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Morningstar | Best Idea WPP Remains on Track for a Turnaround; Maintaining GBX 1,450 FVE; Shares Undervalued

Our takeaway from Best Idea WPP’s analyst day was positive, as the narrow-moat firm appears to be taking the right steps to return to organic growth in North America and expand overall margins. Under the leadership of Mark Read, the firm is taking the route that its peers have already taken--integrating technology know-how with the differentiating creativity expertise. WPP also provided some color on the impact of its strategy two to three years down the road. By the end of 2021, the firm expects organic growth to return to levels of its peers (from organic decline this year) and operating margin to hit nearly 15%, up from our 2018 and 2019 estimates of 11% and 10%, respectively. While these figures are above our 2021 projections, we did not make any adjustments to our model, as we believe risks related to WPP’s client mix remain. Our long-term positive view on the firm has not changed, and we are maintaining our GBX 1,450 per share fair value estimate. While investing in this turnaround name requires patience, we continue to view WPP shares as attractive given the current 0.58 price/fair value. We must also note that, in line with our assumption, WPP’s dividend appears to be safe as the firm said it is committed to maintain it at current levels, which is yielding 7%.

Similar to what we suggested in one of our in-depth reports in December 2017, with Read at the helm, WPP has finally realized that creativity remains the main differentiator for its ad agencies. The firm plans to invest more in that area during the next three years, focusing mainly on the U.S. market. WPP’s performance in that market has been disappointing this year, as it has lost a few accounts, including one of its largest creativity accounts, Ford, in October. The loss of Ford increased WPP’s chance of grabbing the Volkswagen creative account (as we mentioned in our Oct. 9 note), which the firm did win in November. We note that the impact of this win on year-over-year organic growth likely will be minimal until late fourth-quarter 2019 or early 2020.

We believe that WPP can continue to attract talent (albeit possibly at slightly higher costs) to enhance its creative offerings and provide more original, attention-grabbing, and effective ideas. In fact, during the event, Keith Weed, the CMO of Unilever (a client of WPP), reiterated such belief by stating that creativity is needed now more than ever for advertisers and their brands to get noticed. In his view, ad agencies must continue to help advertisers create different and engaging messages to be distributed via various channels, targeting different consumers.

WPP also indicated that it has recognized that creativity must be integrated with technology and data analytics. The firm plans to create an open platform with extensive data analytics functionality. It is planning to make interfaces with such functionality available to its clients, or provide self-service platforms. As mentioned in our December 2017 Select piece, with the aid of WPP’s creative teams, technology, and accumulated client and consumer data, WPP can design and develop more targeted, or below-the-line, campaigns. However, again, we think the dependency of clients on ad agencies such as those of WPP, will be mainly based on creativity.

The one-platform structure will also provide scalability as it will help WPP more efficiently and effectively allocate resources from various agencies to different accounts. Plus, this one-platform may aid the firm to continue to consolidate some of its agencies to further improve the management of larger client accounts.

While this strategy will help WPP improve top-line growth as it may compete more effectively against its peers in attempts to retain or win accounts, the firm is expecting some savings in the future as it also plans to invest in upgrading the technology on which it currently operates. The company will be focusing on standardizing and lowering the number of its many agency-specific ERP (enterprise resources planning) systems. This goes hand in hand with lowering the number of agency offices and creating more co-locations. The firm estimates that this will lead to average annual savings of GBP 275 million through 2021, albeit WPP likely will reinvest half of that into the company.

In terms of M&A, the firm expects to spend around GBP 200 million annually to acquire agencies (lower than our GBP 300 million assumption), while it will continue to dispose of underperforming agencies. WPP is still planning to sell part of Kantar, which may be valued at GBP 4 billion, or 1.6 times 2019 and 2020 sales, equivalent to the sales multiple that our current overall valuation of WPP represents. The firm may not announce a Kantar deal until the second quarter of 2019.

Overall, WPP expects its latest strategy to return the firm’s organic growth to levels of its peers (from organic decline this year) and operating margin to hit nearly 15%, up from our 2018 and 2019 estimates of 11% and 10%, respectively. We have modeled a 2.1% organic growth for WPP in 2021, below our 2.7% average assumption for Omnicom, Publicis, and IPG. In our view, while ad spending by consumer-packaged goods companies may pick up a bit, WPP’s dependency on them remains too high. In terms of margins, we have modeled an operating margin of 13.7% for 2021 as we think WPP may experience slightly higher than expected costs related to the recruitment and retention of talent. Last, WPP expects the combination of accelerating top-line growth, some margin expansion, and the sale of some assets such as Kantar, to help lower its debt/EBITDA ratio to 1.5-1.75 by end of 2021 from the current 2-plus. We have modeled 1.71, which is within that range.