. In fact, 2016 S&P 500 GAAP earnings is probably around 90 per share, but the estimated “operating earnings” are 118. It is the 118 that was used in calculating the P/E ratio of the S&P 500, not the 90. The difference is almost 30%. Adjusting the 30% difference, Omnicom is cheaper than the S&P 500. In addition, the dividend yield at Omni is currently at 2.4%, higher than the 2% at the S&P 500.
Judging from history, the stock has been at higher P/E and price-sales (P/S) in the past 10 years although much lower than the high-growth era before 2006. It is not expensive but not really cheap, either.
In the long term, Omnicom is a good business with nominal GDP like topline growth. There is not a significant margin expansion opportunity when the company grows its revenue. But its high ROIC and strong cash flow generation provide earnings growth through share repurchases. With normal GDP at 4% to 5%, we estimate the EPS growth at about 10% with 4% to 5% coming from the top-line growth tracking nominal GDP, 3% to 4% growth from share count reduction at about $90 and 1% to 3% growth from bigger scale. At the same time, the company pays 2.4% dividend yield.
Omnicom has never decreased dividends per share in the last 20 years. This is certainly a major attraction to income investors. As a result we expect a consistent total return of 12% to 13%. The upside is from higher GDP growth and, ironically, a lower stock price that would allow more share repurchases. The stock would become interesting at $75 per share. That means 15x 2017 P/E, 1.2x P/S and close to 3% yield.
Disclosure: I/we have no positions in any stocks mentioned.
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