Welcome to the UK recovery!

Still faced with a structural deleveraging in personal and public debt, the policy response by those who ought to know better remains the same – juice the system and hope growth miraculously appears.  That’s right, the same strategy as adopted for Greece, Portugal, Spain, France etc, etc, & etc. 

After the >+10% MoM rise in asking prices for London homes published by Rightmove, another vested interest group, the Council for Mortgage Lenders issued a press release highlighting the increase in mortgage approvals from 64k in August to 67k in September. Bank of England data released on 18 October was already showing a 25% YoY increase in UK property backed loans for August.   Consumer credit meanwhile is not being restricted to just property backed loans.  The Arch-Bishop of Canterbury may not approve, but net unsecured debt is also up, rising by £411m MoM in September; a +4.4% YoY increase.   As good Keynsians know well, rising credit equates to increased consumption and therefore growth so all this must be good for the recovery!

Encouraging consumers to leverage into property ahead of a possible rise in interest rates or take on more Wonga type debt however, seems an odd basis for celebration if not supported by real income growth.  Consumer credit may be expanding to fund current consumption, but real income growth will need to be supported by re-investment by industry.  While consumers were loading up with £411m of additional unsecured credit in September, lending to SMEs fell by an almost comparable amount of -£383m.  You can’t blame the banks as they are merely responding to the environment that Governments and regulators have created, just as we saw with most other financial cock-ups from the Savings and Loans debacle to the sub-prime crash.  When you can make a property loan with a Government backed guarantee or a pay-day loan with an APR of >1000%, then why should a bank go at risk to lend to some SME with no realisable assets and a business plan you don’t understand?  

Property back loans continue to rise: +67k in Sept vs +64k in Aug

Consumer credit increases +£411m in September

SME lending however down £383m in September

Not exactly positive for real personal income growth!

Consumers therefore continuing to buy more stuff with cheap credit, but particularly vulnerable to any increase in debt servicing costs while real income growth and SME investment remain constrained.

Will you be see the collapse in the property market coming?

Will you be see the collapse in the property market coming? There is an entire industry of vested interests out there to ensure that you don’t. You have a Government whose declared purpose is to juice demand and support funding with its various schemes to encourage the consumer to put themselves further into hock at current inflated levels. You have the entire financial services industry also pushing the same story along with its cheerleader, the central banks. We are confidently told that the economy is now recovering and as an apparent confirmation of this, Rightmove has reported a month on month increase in central London asking prices for properties of over 10%!

As with any good magic trick however, the audience needs to be distracted from the real slight of hand.  Behind the headlines of meaningless asking price expectations,  a number of long-standing property investors, both UK blue chip as well as overseas (including Russian and Saudi) have been quietly divesting some of their trophy property assets. Rental prices meanwhile are also beginning to crack (check out Zoopla), initially in the financial services exposed areas such as Canary Wharf, but now more recently in Westminster. While asking prices to sell properties may be up over 10% on September, year-on-year rental prices are in places falling by over double this level as increased capacity meets falling demand (and ability to pay).  The Government may be trying to buy votes at the lower end of the ladder with its help to buy scheme, but remember that the additional servicing costs will be passed on to borrowers while banks increasingly curtail interest only mortgages. In some markets such as Canary Wharf, where up to 80% of apartments are buy to let, things look scary.  By way of example, nine months ago a large three bedroom flat at the better end and with a good river view would cost you around £1,250 pw (£65,000 pa) to rent and perhaps £1.15m to buy, representing  a gross yield of approx 5.5%, albeit nearer 4.8% after the steep service costs of over £10k pa.  About five months ago however, rentals on comparable properties were down to £970 pw and are now on offer at £800pw; a drop of over a third in a year. Asking prices meanwhile have yet to reflect this trend, but the maths is not good. On said above property, even assuming an average entry price for your buy to let merchant of £1m, the gross yield at £800 pw would be a net yield of barely over 3%, even assuming a rental over a full 12 month period. At these levels the properties would start to become cash-flow negative even on an interest only funding basis. While big players may have the cash resources to swallow this for a time, smaller ones would be under pressure to sell.  This dynamic in itself could well start a stampede for the exit, even without a possible rise in rates.

