WPP AUNZ Underpriced?

WPP AUNZ (ASX:WPP) is Australia’s largest advertising holding company and is majority (61.5%) owned by its namesake, WPP plc, following the merger of STW Communications Group and WPP plc’s Australian operations in 2016.

 

How Could it Be Mispriced?

WPP is a good candidate for mispricing for a couple of reasons – one global and one local.  Globally, advertising revenue growth has slowed in the last year, resulting in WPP plc reporting a 2% drop in revenue versus the previous quarter.  Locally, STW performed poorly in 2015, posting its first-ever statutory loss due to a large non-cash impairment charge.

One popular theory is that the global slowing in revenue growth is due to the a change in advertising mix away from broadcast media such as TV and radio and towards digital media such as Facebook and Google.  In contrast to broadcast media, digital media’s viewing rates are easy to measure and the cost of testing different ad configurations is much cheaper.  Hence there has been a trend for advertisers to allocate advertising spend according to measurable return on investment (e.g. cost per impression) which has led to a decrease in spend on “brand building” broadcast advertising.

Another possible (but less newsworthy) reason is that advertising spend correlates with growth in GDP.  Global GDP growth has remained sluggish in recent years so it is difficult to know whether the global slowdown in ad revenue is due to the digital shift, sluggish GDP growth or another factor.

 

Does the Industry Have a Future?

A few things appear knowable here:

  • Advertising will continue to exist because there will always be a demand from sellers of products for increased sales.
  • Some large companies do run in-house agencies. However, due to the creative nature of ad production (i.e. the work can’t be highly automated) it seems unlikely that smaller companies will be able to afford the fixed costs involved.
  • The main pressures on the industry seem to result from changes in how advertisers want to allocate spend and measure the resulting ROI.

In summary, advertising will continue to exist as an industry but the structure will likely continue to change.  In the case of WPP we are analysing a company which covers the complete range of marketing services through a number of subsidiary companies so it seems fair to say that the company will remain viable even if there is some rearranging of the deckchairs among its various subsidiaries.

 

Competitive Situation

  • The Australian advertising industry can be broken up as follows:
Advertisers

Myriad – Huge to tiny.

Creative Agencies

WPP

Dentsu Aegis

Interpublic

Enero

Omnicom

H&C Saatchi

Publicis

Havas

Independents

 

 

Ad Production & Media Buying Agencies

WPP

Dentsu Aegis

Interpublic

Enero

Omnicom

H&C Saatchi

Publicis

Havas

Independents

 

Media

Facebook

Google

Free-to-air TV Channels

Radio Stations

Newspapers

 

 

 

 

  • Note that all of the named creative, production and buying agencies are all holding companies. Each is composed of many individually branded agencies.  This is a result of the decoupling of agencies beginning in the 1980’s which was driven by advertiser demand for transparency in pricing and avoidance of conflicts of interest (competing advertisers can buy from different brands within the same holding company).
  • WPP is by far the largest of the holding companies in Australia with 2017 annual revenue of AUD 1,020 million. The next largest is Dentsu Aegis at AUD 311 million.  The total market is around AUD 2.1 billion.
  • The majority of the holding companies are part of global holding companies which don’t split out their Australian segment in their reporting and market share data is scant. However if we make the assumption that the Australian advertising market has much the same characteristics as the global market then we can use the following as our base case:
    • Agencies have a degree of customer captivity. Advertisers rarely put their accounts up for review and poaching of customers is unheard of.
    • Because agencies are paid for advertising by advertisers before paying the media provider they are able to operate with negative tangible equity. In other words, the advertisers provide part of the agency’s capital under zero interest rate terms.
    • Signalling of non-competitive intentions has occurred in the past when holding company CEOs have made public statements about not providing advertisers with extended trading terms.
  • In short, we can reasonably expect WPP to grow at around the same rate as the marketing services industry as a whole. Historically ad spend has tracked GDP growth reasonably well so an estimate of 2 to 4% seems reasonable for the long term.

 

Replacement Cost Calculation

We calculate the cost of replacing the operating assets of WPP as follows:

Original Modification Output
AUD mill AUD mill AUD mill
Cash & equiv 180.5 180.5
Marketable securities 0.0
Accounts receivable 515.9 515.9
Other current assets needed 0.0
Inventory 10.0 10.0
Total current assets 89.7 706.4
Other receivables
Plant, property & equipment 41.7 41.7
Intangibles 1250.7 -1250.7 0.0 Assume zero worth
Other long term assets 59.0 59.0
Total non-current assets 100.7
Add:
SG&A 1653.7 1653.7 Assume one year of SG&A needed.
R&D 0.0
Less:
Spont. liabilities 766.0 766.0
Unneeded cash 160.1 Cash less 2% of revenue
Reproduction cost 1534.7
Shares out (mill) 852.15 1.80 AUD per share

We can see that the main contributor to the replacement cost is the SG&A we assume would be needed to set up a company of this size.  Of course this is an arbitrary figure so we should place less importance on the replacement cost and instead look to the earnings power of the business in determining its intrinsic value.

 

Earnings Power Value Calculation

All values millions AUD except per share figures.

