Industry Overview: Advertising

The Advertising Industry is divided into two types of marketing services companies: large international
ad agency groups and other domestic-focused entities. While the two types are quite different, they
share a few characteristics. All of them help clients sell products or services using one or more media of
communications. As the industry serves the entire private sector in the United States, its revenue and
earnings follow economic cycles to some extent. Advertising outlay is typically a lagging or late-cycle
indicator, falling after the start of a downturn and recovering after the beginning of an upturn.

Marketing through traditional media (newspapers, magazines, radio, television) is a mature activity in
the U.S., and spending usually increases around 4% in an average year. Expenditures through newer
media, the Internet for example, have grown much faster as clients shift ad outlays away from older
methods. But, in time, each new medium eventually matures, prompting ad execs to seek other
emerging channels.

The industry is not particularly capital intensive, since it contracts out what manufacturing is required
and leases necessary office space. In general, capital expenditures are less than annual depreciation
costs. Though, occasionally, there may be some controversy over, for instance, a suggestive ad copy,
spending to comply with government regulation is not significant. Competitive conditions in the ad
industry are not especially egregious, permitting some companies to garner wide margins.

Advertising company pages use the standard Value Line industrial format, with “Cash Flow” per share
the basis for estimated value. As only a few of the companies pay dividends, the group is generally not
for income seekers. But some of the stocks, from time to time, might offer above-average share-price
appreciation potential and appeal to aggressive investors. Those looking for favorable long-term total
returns may want to consider the largest international companies.

The Internationalists

International advertising agency groups originally started as independent ad agencies and grew, through
acquisitions, to offer broad ranges of marketing services beyond the traditional activities of creating ad
campaigns and choosing the media on which to run them. The newer offerings include public relations,
marketing research, events management, and other brand-enhancement activities. Large companies
seek internal revenue growth of just 1% to 6% a year and expect to boost that to around 10% with
acquisitions of ad agencies and other marketing service businesses. The objective is to garner a bigger
share of their clients’ total marketing outlays. Buying earnings, though, can be costly, as seen in the high
price/earnings multiples paid for companies that specialize in creating and placing advertising on the
Internet.

Since the U.S. and Western Europe markets are mature, advertising companies have sought to increase
their international reach, growing via overseas expansion and domestic acquisition. In recent decades,
total U.S. advertising outlays have averaged about 2% of annual gross domestic product, while emerging
market spending has been much lower. Of course, high growth potential comes with greater risks,
particularly that of a deep drop in demand. The business prospects of markets like China and India are
huge, but advertising spend in these countries could plunge in a tough global economic environment.

Another risk of overseas expansion is the danger that financial planning and control will suffer as the
agencies venture ever farther from the U.S. or Europe. That has caused problems for companies in the
past, keeping managements mindful of the risk. The announcement of a large overseas acquisition or
marketing deal can notably affect the share price of any one of these stocks. Too, with around half of
their revenue in foreign currencies, the changing value of the U.S. dollar has had a significant effect on
reported earnings and stock valuations. Thus, investors should keep an eye on foreign exchange rates
when appraising the international agencies and try to invest in them when the dollar is strong, or even
overvalued.

Domestic Focused Companies

Members in the other class of the advertising industry are more domestic and offer marketing services
through just one or two media. Beside a focus on marketing, these firms have relatively little in common.
Media include billboards, free weekly shopping publications, newspaper inserts, and Internet pop-ups.
Domestic-focused companies often hold a large market position in their specific niche. Acquisitions are
less important for these firms than for the large international agencies. Even so, they have done
noteworthy deals in the past.

Summary

John Wanamaker, founder of Philadelphia’s first department store, is reputed to have remarked that
while he knew half of his ad budget was wasted, he did not know which half. Thus, advertising is
essential to most industries that offer products or services to consumers. This industry is mature in the
U.S. and Europe, so advertisers seek to grow by acquisition and by entering emerging markets. A
company with an already high debt-to-total capital ratio could have difficulty growing. While not
particularly cyclical, ad budgets will rise and fall in accordance with business prospects. Advertising
outlays often lag the economic cycle, so the industry’s revenue and earnings may well be impacted a
quarter or two after a sector’s performance changes. Still, investors should remember that stock prices
normally lead changes in operating results.