News Analysis: A Deal or A Steal?

How to read Y&R's financials Since Young & Rubicam announced in February that it would join the ranks of public companies and sell its shares on Wall Street, members of the ad community have been poring over the venerable Madison Avenue agency's never-before-released financial statements with two questions in mind. What do the numbers reveal about how well the agency is run? And would Y&R's initial public offering fly? Now that the dust has begun to settle from last week's offering, the answer to the second query is a resounding yes. Y&R's stock was grabbed up enthusiastically on Wall Street. Some 16.6 million shares were sold last week at an offering price of $25 per share--above the stock's indicated range of $21-24 per share. Of that stake, 6,666,667 shares were offered by the company (raising $166.6 million, most of which will be used to pay down debt), and 9,933,333 shares were sold by Y&R managers and Hellman & Friedman, the California-based institutional investor that partnered with agency management to bring the deal to market. Y&R's total common stock amounts to 66,228,322 shares, which means that 25 percent of the company now resides in public hands. Agency holding companies are hot on Wall Street. In the rush to grab a piece of what had been touted as the next Interpublic Group of Cos., Omnicom or WPP Group, investors bid Y&R's stock up as high as $28 3/4 per share on the first day; Wednesday, when this report went to press, it closed at 27 1/4. Every uptick bolstered the now-considerable wealth of Y&R chairman and CEO Peter Georgescu and other top agency insiders, whose Y&R stock holdings are now worth tens of millions of dollars. What the prospectus reveals about Y&R's business operation is more complex. For while the agency appears to be a bargain, the financial documents released prior to Y&R's IPO reveal there are good reasons why Y&R's stock traded at a fraction of the valuation of IPG and Omnicom, the financial gold standards of the ad industry. It's not only that Y&R's underwriters realize that investors have to be compensated for the risk associated with an agency without a track record of substantial profits. A look at the agency's financial statements through 1997 shows that as a moneymaking machine, Y&R needed a significant tuneup. The biggest problem is that some of Y&R's key ratios match up poorly against the numbers registered by the big guys. This isn't just about bottom-line profits. Although Y&R has posted net losses over the last two years, not all losses are meaningful to investors. That was the case in 1996, when Y&R took a one-time recapitalization charge of $315.4 million. Most of that money was used to buy out former owners of Y&R's privately held stock, a step the company felt was necessary prior to a public offering. If it weren't for that recapitalization, the agency would have posted a modest profit for the year (see table). More crucial measures of success in the minds of potential investors are Y&R's revenues and operating margins. On the revenue side, Y&R has a good story to tell. From 1995 to 1997, the agency's revenues grew by 12.9 percent compounded, from $959 million to $1.382 billion. That's something to crow about. Y&R's problem has not been bringing in the billings that generate revenues, but keeping a lid on expenses. The prospectus reveals that the agency's costs were, dollar for dollar, much higher than its competition. Its operating margin last year was a measly 5 percent. IPG and Omnicom, by comparison, reported operating margins of more than 12 percent in 1997. Put another way, for every $8 IPG and Omnicom received, $1 was operating profit; Y&R had to take in $20 to manufacture the same $1. A partial explanation could be that the agency has been trimming its fees in order to attract new global assignments from key clients, as some competitors have alleged. A common yardstick used by investors to gauge the value of any company is to add equity to debt and subtract the cash. That figure is the "total enterprise value." The ratio of total enterprise value to annual revenues is a good indication of the value placed on a company by Wall Street. In Y&R's case, the projected equity would be $1.856 billion following the offering, with most of the $166 million raised used immediately to reduce debt to approximately $180 million. That sum, $2.036 billion, minus cash reserves of $160 million, gives a total enterprise value of $1.876 billion. With 1997 revenues of $1.383 billion, in Y&R's case the ratio of the total enterprise value to revenues works out to 1.36. For IPG, Omnicom and WPP, that ratio is 2.48, 2.46 and 1.59, respectively. This means that if Y&R's financial performance takes off, there's plenty of room for growth built into its current stock price. Y&R's prospectus provides only consolidated numbers and doesn't break down its performance unit by unit. So it's impossible to say with certainty where in the company the financial drain resides. The most likely culprit is the Burson-Marsteller public relations unit, which brings in about 20 percent of company revenues. Y&R's filing indicates that Burson was a significant drain on operations last year, owing to a $25.5 million write-off arising from, among other things, "inaccurate billing of certain clients" in Europe and Asia. The other principal components of Y&R Holdings are Y&R Advertising, (about 