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Morningstar | With Read at the helm, WPP Reports Mixed 1H Results; Maintaining GBX 1,500 FVE; Shares Undervalued

WPP reported a mixed first-half 2018, with total revenue coming in above expectations but earnings missing consensus. While weakness in North America persisted, mainly on the creative side, WPP did post year-over-year organic revenue growth in the second quarter and the first six months of 2018 for the first time since early 2017. Management, led by the newly appointed CEO, Mark Read, now expects the firm to end 2018 with organic revenue growth, unlike its initial guidance of no growth. However, while the firm had initially guided for no-change in margins, it now expects some decline in operating margin this year as it will invest more in acquiring talent and more effectively combining technology with creativity. We now expect slight organic revenue growth, the impact of which will be offset by a decline in operating margin.

We continue to assign this narrow-moat name a GBX 1,500 fair value estimate per share which translates to our $97 valuation of WPP's ADRs. Mixed first-half 2018 results, along with lower margin guidance pushed WPP shares down more than 7%. While the stock is nearly 10% above its 52-week low (March 26, 2018), it continues to trade an attractive 0.80 price/fair value and remains on our Best Ideas list.

WPP's net revenue declined 3.6% year over year during the first six months of 2018, as the 0.3% organic growth, along with the 1.1% growth via acquisitions, were more than offset by the negative 5% foreign exchange headwind. Despite continuing strength in Europe and other markets, WPP's performance in North America was disappointing. Organic net revenue from that region declined nearly 1% from the first half of 2017. In our view, this is not indicative of the state of the advertising industry as WPP's peers such as IPG and Publicis reported organic growth during first half of 2018. We believe WPP has fallen behind those competitors as it has not yet effectively combined creativity with digital, especially on the data analytics side. However, in our view, the selection of Mark Read as the firm's CEO is the first step toward enhancing its digital agencies throughout the North America market, mainly U.S.

Operating margin during first-half 2018 improved from last year as WPP's compensation for its talent is now more incentivized. While margins are seasonally stronger during the back half of the year, the firm does not expect improvement in the second half of 2018 as WPP will be investing more in acquiring talent mainly in North America.

Looking ahead, we have modeled a 0.3% organic revenue growth for 2018, accelerating to 1.2% in 2019, as WPP regains momentum in winning not only media accounts, but also opportunities focused on the combination of technology and creativity. We have assumed a 2.4% 10-year CAGR in organic revenue for the firm. With some acceleration in top line growth in 2019, we expect the firm to realize operating leverage and gradually expand margin. We look for WPP operating margin to hit 14% by 2022 and to average at around 13% during the next 10 years, above the 12% the firm reported for 2017.

Regarding WPP's management, on Sept. 3, 2018, the firm announced the appointment of Mark Read as its CEO, which in our view ends uncertainty surrounding the leadership of the company. We also think this decision indicates some steadiness for WPP as Read is a veteran of the firm having been there for over 15 years. At the same time, we believe Read will instill more technology-driven creative thinking into the company as he was also the CEO of WPP's Wunderman which is one of WPP's strongest digital agencies, utilizing data to add more value to and enhance the effectiveness of the agency's creativity. Before becoming WPP's CEO, Read served as WPP's co-COO for five months (after the departure of Sir Martin Sorrell in April).