Stockwatch: What to do with this bombed-out blue chip

Is it time to buy a 35% drop in the FTSE 100 (UKX) shares of WPP (WPP) , the world’s largest advertising and marketing services group? That’s lower than other global advertising stocks falling over the same period, partly in response to fears, multinational clients are changing their agency hiring habits.

In the last 12 months, WPP has de-rated from 1,928p, recently finding support in a 1,220p to 1,250p area – currently 1,260p, as if 1 March prelims have affirmed support.

The drop can appear definitive, but on a truly long-term chart, brings the stock back to an upwards trend-line – at least if growth is broadly intact on fundamentals too. On a forward price/earnings (PE) ratio of 11 and near 5% yield covered 1.8 times by prospective earnings, I’d be wary that projections in the table below are likely to get shaved.

The prelims statement has subtle warnings; 2018 results will be “second-half-weighted” and “long-term” earnings per share (EPS) expectations guided down, without formally warning on profits for the year. While various global events encourage advertisers that 2018 should be a better year, seasoned investors will recognise the need for caution too.

Wider relevance for equities and the economy

Ad agencies are a classic bellwether of the economy, and their industry challenges may in due course also have to contend with trickle-down effects of higher interest rates and trade tariffs. This type of company is becoming more relevant to watch now that it appears all is not so rosy in the global outlook. WPP chief executive Martin Sorrell says flat January revenues, year-on-year, reflect partly structural, but also cyclical challenges.

Their stock behaviour can also reflect a technical bias by traders for (contrarian) market timing. Ad agencies are most prone to rise in the teeth of a recession, despite reporting bad figures, as buyers try to pick stocks likely to benefit soonest from economic recovery. Much later as the business cycle matures, cyclical stocks de-rate to superficially offer ‘value’. A situation like now needs extra care to interpret, and if you rate capital protection, then best play it cautiously.

Looking at disclosed short positions, only the hedge fund group Marshall Wace is mentioned with 1.06%, which reduced by 0.13% on 15 February, although disclosed positions are 0.5%+ and this is a £16 billion company – i.e. other positions may lurk. Yet it doesn’t automatically follow that Marshall Wace takes a negative view of WPP. Given the future is not predictable and MW holds over £30 billion assets, it may also be hedging its equity exposure, being short of a liquid cyclical stock.

Can big advertisers reposition to recoup business?

Omnicom and Interpublic in the US, also Publicis in France and Dentsu in Japan have likewise seen their stocks trend down from early-mid 2017. WPP’s narrative is its multinational clients under pressure to cut costs, hence their advertising spend is now the lowest since 2008/09.

Proctor & Gamble (PG) has cut marketing agency/production costs by $750 million (£543 million) and aims to slice a further $400 million by 2020. This is partly in response to greater challenges for branded consumer groups to grow revenues, hence cost-cutting to prop up their ‘growth’ ratings on stockmarkets.

More positively, global advertising spend is predicted to rise 5% this year, for what such forecasts are worth. WPP denies digital rivals are hollowing out its core business; that Google (GOOGL) and Facebook (FB) are enabling clients to engage social media platforms directly, while consultancies muscle into digital marketing, displacing established players. There are also industry analysts who reckon that, given time, WPP will reposition itself capably.

I have a more general concern as a long-time follower of acquisitive plc’s. Sir Martin Sorrell has led this group’s development significantly by acquisitions since the mid 1980’s, as the ex-finance director of Saatchi and Saatchi. Can this now biggest of agencies, reposition smoothly enough? As advertising clients do more themselves, is there really a need for a one-stop shop and wide range of services? Buying into WPP now is taking a view that Sorrell and his lieutenants can streamline as required; that the group isn’t overgrown for industry needs or the next downturn.

Contrasts in revenue versus profit lines

The 2017 results are certainly a dilemma for growth investors: flat like-for-like revenue, and effectively operating margin/profit too; whereas performance is at least towards double digits at pre and post-tax profit levels.

Mind the results are quite complex anyway, and tables such as Company REFS are some way off key published figures also. Varying perspectives mean a range of EPS and dividend cover estimates, inviting questions such as: “Is WPP going ex-growth in a capital sense and, if so, then how robust are its income prospects?”

Continuing such a view, WPP’s de-rating may also reflect a probing for what level of stock price offers a yield able to satisfy investors while the group restructures, and also navigates any economic risks arising.

A healthy return on equity, up from 16.2% to 16.9%, is cited among the highlights, but so it should be. ‘People businesses’ are not capital-intensive.

WPP – financial summary           Estimates year ended 31 Dec 2013 2014 2015 2016 2017 2018               Turnover (£ million) 11,019 11,529 12,235 14,389 15,265   IFRS3 pre-tax profit (£m) 1,296 1,452 1,493 1891 2,109   Normalised pre-tax profit (£m) 1,318 1,417 2,364 2,881   2,024 Operating margin (%) 12.8 12.6 20.3 21.1     IFRS3 earnings/share (p) 69.6 80.5 88.4 108 144   Normalised earnings/share (p) 71.3 76.8 155 184   111 Earnings per share growth (%) -40.8 7.8 101 19.2     Price/earnings multiple (x)           11.4 Historic annual average P/E (x)   17.8 19.0 10.5 8.8 12.1 Cash flow/share (p) 106 130 106 139     Capex/share (p) 21.4 15.9 18.1 21.7     Dividend per share (p) 30.3 35.3 42.5 48.3 60 62 Dividend yield (%)         4.8 4.9 Covered by earnings (x) 2.4 2.2 3.7 3.9   1.8 Net tangible assets per share (p) -264 -315 -367 -477 -394

Source: Company REFS    Past performance is not a guide to future performance

“Second-half weighting” is a mild warning

In just three months WPP has trimmed its own “long-term” earnings growth projection from 15% to 5-10%, thus making a share buyback programme (underway) look defensive. Like-for-like revenue in January revenue was flat, though said ahead of budget, with growth focused on the technology and healthcare sectors – which sounds resilient for Cello Group (CLL), an AIM-listed marketing services group I have drawn attention to since 2010.

Some £300-400 million is budgeted for acquisitions spend, there being “a very significant pipeline of reasonably priced, small to medium-sized acquisitions, except in US digital marketing where prices have run too high.” Quite whether acquisitions can make a material difference nowadays; the board is probably hoping a mix of restructuring, buybacks and smaller takeovers can altogether sustain group financial performance.

Watch and wait, as economic risks manifest

Altogether WPP has positives, the worse-case scenario is a continuing drift to ‘income stock’ identity. In the near term, however, potential income buyers may be wary of an inherently cyclical stock, whose figures are quite complex, and a background of interest rate rises and trade tariffs threatening the commercial climate. Plenty of choice exists among stocks offering a circa 5% yield, until WPP provides evidence of an uptick in performance.

I anticipate volatile-sideways trading in a tug between belief that WPP is a quality operation repositioning, and fear that the macro context may overshadow its ability to do so.

It’s one to watch as a wider tell-tale, and a buying opportunity will eventually result. But despite current support, the stock’s fall is not overdone if the economic risks manifest further. For now: Avoid.

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