The numbers don't lie. Advertising agencies have massively underperformed the S&P 500 in the last five years due to structural challenges coming from a fundamental shift in the business. In concert with their structural challenges, their operating metrics have also declined. As such, high dividend yield companies like Omnicom (OMC) and Interpublic (IPG -0.13%) are yield traps that are worth avoiding, as are their peers such as the U.K.'s WPP (WPP 1.24%). Here's why.
What went wrong
The simple fact is that the growth of digital media has challenged the way the advertising industry does business, and the agencies are finding it hard to keep up. Last year marked the first time that digital advertising spending made up more than 50% of total media spending, and industry forecasters say it will be above two-thirds in 2023.
The future of advertising is digital, and traditional advertising agencies are finding it hard to adjust. Image source: Getty Images.
It's a move driven by the inexorable rise of e-commerce spending and the increasing importance of social media in everyday life. As such, Facebook, Google, and Amazon are the new champions of digital advertising and, on a combined basis, have around two-thirds of market share for digital advertising in the U.S.
Data source: YCharts.
The bad news
All of this is bad news for the traditional advertising agencies. First, the online giants are competitors of companies like Omnicom and Interpublic, and they take massive amounts of revenue that might otherwise have gone through an advertising agency.
Second, they are also changing the way the industry works. The massive amounts of data being produced through online marketing are creating tangible and actionable insights into marketing campaigns that could only be dreamed of by traditional advertising methods. As such, the growth opportunity is in the kind of analytical capability that management consultancies like Accenture and Deloitte do very well.
All this goes a long way toward explaining just why the peer group has massively underperformed the market over the last five years.
Data source: YCharts.
The numbers don't lie
Digging into the details of the operating metrics in advertising agencies reveals the scale of the challenge ahead of them to remain relevant. For example, here's a look at the organic growth trends in Interpublic's peer group.
Data source: Interpublic Group annual report 2019. YOY = year over year.
The industry has struggled to grow the top line, and a look at the five-year operating income of Omnicom, WPP, and Interpublic shows a similar stagnation. Simply put, this appears to be an industry in structural decline.
Data source: Company presentations.
The COVID-19 pandemic
In addition, the coronavirus pandemic has probably made things worse, because it's accelerated the growth in e-commerce and digital marketing relative to traditional advertising. This comes at a time when the advertising agencies are trying to adjust to the new reality by expanding their own digital capabilities through internal expansion and acquiring digital business.
For example, Interpublic bought a data solutions business, Acxiom Marketing Services, for $2.3 billion in 2018. Meanwhile, WPP is trying to integrate its creative and digital capability and Omnicom continues to invest in its "digital transformation."
Bulls on the sector will argue that the advertising agencies are adjusting to the structural shift and the weakness in the share prices, and consequently the high dividend yields of Interpublic and Omnicom make them attractively valued stocks.
The bottom line
Unfortunately, history is littered with cases of companies that failed to adjust to fundamental shifts in their end markets, and until investors see some hard evidence in the numbers, it's best to be cautious with this group of stocks. In addition, the COVID-19 pandemic has skewed the numbers this year, so it's very hard to assess underlying performance or how the industry will emerge from the crisis.
However, investors do know that all the factors that are causing the structural changes -- namely e-commerce and growth in digital advertising spending -- have been strengthened by the pandemic. As such, it's likely that life will get harder for Omnicom and Interpublic, and investors may want to think twice before buying into them as dividend plays.
