$OMC | Omnicom (OMC) - Security Analysis

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Key Statistics

Price/Sales = 1.01x

EV/EBIT = 9.44x

Free Cash Flow/Price = 5.7%

Dividend Yield = 4.12%

Debt/Equity = 263%

Overview

Omnicom is a global advertising company. In 2019, Omnicom did $14.9 billion in revenue and earned $2.1 billion in operating profit. This makes it one of the largest advertising companies in the world. They operate in all forms of classic advertising (TV ads, billboards, magazine & newspaper ads), but they have also adapted to technological change and operate in the online world.

Omnicom was formed in 1986 as a merger between multiple agencies. Currently, it operates globally as the second biggest advertising company in the world, covering all conceivable means of advertising.

Their sources of revenue from advertising are well diversified by industry. The largest industry group that they represent is pharmaceuticals, which is only 14% of revenue. The next biggest is the food and beverage industry at only 13%.

I looked into Omnicom for three reasons:

First, it looks cheap.

Price/sales is 1x. The P/E is 14x. EV/EBIT is 9.44. These are attractive figures, particularly with the current manic state of the broader market.

Second, Omnicom boasts impressive returns on capital.

Return on equity has averaged 32.6% over the last 10 years and ROIC has averaged 19.1%.

Third, Omnicom has grown over the last 20 years and has a decent yield. EPS has grown at a 9.1% clip over the last 10 years, due to some organic growth in the business but mostly due to buybacks. The forward dividend yield is 4.12% and the share count is down 2% in the last year. Dividends have also consistently grown over the years, implying that the yield can grow over time.

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Valuation

However, while the stock appears cheap, it always appears cheap.

The EV/EBIT multiple of 9.44 is close to the average EV/EBIT multiple of 9.6 over the last 5 years. Since 2011, the stock has mostly remained stuck in a range of 8x-12x EV/EBIT. The same is true for price/sales. The 5-year average price to sales has been 1.14. Price/sales have hovered around 1x for the last decade.

Interestingly, after rapid growth in the late ‘90s, Omnicom used to be a very expensive stock 20 years ago. It peaked at 2.5x sales and 30x earnings in 2000. The stock stagnated for a decade as the valuation declined, even though the underlying business did quite well throughout the 2000s.

While the stock looks cheap on the surface, it doesn’t really matter because that is where it has traded for the last 10 years. This makes the odds of a multiple re-rating unlikely, in my opinion.

Financial Health

OMC is a leveraged firm with a debt/equity ratio of 263%, which is more than I am typically comfortable with. The Altman Z-Score of 1.68 is not great. With that said, interest coverage is strong at 9.22, which is solid.

The M-Score is -2.61, so there are not any signs of earnings manipulation.

Omnicom’s cost of capital is estimated at 5.4% and the average ROIC is 19.1%, meaning that Omnicom is not a net destroyer of capital.

While the M-Score and interest coverage are good, OMC lacks the kind of rock-solid bulletproof financial condition that I’m typically looking for, which is evident by the Z-Score and relatively high debt/equity ratio.

Moat & Growth Prospects

I think Omnicom (and the advertising industry) can be disrupted. I don’t think they will get killed, but I do think that alternative media is going to hinder their growth and eat into their pricing power.

Companies used to be totally dependent on firms like Omnicom for their advertising needs. I don’t think this is the case any longer. Now, they can run much more targeted ad campaigns and leverage better data using tools like Google and Facebook.

Having said that, Omnicom has adapted to the challenges of a changing advertising landscape. They help their clients create digital marketing campaigns and utilize data to help these efforts, but I fail to see how more companies won’t pursue their own marketing campaigns in a cheaper fashion. In a world where the best marketing campaigns can spring up organically (and cheaply) on social media, I don’t think that Omnicom has a compelling competitive advantage.

There will always be a need for a major advertising firm like Omnicom, but I think that demand and pricing power is going to slip over time.

I think that their moat is slowly being eroded. This is most evident in the deterioration of gross margins over the last 10 years. Gross margins were 26.5% in 2010 and have since declined to 18.5%. Still respectable, but something is amiss.

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Currently, there is a cost-cutting focus in the advertising industry. Gone are the “Mad Men” days of lavish expense accounts. Ad companies are now merging and “pursuing synergies”, and reducing salary costs. On the surface, the cost discipline is encouraging, but I think it is a sign of a challenging industry.