UK property – a narrowly based bubble

QE funds government deficits, but the accompanying financial repression and hot money only serves to leverage up asset prices rather than the economy’s real ability to service them once rates normalise.  In 15 years, UK average house prices have more than doubled after inflation, while average real incomes are only up 12%.  As a consequence average property prices relative to average incomes have more than doubled over the period, from around 3.5x to almost 7x overall for the UK and to almost 9x income for London. 

With no real income growth and rising food and energy demands on household budgets this relative rise in UK property values has been funded by credit initially, and now more recently with lower mortgage rates.  In essence, the doubling of property values is now supported by a halving of mortgage funding costs.  If one were to apply the UK standard variable mortgage rate to average property values for England and London, then the dangerous excesses up to 2008 (equity withdrawal fuelled) can be clearly seen with imputed(*1) property costs rising to over 50% of income in England and 60% in London.  As credit tightened, rates had to be slashed to avoid a very sharp contraction in consumption. However, reducing the consumers’ property burden with a temporary fix on mortgage rates rather than an increase in income merely defers the problem. The Government is clearly desperate to avoid the reckoning, but with government deficits persisting, they will eventually lose control of long term rates. Should this precede a recovery in incomes, as it assuredly will, then property values will need to contract if there is limited further give elsewhere in household budgets and scope to equity release.   

The Government needs low rates, the Governor of the Bank of England would like to oblige, but ultimately their ability to control rates is limited so long as they need to fund deficits without crushing consumption with further taxation.  While every other Govt/Central bank in town has been playing the same QE game, competition for capital has been neutered and so with it have rates.  There may be an assumption that the UK is the master of its interest rate destiny, although a quick look at the comparative mortgage rates in the UK and US suggests the futility of this.      

 (*1) Yes, not all homes are funded with a 100% interest only mortgage at prevailing property values, but this imputed figure also provides an opportunity cost to the equity component and therefore a valid measure of property service cost relative to average income.    

WPP Q3 - still on track to beat FY13 guidance, albeit discounted by markets and valuation

WPP's Q3 revenue numbers today were solid, but with few real surprises. Year on year organic revenue growth of +5.0% maintained the similar rate already reported for July while also being slightly ahead of rivals Omnicom and Publicis.  Scanning the numbers being reported there are four main points that stand out.

1.  UK organic revenue growth of +8% compared with +7% for both OMC & Pub and the +7% advertising growth also recently reported by Sky in the quarter.  Before you get too carried away about a UK economic recovery, this mainly reflects the phasing benefit of a weak comparative period last year over the Olympics. UK disposable income growth remains below inflation, energy prices are set to rise another +8% and the outlook for consumption remains bleak even assuming interest rates can be held in check.
2.  WPP's organic revenue growth from the BRIC countries all came in at between +5-10%.  This is considerably better than for its rivals and is particularly important for WPP which is the dominant media buyer in India and is leader in China.
3. WPP re-iterated its FY13 margin guidance for a 50bps YoY increase. With average staff numbers broadly flat on an underlying revenue increase that should be heading for +3.5-4.0%, this still looks overly conservative (WYT estimate +80 bps).  This is not Sir Martins first time round the block and notwithstanding his upbeat economic outlook into 2014, he will be aware that his clients may struggle to make their Q4 earnings numbers which could lead to them cutting some discretionary marketing budgets. These year end shortfalls in marginal revenues can be a real pain for agencies own margins, so a smart CEO will carry some extra margin cushion into the Q4, just in  case. In current uncertain markets this is probably very wise!
4. Net new business of $7,896m for the 9 months means a whopping $3,715m was won in Q3;  a +163% YoY increase (x4 for creative and >x2 for media).  What is even more interesting about this spectacular performance however is WPP's inability to account for most of this.  While there is always a sizeable gap between the overall new business number that is reported and the individual accounts identified, this gap is now massive. In its Q3 presentation, 7 wins were identified which totalled only $894m and 1 loss of $50m; a net figure of only $794m and leaving another $2,921m unaccounted for.  Even by agency standards, this must be some sort of record.  Did they win the NSA account, but can't reveal it?

