Publicis Q1 - positive revenue momentum, but is this the real story?

The narrative the markets will focus on will remain the group's ability to translate its digital and emerging market investments into premium revenue growth and further margin progress. From this perspective, Publicis's Q1 revenue performance should be well received. A +6.5% rise in organic revenues pipped Omnicom's +5.2%, reflecting continued progress in digital (+12.6% to 28.2% of revenues) and emerging markets (23.4% of revenues; +1.4pts YoY u/l), while the +58% rise in net new business (to $1.9bn) suggests the service proposition continues to resonate with clients to underpin further relative outperformance. Average net debt meanwhile is down by €500m YoY to only -€100m and the group is sitting on €3.9bn of liquidity, including €2.7bn of committed facilities and €1.7bn of cash and marketable securities.

Markets may focus on the top-line delivery, but the real story should be on what happens to this liquidity. Historically, agencies have applied cashflow to buy new marketing skills to extend their service proposition to clients. This is a great way to build your business and it can also be earnings beneficial as internal investment (thru the P&L) is displaced by acquisition expenditure on intangibles, that loiter in the balance sheet and are broadly ignored in earnings assessments. Markets are not dumb however and recognise that some, or all, of these acquired intangibles are being consumed and discount equity valuations accordingly.

Q1 Revenues
Organic revenue growth of +6.5% vs Q4's +12.8% rate of growth slowed as expected from Q4 spectacular levels (+12.4%), albeit by slightly less than the tightening comparatives might have suggested (Q1 comps at +3.1% were 8pts less favourable than Q4's -5.1%). By region, growth was again driven by

• North America: 49% of revenues and +8.1% u/l in Q1 vs +14% in Q4 with digital continuing to provide the key driver to growth.
• Europe: 32% of revenues and +6.2% u/l in Q1 vs +11.3% in Q4 with growth from N and C&E Europe (France +8.2%, Germany >+10%, Russia & CEE +7%, UK +2.4%, but S. Europe trailing)
• LatAm: 5% of revenues and +8.7% in Q1 vs +22.1% in Q4. Declines across Mexico and  Columbia partially offset continued strong growth from Brazil and Argentina (>+20%) and Venezuela (>+15%)).
• Asia: 12% of revenues with Q1 at +1.5% vs +6.4% u/l in Q4 as declines across Japan, Australia and Korea substantially absorbed the +8.2% increase from Greater China.
• A&ME: 2% of revenues and -0.5% u/l in Q1 vs +15.3% in Q4. With political unrest sweeping across the Middle East, revenues have unsurprisingly stalled, albeit with some regions still posting growth (UAE +7% u/l).
• BRIC: +11.4%

Valuation - Q1 Revenues
As with other agencies I would expect Publicis's valuation range will continue to be defined by its revenue outlook, which for the moment remains positive. Historically, Publicis has tended to trade at a small discount (on a growth rating basis) to larger agencies, such as WPP and Omnicom, although its current revenue and net business performance may challenge this. At current levels I estimate the shares are discounting trend growth at around 3.5-4.0% pa for 2011 and 2012, possibly dropping to approx +2.5% by 2013. This values the equity at nearer the lower end of what I would regard as a comfortable trading range of +3.5-4.5% and with scope to see this edge up the nearer +5% should the group demonstrate restraint on blowing its balance sheet on an aggressive acquisition spree.

Valuation

Acquisitions - earnings accretive, but value destructive?

Has anyone noticed that many agencies are currently priced at little more than they have invested in acquisitions over the past decade? For an industry model based on applying cashflow into acquisitions rather than returning to shareholders, this might seem a little embarrassing. When most agencies are also delivering sub-GDP organic revenue growth, despite heavy investments into 'new' growth areas, this might pose a challenge to the whole growth model on which agencies have been based. For Publicis, I estimate that over €9bn has been spent on acquisitions since 1999 (net of disposals and at constant 2010 prices), which is only 13% less the current EV of the group.

Acquisitions - earnings accretive, but value destructive?

