Agencies 2009.06.16 Initiation

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Media and Entertainment: Advertising Agencies

June 16, 2009

James Dix (213) 688-4315 [email protected]

Sken Huang (213) 688-4503 [email protected]

Initiating Coverage of the Advertising Agencies: Who Moved My Margin? Advertising Agencies Search for Eternal Life

• Grim, but not glum – advertising agency holding companies should weather the recession with their business model bruised, not beaten. This year, advertising agency industry revenue is in its steepest decline in over 30 years. However, we believe the core disciplines in marketing services and media planning and buying are safe for the foreseeable future.

• With all eyes on margin …. Although all businesses face trade-offs between growth and profitability, we think the choice between the two will become particularly important for the agency holding companies (AHCs) during and after the recession. AHC operating margins had generally been flat in the low-to-mid-double digit range over the 2-3 years prior to the current recession, despite an increasing mix in recent years of agency revenue from 1) new media disciplines, where clients presumably are willing to pay more for mission-critical expertise, and 2) faster-growing emerging markets.

• … growth will become the more important issue, in our view. Having lagged U.S. nominal GDP growth in the most recent expansion, the agencies must improve their value proposition in the face of three principal sources of disintermediation: 1) their clients, who can bring work in-house or outsource more of it to non-agency vendors, 2) media companies, which can offer marketing services, leveraging the consumer insights they can gain from the data coming from their media platforms, and 3) major interactive marketing services providers (e.g., the Big 4 – Google, Yahoo, AOL and Microsoft), which have vast stores of data on consumer behavior online, and increasingly elsewhere.

• Bull case: cutting through the clutter with big ideas is as important as ever - agencies have a resilient business model that consistently returns to GDP-plus growth and double-digit operating margins during economic expansions. Large brand advertisers, the agencies’ core clients, may increasingly prefer to manage search and other digital marketing strategies through agencies as part of integrated marketing campaigns. Addressable television and mobile are two important, new marketing platforms where agencies may be able to make up some agency compensation indirectly lost to Google in search marketing. Some trends may favor longer agency-client relationships, which could help agency profitability.

• Bear case: AHCs will be data-mined and left for dead as creative advertising becomes “margin-alized,” integrated marketing campaigns become a crowd-sourced, regression-driven commodity, and search-based marketing spreads to more platforms. Agencies risk falling into the classic trap of super-serving their core customers, at the expense of staying ahead of disruptive innovations. Digital crowd sourcing and feedback may require marketers to more closely integrate consumer insights into their core operations, and rely less on agencies and outside market researchers. The shift of spending to sales activation strategies gauged by quantitative return-on-investment could continue to reduce spending on brand-oriented strategies, where the agencies historically have a comparative advantage. If more media becomes on-demand via a paid-search platform like the Internet, the agencies’ current business model in integrated marketing could be undermined.

• Interpublic Group (IPG – Hold): Initiating coverage with a HOLD rating and $5.75 price target. o Investors should have a better entry point to shares in IPG’s turnaround story, which offers most long-term upside.

• Omnicom Group (OMC – Buy): Initiating coverage with a BUY rating and $38 price target.

o We believe Omnicom is the investor’s surest path to a cyclical operating and valuation recovery for the AHCs, given Omnicom’s solid near-term cost control, superior long-term growth record, and lack of M&A or leverage challenges.

• WPP (WPPGY – Hold): Initiating coverage with a HOLD rating and $36 price target (per ADR).

o We are cautious given decelerating 2Q revenue trends and margin compression risk, reflecting WPP’s greater exposure to spending in the United Kingdom and Europe, although we believe that WPP’s larger-than-usual trading discount could become compelling if investors become more confident about when and where its profit trough will be.

L O S A N G E L E S | S A N F R A N C I S C O | N E W Y O R K | B O S T O N | S E A T T L E

2 | Media and Entertainment: Advertising Agencies James Dix (213) 688-4315 Sken Huang (213) 688-4503

TABLE OF CONTENTS

EXECUTIVE SUMMARY.................................................................................................................................. 3 INVESTMENT THESIS ..................................................................................................................................... 8 BULL CASE: YES, WE CAN........................................................................................................................... 18 BEAR CASE: WHEN A MAN HAS A QUESTION, THE WORLD WILL BEAT A PATH TO HIS DOOR..... 22 ESTIMATES AND OUTLOOK ....................................................................................................................... 26 COMPETITIVE POSITION ............................................................................................................................ 27

Advertising Agency Industry Revenue And Margins By Discipline.............................................. 35 Primary Advertising Agency Disciplines ...................................................................................... 38 Agency Holding Company Business Model .................................................................................. 51 New Business ................................................................................................................................ 56 Client Base .................................................................................................................................... 58 Agency Holding Company Competitive Position In Key Geographies ........................................ 60

GROWTH AND MARGIN TRENDS ............................................................................................................... 67 2009 Growth Comparisons ........................................................................................................... 71 Cyclical Trends ............................................................................................................................. 71

DEAL TRENDS ............................................................................................................................................... 76 TECHNOLOGY AND REGULATORY TRENDS............................................................................................ 77 CAPITAL STRUCTURE TRENDS .................................................................................................................. 78 MANAGEMENT AND GOVERNANCE.......................................................................................................... 78 VALUATION TRENDS ................................................................................................................................... 78

James Dix (213) 688-4315 Media and Entertainment: Advertising Agencies | 3 Sken Huang (213) 688-4503

EXECUTIVE SUMMARY

Structure of the Advertising Agency Industry The agency holding companies (AHCs) sit at the top of a global industry for marketing services, with the four largest AHCs accounting for roughly 20-25% of total advertising and marketing services industry revenue, broadly defined. The subsidiaries of the AHCs serve global clients with the full range of marketing services, including branding strategy, media planning and buying, advertising, direct marketing, customer relationship management, and interactive marketing. The AHCs are global in scope, as our coverage universe reflects: IPG derives roughly 46% of its revenue outside North America, Omnicom 48%, and WPP 65%. AHCs typically create client-specific global teams to provide service, funded by internal cost allocations against the local operations servicing the client. We see a trend for AHCs to manage global accounts from the holding company level. There is the possibility of further industry consolidation. A merger of Aegis, the number 6 global player, and Havas, the number 7 global player, would further concentrate the industry at the top, and potentially allow IPG, Omnicom or WPP to pick up clients and/or talent during the integration of the merger. On the back burner for the foreseeable future in our view is a merger, discussed from time to time in the trade press and elsewhere, between number 3 player IPG with number 4 Publicis, as an exit at the end of IPG’s turnaround. What Agency Holding Companies Do

Traditional advertising and media planning and buying services account for roughly half of advertising agency industry revenue, and marketing services including digital account for the rest. Traditional advertising and media planning and buying typically use marketing channels reaching a mass audience with messages (e.g., “Just Do It”) that reinforce a brand, communicate general product information or inspire an emotional response. The gold standard in branding, for which marketers and agencies strive, is “brand insistence” - when the brand is perceived to be the only viable solution for the customer’s need; they often settle for some decrease in price elasticity. Many believe that good creative advertising is vital to winning new business, because it goes to the core of creating brand insistence. For its part, media planning and buying involves deciding 1) how to allocate resources between long-term and short-term marketing objectives, and 2) given that allocation, how to optimize the efficiency of the resulting media buys. Marketing services focus on establishing targeted relationships between marketers and individual consumers, and the impact of spending on marketing services is often easier to measure (e.g., how many coupons were redeemed, or how much revenue was generated per online paid-search term). Agencies have increased their business mix of marketing services, as their clients shift to more consumer-centric marketing from traditional advertising, with digital marketing services being at the epicenter of this shift. There is some, but not substantial, variation in operating profit margins by discipline, and the AHCs as a group do not provide regular disclosure of margins by discipline. We have a few observations. Media planning and buying services typically have higher margins than creative services. We believe that market research based on proprietary panels or databases generally has higher margins than creative. We believe that shifts of spending to digital from traditional channels have been roughly margin-neutral for the AHCs. Business Model Fees based on an estimate of the demands of a particular project or scope of work account for the bulk of agency compensation, although agencies also charge for their services on the basis of commissions that are a percent of media spending, retainers and pay-for-performance. In terms of costs, an agency’s salary and related expense is typically 50-60% of revenue, and office and other overhead expense 25-30%. Severance expense typically is 0.5% of revenue, but can tick up to 1.5-2.0% of revenue during industry contractions, as agencies reduce headcount in the face of declining demand.

Although agencies historically have had lower operating margins, in the 10-15% range, than many platform-dependent media companies, freedom from platform dependence makes their role in the marketing value chain more secure, especially in this time of rapid change in media usage and marketing models. Agency revenue visibility has typically been substantially greater than for platform-dependent media companies. We believe the core AHC disciplines in marketing services and media planning and buying are safe for the foreseeable future. Spending on marketing services will benefit in particular from the increasing use of


digital and interactive channels. Marketers continue to demand agencies’ media planning and buying services, given the increasing complexity caused by 1) planning and buying digital channels, even on a stand-alone basis (e.g., search engine optimization and search engine marketing), 2) the trend to integrated marketing campaigns, requiring analysis of both traditional and digital metrics, and 3) the trend to quantitative analysis of branding - in part to complement the shift in focus to short-term return-on-investment (ROI) facilitated by new media like search - which could benefit from the integration of market research/analytics with the data warehouses that can be generated by media planning and buying operations. Future Growth For future growth, agencies are focusing primarily on two areas: digital marketing services and emerging markets. Disciplines and geographies experiencing faster top line growth generally have more profit growth potential, initially from lower-margin revenue growth and then as margins improve. The AHCs have been increasing their revenue mix in recent years from 1) new media disciplines, where clients presumably are willing to pay more for mission-critical expertise, and 2) faster-growing emerging markets, where growing local businesses have an increasing demand for advertising and marketing services, and where multinational firms are committed to building their brands. The major AHCs have been competing for digital media acquisitions with the major online advertising companies for the past few years. At present, the AHCs derive roughly 15-25% of their revenue from digital marketing services and 15-25% of their revenue from emerging markets. Client spending is rising on digital and interactive channels. Because the internet now leads television as the driver of media spending growth in the more mature markets, we expect the AHCs to use expertise in interactive marketing as their spearhead for growth. The internet is now the dominant contributor to media spending growth in Western Europe and North America. However, marketers still do not consider their organizations digitally savvy. Thus, we believe that digital agency compensation has been increasing at least as fast as digital marketing spending and should grow this year despite the recession. AHCs have purchased search engine marketing and search engine optimization companies to bolster their digital marketing offerings. In the design of marketing campaigns, one advantage digital agencies may have over traditional creative agencies is their data analytics capabilities. Marketing services companies – and this includes both the AHCs as well as interactive marketing services firms like the big 4 online players Google, Microsoft, Yahoo and AOL - are increasingly competing in their ability to accumulate digital data and then extract from it revenue-driving insights and build upon it new service offerings. Thus, developments in tools to integrate online and offline campaigns could have important implications for the AHCs. The strategy of some agencies rests on a view that integration of data analytics and market research can create an enduring place for agencies in the interactive marketing value chain. A key legal issue is the control and use of consumer data in marketing. For example, restrictions which agencies place on the use of data may limit the ability of media companies and others to compete with the agencies. Geographically, the AHCs have been shifting their focus to the emerging markets. In many emerging markets, media and marketing spending has been growing substantially faster than GDP. Over the long term, a disproportionate share of the growth in the middle class globally will come from these emerging markets, and this should drive a disproportionate share of the growth in global media and marketing spending. The AHCs have other growth initiatives. Digital agencies are building turnkey interactive marketing tools, e.g., software, for license to multiple clients. Agencies are increasingly becoming co-producers of branded content, and looking for compensation based on use of this content on multiple platforms. Many disciplines are considering use of pay-for-performance compensation as a way of increasing their potential compensation.

Competitor Overview Although the recession has increased investor focus on cost control and margin preservation, we believe the more fundamental driver for the agencies going forward, especially as we look past the recession, is growth. After the 1991-92 recession, the agency industry surged to revenue growth consistently above U.S. nominal GDP growth. After the 2001-2002 recession, it did not. To grow, the agencies must improve their value proposition in the face of three principal sources of disintermediation: 1) their clients, who can bring work in-house or outsource more of it to non-agency vendors. 2) media companies, which can offer marketing services, leveraging the consumer insights they can

gain from the data coming from their media platforms.


3) major interactive marketing services providers (e.g., the Big 4 – Google, Yahoo, AOL and Microsoft).

Both media and major interactive marketing services providers are competing with agencies in offering media planning services, as marketers look to bypass their usual media and creative agencies to work directly with media platforms providers with a growing wealth of data on consumer behavior. Challenges Recessions have typically sparked important changes in the advertising agency industry. Out of the 1991-92 recession arose the large agency holding companies and an increased focus on offering marketing services. Out of the 2001-02 recession arose increasing scrutiny of agency compensation by client procurement teams and a growing focus on integrated marketing. Now, the increasing speed of changes in marketing, combined with the recession, could either 1) increase the value of agencies as expert intermediaries, or 2) result in disruptive changes that reduce the agencies’ role in providing marketing and communications planning insights. This recession comes at a time when, in our view, the current AHC business model faces many challenges. As professional services providers, agency holding companies are not at the top of the value chain. Compared to other professional services firms, agencies spend a lot of time and resources on competing for new business, and defending current accounts. Events at a marketer that can trigger an account review include a change in senior management, M&A, and launch of a new product or service. The trend has been for client tenure with agencies to decrease, and clients with shorter tenure may tend to be less profitable. Agencies may have lower operating margins on projects for larger clients, which have been edging up in the mix of the AHCs’ overall business mix. In our view, the value of being the agency of record is becoming less important as clients seek best-of-breed specialists. The agencies’ fee-based compensation system relies substantially on a cost-plus model, which contributes to margin pressure from clients and their procurement teams. Changes in agency compensation set during this downturn could put a crimp on future profit growth. The agencies have difficulty matching compensation to changes in service levels required by accounts over the course of an engagement (e.g., “scope creep”). Inefficient media planning and buying processes drive up costs for the AHCs. Recession With this backdrop, advertising agency industry revenue is in its steepest decline in over 30 years. Although the AHCs have substantially easier growth comparisons in 2009 than they did in 2001, their growth outlook is substantially worse now. Although the AHCs have relatively diverse client bases, in this recession the crisis in the auto industry has been a particular drag on their growth. AHCs derive roughly 10-15% of their revenue from spending by auto makers. With U.S. auto ad spending down 30-40% this year, this alone is creating a stiff growth headwind. New business activity – the life blood of agencies in economic expansions – can recede in importance during recessions. Many marketers are asking their agencies for fee reductions outside of a formal account review. As organic growth goes negative, industry operating margins contract, as the cost of administrative staff and office overhead is relatively inflexible and in the near term. Agencies are focused on cutting costs to match reduced fees and scopes of work. Fortunately, agencies have improved their leverage with their own suppliers since the last recession. On the other hand, recessions tend to turn working capital into a net user rather than contributor of cash for the AHCs. In this recession, agency marketing services revenue appears to be falling faster than advertising and media planning and buying revenue. Because of its higher mix of revenue from spending on projects and discrete events, marketing services as a whole has been hurt more thus far in the recession. Agency disciplines dependent on projects and events tend to be more economically sensitive. Within marketing services, disciplines that deliver measurable sales results should be less affected by the recession. Media planning and buying units tend to feel the impact of a downturn after some delay. We believe one sign of a turn in marketing spending will be selective release of budgets to defend or steal market share. However, margin recovery may be more difficult after this recession, making margin preservation now more important. We believe clients are looking to impose less profitable terms of trade that could make agency margin expansion more difficult during a recovery. These terms include a greater mix of work done on a project basis, greater use of value based compensation or similar systems, and a greater client procurement focus on reducing expenses in interactive marketing. We believe that AHCs may ultimately have to sacrifice some margin to achieve satisfactory post-recession growth.


Some AHC execs disagree, and believe that margins will recover as fast as or faster than in prior economic recoveries. Agencies should hold headcount growth below organic revenue growth and their power to control costs should be greater given that the industry will be more consolidated than it was coming out of prior recessions, and have greater power over its vendors. Bull Case for the Agency Holding Companies The bull case for the AHCs has several points.

