Rapid growth in digital advertising is sending ripples throughout the marketing landscape. This year has seen an unprecedented level of media reviews by some of the biggest advertisers in the world as they seek to optimize their marketing spend and partner with the most tech-savvy advertising agencies. Not surprisingly, the dominant advertising agencies are scrambling to build out their portfolios of digital services to evolve with the market’s changing trends and demands. In this piece, we will look at the historical strengths of the ad agencies and whether or not they still apply in an increasingly digital world. OMC is our favorite ad agency and was added to our Top 20 Dividend Stocks list on 6/24/15 at a price of $70.94.
OMC is one of the largest providers of advertising and marketing communication services (it almost merged with Publicis Groupe to become the largest ad agency in the world, but the merger was terminated in May 2014 due to cultural differences and challenging regulatory issues). The company holds more than 1,500 advertising agencies that specialize in over 30 marketing disciplines, grouped into four segments: advertising (50% of sales), customer relationship management (34%), public relations (9%), and specialty communications (7%). A full-service agency provides numerous services, including designing ad campaigns, making the actual ads, determining where the ads should be placed and distributed, media buying, account management, public relations, consulting, and more. Most clients use ad agencies to perform all tasks of a campaign and prefer to conduct most of their business with just one or two agencies to streamline costs and efficiencies.
Today, OMC has more than 5,000 customers located in over 100 countries, although North America still accounts for around 60% of total sales (United Kingdom 10%, Other Europe 16%, Asia 10%, Latin America / Africa 4%). By client and end market, OMC is well diversified. In 2014, its largest client represented 2.6% of revenue, and no other client accounted for more than 2.5% of sales. Its top 100 clients, ranked by revenue, represented about 50% of OMC’s total sales. Additionally, no industry makes up more than 13% of OMC’s sales. OMC has historically done very well in the food & beverage (13% of sales), pharma & health (11%), consumer products (9%), technology (9%), and auto (8%) markets. According to Advertising Age, some of OMC’s biggest customers include Johnson & Johnson, P&G, Unilever, Campbell Soup, Hershey, Kellogg, Kraft, Mars, PepsiCo, Daimler, GM, Nissan, and Toyota.
While the industry continues evolving, it has historically been a good place to play. According to Advertising Age, five agency networks control about 70% of global ad agency revenues – WPP Group, Omnicom, Publicis Groupe, Interpublic Group, and Dentsu. However, there are thousands and thousands of small agencies in the industry – over 80% have fewer than 10 employees.
In this industry, bigger is certainly better for several reasons. First of all, large multinational clients spend a lot on advertising and are constantly looking for ways to improve their return on investment. One of the easiest and clearest ways to boost returns is to control their costs and use their size to gain efficiencies. Rather than spread their work across multiple agencies, clients typically prefer to work with only one or two agencies because it gives them some negotiating leverage and maximizes the efficiency of their marketing spend. In most cases, only the biggest ad agencies can check all of the boxes that big multinational clients demand.
Larger agencies benefit from being able to offer numerous marketing services, establishing themselves as true one-stop shops for the biggest clients. For example, OMC says that its top 100 clients, which represented about 50% of its sales last year, were each served, on average by more than 50 of its agencies. OMC’s largest client was served by more than 200 of its agencies. Big clients operating all over the world still need a unified marketing campaign, requiring work on a global scale that only the biggest ad agencies can provide. Smaller firms lack the breadth of services, skills, and geographical reach to compete for large accounts, leaving them trapped as niche players in most cases. As globalization and the importance of international markets continue increasing, we wouldn’t be surprised to see the industry continue to consolidate. These are some of the reasons why the largest ad agencies generally achieve margins 25-75% higher than small agencies (10-15% vs 6-8%).
Source: Simply Safe Dividends
Switching costs are also generally favorable in the industry. While the largest players occasionally trade clients, it’s important to remember how closely agencies work with their clients, establishing a deep understanding of the brands, unique value propositions, and customers. Many relationships span decades of time, creating high knowledge barriers that take considerable time to replicate.