Equity markets may focus on earnings before amortising these acquired intangibles, but even on this metric, most agencies have also struggled to demonstrate that they have covered their equity cost of capital. While acquisition contributions cannot be disaggregated from the core businesses, one can look at the extent to which real EBITA has risen over the period and then take this against cumulative acquisition expenditure to calculate an implied acquisition ROIC. In the below analysis, I have calculated this on two EBITA growth assumptions of zero and  +2% pa at constant prices. On both these criteria, the implied ROIC seems to fall below 8%. While above debt financing costs (and therefore probably EPS accretive on the potion financed with cash), this is below ECC and therefore represents a loss of opportunity value, if nothing else. 

Omnicom Q1- EPS flattered by FV adjustment

Revenues on track, but FV adjustments flatter margin and EPS beat

Delivering Q1 EPS of $0.69 vs a consensus expectation of $0.59 ($0.56-$0.63 ranged vs $0.52 for Q1 FY10) seemed like a fairly convincing beat, although the market had not been expecting the $123.4m of book gain from the remeasurement of the fair value of its interests in Clemenger Group, nor the scale of offsetting restructuring charges (of $131.3m, including $92.8m of severance) and nor the accompanying tax benefit which cut 9ppts from the YoY and underlying tax rate (from 34% to 25%). In aggregate these items contributed $19.8m to Q1 net income ($0.07 per share), including -$91.8m/$0.317 ps of restructuring which was clawed back by $120.6m/$0.417 ps of FV adjustments and a -$9.0m/$0.03 ps FIN48 tax accrual.

Without a comparative figure for severance and other restructuring charges that were included in Q1 FY10 it is difficult to draw too many conclusions from the +43bps YoY advance in EBITA margins (to 10.9%). Representing a drop thru rate of under 9% from the Q1 organic revenue growth of +5.2% (vs my +5.1% forecast), this does not seem all that impressive given that Q1 FY10 will have no doubt have included severance charges and while the refilling of bonus pools will have continued to have provided a margin drag into 2011, there should have also have been some compensating cost benefits carrying over from last years cost reductions.

Omnicom EBITA margins & organic revenue growth

Revenues growth continues to define valuation

With net business wins of almost $1.1bn in Q1 ($950m for Q1 FY10) the group remains confident that revenues have now returned to growth in both US (+4.9% and +6.8% excl Chrysler) as well as Internationally (+5.5%, incl >+9% in UK). Prior year comparative however will be progressively hardening throughout the remainder of the year (and by almost 4pts in Q2 vs Q1) and macro uncertainties and moderating GDP expectations (including potential disruptions still to flow thru from Japan) might be expected to provide additional headwinds. For the moment at least, I would expect a neutral to negative forecasting risk to near term consenus revenue growth forecasts.

Omnicom - Organic revenues and growth rating

While these macro uncertainties persist, consensus revenue and earnings momentum for OMC may well stall for the time being. The shares meanwhile (on these consensus forecasts) appear to have already substantially re-rated to reflect the revenue recovery to date and are discounting growth near the upper end of their historic +3-5% CAGR range. Assuming that we are not facing a double-dip, I would scope a +4-5% CAGR growth rating range for this group and therefore a $40-47 ps price range.

Q1 Previews - Agencies

Today's Q1 results from Google provides a prelude to Q1 reporting season for the marketing services groups which kick-off next week (18-22 Apr) with Omnicom which reports on Tues 19th and Publicis on Thurs 21st. The following week IPSOS reports on Tues 27th with WPP and Interpublic on Thurs 28th.

With Q4 recovery momentum already reported to have been maintained into at least the first two months of the Q1 by many of the leading groups, these results will will be scanned more for signs of slowdown into Q2 and the second half of the year as deteriorating macro growth expectations compound the drag from tougher prior year comparatives. While the market's focus will remain on the revenue trajectory, the other feature of note will be any revision to margin expectations and the extent to which the recent uptick in acquisition activity will enable some groups to displace planned internal investment that would have otherwise have diluted this year's margin progression.