50 percent of revenues), Wunderman Cato Johnson direct marketing (about 20 percent), Landor Associates (5 percent) and Sudler & Hennessey (5 percent). If Burson was the problem, Y&R management claims to have fixed it. Credit goes to Jean-Marc Bara, who, in a brief stint as chief financial officer for the troubled division last year, cleaned up the books and imposed badly needed controls. Bara was part of an earlier team led by Ed Vick, now CEO of Y&R Advertising, that successfully fixed Landor in the early 1990s when it was the weak performer in Y&R's stable. Y&R hopes its new compensation system, which gives stock and options to key managers, will convince Wall Street of its commitment to improve profit margins. While the agency's old compensation system rewarded its holders for a good performance, the stock was spread among more than 1,000 employees. (Even at the height of his power, one old Y&R hand reported, former chairman Ed Ney held less than 5 percent of the company's stock.) The real problem with the old system, however, was that it provided no incentives for management to tackle problems like those at Burson. After all, what outgoing chief executive would willingly depress the value of his Y&R holdings by cleaning up problems bequeathed by his predecessor? The new system is intended to spur senior management to make sometimes-difficult decisions by rendering the company's operations more transparent. Years before last week's offering, Y&R's top management identified those employees deemed key to future operations. The 1996 recapitalization, which essentially bought out Y&R's former shareholders, required $242 million to buy back almost all the old stock and stock equivalents at $115 per share, more than twice the $48 internal book value of that stock. Another $69 million was spent on "professional fees and other charges" associated with the recapitalization--much of which went directly into the pockets of Hellman & Friedman as payment for putting up $231.7 million of the buyback cash. Y&R's top management kicked in another $10.3 million into the recap-kitty. New stock was then issued to 325 managers. There are signs that Y&R's new owner-managers have already begun to deliver on their promise. From 1996 to 1997, for example, while the agency's revenues grew by more than 11 percent, its accounts receivable declined by 7.2 percent. In simplistic terms, that's good: it means that even after writing off some of Burson's receivables, the agency collected its bills much faster than the previous year, when there was less to collect. Accounts payable, however, remained virtually unchanged during the same period. That's bad: The 11 percent increase in revenues should have freed Y&R to let its accounts payable figure swell by a comparable amount. The agency could be paying bills too efficiently. In money management the goal is not to wipe out debts, but to keep money in the bank as long as possible. Looking for the real winners in the wake of last week's offering? Here's a hint: It's not Main Street investors. And while Y&R's newly flush owner-managers have plenty to cheer about, the moneymen who made the deal happen received by far the biggest score. Hellman & Friedman netted $195 million on the sale of some 7.8 million shares of Y&R stock. That payday, combined with a big cut of the $69 million in "professional fees and charges" it already earned, makes the company whole on its investment. But wait, there's more: Hellman & Friedman still holds about 22 million shares of Y&R stock. At $28 per share, that stake is now worth some $616 million. And that's not counting Hellman & Friedman's options on 2.6 million additional Y&R shares. At current prices, the investment house will have quadrupled its original investment on paper. That goes a long way toward explaining why today's best and brightest college grads are passing up Madison Avenue and heading straight to Wall Street. Y&R'S PROFIT-LOSS STATEMENT* .....1994..... 1995..... 1996..... 1997 Revenues.....$959,275 .....$1,085,494 .....$ 1,222,139 .....$1,382,740 Compensation Expense.....$594,322 .....$672,026 .....$730,261.....$836,150 General & Admin Expense.....$323,087 .....$356,523 .....$391,617.....$463,936 Recapitalization Charges...............$315,397 Other Operating Charges .....$4,507 ..... $31,465 ..... $17,166.....$11,925 Operating Expenses.....$921,916 .....$1,060,014 .....$1,454,441.....$1,312,011 Income (Loss) From Operations.....$37,359 .....$25,480 .....$(232,302).....$70,729 1996 Income w/o Recap. Charge...............$83,095 Interest Income.....$12,100 .....$9,866 ..... $10,269.....$8,454 Interest Expense.....$(23,027).....$(27,441).....$(28,584).....$(42,879) Income (Loss) Before Taxes.....$26,432 .....$7,905 .....$(250,617).....$36,304 Income Tax Provision (Benefit).....$12,998 .....$9,130 .....$(20,611)..... $58,290 Income of Consolidated Cos......$13,434 .....$(1,225)..... $(230,006)..... $(21,986) Equity in Income (Loss) Subsidiaries .....$4,740 .....$5,197 .....$(9,837).....$342 Minority Interest in Net/Loss Subs. .....$(2,742).....$(3,152).....$1,532.....$(2,294) Net Income (Loss).....$15,432 ..... $820 ..... $(238,311)..... $(23,938) *All numbers in thousands Source: Young & Rubicam

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News Analysis: A Deal or A Steal?

Greg Farrell

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Greg Farrell