Advertising in an age of disruption

An industry is being disrupted, with tech giants moving in and margins shrinking as clients cut costs. A CEO—the founder, inseparable from the company’s identity and the industry as a whole—is ousted, adding to the turmoil.

Is this leadership upheaval more bad news or an opportunity?

This is the scenario unfolding for WPP, owner of more than 400 agencies across the globe.

The year didn’t start well for WPP. Its stock, which trades on the London Stock Exchange, plunged 14% in March when it reported a decline in 2017 organic revenue growth. A flat forecast for 2018 offered little consolation to investors.

“2017 for us was not a pretty year,” WPP founder Sir Martin Sorrell told analysts at the time.

By mid-April, Sorrell, who had built the company and led it for 33 years, had stepped down amid allegations of misconduct that he denied and that still haven’t been completely explained.

When the company reported its first-quarter trading update two weeks later, there was more at stake than usual.

“When you think about WPP, or you think about the advertising industry in general, you think about Sir Martin Sorrell,” said Paul Sweeney, U.S. director of research and senior media analyst at Bloomberg Intelligence. “He was the face and the voice of the company, and arguably its heart and soul. He put the company together.”

Without a successor named, joint chief operating officers Mark Read and Andrew Scott looked to reassure investors and clients when they spoke about the April 30 statement.

Just before the company reported again, on Sept. 4, Read was promoted to CEO. The former CEO at Wunderman, WPP’s leading digital agency, Read had also served on WPP’s board for several years.

Industry under pressure

Ad agencies have been under pressure over the last decade. Facebook and Google have cut into their role as intermediaries, with companies buying advertising space directly on the massive social and search platforms. Online ads are cheaper to make than TV ads, and more brands are producing content in-house.

Big consulting firms like Deloitte and Accenture have started to muscle in on agencies’ territory, competing for business. And consumer brands, long the cash cows for agencies, are slashing marketing budgets as they face competition from startups and cost pressure from activist investors.

The question for many investors is whether agencies’ challenges are cyclical or if there’s a secular decline in their services.

Investors modelling revenue for the big advertising holding companies used to take GDP growth and add 2% or 3%, Sweeney said. “They were predictable growth stories—not real sexy.” Now some are concerned that even that modest predictability is gone.

A Pzena Investment Management white paper published last year, however, said there’s scant historical evidence for a decline in advertising spending.

“Over the last 100 years, advertising spending as a percent of GDP has remained in a tight band, even with the advent of new media over that period,” the paper said. “Although a decline is possible, it is also possible that companies maintain or even increase spending, as they benefit from improved targeting.”

Sweeney said global ad spend would grow 3% to 4% in 2018, while digital ad spend would grow almost 20%. That gain comes at the expense of traditional venues such as TV.

WPP’s leadership change provides an opportunity to look at the industry’s headwinds and underperforming areas of the business, said Andrew Chung, senior research analyst at Pzena Investment Management in New York.

The two trading updates since Sorrell’s departure—on April 30 and Sept. 4—show WPP’s challenges and progress.

Organic revenue growth

Organic revenue growth has been a challenge across the industry in recent quarters, and for WPP in particular. “Some of the more bearish investors” are saying the industry’s growth rate has been structurally reduced, Sweeney said.

In the earnings reports, organic revenue growth is expressed as like-for-like revenue less pass-through costs.

Revenue less pass-through costs, formerly known as net sales, takes the reported revenue without including currency costs—significant for a company with agencies in six continents—or the pass-through costs.

When an agency is hired to make a commercial, some of the expenses pass through to third-party suppliers and don’t benefit the agency. “Pass-through costs tend to overinflate the revenue numbers,” Chung said.

Like-for-like (LFL) revenue less pass-through costs also strips out mergers and acquisitions. “It’s the cleanest metric into organic growth,” Chung said.

For 2017, that number was down 0.9%. In Q1 2018, reported two weeks after Sorrell’s departure, organic revenue growth was -0.1%; for Q2, reported Sept. 4, it was 0.7%, bringing it to 0.3% for the first half of 2018 (see Table 1).