• Large clients may increasingly prefer to manage search and other online strategies through agencies as part of integrated marketing campaigns that use offline media as well. Agencies could increase their value proposition if they could, for example, improve marketing ROI by shifting the marketing mix away from search. Addressable television and mobile are two important platforms where agencies may be able to make up some ground lost to Google in defining the terms of trade in marketing. The large AHCs may be able to create a more enduring competitive advantage as marketing becomes more digital. WPP, for example, sees an opportunity to use the data generated from its media buying to further develop its consumer and strategic insights businesses.

• There appears to be to more outsourcing of media functions to agencies, not less, and secular trends may lead to longer agency-client relationships, and longer-standing clients tend to be more profitable.

• Changes in media usage – toward more fragmentation and less ad-friendly technologies – could place a premium on creative marketing approaches that cut through the clutter with big ideas, which is what the agencies provide. Agencies could gain as new media marketing spawns ever more Darwinian platforms and models … such as “paid-to-search.” The value of a hot prospect is substantially greater than any other target, and as technologies develop to reach hot prospects, the value of well-crafted product offers will increase correspondingly.

• Agencies should be able to add incremental revenue by “going Hollywood,” leveraging their work producing branded entertainment for clients.

• The AHCs have a resilient business model that has typically returned during economic expansions to growth in excess of GDP – at least real GDP – and 10%+ operating margins.

Bear Case for the Agency Holding Companies The bear case has teeth, however.

• Agencies risk falling into the classic trap of super-serving their core customers, at the expense of staying ahead of disruptive innovations. The focus of agencies on client service more than innovation reduces the odds of breakthrough products and accompanying returns.

• The increasing importance of tapping the consumer “groundswell” by having better systems for crowd sourcing and consumer feedback may require marketers to do more of their own consumer insight work, and rely less on agencies, as companies integrate better customer feedback loops into their product design as well as marketing operations.

• Growth in below-the-line media places pressure on the agency’s place in the above-the-line marketing value chain. The shift of spending to sales activation strategies gauged by quantitative return-on-investment could continue to reduce spending on brand-oriented strategies, where the agencies historically have had a comparative advantage. Integrated marketing campaigns may become more of a commodity, as the increasing transparency of the results of marketing will reduce the barriers to entry in marketing services. Low-cost data mining operations could enter the market, putting margin pressure on interactive marketing services.

• If more media become on-demand via a paid-search platform like the Internet, the agencies’ current business model in integrated marketing could be substantially undermined over time. The value of marketing services disciplines not related to search-based marketing could drop.

• The economics of creative advertising services could decline, as consumer-centric marketing increases the value of referrals (“social media” may be the more buzz-friendly term) and reduces the value of brand marketing. Creative agencies could see growth shrivel if spending on brand marketing shrinks as a proportion of total marketing spending. Creative margins could decline as the trend to decoupling production from creative origination continues. Some clients are developing in-house creative capabilities to better and more cost effectively adapt agency ideas to quickly changing market conditions.

• Secular trends may not lead to greater agency leverage with their clients. Clients may be more likely to push for integrated marketing campaigns than for simple consolidation of work at a single agency group.


• The increasing influence of value-based compensation models could put downward pressure on agency profits. The stress in the underlying compensation model for the agencies could make it more difficult to attract and retain talent.

Forecast Agency growth prospects still depend on GDP growth. Inflation is better for the agencies than deflation. Agency industry organic growth slightly lagged U.S. nominal GDP growth in the most recent expansion. AHC operating margins had generally been flat in the low-to-mid-double digit range over the 2-3 years prior to the current recession. For the three companies on which we initiate, which are three of the four largest players in the industry, our mean forecast for organic revenue growth is -6.1% in 2009 and +0.2% in 2010, and for change in operating margins is -130bps in 2009 and +50bps in 2010. We look for 2Q organic revenue growth to decelerate from 1Q. We sense more pessimism than optimism about 2Q and a view that an improvement in ad spending is more likely at year-end than at mid-year. The major positive is that the AHCs seem more confident in their ability to preserve margins in this recession as compared to past recessions. We believe geographic trends are the most useful way of forecasting revenue trends and, to a lesser extent margin trends, for the AHCs. Our baseline assumption is that, during the recession, in the more mature markets of the U.S., Western Europe and Japan, agency organic growth should be down 50-75% of the percentage drop in media and marketing spending. For 2009, media and marketing spending is tracking down in the high single digit percentages in the US and Europe for 2009, and down more in Japan. We expect modest positive media and marketing spending growth from the BRIC countries in 2009. We believe that tracking net new business back to the beginning of 2008 likely captures most of the important trends for purposes of our 2009-2010 outlook. Over the longer term, although AHC organic revenue should hold up better than overall media and marketing spending this year, its recovery will likely lag the upturn in the economy. Given that the majority of revenue for the AHCs still comes from North America and Europe, and that their operating margins in these regions are typically higher, we expect that over the next 2-3 years the major driver of AHC profit growth will be these more mature markets. The profit growth of the AHCs could depend more on how they exploit the shift in spending to interactive media in mature markets than on how they are positioned for the faster growth in the emerging markets. Coverage Universe: Interpublic, Omnicom and WPP Of the agency holding companies on which we initiate, Omnicom has had the highest organic growth, and is the only one whose organic revenue growth has consistently exceeded U.S. nominal GDP growth this decade. Over the past three years, Omnicom has consistently had the highest organic growth, both in the U.S. and internationally, while IPG has closed the gap with its peers. Despite having a higher mix of business from emerging markets, WPP’s organic growth has lagged Omnicom’s. On the basis of return on invested capital, Omnicom has been the best performer, and WPP’s, while solid, has lagged a bit. Compared to its peers, WPP has spent more of its revenue on acquisitions and spent more on later-stage targets, which has reduced its ROIC, in our view. IPG's recent ROIC improvement reflects divestitures of non-performing assets as part of its overall turnaround effort. We believe that the AHCs will attempt to maintain investment grade credit ratings, or at least investment grade credit profiles. In valuing the AHCs, investors typically rely on discounted cash flow, P/E and EV/EBITDA. Due to accounting changes, the P/E ratios of WPPGY, on the one hand, and IPG and OMC, on the other, have become somewhat more comparable over time. In December 2007, OMC and WPPGY both traded at a slight premium to the S&P P/E on a trailing basis. Although they now trade at a discount to the S&P, with OMC at a premium to WPPGY, we favor OMC, because we see OMC shares as the surest path to a cyclical operating and valuation recovery for the AHCs, given Omnicom’s solid near-term cost control, superior long-term growth record, and lack of M&A or leverage challenges. WPP should benefit in the near-term from its greater exposure to China and Brazil, which we expect to provide the most growth of the BRIC countries. Once clouds lift about the impact of WPP’s exposure to the U.K. and Europe on its near-term margins and growth, its valuation discount could make its ADRs compelling. In our view, while WPP digests its 2008 acquisition of TNS, it is unlikely to make any major acquisitions, although Avenue A/Razorfish is a possible wild card. Although we believe IPG’s shares could have the most long-term upside if its under-performing assets continue to close on peer levels of organic growth and margins, we are concerned about near-term deceleration in growth. IPG faces the toughest growth comparisons for the rest of 2009, and lower visibility during the recession on the margin improvement that is critical to improving IPG’s EBITDA and valuation.


INVESTMENT THESIS This year, advertising agency revenues are in their steepest decline in over 30 years. The shift over the past decade in the revenue mix of the larger agency holding companies to more rapid growing areas of the world, such as the BRIC (Brazil, Russia, India and China) countries, is undoubtedly cushioning the blow to their organic growth this year, however. The agencies’ increasing mix of business in support of digital marketing (building micro-sites, search engine optimization, managing analysis of data generated from marketing, etc.) is another buffer.

Source: Bureau of Economic Research, Company data, Advertising Age and Wedbush Morgan Securities estimates

Source: Company data and Wedbush Morgan Securities estimates

Figure 1: Comparison of Advertising Agency Industry Organic Revenue Growth to US Advertising Spending, US Nominal GDP and World Real GDP Growth, 1980-2009E

‐10.0%

‐5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

U.S. Advertising YOY Growth Agency Industry Growth

U.S. Nom GDP Growth World Real GDP Growth

Figure 2: Comparison of Geographic Revenue Mix for IPG, Omnicom and WPP, 2008

Revenue Mix by Geography, 2008

North America, 54.4% North America, 51.6%

North America, 34.8%

United Kingdom, 8.8% United Kingdom, 9.9%

United Kingdom, 12.8%

Continental Europe, 16.5% Continental Europe, 22.3%

Continental Europe, 28.5%

Asia Pacific, 9.4% Asia Pacific, 6.2%Asia Pacific, 14.4%

Other, 10.9% Other, 9.9% Other, 9.6%

IPG OMC WPP

North America United Kingdom Continental Europe Asia Pacific Other

This year, advertising agency revenues are in their steepest decline in over 30 years



Recessions have typically sparked important changes in advertising agency industry structure and/or terms of trade. Out of the 1991-92 recession arose the large agency holding companies and an increased focus on offering marketing services. Out of the 2001-02 recession arose increasing scrutiny of agency compensation by client procurement teams and a growing focus on integrated marketing. Now, the increasing speed of changes in marketing, combined with the recession, could either 1) increase the value of agencies as expert intermediaries, or 2) result in disruptive changes that reduce the agencies’ role in providing marketing and communication planning insights. Thus, in addition to laying out the broader investment case for the agencies, in this report we will describe a likely base case for the agencies in and after this recession, then a more bullish scenario, and finally a more bearish scenario. These scenarios correspond to the forecast and valuation scenarios on which we base our recommendations for the shares of the three companies on which we initiative coverage, those of Interpublic (IPG - Hold), Omnicom (OMC - Buy), and WPP (WPPGY - Hold).

Although this deep recession is in some ways the worst of times for the advertising agencies, we believe their core disciplines in media planning and buying and marketing services are safe for the foreseeable future. In our view, this is a fundamental competitive and investment advantage of the agencies relative to media companies primarily wedded to a particular media platform (e.g., cable TV or radio). As the CEO of WPP, the largest agency holding company, has stated, the agencies’ “job as purveyors of media investment options will remain valuable to our clients, provided we are not excluded from any single powerful technology and have the talent to analyze the media options.” Omnicom’s CEO has observed that the fragmentation of audiences “make[s] it increasingly more difficult for marketers to reach their target audiences in a cost-effective way, causing them to turn to marketing service providers such as Omnicom for a customized mix of advertising and marketing communications services designed to make the best use of their total marketing expenditures.” Although agencies historically have had lower operating margins than many platform-dependent media companies, freedom from platform dependence makes their role in the value chain more secure, especially in this time of rapid change in media usage and marketing models.

Spending on marketing services will benefit in particular from the increasing use of digital and interactive channels (e.g., mobile). In these rapidly changing and growing areas, there is more need for agency advice on creative (e.g., setting up micro-sites, integration with social media), data collection across multiple platforms, and analysis of this data to obtain actionable recommendations for how marketing campaigns should be launched and adjusted.

Figure 3: Comparison of Revenue Growth Contribution by Geography for IPG, Omnicom and WPP, 2008

Revenue Growth Contribution Mix by Geography, 2008




United Kingdom, ‐10.3% United Kingdom, ‐4.0%

Continental Europe, 19.6%Continental Europe, 41.4%



IPG OMC WPP

North America United Kingdom Continental Europe Other

Recessions have typically sparked important changes in the advertising agency industry

Core media planning/buying and marketing services disciplines are safe for the foreseeable future

Marketing services will benefit from increases in spending on interactive channels


Figure 4: Top 50 Agency Companies Worldwide

2008 2007 AGENCY 2008 2007 % CHG 2008 2007 % CHG 2008 2007 % CHG1 2 WPP $13,598 $12,383 9.8 $4,735 $4,538 4.3 $8,864 $7,846 132 1 Omnicom Group 13,360 12,694 5.2 6,890 6,704 2.8 6,470 5,990 83 3 Interpublic Group of Cos. 6,963 6,554 6.2 3,786 3,651 3.7 3,176 2,903 9.44 4 Publicis Groupe 6,900 6,393 7.9 2,946 2,760 6.7 3,954 3,633 8.85 5 Dentsu* 3,296 2,932 12.4 111 110 1.1 3,185 2,823 12.86 6 Aegis Group* 2,490 2,215 12.4 504 512 ‐1.6 1,986 1,703 16.67 7 Havas 2,307 2,094 10.2 702 694 1.1 1,605 1,400 14.78 8 Hakuhodo DY Holdings* 1,560 1,392 12.1 NA NA NA 1,560 1,392 12.19 9 MDC Partners 585 534 9.5 485 427 13.6 99 107 ‐6.910 11 Asatsu‐DK 503 454 10.8 4 3 38.4 499 451 10.6

11 10

Alliance Data Systems (Epsilon) 491 469 4.8 461 440 4.7 31 29 6.6

12 12 Media Consulta 427 415 3.1 32 49 ‐33.9 395 366 8

13 13 Microsoft Corp. (Razorfish) 409 368 11.1 317 299 6 92 69 33.314 15 Photon Group* 383 314 21.9 NA NA NA 383 314 21.915 14 Carlson Marketing* 367 349 5.1 265 253 4.8 102 96 616 16 Cheil Worldwide 340 300 13.4 31 27 14.6 308 272 13.3

17 17 IBM Corp. (IBM Interactive)* 313 278 12.6 205 188 9 108 90 20

18 19

Sapient Corp. (Sapient Interactive) 306 241 27 211 166 27 95 75 27

19 26

inVentiv Health (inVentiv Communications) 280 204 37.1 238 184 29.4 42 21 105

20 22 Grupo ABC (ABC Group) 280 228 22.6 4 NA NA 276 228 20.721 20 STW Group 256 235 9 NA NA NA 256 235 922 25 LBi International 241 211 14.2 47 28 68.5 194 183 623 23 Clemenger Group 239 220 8.5 NA NA NA 239 220 8.5

24 24

Cossette Communication Group 238 218 9.6 20 17 15.1 218 200 9.1

25 18 George P. Johnson Co. 238 256 ‐7 162 188 ‐13.8 76 67 12.126 21 Aspen Marketing Services 213 233 ‐8.8 213 233 ‐8.8 0 0 NA27 29 Merkle 211 181 16.8 211 181 16.8 0 0 NA28 36 Wieden & Kennedy* 204 165 23.7 108 90 20.7 96 75 27.229 27 Chime Communications 203 193 5.2 4 3 74.6 199 191 4.330 31 Mosaic Sales Solutions 199 175 13.6 128 121 5.5 71 54 31.731 33 Commarco Holding 197 172 14.4 NA NA NA 197 172 14.432 37 M&C Saatchi 189 164 15.2 7 7 ‐2.3 182 157 16.1

33 38 Serviceplan Agenturgruppe 189 149 27 NA NA NA 189 149 2734 28 Harte‐Hanks Direct 183 182 0.9 178 182 ‐2.3 6 0 NA35 30 Doner 182 176 3.1 169 164 3 13 12 4.236 34 Richards Group 169 168 0.5 169 168 0.5 0 0 NA37 32 Bartle Bogle Hegarty* 169 174 ‐2.9 42 43 ‐2.3 127 131 ‐3.138 39 Tokyu Agency 165 148 10.9 NA NA NA 165 148 10.939 40 Creston 146 139 4.7 0 1 ‐23.5 146 139 4.840 41 Cramer‐Krasselt 145 137 5.6 145 137 5.6 0 0 NA41 42 AKQA 140 128 9.4 140 128 9.4 0 0 NA42 35 Media Square 136 168 ‐18.6 11 13 ‐13.6 125 154 ‐1943 43 Marketing Store 135 127 6.8 42 45 ‐7.1 93 81 14.644 49 Rosetta 130 96 35.1 130 96 35.1 0 0 NA45 48 iCrossing 122 100 22.4 120 98 22.4 2 2 18.246 46 Derse 121 109 11.2 117 106 9.8 4 2 76.447 44 RPA 119 119 ‐0.3 119 119 ‐0.3 0 0 NA

48 50

D.L. Ryan Cos. (Ryan Partnership) 109 94 15.1 107 92 15.8 2 2 ‐14.6

49 59 FullSix 108 74 45.3 5 2 164 104 73 42.6

50 47

TMP Worldwide (Veronis Suhler Stevenson) 102 107 ‐4.1 75 87 ‐14 27 19 41.1

Source: Ad Age DataCenter

Ranked by 2008 worldwide revenue from companies' agencies and related services. Dollars in millions. Asterisk (*) indicates estimate.RANK WORLDWIDE REVENUE U.S. REVENUE REVENUE OUTSIDE THE U.S.


For different reasons, we do not fear for the survival of media planning and buying. Marketers continue to demand agencies’ media services, given the increasing complexity from 1) planning and buying digital channels, even on a stand-alone basis (e.g., SEO and SEM), 2) the trend to integrated marketing campaigns, requiring analysis of both traditional and digital metrics, and 3) the trend to quantitative analysis of branding (to counterbalance the shift in focus to short-term return-on-investment (ROI) facilitated by new media like search), which could benefit from the integration of market research/analytics with the data warehouses that can be generated by media planning and buying operations.

We believe that the outside creative agency’s role is safe for the foreseeable future, although its profitability may be more threatened. If brand cycles are growing longer, and product cycles are growing shorter, as WPP among others assert, then the value of branding may be increasing, which would be good for the agencies. The agencies could shift their focus back more to being brand stewards, and sell the economies of scale in expertise in branding in a landscape of more fragmented media, more niches of consumers, and more digital data to crunch. Many creatives – and a disproportionate share of the best - prefer to work on more than one account at a time, only possible at agencies and large, many-brand clients (e.g., Procter & Gamble). Although the value of the ‘big idea’ may be relatively smaller in a more fragmented, interactive, and measurable media world, we still expect marketers to look for these big ideas from their agencies, just like studios continue to look for ‘blockbuster’ franchises from the Hollywood creative community.

At this juncture, the main similarities in agency group strategy are 1) increased investment in staff and infrastructure to offer digital marketing services to large clients, to strengthen the agency’s ability to offer integrated marketing services, 2) increased investment in emerging markets, where GDP and marketing spending growth should be greater, 3) continued focus on more efficiently matching resources to scope of work (e.g., reducing the number of agency offices involved in servicing a multi-national campaign), and 4) cost reduction, such as through outsourcing. We believe that the revenue mix by discipline and the outlook for revenue growth and margins by discipline will be the major driver of agency holding company performance in the developed markets (primarily the U.S., Western Europe and Japan), while the revenue mix by geography and the outlook for GDP and marketing spending growth will be the major driver of performance globally.

Agencies have increased their exposure to faster-growing marketing services as one strategy to exceed the growth in so-called above-the-line (ATL) media. “Above-the-line” refers to those traditional marketing channels that strive to reach a mass audience with messages that reinforce a brand, communicate general product information or inspire an emotional response. Agencies generate their revenue – primarily fees, at this point – from being hired to manage advertising, aka ATL, campaigns as well as marketing services, aka below-the-line (BTL), campaigns. “Below-the-line” initiatives, by comparison, act like traditional direct marketing efforts – they aspire to establish targeted relationships between marketers and individual consumers, and offer comparable ease in measurability. BTL spending has been increasing faster than ATL spending, in part because much spending on digital media is classified as BTL. Another reason is that pricing on network television, the largest part of ATL spending, has been increasing faster than the rate of inflation, giving marketers additional incentive to look for more cost-effective marketing channels. Media fragmentation should continue, increasing the relative advantage of targeting, which is the strength of both traditional marketing services disciplines as well as digital media.

Figure 5: Spending On Below-The-Line Marketing Is Growing Faster Than Above-The-Line Above Line vs. Below Line Marketing

2001‐2005 CAGR 2006‐2010 CAGRNon‐Internet Media Advertising 3.6% ‐11.8%Internet 12.8% 22.1%Direct Marketing 15.1% 1.1%Consumer Promotion / Incentives 5.1% ‐4.1% Below‐the‐Line DoingTrade Promotion 8.8% ‐0.1% Better than Non‐Internet MediaEvent Marketing/PR/Other 10.2% 0.6%

Source: Jack Myers Report, VSS, and Wedbush Morgan

Agencies are focused on expanding in digital and emerging markets for the future, while cutting costs to match reduced fees and scopes of work in the present

Agencies have increased their exposure to below-the-line marketing services

The outside creative agency’s role is safe for the foreseeable future, although its profitability may be more threatened

Media planning and buying should benefit from the trend to marketing campaigns integrating online and offline


Source: Advertising Age and Volkswagen The challenge for the agencies’ businesses in ATL is not simply the slower growth of this segment of the market, especially in developed economies, but the pressure on the agency’s place in the ATL marketing value chain. Many agencies maintain that, even in digital media, creative agencies (e.g., like Doyle Dane Bernbach, the architects of VW’s “Think Small” campaign) are still in the best position to be brand stewards and still the best equipped to create the short-form, micro-versioned content that may be increasingly needed in interactive campaigns. We believe that these advantages are lower in digital media than traditional, however, and that the competitive position of creative agencies is likely to suffer as a result. The share of media and marketing spending of GDP has remained relatively stable, suggesting that agency growth prospects will not depend substantially on their mix of ATL and BTL services. Per data from GroupM, media and marketing spending’s share of world GDP declined marginally to 1.46% in 2007 from 1.50% in 2001. The trend varies by geography, but not dramatically. For example, in the fast-growing Asia Pacific region, media and marketing spending’s share of GDP increased to 1.16% from 1.08% from 2001-2007. In North America, media and marketing spending’s share of GDP increased to 1.89% from 1.81% from 2001-2007. By contrast, in Europe, media and marketing spending’s share of GDP decreased to 1.35% from 1.54% from 2001-2007.

Figure 6: Volkswagen - “The Campaign of the Century” per Advertising Age

Growth in below-the-line media places pressure on the agency’s place in the above-the-line marketing value chain

Agency growth prospects still highly depend on GDP growth


In addition to looking for growth from BTL and digital marketing spending, the agency groups are looking to boost their organic growth and margins from their increasing mix of business from markets outside of the U.S., Western Europe and Japan. Of the three companies on which we initiate, WPP has the highest mix of revenue from emerging markets. We believe that, in general, the share of profit from emerging markets is below the share of revenue from these markets for all the agency holding companies, given that the AHCs are investing to build their operations in those regions, and thus generating lower margins.

Source: Company data and Wedbush Morgan Securities estimates Of the agency holding companies on which we initiate, Omnicom has had the highest organic growth, averaging roughly 400bps higher than real GDP growth this decade.

Figure 7: WPP’s Revenue Mix Is More Balanced By Geography










IPG OMC WPP


Figure 8: Omnicom Has Grown The Fastest Organically, While Both Omnicom And WPP Have Grown Faster Than U.S. And World Real GDP Comparison of organic revenue growth of IPG, OMC and WPPGY to US and world advertising growth

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009E 2010E 2000‐08 2000‐10E

US Real GDP 3.7% 0.8% 1.6% 2.5% 3.6% 3.1% 2.9% 2.0% 1.3% ‐2.0% 2.9%World Real GDP 4.2% 1.7% 2.0% 2.5% 4.0% 3.4% 4.0% 3.8% 2.5% ‐1.7% 2.3%

OMC 16.6% 8.4% 1.7% 4.6% 6.7% 7.3% 7.6% 7.1% 2.9% ‐5.5% 0.3% 6.9% 5.1%OMC‐US 13.0% 7.6% 0.1% 2.1% 3.1% 4.2% 4.7% 5.0% 1.6% ‐3.5% ‐2.6% 4.6% 3.1%OMC‐World 12.5% 6.7% ‐0.3% 2.1% 2.7% 3.9% 3.6% 3.3% 0.5% ‐3.8% ‐2.0% 3.8% 2.6%

WPP 15.0% ‐3.0% ‐5.9% 0.7% 4.0% 5.6% 5.4% 5.0% 2.7% ‐6.2% 1.2% 3.1% 2.1%WPPGY‐US 11.3% ‐3.8% ‐7.5% ‐1.8% 0.4% 2.5% 2.5% 3.0% 1.4% ‐4.2% ‐1.7% 0.8% 0.1%WPPGY‐World 10.8% ‐4.7% ‐7.9% ‐1.8% 0.0% 2.2% 1.4% 1.2% 0.2% ‐4.5% ‐1.1% 0.1% ‐0.5%

IPG 12.5% ‐2.9% ‐3.0% ‐3.0% 1.2% ‐0.7% 1.0% 3.8% 3.8% ‐6.5% ‐1.0% 1.3% 0.4%IPG‐US 8.8% ‐3.7% ‐4.6% ‐5.5% ‐2.4% ‐3.8% ‐1.9% 1.8% 2.5% ‐4.5% ‐3.9% ‐1.1% ‐1.6%IPG‐World 8.3% ‐4.6% ‐5.0% ‐5.5% ‐2.8% ‐4.1% ‐3.0% 0.1% 1.3% ‐4.8% ‐3.3% ‐1.8% ‐2.2%

Source: Company data, WARC, Wedbush Morgan Securities estimates

CAGR

Agency groups seek boost in organic growth and margins from emerging markets

Of the agency holding companies on which we initiate, Omnicom has had the highest organic growth


Investors sometimes contrast the focus of Omnicom on building with the focus of WPP, Omnicom’s peer at the top of the industry revenue table, on buying. Building operations (such as a new office in an emerging market) can take longer than buying, but the strategy can also result in higher organic growth, because it captures more of the faster, early stage growth than does the building strategy.

Figure 9: Omnicom Is The Only AHC In Our Coverage to Have Grown Faster Than U.S. Nominal GDP Growth This Decade

Source: Company reports, Economic Research Service, World Bank, and Wedbush Morgan Securities

Comparison of Organic Revenue Growth to US Nominal GDP Growth for IPG, OMC and WPP, 2000‐2008

‐10.0%

‐5.0%

0.0%

5.0%

10.0%

2000 2001 2002 2003 2004 2005 2006 2007 2008

OMC‐US Nominal GDP WPPGY‐US Nominal GDP IPG‐US Nominal GDP


Agency holding company operating margins were generally flat over the 2-3 years prior to the current recession, despite an increasing mix in recent years of agency revenue from 1) new media disciplines, where clients consider themselves particularly in need of expertise, and 2) faster-growing emerging markets, where many multinational companies are committed to building their brands over the long term. We believe that the increased transparency of agency compensation has generally put downward pressure on margins from some of the agencies’ core traditional disciplines and geographies. The outlook for moving margins higher on the back of increasingly accurate measurement of the contribution of agency work to clients’ sales and key performance indicators (KPIs) is unclear. On the one hand, some agencies seem to welcome a shift in compensation mix to more pay-for-performance (p4p). On the other, the industry has spoken about increasing use of pay-for-performance for well over a decade, and these business models have not gained substantial traction. Fundamental challenges are that agency work that has a clear sales impact does not necessarily generate the highest margins, while the impact of work aimed at increasing demand elasticity still seems difficult to quantify, and thus compensate on a p4p basis. Changes in agency compensation set during this downturn could put a crimp in profit growth thereafter. On the one hand, some marketers could be using the recession as leverage to set stricter terms on matters like scope of work, pay-for-performance (i.e., putting more of the agency’s margin at risk), and payment terms (i.e., lengthening them). In this case, deals done in this environment could have a longer-term impact, simply because they could outlast the recession. On the other hand, some marketers could be expecting a more sustained period of reduced marketing budgets, and be planning to grandfather more favorable terms obtained now into future deals regardless of a recovery. Either way, these trends suggest that agencies may have to deal with slower growth for a matter of years, not months, and plan to improve margins by increasing operational efficiency. Although all businesses face trade-offs between growth and profitability, we think the choice between the two will become more important for the agencies during and after the recession. Large marketers that cut budgets end up cutting fees, requiring agencies to reduce scopes of work. Although an agency can manage reductions of scope of work to be margin-neutral, the entire process usually reduces the agency’s revenue

Figure 10: “Build” Strategy Can Help Organic Growth, While “Buy” Strategy Offers First-Mover Advantages Hypothetical comparison of buy vs build strategy

Year =>: 1 2 3 4 5 6 7 8 CAGRCompany ACore revenue 100.0 105.0 110.3 115.8 121.6 127.6 134.0 140.7 Growth 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%Incremental revenue 1.0 2.5 5.0 7.5 9.0 10.0 10.8 Growth NM 150.0% 100.0% 50.0% 20.0% 11.0% 8.0% 48.6%

Reported = Organic revenue 100.0 106.0 112.8 120.8 129.1 136.6 144.0 151.5 Organic growth 6.0% 6.4% 7.1% 6.9% 5.9% 5.4% 5.2% 6.1%

Company BCore revenue 100.0 105.0 110.3 115.8 121.6 127.6 134.0 140.7 Growth 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%

Acquisition revenue 10.0 10.8 11.3 11.9 12.5 13.1 13.8 Growth NM 8.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.5%Reported revenue 100.0 115.0 121.0 127.1 133.4 140.1 147.1 154.5Pro forma adjustment 9.0Organic revenue 109.0 115.0 121.0 127.1 133.4 140.1 147.1 154.5 Orgranic growth 5.5% 5.3% 5.0% 5.0% 5.0% 5.0% 5.0% 5.1%

AssumptionsCompany A and Company B have the same revenue base in year 1Company A pursues build strategy, shown as incremental revenueCompany B pursue buy strategy, shown as acquisition revenue after acquisition in year 2We assume the incremental revenue of the build strategy in year 7 equals that of the buy strategy in year 2

ConclusionsCompany B has a slightly larger revenue base in year 8, reflecting its earlier entry into the new marketCompany A has higher organic growth (6.1%) than Company B (5.1%)

The better strategy is the one that produces the higher ROIC, not the higher organic growthSource: Wedbush Morgan Securities

Organic growth lift for Company B at time of acquisition in year 2 is reduced by including the acquisition's year 1 results in its pro forma base

Agency holding company operating margins were flat over the 2-3 years prior to the current recession

Changes in agency compensation set during this downturn could put a crimp on future profit growth


base, and generally its profit (e.g., a similar margin on a smaller revenue base) and staffing. We believe some large advertisers, such as Pfizer, are systematically reducing scopes of work to improve marketing efficiencies. Even if the agencies can leverage the scale of producing an end-to-end solution for larger clients, such as by off-shoring where appropriate, and maintain or even improve their margins, the total fee and profit could fall. We also hear of pitches where all of the agency’s profit margin is ‘at risk,’ that is, subject to meeting some pay-for-performance metrics. Thus, agencies must seek to increase their profits on a risk-adjusted basis as well. Some agency executives doubt that value-based compensation (VBC) schemes have any greater chance of traction now than when they surfaced over a decade ago. In their VBC proposals, marketers have generally been unwilling to give agencies greater intellectual property rights or a higher p4p target than the agency’s current profit margin, and as a result the agencies balk. Some agency execs believe that P&G has most rational approach on agency compensation. P&G is moving to appoint “brand agency leaders” as single points of contact for a brand’s marketing, and compensation is a mix of sales commission and value-based compensation.

The agencies face three principal sources of disintermediation: 1) their clients, who can bring work in-house or outsource more of it to non-agency vendors, 2) media companies, which can offer marketing services, leveraging the consumer insights they can gain from the data coming from their media platforms, and 3) major interactive marketing services providers, which have vast stores of data on consumer behavior online, and increasingly elsewhere. Secular trends may favor agency holding companies over smaller competitors, but not necessarily the holding companies’ leverage with clients. We believe clients are increasingly using integrated marketing campaigns, and that best practices support this shift. This approach can benefit from having a large agency to coordinate multiple marketing channels in many markets. Some agency execs, including IPG’s management, for example, believe that consolidating the roster of agencies working on an account can lead to greater efficiencies in delivering services. Some trends may favor longer agency-client relationships, from which agencies could benefit. First, for marketers, there is evidence that the more valuable brands have longer-term agency relationships. Now, the average tenure of chief marketing officers (CMOs) has been trending down over the past several years, standing now at roughly two years. A change in CMO is a typical catalyst for an agency review, and a potential change of agency. For agencies of all sizes, the trend has been for client tenure to decrease. For agencies, clients with shorter tenure have tended to be less profitable. Recent data suggests that CMO tenure could now be showing signs of reversing its long-term downward trend. If CMO tenure increases, it could lead to longer tenure in client-agency relationships, which we believe is generally favorable for agency economics. On the other hand, over time, the agency’s position as brand steward could be weakened if CMOs with longer tenure are given the mandate and resources to build out more in-house creative and analytic capability. The increasing importance of integrating marketing communications into the company’s strategy would suggest that CMOs need a longer horizon for developing marketing communications strategies. Spencer Stuart's annual survey of CMO tenure at the 100 most advertised brands in the U.S. reveals average time on the job rose to 28.4 months in 2008 from 26.8 months in 2007 and 23.2 months in 2006. If the recession speeds the shift of CMOs to being more facile with finance and marketing analytics, the recession could position CMOs for even more gains in tenure. Already, CMOs with backgrounds in sales or with responsibility for product P&L have higher average tenure than those with traditional marketing and communications backgrounds. We believe that, on balance, clients will be more likely to push for integrated marketing campaigns, rather than a simple consolidation of work for campaigns at a single agency group. We do not sense a strong trend to consolidating business with a single holding company. Some clients are willing to appoint smaller agencies be the brand leaders, managing the work of networks affiliated with the larger groups. Other clients prefer to have agencies compete for work at the local level as a competitive check. Per a recent Association of National Advertisers survey, the trend in some growing disciplines, such as digital marketing, has been for clients to use more, not fewer, agencies. Large marketers are 1) shifting to more use of outside agencies in managing digital campaigns, 2) engaging a greater number of digital agencies (in a recent ANA survey, 42% used 5+ digital agencies, up from 23% in 2007), and 3) shifting spending to best-of-breed digital agencies unaffiliated with holding companies, although this may cycle back. Clients are more interested in hiring best-of-breed agencies, and having them collaborate, than hiring one super-agency as a one-stop shop. Many of the best-of-breed digital agencies are in fact independents.

Agencies face three principal sources of disintermediation: 1) their clients, 2) media companies, and 3) major interactive marketing services providers

Secular trends may lead to longer agency-client relationships, but not necessarily greater agency leverage with their clients

We believe that clients are more likely to push for integrated marketing campaigns than for simple consolidation of work at a single agency group


That said, undoubtedly some clients, to improve efficiency in their integrated marketing communications, are consolidating their marketing relationships with a smaller number of service providers. This favors the large holding companies. Indeed, some large accounts (e.g., spending annually $1.5bn on marketing and $150m in agency fees) require the creation within the agency holding company of a customized agency. One of the top services marketers demand of agencies is consumer insight, which helps marketers choose the proper equilibrium for their brands between micro-targeting, which requires a high degree of customization, and mass reach vehicles, which inherently include wasted spending. Digital platforms and data continue to shift the marketer to targeted campaigns away from mass-reach campaigns traditionally designed by agencies. Improvements in data analytics and in versioning of marketing messages will increase the economically viable scale of targeting campaigns, and agencies must look for growth here to offset declines in business elsewhere. In this context, in digital marketing the consumer data being collected by advertisers and publishers is in many cases more valuable than the advertising itself. WPP has stated that the greatest benefit of scale in media planning and buying is not the ability to get lower prices per se, but rather to collect the most data and have the scale to warrant the investment in the analytics to produce the most valuable competitive insights for its clients. Those with the most actionable online data can add the most in the marketing value chain. The Big 4 online companies -- Google, Yahoo, AOL and Microsoft – collect a lot of consumer data by means of their search engines, ad networks, behavioral-targeting firms, and ad servers. The strategy of some agencies, such as WPP, rests on a view that the integration of data analytics and market research can create an enduring place for agencies in the interactive marketing value chain. Through GroupM, WPP has the largest concentration of ad dollars spent in the online world, which it believes entitles it to the largest share of advertising-derived data. An open issue is whether, as in other areas of business, the sales payoff from data mining (e.g., beer sales often spike with diaper sales) will become more important than “fundamental” research into consumer behavior that can lead to creative marketing (e.g., “Just Do It”). Who owns what online data is not a settled issue. We think disputes over data ownership are proxy battles in the larger war over position in the data analytics value chain. Until recently, ad networks used the data from their networks somewhat freely. We expect further guidance on data ownership the issue from the Interactive Advertising Bureau and the American Association of Advertising Agencies later this year.

The threat to the agencies is that the shift of spending to ROI-driven activation strategies, which are substantially facilitated by search, will reduce spending on brand-oriented strategies where the agencies have a comparative advantage and potentially adversely change the agencies’ business model. Google is not an advertising agency, and it does not seek to displace the agency as ‘brand priest’ per se. However, by controlling a major marketing platform, Google controls how agencies service their clients, affecting the development of the agencies’ business model. Google’s paid-search listings are not fully transparent, in that the rankings are based on auctions that are adjusted by proprietary algorithms that assess user experience after clicking on the link for the paid listing. Google’s algorithms in organic and paid search influence branding and activation strategies. They were a catalyst for the entire search engine optimization and search engine marketing industries. The situation has parallels in the development of prior marketing platforms, like television. By establishing the 30-second spot as the standard format for network prime time, the TV networks influenced the focus of the agencies’ creative and media efforts. Although the TV networks never sought to compete with the agencies per se, their decisions regarding their platform – albeit with agency involvement - had an important influence on the agency business model. In our view, agencies have not captured an important place in the search marketing value chain, and the spread of search to more platforms could erode the value of their media planning and buying operations, which have consistently been among their highest-margin disciplines. Agencies were late-comers to specialty of search engine marketing, and we believe they have less advantage in search engine marketing than in designing traditional advertising campaigns. The spread of high-speed digital content delivery could make more media available on an on-demand basis on a wider variety of platforms, including mobile. This could increase the value of search marketing, and reduce the value added by agency specialists, just as it has in the online platform. Now, the agencies have an opportunity to advise marketers not only on search strategy, but on broader issues of attributing the effectiveness of search both among online channels and in the more complicated case of integrated marketing campaigns. Complaints from marketer about the lack of transparency in Google’s natural and paid search suggest some demand for agency services in this area. That said, exploiting this opportunity will likely involve more competition with the Big 4 online companies, which are

The strategy of some agencies rests on a view that integration of data analytics and market research can create an enduring place for agencies in the interactive marketing value chain

The shift of spending to ROI-driven activation strategies could continue to reduce spending on brand-oriented strategies, where the agencies have a comparative advantage

The focus of agencies on client-service more than innovation reduces the odds of breakthrough products and accompanying returns


acquiring technology to support their core revenue channels and combining their display, search and affiliate marketing assets into integrated online advertising solutions, provide creative and planning tools for advertisers. Competition in this area could limit growth and margin expansion opportunities for the agencies. The eternal return: agencies are not plays on technology, and that has a downside as well as an upside, as their focus on client-service over innovation reduces the odds of breakthrough products and accompanying returns. As a result, we are skeptical that agencies can build competitive advantages in digital that are more sustainable than those they have had in traditional advertising. For example, some media planners say the key driver of their plans is changing media usage patterns of the audience. However, focusing on the relationship between marketing spending and media usage would have led you to miss the most important development in marketing this decade – paid search. Paid search accounts for a small portion of media usage online (<5% of page views), much less of total media usage online and offline. Rather, paid search was important because it reallocated marketing spending across the traditional purchase funnel, more to reaching users who identified themselves as interested in a particular topic.

BULL CASE: YES, WE CAN

Changes in media usage, magnified by changing demographics, could place a premium on creative marketing approaches. Creative agencies are adapting to the increasing need for digital creative and micro-versioning of creative to serve a much wider variety of platforms and demographics than in traditional media. For example, we agree with WPP that the digital video recorder (DVR), and the proliferation of low-interruption channels (like online video), will put more pressure on network TV and agencies to develop better programming and sponsorship opportunities. WPP management has also observed that “media fragmentation, overproduction, commoditization, and Big Retail will make branding and product differentiation crucial.” As one of an agency’s historical core competencies has been as brand steward, an increased focus on brand value creation could be bullish for the industry. The trend appears to be to more outsourcing of media functions to agencies, not less, particularly from larger clients. Brief CMO tenures may aggravate the challenge marketers have in developing the in-house infrastructure to support a more data-intensive marketing strategy, built on better insights into the company’s core consumers from the explosion of data that is becoming available from online and other digital platforms. The fragmentation and rapid changes in media channels make developing an integrated marketing plan more difficult, increasing the importance of agency expertise. An agency can save both marketers and media companies a lot of time in crafting media plans. Marketers do not have the time to listen to an increasing number of pitches from media sellers, and media companies do not have the resources to staff their increasing number of outlets for direct outreach to marketers. Agencies should be the bridge.

We believe that clients have been more likely to consolidate their media planning and buying accounts than their creative and digital accounts, which could favor the agency holding companies. The large agency holding companies can benefit from economies of scale in planning and buying. WPP, with the largest media business, could gain the most from this trend. Agencies should be able to add incremental revenue by “going Hollywood” - becoming co-producers of branded content for use on multiple platforms. Some agency execs have predicted to us that some advertisers will be spending roughly half their marketing budget on branded content in the next 2-3 years. Although film/TV production company margins have historically not been particularly high, and the volatility of results has further detracted from the investment case for such companies, a branded content production model might not be dilutive to agency operating margins (only 10-15% in recent years), and risks could be reduced through partnerships with client brands. Although we believe this business model could be complicated, we do not doubt that agencies will invest to capitalize on branded entertainment’s likely gains in share of the marketing spend. Large clients may increasingly prefer to manage search and other online strategies through agencies as part of integrated marketing campaigns, and thus a shift in budgets to digital may pose less of a revenue risk to the agencies. The bigger the ad campaign, the more data are generated. Agencies could capture value by developing the standards and tools to give better insights to clients on cross-channel (both digital and analog) attribution of impact on sales or other key performance indicators to marketing messages. Advising on strategies for integrating search into integrated campaigns could be particularly important, because search is likely to continue to gain share of marketing spending. Two particular opportunities seem ripe for the agencies: 1) developing better attribution of KPI impact to search than the so-called “last ad” standard,

Changes in media usage could place a premium on creative marketing approaches

There appears to be to more outsourcing of media functions to agencies, not less

Agencies should be able to add incremental revenue by “going Hollywood”

Agencies may have an opportunity to improve marketing ROI by shifting the marketing mix away from search


which many advertisers believe leads to too much spending on search marketing; and 2) leading the way in developing the analytical tools to manage integrated campaigns as they encompass other, potentially powerful platforms, including interactive and/or addressable television (e.g., Project Canoe) and mobile (what it lacks in screen size and web interactivity it makes up for with ubiquity). Microsoft, although not unbiased, has argued that more detailed attribution of performance of online campaigns results in a higher value of advertising networks, for example, and a lower value of search engines and affiliate networks, as compared to attribution under the “last ad” reporting standard (where most of the impact is attributed to the last site before conversion).

Source: Microsoft Atlas Institute Agencies could capitalize on a surge in marketing campaigns in response to some potentially important cyclical and secular changes in consumer behavior. There is a chance that there will be a larger-than-usual increase in corporate branding advertising coming out of this recession, which should benefit the advertising agencies. First, changes in consumer behavior in response to this recession actually vary widely, as a recent global survey by M&C Saatchi indicates. A central point of the research – based on a global consumer survey – is that consumers are adjusting their spending plans in this recession in a wide variety of ways. Tailoring marketing messages to account for these differences could mean increased work for advertising agencies. Second, certain industries have particular issues to address as a result of this recession. I do not know about you, but “Citi” does not mean the same thing to me now as it did a year ago. Third, there are secular changes – there always are – which marketers will have to address with marketing campaigns after the recession, such as increased savings rates and the movement to purchase “green” products and services. Driving my Chevy to the levee means I cannot use the HOV lane like my buddy in the Prius.

Figure 11: Research Suggests That Marketers Attribute Too Much Value To Search Engine Listings


Source: M&C Saatchi and Wedbush Morgan Securities There are two important platforms where the agencies may be able to make up some of the ground they have lost to Google in search and data analysis: television and mobile. • First, addressable TV advertising, if it takes hold, could become an area of particular opportunity for the

agencies. This is because 1) addressable TV affects the largest single pool of advertising spending – TV, and 2) it is a platform from which search engines like Google are currently excluded by the cable MSOs. The cable MSOs are in the midst of launching their Project Canoe platform, which should generate data on response rates to targeted TV ads, which could be cross-referenced with other data, such as online browsing, household/viewer demographics, and purchasing behavior. The CEO of Project Canoe said last fall that he expected half of TV advertising over cable could be advanced (addressable or interactive) in three years. WPP has indicated publicly a particular interest in addressable TV, although we assume all the agency groups are exploring it. WPP has invested in Visible World and INVIDI, two important technology providers in the area of addressable TV advertising. We do not believe that addressable TV will be a substantial catalyst for cable TV advertising or the agencies in the next 1-2 years, however, because 1) industry initiatives are more likely to focus initially on interactivity, not addressability, and 2) based on discussions with numerous agency and media execs, the magnitude of the upside from better-targeted TV ads is not clear.

• The second platform, mobile, is controlled by another set of telecom infrastructure providers. The

agencies may be able to leverage their global scope and learnings in providing mobile marketing services. This is of particular importance given the agencies’ geographic focus on emerging markets and the growth of the mobile phone platform in these markets.

Agencies may have an opportunity to improve marketing ROI by shifting the marketing mix away from search. Some, such as IPG and WPP, believe that as marketers use the increasing amount of data available to assess the return on integrated marketing campaigns, there may be some shift in spending back to more traditional media channels. In our view, where agencies are more likely to add value is advising better allocation of spending to platforms other than search. Agencies can add value by directing the development of standards and systems that allow for better cross-channel attribution, particularly in campaigns involving both online and offline assets. There is evidence that marketers allocate too much spending to search, because it is used as a navigational tool to e-commerce sites or even to offline locations. Thus, search may receive too high an attribution of sales impact because of the so-called ‘last ad standard,’ described at a recent conference as akin to attributing all the sales impact of a beer marketing campaign to the “Budweiser” neon sign hanging behind the bar. Microsoft, for example, makes this point with its line ‘engagement mapping’ line of research, and claims that 71% of total sponsored search clicks are navigational in nature. To the extent that agencies can parse the value of money spent on search marketing from search’s role as a mere navigation tool, they may be able to justify a greater spend on other new and traditional media. As agencies have an advantage in offline data, they could extend these insights to give better recommendations on integrated campaigns.

Figure 12: Mix Of Consumer Spending Attitudes In Recession Typology % of Adults Description and Behavior Patterns

Crash Dieters 26% Crash‐dieters aim to cut out all non‐essential spending until things improve. Debt clearly frightens them (or is unavailable to them). They live from week to week and when the money runs out they're forced to take quite drastic action.

Abstainers 15%

Abstainers want to maintain their lifestyle and so haven't completely stopped spending on day to day items. Their response however has been to postpone big purchases until the situation improves. This group has not started budgeting or chasing the lowest prices, and are relatively unmotivated by coupons and ‘money off' deals. They are, however, open to anything that allows them to have their cake now, but pay for it later. Interest free credit, nothing to pay until 2010, 0% credit cards and balance transfers are all offers that fall neatly into this camp.

Scrimpers 13%Scrimpers want to maintain their lifestyle and are reluctant to make sacrifices. So their strategy is to down trade rather than cut out. They are much more likely to substitute brands with private label, rather than dropping them altogether.

Treaters 12%Treaters don't find it easy to cut back, but know they have to. So they reward their frugal behavior with regular small treats.

Justifiers 12%Justifiers are happy to spend, but in the current climate are looking for a good reason to. They're less interested in huge ‘money off' deals, but are more motivated by limited offers, new models or added value deals that help them justify the purchase to themselves.

Balancers 9% Balancers are reluctant to compromise on quality of life, but recognize the need to balance their budgets accordingly.

Ostriches 9%

Ostriches are spending as normally. Some of them are well paid enough to get away with this, but the bulk of this group are in denial. They're a younger, more carefree group who are happy to load up their credit cards. In the short term, they're great for the bottom line, but in the long run, many of them may be forced to raise their heads and lower their spending as the crisis catches up with them.

Vultures 4%Vultures love a good economic crash. While others suffer, they're circling Main Street, making a killing on all the bargains. They eye the property market, looking to profit from others' misfortune.

Addressable television and mobile are two important platforms where agencies may be able to make up some ground

Agencies should gain as new media marketing spawns ever more Darwinian platforms and models … such as “paid-to-search”


Agencies should gain as new media marketing spawns ever more Darwinian platforms and models. We have heard that some advertisers are concerned about Google’s increasing market share and declining search-metric transparency. This could be an opening for the agencies, or another player entirely. For example, one development we can foresee is “paid-to-search.” This would involve direct compensation to potential consumers for their engagement with brands during the purchase path. The technology will likely develop to make such payments, target them at various points along the purchase path, and defeat wastage on mere tire kickers. This would be a natural evolution – all marketers know the value of the ‘hot prospect.’ CPMs for a TV audience are $30, while CPMs for actual prospects can go to the thousands of dollars – whatever the lifetime value of the customer is, as discounted by the likelihood that the customer will purchase your brand as opposed to a competitor’s. This shift to direct compensation of prospects would be an important evolution for search marketing, not simply for search engines, as well as for advertising agencies. This evolution could substantially increase the value of the well-crafted marketing message, the agency’s stock in trade. If a car dealer pays a prospect $20 to listen to a 15-minute pitch for a particular brand, the dealer will have greater incentive to optimize this pitch. This will likely involve an integrated message – video, audio, references to social sites for recommendations, rebuttals of key competitor claims – a message that will incorporate the insights from the interactive feedback loops that the marketer has and can access through its marketing consultants. The message could even be – and likely will increasingly be - an experience, continuing the trend in marketing services to experiential marketing. Paid-to-search could 1) push the search marketing model in a more consumer-centric direction, 2) help simplify the digital marketing process (its complexity being one of its primary flaws), and 3) more starkly differentiate between effective and ineffective marketing offers. Just as paid search allows companies to ‘buy’ a brand directly, so could paid-to-search allow would companies to buy a customer’s attention at the end of the purchase cycle. Ineffective offers would become dramatically more expensive because consumers would be paid to engage with them, but the offers would generate few sales or other positive key performance indicators. Conversely, effective offers would become dramatically more lucrative, making the customer acquisition process less expensive. Paid-to-search could allow marketers to improve their offers to better capture the ‘consumer that got away’ (i.e., who engaged with the offer but was not converted to purchase). As advertising becomes more targeted and wastage easier to isolate, the payback from good creative should increase, not decrease. Creative has long been a core competence of the advertising agency.

We believe such an evolution in search could increase the value of communications planning and the role of advertising agencies. It would require the most granular insights into consumer behavior as well as the most integrated approach to messaging, and in that sense be likely to contribute the most value. Paid-to-search would place more value on the well-constructed pitch, not less, and the agencies have a painfully intimate familiarity with the pitch process. A paid-to-search marketing strategy would involve tailoring offers to different platforms (online, enhanced TV, and mobile). Large agencies may be able to build a more enduring competitive advantage as marketing becomes more digital, although they may have to sacrifice short-term profits to make the necessary investments. The positive is that accurate and meaningful measurement requires building databases and hiring staff with sufficient analytical background (e.g., applied mathematics) to use them. Agencies are using proprietary technology, client data and analysis to execute new audience aggregation and behavioral targeting strategies, such as agency MDC Partners’ Varick Media Management. Some argue that digital marketing requires substantial investment in developing sophisticated databases of consumer activity and sales and a team of applied mathematicians, which usually only certain digital agencies and larger agency groups have. The downside is that these investments, and integrating them into the structure of large agency networks, could take years to recoup.

Evolution of search could increase the value of communications planning and the role of advertising agencies

Large agencies may be able to build a more enduring competitive advantage as marketing becomes more digital

Large clients may increasingly prefer to manage search and other online strategies through agencies as part of integrated marketing campaigns


BEAR CASE: WHEN A MAN HAS A QUESTION, THE WORLD WILL BEAT A PATH TO HIS DOOR

“You can't be a management consultancy, a brand consultancy, an ad agency and a below-the-line agency all rolled into one. It's naive and arrogant to try to claim that. When agencies do claim to do all of this, they instantly lose credibility in the client's eyes.” – Anonymous agency head, commenting on Digital Essays: Roundtable Discussion - The battle for digital, Suzy Bashford, 27 June 2008, Campaign. To quote Hemingway, how did Mike Campbell go bankrupt? “Gradually, then suddenly.”

Creative agencies could suffer if spending on brand marketing shrinks as a proportion of total marketing services spending. We have heard agency execs at creative shops decry the agencies’ diminishing role as the brand steward for their clients. This is despite a sense that, even as product life cycles are decreasing, brand life cycles are increasing, making brand management all the more important. Although improved data analytics may allow better attribution of branding to sales impact, it is still possible that measurement of the impact of spending on short-term ROI will improve even faster, further tilting the spending mix to below-the-line channels. The rise of mobile marketing will further improve the measurement of the impact of intent-based spending, making longer-term brand-oriented spending via creative agencies relatively more difficult to justify quantitatively. Over time, there could be a large shift in marketing to mobile phones from television. People are increasingly exposed to marketing messages on smaller, more interactive screens, and mobile will take this transformation even further, shrinking the screen by necessity, and increasing the interactivity by being with the consumer almost 24/7, unlike any other platform. Growth and margins of the creative advertising discipline are at risk over the long term. This reflects:

1. More of the higher-value strategic consulting is shifting to the media agencies, especially on how to navigate the increasingly complex media landscape. This could erode the premium which creative agencies have traditionally charged for being the ‘brand stewards.’ Some research indicates that many clients view creative as secondary to the agency’s delivery of effective and efficient media buying.

2. Media fragmentation has made it more difficult to generate consistent value from the ‘big idea’ – social media and other digital channels put smaller ideas (like offbeat You Tube videos) on a more even footing.

3. Over time, more hybrid production studios – working for both entertainment and marketing companies – may gain share of execution of creative strategies from the agencies.

4. Creative agencies have lower barriers to entry, which can reduce their ability to raise fees.

The increasing influence of value-based compensation models could put downward pressure on agency profits. At present, little agency compensation is determined by value-based compensation systems, with most still being determined by a fee-based approach, either labor-based or fixed fee (e.g., per project). However, some large marketers are determined to move to a VBC agency compensation model. For example, Coke has this year rolled its VBC system out to brands in 35 of its markets worldwide, with the goal of deploying it in all 200 of its markets by 2011. The essence of the Coke’s VBC approach is to pay agencies not based on their labor, but by a two-part fee with:

1. A base fee determined by the client’s estimate of the value of the various deliverables in the scope of the work to the client’s business. This is designed to replace the old labor-based fee with no profit mark-up and is determined as much as possible by reference to historical market data and industry competitive conditions (e.g., if many agencies can provide the deliverable, this would tend to lower the value a client assigned to it).

2. an agency profit determined on a ‘pay for performance’ (p4p) basis, determined as much as possible by reference to achievement of specific metrics in terms of agency evaluation, specialist metrics, marketing communications metrics (e.g., brand), and business performance metrics (e.g.,

Creative agencies could suffer if spending on brand marketing shrinks as a proportion of total marketing spending

The increasing influence of value-based compensation models could put downward pressure on agency profits


client sales or market share). Under Coke’s system, the maximum agency margin on an engagement would typically be ~23%, we estimate, dependent entirely on the agency’s p4p bonus. We have heard some agency execs express concern that such p4p schemes can become tools simply to reduce agency fees.

Despite conflicting views on the topic, we believe that there is a reasonable chance that the continuing trend to decoupling production from creative could put downward pressure on agency margins. As client procurement teams at agency clients put downward pressure on production margins – historically one of the least transparent and negotiated parts of the agency’s work - agencies may need to increase rates charged on creative to maintain their profitability. Production de-coupling can involve an in-house agency team’s handling the figurative transliteration of the creative concept to various media and countries, an outside production company’s doing so, or a combination of the two. Agencies face increasing competition from independent production companies that can manage the rollout and implementation of creative ideas on a global basis. By our rough estimates, to maintain its margins, a creative agency would need to increase its margins on creative work to 15% from 10% to offset a reduction in production margins to 20% from 40%. The stress in the underlying compensation model for the agencies could make it more difficult to attract and retain talent. The fee model – which generates most over 75% of agency revenue currently – is suspect because of client ambivalence over paying by the hour and agency frustration that hourly fees offer no upside for the truly “big idea.” And yet widespread use of a performance-based model does not appear likely in the near-term, due to the difficulty of attributing impact on sales or other KPIs to specific agency deliverables. Even if implemented, a performance-based model might lead to relatively little net value creation for the large agencies – many of whose clients are simply swapping market share - and simply more revenue volatility. Cracks in the agency compensation model could be aggravated by an increasing need to compete with: 1) consulting and investment firms to staff agency practices in strategic insights, 2) clients and entertainment companies to staff their creative departments, and 3) digital marketing and technology companies to staff their digital marketing and analytics teams. Rapid changes in marketing spending allocations by clients could destabilize the agency model. To some extent the agency model has benefited from more gradual changes in spending patterns by larger clients. For example, larger clients generally use less search marketing than average, despite the fact that search is the most significant marketing development of the past 10 years. If larger clients, on whom the agencies have been more dependent for revenue in recent years, begin to rapidly change their marketing mixes, they could tax agency infrastructures, opening the door for new agency competitors. Crowd sourcing and consumer feedback may allow - indeed require - marketers to do more of their own consumer insight work, and rely less on agencies and outside market researchers. If a company has a good product or service (Google, say), then you could argue that it has relatively little need to advertise, provided it 1) maintains a strong relationship with its core customers (who often account for 80% of its sales), and 2) these customers directly or indirectly sell its product or service through word-of-mouth or other social media. On the first point, the higher a proportion of sales accounted for by a brand’s best customers, the more technology will allow the brand to build a database of information about these customers, increase their likelihood of repeat purchases, and further bolster their “brand insistence.” Internet interactivity and the increasing availability of data on consumer media and product usage allows companies to develop more dynamic yet stronger relationships with their core customers. To paraphrase the former North American CEO of Carat, a company gains a big advantage if it can develop a mechanism where it is continually in contact with its consumers. Marketers will capitalize on digital data and related analytics to improve product development and customer service. On the second point, online search and social media are facilitating connections between potential consumers and customer evangelists. Customer service and peer-to-peer (aka word of mouth) advocacy may substantially replace “push-based” marketing services. Technology may improve the ability of customers to sell a company’s products more than it may increase the leverage of any other part of marketing. Marketers may increasingly measure the ROI of marketing against that of product design and CRM, with the latter winning out. If data analytics generates valuable proprietary insights in the customer “groundswell,” then marketers (and even media companies) may profit from developing in-house teams to do these analytics. Larger brand marketers, which account for most of agency holding company revenue, may bring more analytic capabilities in-house. Marketers could economize through the use of customized solutions provided by outside vendors and number-crunching outsourced to lower-wage countries. This could thwart agency efforts to generate meaningful new profits from consumer insights and brand and strategic consultancy services. A trend to CMOs with a higher profile, greater financial savvy, and a longer tenure could contribute to developing this

We believe that the continuing trend to decoupling production from creative could put downward pressure on agency margins

The stress in the underlying compensation model for the agencies could make it more difficult to attract and retain talent

Crowd sourcing and consumer feedback may require marketers to do more of their own consumer insight work, and rely less on agencies


digital marketing expertise in-house. Ultimately, even if it remained primarily an agency function, marketing data analytics could revert to being a more commoditized data collection and data mining task, outsourced to lower-cost regions, and not the source for high-margin profit centers inside the agencies. Some clients are developing in-house creative capabilities, not necessarily to supplant the outside agency, but to be able do in-house the initial creative rendering, and to better and more cost-effectively adapt it to quickly changing market conditions. Engagement with clients with in-house creative teams can be less profitable than average, as these clients can reduce the scope of work so that the fee covers less of the agency’s fixed costs. We believe that clients in creative and technology industries have traditionally been more likely to develop in-house advertising agency capabilities. But now, even companies in segments like home cleaning products (e.g., Method) are doing so. Even if branding remains an important component of value, it does not follow that the agencies will capture as great a share of business in branding campaigns as they have in the past. The in-house creative capability allows a marketer to pay outside agencies primarily for their ideas – rather than for execution, which can generate a greater volume of fees. We believe there are important examples of companies which have built brands without paying substantial fees to agencies. For example, the Method brand of ‘green’ household products was created with an in-house creative team collaborating at first with a large agency, and subsequently a smaller agency, on a marketing budget of roughly $5m per year. One of Method’s co-founders, who has an agency background, has stressed the importance the company places on having an in-house advertising capability. This example of a new brand making its way in the ‘green’ space without a relationship with a major agency holding company is somewhat cautionary – WPP highlighted ‘green’ branding in its 2007 annual report as a growth opportunity for marketing communications. The increasing use of user-generated advertising will reduce the demand for run-of-the-mill creative services from the agencies, putting pressure on organic growth from this discipline. Concepts like crowd sourcing have begun to move creative development beyond the walls of the agency. For example, CrowdSpring lets companies use the web to go directly to the creative community and post creative assignments with a cash prize. Although discussions with wikipedia make us skeptical of a similar “ad-wiki” (basic problem: it is not clear what those using such a site would be expected to do – post UGC, review other UGC, discuss only professional ad campaigns, etc.), we cannot rule out the negative impact of user-generated advertising on the demand for agency creative services. Marketers may increasingly bypass their usual media and creative agencies to work directly with media providers. Companies such as Johnson & Johnson, Kimberly-Clark Corp., Clorox Co., Hewlett-Packard and Verizon have enlisted media companies lately not just as conduits to reach consumers but also as co-creators of programs to do so. As marketing becomes more about aggregating niches to scale, other players – such as technology companies and advertising networks – may take share from advertising agencies. Faster improvement in short-term measurement than long-term measurement may continue to lead to a skew in marketing budget allocation to short-term ROI. Advertising campaigns continue to rely on less reach (few gross ratings points, or GRPs) and higher rates (or CPMs). Much of the marketing information that is being aggregated and used online is being generated by users (in product reviews and forums, and informal recommendations, such as what can be captured from Twitter), not marketers or agencies. Agencies risk falling into the classic trap of super-serving their core customers, at the expense of staying ahead of the disruptive innovations with more important implications for their business models. We can think of several examples in the agency world. First, the legacy of agency management’s focus on media usage in media planning may blind it to more important changes in the marketing landscape, such as in advertising models themselves. A focus on the relationship between marketing spending and media usage likely contributed to the agencies’ missing at the early stages the importance of internet search, which even today accounts for a small percentage of online page views, and still less of overall media usage time. Probably not coincidentally, agency clients have been slower than others to adopt the rapidly growing online search technology for marketing. Second, assuming that disruptive technologies like search engine marketing will need to develop “relationships” with new categories of advertisers, like CPG, would appear to miss the point that many of these technologies grow by establishing new markets, not new webs of relationships Third, agencies seem prone to view branding as likely to be of greater importance in every coming new era in marketing. That is what many said after the dot.com bust of 2001. In fact, the rise of paid search turned out to be the most important development in marketing this decade, and it had little to do with branding, in

Some clients are developing in-house creative capabilities to better and more cost effectively adapt agency ideas to quickly changing market conditions

Marketers may increasingly bypass their usual media and creative agencies to work directly with media providers

Agencies risk falling into the classic trap of super-serving their core customers, at the expense of staying ahead of disruptive innovations


our view. And yet, in the froth formed by rapid advances in digital marketing and the decline in overall marketing spending in the current severe recession, we see the perennial calls to acknowledge the triumph of branding over ROI, as, for example, “brand distinction is what creates ROI.” Faster improvement in short-term measurement than long-term measurement may continue to lead to a skew in marketing budget allocation to short-term ROI. Finally, we think some creative agencies have been slow to recognize the threat to their margins from in-house and third party production platforms. Going forward, if digital technology makes most media on-demand and a single search engine across all such media is ad-supported, as Google is now, the value agencies create through planning and execution across multiple platforms (search and non-search) might not offset the impact of the shift of marketing spending to search. Managing search campaigns could become an even more dominant feature of marketing. Marketers could bid for placement of messages cued by any search for any content or information in a wide number of media – interactive TV, online text, online video, mobile, gaming, etc.

If more media become on-demand via a paid-search platform, like the Internet, the agencies’ current business model in integrated marketing could be substantially undermined over time


ESTIMATES AND OUTLOOK



Our baseline assumption is that, during the recession, in the more mature markets of the U.S., Western Europe and Japan, agency organic growth should be down 50-75% of the percentage drop in advertising and marketing spend. For example, if media and marketing spending were down 10% in the U.S., an agency could be down roughly 6-7% in organic growth. Agencies can mitigate changes in compensation through 1) a greater mix of disciplines that escape cuts (e.g., below-the-line) and a smaller mix of project

Figure 13: Comparison Of Organic Revenue Growth By Year For IPG, Omnicom, And WPP And Market To Economic Growth

Organic Revenue Growth

‐7.0%

‐2.0%

3.0%

8.0%

13.0%

18.0%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009E 2010E

IPG OMC WPP Market Growth US Real GDP World Real GDP

Figure 14: Comparison Of Operating Margins By Year For IPG, Omnicom And WPP, 2000-2010E

Adjusted Operating Margins

‐5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009E 2010E

IPG OMC WPP ‐ Operating Margin WPP ‐ Headine Margin w/o Assoc. Income WPP ‐ Headline Margin


work, which has been cut disproportionately in this recession, 2) disciplines whose agency compensation is less proportional to the spending cuts (e.g., media buying) than others (e.g., strategic consulting), and 3) shifts of spending to digital from traditional, as agencies tend to capture a greater share of the total digital spend. Agencies can retain 2-3x the amount of client spending on a digital engagement, compared to a traditional engagement, because more of the spending goes to determining the media plan across the more fragmented online universe, creation of digital content (e.g., micro-sites), and setting up and monitoring the data on the impact of the campaign. Agency engagements in social media, which are increasing, are relatively unrelated to media spending in social media at the moment, given that social media has relatively little advertising. In geographic markets that are still growing, agency organic growth could actually exceed the growth of advertising spending. We expect margin compression across the board in 2009, despite more aggressive cost management than in prior recessions. Some execs believe they can maintain operating margins even if organic growth is down ~5-6%. At this stage in the cycle, the agencies’ primary tool for cost control is headcount reduction. We are somewhat more skeptical, given that, despite the recession, agencies are having to reposition their businesses to respond to secular changes, including: 1) adapting the AHC model to more value-based and performance-based compensation models, which can result in lower fees, if not margins, on average, 2) shifting resources to faster-growing from slower-growing geographic markets, 3) decoupling production from creative, which can put pressure on overall margins, and 4) possible long-term changes in payment terms by some major clients (such as Anheuser-Busch InBev), which could reduce the cash flow from working capital from which the agencies have typically benefited. We believe the groups are generally looking to cut headcount in line with anticipated revenue declines, so roughly 5% this year by current plans, which could change depending on marketers’ mid-year spending decisions. We believe that all the agencies are doing internal restructurings. For example, WPP is merging its Enfatico group into its Young & Rubicam agency network. Margin improvement this year seems off the table, unless the economy and employment trends do an about-face. Our mean organic revenue growth forecast for IPG, Omnicom and WPP is -6.1% in 2009 and +0.2% in 2010, while our mean operating margin changes are -126bps in 2009 and +50bps in 2010. Our top line estimate compares to guidance generally calling for organic growth to be down in the mid-single-digit percentages. We estimate that agency revenue growth will decelerate in 2Q. Many negotiations between clients and agencies only entered the critical stage in 2Q, where agencies may have to bite the bullet and accept some less favorable economics to keep business relationships, which essentially become an option on better economics when conditions improve. We tend to see marketing spending staying at reduced levels for another 9-12 months, with growth rates improving in 2H on the basis of easier comparisons. Agency execs have cautioned us privately that the revenue outlook is probably more likely to get worse before it gets better. This gibes with statements by Havas and WPP in early June indicating organic revenue growth in April was down ~9%. If consumer marketers see weak 2Q results, mid-year budget reviews could result in another round of spending cuts, and additional pressure on agency fees. We believe that there are only a limited number of major advertisers who are increasing spending and looking to boost market share at present, including, for example, Wal-Mart, Unilever and Verizon.

COMPETITIVE POSITION Overview: What Agencies Do Despite rapid change in media usage (especially among younger demographics against which marketers tend to over-index their spending), increasing importance of data ownership and analytics, and the likely continuing shift of spending to strategies of measurable sales growth from more unmeasurable brand-building, we see a continuing roll for advertising agencies.

“I see the Agency of the Year as the people who can combine the efficiencies of the ad exchanges, search bid management, ad-serving and the digital dashboard with traditional buying services and research tools, as well as creative tactical execution, and layer these under the strata of strategic and business-building services typically offered by consultants.” - Cory Treffiletti, “Is This the Year of the Un-Agency?” MediaPost, January 23, 2008

Our baseline assumption is that, during the recession, in the more mature markets of the U.S., Western Europe and Japan, agency organic growth should be down 50-75% of the percentage drop in media and marketing spending

Our mean organic revenue growth forecast for is -6.1% in 2009 and +0.2% in 2010, while operating margin changes are -130bps in 2009 and +50bps in 2010

We look for 2Q organic revenue growth to decelerate from 1Q


To quickly review the traditional view of the purchase funnel, against which marketing spending is directed: 1. The consumer needs to be aware of the product or service. Broad reach media like TV and national

magazines have traditionally been used to create awareness. 2. The consumer needs to put the advertiser’s brand in his/her consideration set. Media like cable, print

and radio have traditionally been used. 3. The consumer must try the product or service. Direct marketing, promotions, and package design can

help here. 4. The marketer converts the trial customer into the repeat customer. Loyalty programs can be used here.

Source: The Route to the Cash Register (Yahoo/OMD)

Figure 15: Advertising Agencies Are The Primary Outside Service Providers In Marketing

Seven Primary Services:1. Complete a Marketing Analysis2. Develop and Advertising Plan3. Prepare a Creative Strategy4. Create Advertising Executions5. Develop and Implement a Media Plan6. Handle Billing and Payments7. Integrate other Marketing Communications

Source: http://www.slideshare.net/atulravish88/ad‐agency‐presentation

Figure 16: Comparison Of Purchase Paths For Selected Product Categories

Product Category Most Common Purchase PathAutomotive Long & WindingFinance Long & WindingTechnology Long & WindingRetail Goods LongConsumer Packaged Goods QuickSource: The Route to the Cash Register (Yahoo/OMD)

Figure 17: Comparison of number of brands considered for purchase for selected product categories

% Knowing What They Want to Buy Before Shopping

71%

86%

88%

80%

86%

60%

63%

58%

30%

43%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Automotive

Consumer Packaged Goods

Finance

Retail Goods

Technology

Item(s) Brand(s)

Mean # of Brands Considered

3.1

2.6

2.9

2.8

2.9


If brand stewardship would be the agency’s task, then brand insistence would be the best it could deliver – when the brand is perceived to be the only viable solution for the customer’s need. When this occurs, demand elasticity drops and unit profit increases. Put another way, the customer does not pursue substitutes if the brand is not available. The progression to brand insistence is like the path to true love, roughly:

• I would never choose to buy this brand or I’ve never heard of this brand • I’ve heard of this brand but don’t know much about it • Not one of my preferred brands but I’d try it under certain circumstances • Not one of my preferred brands but from what I’ve heard about it recently I’d like to try it/try it again • This is one of my preferred brands • This is the only brand I would ever consider buying

Figure 18: The Five Drivers Of Brand Insistence

Source: http://www.brandcoolmarketing.com/branding‐101.html

Emotional Connection

Relevant Differentiation Value

AccessibiltiyAwareness

Does the brand connect with consumers emotionally?

Is the brand unique or different in a customer‐relevant, customer‐compelling way?

Are the target customers and key stakeholders aware of the brand? Is it top of mind?

Do customers and potential customers perceive the brand to be convenient?

Does the brand deliver a good value?

Creating Brands: 5 Drivers

The gold standard in branding, for which marketers and agencies strive, is “brand insistence” - when the brand is perceived to be the only viable solution for the customer’s need


Agency holding companies seek to offer a diverse – perhaps too diverse – range of marketing services, from search-engine marketing to branded content creation. After all, if search engine platforms extend from online, to mobile, to non-linear TV, and numerous other interactive platforms not-yet-devised, then agencies would seem to forego an increasingly important point-of-contact with their clients if they ceded management of search campaigns to Google and the tech-driven marketing consultants in the growing search ecosystem. On the other hand, the continuing pressure on the model of advertising-supported content in the traditional, mass media, on which the agencies have built their above-the-line business model (roughly 50% of agency industry revenue), has prodded many agency executives to “go Hollywood” - and back in time (e.g., to the soap opera) - to become production houses for branded content. We have heard more than one senior agency group exec say that this is no dalliance - advertising agencies will move further into the business of content distribution.

We are more optimistic about agency efforts in the data-driven below-the-line business than about their efforts in branded entertainment. If the agency business adopts a more Hollywood-style model, it risks taking on the volatility and relatively low margins of the film business. Film production relies heavily on outside production companies and free lance labor. Film studios are not known for high returns on invested capital. Agency groups are looking across disciplines for additional revenue streams. For example, the creative advertising agency executives could be the source for entertainment content for license beyond the scope of the client brief. Media planners could assist in choosing the best channels for exploiting such content. Those with digital expertise could capitalize on the rapidly changes in interactive marketing to devise turnkey tools for license.

Substitutes and New Competitors for Advertising Agencies As media fragment, become more interactive, and generate more digital data that can be used by marketers in the design as well as marketing of their products and services, the AHCs will face new competitive threats from their clients, media platforms, and interactive marketing companies (e.g., the Big 4). A basic point of IBM’s research is that “as advertisers, Internet/interactive players and consumers gain power, traditional agencies and broadcasters must evolve or risk being disintermediated.” Across industries, we find that it is actually less likely that a marketer will bring in-house advertising services as the size of marketing budget increases, but it is more likely that marketers will internalize advertising services if the marketers are in industries that use a lot of advertising, are more technological, and more or are more creative (e.g., film).

Figure 19: Expected Impact On Advertising Value Chain

Relative Economic Value Creation: Premier Moderate Non‐Differentiated Arrow represents change in position

from 2007Source: IBM Institute for Business Value

Advertiser

Full service media/advertising agency

Traditional direct marketing

Traditional media buying, planning and measurement

Interactive media buying, planning and measurement

Content owners and producers

Consumer

Traditional Distributor (MSO,

Telco)

Broadcaster

Interactive distributor (Internet, mobile)

AdvertisersCreative advertising agency

Media planning and buying

Content Owner / producer

Media aggregator /distributor

Consumer

The range of marketing services which agency holding companies provide is extremely diverse … perhaps too much so Agency groups are looking across disciplines for additional revenue streams


Shifts in the players involved and their relative capabilities in accumulating digital data and extracting revenue-driving insights from it will be important to the competitive structure of the marketing services industry. Large brand marketers themselves are developing in-house analytic capabilities that they are even offering as services to third parties. Media companies are using their behavioral targeting capabilities as a means of getting more business from advertisers. In the ongoing study “Marketing & Media Ecosystem 2010,” marketers rank at the top of the list of capabilities that will become more important by 2010 “consumer insights” (82% believe this will be more important) and “behavioral targeting” (80%). For their part, 91% of media respondents in this survey believe they already provide ‘agency-like’ services to their clients. And 77% of media respondents expect to offer consumer insights to clients by 2010. Consumer insights generally require capabilities in behavioral targeting, linking media usage to sales, having a consumer feedback mechanism, and building predictive models from the consumer insights obtained.

Figure 20: Marketers Have The Option Of Bringing Marketing And Advertising Functions In-House

Pros: Cons:1. Familiarity 1. Lack of Objectivity2. Specialization 2. Lack of Resources3. Fast Service 3. Insufficient Fresh ideas4. Cost Savings 4. Extra Cost and Overhead5. ConfidentialitySource: http://www.slideshare.net/atulravish88/ad‐agency‐presentation

Pros & Cons of In‐House Agencies

Figure 21: P&G Offers Consumer Insights Services To Other Companies

Services:‐ Consumer Research‐ Message Development‐ Campaign Execution‐ Quantifiable Measurements of Business Results‐ Panel size: over 250,000 teens, and 600,000 moms

Source: www.tremor.com

***Half of Clients are Outside of Procter & Gamble***

Procter & Gamble Move into Consumer Insights Business

Marketing services companies are increasingly competing in their ability to accumulate digital data and extract revenue-driving insights from it


Source: Marketing & Media Ecosystem 2010 - an ongoing study jointly sponsored by the ANA, IAB, AAAA & Booz Allen

Figure 22: J&J Has Invested In In-House Capabilities, Particularly Regarding New Media

Marketing Changes

Source: http://www.slideshare.net/atulravish88/ad‐agency‐presentation

4. Increased Investment in BabyCenter.com

1. New Media Marketing Roles at Corporate ‐ Recruited New Sr. Talent

2. Integrated Communications Planning Approach3. Central "Media Innovation" Fund at Corporate

1. New Metrics

2. Reduced Measured Media Spending by 22% in 20073. Shifted ~20% of Media Spending to Non‐Traditional Media

Marketing Organization Changes

Marketing Mix Redesign

Figure 23: What Marketers Expect From Advertising Agencies Versus Media Companies

Responsibility For Each of These Functions Lies With....

72% 69%

56%52%

12%

32%25% 25%

16% 17%

76%

33%

0%

10%

20%

30%

40%

50%

60%

70%

80%

CreativeProduction

CreativeDevelopment

CommunicationsPlanning

Media Planning BehavioralTargeting

Consumer InsightResearch

% o

f Res

pons

es

Agency of Record Media Company


We believe that media companies themselves are competing more with agencies in offering media planning services, leveraging the audience data and insights these companies gain from their particular platforms. AHCs have the advantage over most of their media ‘competitors’ of having global scale. In addition, different regulatory schemes under which media outlets must operate in different countries make it more challenging for them to integrate their operations relative to the agencies. We believe that restrictions which agencies place on the use of data may have the effect of limiting media companies’ ability to develop in-house brand consulting expertise, or to sell the data to marketing services companies seeking to build that expertise. Restrictions which agencies place on the use of data generated in ad campaigns appear often overbroad and unenforceable to the letter. For example, WPP Group's media-buying arm, GroupM, has changed the terms of its online-ad deals to the following: "All data generated or collected by the Media Company in performing under this Agreement shall be deemed 'Confidential Information' of Agency/Advertiser." We believe other agencies have moved or are moving to using similar terms. However, if a cable TV network generated data indicating that a particular client’s integrated campaign on its affiliated web sites was successful, this network likely would pitch this experience to other clients in that or related categories, regardless of how the underlying data was classified. However, perhaps such a clause would prevent the cable network from putting the underlying data into a larger database with results from other campaigns for analysis. Competitive Rivalry We believe that the value of being the agency of record, while still undeniable, is becoming less important, as clients push their lead agencies to assemble teams of best-of-breed specialists. Traditionally, the agency of record has had an inside track at developing and winning new business from larger clients. The agency of record has the perspective on the client’s overall marketing strategy, which gives the agency of record a better opportunity to cross-sell its own services. In turn, having agency of record status for particularly large or prestigious clients can help an agency recruit talent.

Source: Aligning the Stars, Lorsch & Tierney, Harvard Business School (2001)

Figure 24: Advertising Agency Concentration Compared To Other Industries

Top 10 Firms as a % of Total Market

78% 77%

63%

53%

41%

33%28%

6%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

HumanResourcesConsulting

InvestmentBanking

Advertising Accounting IT Consulting ManagementConsulting

ExecutiveSearch

Law

Media companies themselves are competing with agencies in offering media planning services Restrictions which agencies place on the use of data may limit the ability of media companies and others to compete with the agencies The value of being the agency of record is becoming less important as clients seek best-of-breed specialists


Client Bargaining Power The AHCs sit at the top of a fairly concentrated global industry for marketing services, but not at the top of the value chain as professional services providers to their own clients. We believe the leverage of clients – to reduce fees, increase scopes of work or both – stems from this latter point. Competitive pressure from clients in terms of cost control has been a major competitive development for the advertising agencies since the 2001-2002 recession, after which client procurement departments became more directly involved in reviewing agreements relating to agency compensation and scope of work. That said, the fairly concentrated structure of the global marketing services industry does put the AHCs in position to resist adverse changes in the terms of trade. A recent example concerns payment terms. Agencies have pushed back against paying media costs for clients before the agencies have received the cash for the media buys. And as yet, there has not been a material change in payment terms to agencies industry-wide, despite a push by some clients to do so to improve their own cash flow positions.

Supplier Bargaining Power Agencies have improved their leverage with their own suppliers since the last recession by centralizing procurement, installing better systems, and being more proactive in managing real estate expenses (e.g., by staggering lease expirations). Again, we believe that the concentrated nature of the industry at the global level contributes to the leverage of advertising agencies with their own vendors.

Agency holding companies are not at the top of the value chain as professional services providers Agencies have improved their leverage with their own suppliers since the last recession


ADVERTISING AGENCY INDUSTRY REVENUE AND MARGINS BY DISCIPLINE

Source: Advertising Age and Wedbush Morgan Securities estimates Across the entire advertising and marketing services industry, traditional advertising and media (planning and buying) services account for roughly half of revenue, and marketing services including digital the other half. Advertising – primarily the services related to the creation and execution of campaigns on traditional media – accounts for roughly one-third of industry revenue. The related but distinct services of media planning and buying – determining how to allocate spending across media and executing the media buys – account for roughly 15% of agency revenue. Thus, these two broad activities, essentially ATL services, accounted for roughly half of industry revenue. Although there is no such thing as a typical ATL media campaign, we generalize that agency fees on a traditional marketing campaign are in the range of 60% for creative and production, 20-30% for media planning (more for a more complicated campaign), and perhaps 10% for media buying, the fees for actually placing the buys with the various media channels. The other, faster-growing, half of agency industry revenue comes from BTL services including digital. Digital and direct marketing services each account for roughly 12% of industry revenue. The remaining quarter of industry revenue comes from public relations (14%), promotion (8%) and healthcare marketing (7%), this last a specialty largely because of the regulations and purchase path peculiar to the health care industry. We note that the major AHCs break out their revenue by discipline slightly differently, thus complicating comparisons among them.

Figure 25: U.S. Advertising Agency Industry Revenue By Discipline, 2008

$34 Billion in Revenues in 2008 ‐ By Discipline

Advertising, $11.2, 32%

Media, $4.9, 15%Digital, $4.0,

12%

Direct Marketing, $4.0, 12%

Public Relations, $4.6, 14%

Healthcare, $2.3, 7%

Promotion, $2.7, 8%

Traditional advertising and media planning and buying services account for half of industry revenue, and marketing services including digital the other half


Source: Advertising Age

Although it is difficult to make general statements about margins by discipline, we believe that media planning and buying services typically have higher margins than creative services, although this depends on among other things how the agency accounts for production of the creative campaign, which can be allocated some of the margin. As media planning tools have become more sophisticated and capable of optimizing spending across digital as well as traditional channels, media planners have been able to more convincingly show the savings in media cost which their planning insights are yielding, thus supporting the fees they charge. Media fragmentation has increased the opportunities for arbitrage of sorts across different media channels (e.g., moving budget to cable networks from broadcast). All that said, a complicated creative campaign can generate a higher margin than a more routing planning and buying project.

We believe that market research can have higher margins than creative, if the research is based on proprietary panels or databases that are difficult to replicate. In such situations, first movers with a solid reputation in particular niches of market research can have more pricing power than other marketing service providers. Some market research niches – e.g., those depending on large consumer panels – can also benefit from scale barriers to entry. Event marketing has among the lowest margins of the BTL disciplines because of the gross-up that occurs when the agency passes through revenue and expense to third-party vendors engaged for the event. For example, if an agency organizes events related to an auto show, it could bill the client a few million dollars, most of which would be distributed to vendors hired to stage the event. If the client eliminates this event, the agency would lose the corresponding fees, but still have the payroll expense of its own events marketing staff.

Figure 26: Comparison Of Revenue By Discipline For IPG, Omnicom, WPP, and Industry, 2008

2008 Revenue Mix by DisciplineIPG OMC WPP Aegis Havas Industry

Marketing Services 42.0% 56.7% 61.7% 39.1% 34.8% 52.2%Advertising 37.7% 35.1% 23.4% 0.0% 43.5% 33.3%Media 20.3% 8.2% 14.9% 60.9% 21.7% 14.5% Total Revenues 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Source: Company data, Advertising Age and Wedbush Morgan Securities estimates

Figure 27: Public Relations And Digital Disciplines Were Fastest Growing Disciplines In 2008

$ in billions2008 2007 YOY

Public Relations $4.6 $3.2 42.8%Digital $4.0 $3.4 20.2%Direct Marketing $4.0 $3.4 18.5%Promotion $2.7 $2.5 10.9%Healthcare $2.3 $2.3 0.9%Media $4.9 $4.9 0.2%Advertising $11.2 $11.6 ‐3.0%Total $33.7 $31.1 8.4%

Media planning and buying services typically have higher margins than creative services

We believe that market research based on proprietary panels or databases generally has higher margins than creative


Source: Advertising Age and Campaign In general, agency services experiencing faster growth have more profit growth potential, initially from the top line and then as margins improve. For example, digital campaigns involving micro-versioning of creative for multiple platforms and numerous sites, as well as applying analytics to manage the campaigns, offer agencies above-average profit growth potential.

Figure 28: Comparison Of Operating Margins By Discipline 2008 Est. Margin

Media Agency 17.6%Web Design Firm 15.0%PR Agency 12.0%Direct Marketing Agency 11.3%Sales Promotion Unit 11.3%Promotion Agency 11.3%Marketing Services Agency 11.3%Event Marketing Agency 11.3%Yellow Pages Agency 11.3%Search Marketing Ad 11.3%Digital Agency 10.6%B2B Agency 10.6%Branding Consultancy 10.0%Recruitment Agency 10.0%Research & Consultancy Network 10.0%Sports Marketing Agency 10.0%Healthcare Agency 9.5%Hispanic Ad Agency, 9.5%African‐American Ad Agency 9.5%Political Ad Agency 9.5%Asian‐Based Agency Network 9.5%Ad Agency 8.5%Lead Network Agency 8.5%Multi‐Discipline Marketing 8.5%

Agency services experiencing faster growth generally have more profit growth potential, initially from the top line and then as margins improve


PRIMARY ADVERTISING AGENCY DISCIPLINES

Advertising Creative Services

Source: The Big Won

Figure 29: Creative Awards Won, 2008

The Top 10 Agency Holding Companies in 2008

Won Scoring Points % of Top 10

Cumulative % of Top 10

1 Omnicom 10,586 43.0% 43.0%2 WPP 7,306 29.7% 72.6%3 Publicis 3,162 12.8% 85.5%4 Interpublic 2,099 8.5% 94.0%5 Havas 821 3.3% 97.3%6 Hakuhodo 241 1.0% 98.3%7 M&C Worldwide 230 0.9% 99.2%8 Aegis Group 85 0.3% 99.6%9 Asatsu‐DK (Japan) Worldwide 64 0.3% 99.8%10 Cossette Communication Worldwide 38 0.2% 100.0%

Total 24,632

The Top 20 Agency GroupsHolding Company



1 BBDO Worldwide OMC 3,837 14.6% 14.6%2 DDB Worldwide OMC 3,263 12.4% 27.0%3 Ogilvy WorldWide WPP 2,610 9.9% 36.9%4 Leo Burnett Worldwide Publicis 2,514 9.6% 46.5%5 Saatchi & Saatchi Worldwide Publicis 2,303 8.8% 55.2%6 TBWA Worldwide OMC 1,532 5.8% 61.1%7 Lowe Worldwide IPG 1,392 5.3% 66.4%8 McCann Erickson Worldwide IPG 1,058 4.0% 70.4%9 Young & Rubicam Worldwide WPP 998 3.8% 74.2%10 Jung von Matt Group 951 3.6% 77.8%11 Publicis Worldwide Publicis 859 3.3% 81.1%12 Proximity Worldwide OMC 858 3.3% 84.3%13 Grey Worldwide WPP 852 3.2% 87.6%14 Euro RSCG Worldwide Havas 818 3.1% 90.7%15 DraftFCB Worldwide IPG 633 2.4% 93.1%16 Dentsu Worldwide Dentsu 345 1.3% 94.4%17 Wunderman Worldwide WPP 331 1.3% 95.7%18 Hakuhodo Worldwide Hakuhodo 227 0.9% 96.5%19 Rapp Collins Worldwide OMC 216 0.8% 97.3%20 AKQA Worldwide AKQA 201 0.8% 98.1%21 OMD Worldwide OMC 177 0.7% 98.8%22 Springer & Jacoby Group 118 0.4% 99.2%23 RMG Connect Worldwide WPP 112 0.4% 99.7%24 Bates Worldwide 91 0.3% 100.0%

Total 26,296


Source: The Big Won

Figure 30: Creative Awards Won, 2008 (Continued)

The Top 20 Agencies Holding Company



1 BBDO New York OMC 1,112 12.0% 12.0%2 Jung von Matt, Hamburg 614 6.6% 18.6%3 Scholz & Friends Berlin 535 5.8% 24.4%4 DDB Germany, Berlin OMC 529 5.7% 30.1%5 Abbott Mead Vickers BBDO, London OMC 501 5.4% 35.5%6 Ogilvy Frankfurt WPP 472 5.1% 40.6%7 Fallon London Publicis 439 4.7% 45.3%8 DDB London OMC 393 4.2% 49.6%9 BBDO Duesseldorf GmbH OMC 356 3.8% 53.4%10 Shackleton Madrid 341 3.7% 57.1%10 Nordpol + Hamburg 341 3.7% 60.8%12 AlmapBBDO, Sao Paulo OMC 328 3.5% 64.3%13 Ogilvy Singapore WPP 320 3.5% 67.8%14 BBH London 275 3.0% 70.7%15 Leo Burnett Chicago Publicis 272 2.9% 73.7%16 Saatchi & Saatchi New York Publicis 269 2.9% 76.6%17 Crispin Porter + Bogusky, Miami MDC Partners 265 2.9% 79.4%18 Dentsu Tokyo Dentsu 259 2.8% 82.2%19 Saatchi & Saatchi Singapore Publicis 247 2.7% 84.9%20 FP7 Doha 245 2.6% 87.5%21 BETC Euro RSCG, Paris 235 Havas 235 2.5% 90.1%22 Goodby, Silverstein and Partners, San Francisco OMC 234 2.5% 92.6%23 kempertrautmann, Hamburg 232 2.5% 95.1%24 Leo Burnett Mumbai Publicis 229 2.5% 97.6%25 Del Campo Nazca Saatchi & Saatchi, Buenos Aires Publicis 227 2.4% 100.0%

Total 9,270


Many believe that good creative is vital to winning new business. Omnicom has a deserved reputation for having, on balance, the strongest creative agencies. Perhaps not coincidentally, Omnicom has had among the higher organic revenue growth rates among the agency holding companies. In digital advertising creative, IPG, for example with its R/GA digital agency, is developing a good reputation.

Figure 31: Creative Awards Won, 2009 January 1st to April 20th 2009

The Top 20 Agency GroupsHolding Company



1. Leo Burnett Worldwide United States Publicis 366 15.2% 15.2%2. Proximity Worldwide United Kingdom OMC 326 13.5% 28.8%3. Ogilvy Worldwide United Kingdom WPP 234 9.7% 38.5%4. BBDO Worldwide United States OMC 205 8.5% 47.0%5. DDB Worldwide United States OMC 200 8.3% 55.3%6. Saatchi & Saatchi Worldwide United States Publicis 180 7.5% 62.8%7. Young & Rubicam Worldwide United States WPP 159 6.6% 69.4%8. Lowe Worldwide United Kingdom IPG 96 4.0% 73.4%9. TBWA Worldwide United States OMC 87 3.6% 77.0%10. Euro RSCG Worldwide United States Havas 85 3.5% 80.5%11. OMD Worldwide Canada OMC 70 2.9% 83.5%12. Jung von Matt Group Germany 69 2.9% 86.3%13. McCann Erickson Worldwide United States IPG 53 2.2% 88.5%14. Grey Worldwide United States WPP 52 2.2% 90.7%15. ADK Tokyo Japan WPP 49 2.0% 92.7%16. Dentsu Worldwide Japan Dentsu 46 1.9% 94.6%17. Publicis Worldwide France Publicis 37 1.5% 96.2%18. Wunderman Worldwide United States WPP 34 1.4% 97.6%19. Hakuhodo Worldwide Japan Hakuhodo 30 1.2% 98.8%20. Draft FCB Worldwide United States IPC 28 1.2% 100.0%

Total 2,406

The Top 20 Agencies Holding Company



1. Aim Proximity Auckland New Zealand OMC 121 8.4% 8.4%2. FP7 Doha Qatar 94 6.5% 14.9%3 Leo Burnett Beirut Lebanon Publicis 87 6.0% 20.9%3 Starcom Mediavest UAE United Arab Emirates Publicis 87 6.0% 26.9%5. Memac Ogilvy & Mather Dubai United Arab Emirates WPP 85 5.9% 32.8%6. Y&R France France WPP 80 5.5% 38.4%7. JWT Shanghai China WPP 79 5.5% 43.8%8. BMF Sydney Australia 76 5.3% 49.1%9. JWT Dubai United Arab Emirates WPP 75 5.2% 54.3%10. DDB London United Kingdom OMC 66 4.6% 58.9%11. JWT Beirut Lebanon WPP 58 4.0% 62.9%12 Leo Burnett Frankfurt Germany Publicis 54 3.7% 66.6%12 Shackleton Madrid Spain 54 3.7% 70.4%14. Saatchi & Saatchi Petaling Malaysia Publicis 48 3.3% 73.7%15 Proximity London United Kingdom OMC 46 3.2% 76.9%15 Dentsu Tokyo Japan Dentsu 46 3.2% 80.1%17 Leo Burnett Mumbai India Publicis 43 3.0% 83.0%17 Jung von Matt, Hamburg Germany 43 3.0% 86.0%19. Rapp New Zealand New Zealand OMC 42 2.9% 88.9%20 Proximity BBDO Malaysia OMC 40 2.8% 91.7%20 McCann Worldwide group Hong Kong IPG 40 2.8% 94.5%20 OMD Middle East United Arab Emirates OMC 40 2.8% 97.2%20 Ogilvy & Mather Bangkok Thailand WPP 40 2.8% 100.0%

Total 1,444

Source: The Big Won


Agencies are looking to increase profit growth from the creative discipline, but face challenges doing so. Rate negotiation and staffing decisions will be important tests of the quality of operating management at the creative agencies in particular. To preserve and increase creative agency margins, agencies will need to streamline the initial briefing process from the client, better tailor the scope of work, better match the experience level of assigned staff to the scope of work, and possibly reduce salaries in certain regions and disciplines. Some consultants state that fee pressure has caused reduced staffing on creative assignments. In our view, there are inherent limits to how specific the creative brief can be. If the client knew exactly what it wanted, it would not hire an agency, or certainly pay the agency very much if it did. Another challenge for creative agencies is negotiating for revenue streams from exploitation of the intellectual property in the campaign in other channels (e.g., Method’s forthcoming book or Renault TV). Advertisers are increasing their mix of marketing spending on branded content. As some clients do more multi-media exploitation of ideas, they may be less likely to incorporate production costs into their base fee with the agency, on the ground that at the beginning of the process the client is not entirely clear what it will ultimately produce. Creative agencies face continuing fee pressure from advertisers that seek to take the advertising production process, outsource it directly to third-party production companies, or have a media partner do the production. For example, Hyundai just this year moved the creative accounts for its Hyundai and Kia brands in Australia to its in-house agency, Innocean, which already works on the Hyundai business in several other markets around the world, including Germany and India. Major advertisers in mature markets have launched new brands without involving agencies in the production process. This has led many agencies to reduce the size of their TV production departments, for example. Production of ads generally has become less profitable for the agency groups. Over time, the same trends to decoupling production from creative, which are affecting margins for traditional advertising agency work, may start to pressure margins for digital campaigns. Production for creative campaigns tends to be done within agencies more for digital than traditional media, increasing the agency’s profit potential for digital at present. We would expect the production process for digital to change over time, however, allowing for more efficiency from outsourcing, for example.

