P&G swaps Duracell at 7x EBITDA for shares in itself at 13x. Buffet wins again!

When a company such as P&G can sell 10 year debt at little more than a 3% coupon, then we should not be surprised at some of the pricing decisions being taken. With regards its subsidiary Duracell, it has a business in slow structural decline, which provides a drag to its own organic growth figures, but with good cash flow. With an adjusted EBITDA of approx. $670m and we estimate approx. $400m of underlying operating FCF, the $4.7bn imputed valuation being paid by Berkshire Hathaway for Duracell is 7x EBITDA, an EBITA yield of 12% and more importantly a 8.5% Op FCF yield. As a carry trade against even BH’s funding costs, this is obviously highly accretive to its short term earnings even without some clever accounting slight-of-hand to exploit tax shields etc. The high initial exit return however is a reflection of potentially diminishing longer term returns as demand for disposable batteries are displaced by rechargeables and against the still relatively high market cost of equity of around 10.5%, the exit FCF yield of approx. 8.5% is still discounting growth at around +2% pa. So from P&G’s perspective, it has sold an ex-growth asset at a small growth premium, although in the current environment this would raise the problem of what to do with the cash and the prospective earnings dilution. For a business struggling with only +3% pa organic revenue growth, one might have thought that the great P&G would have no shortage of projects where it could allocate the capital efficiently, as clearly it needs to raise its value proposition to customers.

Think again. As with most other large groups that can borrow at sub real longer term interest rates, money is being returned to shareholders and particularly via share buybacks rather than being re-invested back into their businesses. While this may often be value destructive, in that they are over-paying for growth, the low rate environment ensures significant short term earning accretion on which so much of board variable compensation seems still to be exposed to. P&G’s decision to effectively swap Duracell for BH’s shareholding in P&G therefore makes perfect sense from the distorted perspective of financial repression, but may prove less attractive if reviewed in hindsight should markets ever recovery from central banks the role of pricing capital. Accepting its own shares at 13x EBITDA for payment of a subsidiary sold for 7x, or selling a -2/0% growth business on a +2% growth rating for a +3/4% growth business priced at a +6/7% CAGR is no more than a short term game in relative returns and ought not to mistaken for a real value proposition. BH may well be overpaying for Duracell, but this is more than compensated by the premium received on its P&G stake. P&G however has merely recycled its Duracell premium into paying an even bigger premium for itself while doing nothing to address the real problems of restoring its own organic growth.

ITV - Onus on content delivering the goods as NAR growth slows and audience share erodes

New management with a new veneer to the content strategy and a cyclical recovery in UK TV advertising have all encouraged markets to give ITV the benefit of the doubt that this time it can manage the transition from distribution monopolist to a more balanced content origination and distribution business, albeit in a considerably more fragmented and competitive environment.  As advertising comes off its QE and World Cup highs and content acquisitions bed down markets will need to review whether there is scope for structurally raising an already competitive operating margin of around 30% or whether the growth in demand for its originated content will be great enough to offset the prospective erosion in free to air audiences (NB 9 mth SOCI -6% YoY)and share of future advertising to support the current approx. GDP average growth rate implied by the operating free cash flow yield.  Acquisitions of content originators, such as Pawn Stars producer “Leftfield”, usually sound beguiling initially, but these are invariably bought at their peak and only justify the prices if they can continue to originate new hit series. Anyone remember “MTM”, “Reeves and Allen”, “All American” or “Grundy”? Nuff said!

Trading 9 month IMS:  Revenues reported up +8% including +6% for NAR (implies Q3 at +4% vs +4/5% target and +7% for H1) and +24% for online and +10% for Studios (all acquisition led). Notwithstanding the World Cup in the summer, viewing share remains disappointing with overall share (SOV) for all ITV channels down -5% from 23.0% to 21.8% and Share of Commercial Impacts (SOCI) -6% from 38.4% to 36.1%. Total ITV adult impacts declined by -9%, although long form video requests increased by 24%. Costs: Co reporting it is on track to deliver the planned FY14 savings of £15m.

Trading H1 FY14:  Revenues +7%/+£81m to £1,225m including NAR +7%/+£54m to £795m, online +20%/+£11m to £65m and Studios +6%/+14m to £240m (-10%/-£23m organic however).  EBITA advanced by +11%/+£31m to £322m, including +10%/+£22m to £250m for Broadcast & Online (o/w gross margin for broadcast increased by +14%/+£14m) and +14%/+£6m to £78m for Studios.  Including reductions in funding charges, adjusted PBT increased by +16% to £312m with EPS +15% to 6.1p and DPS +27% to 0.3p.

