MDCA is the fifth largest advertising agency holding company and is dramatically undervalued on a relative and absolute basis. The stock has had an unwarranted 55% decline since reporting Q2 and reducing revenue and EBITDA guidance by $20 million. The $20 million cut reduced revenue growth estimates from 7.4% to 5.9% and EBITDA growth estimates from 16.2% to 6.2% at the midpoint of guidance.
MDCA is still healthy, yet is trading like the business is going away. The Company posted 2.4% organic growth in the first half of 2016 (excluding 120 bps of pass through) in line with peers, yet trades at a 26.8% 2016 FCF yield and 10% dividend yield and a 31% FCF on my 2017 estimates. Said another way, MDCA guided to $115M of FCF relative to a market cap of $430 million. The bridge from EBITDA to FCF is below:
EBITDA of $210M less $4M of minority interest less $25M of capex, less $3M of cash taxes, less $63M of interest = $115M
Here it is important to note, that the company has paid less than $3M of cash taxes since 2011 and is not forecasted to be a cash tax payer for many years given NOLs and tax shield from amortizing acquired intangibles.
The guidance cut followed a bullish investor day on June 1st as already won new business (21st Century Fox, E-Trade, Four Seasons, Beats by Dre, etc.) ramped a few months slower than management expected. While the delay is disappointing and the lost months of revenue cannot be recovered, the Company has guided to mid single organic growth in the 2H of 2016.
Following the quarter and after conducting a thorough review of Advertising Age, Agency Spy, and Twitter we have identified a number of notable account wins following Q2 including: Diesel, Red Robin, Huwai, Famous Dave, Oxo, Country Harvest Bread, UFC, El Pollo Loco, Alfa Romeo, multiple Quaker brands, Vital Tea, mypakage, Walmart, Smithfield Foods, AEO, Diageo Hispanic, LCBO, Lenovo, and Venmo to name a few. We believe the return of growth will lead to a re-rating of the stock.
In addition to the currently attractive FCF valuation, the Street misunderstands net working capital. Advertising and media in particularly is a net working capital drain in the 1H and a source in the 2H. Year to date, net working capital has been a $180M use of cash (41% of the market cap). This cash plus $87M of guided FCF in the 2H will lead to $267M or an eye popping62% of the market cap by year end.
MDCA trades at 7.3x EV / 2017 EBITDA of $227M (including earn out or deferred acquisition cost obligations). Adding back 2H FCF, reduces that number by a turn. In contrast, WPP trades at 10.6x 2017 EBITDA, OMC trades at 9.3x forward EBITDA, Havas trades at 8.6x, and IPG trades at 8.2x. Given that MDCA pays no T or taxes, using EBITDA multiple obscures how much cheaper MDCA is relative to peers on a FCF basis.
Given the 10% dividend yield and 30% FCF yield, I want to address the bear case which relates to leverage, earn outs, and dividends. MDCA’s $900M of 6.5% Senior Notes are not due to 2024. While this requires $58.5M of debt service, MDCA seems well covered given over $200M of EBITDA, 25M of capex, and minimal cash taxes and minority interest payments. Additionally, they have $42 of annual dividend which seems well covered given 115M of FCF after debt. On the earn outs, the company has reduced earn out obligations from $347M at the end of 2015 to $232M in Q2 16. The Company will pay another $150 of earn outs over the next four quarters and will largely retire this obligation. The Company will generate $87M of cash in the 2H and another $130M in 2017 so is well covered here as well. The debate is that once they pay the earn outs and own 100% of the agencies will they be able to retain the talent. Is growth now slowing as top talent is cashed out? While MDCA is a people business and employees come and go (like the other holding companies which trade at drastically different yield) it is a business with 5,690 employees so we are not worried that a handful of employees will be paid out.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.
Continued FCF, a return to growth, and a reduction in DAC payments will lead to a re-rating