AUD mill 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Revenue 298.7 272.6 307.2 310.7 345.7 393.5 451.9 474.1 902.6 1020.0
EBIT 53.0 54.6 70.2 71.2 75.3 81.6 72.2 -28.7 94.9 108.0
EBIT Margin 0.2 0.2 0.2 0.2 0.2 0.2 0.2 -0.1 0.1 0.1
Non-recurring Items 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Chosen EBIT Margin 10.5%
Normalised EBIT 31.4 28.6 32.3 32.6 36.3 41.3 47.4 49.8 94.8 107.1
Tax Rate 0.3
Normalised EBI 22.0 20.0 22.6 22.8 25.4 28.9 33.2 34.8 66.3 75.0
Depreciation 3.9 5.7 5.9 6.5 8.6 8.4 10.0 10.9 29.0 34.9
Current Year Increase in Sales 0.0 -26.1 34.6 3.5 34.9 47.8 58.4 22.2 428.6 117.4
Property, Plant & Equipment -10.3 -4.2 -5.3 -6.5 -8.6 -15.9 -9.1 -5.5 -13.2 -16.5
PPE/Revenue Ratio 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Growth PPE 0.0 0.0 -0.6 -0.1 -0.9 -1.9 -1.2 -0.3 -6.3 -1.9
Maintenance PPE -10.3 -4.2 -4.7 -6.5 -7.7 -13.9 -7.9 -5.2 -6.9 -14.6
SG&A 201.0 190.3 241.3 243.4 266.2 309.4 321.0 343.2 618.1 692.4
SG&A/Revenue Ratio 0.7 0.7 0.8 0.8 0.8 0.8 0.7 0.7 0.7 0.7
Growth SG&A 0.0 0.0 27.2 2.7 26.9 37.6 41.5 16.0 293.5 79.7
Maintenance SG&A 201.0 190.3 214.1 240.6 239.3 271.9 279.5 327.1 324.6 612.7
Inventory 0.0 0.0 0.0 0.0 0.0 0.0 4.9 5.6 12.6 10.0
Inventory/Revenue Ratio 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Growth Inventory Increase 0.0 0.0 0.0 0.0 0.0 0.0 0.6 0.3 6.0 1.2
Distributable Earnings 15.6 21.6 51.0 25.7 53.2 61.0 77.5 56.8 387.9 176.1
Discount Rate 8%
EPV 1898
Cash 180
Non-op Cash 160
Debt 430.99
EPV of Equity 1627
EPV/Share 1.9

To calculate the EPV we have assumed an EBIT margin of 10.5% based on the average of WPP’s depressed results.  Globally 12 to 16% is a more typical figure but even with this handicap we still obtain an EPV which is double WPP’s recent price of around AUD 0.95.  A discount rate of 8% was used based on the estimated cost of capital for WPP.

Balance Sheet Strength

Term debt is approximately 2.5x and spontaneous liabilities (owings to suppliers etc) 4.4x 2017 distributable earnings.  All of the term debt could be paid off within 2.5 years.  The difference in payment terms WPP offers to its customers versus WPP’s media vendors means that the company is working capital negative, hence the large spontaneous liabilities.   For this to become a problem sales would need to contract at a rate faster than what WPP could top up its working capital from free cash flow (i.e. >25% per year).  If that were to occur we would need to revisit the whole investment thesis.

How Will Return be Delivered?

From the EPV calculation we can see that growth in sales correlates with investment in SG&A and to a much lesser extent, inventory and PPE.  As a healthy operating business we can estimate the shareholder return from WPP as the sum of:

  • Distributed free cash flow. WPP’s 5 year average dividend payment is AUD 0.10 per share.  Say 10% at the current share price.  If we convert the per share EPV value back to a distributable earnings figure attributable to the share equity by multiplying by the discount rate we get a figure of AUD 0.15 per share.  Hence the dividend payout rate seems sustainable.
  • Franking credits (eligible tax resident shareholders only). The dividend is fully franked so we can allow 4% in franking credits.
  • Retained earnings x return on replacement cost. Multiplying the AUD 0.05 per share of undistributed earnings by the return on replacement cost we get a return of 0.5%.  This is less than the expected growth rate but we will assume this figure for the sake of conservatism.
  • Re-rating to a share price which reflects the intrinsic value. The EPV figure of AUD 1.90 equates to a P/B of around 2 which is not extravagant for a company which has such a strong moat and access to zero interest float.  If we assume this figure is reached over a period of three years we get a boost to returns of around 33%
  • Dilution in the number of shares issued. In recent years WPP has grown its share count at between 1% and 5% annually due to executive incentives.  Let’s assume 1% if the business does not return to a more ‘normal’ EBIT margin, 5% if it does.

Putting it all together the two foreseeable cases are:

  • Low-return scenario would be 13% if business continues at the current rate with no re-rating. Given an assumed ASX200 return of 7% during this period a return of 13% gives us significant margin of safety if we are wrong about the stability of WPP’s business.
  • With improved performance leading to re-rating we could expect around 42% return.

Further Reading

Geoff Gannon’s 2011 writeup on Omnicom at csinvesting.org has some great insight into the global marketing services industry.  You can find it here.

If you have questions or comments please write to Warwick at oceaniavalue@gmail.com.  I answer every email that I receive.  You might also be interested in my writeup on ERM Power.

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.

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