Q1 Revenue growth
For the overall sector, I am expecting YoY organic revenue growth to ease back from Q4's +8.9% to just over +5% for Q1 2011, in large part reflecting the increasingly less favourable comparative tailwind as we progress into the current year. After Q4's -6.4% prior year comparative, Q1's hardens to +1.5% while Q2 rises to +5.5% for agency organic revenues. As with the slowing YOY growth rates being reported across a number of media advertising markets such as TV into Q2 as they also cycle through tougher comparatives, we would expect a slightly more cautious tone to adopted by the industry than during the February year end reports, albeit with digital and emerging markets segments remaining strong.

Agency organic revenue growth rates (YoY change)

Margins
 Not all agencies will report Q1 margins (eg WPP), and for those that do, quarterly margins (and especially those for the thinner first quarter) are usually not that reliable an indicator for the full year anyway. More important will be any change in outlook for the year as a whole. While pricing pressure and pent up cost inflation after the squeeze in 2008 and 2009 will have already have been factored into current year forecasts, competition to invest in new digital services provide an additional potential drag to the pace of margin recovery. For group's such as Gfk which have focused on internal investment (into new measurement and internet services), this could absorb a further 70bps of margin growth in 2011, in addition to the c. 100bps in 2010. Others such as Publicis, WPP and possibly even Havas however are beginning to flex their funding headroom to pursue a more aggressive acquisition strategy, particularly in those areas that might otherwise have been the focus for internal investment. How much of this investment will get shifted off the P&L and into balance sheet intangibles remains a guess, but the sector's record of value creation from acquisitions is poor and also recognised by markets in share prices.

Agency EBITA margins (by key holding group)

Agency sector EBITA margin change and organic revenue growth (YoY change)

Agency organic revenue growth and growth ratings

Finally a media example!

All very interesting you might say, but isn't this a 'media' blog?  
Indeed it is, but just as any great sauce needs to be based on a good stock (yes I spent the best part of a decade at a leading French bank), so a meaningful media valuation needs to be rooted in a coherent and consistent valuation for the market against which one can assess the relative risk and return.

But where to start?  Well, why not go from the sublime to the ridiculous and choose a stock from the valuation extremes; at least from the perspective of traditional earnings based criteria - Yell.

"Broker cuts its target price for Yell by 38%!" While perhaps a little belated given that the shares at 7p are already below the revised target of 8p, the event is of interest in that it highlights the absurd attempts at valuation accuracy. On an earnings basis, the shares may have seemed cheap when they halved from 10x earnings to 5x, then to 4x, to 3x and now to 2x. Since all these metrics are broadly meaningless, none have so far provided the fundamental support level than many bulls have hoped.

PER - 15x, 10x, 2x. Take your pick, they are all irrelevant as a valuation metric

As I have already argued from my earlier blogs, that beyond the tax shield, the cake doesn't get bigger when you cut it into more slices. Valuing an equity from post interest earnings irrespective of its capital structure can provide the illusion of value accretion from enhancing earnings, but in the real world markets continue to value to overall value of the operations, less the NPV of liabilities. Think of the operations as the proverbial iceberg, with the volume above the water representing the market value of the equity and the submerged portion representing the NPV of the liabilities. For Yell, this relationship is somewhat extreme, in that the equity component represents a mere 6% of the overall value of the business. For an analyst to confidently cut 38% off their value of the equity may sound punchy, but this represents a mere 2% cut in overall valuation which is certainly a lot less than the margin of error I would factor in to my valuation an a multitude of issues such as market ECC, the companies structural growth prospects, margins etc.

Yell's MV represents < 6% of EV, which is way less than my margin of error

Notwithstanding the extremes of the Yell financial leverage, a valuation analysis on an EV and operational FCF yield basis starts to make a lot more sense when translated into a growth rating. Here we can see a growth rating that was raised from around +2% CAGR at the time of floatation to over +4% as expansion into the US lulled a market into believing that this mature segment might still have some legs left in it. Once online migration and recession hit however and organic revenues turned negative, the perceived growth rating evaporated along with it.

