Stockwatch: is WPP optimism the bellwether we’ve been waiting for?

Advertising giant declares it is over the worst, which could spell a turnaround for the wider economy. Our analyst reports.

The world’s largest advertising group, WPP, asserting an optimistic outlook is for me the most significant current development.

Yes, there are fears of a Covid-19 second wave, but it seems barely a few weeks ago that the US and India were heading for catastrophe.

One might expect the message from business to err on the cautious side, compared to the shifting agendas of governments in confusion and the media focusing on the negative. 

Yet here is a near £8 billion marketing services group of global reach, turning positive. 

Advertising especially is meant to be a leading indicator of recovery.

Over the trough and paying a dividend

FTSE 100-listed WPP (LSE:WPP) says the second quarter of 2020 should be the trough for its revenues, which also fell less than expected: down 15% on a like-for-like organic basis, versus 19% targeted. You might also think a group that includes a Buchanan, a City of London financial PR adviser, would tread carefully as to guidance.

Moreover the board has declared a 10p interim dividend, where expectations had been for nothing. This is significant also because marketing services are fundamentally cyclical, and the general fear is governments –especially the UK - running into constraints with their stimulus programmes. Unemployment will soar, according to the media.  

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The decision is likely helped by WPP’s agency business model of relatively low capital expenditure needs versus cash flow from operations, although any dividend at all in these circumstances shows confidence.

If consensus expectations are fair, a 60p annual pay-out from the last three years is projected to drop to 19p then recover to 46.5p in 2021.

With the stock around 610p currently that implies a prospective yield near 3% rising to 7.6%. 

Price-to-earnings ratio cheap around an earnings trough 

The crux of weighing up WPP is whether its business trend is positive enough to tip the stock’s risk/reward favourably, when as a cyclical it can be priced for an attractive yield as compensation for those risks. 

As a big business, and in the wake of founder Martin Sorrell leaving as chief executive two years ago, it leaves questions whether his successor and the strategy can work well enough. Even before Covid-19 disrupted the business environment, normalised earnings per share (EPS) had been in a sharp downwards trend. These were 140p in 2017 but fell to 65.6p in 2019. First quarter 2020 net sales eased 3.3% organically.

At 610p a share the price-to-earnings (PE) ratio is 11.1x the 2020 consensus EPS expectation for 55p, falling to 8.6x the target for recovery near 71p in 2021. Admittedly this is speculative while Covid-19 grinds on.

However, more positively the 2020 consensus likely does not reflect WPP’s numbers already beating expectations. A global stock like this, well-positioned in its markets, would more normally trade on a PE around 20x or more as it passes an earnings trough.

Clearly the market still lacks much confidence in this group. That said, its ‘discount’ likely also reflects polarity in sentiment where growth/technology stocks have reached ridiculous levels, while mainstream or cyclical ones are shunned.

If tech stocks hit any disruption then an extent of mean reversion would benefit those now modestly priced, recalling the 2000 debacle.

Further reasons for WPP being past a low

WPP made a £2.58 million pre-tax loss due to £2.5 million goodwill impairment. There was a further £221 million in other write-downs, plus £39 million of Covid-19 related and restructuring costs. 

This reflects dealing with the aftermath of Sorrell’s reign and adjusting to weaker demand in some markets for example as US/China trade tariffs have taken a toll on the global economy. 

Given this extent of writing down, and if the board is astute, it gets the issues cleared and ought to also mark a low point. 

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Margins manifestly need to improve, given the table shows a fall from respectable double-digits at the operating level, near 9%. 

The interim gross profit margin has continued to fall, from 16.3% to 13.9%, as cost of services rose. The headline operating margin is down from 11.9% to 8.2%. Guidance for the full year however (see outlook statement) is for 10.4% to 12.5%. Some contrarian investors would say there needs to be evidence of improvement here, quite whether the stock would be significantly higher by the time published. 

A reason to trust in better margins ahead is cost savings of £296 million achieved in the first half, with full-year guidance towards the upper end of £700 million to £800 million savings planned for 2020. Around 25% of these savings are expected to be permanent. 

Despite a £402 million net cash outflow from operations in the first half, 2019 showed a £126 million interim outflow improve to a £1.85 million inflow for the year. I would not therefore panic about cash flow.  

Debt/cash mix is moving in the right direction 

At the end of June there was £5.13 million long-term debt and £352 million short-term debt (down from £1.13 million), versus cash increased from £2.17 million to £2.76 million. 

Net debt of £2.72 million generated an interim net service cost of £106 million, covered 3.6x by headline operating profit, hence the balance sheet still needs some cleaning up. 

The most likely reason for a three-year bear market in WPP stock, even before Covid-19, was a sense of relatively high debts meeting a sluggish global environment.

It is a classic aftermath of an ebullient entrepreneur-style chief executive, having made countless acquisitions, but at least the current management is moving the debt/cash mix positively despite a challenging environment.

Otherwise the balance has no material compromising issues. An acquisitive past means £8.12 million goodwill plus £1.48 million of further intangibles, tipping £5.76 million net assets to £2.35 million or 192p a share, in the red. For an agency-type business group however, the valuation focus is going to be very much on earnings, cash flow and dividends. 

Quality substance within the group

Arguably the intangible assets do have value that should be respected. Last June WPP was ranked the most effective communications company in the world for the ninth year running. 

Obviously, such a trend has not prevented the underlying business and its stock de-rating since early 2017, when market price hit £18.93. 

But it would be a glass-half-empty view to dismiss how four WPP agencies are recognised by Gartner analytics in its “magic quadrant” for global marketing agencies. The AKQA subsidiary in particular was rated highest globally for vision and execution. There is substance for current WPP management to work with.

Admittedly the present chief executive is an insider rather than a truly fresh pair of hands. But they should know the group well – having had 12 years as head of strategy then chief executive of WPP Digital, being global chief executive of Wunderman, one of the largest WPP businesses.  

Prudently cautious on the speed of recovery

Management recognises an uncertain macro environment, and its guidance for an overall 10% to 11.5% fall in annual revenue assumes no further lockdowns in its major markets. The chief risk would seem to be whether populations can adjust to being indoors as summer ends, without compromising distancing, such that Covid-19 infections soar. At least it appears death rates remain well down for now.

I like WPP also as a potential hedge against Brexit talks ending in acrimony with the European Union. 

The UK constituted 9% of interim operating profit versus 56% for the US, hence the stock is a means to portfolio diversification from UK earnings and sterling. 

The stock has started September down over 5% in early trading but I would focus on the PE and yield suggesting scope for mean-reversion upwards. ‘Buy’.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.