Art & Commerce: Natural Limits

Advertising-agency stocks are not especially hot; they never have been. But the industry is becoming a creature of the stock market, with obvious effect on the big public companies. It all started innocently. The first shops to go public did so largely as a means to help their founders and the postwar generation of managers cash out. "Capital," in the classical sense, is not a big consideration in this industry. Companies don't need to raise huge sums to finance the construction of a new ad factory. But they might need money to buy back the shares held by retiring (in the senior-citizen sense, hardly bashful) leaders, or to repay the debt some took on to accomplish that. Having a publicly traded stock is handy in other ways. Tradable stock makes it easier to reward employees and more economical to buy other companies. You need not break into the piggy bank for cash or go to the real bank and borrow. And senior executives, who might have been given their shares as a form of compensation, can sell them in the open market without placing a call on their companies' cash. Over time, as the business has grown--the industry typically outperforms the Gross Domestic Product by a percentage point or two--the stocks have also risen in price. With so many insiders holding stock, there was a strong urge to keep prices up. The best way to propel a stock's price over a sustained period of time is to grow earnings per share. And for a stock to perform better than the market, share earnings ought to grow faster than the average company. Although the ad industry has a demonstrable upward growth bias, it's fairly slight. Ad spending--and aggregate industry revenue--grows by about 6 percent in a typical year, which is not very sexy. To do significantly better, companies needed to merge, either with like companies or with those in allied fields. (There have been some efforts at broad diversification--one agency, Doyle Dane, even owned a sailboat manufacturer--but these have almost always flopped. Investors would probably react with dismay at similar tangential tacks.) Today's industry leaders do both. Merging creates larger revenue pools and, at the same time, provides opportunities to squeeze costs, thereby enhancing margins and all-important earnings per share. But as companies get bigger, the deals need to get bigger. A shop with $100 million in revenue can grow 50 percent by acquiring something with a top line of $50 million. The same transaction by a $2 billion company would barely tickle the growth-o-meter. There are now three companies at the $5 billion level, for whom $50 million is a rounding error. They'll still do deals, these industry giants, because it makes great economic sense to buy good-performing, though small companies at prevailing private-market prices--which are less than half their own public-market valuations. But the hunting ground is running low on big game. Aside from each other, there aren't many big agencies left to buy that would have a dramatic impact on growth. And if the growth abates, watch out for receding stock prices. K Alan Gottesman is principal of West End Consulting in New York. He can be reached at al@westendal.com

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Art & Commerce: Natural Limits

Alan Gottesman

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Alan Gottesman