The knowledge agencies build up about specific clients creates another unique switching cost – client conflicts. If you were the Chief Marketing Officer of Coca-Cola, would you want the same agency you used to also take on Pepsi’s account? Probably not. Given the limited choice of big ad agencies (recall that the top five ad agencies account for 70% of the industry’s revenue), large multinational clients have few conflict-free alternatives to turn to for their marketing needs. For these reasons, media agency relationships tend to be stable – most client reviews historically took place only every 5-10 years, according to MediaCom’s COO Toby Jenner.
The biggest change rippling through the industry today is the rapid rise of digital advertising and all of the data and analytics that come with it. According to eMarketer, online ad spending topped print magazine and newspaper ad spending for the first time in 2012. Consumers can be reached through more mediums than ever before today, causing all marketers to rethink their strategies. While the landscape is still evolving, we think that the slew of new advertising forms will only serve to make the biggest ad agencies stronger and more wedded with their clients. The need to develop a unified marketing message remains, but the challenges of which demographic to reach, how to reach them and what to say only increase with more advertising forms available. Firms with the most resources to invest in digital capabilities and make sense of the fragmented media world will continue to distance themselves in the one-stop-shop ad agency game.
From a growth perspective, advertising spending is generally driven by corporate profits and consumer spending trends. However, brands still need to maintain their reputation and awareness in the market, even during difficult times. This helps reduce some of the industry’s cyclicality (industry sales were down less than 10% in 2009 and have grown at a consistent single-digit pace most years).
The proliferation of digital media is causing the most change across the industry. According to Magna Global, US digital advertising spend is expected to jump from about $60 billion in 2015 to $95 billion by 2019. Digital media is much more fragmented as the rise of connected devices has enabled fragmented content consumption across smartphones, tablets, computers, and more. Ad agencies have become tasked with developing effective cross-platform marketing solutions with tangible results, a meaningful evolution from the past.
As a result of digital marketing’s surge, and perhaps a desire to cut costs, many of the industry’s biggest clients are reevaluating the digital skills and abilities of their existing ad agencies. Over $30 billion of annual contracts have been put out for tender / review since the beginning of 2015, the most ever (typically about $20 billion is put up for review). More than ever before, marketers want to know how their ad dollars are being spent, especially as it relates to media buying activities (ad agencies are tasked with buying advertising space for clients, and there is some concern that certain agencies are taking rebates / kickback from media companies in exchange for spending their clients’ money with them). It’s hard to say which factors are primarily behind the unprecedented amount of reviews, but evaluating the digital capabilities of existing ad agencies is probably at the top of the list.
Most of the media reviews are expected to close by the end of October 2015, and OMC has fared well thus far, picking up additional business with Unilever and Wells Fargo. Given the scale advantages that the large ad agencies have and the switching costs faced by multinational clients, we wouldn’t expect to see much of a shift in revenue.
We believe the bigger risk is related to margins – are big clients applying more price pressure throughout these negotiations? Will digital services prove to be as profitable as traditional channels as mix shifts in coming years? While it’s still early days, OMC’s results have been rock solid in recent quarters, and its digital businesses are driving its growth. Perhaps digital services, such as programmatic ad buying, will ultimately result in even higher margins if they are less labor-intensive. Time will tell, but we will maintain a close eye on profitability.
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. OMC’s long-term dividend and fundamental data charts can all be seen here and support the following analysis.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
OMC recorded a solid Safety Score of 81, suggesting its current dividend payment is safer than 80% of all other dividends available in the market. The company’s sub-50% payout ratios, reasonably stable business model, sticky client relationships, and strong cash flow generation support the favorable ranking.
Over the trailing twelve months, OMC’s dividend has consumed 46% of its GAAP earnings and 37% of its free cash flow. Considering the stability of OMC’s business, these levels provide a nice cushion and leave room for continued divided growth.
