There has been a lot of bad news in the marketing services industry lately. Global holding companies such as WPP Plc (LSE:WPP) and Havas (FRA:HAV) have reported decreases in revenue, rapid growth in digital advertising has led to reduced media sales margins and management trends such as zero-based budgeting have reduced the amount that large global brands spend on marketing.
However, when viewed in the context of the industry’s history, current economic conditions and other industries with similar characteristics, there is a strong case that long-term profitability will be healthy. There are many factors that affect profitability, particularly on WPP AUNZ Ltd. (ASX:WPP), the largest marketing services holding company in the Australian market.
WPP’s share price has declined by around a third since 2013 despite the company growing significantly due to the merger of STW Communications with WPP Plc’s Australian subsidiary to form the current entity in 2015. You don’t have to look far to see the bad news that has contributed to the pessimism. The most visible items are:
- The rise of digital advertising. In contrast to broadcast media, purchasing methods such as Google Adwords auctions lack the economies of scale for larger purchasers such as large agencies.
- Recent decreases or plateaus in revenue by global holding companies such as WPP Plc and Publicis.
- High-profile announcements of in-housing of marketing services and spending cuts by companies such as Unilever and P&G.
The less-visible long-term trends are:
- Slow but steady long-term growth of in-housing. In 2013 the U.S. Association of National Advertisers reported that 58% of its members operated internal advertising agencies. In 1999 the figure was 53% and in 1976 it was 11%.
- A move from billing according to the amount of media purchased towards billing according to employee hours worked (actual or estimated). While still much lamented by the industry, much of this changeover was completed decades ago.
- Increased cost scrutiny from clients coupled with project scope creep due to the labor-intensive nature of digital advertising projects.
- Reduced economies of scale in media purchasing due to the growth of digital media at the expense of broadcast. Digital media tends to be sold per impression or click rather than per broadcast ad so in digital, smaller purchasers are not at such a large disadvantage to large purchasers compared to broadcast media.
- Inroads into media consulting made by the "Big 4" accounting consulting agencies.
That’s the bad news occurring in what historically has been a fabulous industry. Much of the present pessimism is due to comparisons with past glories, not the bottom-up economics of the present business. Holding companies such as WPP tend to consist of a lot of specialist agencies that make them hard to parse, but we can break what WPP does down to the following activities:
- Creative Agencies. These are consulting businesses that perform research and create ideas that can be produced into advertising by production agencies.
- Production Agencies. Labor-intensive contract manufacturing businesses that create advertisements.
- Media Agencies. These companies are responsible for buying, selling and trading media. These look like commodity trading houses.
On top of the above components we can layer the two main benefits that holding companies offer their large clients: global project coverage for multinational advertisers and economies of scale in media buying. These two benefits when considered together form a significant scale barrier to entry. In order to bid for large accounts, any industry entrant would need to either have the ability to deliver at least a large regional project and have size to enable buying several types of media at competitive prices. Advertisers also incur significant search costs when changing or "reviewing" agencies due to the time required to brief potential suppliers and hear their pitches. These search costs form a second barrier to entry.
So now that we have some idea of the threats to the industry and a basic idea of what WPP does, what is likely to happen? It’s inevitable that the individual businesses within WPP will experience change, but overall, the holding company will probably still earn returns in excess of its cost of capital for the following reasons:
- The recent downturn is likely to be due to slowing GDP growth as much as changes in industry structure. GDP growth has slowed recently both in Australia and worldwide. Growth in advertising spend has historically tracked GDP growth and gone negative during periods of recession. If we ignore the headlines and just look at GDP growth and ad spend together then the trend looks pretty similar to the past.
- Agencies shrink their fixed cost base when advertising spend shrinks to maintain margins. During recessions underperforming agencies reduce staffing in response to client demand. The minimum viable scale for an agency is small so agencies are still able to turn a profit during hard times without sacrificing the global reach of the holding company.
- The two companies that have made headlines by cutting agency spend (P&G and Unilever) have simultaneously argued for more creative content per dollar spent and for simplified interaction with the many holding company subsidiaries (i.e., re-bundling of services).
- Several studies exist which conclude the either TV or radio provide higher ROI than digital media. If media spend follows ROI in the long term, then it is likely that broadcast media advertising spend will begin to grow again, reinforcing WPP's scale economies in media buying.
- The "Big 4" accounting firms tend to operate at margins at least as large as (and often higher) than those advertising agencies are accustomed to. It's unlikely they could take a large amount of market share without reducing their financial performance. They also don't have media buying economies of scale available to them, so their only survivable niche is likely to be in the creative and production sectors of the industry.
- Finally, and most importantly, the ability of holding companies to service large global advertisers sustains barriers to entry to the top end of the market. Large advertisers still need large holding companies with simplified (i.e., bundled) points of contact and are only willing to switch agencies after investing significant amounts of senior executive time in search costs.
In summary, a lot of the pessimism about WPP seems unwarranted. Now is a good time to look for mis-priced opportunities among media services holding companies.Â
Disclosure: We currently hold WPP. This is not a recommendation to buy or sell any securities. All information presented is believed to be reliable and is for information purposes only. Do your own research before purchasing any security.
