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Morningstar | No Sign of WPP Revenue Growth Improvement Yet; Lowering FVE to GBX 1,450; Shares Undervalued

WPP reported a very disappointing third-quarter revenue update, as recent account losses and lack of more aggressive talent recruitment is costing the firm organic growth, unlike its peers such as Omnicom, Publicis, and IPG. The turnaround that we expected to take place in 2019 appears to be delayed. The firm lowered its 2018 organic growth and operating margin guidance for the year. Accordingly, we lowered our projections for 2018 and 2019 and now do not expect much indication of a return to growth until late 2019 or in 2020, due to account losses this year and the firm’s necessary additional investment in technology and talent on the creativity front. We must note that net revenue to be generated from new account wins during the first three quarters exceeded those lost, which may indicate that a recovery for the firm is in the making. For this reason, we are maintaining this narrow-moat name on our Best Ideas list, albeit with lower expectations. The result of updating our model is a new per share fair value estimate of GBX 1,450, lower than our previous GBX 1,500. While WPP shares declined significantly after the third-quarter results, we believe the stock’s potential 50%-plus upside is attractive. In addition, we think WPP’s dividend, which we view as safe, currently yields more than 6%. Plus, in our view, WPP shareholders may benefit from the possible sale of a portion of Kantar as the proceeds may be used for share buybacks.

Total net revenue for the quarter was down 3% year over year, to which foreign exchange contributed negative 2%, acquisitions added 0.6%, and organic took away 1.5%. While weakness of organic growth in North America was expected, declines in the U.K. and Western Europe is concerning, in our view. WPP had many large accounts in review during the last nine months, which we think may have caused some of those accounts to not spend as much as they normally would. The only bright spot during the quarter was the 2.4% organic growth in non-Western Europe, U.K., and North America markets, which represent around 30% of total net revenue.

In terms of service types, the creativity of advertising remained weak and pulled organic advertising, media investment management net revenue down 4%. Such weakness was evident in all major developed markets – U.S., U.K., and Western Europe. Data investment management services also declined, but at a slower rate than the first two quarters. There was strength in public relations and public affairs, which posted 2.5% organic growth, helped by stronger public relations demand in Asia and Germany.

Per management’s guidance, we lowered our organic net revenue estimates through the next 10 years. We are now expecting a 2% organic 10-year CAGR, down from our previous assumption of 2.4%. We expect WPP to return to at least 1% organic growth in 2020 as more revenue from its newly won accounts kicks in, plus our expectation that 2019 may represent easier comps for the following year. We think operating leverage will be created from higher organic growth beginning in 2020. For the next 10 years, we have assumed average operating margin of 13.5%, up from 12.1% in 2017.

In our view, WPP is still working on what its peers have had at least a 24-month head start – creating an efficiently run one-stop shop by combining technology and data analytics with creativity. While WPP is losing some market share, we think down the road, during additional account reviews and opportunities, the firm will have a chance to regain some share. We note that the top ad holding firms (including Omnicom, Publicis, IPG, and the largest, WPP) will continue to be the main ones pitching to the biggest advertisers.

We are confident that the brand equity of WPP and its agencies remains strong, as while organic growth numbers have been disappointing, we might see improvement during the next one to two years as indicated by WPP’s year-to-date big account wins and losses. Based on the firm’s numbers and our estimates, the wins year to date represent around 34% more advertising billing than the losses. While WPP has lost some large and well-known accounts such as Glaxo SmithKline, American Express, HSBC, United Airlines, and the creativity part of its longtime Ford account, it has also won businesses with Mars, Mondelez, Adidas, Hilton Hotels, Unilever, Sky, and T-Mobile. In addition, WPP is currently competing for the big Volkswagen account, on which a decision is likely to be announced in the next few months, a possible short-term catalyst for the stock. Publicis and Omnicom are also pitching for this account.