The Interpublic Group, as the 3^rd largest advertising agency in the world, is trading at levels that suggest a 40%-60+% price appreciation potential to an intrinsic value of at least $16.60, assuming that management is able to successfully execute a turnaround of the business.   

 

(Chart based on Value Line estimates for FY07)

 

 

On the face of it, one might be thinking where the value is here given the Company’s history and the fact that it is now trading at 11.9x EBITDA, in-line to higher than its two larger ad agency brethren, Omnicom and WPP Group.  However, as one can see in the chart above, IPG’s EBITDA margins are 650-800 bps lower than its peers.  Given that IPG is not too different from these other ad agency competitors, there is no reason why a successful turnaround executed by a capable management team can’t result in IPG’s profitability being more in-line with its peers.  Moreover, due its status as the world’s third largest ad conglomerate that owns several venerable ad agencies, there is the possibility that another ad agency could acquire IPG (in fact, there have been rumors of an acquisition by Publicis--although IPG has denied having any discussions about an acquisition).    On an EV/Sales basis, IPG is trading 0.6x less than the 1.6x-1.7x EV/sales ratios of OMC and WPP.  Thus the market is not pricing in the true turnaround potential of the business, which I believe has a very good chance of occurring.  The turnaround involves two major components:  1) the elimination of costs incurred as a result of poor financial controls, Sarb/Ox compliance, management turmoil/turnover poor optimization of assets post the rollup of several businesses in the 1990s;  2) With its financial and compliance house in order, IPG can then focus on gaining more client wins than losses so that organic growth can be restored to industry-wide levels (5%-6%).  A rationalized cost structure and peer-like revenue growth would cause the company to be valued similarly to peers at 1.6x sales or 10-11x EBITDA (with EBITDA margins at the 15% level).   The absolute dollar amount of EBITDA could get to $1+ BN by 2008-2009.  IPG’s stock has run up over the past few months, however a good entry point has presented itself as Wal-Mart dropped IPG agency Draft FCB from its roster of agencies after awarding the creative and media account to DraftFCB in late Oct. (IPG’s stock dropped 6.4% on Dec. 7^th).  However, this win was more about the headline more than the actual financial impact, which would have added a modest $20-$30MM in annual net revenue.  The bottom line is that IPG has had significantly more client wins vs. losses overall, which is likely to lead to continued organic revenue growth over the next few years.

Description and History of IPG: 

IPG is the third largest advertising and marketing services agency in the world (behind US-based Omnicom and UK-based WPP Group), operating through offices in 130+ countries.  It was initially incorporated as McCann-Erickson in 1930, based on the original ad agencies founded by the respective partners in the early 1900s.  IPG is organized into two main divisions: The Integrated Agency Networks segment (or IAN) is comprised of McCann, FCB Group, Lowe, Draft, Campbell-Ewald, Hill Holliday and Deutsch. (all these agencies together represent about 85% of revenues and operating income). Traditional advertising agencies (such as those represented by the IAN group) create, design and place advertising into various traditional media such as TV, newspaper and magazines.  The Constituency Management Group (CMG, the other 15% Of the business) includes Weber Shandwick, MWW Group, FutureBrand DeVries, Golin Harris, and Octagon Worldwide, which provide PR, meeting/event production, sports/entertainment marketing, corporate and brand identity and strategic marketing consulting services.  Marketing services, often referred to as “non-traditional advertising”, encompasses all other aspects of advertising, including newer media such as internet and direct marketing.

 

