The mad men of STW

Recently retired STW Communications chairman Russell Tate was reminiscing on his first days with the predecessor to STW: ‘90% of the 20-30 [staff] were very attractive blondes with not a very high IQ but were running around trying to do ‘stuff’... it was chaos’.

Founder John Singleton and pivotal executive Russell Tate sorted the place out but have since departed. Michael Connaghan now fills the executive seat in what is now a very different business. Where once existed a single operation, Connaghan sits atop a 70-agency group.

The numbers look impressive. Since listing in 1994 with revenues of $12m, this year STW will book over $300m, a 25-fold increase.

Only the recent share price performance strikes a discordant note. In 2007 the company’s shares changed hands at over $3. Now they trade at 85 cents, a fall of 75%, following the company's painful capital raising in 2009. The company borrowed too heavily acquiring new businesses.

But with many investors left scarred, on a forecast price-to-earnings ratio (PER) of 8.7 STW is a company discarded and ignored.

A model acquirer

To an outsider, a 70-odd collection of businesses may seem anachronistic and inefficient. But behind the apparent oddness rests a rock-solid rationale.

In advertising, clients demand exclusivity. McDonald’s, for example, wouldn’t want its strategies shared with KFC. Qantas, like Telstra, a client of STW’s for over 15 years, wouldn’t accept a creative or accounts team working on Virgin Australia.

For many agencies this effectively puts a cap on growth. In the ad business, you can have one airline, one car company and one breakfast cereal company but no more.

With an array of separate, competing businesses, STW wonderfully circumvents this conflict. Don’t like the work of JWT? Fine, try Ogilvy & Mather. Conflict of interest there? No problem, what about junior or human?. Bit edgy for you? How about The Brand Agency or IKON?. Either way, you’ll end up doing business with STW.

Sure, it’s more expensive—although back office systems and training are pooled—but it’s worth it. Clients need the exclusivity and benefit from an ongoing relationship with a particular agency’s principals, often the reason why they signed up in the first place. They also get the benefits of a larger group with every possible service available to them.

It also thwarts a difficult problem for small agencies, which often lose clients because the overseas head office insists they use the same group worldwide. STW, 20% owned by WPP, one of the world’s big four agency groups, offers that facility. Loss of clients due to ‘international realignments’, as they’re called, is much reduced.

Separate brands

Advertising agencies are a bit like investment banks. Each night, the intellectual property of the business goes home in the lift.

The separate brands under the STW banner offer staff increased autonomy, help foster unique workplace cultures and offer improved accountability thanks to reduced hierarchies. And healthy competition between agencies (each year STW presents an award to the best performing group) keeps everyone on their toes.

The business mix also creates a more interesting and diverse career path for staff. It’s a place where you might work in a relatively small business with all the freedom that brings but get the support and opportunities of a far bigger group.

The strategy appears to be working: STW enjoys above average staff retention rates. That’s important where the business is the staff.

Fragmented markets

Mad Men’s Don Draper wouldn’t recognise today’s fragmented media market. Whereas companies could once choose from three free-to-air commercial TV stations, now there’s 11, plus another 90-odd pay TV stations, each targeting an ever narrower demographic.

The Internet has played havoc with advertising, too. An estimated 15% of ad spend now occurs on channels that didn’t exist 10 years ago, to say nothing of entirely new mediums like Twitter and Facebook (with over 1.2bn users between them) and novel ideas like ‘rainvertising’.

Media consumption is also changing. The world now has over 60m iPads and over 5% of internet traffic comes from mobile devices. Audiences are fragmenting, niches are becoming narrower and the skills needed to market to them more demanding. There’s now far more to advertising than the big, creative idea, which is why STW owns a stable of research and PR agencies, too.

For a big company like Fairfax, adapting to these changes has proved difficult. For STW, it’s an opportunity. As a new segment develops, it simply makes an appropriate acquisition in the area or expands into it using an existing agency. Ogilvy Earth for example, an extension of the Ogilvy & Mather brand, specialises in green marketing.

Last year, Feedback ASAP, which operates in the booming area of customer relationship management, joined the stable. In July 2009, STW took a 20% shareholding in Taguchimail, which offers a customised, real time platform for email marketing optimisation.

You can see the approach: As a new area of specialisation develops, STW can very easily enter it. The effects are evident in the company’s revenue sources. In 2009, for example, revenues from digital advertising contributed 17% of total revenues. Now they account for 25%. Non-advertising revenue now accounts for nearly half of STW’s business.

Not without risk

Whilst the strategy is sound, it has its temptations. Some members may remember Photon Group, which recently emerged from a near-death experience having overpaid for acquisitions (see Acquisitions: Danger below).

With return on incremental capital employed (see this video for more on ROICE) of around 30% since 2006, STW's acquisitions have added value (in comparison, Photon generated a 6% ROICE over the same period) but it remains a risk.

Constantly making acquisitions also requires a constant source of funding. STW, despite producing generous cash follow (more on that later), has tended to fund acquisitions via debt or equity issues. Recently, it has discovered a renewed respect for the company’s equity (it’s even buying back up to 10% of outstanding shares), which has shifted the funding burden to debt.

Bank debt is currently $115m, plus $24m of ‘earn-out’ payments due over the next few years ($38m total). Earn-out payments are contingent liabilities arising from acquisitions, paid only if certain hurdles are met, although they’re often set so low as to guarantee payment.

The current debt facilities include $55m in additional available funds and don’t require refinancing until 2014. However, this sum will be quickly absorbed by buyback and earn-out payments.

Debt isn’t a concern at the moment but could be if economic conditions deteriorate. More worrying is the fact that STW has quickly regeared after the 2009 capital raising. We’d be more comfortable if the company temporarily cut the dividend to reduce its debt, although with interest cover of seven times it’s manageable and not enough to deter us.

Table 1 summarises the argument in favour. On a forecast PER of less than nine and free cash flow yield of 13%, if the company merely repeats the performance of the past few years, the stock looks cheap. If it can grow earnings at a modest clip, it could well be a bargain.

Advertising, though, is notoriously prone to the whims of the economic cycle. It’s seductive to think of earnings growth of 8% but less easy to imagine the impact of the contrary. Locally, we haven’t had a ‘proper’ recession in 20 years but the global environment is such that that possibility is greater now than at any time since the GFC. If we did enter recession, how would STW fare?

The big four overseas-listed global advertising groups (Omnicom, Interpublic, WPP and Publicis) in the United States experienced revenue declines of between 5%-10% and earnings-before-interest-tax-depreciation-and-amortisation (EBITDA) margin compression of between 10%-20% between 2008 and 2009. If that happened here, expect STW to conduct another, perhaps less-dilutive, capital raising.

But as Table 1 shows, even in a US-style recession STW would be trading on PER of 17, FCF yield of 6.6% and dividend yield of 4.1%. That’s far from a dire outcome.

If earnings remain flat, STW trades on an attractive FCF yield of 13.0%, PER of 8.7 and dividend yield of 7.1%. Should management meet its 5%-10% per year growth targets, the PER drops again to 8.4-8. Not much has to go right for this recommendation to go well.

The current price provides an adequate margin of safety and with STW’s share price down 5% since 15 Aug 11 (Hold - $0.89), it’s back on buy list. LONG TERM BUY.

Note: The model Income portfolio owns shares in STW Communications.