PUBGY - WPP plc: Significant Upside Potential If Valuation Gap Closes Vs. Peers

Summary

• I believe short-term factors, rather than long-term structural ones, are to blame for the slowdown in the advertising agency industry.
• WPP is well-positioned to thrive in this market due to its size, global presence, and breadth of knowledge in a variety of fields.
• I believe the key driver to investment returns is from valuation re-rating upwards to close the gap vs. peers.

Recommendation

Short-term factors, rather than long-term structural ones, are, in my opinion, to blame for the slowdown in the advertising agency industry, and I think the bears are exaggerating the severity of their structural concerns. WPP plc ( WPP ) is, in my opinion, still very important because it assists clients in optimizing their marketing budgets throughout the entire marketing funnel. More importantly, I believe that digital advertising spend will continue to grow the overall market, enabling agencies to go beyond conventional marketing in order to stimulate thought, interest, and action. Due to its size, global presence, and breadth of knowledge in a variety of fields, WPP is in a strong position, in my opinion.

WPP is a buy in my opinion, as I believe there will be an increasing demand for agencies' counsel and execution across a more intricate customer journey. Further, I think WPP should be trading at a forward PE of 12x, similar to its competitors, given that its earnings growth is anticipated to outpace its competitors'. This re-rating of valuation would be the primary driver of investment returns.

Latest earnings highlights

WPP's organic growth for FY22 was 6.9%, which was higher than both the consensus estimate of 6.6% and the company's own guidance of 6.5% to 7%. This implies a slower annual growth rate of 10.2% for 4Q22 compared to the 11.0% seen in 3Q22. The 14.8% operating profit margin was in line with consensus and guidance. EPS grew 4% to 98.5p mainly due to a more than expected increase in associate contribution, which was above consensus. Additionally, WPP announced a dividend payment of 39.4p per share, corresponding to a payout ratio of 40%.

Associates

Associates earning of £74 million in 2022, far exceeding my expectations, was largely driven by Kantar. I believe it is important to point out not to miscalculate WPP earnings as £40-50 million of Kantar income from associates cannot be recognized as the carrying value for Kantar has been reduced to zero.

Balance sheet

The balance sheet of WPP is still robust, as indicated by its net debt to EBITDA ratio of 1.46x, which is slightly lower than the target range of 1.5x to 1.75x. WPP's cash flow management saw a trade working capital outflow of £226 million, which was mainly due to year-end mix and timing factors, rather than being flat year-on-year as previously guided. WPP policy to return shareholders capital is encouraging as well as it has exceeded its planned total share buyback by completing £807 million in FY22, and plans to buy back an additional £50 million worth of shares in 2023 to offset dilution resulting from share-based payments.

Guidance

Management expects organic growth of 3-5% in FY23 and a contribution of 0.5-1% from acquisitions. If I were to compare this against peers, it is on par with guidance made by the Omnicom Group ( OMC ), Publicis ( PUBGY ), and the Interpublic Group of Companies ( IPG ). Furthermore, management anticipates a 20bps margin improvement, while OMC and PUB anticipate a slight decline, as revenue growth and cost savings from the transformation project more than offset cost inflation. Over the long-term, WPP's targets include a 3-4% increase in revenue and a margin of 15.5-16%.

Valuation

WPP is expected to generate £1.17 in EPS in FY25, which I believe is achievable given the expected growth and potential margin improvement. Applying the current multiple of 10x forward PE to that EPS figure in FY24 results in a share price of 1170p, making the stock roughly fair valued. However, I believe the path to returns will be when the valuation gap between WPP and peers such as IPG and OMC closes. OMC and IPG both trade at 12x forward PE, a 20% premium to WPP. I believe the discount to WPP valuation is not justified given that they are expected to grow at the same rate, but WPP has guided to margin expansion. If we apply a 12x forward PE to that £1.17 EPS in FY25, we get a share price of 1404p, or a 40% increase.

Summary

In conclusion, the advertising agency industry's slowdown is largely due to short-term factors rather than long-term structural issues, and WPP is well-positioned to thrive in this market. While the stock is currently fairly valued, I believe that if the valuation gap between WPP and its peers like OMC and IPG were to collapse, WPP's stock could potentially offer a 40% upside. Therefore, I recommend buying WPP's stock.

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