During the 1990s, IPG was the quintessential “rollup of ad agency rollups”, acquiring dozens companies (some of which had just merged together themselves) to the point where the cost structure became egregiously bloated and management was unable to integrate (or even get a handle on) the disparate companies successfully.  Coupled with the economic/ad downturn of 2001/2002 and the discovery of accounting discrepancies due to poor financial controls, the Company’s reputation was damaged and it began to experience client losses, causing EBITDA margins to plummet from to 3.2% in FY05.  David Bell, (former CEO of True North Communications, an IPG subsidiary) was appointed as Chairman/CEO in 2003, and was tasked with straightening out IPG’s financial controls and improving its balance sheet.  However, given that there was no unified IT platform, no financial controls, poor oversight over compliance/procedures, and insufficient an internal audit/accounting staff internal, extensive bookkeeping problems were discovered (primarily in its overseas operations) and IPG had to restate financials going back to FY00.  These restatements included improper accounting of vendor discounts/credits, customer contracts, out-of-pocket expenses, leases,  and compensation expense (associated w/ options).   Post the restatement, revenues increased by an aggregate of $983MM, operating expenses increasing by $1.38BN, and shareholder equity was reduced by $550MM.  Most of these  numbers dealt with revenue/expense recognition issues and the cash impact was around $200MM.   In 2005, as these problems were surfacing, former MONY Group chief Michael Roth took the CEO spot (he was appointed Chairman in 2004), to continue the work Bell had started.  Bell finally left the company in early 2006.

 

While this history is a clearly an accumulation of a bad fact pattern, the bottom line is that these problems are ones that are fixable;  Michael Roth thus far has appeared to be doing a good job in executing the turnaround, reducing costs, and actually winning new clients after some notable defections occurred in the prior few years.  Winning new clients is the lifeblood of this business, something the market has been clearly worried about with IPG given that organic revenue growth was flat/down over the past few years given the large client defections.  This year, organic revenue is actually up (was up 2.7% in 3Q) due to some recent client wins.

 

In March of this year, management provided more details on the turnaround plan, which would result in operating margins of 10% by FY08 (still 400 bps below peers).  It would be achieved by: 1) generating industry revenue growth of 5%-6%; 2) taking $200MM of transitional costs out of the expense base; 3) lowering SG&A as a percent of sales to 59% (vs. 63.7% in FY05); 4) reducing overall overhead expenses.  Management is well on track to achieve these metrics and I actually believe they are being pretty conservative if one looks more closely at the components of cost structure rationalization and leveraging of cash flow that would occur from organic revenue growth.  Admittedly, it may take a year or two beyond 2008 to achieve EBITDA margins in the 15% range, however, to the extent that it appears to the market as being achievable, the valuation gap between IPG and its peers would close (esp. on an EV/Sales basis) probably 1-2 years ahead of the Company achieving that performance.

 

As the product of dozens of acquisitions that were never properly integrated and not subject to real financial/reporting controls, further analysis demonstrates that IPG has approximately $415MM in costs that can be completely eliminated in a successful turnaround in an amount that far exceeds management’s near term targets;  these include costs for professional fees, temporary help, Sarb/Ox compliance, non-rationalized real estate, severance and expenses associated with having 1,300+ separate legal entities:

 

 

IPG’s  ‘transitional expenses’ peaked in FY05 at a combined level of $477MM (includes prof. fees, severance, temporary help).  In FY06, the company made considerable progress on reducing these expenses (forecast to be about $340MM for all of FY06)  Most of this is comprised of professional fees, primarily related to Sarb/Ox compliance and improving financial reporting systems and largely represents the hiring of consultants, accountants, lawyers and other personnel to help fix the financial control/reporting, reduce the number of global financial platforms (currently has 150 and wants to move to 4 over next few years) and reduce the number of subsidiaries to 800 from a current 1,300.  Over time, these fees can be completely eliminated.

 

Severance:  Due to declining turnover and the significant amount of new talent that is now in place, this cost can be reduced by $40MM per year to a more normalized level of about $25MM per year.

 

Temporary Help:  represents the hiring of temps primarily for corporate/OH/accounting functions.  As financial controls and reporting costs come down and turnover on the creative side is reduced, , temporary help can be reduced to 1% of revenue from the current 2.5%-3%  (represents about $90MM in expense savings).

