Description

Asatsu-DK (“ADK”, ticker 9747 JP traded on the TSE, price=JPY 3,610) is Japan’s 3rd largest advertising agency which is trading extremely cheap, at discount of 40%-110%+ versus comparable Japanese and global advertising agencies. The company has no debt, is extremely cash rich (cash, marketable securities and investments account for 70% of the market cap), and is well-positioned in an industry that is continuing to witness rapid consolidation at multiples far in excess of 5.7x EBITDA, which is where ADK is trading (after adjusting for cash and the fair market value of investments); global acquisitions over the past few years have been in the 10x-20x EBITDA range, and have averaged around 12x-13x. ADK’s valuation is also substantially lower than the public market multiples of global ad agencies (including WPP, Omnicom, Publicis Group, Dentsu, Havas), which currently trade at 8.0x – 12.0x EBITDA.

ADK is a full-service global advertising agency with total billings of JPY 430BN, ranking it # 10 in the world and #3 in Japan, behind Dentsu (JPY 1,960BN) and Hakuhodo-DY (JPY 1,120BN). ADK is a member of the UK-based WPP Group of Companies, which owns 20% of ADK’s outstanding shares (ADK in turn, owns 2.5% of WPP’s public shares). WPP bought its stake in 1998 and maintains that it is a strategic long-term investment (Sir Martin Sorrell, CEO of WPP is an executive director of ADK). For ADK, the alliance with WPP is beneficial in that it can hitch onto WPP’s overseas business network (to help win clients with global ad campaigns), while WPP can utilize ADK for ‘media buying’ in Japan which is essentially buying ad space to clients of its two affiliates in Japan, JW Thompson and Ogilvy & Mather. Clients of ADK include many leading Japanese and multinational corporations and Asatsu works for a number of WPP clients in the Japanese market, including AIG, Bandai, IBM, Nikon, Unilever, and Pfizer. ADK’s revenues are primarily generated in Japan (95%), however it is expanding in other markets (particularly Asia, ex-Japan which are rapidly growing) and maintains offices in over 20 countries. Japan is the second largest ad market is the world, measuring over $36BN, which is below the US at $147BN, but well ahead of Germany, the UK, and France (at $18BN, 17BN, and $11BN, respectively). It is also larger than the rest of Asia ($33BN) and Latin America ($13BN)

Similar to most of the global ad agencies mentioned above, ADK is in two primary businesses: 1) purchasing ad space as an agent for clients; 2) producing advertising for commercials, newspapers, magazines, posters, outdoor & other media. As a purchaser of ads, agencies purchase advertising time and space from mass media on behalf of clients, and in turn, sell it to them, charging a commission (typically 15% of gross billings—this applies to ad firms across the world, however some of the scales vary). For the production side of the business, the standard mark-up on billings ranges from 15%-18%. For ADK, media buying comprises about 15% of total billings while brand-related advertising production, promotion (typically of sporting events), creative production and miscellaneous activities (magazine/book publishing) make up about 85% of total billings.

Over the past several years, client companies have made greater demands of ad agencies. Ad firms not only buy media and produce advertising, but they must also provide all-around marketing support for clients. Due to clients increasingly developing and managing their businesses globally, it has become very important for agencies to build systems that can offer worldwide services in a “one-stop-shop” format that can deal with ad needs across several countries/continents. Also, advertising clients are increasingly trying to concentrate their ad spending with fewer agencies; by doing so, they are better able to control ad spending by taking advantage of bulk media discounts. Clients have also focused on ways to improve their own costs by devoting fewer employees to managing external ad agencies; thus clients are doing more business with fewer ad firms and with firms that can provide multiple ad services across the entire advertising chain (from production, media placement, promotion, and global account management). From the advertising industry perspective, larger ad firms are able to develop economies of scale by offering/cross-selling more services to their clients and by negotiating better discounts with the media firms—it is no coincidence that in Japan, smaller ad firms’ margins are somewhat lower than the largest player, Dentsu, which has achieved the scale to cross-sell more ad/marketing services and drive more revenues per employee. Finally, advertising is an intensely competitive business and in the midst of price competition, larger ad firms have the ability to pass on the savings from economies of scale/bulk media discounts onto the client, while offering more value (vs. smaller ad firms) via more service offerings. As a result of these secular trends, over the past decade there has been a strong desire to for ad firms to expand (both in business lines and geographically) and improve their economies of scale by via acquisitions. Companies such as the Interpublic Group (IPG), WPP Group, Omnicom, Grey Global, Publicis, have been formed through dozens of acquisitions of smaller ad firms. Over the past 10 years, these “roll ups” have been conducted at multiples ranging from 10x-20x EBITDA (averaging around 12x-13x, based on last 23 major global ad agency transactions); the most recent global transaction, Omnicom’s purchase of Grey Global in late 2004, was done at 9.5x (Havas also tried to acquire Grey, but lost out to Omnicom). Publicis Group recently announced that it is in talks to buy Aegis, plc (trading at 14x EV/EBITDA). Japan has also seen its fair share of rapid consolidation, most recently with the triple merger (and subsequent early 2005 IPO) of #2 ranked ad firm Hakuhodo (merged with Yomiko, and Daiko), and Dentsu’s purchase of 50% of a small Japanese ad firm, Meitetsu, from its owner, the Nagoya Railroad (price undisclosed). While nothing is imminent in terms of consolidation activity, ADK would make a prime acquisition candidate, either by one of the two larger Japanese ad firms (most likely), or by another large global ad firm (possibly WPP or one of its competitors). The attributes of ADK are pretty attractive: the ultra-cheap price, good management team, strong/improving operations, deep client relationships (both local and multinational) that go back to the 1950s, significant market share as the #3 player in Japan (which has grown and is much larger than the next three largest players), and the potential for an acquirer to gain access to the Japanese and Asian markets, improve their product offering to global clients that operate in Japan/Asia, and gain scale and reduce costs.

