Geoff Gannon April 13, 2020

Interpublic (IPG): An Ad Agency Holding Company Trading at 10 times Free Cash Flow and Paying a Nearly 7% Dividend Yield

Interpublic (IPG) is one of the big ad agency holding companies around the world. Other examples include Omnicom (also a U.S. company), WPP (a U.K. company), Publicis (a French company), and Dentsu (a Japanese company). There are countless other publicly traded advertising stocks. Some are affiliated with one of those big groups. Others aren’t. Interpublic might be the first real ad agency holding company. The name Interpublic dates back to 1961. If you read the 10-K, you’ll notice PriceWaterhouse has been auditing Interpublic’s financials since the 1950s. Before the name change in 1961, the company was called McCann-Erikson. Late in the TV series Mad Men this is the agency that buys up the company all the main characters work for. Mad Men ends with the “Hilltop ad” (I’d like to buy the world a Coke) for Coca-Cola. That’s not made up just for the show. McCann-Erikson did make that ad. The McCann-Erikson combination dates back to the 1930s. Each of those two agencies (McCann and Erikson) were founded in the first decade of the 1900s. Omnicom and other advertising agency holding companies that came later were probably based in part on Interpublic in the early 1960s. For decades now, it’s been a common strategy for publicly traded advertising companies to own different agencies and provide certain centralized functions (basic corporate functions, capital allocation, setting compensation of top executives at the agencies, managing conflicts of interest between agencies they own, etc.). To some extent the individual agencies are independent and run sort of like Berkshire Hathaway runs its subsidiaries. But, in other ways they aren’t very independent. For example, Interpublic explicitly says that corporate HQ provides guidance, advice, etc. on both certain human relations stuff and on real estate. The cost structure of ad agencies is very different from most companies. At Interpublic, close to 65% of revenues are spent on base salaries, benefits, rent and office expenses. A huge proportion of the company’s total cost structure is really just base salary and rent. These are both very fixed. This is a pure service business. It’s largely “cost plus” – though how that works is a bit complicated.

So, the actual way ad agencies bill can be pretty complicated. Interpublic gets 50-60% of its revenue from its top 100 clients. Usually, client retention rates among big accounts are incredibly high. This is not due to contracts. The industry standard is for all contracts to allow either the agency or the client to fire the other with 30-90 days’ notice. Each of the contracts are customized. So, in theory, profits could vary a lot relative to the amount of revenue booked depending on the client. But, in reality, this does not happen. The contract can be created to involve a lot of cost plus, a lot of commission, flat fees, incentives for hitting certain quantitative targets for the effectiveness of campaigns, etc. If you look at the long-term margins of all different ad agencies around the world that once took very simple fees based on just two kinds of work – fixed commissions on media buying and cost plus on creative work – and compare it to margins with the various structures they operate under now, there’s no way to tell the difference. The agreements are always made to work out – over a diversified client base – to a very predictable return relative to sales. One thing to keep in mind though is that certain revenue figures are overstated at a company like Interpublic because they are counting “pass through” billable expenses. If Interpublic bills a client (when acting as a principal), the accounting will show that as revenue. However, it is profitless revenue, because some billing of clients is just reimbursement. Interpublic backs this out of its adjusted earnings figures. While we’re on the topic of adjustments – note that ad companies like to use “EBITA” instead of “EBITDA” because depreciation is a real expense (they’ll need to spend on cap-ex to make leasehold improvements) but amortization of identified intangibles of agencies acquired in the past is a non-cash charge. In general, I’d say the adjusted figures presented by companies like Interpublic (and others in the industry) are a lot cleaner and more conservative than adjusted figures you find in other industries. In normal times, ad companies like Interpublic convert a lot of their “adjusted” earnings numbers into actual free cash flow. So, there’s very little gaming of those reported figures. I think much of the accounting at Interpublic – and elsewhere in the industry – was less conservative about 20 years ago. The adjustments I see now don’t worry me.

What does worry me?

In the 10-K, Interpublic makes it very clear they are economically sensitive. In fact, they make it clear they are more economically sensitive than other industries. This is true. And I can’t reiterate enough how cautious you have to be buying an ad agency at this economic moment. Lately, you’ve probably heard the term “canary in the coal mine” used a lot about both public health and economic data about some specific city, state, industry, company, etc. – well, ad agencies are the “canaries in the coal mine” when it comes to business confidence. Ad spending by the 100 biggest clients at Interpublic won’t drop off a cliff because clients don’t have money. It won’t even necessarily drop off a cliff because GDP has declined by “x” percent. It’ll drop off a cliff if “animal spirits” die down. In the long-run, ad spending – and other corporate communications – track GDP awfully closely. You’d be amazed at how narrow the range of advertising spend as a percent of GDP has been over the last 100 years. Things shift from direct mail to newspapers to radio to magazines to TV to online at your computer to mobile on your phone. But, these shifts don’t change the amount of spending advertisers do by very much at all. Really, they can’t. Advertisers get a certain return on their ad spend. In some industries – if they go more and more online – it may be possible to say shift high rent expense to more ad spending, because high-profile locations are often just a form of advertising. But, other than that – it’s not correct to think the ad pie can outgrow the GDP pie. So, in the long-run – GDP and ad spending are closely tied. In the short-run, it’s business confidence and ad spending that are closely tied.