OUTLOOK:  FY14 NAR growth is forecast at +5% with Studios up by approx. £100m after absorbing around £30m of fx drag. For FY15 the group is predicting improved revenues based on a positive economic outlook, an additional 2 new channels and a return to organic growth for Studios and a focus on improving SOV from investments in new scripted content.  Well, that’s the plan! It does however suggest additional investment in origination (and deficit financing) which may provide a margin penalty. In itself that ought not to worry markets, but only if balanced by viewing improvements, otherwise we are back to where we were a few years ago, albeit with a less stressed balance sheet if one turns a blind eye to the increased pension deficit (from -£362m in June to  -£456m in September following reductions in discount rates).

ITV growthrater tab

Digital plonkers

WPP’s annual digital investor day provided Sir Martin Sorrell another opportunity to show off his digital wares as well as take some entertaining swings at rivals; particularly the “plonkers” who had recently been over-paying (ie out-bidding WPP) for digital assets and particularly those in Brazil. Comment est-ce qu'on dit ça en Francaise Maurice?

At some point ‘digital’ media and interaction will become so ubiquitous, it will become obsolete to try and split it out as a discrete area of activity for marketing agencies. In the meantime it will provide a rich seam to be mined for corporate finance and purveyors of charts showing the exciting growth opportunities in most things digital that can be displayed to starry-eyed investors.

A digital presentation needs a chart showing digital growth, so here it is!

Yesterday’s digital investor day by WPP therefore pretty much delivered to cue; lots of charts with lines rising diagonally from bottom left to top right together with accompanying suits from often recently acquired digital properties to explain why their piece of the pie was going to grow faster than everyone else’s. This was clearly not the forum for discussing falling gross margins, sub-GDP net sales growth or the reliance on acquired digital skills and the extent to which these acquired intangibles are consumed and therefore ought to be recognised as a real P&L and cash flow expense.

Amongst all of the digital brouhaha however was a chart that was so incongruous as to represent a sort of Banquo’s ghost.  This was the rather worn analysis of comparing time spent on various media with the proportion of advertising expenditure.  The premise of course is that the two should ultimately converge and therefore digital budgets (especially mobile) should continue to rise.  Forget the billions spent on marketing effectiveness studies and research to measure and improve advertising effectiveness and accountability, let’s just assume a linear relationship of time to effectiveness regardless of media and type of interaction and plan budgets accordingly.

Time = Value? really?!!!

I am not too sure what place a chart such as the one above still has in a presentation of digital businesses whose main value proposition is that they can improve marketing effectiveness and therefore de-commoditise the time/spend relationship and better identify which “half of the advertising budget is wasted” as allegedly quoted by John Wanamaker.  Perhaps WPP was trying to keep it simple for the audience, although perhaps there remains an element of truth in it as well. Despite all the spend on research and data, perhaps a large section of the advertising customers really are so unsophisticated as to run with such a simple an unrepresentative metric. Heck, it’s not as if financial markets are any better. How many investors still value stocks on a price to earnings ratio (PER) and usually against an earnings denominator that has been adjusted by the company to exclude all the bad stuff (EBBS  - earnings before the bad stuff) and also may have little connection with the real cash flow or profitability of the business?

In the real World, it may be that little has really changed over the past decade when I trawled through a number of planning and buying agencies to try and understand whether there was an objective basis to determine the relative effectiveness of various media.  I remember the shock of discovering how little hard data to measure marketing cause and effect there actually was and the extent to which budgets were allocated on soft metrics including share of voice, competitor media mix, unaided brand recall and a whole host of other factors that were divorced from any type of ROI analysis. In yesterday’s WPP presentation, it’s market research head, Eric Salama presented his strategy of connecting audience measurement with retail measurement, as Nielsen tried with Apollo about a decade ago (without success), and in another attempt to get closer to that holy grail of market research, measuring cause and effect.  Unfortunately theory and execution can be strangers in this field. As other panel members were pressed to back-up their value proposition claims or discuss forecasts of changing media mix in budgets they often appealed for Eric to step in with some data to support their position, but to no avail. If Eric’s division has been able to measure relative effectiveness of marketing spend by media platform, then he was keeping it to himself!

Recency bias – the curse of financial markets!

We are all guilty of it, but it is probably the single most dangerous investment sin. Perhaps it is part of our social evolution to conform. A sort of “Eat shit 17 quadrillion flies can’t be wrong”. With regards to financial markets you may have seen the same shit, but given a pseudo- intellectual spin such as “perfect market theory” or its ilk which implicitly suggest that markets are right and you are wrong, albeit an imperfect market theory would be just as valid. Human capacity for self-delusion based on information and normative conformity bias is well documented and includes Asch’s classic Conformity experiment which is well worth watching, if only for the appalling 1970’s hairstyles.
http://www.youtube.com/watch?v=sno1TpCLj6A
Ok, so over the past five years we have been taught that bad news is good news as market liquidity is dominated by central bank policy and that all dips should be bought (see http://www.youtube.com/watch?v=0akBdQa55b4) and that yield is good, almost regardless of risk. If it’s gone up in price, find a justification, however spurious and then flex the assumptions to add at least 10% to the price to keep compliance happy with the endless buy recommendation. This self-reinforcing consensus however is little more than a mass goal-seek. Sell side careers do better during the longer periods of cyclical upswing and if it all goes pear-shaped, then the flawed recommendation can be buried along with the general debris. For buyside, the pressure on short term returns is also intense and bucking the trend can also be expensive to careers, ergo momentum investing rules and in turn merely reinforces the conformity bias until the big reset. A particularly interesting feature of the Asch experiment was also the effect of introducing an additional potential dissenting voice to the group and the speed at which it could puncture the group delusion. Quite what will represent that ‘additional voice’ in today’s markets will have to be seen, but take care because when it happens, as it always does, it will be quick.