Revenues have grown over the last decade, but not at a particularly fast clip. Nominal GDP grows at a roughly 4% pace, but Omnicom’s revenue has only grown at a 2.5% pace, increasing from $12.5 billion in 2010 to $14.9 billion in 2019. This is also a sharp contrast to the strong rate of growth in the 2000’s – when Omnicom’s revenue grew from $6.1 billion in 2000 to $12.5 billion 2010, or a 6.6% pace.

Since 2016, revenues have actually declined. In 2016, Omnicom did $15.4 billion in revenue, and in 2019 that declined to $14.9 billion.

Advertising is not an industry in secular decline, but I also don’t think that it will achieve the kind of growth & returns on capital that it previously achieved. It’s quite possible that companies will start to pursue their own online marketing efforts, meaning that a firm like Omnicom loses the historically strong margins that it was accustomed to.

There are strong incentives for companies to use cheaper advertising alternatives and technology is making that easier to achieve. That is bad news for the advertising industry, even though it isn’t fatal.

I might be wrong, but I see the erosion of the moat as a strong possibility. I doubt that Omnicom will be able to grow and maintain strong returns on capital over the next decade.

Checklist

  • Can the stock deliver a 10% CAGR for the next decade?

Assuming that the company maintains its 2% revenue growth rate and continues to buy back shares, along with paying out the 4% dividend yield, it could potentially deliver a 10% CAGR. However, I don’t think that this is a guarantee. If top-line growth continues to stagnate & returns on capital decline, then it’s possible it won’t reach this hurdle.

I also don’t think multiple appreciation is a strong possibility, as the stock has remained stagnant around the same valuation multiples for the last 10 years.

Fail.

  • Has the business delivered consistent results over a long period of time?

Omnicom has been a consistent business over a long period of time. Over the last 20 years, they have continuously grown sales, earnings, and cash flows.

Pass.

  • Does the return on equity consistently exceed 10% without the use of heavy leverage?

Return on equity has averaged an extremely high level of 32.6% for the last 10 years. This has been boosted with leverage, but it is also supported by the business itself, which boasts strong margins.

Pass.

  • Is management sketchy?

Management strikes me as competent and honest. John Wren, the firm’s current CEO has led the company since 1997 and the company has been successful since then. He strikes me as an honest and capable leader.

Pass.

  • Is the company financially healthy?

Interest coverage is robust, but the debt/equity is too high for my tastes and the Altman Z-Score is also too close to the red zone for my comfort.

Fail.

  • Has the company consistently generated returns for shareholders?

Omnicom has consistently generated returns for shareholders. Since 1991, the stock has delivered a 13.12% CAGR. Since 2000, it has only returned 3%, but this was due to the fact that it was extremely expensive in 2000 and the multiple compressed from 2.5x sales to 1x sales. Since 2010, the stock has returned 7.32%. It has not destroyed shareholder value.

Pass.

  • Has the company survived previous recessions?

Omnicom has survived numerous downturns in the economy. In the GFC, revenue declined from $13.36 billion in 2008 to $11.7 billion in 2008. The company remained profitable during the GFC, bringing in $841 million in net income (down from $1.07 billion). The business proved to be quite resilient during that recession.

Pass.

  • Does the company have a moat?

Currently, Omnicom has a moat. It’s the second-largest advertising agency in the world and is a strong partner for any company that wants to pursue a significant advertising campaign.

However, I am not convinced that the moat is durable. I’m not certain that the advertising industry won’t suffer over the long haul. The wide availability of social media makes guerilla marketing campaigns cheap and easy. I imagine that this will eat in Omnicom’s business over time. They won’t be disrupted to the point where they will be killed, but I don’t think that the industry will be as attractive in the future as it was in the past.

Fail.

  • Is the stock cheap on an absolute and relative basis?

Omnicom’s stock is cheap on the surface, but it doesn’t look like a compelling bargain relative to its history. Its current valuation multiples are in line with where it has traded over the last decade even though they are low compared to the rest of the market.

Fail.

  • If I was forced to hold the stock for 10 years, would I be terrified?

I wouldn’t be terrified to hold Omnicom for 10 years, but I wouldn’t feel very comfortable, either. I think that the moat can be attacked. I’m also not completely comfortable with the company’s current debt levels. If the moat erodes further, I think that the valuation multiples can compress further. It’s also difficult for me to see how the valuation multiples can expand back to their year-2000 glory days. Because the competitive and financial position isn’t bulletproof and I’m not comfortable with Omnicom’s moat, I will pass on this stock.

Fail.

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