Interpublic does serve some clients that are shutdown, will be shutdown, etc. Usually, these big ad agency holding companies have at least one big client in every industry you can imagine. The same agency wouldn’t have more than one big client in the same industry, because that’s a conflict of interest. Sometimes, the holding company can get around this by having multiple agencies and multiple media buying groups to serve different clients in the same industry. But, in part because of conflict of issue concerns and in part because there are only so many supersized ad holding companies ready to serve supersized companies – you’ll see a pattern where every holding company has “their” car company, “their” airline, “their” credit card company, etc. This means they are somewhat exposed to all industries – but they’re very diversified. Interpublic’s top 10 clients are just 17% of revenues. The number one client is 3% of revenues. And, although I’ve been talking like Interpublic is just McCann-Erikson – that’s not true. It’s also things like The Martin Agency (and countless others). The Martin Agency is probably best known for the GEICO ads (the Gecko, the Cavemen, etc.) The level of diversification here is so extreme in terms of number of agencies, number of clients of each agency, work done for the same client by multiple parts of Interpublic, etc. – it’s just way too much to detail here. I’d just be throwing out a bunch of names you don’t recognize. The same is true of clients. I could list a lot of clients Interpublic has – but, all the major competitors of Interpublic also have impressive and diverse client lists. Also, remember, it’s uncommon for one company to have all the business of its client worldwide across all brands, demographics, etc. So, even when I name a client – that could just mean Interpublic is handling all the mass advertising stuff in the U.S. like TV while others are doing ads for that same company in other countries, targeting specific niches, for some new product the company has come out with, etc.

So, the company is diverse – but, all ad spending is tied to business confidence and that will plummet. Now, there’s a small part of Interpublic’s business that will be hurt for additional reasons. Interpublic gets about 85% of its revenue, profits, etc. from what I’d call more of your traditional “corporate communications” plus data. This is basically what you’re probably thinking of when you’re thinking of an ad agency. Although, chances are you’re underestimating two things: 1) The data aspect of what they do and 2) The actual media buying. Whenever I talk about ad agencies, I feel like people get the creative side of what goes on just fine. But, I don’t think they appreciate the fact that ad agencies are literally the client’s “agent” who goes out into a marketplace and buys ad space on their behalf. This can be done in a variety of different ways. A lot of it is more technical now than it used to be. But, it is a big part of the business for several reasons. One, it’s a competitive advantage that a middleman has. Interpublic is more than 30 times the size of its biggest client and spends all day every day buying media. It’s very obvious to investors that agencies – as middleman – take a commission on their buying on the client’s behalf. It’s less obvious to investors that the middleman serves a very good purpose in this industry. The commission is awfully small compared to the benefit the client can get. However, there’s an extra embedded cost that the agency extracts – and it’s “float”.

This gets back into the risks that an ad company faces in an economic downturn. So, agencies are theoretically on the hook for buying media that is way, way more than the entire revenues you see in their 10-K. Those are revenues – not billings. The agency only converts a small part of what it spends on a client’s behalf into actual revenue. So, the theoretical amount of promised media purchases agencies have made at any one time is off the charts. If all clients said they didn’t really want the media they said they wanted – no agency could ever pay for it. Luckily, they often wouldn’t have to. Specific “outs” can be written into deals so that if a client fails to perform, the agency doesn’t have to perform as promised to the media seller. On top of that, the risks of this really happening in a big way are lower than they appear. One, the client has a close relationship with their agency and knows it’s a bad idea to back out of taking media they wanted bought. Two, the media outlet (the seller) is usually 100% dependent on ad revenue in their own business. A lot of their revenue comes through a small number of big agencies. It’s not in the interest of any media outlet to demand payment from agencies that can’t make it. So, although this is theoretically a devastating off balance sheet liability – I don’t think it’s the biggest risk to agencies.