Table 1: Revenue less pass-through cost analysis

		Change
£ million	2018	Reported	Constant	LFL	Acquisitions	2017
First quarter	2,948	-5.1%	1.0%	-0.1%	1.1%	3,107
Second quarter	3,201	-2.1%	1.8%	0.7%	1.1%	3,269
First half	6,149	-3.6%	1.4%	0.3%	1.1%	6,376

It’s good to see that number positive again, Chung said, but it’s still “nothing to write home about.”

“WPP has been the biggest underperformer relative to its peer group over the last two or three years,” Sweeney said, referring to organic revenue growth. “I think that was one of the reasons the board was comfortable forcing Sir Martin out of the company.”

Competitor Interpublic Group (IPG) reported second- quarter organic revenue growth of 5.6% while Omnicom reported 2% growth. Publicis’s organic growth was down 2.1% in Q2 and negative for the first half of the year.

WPP’s guidance for the rest of the year forecast organic revenue growth on par with the first half.

Regional breakdown

On a regional basis, North America carries the most weight for the holding companies. “That’s where 40% of advertising dollars are spent,” Chung said.

For WPP, organic growth in North America was down 2.9% for the first half of 2018 (see Table 2). That’s where spending cuts from consumer packaged goods (CPG) companies have been felt most, he said (more on this below).

Over the last five or 10 years, investments in emerging markets—Asia Pacific, Latin America and Eastern Europe—propelled WPP, Sweeney said, as those regions grew faster than developed countries.

Those investments drove strong revenue as about 30% of the holding company’s business is in these regions, Chung said. That compares to about 20% of business in those regions for WPP’s competitors, he said.

But growth in emerging markets has slowed just as North America and Western Europe have exceeded expectations. “On a relative basis, WPP is less exposed to North America than IPG or Omnicom,” Sweeney said. This year, that hasn’t helped.

The earnings report shows 35% of the group’s revenue less pass-through costs came from North America, compared to 30% from emerging markets.

Table 2: Revenue less pass-through cost analysis (regional breakdown)

		Change
£ million	H1 2018	Reported	Constant	LFL	% group	H1 2017	% group
North America	2,155	-10.5%	-2.4%	-2.9%	35.0%	2,407	37.7%
United Kingdom	833	2.2%	2.2%	1.5%	13.5%	815	12.8%
Western Europe	1,319	6.7%	5.5%	1.9%	21.5%	1,236	19.4%
Rest of Europe, Africa, Asia, Latin America	1,842	-4.0%	3.1%	2.6%	30.0%	1,918	30.1%
Total group	6,149	-3.6%	1.4%	0.3%	100.0%	6,376	100.0%

Sector breakdown

One criticism of holding companies is that they’re too big and complex. Sorrell was a big proponent of “bigger is better,” Sweeney said. There are indications the new management is ready for a leaner approach.

“When investors look at WPP, it’s so big that maybe it requires more than just pruning,” Sweeney said. “Maybe they’re going to think about getting out of some lines of business or significantly reducing the exposure to certain lines of business.”

A holding company managing hundreds of agencies may not be the best model anymore, he said.

In the first-half release, Read highlighted efforts to simplify the organization, while maintaining that there wouldn’t be a larger breakup of the company.

“We have looked at our offering and begun to focus our portfolio,” he said in the Sept. 4 statement, pointing to 15 disposals and divestments that generated £676 million in cash. “And we have accelerated initiatives that will simplify our organisation, making it easier for us to manage and clients to access,” he said.

The statements break down organic growth across the holding company’s various business sectors.

Data investment management, the business category that includes audience measurement, ad testing and custom research for brands, has been “the problem child for WPP over the past couple years,” Chung said. That category was down 2.2% for the first half of 2018.

CPG companies—which, along with food and beverage brands, make up about 30% of WPP’s sales—have cut spending on this high-value work due to cost pressures, Chung said, and have cut the number of agencies they’re working with by about half.

“That’s been a big headwind for the agencies. But we believe that a lot of this is actually cyclical,” he said. “Longer term, the numbers show that, to grow, brands do need to invest in advertising.”