I was reminded of the pervading power of recency bias in a meeting with an investment manager who was interested that my growthrater system did not share his upbeat view of the value of a stock; in this case Nestle, a solid consumer group with a good record of historic growth but with current revenue growth falling short of the expectations that rising Asian demand were expected to deliver. Notwithstanding, the investor was probably referring a post interest cost of capital (WACC) rather than a more robust pre-interest one, his position was that the market (aka big sell-side) were pushing the stock on the basis of a seriously sub-market cost of capital. If growth is slowing and volatility increasing however, this looked more like a goal seek to justify where the stock, or they would like it be, rather than a serious revaluation argument. In the ‘growth-rater’, the equity risk premiums used are those for the market average, with the flex in target operating free cash flow yield determined by variances in discount growth rating. Unlike the above flexing of specific risk premium, this is not a function of a subjective discount plucked out of the air to goal-seek a share price, but directly related to what the company is actually achieving and is expected to deliver in terms of organic revenue growth. As a consequence it is considerably more immune from the group goal-seek. It may provide uncomfortable results, but this should be expected from any rigorous structured approach. My response to the cost of capital issue on Nestle is simple and demonstrated with two charts. First, the chart of the group’s organic revenue growth vs the growth rating being priced in by markets against the backdrop of the share price. From 2004 to end 2011, Nestle’s organic revenue growth was consistently above the growth rate that was being priced into the shares. In other words you could buy growth at a discount, ie Cheap. After that point, the relationship inverted and markets were pricing growth at a premium to that being delivered, a feature that has become more pronounced as organic revenue growth rates erode, ie Expensive. As the Growt-rater automatically provides target price ranges (second chart) one can see that the time to buy Nestle was before the shares outperformed and the to sell it before it went down. Now how about that for a revolutionary investment strategy!

Cheap growth for the price up to end 2011, then expensive

Back-test analysis of target price ranges

Publicis bids $3.7bn for Sapient Inc. - how to buy 'organic growth'

Finding a marriage of 'equals' with Omnicom was not to its tastes, Publicis is back to what it does best; hoovering up smaller digital marketing operations. When you are not a Wonga client and can borrow at only 2.6%, then buying in a business on an operating profit yield of approx 5.5% before synergies and 7.0% proforma post synergies also makes a lot short term sense in terms of short term EPS accretion, particularly when it enhances your own flagging organic revenue growth and you can step-up the proportion of claimed digital component from 40% to 50%.  EPS accretion however does not equate to value enhance in these QE distorted markets

So what is Publicis buying here? Sapient is essentially a consultancy business focusing on digital marketing solution for range of both commercial and government clients. Revenues are substantially generated from fees (usually time +costs) and as with all consultancies, compensation is the major cost. At almost 72% of revenues however it is considerably higher than the approx 60% ratio for most larger marketing agencies, notwithstanding that 66% of Sapient's staff are located in India. In terms of historic revenue growth, Sapient's performance  has been good at >+10% pa, albeit with limited operational leverage to margins that remain at under 11%.

  The valuation
Historically, Sapient has traded in a growth rating range of +3.8%/+6.8% and a mean average of +5.2% against an average revenue growth rate range between +5%/+25% and +14% average.  Applying a growth rating range of +5.6/+5.8% on prospective operating FCF, the valuation for the stand alone enterprise comes in at approx. $19/$21 per share vs the $25.0 ps cash offer being made this morning by Publicis

Sapient worth $19-21 ps pre-synergies

Mapping the WYT npv calculator into a chart (below) suggests that the shares had not been running ahead of their growth delivery in the run up to this offer



Post acquisition synergies take the valuation range to $25-$26 per share

Publicis is a past master in eking out cost savings from its acquisitions without imploding  the acquired growth.  For Sapient, Publicis expects to extract cost synergies of $50m/$60m pa which is probably an under-estimate on past performance. Adjust Sapient's earnings for this to derive a proforma operating FCF and see what happens to the valuation in the table and chart below.

proforma incl €50m savings

Include an adjusted chart history and presto!

Proforma