 

Rent:  Compared to its peers OMC and WPP, IPG pays significantly more in rent per employee because it has more under-utilized square footage as real estate was never really rationalized post the late 1990-rollups.   With 43k employees, IGP pays rent (property and equipment) of $8,800 per employee, versus OMC, which pays rent of $7,600 per employee and WPP pays around $7,000 per employee.  Assuming savings of $1,300 per employee if R/E were rationalized, IPG could end up saving $55MM in rent.  Looking at square footage, IPG has 316 sq. feet of real estate per employee vs. WPP’s 240 sq. ft.  Assuming that IPG could reduce sq. footage to WPP’s levels and assuming a rental rate of $20/sq. ft on 43,000 employees, that could save $65MM in rental expense.  Thus I assumed an annual savings of around $60MM over the next few years if management can further rationalize real estate to the level more commensurate with peers.

 

Based on its current revenues, IPG is overstaffed (excluding temp workers) considering revenue/employee is significantly below those of its competitors (IPG at $145k/employee vs. $169k for OMC), suggesting that expense savings can be even greater than what is outlined above.  However, for the purposes of this analysis, I will assume that the lack of productivity per employee is partly due to sub-par organic revenue growth—something that the company can bolster now that its financial house is in order and the company appears to have been able to salvage its reputation and win new clients.

 

Management changes at IPG have clearly had a positive impact on the business.  Since the appointment of Michael Roth as CEO, revenue declines have subsided and turned positive in 2006.  When Roth took the helm, he met with IPG’s large clients to reassure them that staying with the company was the appropriate decision and that IPG was making progress in fixing its problems.  He also helped upgrade the talent pool by making several key senior-level hires to the company and improved accountability standards  for individual performance.  Frank Mergenthaler was appointed CFO in July 2005 (formerly CFO of Columbia House) is overseeing the implementation of financial controls/reporting (via SAP).  Other recent hires include Steve Blamer to head the FCB businesses (former CEO of Grey Worldwide), Nick Brien as CEO of Universal McCann (formerly CEO of Arc Worldwide) and Steve Gatfield as CEO of Lowe Worldwide (previously EVP of Global Operations and Innovation).  

 

After posting an organic revenue decline of 0.7% in FY05, organic revenue is up 1.4% YTD in FY06, with growth of 2.7% during the 3Q, which is fairly respectable vs WPP (+4.7%) and other global ad agencies such as Publicis (up 2.6%) and Havas (up 1.9%).  Key client wins in FY06 include Gateway, Supervalu, AOL, Merril Lynch and Lion’s Gate films.  Recently, Wal-Mart dropped IPG agency DraftFCB from its roster of agencies after awarding the account to DraftFCB and Aegis (another IPG agency) in late October.  Wal-Mart stated that it is reopening the account pitch and that Draft FCB will not be able to participate due to “new information (Walmart) received over the last few weeks.”  WMT also said that two of its senior marketing executives that were responsible for the account decision were asked to leave the company.  While impossible to truly confirm, I don’t believe that this loss is reflective on Graft’s or IPGs ability to win future business.  While there is definitely headline risk associated with the account loss, WMT was not a top 20 client for IPG and the estimated financial contribution from the account would have been small, about $30MM in annual revenues, and WMT was just one of a long list of new accounts won by Draft/FCB this year.  IPG’s other agencies would actually also be allowed to participate in the account pitch (evidence that WMT doesn’t seem to have a problem with IPG as a company, and that the loss may be related to cozy relationships or improper behavior of WMT’s marketing execs).   It was reported in the WSJ that DraftECB threw a large dinner party in NY, inviting its largest accounts and people familiar with the situation said that the WMT marketing execs attended even though WMT has a very strict corporate policy on employees receiving gifts from vendors/service providers (even receiving one free meal could construe a violation of corporate policy).

 

IPG’s goal is to achieve “peer-level” organic revenue growth of 5%-6% a year by FY08.  Let’s assume it does 3% next year and 5% in FY08, levels that are reasonable considering the significantly improved results in the 3Q as well as the recent client wins.  That would imply over $500MM in incremental revenues, which would have a high contribution margin considering the transitional costs currently in IPG’s structure as well as below-average revenue/employee, and high occupancy expense/sq. footage per employee.   IPG has a goal of achieving a 59% salary expense margin, which would be a variable cost, and office/general expenses would be largely fixed—however I assumed that O&G expense would incrementally increase by $25MM or 5% of revenues vs. about 20% on a company-wide given the low productivity per employee (labor force can be better optimized). Under these assumptions, $500MM in revenue would result in EBITDA of about $170MM.   Looking at IPG’s  revenue/employee based on this new revenue (and assuming no headcount increase or reduction),  the metric would be about $155k, which is still below the $169k of Omnicom, suggesting that that there may actually be upside to the incremental revenue and EBITDA contribution if IPG achieves productivity levels similar to its peers.