Growth rating - systematic relationship to organic revenue delivery

Facing a structural decline in classified revenues and possibly also margins against an equity component that is less than 6% above the NPV of liabilities, Yell's equity probably owes more to expectations of the market's overall ECC than any real confidence one can have with regards its own specific medium term forecasts. On my own forecasts and applying a 0-2% CAGR growth rating ranges I would get an equity range anywhere between -19p ps and +16p. This however assumes they can deliver on my reducing rates of revenue decline (to -5% for Cal 2011 and to 0% by 2013), notwithstanding their continued revenue shortfalls against budgets. Applying a more realistic margin of error to my central case revenue targets of +2.5%/-5% pa, would widen this valuation range to anywhere between -60p ps and +26p ps. Is it any surprise that markets treat these shares as little more than momentum plays on short term revenue trajectory or an option on changes in market ECC?

Earnings to FCF in pictures

Before I start to drill down into how a market ECC can be used to translate company FCF yields (operating) into growth ratings, I thought a few parting shots at the PE merchants was in order. If you're seriously trying to explain equity valuations on the basis of reported earnings please consider the following 7 charts relating to the broader market (FT Allshare).

FT Allshare PE multiple was progressively de-rated from 2000-2008

Despite an acceleration in relative earnings growth (vs GDP) over the same period

How much of this acceleration was a function of increased financial leverage however?

Which saw debt as a % of EV more than double

More of this earnings meanwhile was being absorbed by additional investment 

Which reduced to conversion of earnings into FCF

Which presents a somewhat less rosy picture on current valuations

Source: Thomson Reuters (Worldscope)

Risky business

If something happens a lot, then a few bright sparks may deduce that the probability of it happening again will have gone up. It was on this theme and with reference to the longer term outperformance of equities vs bonds that a number of equity strategists were arguing for a structural decline in the equity risk premium (the additional return demanded over government bonds; albeit probably not any of the PIGGS) to justify a further surge in equity prices. It was October 1987 and I was returning from St Louis and little did I know that I (literally) and the market (figuratively) were flying into a hurricane.

In those days however the 'equity risk premium' was a still a fairly undeveloped area of study. Until the emergence of indexed linked gilts in 1981, markets were only guesstimating the inflation rate being priced into long gilt yields markets. Without this, determining a reliable forward looking estimate of the risk premium being priced into equities was impossible.  Instead, most learned studies derived their equity risk premiums on a post-ante basis; effectively using the excess returns delivered by equities vs Gilts over various timescales.  Unfortunately, this tended to reveal more about the mispricing of inflation expectations in historic bond prices than the forward risk premium required to hold equities. It also had the incongruous result of attempting to explain an inherently dynamic market with a static risk premium - it just doesn't work! Market pricing feeds on changes in perceived risk and growth into the future rather an historic absolute of either.

So what is the risk premium being priced into equity prices and how does this compare with past levels?

Taking the UK FT All Share index as a representative equity market and using the UK long indexed linked yield as a proxy for a risk free return suggests the current (2011e) equity risk premium (ERP) of approx 6.8% within a total ECC (equity cost of capital) of around 11.3%.  Historically, this puts the overall ECC at the highest levels since the early 1990's with the ERP at record level having exceeded the spike in 2008.

Equity Cost of Capital (FT All Share - unadjusted)

Does this make equities cheap then? If one believes the consensus forecasts of a further +19% rise in market earnings for 2011 after the +50% rebound in 2010 and that the long gilt markets are not being distorted by Quantitative Easing, then maybe.  While the market is perhaps aiming off for a possibly slowing earnings recovery (as per 2008) as well as the abnormally low long indexed linked gilt yield (of under 1% vs its longer term trend of 1.5-2.0%), even adjusting for these would still suggest an ERP in the 5.5-6.0% range. Although equity markets were not strong real performers during periods of high inflation, they nevertheless do offer a partial hedge against inflation both in terms of earnings as well as a tendency for the ERP to contract.

ECC sensitivity to changes in earnings growth expectations (FT All Share)

ERP sensitivity to changes in earnings growth expectations (FT All Share)