So, why is ADK only trading at 5.7x EBITDA? Due to the maturity of the Japanese ad market, slow top line growth associated with a struggling economy, and historically lower/more erratic profitability vs. their global counterparts, Japanese ad firms have generally traded at lower multiples. The economics of the ad business are actually very similar from country to country, however higher employee costs and less discipline in cost controls (vs. US and European counterparts), coupled with a horrendous 4-year ad slump that ended in 2004 (which really depressed the earnings of Japanese ad firms), have resulted in slow growth and depressed ROIC/ROE, especially with ADK and #2 player Hakuhodo. Dentsu, which has the highest profitability and generates more business from growth markets, trades at over 10x EBITDA. Hakuhodo, which was recently IPO’d in March of 2005, currently trades at 6.8x adjusted for cash & investments (still a 20% premium to ADK). Hakuhodo also appears to be undervalued, reflecting integration risks of its triple-merger, the need to expand profit margins/reduce costs, and the fact that it not been a public company for a long time (its early 2005 IPO price implied an approx. 6.4x multiple). The low multiple of ADK also reflects the fact that cash, marketable securities, and investments make up nearly 70% of ADK’s enterprise value (a much higher % vs. its competitors which also maintain cash/investments); this creates a “drag” on the performance of the equity, rendering it less attractive to many investors (and like most Japanese management teams, has not been all that aggressive in selling/redeploying investments and free cash flow into huge dividends/large scale share buybacks). Hakuhodo also maintains cash & investments equaling 40% of its Enterprise Value (also a reason for the lower multiple of 6.8x versus Dentsu, which has the least cash/marketables). ADK also has about JPY 14BN of “off balance sheet” asset value representing a 27% stake in a company called the Digital Advertising Consortium, Inc. which is carried on the books via the Equity method at only JPY2BN, but is currently worth around 16BN. Finally, many of the sell-side analysts that cover the Japanese ad firms don’t adjust for the cash & investments on the balance sheet, which on the surface, makes it look as though ADK and Hakuhodo are trading at over 10x EBITDA.

Below is a comparative valuation of ADK versus its Japanese and US/European counterparts.

Comparative Valuation

ADK (Projected 2005 financial performance as given by Co. management)

49.3 BN JPY Revenues (Net revenue retained or commissions earned on total billings,
which is how all US and some European firms report)
10.1 BN EBITDA
20.5% EBITDA margin
4.6 BN Earnings (excludes dividend, interest, & investment inc)
38.0 BN Cash & Equivalents
92.2 BN Investments* (see below)
1.0 BN Debt
186.9 BN Mkt Cap.
57.7 BN EV (adjusting for cash & investments)

5.7x EV/EBITDA (adjusted for cash/investments)
1.5x Price/Book
12.3x Price/Earnings (adjusted for cash & investments)

*JPY 92.2 bn in investments includes:
35.9 BN JPY WPP Group equity (31,295,646 or 2.5%--publicly traded)
16.2 BN Digital Advertising Consortium, Inc. (27.09% ownership—public)
21.8 BN Other Publicly traded equities (mostly in affiliates)
5.9 BN Non-Publicly traded equities (book value – 116 issues)
10.1 BN Bonds (35 issues)
2.3 BN Mutual Funds (30+ funds)

The major risk with the investments above is a fluctuation in the price of WPP Group, however this can easily be hedged (additionally, WPP trades at the lower end of global ad agencies—see below).