 

Industry consolidation will likely continue:  There is the possibility that IPG could be taken over by a number of other advertising firms (there have been reports that Publicis Group has been interested).  IPG’s well-established, extensive and reputable portfolio of advertising agencies is a key competitive strength.  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 general smaller ad firms’ margins lower vs. those of largest players, which in contrast have 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 for ad firms to expand (both in business lines and geographically) and improve their economies of scale by via acquisitions.  Companies such as IPG, OMC, Publicis, and Havas, have been formed through hundreds 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 ~10x (Havas also tried to acquire Grey, but lost out to Omnicom).  Publicis Group, in 2005, announced that it was in talks to buy Aegis (trading at 14x EV/EBITDA at the time—although nothing materialized) and currently the largest investor in Aegis (Vincent Ballore who is the Chairman of Havas) is trying to get two seats Board in order to effectuate a merger with Havas.   Asian ad agencies 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).

 

Valuation:  The adjusted EBITDA that would be derived post  the cost cuts over next 2-3 years would be about $830MM, while EBITDA from assumed incremental revenue growth of $500MM ($6.7BN total company revenues) over the next two years would be $170MM, resulting in total EBITDA of approximately $1.0BN--for an EBITDA margin of 15%, in-line with IPG’s peers.

 

The table below demonstrates that if IPG is valued to similar levels as peers based on the adjusted financial metrics 2-3 years form now and using multiples of EV/Sales and EV/EBITDA (at peer levels of 1.6x and 10.0x, respectively), this yields a price of between $17.50-$18.70/share on a fully diluted basis.  With the share count, I have assumed that the convertible debt issue (all $800MM can be converted at $12.42/share;  $400MM can put to the company at par after 3/15/2008, the other $400MM at 3/15/2012; or IPG can call $400MM of bonds at par on 9/15/2009 and $400MM on 3/12/2012 for cash) will be converted into equity  (64.4MM dilution potential) as my target price would be far above the conversion prices (and the company can call the bonds at par, which would force conversion).  With regard to the Series A and Series B preferreds, the $347MM Series A have an automatic (mandatory) conversion date of 12/15/2006 (21.1-25.7MM share dilution potential), while the $525MM in Series B perpetual preferred is convertible at holder’s option into 73.1904 shares of common stock (conversion price of $13.66).  The Series B can also be converted at IPG’s option (after 10/15/2010) if the closing price of the stock multiplied by the conversion rate, equals or exceeds 130% of the liquidation preference of $1,000 per share.  If the stock goes above approximately $17.80, and convert holders have not yet chosen to convert, then the Company would likely exercise its conversion option ($17.80 x 73.1904 = 1,300 or 130% of the liquidation preference of $1,000 per share)—this feature would also ‘force’ the preferred holders to convert into common if the stock goes above $17.80.  Assuming full conversion of the notes and the mandatory convertible preferreds, the Company would be in a zero net debt position (currently has $1.5BN in cash vs $2.25BN in debt less 800MM in converts =$1.45BN of adjusted debt).  However, if the Series B preferred holders chose not to convert and the share price would still be below $17.8, there could  be an additional $525MM in front of the common stock, thus I have included this as the net debt position in the calculations below.   Also the calculation excludes the net FCF that would be generated over the next 3 years--Assuming $1+ BN in EBITDA, FCF would be in excess of $400MM per year (there is minimal Capex required in this business).

 

Valuation assuming conversion of the Preferreds:

 

 

 

Valuation assuming no conversion of Preferreds

 

 

 

 

 

If the preferreds are converted, the upside potential would be even greater as the $525MM is removed from the EV calculation, and the equity shares would be issued (fully diluted share count would remain unchanged)

 

 

Risks and Weaknesses: