Will This Mega-Merger Revolutionize the Advertising Industry?

In 2013, the No. 2 and No. 3 ad agency holding companies as measured by revenue, Omnicom Group (NYSE: OMC  ) and Publicis, announced a merger of equals. This action caught most investors by surprise, as they considered the industry already pretty consolidated. In fact, the top five players combined account for around three-quarters of global revenue.

The new company will be an indisputable No. 1, as the two companies together generated $22.7 billion of revenue in 2012 -- almost 38% more than the largest player in the industry, WPP (NASDAQ: WPPGY  ) , which made $16.5 billion.

What are the motivations and strategies behind this merger?

Well, the two companies decided to combine to be able to face greater external competition in five to 10 years. Management believes that non-ad agency competitors, such as Google and Facebook, will become more relevant looking ahead, with big data taking a major role. In fact, both companies are convinced that the new combined entity will enhance their competitive position in big-data analytics.

Fundamentals
Large global ad agencies benefit from intangible assets, as they have managed to establish a brand reputation that most Fortune 500 firms in the marketplace trust. When companies have multibillion-dollar brands at stake, they want the best experts providing the best marketing solutions possible. So being No. 1 in terms of size and coverage should attract big firms and reduce the already infrequent client turnover.

In addition, online and digital advertising have become more complex than ever because of the growing number of options, and the merger has set growth in these areas as their main strategic priority.

So how will the merger affect WPP's position? Well, until the merger takes place, the company remains the world's largest agency holding company. Its revenue increased 3.5% in 2013 to more than $18.4 billion, while profit grew 13.1% to nearly $1.7 billion. Not bad at all.

During the presentation of full-year results, WPP CEO Martin Sorrell gave a few hints toward the implications of the operation. He considers that the integration will bring some problems regarding what side will take command of the new company -- the U.S. or the French office. (Publicis is headquartered in France, Omnicom in the United States.) He adds that integration would need at least three years to fine-tune strategies, which will gives WPP some opportunities both on the client and the people side.

It's important to note that WPP does not lack scale, as the company is about two-thirds to three-quarters the size of the new merger. The CEO clarified that size and reach matters most with smaller competitors, and it will not affect a company the size of WPP. He added that the company has a "significant pipeline of reasonably priced small and medium-sized potential acquisitions," which could modify its relative positioning as well.

One last thing to take into account is that the new company will include rival clients such as Apple and Samsung, or Coca-Cola and PepsiCo, which could generate conflicts of interest, information leaks, and the loss of accounts. This is a big deal that investors need to be aware of, especially considering that the company has not commented on how it will be dealt with.

Final Foolish thoughts
Digital tools for advertising will only accelerate their penetration, especially in the emerging markets, which represent a sizable long-term growth opportunity. If the new merger succeeds in its strategy, it will be highly profitable.

The combination of the two businesses makes strategic sense, as Omnicom's top agencies hold a reputation for strong creative work, while Publicis is known to be second only to WPP with its digital offerings. Scale is growing in importance, as digital has become a part of every major marketing campaign. So the merger should turn the new scale into a competitive advantage.

Nonetheless, revenue for advertising companies is affected by the broader economy, so in the event of a slowdown, top-line results would take a hit. The outlook for developed markets for this year is positive, and the major players should be able to surpass their 2013 sales levels in these markets at least.

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