The shares. It's big, it's geographically diversified, the shares are liquid and it is still delivering slightly ahead of forecasts, albeit the market must surely already be baking this into real expectations. As such, the shares have continued to act an attractive haven for money scared into equities by the prospect of QE infinity.  In these circumstances, investors are being faced with a choice to find returns. Either move up the risk curve or extend your valuation horizon. While neither are particularly palatable and both of course carry risk, the latter is less overt and may seem more digestible. We saw this rather spectacularly recently with the pop in the Google share price as markets played catch-up.  For WPP meanwhile, its has been more of a seemingly inexorable grind upwards with the shares now having to reach out a further 18 months on current forecasts (both WPP and market) to support the present valuation and growth.

(see also www.wyt-i.com)

The need to look beyond the quarterly agencies reports

My iPhone weather App is like a set of Agency results.  It gives me a largely coincidental view of the weather if I don’t want to look out of the window, but is pretty useless as a meaningful forecasting tool.

With two of the big four agencies reporting, are we much the wiser?  Omnicom edged it’s organic revenue growth ahead to +4.1% against slightly easier comps while those at Publicis were a little easier at +3.5% against tougher comps.  Both groups did over +7% in the UK and >+4% for the US and Europe is touted as being through the worse; albeit at +0.4% for Publicis (including the UK and some strong performances across parts of Eastern Europe), this is not particularly meaningful. Of greater interest was the weakening trend across some emerging markets, in particular India, Brazil and even China, the latter two at +3.4% and +2.4% respectively in the period for Publicis.  Quarterly trends of course are notoriously volatile and Maurice was careful to point out the its Zenith advertising forecasts for 2013 remain unchanged at +3.5% while suggesting a figure of nearer +5% was expected for a “vintage” 2014.  But did I detect a hint of concern behind the bravoure when alluding to weakening market earnings expectations and the fourth quarter? As a discretionary expenditure, marketing costs come straight off company profits, and as such budgets can be vulnerable, particularly when companies need to salvage a year-end earnings forecast.
“No problem” according to the majority of market pundits and economists.  GDP expectations may have eased for 2013, but 2014 is forecast to be better. Europe is allegedly through the worse even,  for Spain and the US debt issues are surely just a bump in the road ahead of ‘MOAR’ from the new Fed chairman.  With the GDP wheels greased with endless liquidity, so goes marketing expenditures and as a consequence the good times for Agencies.

Somehow this all seems a little Panglosian and it can’t have escaped a Frenchman’s attention that all may not necessarily be at its best in the ‘Jardin’.  So let’s look at some of the evidence.

Exhibit 1:  Macro growth expectations are falling
Financial repression of the market cost of capital may be engineering a rise in asset prices, but it has done little for GDP forecasts which have dropped by around 70bps over the past year. A lower base may assist the comparative rate of growth for 2014, but Western economies still face the great de-leveraging and have hardly even scratched the surface in preparing for the impending demographic time bomb. Economists and politicians keep on reaching out for ‘green shoots’ but these are again proving illusionary.  Can the Fed keep on funding the US deficit and if not what then for interest rates and growth expectations?

Exhibit 2: Company earnings expectations are also falling
Companies guide markets on short term expectations and aim to over-deliver.  Notwithstanding the immediate puff of headlines of quarterly forecast beats, the longer term trend is less positive.  This is the third year when initial earning expectations have proved far too high, despite $85bn per month of Fed liquidity. On the below analysis from Morgan Stanley, 2014 earnings expectations for the S&P 500 are almost back to where 2013 was originally forecast which in turn was only around 5% above the top estimate for the prior year, 2012! This may be ignored by what has become a financial command economy, but it will have been felt by the companies themselves as well as  anticipated by their suppliers.

