By William Donald
We at Standard & Poor's expect superior gains over the next 12 months for Omnicom Group, based on our renewed optimism about the economy and business spending on advertising and marketing. We expect the company to produce earnings growth in excess of 20% in both 2004 and 2005, and to continue to outperform its peers in revenue and profit generation. Omnicom (OMC; Nov. 7 price: $81) has our highest investment ranking of 5 STARS, or buy.
New York-based Omnicom is one of the largest marketing and corporate-communications companies in the world. It manages more than 1,500 subsidiary agencies serving over 5,000 clients and operates in virtually all markets worldwide. OMC's agencies provide an extensive range of advertising-and-marketing services, as well as specialty communications, interactive/digital-media, and media-buying services. Some of its major agency brands include BBDO Worldwide, DDB Worldwide, TBWA Worldwide, Ketchum, Rapp Collins Worldwide, Tracy Locke, and Porter Novelli International.
Substantially all revenue is derived from fees for services. Organic growth and acquisitions should boost revenues going forward. Foreign-exchange gains or losses can also play a significant part. The company has always been an active acquirer of smaller agencies to expand existing client relationships. As a result, a significant proportion of an acquired company's revenues are often from clients that are already OMC clients. While acquisitions do add to OMC's growth rate, we think the company's decisions reflect a larger strategy beyond just giving the numbers a quick lift.
In 2002, OMC expended cash, stock, and the assumption of net liabilities totaling $680 million for 40 acquisitions. Total expenditures on 39 acquisitions in 2001 amounted to $845 million. The company has spent roughly $330 million on acquisitions year-to-date through September. OMC noted recently that its slower acquisition spending pattern is part of a go-slow strategy, rather than a sign of a dearth of buying opportunities.
Last year marked the 16th consecutive year that OMC reported higher revenues and earnings. Of the major advertising agency groups worldwide with $500 million or more in revenue, only OMC posted favorable year-over-year revenue comparisons (excluding acquisitions) for 2002. Its revenues rose 9.4%, to $7.5 billion. Revenues from U.S. business climbed 15%, and those from international sources rose 2.5%.
Similarly, while other major companies reported weaker earnings, OMC enjoyed a 10% advance, to $643.5 million. It continued to outperform in 2003. In the nine months through September, OMC's worldwide revenue gained 13% and net income rose 3%, as margins came under pressure from upfront costs of gaining new business, severance payments, and changes in the revenue mix and greater utilization of freelance labor.
Consolidated revenues are about evenly divided between U.S. and non-U.S. operations. Due to a number of factors, in the normal course of a year, OMC's agencies both gain and lose business from clients. Overall, it usually results in a net gain in business. Net new billings in 2002 were $4.2 billion, only slightly lower than 2001's $4.4 billion. Net new business gains in the nine months through September, 2003, were $3.1 billion. In 2002, revenue from OMC's single largest client represented 5.0% of worldwide revenue (5.4% in 2001).
Traditional media advertising revenue represented roughly 44%, or $3.3 billion, of worldwide revenue in 2002. The remaining 56%, or $4.3 billion, was related to other marketing and corporate-communications services, including customer relationship management (CRM; 32%), specialty communications (12%), and public relations (12%).
OMC's business mix stands out from its peers. On average, traditional media advertising accounts for more than 55% of business, vs. 44% for OMC. We believe this was one of the reasons why OMC was able to outperform its peers in top-line growth during the recent ad slump. Although public-relations business also slowed, OMC's CRM and specialty-communications business continued to show healthy gains. By William Donald
S&P believes the outlook for U.S. advertising and marketing is generally positive for 2004 and beyond. The U.S. economy is expanding at a healthy, though moderate, pace and demand for advertising and marketing also appears to be strengthening. For 2003, S&P expects total advertising spending to rise 4%, aided by a projected 2.8% rise in real GDP. Most of the comparative growth is expected to show up in the second half of the year. Non-U.S. advertising is projected to grow roughly 2% in 2003.
We believe that many of the uncertainties that plagued governments, businesses, and consumers in the early months of 2003 have largely abated. Delayed spending by consumers and marketers has created pent-up demand, which we think has begun to boost business in the second half. For 2004, we expect total expenditures on advertising to rise by 7% or more. We project a 5% gain in non-U.S. advertising in 2004.
Compared with its peers, we believe Omnicom has a number of factors in its favor, including its revenue mix and savvy management. The company has been cushioned by direct marketing -- one of the advertising sector's few sources of strength during the recent downturn. Although companies have cut back on PR spending, they've been spending more on other forms of direct marketing, such as CRM and other specialty communications such as sports marketing.
A LOOK AHEAD.
Direct marketing accounts for about 56% of Omnicom's business, vs. roughly 47% for the industry. We believe the company should also see its fortunes improve as the rebound in advertising and marketing spending takes stronger hold, given our view that direct marketing in its various forms is likely to expand well ahead of the rest of the market. The company's operating margins have typically been better than its peers, aided by its business mix, operating structure, and attention to costs.
We expect Omnicom's revenues to advance nearly 13% in 2004, on top of the roughly 14% gain we estimate for 2003. Its operating margin should widen to roughly 15%, from the 13.5% that we've pegged for 2003, which compares to the 14.7% of 2002. Looking ahead, we expect a nearly 13% gain in commissions and fees in 2005, with operating margins widening to 16.6%.
We see EPS advancing nearly 22% in 2004, to $4.40, and another 24% in 2005, to $5.45. OMC's EPS growth in 2003 is likely to be only 6% ($3.62), since its margins are under pressure as a result of upfront costs associated with winning new business, severance payments, greater utilization of freelance labor, and changes in the business mix. Those pressures should ease in 2004, we think.
IN THE PINK.
We expect Omnicom to continue to outperform its peers in revenue growth, profitability, and rate of earnings growth over the next three to five years. We think the company can sustain average EPS gains of roughly 23% in that period. Part of Omnicom's edge, in our view, is due to its emphasis on non-traditional marketing and services, which we see enjoying stronger growth rates over time than traditional advertising.
Our S&P Core Earnings estimates, which includes stock option expenses, are $3.47 a share for 2003 and $4.24 for 2004, or about 4% below our operating EPS estimates. While these costs are not negligible, they're not out of line with other companies in the industry.
Based on our discounted cash flow calculations, Omnicom stock trades 28% below its $111 intrinsic value. Our 12-month target price is $100, and assumes that OMC will trade at a forward p-e multiple of 23 times our 2004 projection.
We believe Omnicom's balance sheet and financial position are healthy. As of June 30, the company had cash and liquid investments of roughly $544 million. The company should generate over $1 billion in net cash flow from operating activities in 2004, more than enough to service its $2.5 billion of debt, which is largely convertible notes. We think Omnicom will continue to use retained earnings for acquisitions and working capital purposes.
Analyst Donald follows advertising stocks for Standard & Poor's