Comparative Valuation – Japanese firms

Dentsu (based on 2005 company projected revenues/EBITDA), ratios adjusted for cash/investments)

322 Bn JPY Revenues
22.3% EBITDA Margin
10.4x EV/EBITDA
1.9x Price/Book
25.5x Price/Earnings

Hakuhodo-DY (2005 Co. estimates; ratios adjusted for cash/investments)

158 Bn JPY Revenues
17.3% EBITDA Margin
6.8x EV/EBITDA
1.8x Price/Book
14.5x Price/Earnings



Comparative Valuation Global Publicly Traded Ad firm Comparisons (2005 estimates):

EV/EBITDA
Aegis: 10.4x
Havas: 9.7x
Publicis: 9.6x
WPP Group 9.6x
Omnicom 11.0x
IPG: 8.5x

P/E:
Aegis: 25.8x
Havas: 21.0x
Publicis: 9.6x
WPP Group 16.9x
Omnicom 19.1x
IPG 46.0x



Other Positive Factors:

--The Japanese economy is expected to continue along its path of modest growth, which will help advertisers overall. ADK and other advertising firms were victims of a horrendous 4-year advertising slump that ended in 2004. Japan’s economy improved beginning in 2003, with real GDP growth 2%, growth of 1.9% in FY04, and economists believe GDP is expected to grow by 1.1% in FY05 and by 1.8% in FY06. Ad spending increased in FY04 (up 3%), following a flat FY03, and is currently growing at a run rate of about 1.4%.

-- A better economy, coupled with aggressive restructuring and cost containment initiatives instituted by a new management team (see below), resulted in ADK’s operating income growing to JPY 8.3BN in FY04 (will be modestly higher in FY05) from a low of JPY 4.0BN in FY02. Over the past 5 years, operating margins have expanded to 18.7% currently from 10.0% in FY00. Meanwhile, staff costs/gross profit have declined to 54.7% from 62.1% in FY00. Now ADK has operating margins that are higher than #2 player Hakuhodo-DY, and in-line with those of other global competitors.

--Strong free cash flow characteristics; TDK, like most ad firms whose ‘invested captal’ represents mostly human capital, do not require a large amount of Capex. In fact virtually all the Company’s cash flow and earnings are converted into free cash flow; Capex over the past few years has averaged below JPY 0.2-0.3 BN.

--The economics of the advertising business are fairly attractive. TDK maintains attractive business characteristics and good returns on invested capital—free cash flow, excluding interest/dividend income from the investment portfolio has averaged over JPY 8 BN over the past two years; On a ‘business capital’ base (excluding all cash & investments) of JPY58 BN (which is the EV you are paying based on the current stock price), this free cash flow represents a decent return on invested capital of nearly 14%, especially considering you’re paying 5.7x cash flow for the business!

--Other shareholder initiatives: Albeit modest initiatives, ADK did recently increase their dividend (will go up by 75%, yielding 1.1% on current price and future payouts will be business/performance based), and management has stated that it plans to achieve FY07 EPS of JPY of 130 per share through continued cost reductions and much share buybacks of 1%-2% of stock outstanding per year( bought JPY 2.6BN in FY04); FY05 EPS is estimated to be 97 JPY.

--Shareholder-oriented management and owner: ADK’s management focus has been changing, albeit in a gradual fashion. In 2001, Koichiro Naganuma replaced Tsutomu Takeda as CEO, ushering a new (essentially more US-like) style of management. Naganuma worked at Hakuhodo and its affiliates before moving to Asatsu in 1981 and is well-regarded as an effective manager. When he became CEO, he stated that raising EPS and ROE were key goals for the company and the way to drive it was by improving the cost structure and restructuring operations. He also stated that over time, ADK would buy back shares and would not add to cross-shareholdings (very common in Japanese practice) and instead re-invest in the business. His efforts have thus far proven successful, however share repurchases and dividend hikes could be considerably more aggressive (and management has stated that it intends on increasing shareholder initiatives, particularly the dividend, which will be performance-based). Prior to Naganuma’s tenure, ADK never sent such strong shareholder-oriented messages (which are pretty uncommon for Japanese firms) and the company had embarked on a decade-long quest to gain market share at the expense of improving profitability, leaving shareholders as an afterthought. Also, WPP’s ownership has been instrumental in ADK’s efforts to improve its cost structure and margins. As part of its ownership/alliance with ADK that was formed in 1998, WPP stated that ADK must make efforts to improve profit margins, increase cash flow, and buy back shares. ADK has essentially executed aggressively on the first two initiatives, but less so on the third (at 1-2% of shares OS per annum).

Catalyst

Cheap price vs. peer ad firms and rampant global consolidation of ad agencies (including Japan) render ADK an attractive takeover candidate.

Japanese economy continues to improve, benefiting ad firms such as ADK and makes Japanese ad agencies more attractive as investments.

Continued cost containment measures/driving more revenues per employee.

Continued share buybacks and dividend increases as the business generates more free cash flow.

Potential actions by WPP (20% owner of ADK) to either buy the entire business, or act as a catalyst for selling its stake or the entire business to another global ad firm.