 

The squeeze on corporate revenue growth is not new. What is interesting with the current Q3 earnings season to date however is that the earnings misses are on the increase, albeit still outnumbered by revenue misses .  In its recent analysis of results to 10 October, Factset’s research, average YoY revenue growth of +2.2% compared with expectations of +2.5% at the start of the month while average earnings growth of only +0.8% had dropped from +3.5% over the same period.

http://www.factset.com/websitefiles/PDFs/earningsinsight/earningsinsight_10.11.13

But, don’t worry, analysts have only marginally trimmed their Q4 earnings forecasts, from +10.1% to a still healthy +9.8% over the past month!  With a strengthening US dollar working against US dollar earners in some markets (eg US$ +20% vs Yen), expect management to be scrambling around for things to cut in an attempt to make these ambitious Q4 numbers. In these circumstances, why wouldn’t a smart CEO not be concerned that some of this might come out of his industry’s pot?


Q3 2013 Earnings (S&P 500 to 11.10.2013): Above, In-Line, Below Estimates

Q3 2013 (S&P 500 to 11.10.2013): Revenues: Above, In-Line, Below Estimates

 

“Trust us, we know what we’re doing”

Am I missing something here? No sooner than central bankers on both sides of the pond had impressed upon us the importance of managing expectations and newsflow for fickle markets, than Bernanke throws us a very curved ball. Was this the same person that has for months been sending out signals of tapering QE, that announced that the taps remain turned to maximum yesterday? Excuse me, but I’m confused as to what might have changed in the meantime. Indeed, looking at the predicable market reaction to the news (with asset classes rebounding across the board), I was not alone. The economic data has hardly changed (including the continued absurdity of the Fed’s +3-3.5% real GDP growth forecasts for 2013), although the ‘surprise’ emergence of Dr Yellen again as a possible replacement for Bernanke, following Summers bailing out, may have provided the catalyst. An uber dove like Yellen would not want to inherit an existing tapering policy.


Unfortunately our natural cynicism that politicians (including central bankers it seems) will continue to follow the line of least resistance until this is no longer possible, appears to be confirmed. We all know QE doesn’t work, so claiming the need to keep pumping must therefore assume the last 4 years of QE hasn’t worked and therefore smacks of insanity if this were the real reason. The real reason of course is two-fold. First, the need to keep the asset bubble of toxic bad loans inflated, at least, long enough for banks to foist them on the rest of us and secondly to keep funding a structural deficit that politicians and consumers do not have the stomach to honestly tackle before the demographic time-bomb explodes. Running these twin deficits has only been facilitated by the US dollars status as reserve currency. With over half of all US dollars offshore, this has also meant that the subsequent dollar depreciation has forced those overseas dollar holders to effectively fund the majority of this excessive expenditure. Thank you Johnny foreigner!

This strategy however is not a sustainable state of affairs. It is clear there is no political will to balance budgets even before the baby boomers retire. Congress is stymied by pork while the President seems to be on another planet. In his recent business roundtable speech came the simply jaw-dropping assertion that raising the debt ceiling does not increase US federal debt. And this after castigating his audience that “ I just want to remind people in case you haven’t been keeping up”. Ha, the audacity. It reminds me of the line in Josey Wales “Don’t piss down my back and tell me it’s raining”. Obama claims a 3% deficit is OK, while his key policy suggestion is to increase immigration (a bit like Labour in the UK). Although I presume that this would only work if only young and productive immigrants were let in rather than benefit scroungers plus their retired relatives.

http://www.whitehouse.gov/the-press-office/2013/09/18/remarks-president-business-roundtable

http://cnsnews.com/mrctv-blog/craig-bannister/obama-raising-debt-ceilingdoes-not-increase-our-debt-though-it-has-over

