Elevator Risk
Institutional investors, once upon a time, were scared of advertising stocks. Why? The assets go down the elevator every day. Of course, portfolio managers and financial analysts--who wield their skills hoping their investment institution will distinguish itself and prosper--also go down in elevators (though at distinctly different hours than the ad folk), but the ad business was thought to be especially ephemeral and insubstantial.
Early investors in the stocks of Interpublic and Omnicom, not concerned with the elevator risk, or perhaps in spite of it, have been amply rewarded with market-beating returns. Fear of service companies is not much of a factor anymore, and investors rarely ask about the state of the ad industry's physical capital.
That may be a mistake.
Marketing services businesses-- including advertising--are becoming more capital intensive, and that's apt to continue or even accelerate. There are two forces moving this process along, one acting as a push, the other as a pull.
On the push side are the clients, especially the big ones, that want to rely on fewer but larger marketing service providers. It's expensive to coordinate the efforts of many agencies, PR firms and the like across the various geographic and disciplinary borders. By consolidating the work at the larger service firms, clients can dump a lot of those coordination costs onto the service providers.
On the pull side is technology. Advances in computing and communications--even to the point of blurring where the one ends and the other begins--are driving down the cost of producing work and of coordinating efforts. However, what started as an advantage to the early adopters--whoever, say, was the first to use Apples to create layouts or run interoffice memos across a computer network--can turn into a problem for those relying on last year's machinery or programs. Technology (like advertising and research) can bring many benefits if it's up to date--and many problems if it's not.
For marketing services companies, technology saves money in one corporate pocket, the one that covers operating expenses. But it also takes money out of another, that which funds capital expenditures. And when an analyst looks at the recent results of the larger public companies, two trends are apparent. Profit margins are widening--and the midyear results reported over the past few weeks show that this trend is intact. At the same time, capital spending is increasing. Last year, for example, capital expenditures at WPP grew nearly 50 percent--an extreme degree, but the company has a large research business, where they probably eat computers. Interpublic and Omnicom saw their capital appropriations gain 28 percent and 18 percent, respectively. Those are big gains for companies whose capital bases, according to the theory, ought not matter. And their investment spending is understated because of certain accounting conventions.
Investors, rightly, have overcome their early fear of elevator risk. Advertising is a service business, where 50 percent or more of the revenue that comes in goes back out through the payroll department. Analysts now pretty much ignore that traffic in the lobby cars. But with the increase in the industry's capital intensity, they might want to check the action in freight cars out back.