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Omnicom's Dividend Remains a Top Priority But Digital Acceleration Creates Longer-term Uncertainty

Omnicom reported earnings on October 27. Organic revenue fell 12% as clients in struggling industries such as auto (10% of sales), retail (7%), travel and entertainment (5%), and energy (1%) reduced their marketing spending.
Source: Omnicom Earnings Presentation

Omnicom's sales decline was better than the company's 23% slump in the second quarter. But investors were disappointed by management's remarks that a similar pace of sequential improvement is not expected to continue in the fourth quarter. 
 
Omnicom usually benefits from a jump in more discretionary project-based business near the end of the year, but visibility is very low due to COVID's effect on many marketing budgets. 

Despite Omnicom's revenue challenges, the company's dividend remains safe.

Omnicom's year-to-date free cash flow, even after deducting over $300 million of "one-time" restructuring charges and non-cash stock compensation expenses, totaled $804 million, nearly doubling the firm's $423 million of dividend payments.

Most of Omnicom's costs are variable in nature (e.g. labor), helping the company protect its profitability during downturns. In fact, Omnicom's operating margin and profits grew last quarter despite its double-digit revenue decline. 

In addition to the firm's reasonable dividend coverage, Omnicom's balance sheet remains solid with low leverage and a BBB+ credit rating from Standard & Poor's. 

Management reiterated their commitment to the dividend as well:

"Our #1 focus when looking at all of this is maintaining our investment-grade rating. So that will govern a lot of the conversation in terms of when we restart our share repurchase program. Also, dividends are our main focus. Acquisitions, where they're possible, is the second place we allocate capital. And finally, we'd use excess cash, if we determine to have excess cash, to start repurchasing shares again.

"So it's a complex conversation. But as I said, dividends are #1, acquisitions will be #2 and share repurchases will be the last."

– Chairman and CEO John Wren, 10/27/20 Earnings Call

That said, the pandemic appears to have accelerated some of the long-term challenges facing large ad agencies such as Omnicom.

Until Omnicom demonstrates a sustainable return to profitable growth, we are downgrading the company's Dividend Safety Score from Very Safe to Safe.

Prior to this downturn, Omnicom and ad agency rivals such as WPP and Publicis struggled with years of stagnant revenue growth as marketing spending shifted from traditional to digital channels.
Omnicom Sales; Source: Simply Safe Dividends

Consumers today can be reached through more mediums than ever before and a rising share of their spending continues shifting online, causing marketers to rethink their strategies and budgeting decisions in an effort to reach their target audiences in a cost-effective way.

As a result, companies have increasingly emphasized performance marketing tied directly to purchasing activity rather than brand promotions aimed at hard-to-measure audiences.

Digital channels such as social media ads and paid search provide a mix of data that can help marketers figure out exactly who bought what and saw which ad. With this information, ad strategies can be measured more effectively and adjusted quickly.

Thanks to these benefits, digital advertising has grown from 12% of the overall ad budget in 2008 to more than 50% this year, according to data from Barron's.

The pandemic has accelerated this shift as more consumers shop online, stream content, and spend additional time on digital channels while at home.

The Interactive Advertising Bureau, a marketing trade group, expects U.S. ad spending to fall 8% this year. But digital media is expected to grow 6% while traditional media shrinks 30%, driven by double-digit declines across the board.

Some of Omnicom's legacy areas of expertise such as producing commercials for linear TV are losing relevancy as the influence of these traditional channels fades.
Source: The Interactive Advertising Bureau

Facebook and Google's multibillion-dollar advertising businesses in the third quarter recorded 22% and 10% revenue growth, respectively, providing a stark contrast to Omnicom's 12% decline and highlighting the latest example of this accelerating shift.

Increased use of self-serve digital channels has helped some major companies take more control of their advertising and marketing work as well.

For example, PepsiCo in July said on its earnings call that it had built more capability to do marketing work in-house. The firm's CFO claimed that PepsiCo "can actually get the same or more value for less money" given its increased speed and efficiency.

Omnicom understands the importance of data-driven marketing and has invested billions over the past decade to bolster its own digital services, including its data and analytics platform Annalect which debuted in 2010.

Yet the firm's web of more than 1,500 creative agencies, media buying companies, and PR groups has made it difficult for Omnicom to effectively harness data across its organization and transition fully to the digital age.

As management has said in the past, "the hardest part about this is doing integration with your traditional assets at scale. Anybody who does this can tell you that mass personalization at scale is extremely hard."

Omnicom's sprawling operations make it difficult to assess the company's ability to return its top line to meaningful long-term growth, but management does not believe the company needs to make any major divestitures or acquisitions to remain competitive.

That could change if digital marketing's pandemic-driven acceleration pushes more clients to go direct to advertising platforms such as Google and Facebook and take more of their marketing activities in-house. This appears to be playing out to some extent.

Despite this challenging backdrop, we don't believe Omnicom's business will fade quickly. The firm has longstanding relationships with many of its 5,000 clients, establishing a deep understanding of brands, unique value propositions, and customers that creates high knowledge barriers.

The increased complexity of optimizing marketing activities across traditional and digital channels could also provide more opportunities with companies that continue to outsource most of their advertising work.

Investors just need to remain mindful of the risk that Omnicom evolves into a value trap in the years ahead as the media landscape continues evolving.

We've held shares of Omnicom in our Top 20 Dividend Stocks portfolio since June 2015 and plan to maintain our position for now. 

The cyclical ad weakness impacting the firm's short-term results will eventually reverse when the economy recovers. And with shares trading at a forward P/E ratio below 9x, the market appears to already be pricing in minimal growth from the business going forward.

Given some of our growing concerns about Omnicom's ability to be a larger and more profitable business in the decade ahead, we'd be open to exploring alternative ideas if and when the stock's valuation recovers.

In the meantime, we expect the company's streak of paying uninterrupted dividends since 1986 to continue, albeit with muted dividend growth prospects.

We will continue monitoring the situation and provide updates as needed.

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