The cuts have been partly due to activist investors looking for efficiencies through marketing budgets, he said, and partly because upstart brands have taken share from some of the big companies. As central banks raise interest rates, the venture funding some of the small brands rely on will become more expensive, solving the latter problem, he said.

“We believe once these CPG companies are done cutting their ad spend, the whole business will rebase,” Chung said.

Billings

Billings top the list of key figures in earnings reports, but Chung said they’re difficult to match to revenue.

Table 3: Key figures

		Change
£ million	H1 2018	Reported	Constant	LFL	H1 2017
Billings	26,656	-1.0%	4.1%		26,920
Revenue	7,493	-2.1%	2.9%	1.6%	7,650
Revenue less pass-through costs	6,149	-3.6%	1.4%	0.3%	6,376
Headline EBITDA	948	-6.7%	-1.9%		1,016
Headline PBIT excluding share of associates	783	-6.3%	-1.6%		836
Headline PBIT	821	-7.0%	-2.3%		882
Headline PBIT margin	13.3%	-0.5	-0.5	-0.4	13.8%
Profit before tax	846	8.6%	14.2%		779
Profit after tax	705	11.3%	16.8%		634
Headline diluted EPS	42.6p	-6.2%	-1.3%		45.4p
Diluted EPS	53.4p	14.6%	20.3%		46.6p
Dividends per share	22.7p	0.0%	0.0%		22.7p

Billings from WPP’s media companies (which place the ads) tend to be “big headline numbers,” he said, but they generate a lot less revenue than billings for creative agencies (which make the ads). The creative billings are smaller but the agencies’ take is much higher, he said.

With the sudden departure of Sorrell, who Sweeney said was “instrumental” in winning big accounts, analysts wondered how WPP would manage its client pitches and reviews as competitors looked to take advantage of the leadership void.

Further, account reviews have become more frequent as advertisers become less certain about how they’re spending their marketing budgets.

“Advertisers are afraid of what they don’t know,” Sweeney said. “They don’t understand digital and they’re always afraid that they’re missing the next new thing in digital advertising.”

WPP estimated net new business—the amount after subtracting the accounts their agencies won from the ones they lost—of $3.2 billion for the first half after winning new assignments from Adidas and others, and expanding important relationships (see Table 4).

Table 4: Internal estimates of net new business wins

	2018 second quarter			2018 YTD
$ million	Creative	Media	Total	Total
Advertising	386	629	1,015	2,271
Other businesses	504	—	504	919
2018	890	629	1,519	3,190

Operating margin

Chung said it’s good to see WPP winning and retaining accounts despite the leadership turmoil, with 2018 first-half net new billings similar to last year’s. But the shrinking margins are a concern.

The company reported first-half headline profit before income and tax (PBIT) as a percentage of revenue less pass-through costs—or headline PBIT margin—of 13.3%. That’s down 0.4 margin points on a like-for-like basis from 2017 (see Table 3).

Read said the lower margin was due to investments “in the growing areas of our business” and a rise in spending on employee incentives.

The target operating margin for the year is similar to the first-half decline of 0.4 margin points, while the long-term target is an improvement in the headline PBIT margin of between zero and 0.3 margin points ex-currency.

“This is the first time you see an agency margins go down, and that may be the result of slowing overall organic growth,” Chung said. Price competition on the accounts they’re winning and retaining could be a factor, he said, with new deals “less lucrative for WPP.”

Looking ahead

Chung took some positives from the first-half report, including Read’s willingness to address new competition from consulting firms and focus on acquiring tech talent.

“It was definitely not an encouraging half, given the weak organic growth and the decline in margins. But I think the overall story remains intact,” he said. “We believe a good portion of the slowdown in organic growth is due to cyclical declines” from the CPG companies.

When that spending returns, advertisers will still need agencies to help determine how to spend their money, he said. That’s why his firm holds a long position on WPP.

“Agencies are helping the advertisers navigate all the confusion out there that’s come up with having so many mediums with which to advertise,” he said.

“We believe they will be relevant in the future, that there should be a pickup in organic growth and the cyclical portion of the slowdown should roll off.”