How Should You Play This Big Advertising Tie-Up?

Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In July 2013, global advertising giants Omnicom Group (NYSE: OMC) and France-based Publicus Groupe announced a merger of equals, thereby creating an entity that recorded $22.7 billion in revenues during 2012 and has a gold-plated list of Fortune 500 clients.  Their intention was likely to protect their existing advertising businesses and client rosters, in the face of competition from rising digital ad network operators, like AOL (NYSE: AOL).  Despite record operating income for both companies in their latest fiscal years, organic top-line growth was hard to come by at both companies.  So, how should investors play the sector?

Safety in numbers

Of course, investors could buy into Omnicom Group, assuming the deal successfully closes with regulatory approvals.  In FY2013, Omnicom itself has reported slow growth, with increases in revenues and operating income of 2.4% and 3.0%, respectively, versus the prior-year period.  The company’s top-heavy exposure to the traditional advertising segment, through agencies that include BBDO and DDB Worldwide, provided an uptick to the company’s top-line growth, as customers in the auto and financial services sectors increased their advertising budgets.  More notably, Omnicom generated a higher operating margin as it achieved greater efficiencies from its existing administrative and production staffs.

While Omnicom has been making tuck-in acquisitions in the digital arena, it probably realized that it couldn’t build a digital segment to challenge Publicus’ strength in the area.  Publicus has made digital a core part of its strategy for years, through its ownership of digital focused agencies like Starcom Mediavest Group and Razorfish.  The company generated 33% of its total revenues from its digital segment in 2012, leading it to a record operating margin of 16.1% despite the weak economies of its home European base.

Elsewhere in the sector, investors could take a look at Interpublic Group (NYSE: IPG), an advertising agency that bears a striking resemblance to Omnicom with its focus on traditional advertising through its global agencies, including McCann WorldGroup and Campbell-Ewald.  However, the company is a riskier option as it generates a greater percentage of revenues from its large enterprise customers, with the top ten customers accounting for 22% of its total revenues in 2012.  Interpublic's greater reliance on a few key customers, like General Motors, puts in a weaker price negotiating position, leading to a lower operating margin than its competitors.

In FY2013, Interpublic has reported mixed financial results, with a 2.4% increase in revenues, but a 3.4% decline in operating income.  Its results have been hurt by weakness in its traditional agency business, which accounts for roughly 75% of its profit.  While Interpublic has been actively expanding its digital marketing segment, with eight acquisitions in 2013, the unit has yet to create a meaningful impact on the company’s overall bottom line.

An alternative for a digital age

Not surprisingly, the Internet has changed the advertising business irrevocably as advertisers try to reach an increasingly mobile consumer base that gets its news and information from disparate sources. The power players in the new paradigm are the operators of third party networks of content properties that can bring advertisers more value for their advertising dollars. One of the best positioned operators with both strong content and distribution networks is AOL (NYSE: AOL).

After struggling with its identity and unhappy shareholders for a number of years, AOL has found its stride with a focus on content creation and the management of one of the largest ad networks for third party website publishers.  In FY2013, the company has reported solid growth in its core businesses, led by a 12% revenue increase in its brand segment, which includes Huffington Post, Patch, and TechCrunch properties.  While its membership segment continues to decline, due to falling subscribers for its access services, the segment continues to produce the operating cash flow that allows AOL to reinvest in its content and network businesses.

With 187 million unique monthly users to its network of proprietary and third party properties, AOL provides advertisers with a valuable, captive consumer base that they can effectively market to.  Publicus also saw the value of teaming up with AOL, recently forming a partnership to provide advertisers with live marketing services across digital platforms.  As advertisers continue to try to reach consumers on the Internet through video ads, these two players are positioned to capture a meaningful share of the market.

The bottom line

The potential tie-up of Omnicom and Publicus shows the real threat that digital advertising networks bring to the traditional advertising business.  While the merger will undoubtedly create an improved cost structure for the combined business, it is unlikely to reinvigorate their top-line growth, which is stuck in the low, single-digit range.  Thus, investors should pass on the traditional agencies and focus on the operators of online ad networks.  AOL is one for the portfolio.

Robert Hanley owns shares of AOL. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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