A better way to play the advertising recovery

It is fast becoming fashionable to be long the imminent advertising recovery. Formerly must-avoid companies such as WPP, ITV, TF1, ProSieben are fast becoming consensus buys both on the buy-side and the sell side. Personally, I do not have a strong view as to the strength of the advertising recovery (there is likely to be some recovery seeing as global spend was down something like 7-8% last year). However, what I am a lot more confident about is that there is a much better way of playing the advertising recovery than through the above shares, providing one is willing to go some way down the market cap curve.

M&C Saatchi is a small aim listed advertising agency, that floated back in 2005. It was founded by the Saatchi brothers after they were kicked out of the former Saatchi & Saatchi in the 1990s following a shareholder revolt. The company has around £100m in sales, on which they made just under £14m of operating profit in 2008, although the true underlying operating profit is actually somewhat higher due to the start-up losses in some geographies. The company, unlike the behemoths (WPP, Omnicom, Publicis etc.) has an organic growth strategy, which means they actually start from scratch when they go into new markets rather than buying up existing players. This means they grow slow, but, over time, should generate decent shareholder returns provided they execute the strategy effectively (advertising agencies generate high returns on capital so if they can genuinely grow organically, that is good). Sixty per cent of the profit comes from the UK, where they actually produced a very respectable 16.5% margin in 2008. Margins in the other regions are lower (generally sub 10%) as these regions are growing and are less mature in terms of the cost base.

So why is this company interesting? Answer: it is extremely attractively valued.

Although this year sales and margins will be down (likely around 10% EBIT margin), on any kind of “normalised” valuation, the shares do look very cheap. For example, a conservative valuation approach might look something like this: Subtract 10% from 2008 sales = £94m, apply a 12% operating margin to this (which is 150 bps below the peak) and add back start up losses, set capex equal to depreciation and tax at 30%, all of which leaves approximately £10m of normalised earnings. If I then use a 12% discount rate (or 8.3X p/e) and add in the net cash I am still getting 20% upside to the shares (note this is after capitalising operating leases).

20% upside may not sound like that much, but actually when you consider how conservative the above assumptions are it is actually very attractive indeed. For example, most sell side analysts are already assuming WPP and Publicis return to more or less peak margins, and even on these assumptions they are still being valued at or over 10X p/e. Moreover, the revenue assumptions for these companies are also much more favourable. If I were to assume that M&C Saatchi could return to 2008 margins, hold revenues flat, and value this on 10X than 8.3X, then I would have almost 100% upside to fair value.

Now admittedly that is probably too optimistic, as historically the M&C Saatchi shares have been valued at a discount to peers such as WPP. But generally the discount has been a lot lower than it is currently (see chart). All in all, these shares look like good value to me, with easily 30-50% upside to intrinsic value. The main risk is the asset light nature of the business. It is not really possible to value a business such as this on the basis of its assets as they walk in and out of the door every day. Therefore, one is always vulnerable to key person losses which may well be followed by big account losses. But this is risk is easily compensated for by the attractive valuation in my view.

Long term equity indicator turns negative

The primary long term asset allocation indicator that I use for equities has recently gone negative for the first time since the crisis began. The cyclically adjusted p/e ratio averages the last ten years earnings in real terms and compares them to the current price. It is far superior to one year p/e ratios as it effectively smoothes out for economic cycles. Indeed, one year p/e ratios have been shown to have no predictive power at all with regard to future equity market returns.

I take the publicly available Robert Shiller data on the US market which shows real earnings and index levels going back to 1871. I then look at the real return for every individual one, two and ten year period and compare this with the cyclically adjusted p/e ratio at the start of the period. Obviously, the idea is that subsequent returns should be lower when the starting valuation is higher and vice versa.

What I have found by playing around with the data series is that looking at quartiles provides a fairly good indicator. For example, if I take every reading where the cyclically adjusted p/e ratio is in the bottom quartile, I find that the average subsequent real compound annual return (CAGR) is 10% for the following year, 9% for the following 2 year period and 6.6% for the following 10 year period. This is from a total of 387 observations (the data set is monthly). If, on the other hand, I take every reading where the cyclically adjusted p/e ratio is in the top quartile, I find that the average subsequent real CAGR is barely 0% for each of the one year, two year and ten year periods.

This tells me that, statistically speaking, I should be reducing equity holdings when the cyclically adjusted p/e moves into the top quartile. Unfortunately, according to the Shiller data, the ratio for US market has just in the past month moved back into the top quartile for the first time since the crisis began. So prospects for long term equity returns don’t look that rosy any more.