So where does this leave us all. A political class that remains in denial and will not act until forced to, but by then it may be too late and a cabal of central bankers and their bank paymasters who have lost control of events. They have been able to get bailed out while making vast carry-trade profits from easy money, but lack the self-restraint to get their snouts out of the trough before the abattoir doors slam shut. In case you “haven’t been listening” the world is increasingly polarising around two camps. The newly wealthy cold war losers of China and Russia bearing a grudge, but also owning substantial US debt and a US that has been blundering around in its foreign policy while alienating its allies (as well as many Americans). It may not happen this month or even this year, but at some point and with the right catalyst there will an assault on that bastion of US power, the US dollar and its role as the world’s reserve currency. Without it, the US is bust on its current military and social commitments and everyone knows it. Should this happen, and it inevitably will on its current trajectory, then expect a run on the dollar which would rapidly increase its funding costs. Bernanke’s signal since May that tapering will happen sooner rather than later may not have been welcome by the QE addicts at the trough, but it suggested that responsible individuals were still at the helm of monetary policy and would force some much needed fiscal discipline to those who had been relying on central banks to monetise their deficits for too long. Yesterday’s apparent volte face on this therefore is a very sad day. Perhaps it may be temporary, but it has sent out all the wrong signals and that there is no monetary or fiscal discipline to rely on. As such it will have to be for markets to eventually provide this discipline, but painfully. Despite its best attempts, 10 year interest rates have already doubled in a year and mortgage rates are also up around 100bts. When the Govt and the Fed lose control of markets, then caveat emptor.

Publicis Omnicom Groupe - financials less exciting than the impending management soap opera

Oh la la, Omnicom is to be bracketed by Publicis to become part of the greater "Publicis Omnicom Groupe" with deal to be signed in Paris rather than New York or a neutral country. Does this mean a corporate coup for the French or will the emergence of a balanced board and possible removal of Publicis's voting restrictions mean that its ambition will ultimately be its undoing? From what has so far leaked out with regards future management structure, it does not look like a viable longer term proposal, with the enlarged group(e) managed out of both NY and Paris and with a head office in the Netherlands. Perhaps they will go down the Reed Elsevier route and have a dual listing as well, in order to secure their borders from too much Franglais.  It is worth noting however that the original dual management structure at Reed was a disaster and soon dropped; something that will inevitably happen here if adopted unless it is to become a mongrel.

From what we know so far, the enlarged group(e) will reflect an approx 50:50 split between Publicis and Omnicom.  Surprise, surprise, but this is broadly where the respective market capitalisations are already.  Can you imagine the feverish activity as both shares were rising ahead of this announcement the secure this or perhaps we are expected it to be merely fortuitous.


On an EV basis, Omnicom's net debt position v Publicis means that it will be the larger of the two group(e)s going into this 'merger' at around 52% of combined EV


So far we haven't seen much in the way of financial implications of the merger beyond an expected cost synergy of $500m. In the context of around $25bn of consolidated revenues this is about as spot on to my estimate yesterday of a 200bps margin benefit as one might expect some corporate planner also putting his finger in the air to come up with a figure that might impress markets.  What we don't know at this stage however is the level of dislocation to staff and clients this may also bring and the level of revenue leakage one should also be factoring in. For such a big deal, with so much potential for dislocation, this is not that exciting given the pop in both share prices in the run up to all of this. At least the impending soap opera of corporate manoeuvring and back-stabbing between NY and Paris should provide some more excitement!


Is there a winner from all of this?  Well the bankers and advisors of course. Shareholders of Omnicom will probably see their valuation in terms of growth rating back to where it started (posted savings) while Publicis's rating should drop by around 100bps to around +3% CAGR. Omnicom shareholders may consider this as the cost of not chasing after digital acquisitions earlier while Publicis shareholders may wonder whether the dilution in growth rating merely reflects the reality of the situation.






from wyt-i.com

Omnicom & Publicis – a marriage not made in heaven

Business struggles to deliver above market organic growth and therefore resorts to sector consolidation to cut costs and obscure the maturing growth profile. It is a well enough used stratagem.  Pharma has been there and done it, Telecom consolidation is currently in full flood and once again, major consolidation is being proposed in the marketing services segment with Bloomberg’s supposedly authoritative news on Friday of the advanced merger negotiations between the number two and number three agency holding companies, Omnicom and Publicis. 

