HARD-CHARGING AGENCY STOCKS FUEL DEALMAKING: SOME INDUSTRY OBSERVERS ASK IF SHARES ARE OVERVALUED

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With agency stocks trading at all-time highs, dealmaking in adland has assumed a sense of urgency as buyers and sellers move to capitalize on marketplace momentum.

The currency of the moment is the high-price stock of public holding companies and agencies. But some observers warn the share price run-up can't last, saying the acquisitions are supporting artificially inflated stock prices.

NEWSLETTER WARNS

Grant's Interest Rate Observer, a newsletter for Wall Street insiders, warned in a recent article that agency stocks are overvalued, saying the market has factored out any economic or market risk, treating ad stocks as if they trade in a vacuum. Publisher Jay Diamond said advertising and marketing are sensitive to economic factors, and so are agency earnings.

"The market is forgetting that there are economic cycles and market cycles," he said, adding he believes it's late in both cycles.

So at today's prices -- with Omnicom Group stock trading at a price-earnings ratio of 31, Interpublic Group of Cos. at 28 and WPP Group at 20 -- advertising stocks are a risky investment, he maintained, calling for some skepticism even as the Dow Jones Industrial Average blasted past 9,000.

Y&R OFFERS A SIGN

Grant's especially pointed to the pending initial public offering of Young & Rubicam as a sign the market is overheated. Y&R, which posted losses two years in a row and is going public this spring, just announced it expects to post losses again this year due to charges related to the stock offering.

Still, industry observers and investors in the agency sector expect the offering to be a success based on the company's business strength and growth prospects (AA, April 13). Y&R expects to begin trading at $21 to $24 per share, though Mr. Diamond said it's hard to gauge Y&R's value when "there is no `e' " -- no earnings -- in its price-earnings ratio.

A Y&R spokesman said the company could not comment, citing Securities & Exchange Commission regulations. But executives close to Y&R said the company's earnings are artificially depressed by the debt it took on in a 1996 recapitalization, part of which will be repaid with the proceeds from the IPO.

WORTHY OF ENTHUSIASM

Still, investors said Y&R's IPO deserves enthusiasm, as does the sector in general. Agency stocks are not overvalued on average when compared to the market average, they said, and industry forecasts are still good.

Agency companies -- whose total capitalization is on average 10 to 12 times operating earnings -- are reasonably priced, said David Herro, portfolio manager with Harris Associates, Chicago, and a long-time, vocal Saatchi & Saatchi Co. shareholder who helped orchestrate the ouster of Maurice Saatchi. Mr. Herro's portfolio holds stakes of about 13% in both Cordiant Communications Group and Saatchi & Saatchi, the two spinoff companies from the breakup of the former Saatchi empire.

Mr. Herro compared agencies favorably to media companies, saying agencies are cash generators that benefit from media industry growth in the U.S. and abroad.

"It's probably a better way to play the media sector than the media companies," Mr. Herro said.

WEAKNESS AT BOTTOM

If there is a market weakness, observers said, it is in the bottom tier of the agency sector. The top tier is dominated by the Big 3 of Interpublic, Omnicom and WPP. That top tier also includes a number of secondary holding companies, such as Cordiant, Saatchi & Saatchi and True North Communications.

In the bottom tier are such companies as Leap Group and CKS Group, which are younger and smaller and have seen their stock prices go on roller-coaster rides.

These stocks fluctuate "all over the place" based on speculation, said Abe Jones, managing director of investment banker AdMedia Partners. Leap's stock, for example, shot up 370% this month for reasons still unclear, while CKS' dropped 63% in one day last year after it announced fourth-quarter earnings would be less than half original projections.

The stocks in the upper tier don't get inflated or deflated as easily, said Steven Gundersen, president-CEO of Gundersen Partners, a New York consultancy. "They're used to playing in an up market and in a down market," he said. "They're very well-run businesses [overseen] by very smart folks."

Those smart folks are using their consistently high stock to snap up independent agencies and boost growth while driving up the price tags for acquisitions.

INTERPUBLIC'S BUYING SPREE

In the first quarter alone, Interpublic acquired Carmichael Lynch, Minneapolis, and Hill, Holliday, Connors, Cosmopulos, Boston. Omnicom added billings through its acquisition of GGT Group, London, while Snyder Communications, a lesser-known player, picked up Arnold Communications, Boston, in a $120 million stock swap.

According to a survey by AdMedia, the price that buyers are willing to pay has risen considerably during the last year, from five times operating profit in 1996 to 5.5 times in 1997. It is expected to increase to 6.5 times operating profit in 1998.

Investment bankers and consultants said nearly every independent agency they work with has been approached by a prospective buyer recently -- 60% of respondents to AdMedia's survey said they had.

CONDITIONS ARE FAVORABLE

It's not so much that respondents believe a bear market is imminent, AdMedia's Mr. Jones said. Rather, all economic, industry and market conditions are favorable.

Prospective sellers who see the estimates for some recent stock-based acquisitions -- more than $30 million for Carmichael Lynch and up to $100 million for Hill Holliday -- can assume that if they are willing to accept stock instead of cash, they can get a higher price, he said.

Also, by using stock instead of cash, the big holding companies can offer the prospect of a higher payback down the road as stock appreciates.

There is no issue of using overvalued stock to overpay for acquisitions, said Mr. Gundersen, noting even if companies are paying a price 10 times the agency's annual earnings, if stock is trading at 28 times earnings, there's still plenty of room to maneuver.

"If you've got an 18 [multiple] spread in the thing, what does it matter if you're overpaying?" Mr. Gundersen asked. "The net-net result is you come out ahead."

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