Grey's allure hidden behind fat costs and weak margins

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Whoever snares Grey Global Group will be buying a problem and an opportunity. The problem: weak profit margins due to a big expense line. The opportunity: a chance to slash costs, improve financial discipline and watch profits soar.

It won't be an easy fix, but industry experts say it's a risk worth taking. "If there is a change in management, you could see significant improvement in profitability," said Alexia Quadrani, analyst with Bear, Stearns & Co.

While Grey went public in 1965, it's acted more like a private company since Chairman-CEO Ed Meyer took the top post in 1971. Mr. Meyer has amassed a 20%-plus stake, but his Class B shares give him voting control. Grey is thinly traded and long has been ignored by Wall Street. In turn, Grey watchers say, Mr. Meyer has instilled a culture where managing relationships with clients and keeping clients happy is valued far more highly than making numbers or matching margins of peers.

Grey trades below the revenue multiple of rivals. But the stock's been a strong performer, besting the top four holding companies since the ad recovery began in 2002 and outperforming all but Omnicom Group over the past 15 years. That partly reflects anticipation that Mr. Meyer eventually would sell. Mr. Meyer and Grey declined to comment for this story.

subpar profit

Grey generated a double-digit return on equity in seven of the past 10 years. But profit performance has been subpar. Grey's operating margin-operating profit as share of revenue-has been below 8% for the past 10 calendar years and was just 5.7% last year, less than half that of Omnicom, WPP Group and Publicis Groupe.

Grey's big cost problem: labor, agencies' biggest expense. Grey last year spent about 66¢ of each revenue dollar on salaries and related costs, vs. less than 60¢ for rivals Interpublic Group of Cos., Publicis and WPP. (Omnicom doesn't report the number.)

Grey also spent more on real estate, typically agencies' second-largest expense. Grey's real estate last year cost about 6% of revenue vs. 4% at Omnicom, said Tim Fidler, director of research at Chicago money manager Ariel Capital Management. Ariel is Grey's largest shareholder with a 28.5% stake.

Grey could add 1% to 2% to margins simply from efficiencies as part of a larger network after a sale, Mr. Fidler said. With reductions in overhead and probable staff cuts, he bets Grey margins "could close a substantial gap" with Omnicom's 13.5% margin.

"There is enormous earning power in the company that is somewhat masked by the financials," he said.

Any buyer, though, would need to move with care: Cut costs, but don't mess up a culture that works for clients. Grey margins, while low, aren't necessarily unusual for big private agencies. Bcom3 Group had a 7% margin before Publicis bought it in 2002. Young & Rubicam had a margin of 5.1% before going public in 1998; it grew the margin to 12.1% before selling to WPP in 2000.

Combine profit upside with a cache of client relationships, and Grey's appeal is clear. Ms. Quadrani estimates Grey's value from $1.5 billion to $2 billion based on valuations of peers. Grey closed last week with a market cap of $1.36 billion.

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