Wall St. Speaks Out on Agencies' Digital Compensation

For Agencies, Digital Means It's Good To Get Paid By the Hour - Brian Wieser, Pivotal Research

The US advertising economy is weak at the present time. This may appear surprising to some given what appears to be a relatively healthy economy when compared with last year. The forecast we published in June for 2.5% underlying (excluding the impact of spending from political advertising and incremental Olympic activity) growth appears increasingly optimistic with deceleration from last year's 3.2% growth rate highly certain.

Part of the problem is that last year we saw an outperformance of underlying advertising growth of more than 1 standard deviation (around 2%) vs. what our model suggested should have occurred. The reasons behind this outperformance of total advertising spending are unclear, but deserve more of a focus (was it due to pent-up spending demand as a consequence of the fiscal cliff episode in 2012, for example?). This year we think we are seeing a reversion to the mean, and this explains some of the underperformance we are seeing in national TV as well as the decelerating growth that internet advertising has posted this year.

To get a better sense as to whether or not we are seeing this reflected in the financial reports of large advertisers, this week we decided to take a look at those among the 100 largest which have reported so far this quarter, which report a specific line item which should track generally with advertising, and which provide roughly comparable data to cover growth for all of this year and last. We recognize that there are significant caveats to this data, of course: the figures are often broader than just ad spending and they are global. Nonetheless, the trend is pretty clear and we think reflective of reality.

Among the 13 companies we captured data from (Comcast, American Express, Microsoft, Amazon, Capital One, Google, Discover Financial, Hershey, Coca-Cola, Apollo, eBay, Colgate and Mattel) we saw median growth rate of 0%, 1% and 1% in each of the first three quarters of this year. Over last year's four quarters, this group posted median growth in spending of 7%, 9%, 6% and 5%. The data is starker if we exclude Amazon, Google and eBay: this year we would note the first three quarters saw median growth of -2%, -5% and +1% growth.

Commentary on 3Q14 trends from other companies for whom more specific data is unavailable amplifies this point:

• P&G (last year's largest advertiser on US TV) noted it cut $100mm in ad spending during 3Q14 out of an advertising budget which averaged $2.3bn each quarter last year

• Yum Brands (last year's #4) noted "lower advertising expense"

• Samsung (last year's #29) noted reduced marketing

• Kraft Foods (last year's #48) noted "advertising was down meaningfully in the third quarter…traditional media is down double digits"

In the face these trends, agency holding companies are posting remarkably strong results. In the United States and North America, respectively, IPG and Omnicom both produced high single digit growth rates in the third quarter and nearly-as-strong results for the full year so far. WPP had a relatively soft quarter in 3Q14 with nine-month net sales in North America only up by 3.6% (and the US up by 3.8%), although this is held back by the much slower growing Kantar division which is a unique factor for WPP. Publicis is clearly losing share when compared with these figures, but the total like-for-like agency services business is probably still growing ahead of total advertising in the region with a +2.3% year-to-date organic figure. Combined, the "big four" agency holding companies grew by around 5.3% in the third quarter, vs. 4.7% in 2Q14 and 4.8% in 1Q14. We note that Omnicom's booking of gross revenues in association with its trading desk activities probably added 4% to that company's growth rate – which, if excluded, would mean the big four still grew by 3.9% (although by the same token we might add back something to this figure given the aforementioned drag that Kantar produces on WPP's totals).

On balance total industry growth is trending above 4% for the big holding companies this year in the United States. When we consider that smaller agencies tend to grow faster than their larger peers, the higher end of this range is more likely to reflect the industry's growth rate. This conveys to us an unambiguous gap for the agency industry this year vs. total growth in ad spending that will probably end up at closer to 2% on an underlying basis.

Such a gap contrasts with commonly held views that agencies should grow in line with ad spending, and that both should generally grow with some relation to broader economic conditions. By contrast, the data we are highlighting here reflects our view has been that agency growth is increasingly decoupled from the health of the media owners whose businesses they largely support.

The reasons for this decoupling include the following:

• Many activities associated with digital media (such as website design or search engine optimization) do not involve spending on media, but do require spending on labor.

• Digital media buying tends to be substantially more labor-intensive than buying traditional media. Anecdotally, we have observed that the number of bodies agencies require to plan and buy digital media within media agencies may match or exceed the number of bodies required to do the same for television despite capturing less than half the total media budget volume.

• The aforementioned activities (website design, SEO, planning and buying) tend to pay agency professionals on an FTE basis, which means that ultimately agencies get paid by the hour. More hours of labor means more revenue which more than offsets demand from clients to pay less for like for like services.

• New activities which are relatively under-the-radar are driving a significantly share of agency growth, especially for media agencies. Content production (especially for digital environments), barter and a host of other diversified agency services are increasingly important revenue generators and are harder for clients to benchmark on costs because of the degree to which they feature custom solutions (allowing the agencies to realize better pricing and operating margins than is the case for conventional media and creative activities).

• Proprietary trading is adding to the top-line results as we have noted for some of the holding companies (included in what Omnicom reports as net revenues and in what WPP reports in gross revenues), and as many advertisers are increasingly willing to buy digital media inventory on an audience-basis – indifferent as to which media owner they transact with – there will remain a growing opportunity for more of this kind of activity, at least so long as clients tolerate it (while some protest at present, many are not particularly bothered so long as the nature of the transaction is made clear from the outset). We note that Publicis' purchase of a DSP this past week called Run – paired with their own characterization that it would operate as an agency – suggests to us the potential that Publicis will move into this space more overtly.

• Less favorably for the industry, we note that revenues undisclosed to clients associated with digital trading and the licensing of ad tech services are probably also helping the holding companies out, collectively. While rebates from media owners have a long history and marketers are generally aware of them, those which are associated with digital media are less-well understood. Repeated anecdotes from vendors in the space have confirmed to us that some agencies' centralized trading desks will prioritize the purchase of programmatically-traded media or the use of digital trading tools from preferred vendors, who in turn agree to return back to the agency a certain percentage of volume via a sibling entity in a third country. Such rebates are facilitated by the uniquely global nature of digital media. These are difficult for clients to audit and thus less likely to be clawed back by those marketers who prefer to do so, as would be the case with traditional media where rebate mechanics are better understood.

We note that pressure on agency fees should be a meaningful consideration that partially offsets the above growth drivers. For example, Unilever highlighted during its earnings call last week the degree to which it is driving a substantial volume of "non-working" spending out of its total advertising budget. Despite this focus, it may very well be that when most marketers look at the choice of spending money on services with agencies vs. money on media tonnage, the dollar-for-dollar return on services may be viewed as more favorable. To the extent that this is particularly true for digital activities and digital media continues to become increasingly important for brands and consumers alike, the agency industry should be able to sustain a gap with media owners for the foreseeable future.

REPORT INCLUDING DISCLOSURES CAN BE FOUND HERE: Madison and Wall 10-31-14.pdf

Brian Wieser is a Senior Analyst at Pivotal Research Group, where he covers securities which areimpacted by the advertising economy, including Facebook, Google, Yahoo, Interpublic, Omnicom, WPP, Publicis, Nielsen, CBS, Viacom and Discovery Communications. Brian can be reached at brian@pvtl.com.

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