Is MDC Partners a Good Bet in Advertising's New Pecking Order?

Advertising agency MDC Partners (NASDAQ: MDCA  ) has built itself into a billion-dollar business by rolling up a motley assortment of niche advertising agencies and leveraging their individual strengths, creating significant shareholder value over the past five years.  The company has benefited from a multiyear rebound in advertising spending from its diversified customer base, especially from heavy marketers like the auto industry.  However, competitors aren't exactly standing still, as exemplified by the July 2013 proposed combination of Omnicom Group (NYSE: OMC  ) and France-based Publicis Groupe.  So, is MDC Partners still a good sector bet?

Chart forMDC Partners Inc. (MDCA)

Source: Yahoo! Finance.

What's the value?
MDC Partners has created a national agency network and doubled its revenues over the past three years by buying up growing, specialized advertising agencies and instilling a collaborative culture across the enterprise.  It has also been diversifying beyond the traditional agency space, focusing on digital marketing and consumer research areas. The result has been a lower reliance on a small subset of big clients, with MDC Partners' top 10 clients accounting for 26% of total revenues in 2012 versus 49% in 2009.

In fiscal year 2013, MDC Partners has continued its industry-leading top-line growth, up 9.1%, led by its traditional agency segment, which enjoyed a double-digit gain for the period.  The company benefited from its growing assortment of service capabilities, as clients increasingly look to advertisers for advice on effectively reaching their core constituencies, many of whom use so-called new media channels. More important, MDC Partners' adjusted profitability increased at an even faster rate, up 50.5%, due to a solid pricing environment and efficiencies from its low-overhead business model.

Battling global giants
Of course, in an industry that has a cost structure skewed toward compensation for highly paid professionals, the economies of scale of large global networks are a key factor for overall success. This dynamic has driven the sector's ongoing wave of consolidation activity, especially prevalent at leading competitors Interpublic Group (NYSE: IPG  ) and Omnicom Group.

Interpublic was hit hard by the financial crisis, given its position as one of GM's key advertising partners, but its fortunes have rebounded alongside strong sales volumes for the auto sector. Like MDC Partners, Interpublic has been pursuing growth in nontraditional areas, focusing on public relations, market research, and sports marketing. In addition, the company has been trying to reduce its business risk through an expansive geographical footprint, roughly 100 countries, which was boosted by recent niche acquisitions in India and Australia.

In fiscal year 2013, Interpublic's top-line growth has trailed that of MDC Partners, up 2.2%, hurt by relatively weak performance in its agency business due to client losses in key areas, like retail. However, the company generated a solid revenue increase in its nontraditional communication services segment, a higher-margin area that doesn't require the significant capital outlays associated with traditional media buying activities. The net result has been the maintenance of operating profitability for Interpublic, despite an overall uptick in compensation costs.

Meanwhile, Omnicom's financial performance in fiscal year 2013 has been nearly identical to that of  Interpublic, with both revenues and operating income up marginally. More so than its competitors, Omnicom has bet big on the nontraditional services area, highlighted by its 2012 acquisition of NIM Digital, one of China's leading advertising agencies. The upside of this operating strategy has been consistently above-average operating profitability, resulting in strong cash flow generation.

The proposed merger with Publicis, which recently received U.S. regulatory approval, vaults the combined company to the industry's pole position, with a strong stable of advertising agencies in traditional and digital areas, including BBDO, Leo Burnett, and Razorfish. The combination also provides a substantial opportunity for cost savings, initially estimated at roughly $500 million, further building upon Omnicom's already solid profitability level and putting pressure on its competitors to match its value proposition for clients.

The bottom line
All of the major advertising agency conglomerates have generally followed the same blueprint, consolidating diverse groupings of specialized advertising agencies into one enterprise, believing that incremental overall value would flow from an aggregation of individual strengths.  While MDC Partners looks positioned for success in domestic markets, future growth is likely to come from international markets, an area where it trails both Interpublic and Omnicom.  As such, investors might want to let this highflier cool off before taking a position.

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