Agencies do have some risks in a downturn though. Interpublic has debt. It’s fairly long-term, well spaced out, and just all around manageable. They’re at about 2 times Net Debt to EBITDA. That doesn’t worry me. They also have a commercial paper program. That worries me a bit more. So, they can borrow up to $1.5 billion in the commercial paper market (the commercial paper program is backed by a bank’s promise to backstop all the paper provided Interpublic maintains certain financial ratios). At year end, Interpublic wasn’t using any paper. On an average day during the year, they would be using about 20% of the potential size of the commercial paper program.

Salaries are high and fixed. And this is a people business. If you cut pay, you have to figure out other ways to keep people. I’d compare this to something like investment banking, big tech, etc. Ad agencies don’t like to lose key people. If you look at the mean – remember, I said “mean” so this vastly overstates the median (a better gauge of the average in this case) – base salary and benefits for an Interpublic employee, it’s about $103,000 a year. There’s also incentive compensation for some people. And there’s a pension plan (underfunded but manageable). Rent is also especially fixed at ad agencies. Occupancy alone – this is the truly fixed part of office expense – is more than 5% of total revenue. Given where these leases are, how long-term they are, etc. that’s 5-6% of revenue that just can never be cut.

So, you’ve got fixed expenses. And then you have this reversal of “float”. In normal times, ad agencies grow a bit and as their billings grow – remember, billings are to ad agencies what premiums are to insurers – float grows too. When billings shrink, float shrinks. Ad agencies are always in a deficit position in terms of current assets versus current liabilities on their balance sheet. But, they are normally having additional cash flow from operations generated by changes in working capital moving in their favor. In 2020, it’ll be working against them.

Nonetheless, there’s a ton of CFFO at Interpublic to take a blow like that. Over the last 3 years, cash flow from operations has averaged $1 billion. Cap-ex has been like $200 million. That leaves $800 million in free cash flow. Shares outstanding are 388 million. So, that’s $2.05 a share in FCF. The company does have about $5.40 a share in debt, though. As I write this – IPG stock is at $15.02. If we add the $5.40 a share in debt to the $15.02 in equity, we get a share price of $20.42. That’s against $2.05 a share in average free cash flow. So, that’s a debt adjusted “cash P/E” of 10.

Is that cheap?

Based on Interpublic’s recent performance – it’s very cheap. The company has been successful in growing organic revenue in almost every country in each of the last 3 years or so. It’s often grown as fast as GDP. There’s no sign Interpublic is losing share. The stock is cheap.

Is it safe?

Debt payments in 2020 – I’m not including leases since rent flows through the income statement – are about $635 million. In 2021, it’s $617 million. It drops off after that. Basically all debt is fixed. The company will have some real liquidity shifts this year. But, I’d say an ad company with debt spaced out and fixed the way they’ve got it should be able to access debt markets if needed. They might have to pay a bit more at times. But – this is a big, diverse, old, predictable company. It’s not a risky thing to provide financing to. It’s a good credit. I’m not worried about these ad giants the way I am about something like Hamilton Beach Brands. Interpublic has been in the market plenty of times with various bonds that now trade every day. It has commercial paper. It has banking relationships.

So, my concern in not that the company will fail. But, it will see a big decline in earnings. For example, I stuck to just talking about the traditional part of the business here. That’s 85% of Interpublic. The other 15% is stuff like events, sports marketing, etc. None of that is going to do as well during a shutdown for the coronavirus as the 85% I’ve been talking about. And – in a deep recession – the 85% will get hurt pretty hard too.

I don’t do macroeconomic projections. But, if you’re going to buy an ad company in 2020 based on its 2019 earnings – you need to be prepared to wait till 2023 or so before you see a return to (and eventually surpassing of) the 2019 earnings you based your purchase on.

So, Interpublic could effectively tread water for 3 years.

Unlike Omnicom, Interpublic will not buy back stock. It did an acquisition in 2018 that required the use of a lot of debt. Historically, Interpublic has bought back stock. But, it hasn’t bought back a single share since that acquisition – and I don’t expect it to till it pays that debt down further. As I write this – the dividend yield is 6.8%. Is the dividend safe?

I don’t know. I don’t think it’s sacrosanct at Interpublic. But, I also think Interpublic is only paying out about 50% of its free cash flow in dividends. So, the dividend is theoretically covered about 2 to 1 in normal times. That coverage ratio will not hold up in 2020. But – if the dividend is suspended, cut, etc. it’ll be reinstated a few years down the road and surpass the current dividend rate (just as earnings will reach a new peak a couple years after we emerge from this recession).

The question everyone will ask me is: do I like Interpublic more than Omnicom?

I have no answer for that yet.

But, at $15 a share – I do like Interpublic.

Geoff’s Initial Interest: 70%

Geoff’s Revisit Price: $9/share