Interpublic Group (IPG) – BUY
Interpublic Group is a good business selling at a good price. At the current price ($11.94), Interpublic trades at a discount to peers. Catalysts for stock appreciation include:
1) Recognition of a successful turnaround
2) Increase in ad spending on new forms of media
3) Buyout due to further consolidation in the ad agency industry
Interpublic is one of the largest ad agencies that purchase media and provide creative services for clients. Ad agencies have buying power that is much greater than their individual clients and with economies of scale, act as a toll booth to advertising spending. The business is not capital intensive and benefits from a float where Interpublic receives payment from clients before paying for media advertising.
Interpublic started to fall behind its largest competitors [Omnicom (OMC), Publicis (PUBGY), and WPP (WPPGY)] during the 90’s due to its own acquisition spree and the inability to fully integrate the new acquisitions. Its operating margin declined significantly compared to peers. At the end of 2004, the operating margin for IPG was -1.5% compared to 12.5% for OMC, 11.5% for PUBGY, and 11.3% for WPPGY. In 2005, a new CEO, Michael Roth was hired. He focused on organic growth and improvements in operating margin. Since then, operating margins have improved over the years. At the end of 2011, the operating margin for IPG was 9.8% compared to 12.0% for OMC, 16.0% for PUBGY, 11.9% for WPPGY. As the turnaround continues, operating margin can get closer to 11-12%. Each 1% improvement is about a $60-$70 million increase to operating income, assuming revenue remains stable at $6-$7 billion.
Rather than cut ad spending on old media (tv, radio, print), the increasing popularity of new digital media (internet, social media, video games) leads to more ad spending by firms and consequently an increase in revenue for ad agencies. This will be true as long as consumers have enough time to spend on the various forms of media and if the content doesn’t overlap. It should be possible for people to consume more media since people can multitask and have more than one device that displays ads at a time (e.g. using a computer and listening to the radio at the same time). For content that overlaps, ad spending will shift to the form of media that consumers use, but it shouldn’t cause a change in total ad spending.
A reason why advertising spending will increase is because advertising is like a prisoner’s dilemma. If one firm spends on advertising and another does not, the firm that spends will gain market share from the other firm. If both firms spend on advertising, market shares will remain the same, even though costs increase. In order to gain market share or prevent falling behind in market share, firms must spend on advertising, a benefit to ad agencies like Interpublic.
At $11.94/share, IPG has an EV of $6.15 billion. Revenue has been $6-7 billion for the past decade, except for 2003 with $5.8 billion in revenue, but with the problems from the acquisition binge behind them, IPG can now grow like its peers. Operating margin has ranged from -1.7% to 9.8% in the past decade, but has steadily improved under new leadership. Below is a chart that estimates operating income under different situations.
|$6 billion||$300 m||$450 m||$540 m||$600 m||$660 m||$720 m|
|$6.5 billion||$325 m||$488 m||$585 m||$650 m||$715 m||$780 m|
|$7 billion||$350 m||$525 m||$630 m||$700 m||$770 m||$840 m|
Revenue for 2011 was $7 billion and with operating income at $687 million, margins of 9.8%. With an EV of $6.15 billion, this leads to an EV/operating income multiple of 9.0. If margins improve to 11% and revenue remains the same, operating income comes in at $770 million and a corresponding 8.0 x EV/operating income multiple.
The downside risk of both revenue and margins declining with a resulting $300 million in operating income would imply a multiple of 20.5 ($6.15 billion EV/$300 million). This would be an extreme case because even with the financial crisis, revenues were $6.9 billion for 2008, with margins at 8.5% ($586 million in operating income and 10.5 multiple).
Peers currently trade at higher multiples, with OMC at 9.9 times, PUBGY at 10.0 times, and WPPGY at 12.9 times.
At the current price of $11.94, investors are getting a high quality business at a reasonable price even without continued improvement in margins and growth in revenues.
With a low multiple and room for improvement in margins, Interpublic might be an acquisition target as ad agencies continue to consolidate.
Interpublic is a good investment that trades at a discount to peers, but will appreciate in value as the market realizes that it has successfully turned itself around. The potential for further improvements in revenue growth and margin improvement adds even more value to the stock. IPG stock should be worth at least $15/share.
Disclosure – Long IPG at time of writing
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