At first glance such a combination may seem a value enhancing, if somewhat unimaginative plan.  In media, where scale really counts, the combination would combine three strong media networks, equalling WPP, but with more clout with approx. 40% market share vs WPP’s c. 32%.  While the core creative and media networks would be largely retained to avoid too much revenue leakage from the inevitable client conflict issues (eg with both Pepsi and Coke), there would be scope for sizeable cost savings and back office (including technology) efficiencies.  As a rule of thumb I would expect at least +200bpts to net operating margins over the initial 3 years (net of revenue leakage) with after leveraging thru debt and tax benefits could be raising earnings by around +20% over the same period.  So what’s the problem?

Barring the possible anti-trust issues, particularly in the US (see above chart), this story/deal smells fishy.   This is being touted as a merger of equals, but has anyone pushing this story ever actually worked for a French national champion?  Is this the same company (Publicis) that accepted the resignation in 2010 of the CEO (David Kenny) of its then US digital prize, Digitas, because he was not able to relocate to Paris? Is this the company with a restrictive voting structure and a decidedly Gallic flavour to its supervisory board which includes the daughter of the founder as Chair and two of his grand-children and an executive board headed by the archetypal suave Frenchman, Maurice Levy from his offices overlooking the Arch de Triomphe?

In addition to the inevitable cultural clash, the strategy embarked by each group has also been very different. Omnicom has eschewed large acquisitions while Publicis has aped WPP with a spectacular pace of corporate expansion, particularly with its recent digital acquisitions.  If Publicis still believes that these will deliver the growth and returns, why is it selling out on a nil premium merger basis to the Americans who have invested less in these tools and services? It is not as if Omnicom would provide a significant advantage in geographical coverage or exposure in growth markets given both companies heavy exposure to the US.  If Publicis was just after a third media network and more Asian exposure, it could have always have pursued Aegis again, which it didn’t.   If Publicis is seriously selling out control at this stage without a significant control premium it should sound a warning claxon as to what they know that markets don’t.  Has there been a dud or two amongst its vaunted digital acquisitions that is going to bite them where it hurts?

A brief history of these groups by charts

1   1)      Touted as an above growth segment, agencies have failed to deliver above GDP rates of organic revenue growth, notwithstanding the network benefits of folding in acquired new skills. Since 2000, there really has not been much to separate the top 3 players (WPP, Omnicom and Publicis) in terms of cumulative organic revenue growth; all of which have substantially lagged cumulative Global GDP. So much for the organic growth story! 

       2)      Margin expansion. If you can’t out-grow on the top line, try to make up the slack on the bottom line. The first stop of course is EBITA margins (then capital structure and tax). Downward pressure on gross margins from clients however makes this tough to achieve, particularly if you have to invest (internally) in new service development. No problem, just buy in these skills with acquisitions where the previous development spend will sit unamortised on your balance sheet as an intangible. As investors tend to exclude the arbitrary amortisation of acquired intangible, this provides a free get out of jail card while stripping out overlapping operating costs to deliver on the margin story.

3    3)      Not-withstanding all this, the ‘underlying’ EBITA story is not particularly impressive with only Publicis running ahead of GDP. But with enough financial leverage, falling interest rates and all that US tax relief on acquired intangibles, the sector can deliver what the market thinks it wants and thinks it is getting, above market EPS growth.  With multiple of billions of £/$/€ of acquired intangibles on each group’s balance sheet however this is somewhat of a moot point. How much of this is really being consumed is tough to calculate, but even a 15 year amortisation could more than halve the perceived returns of some of the groups. Well worth remembering when someone tries to flog an earnings based valuation to you.

  

4    4)      Acquisition ROI? Although the below table does not attempt to apply an amortisation for consumed acquired skills and services (intangibles), the implied pre-tax returns do not suggest either significant growth from acquisitions unless the core businesses are in decline. Having spent least on acquisitions, the implied real ROI by Omnicom heads up the pack with both Publicis and WPP languishing at only around 8% if one assumes an inflation adjusted  market average growth of +2% pa over the period (15 years).  

Valuation by growth rating – added without comment or recommendation