Top investor David Herro on WPP vs Publicis and why he's keeping faith in agencies

One of Wall Street’s top investors in the ad agency sector has said he still backs WPP’s management because they are “moving the ball forward”, despite the company’s “extremely disappointing” share price performance in recent years.

David Herro, the chief investment officer, international, at Harris Associates, a leading US-based investment fund, told Campaign that Mark Read, the chief executive of WPP since autumn 2018, was right to restructure and simplify the group and “it takes time and money”.

However, WPP is “behind” rival Publicis Groupe in several areas, including offering an integrated solution for clients, according to Herro, who rose to prominence as an investor when he clashed with the Saatchi brothers during their final days running Saatchi & Saatchi in the 1990s.

Herro, a longstanding investor in WPP,  predicted an activist shareholder or private equity bidder could take a position in the agency group because it is trading at “an unrealistically low valuation for what it is”.

WPP’s share price has dropped by about a third to about £7.50 and its valuation has roughly halved to £8 billion (partly because of asset sales such as Kantar) since April 2018 when Martin Sorrell departed as chief executive.

The company was already under pressure during Sorrell’s final year in charge, as the stock price tumbled from a peak of £19 and valuation of about £24 billion in March 2017.

Harris Associates cut its shareholding in WPP from 7.35% in April 2018 to 4% last year but has increased it since then to a current level of 6.07%, according to the company.

Herro insisted large agency groups are still a good investment, particularly in the current economic environment. It is a “misnomer” to think they will perform poorly in a downturn because they are capital-light with a variable cost base that means they can maintain profitability.

Here is an edited transcript of Campaign’s interview with Herro.

How do you rate WPP’s performance, particularly in the past five years? It was evident before Martin Sorrell stepped down that the company was in revenue decline and needed to restructure.

Yes, this is a key point. WPP did need to restructure. The company was built by a number of acquisitions. Many of them were very good acquisitions. They bought some good businesses, they paid OK prices. But one of the things that they failed to do is integrate these businesses in a way such that you can present a unified front to a client – [WPP had] separate systems, often you had WPP companies pitching against WPP companies, et cetera, et cetera.

So this huge conglomeration of different companies needed to be consolidated and this is not something that takes a year or two – this is something that is still going on today [in terms of restructuring]. This is the way the industry has moved: clients want a turn-key solution to their advertising and marketing issues. And WPP was not able to provide that, given the set-up of their company.
 
I think what Mark Read and his team have done is strive to accomplish just this [to offer clients a more integrated solution] and so, to that degree, the company is moving in the right direction. But you can't work efficiently if you are not adequately consolidated and that is what the company has had to do over the last five years.

Now, is the share price disappointing? It's extremely disappointing. You have a company that trades at eight times earnings and if you adjust it for their Kantar holding, even less than that. So it trades at a significant discount to its peers.

I don't believe the discount is reflective of the business. This company really should trade at a lot higher multiple. And if they can continue to demonstrate profitable growth, they will. That's the key – to continue to expand operating margins, while growing revenues at least three, four, five, six per cent a year. If they can do this, I do believe they will be re-rated. But this is what has to be done.

If we take the past five years as a time when the company has required simplification and restructuring, does WPP need to be bolder going forward? It’s been more about shrinking the overall scale of the operations and divesting, rather than expansion. Do they need to be bolder going forward to generate three, four, five, six per cent a year medium-term growth?

If a business can't grow, they shouldn't own it. Or if it can't contribute to growth, they shouldn't own it. So if they have businesses that are not operating up to par – if we can't extract value out of businesses under the umbrella – you have to take the necessary steps to either fix them or, if they're not fixable, to sell them or to close them.

With the creative agencies – this is obviously not just a WPP issue – a lot of them are low growth and it's hard to see them growing at a fast rate. It's other services such as media, technology, commerce and data that have been growing faster. Yet there's a paradox when WPP  calls itself the creative transformation company. As an investor, what do you see the role of the creative agencies?

The creativity within the agencies is what differentiates them from IT integrators, et cetera. So it is important to maintain a level of creativity because this is how you deliver a differentiated solution to your clients. But again, if you look at one of the things that has caused the growth to slow for all of these agencies [across the holdco sector] in the last half decade, it’s that slice of creativity, the creative analogue part of the business, which has shrunk. So you have to find a way to maintain the differentiation that creativity provides but attach it to platforms that grow. You have got to be creative. You can't just tolerate status quo.

You mentioned profitability and growing profitability – so bottom-line growth as well as top-line growth. How much is margin an issue? WPP’s margins are about 15%. You have Publicis, which you're also invested in, with a margin of 17.5%. Is there a WPP issue around margin and is this connected to complexity? And what is the change, if there hasn't been the change already, that you need to see?

You can't compare completely apples to apples because of their [different] business mix and their geographic mix. However, what Publicis has done very well is integrate their agencies and put businesses on common platforms and this type of thing, and this is what WPP is doing now. But they're behind – they’re behind Publicis. I think everyone knows this, they know it.

But because of the complexity, which they started with – Martin [Sorrell] built this complex web of businesses that were never [fully] integrated and were on various different platforms et cetera – you need to simplify and unfortunately this takes time. When you have all these companies and all these localities, it takes time – and money, by the way. But it will be money well spent if you do it correctly, like Publicis has done, and they get 17% to 17.5% margins and they aspire to even grow their margins a little higher.

There has been a lot to do to restructure WPP in the past five years and there has been the pandemic. But at what point do investors say to current management at WPP: ‘You’ve had your time to do this’? Or maybe it requires more time to make the necessary changes?

As long as they keep making progress and can demonstrate that, we have to be patient with them. If they're unable to move the ball forward, then you have to think. Given the situation – the pandemic, the structure of the business, et cetera – I think they have been able to move. They are moving the ball forward and I think if they stop moving the ball forward, then you have to question management.

When it comes to the agency sector, there are plenty of investors who are negative on agencies – they have been for six or seven or eight years. Ultimately, as an investment, what are the pros and cons of the agency groups because, with this push for simplification, some people ask: Is the agency holding company model still relevant?

Agency holding companies have desirable financial characteristics, as long as they're able to maintain at least low single-digit growth. They're highly profitable and highly cash-generative and very capital light – [in terms of] working capital, physical capital. So these businesses extract a lot of free cash flow out of their businesses. And given the variable cost nature of their business, their margins often hold up much, much better than people think in periods of economic weakness. So they're actually somewhat defensive because of the nature of their businesses.

Now why people have been dissatisfied is because, as we've gone through this transition to more digitalisation, this has impacted the growth rates of agencies, which used to be easily [at the same level as] GDP or GDP-plus. They've struggled. And what they've needed to do was to be able to provide digital solutions, which at first, they were somewhat slow at doing. I believe they have now improved upon this, and as long as these agencies can keep improving upon their abilities to deliver digital solutions, they should be able to grow.

This is something they have to be able to do because this is where advertising and marketing has gone. And by the way, this also becomes a barrier to some of these little guys [smaller agency groups]. Some of these little guys can't afford to keep up – they don't have the breadth to keep up and the resources to keep up. And a lot of the big holding companies do have the ability to keep up and to compete with some of the more digital-oriented businesses. So I think, generally speaking, they're not bad businesses to own and to invest in. We also own some IPG.

But one of the misnomers is during economic periods of slowness, you don't want to own an agency because advertising gets cut. It’s true that advertising gets cut – it's often the first thing that gets cut because it's the easiest thing to cut. But you can't cut it forever or your brands will go to mush. It's a misnomer because agencies are capital-light and have a huge variable cost base, so even in periods of economic slowness, they can protect profitability – unlike other businesses.

What's going to happen to some of these smaller businesses – the 10,000-people agency groups? I'm thinking here of Stagwell, S4 Capital, The Brandtech Group, Dept – to the extent you track them or invest in them.

The problem with some of those little companies is, if they can't keep keep up, then if they have something, maybe someone else will buy them and integrate them. And if not, they'll just fade away, they'll just break up and the people will go elsewhere. So number one, they either have to have a competitive edge or number two, if they don't have a competitive edge, they have something within their business that somebody else wants. Or number three, they just won't be able to compete.

I've been in this business now since 1986 and how many of these little agencies have we just seen come and go? The ease of entrance [in terms of the marketplace means] it’s a very low barrier to start up — you might have a client, you might have a key person. But you have to be able to keep things going and often they just don't make it. They get folded into someone else or they go away.

What about the consulting firms? Accenture is the one that has made everyone sit up and take notice but none of the big consulting firms have marketing services at the core. How much have consulting firms really chipped away at the big holding companies or perhaps you don’t seem them as a direct threat?

They are an indirect competitor for sure. This is what Publicis has tried to do  – to bolster those areas where they are helping their clients with digital fulfilment and all of this – because they want to blunt the ability of the consulting companies to encroach on their territory. Publicis, in particular, has done a pretty good job at it and perhaps WPP could do better in that area.

Think of [marketing services and business consulting as] circles intersecting with each other and you want to keep that little intersection as small as possible. And at first it grew [when Accenture and others moved into marketing services] and I think the low-hanging fruit has been had by some of these consulting companies. But, again, ultimately, you have to offer other things than digital consulting – clients want more than that. And creativity does play an important role and does become a differentiator.

Do you think there is value in WPP because it could end up being bought or, for that matter, broken up? I guess it's available to buy every day of the week if people want to buy it.

It sure is. And if someone wants to buy it and break it up, that could happen too. At this kind of price level, I think it might attract more of a corporate activist or a private equity fund because it's really selling at what I think is an unrealistically low valuation for what it is.