Looking at longer-term trends in payout ratios can be even more helpful. Our dividend tools let you view a stock’s EPS and free cash flow payout ratios over the last decade. As seen below, OMC’s payout ratios have remained below 40% each year over the past decade.
Source: Simply Safe Dividends
For dividend companies with enough operating history, it’s always a prudent exercise to observe how their businesses performed during the financial crisis. Our Recession Performance Analyzer tool shows how much sales and earnings fell for a company during the financial crisis. OMC’s reported sales fell 12% in fiscal year 2009, and its GAAP earnings dropped by 19%, reflecting the largely variable cost structure OMC enjoys. Capital intensity is low because the ad agency business is heavily dependent on people to carry out its services. This makes it easier for these companies to flex their costs during difficult times (it’s easier to make layoffs than fill a big factory). See more recession-resistant stocks here.
Source: Simply Safe Dividends
High quality companies are able to generate free cash flow year in and year out. Rising cash flow is very important because it supports continued dividend growth without expanding the payout ratio. As seen below, OMC has generated healthy free cash flow each of the past 10 years. Ad agencies enjoy a very low level of capital intensity because labor is the primary cost attached to the services they provide. Low capital intensity has also enabled OMC to maintain high and stable returns on invested capital over the last decade.
Source: Simply Safe Dividends
While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during the recession help give us a better sense of a dividend’s safety, the balance sheet is an extremely important indicator as well. When times get tough, a healthy balance sheet can continue funding a company’s dividend. We can see that OMC has maintained a meaningful amount of debt on its balance sheet for quite some time. We prefer to invest in companies with no more than a 50% debt to capital ratio, about where OMC has historically been. However, given the greater stability of OMC’s business fundamentals, its debt load appears reasonable to us.
Source: Simply Safe Dividends
Looking at the balance sheet, OMC again appears to be in decent shape. While the company doesn’t have the most flexible balance sheet out there, its debt is well covered – net debt would be covered with less than two years’ worth of EBIT generation (net debt / EBIT = 1.7x). Most of OMC’s debt is not due for at least five years as well.
Source: Simply Safe Dividends
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
OMC’s Growth Score is 84, meaning its dividend’s growth potential ranks higher than 84% of all other dividend stocks we monitor. The company’s sub-50% payout ratios, consistent free cash flow generation, solid returns on invested capital, and stable sales growth support a healthy outlook for continued dividend growth.
By calendar year, OMC has increased its dividend payments by 15% per year over the 10-year period ending on 12/31/14 and has maintained a double-digit annual growth rate over the last 3- and 5-year periods as well. We believe the company continues to have double-digit dividend growth potential going forward.
While the company’s dividend growth streak is less than 10 years, it has never reduced its dividend since its founding in 1986. While OMC is far from being one of the dividend aristocrats, its dividend payments are pretty impressive nonetheless:
OMC trades at about 15x forward earnings. We think the stock trades at a reasonable price considering its competitive advantages as one of the largest global ad agencies. While growth in digital advertising is forcing the industry to evolve, we believe OMC’s market position will remain strong and expect the company to continue growing sales at a mid-single digit rate with slightly faster earnings growth. The stock’s dividend yield is 3.0%, good for a Yield Score of 56. This means that OMC’s dividend yield is higher than 56% of all other dividend-paying stocks. A 3% yield, coupled with 5-10% earnings growth, offers 8-13% total return potential with less business volatility to worry about.
The dominant market share of the largest ad agency players (top 5 = 70% of industry revenue) creates several competitive advantages that we believe will be maintained or made stronger by the rapid growth in digital advertising. OMC is trading at a reasonable price (15x forward earnings) given its sturdy business model, cash flow generation, and potential for continued 5-10%+ annual earnings growth. At today’s price, dividend growth investors can enjoy a starting yield of 3% for a stock with an extremely safe dividend and above-average dividend growth potential.