Media planning and buying

Figure 32: Market Shares In Global Media Buying Billings, 2007

Owner GroupsMarket Share

Growth Rate '07 vs '06 US $ M

WPP / GroupM 16.3% 7.3% $65,315Publicis / VivaKi 11.9% 7.2% 47,670Omnicom / OMD 8.3% 7.3% 33,327Interpublic / Mediabrands 6.0% ‐4.4% 24,109Aegia / Aegia Media 5.6% 8.3% 22,438Havas / Havas Media 3.1% 14.5% 12,305Source: RECMA

Many believe that good creative is vital to winning new business … … but creative agencies face challenges in their quest to increase profit growth

Creative agencies face continuing fee pressure related to the production of advertising campaigns


Those in media planning decide on 1) the allocation between marketing designed to have a long-term effect and marketing designed to have a short-term ROI, and 2) how to optimize the efficiency of media buys, using the increasing number of available metrics and analytical tools in a fragmenting media marketplace. In a recession especially, one could view media planning as the art of reducing the media budget as much as possible without an adverse impact on sales. Given rate declines in traditional media during the recession and improved planning tools, agencies may be able to offset rising CPMs in certain new media channels by recommending plans which shift some spending back to more traditional channels. We believe that the media planning and buying businesses of the AHCs will continue to grow, although the increasing role of technology and automation in the media buying process, both traditional and digital, could cause margins to erode over time. Media planning and buying discipline could be better positioned for growth than many other agency disciplines coming out of the recession. There is new investment in media agencies, and not necessarily simply as plays on a near-term advertising recovery. Holding companies are making investments to increase the value proposition of the media discipline, such as taking stakes in new media shops and investing in more analytic capabilities. Even traditional media planning can add value by solving the complexity of branded entertainment and in-depth matching of a marketer’s brands with the different types of content offered by particular TV networks. There is a perception that media consultation and planning adds more value, while media buying is more of a commodity. However, the reality is that media buying often involves a fair amount of judgment. For the AHCs, media buying has had the benefit of economies of scale, particularly in traditional media, as larger buying organizations can amortize the cost of buying tools and software over a larger revenue base. The buying arms of large AHCs typically have an advantage in pitching for the business of clients who consolidate media buying centrally, rather than decentralizing it to their local markets. Over time, many clients have actually reduced their in-house capability to do planning and buying, offering more potential business to agency media operations. Agency execs tell us that the recent trend has been

Figure 33: Market Shares In Global Media Buying Networks, 2007

Global NetworksMarket Share

Growth Rate '07 vs

'06 US $MOMD (Omnicom) 6.6% 6.7% $26,311Starcom MediaVest SMG (Publicis) 6.3% 6.4% 25,355Mindshare (WPP) 5.7% 0.8% 22,835ZenithOptimedia (Publicis) 5.6% 8.0% 22,315MediaCom (WPP) 4.9% 10.5% 19,755Mediaedge: cia (WPP) 4.8% 10.6% 19,114Carat (Aegis) 4.7% 5.8% 18622Universal McCann (Interpublic) 3.0% ‐6.5% 11924MPG (Havas) 2.8% 15.5% 11244Initiative (Interpublic) 2.8% ‐3.7% 11109PHD (Omnicom) 1.6% 10.3% 6509Vizeum (Aegis) 0.9% 23.3% 3771MAXUS (WPP) 0.4% 20.5% 1775Arena (Havas) 0.3% 5.0% 1061Total 6 Groups/ 14 Media Networks 50.4% 6.1% $201,700Independents / In‐House/ Other Players 49.6% 4.8% 198251Total Global Buying Market 100.0% 5.6% $399,951Source: RECMA 2007

Media planning involves deciding 1) how to allocate resources between long-term and short-term marketing objectives, and 2) given that allocation, how to optimize the efficiency of the resulting media buys


generally to even more outsourcing of media planning and buying, as reduced client marketing staffs seek guidance on dealing with fragmenting media channels and data glut. There are notable exceptions to the trend by clients to give more media services work to agencies – worth monitoring if they become a trend. For example, Anheuser-Busch buys its media internally. An analysis of A-B’s media buying by an outside consulting firm recently confirmed that this in-house group was delivering good performance versus agency benchmarks. Media services are typically the most profitable major discipline for the AHCs, despite the apparent threat from commoditization as better systems improve the transparency of its results. For example, in the 2009 Willott Kingston Smith review of agency performance in the United Kingdom, media buyers posted an average operating profit margin of 20.8%, well above the average across all disciplines. Some of this may relate to profits from media planning, which is under less margin pressure, especially given the increasing complexity of marketing channels. We note that an increase in new business could actually put downward pressure on media buying margins, particularly if it results in little increase in market share. Media buying agencies may have a tendency to offer lower fees to win new business, subsidizing the lower margins on the new business with higher margins on the buying done for longer-standing clients. Trade press reports have suggested, for example, that Omnicom’s OMD unit likely won the pan-European Renault-Nissan media buying review from Carat on terms that offer little profit in the near term. The agencies see an opportunity to use the data generated from large-scale media buying as an important competitive advantage in producing consumer and strategic insights for clients. Agencies may have to offset the margin erosion in their core media buying business with incremental profits from the planning and consulting fees they can generate from having access to the data of their media buying operations. Whether clients ultimately choose to un-bundle this data from the agencies and give it to other parties they believe can create more value with it remains to be seen. Whether there are scale advantages in media buying in online search is an open question, in our view. For example, Google eliminated volume discounts to agencies in the U.K. in 2007. Search marketing grew from spending by smaller, unsophisticated marketers. SEM and SEO firms arose to assist these marketers in managing their search campaigns. We believe the margins of SEM/SEO firms are in line with those of other agency disciplines. We do not see why marketing services firms will be able to increase their margins as they expand their client base to larger, more sophisticated national advertisers, with the infrastructure to support in-house analytics of their own. One key issue that could cut either way for the growth of media planning is the difficulty of determining the impact on demand elasticity from marketing services spending. On the one hand, this could increase the potential value added by agencies that can offer good insight into this key problem in ROI. Analytics relating to ROI of marketing spending are increasingly important in winning and increasing media planning business. On the other hand, cost-conscious and results-oriented marketers may at some point cut the fees and commissions paid for advice on this issue if its value cannot be proven.

Media services are typically the most profitable major discipline for the AHCs

The agencies see an opportunity to use the data generated from their media buying to further develop their consumer and strategic insights businesses


Source: GroupM and Wedbush Morgan Securities estimates

Digital marketing services Internet spending has become the dominant contributor to growth in media and marketing spending in North America and Western Europe, and thus the AHCs have invested substantially in their interactive marketing services offerings in these regions. In the U.S. and Western Europe, online marketing spending now accounts for roughly half of the growth in overall media spending. In other regions, online marketing spending still accounts for less than 20% of the growth in overall media spending. In these regions, television typically is the dominant contributor to media spending growth.

Figure 34: Internet Is Now The Primary Driver Of Media Spending Growth In Western Europe And North America

Internet's Contribution to Media Spending Growth in Major Geographies, 2002‐2008

‐120%

‐100%

‐80%

‐60%

‐40%

‐20%

0%

20%

40%

60%

80%

2002 2003 2004 2005 2006 2007 2008E

Year

Percentage Con

tribution to Growth Middle East & Africa

Western Europe

North America

North Asia (1)

Central & Eastern Europe

Asia Pacific (All)

Latin America

ASEAN (2)

Middle East & Africa

The Internet is now the dominant contributor to media spending growth in Western Europe and North America


Despite the rapid growth of interactive marketing spending in the developed economies, marketers themselves still do not consider their organizations particular expert at using interactive marketing. This has created a growth opportunity for advertising and marketing services companies. Large brand advertisers have been somewhat slow to embrace interactive marketing, giving the agencies some time to buy or build the expertise necessary to service the transition currently ongoing. Digital marketing is changing so fast that demand for digital agency services is only increasing. Thus, in serving their clients, AHCs have increased their mix of business from disciplines that directly or indirectly involve digital media. The integrated nature of many marketing campaigns makes difficult precise definitions of what revenue is generated from “digital” work. For example, WPP reports both a “wide” definition of its digital revenue - $3.9bn in 2008 – as well as a “narrow” definition - $2.4bn. Thus, comparisons of each company’s exposure to this fast-growing specialty are approximate. In general, company figures and industry estimates generally place AHC exposure to digital revenue streams in the 15-25% range.

Figure 35: Marketers Believe They Need Assistance In Best Using Digital Media

nsored by the ANA, IAB, AAAA & Booz Allen

nsored by the ANA, IAB, AAAA & Booz Allen

Source: Marketing & Meda Ecosystem 2010 ‐ an ongoing study jointly sponsored by the ANA, IAB, AAAA & Booz Allen

Marketers' View of the Ecosystem

62%57%

52%

26%

0%

10%

20%

30%

40%

50%

60%

70%

Inability to measure theeffectiveness is a barrier

Creative, strategic and mediabuying capabilities should be

rebundled

Partnerships with medacompanies are important

Marketers believe theirorganizations are digtial savvy

% of R

espo

nses

Figure 36: Agency Holding Companies Generate 15-25% of Their Revenue from Digital Media

Source: Company data, Advertising Age and Wedbush Morgan Securities estimates

2008 Digital Revenue (in $bn) and % of Total Revenue

$2.2

$1.3

$1.1

$0.6

$0.3

$2.4

13%

26%15%

19%

16%

18%

WPP Omnicom Publicis IPG Aegis Havas

Marketers still do not consider their organizations digitally savvy


Figure 37: Top-50 U.S. Digital Agencies

2008 2007 AGENCY [PARENT] PARENT 2008 % CHG1 1 Digitas* [Publicis (Digitas)] Publicis $377 9.3%2 2 Razorfish [Microsoft Corp.] Microsoft 317 6.0%3 5 Sapient Interactive Sapient 211 27.0%4 3 OgilvyInteractive* WPP 208 7.0%5 4 IBM Interactive* [IBM Corp.] IBM 205 9.0%6 7 Wunderman* [WPP (Y&R {Wunderman})] WPP 161 16.9%7 6 MRM Worldwide* [Interpublic (McCann)] IPG 160 14.3%8 9 Rapp* [Omnicom (DDB {Rapp})] OMC 149 27.7%9 13 Rosetta Rosetta 130 35.1%10 8 Organic* [Omnicom (BBDO)] OMC 129 3.0%11 12 iCrossing iCrossing 120 22.4%12 10 R/GA* [Interpublic (DraftFCB)] IPG 117 14.1%13 11 DraftFCB* [Interpublic (DraftFCB)] IPG 115 15.0%14 14 Tribal DDB* [Omnicom (DDB)] OMC 103 20.0%15 16 Euro RSCG Worldwide (includes Euro RSCG 4D)* [Havas (Euro)] Havas 102 24.4%16 15 Acxiom Corp. Acxiom 94 11.4%17 18 VML* [WPP (Y&R)] WPP 84 13.5%18 19 Critical Mass* [Omnicom] OMC 83 12.9%19 17 Epsilon/Purple@Epsilon [Alliance Data Systems (Epsilon)] 78 ‐2.3%20 22 AKQA* AKQA 70 13.3%21 23 Goodby, Silverstein & Partners* [Omnicom] OMC 65 7.5%22 24 Isobar (excluding U.S. iProspect rev.)* [Aegis Group (Isobar)] Aegis 63 4.5%23 20 Agency.com* [Omnicom (TBWA)] OMC 62 ‐9.1%24 21 IMC2 61 ‐4.8%25 26 G2* [WPP (Grey)] WPP 61 7.5%26 43 Ascentium 60 100.0%27 34 Atmosphere* [Omnicom (BBDO)] OMC 60 55.0%28 32 Arc Worldwide* [Publicis (Burnett)] Publicis 60 44.3%29 27 Digitas Health* [Publicis] Publicis 58 14.3%30 31 360i 50 19.0%

31 28TMP Worldwide Advertising and Communications [TMP Worldwide (Veronis Suhler Stevenson)] 46 ‐4.1%

32 29 Fry* 45 0.0%33 30 Blast Radius* [WPP (Y&R {Wunderman})] WPP 45 0.0%34 33 Schematic* [WPP (WPP Digital)] WPP 44 9.0%35 36 Publicis Modem & Dialog* [Publicis (Publicis)] Publicis 39 7.4%36 25 WhittmanHart Interactive 38 ‐33.0%37 39 Hawkeye 38 17.5%38 40 Bridge Worldwide* [WPP (WPP Digital)] WPP 37 18.0%39 42 Targetbase* [Omnicom] OMC 36 19.6%40 54 Hill Holliday* [Interpublic] IPG 36 58.1%41 35 Resource Interactive 36 ‐6.5%42 38 RMG Connect* [WPP (JWT)] WPP 36 5.0%43 41 T3 35 14.8%44 37 Performics* [Publicis (VivaKi)] Publicis 34 ‐1.2%45 46 iProspect* [Aegis Group (Isobar)] Aegis 33 16.2%46 60 Carlson Marketing* 32 67.7%47 44 Campbell‐Ewald* [Interpublic] IPG 32 10.0%48 47 Web.com* 31 9.7%49 45 Idea 30 5.3%50 51 Efficient Frontier* 30 16.3%

Source: Ad Age DataCenterPublished April 27, 2009, as part of the 65th Annual Agency Report.

Ranked by 2008 U.S. revenue. Dollars in millions.RANK U.S. REVENUE (in $m)


Digital ad agencies have been gaining share by focusing on strategies for generating measurable, short-term sales results. They have done so by applying below-the-line principles to digital media, including search. Digital agencies help marketers make the glut of digital data actionable in integrated marketing campaigns, which are increasingly popular. What digital agencies have not done so much is pose as brand stewards or try to clamber up the ‘value chain’ to offer more strategic insights into long-term marketing strategy, branding and the like. Some business units of AHCs, such as WPP's Wunderman, Omnicom's Rapp Collins and Interpublic's MRM have become top-tier digital marketing services firms.

Agency media operations have purchased search engine marketing and optimization companies, and continue to hire outside search specialists to bolster their offerings. For example, Publicis acquired the Performics search marketing business from Google in 2008. As search strategies interact with the continuing fragmentation of media channels – from social to mobile – the agencies see an opportunity to capture more of their clients’ SEO and SEM business from specialist shops. That said, in Forrester’s recent review of search engine marketing firms, the leaders were all independent of agency holding companies. Although in the tier below the three leaders – iProspect, iCrossing, and 360i - IPG’s Reprise Media (an acquisition) was highly rated, ahead of WPP’s GroupM Search and Omnicom’s Resolution Media. We believe that digital agency compensation has been increasing faster than digital marketing spending. Per an ANA survey this year, digital agency compensation is increasing as a percent of digital marketing spending. This reflects the increase in the number of services which digital agencies are providing. Digital compensation is primarily through fees. In digital media buying, compensation is more likely to be through commission, and digital media buying commissions are ~10%, well above the 3-4% level typical for traditional media buying. Despite the recession, we expect digital agencies to have positive organic revenue growth this year. First, among BTL services, digital marketing spending stands out as offering a more quantifiable ROI. Second, digital agency compensation could grow this year even if digital marketing spending declines. Not all of the new services which digital agencies provide relate to increased digital marketing spending. For example, digital agencies are creating smart phone applications and tools for marketing on and analyzing the buzz of various social media platforms (e.g., Facebook, Twitter). None of these channels are attracting a substantial increase in media spending this year, and yet the fees paid to the digital agencies for these services are increasing. There is a growing demand for simplicity, especially in digital media marketing. Complexity creates friction to completing transactions, and thus simplicity boosts sales. Agency compensation tends to follow the sales curve. Even if interactive agencies may lack creative visionaries, they tend to have more real time access to and ability to analyze consumer data from the web and other sources, which may give them an advantage over traditional creative agencies in being the modern-day “marketing stewards,” if not brand stewards. Right now, the traditional agencies often help determine the marketing strategy, and then outsource to the

Figure 38: Top-Rated U.S. Search Marketing Agencies, November 2008

Top‐Rated U.S. Search Marketing Agencies per Forrester, November 2008

Tier Vendor Parent/Agency Group

Search Marketing

Revenues (2007) Enterprise‐Level Clients

Percent of clients using vendor for both paid search and SEO

OneiProspect Aegis $40m 65% 40%iCrossing Independent 79m 73% 30%360i Innovation Interactive (Independent) 34m 78% 38%

TwoIMPAQT Independent 18m 59% 41%Razorfish Microsoft 31m 77% 25%Reprise Media Interpublic 60‐70m 85% 20%

ThreeOneupweb Independent 13m 40% 26%

Source: The Forrester Wave™: US Search Marketing Agencies, Q1 2009

AHCs have purchased SEM and SEO companies to bolster their offerings

We believe that digital agency compensation has been increasing faster than digital marketing spending and should grow this year despite the recession

Digital agencies may have an advantage over traditional creative agencies through their data analytics capabilities


specialist shops. However, we have heard from industry execs that many creative shops tend to invest less in research than their peers at even media planning and buying shops. This habit might ill-serve the traditional creative agencies in competing with interactive agencies. Some digital agencies are integrating their operations into the IT and data analysis of their clients, so as to better assist in monitoring and adjusting marketing campaigns in real-time based on data analysis. For example, IPG’s HUGE is providing such back-end type services for clients Jet Blue and IKEA. We believe agencies are closely integrating with some retail clients as well. Digital agencies have made some inroads at being named the agency of record, initially more with technology companies and more recently with more traditional brand advertisers, such as retailers and some categories with more potential for e-commerce. It may be easier for shops such as independent IMC2 or AKQA to take on AOR duties since they don't have holding-company politics to contend with. That said, as of recently, even a major digital shop like Razorfish had no full agency-of-record relationships.

Source: Company data, Thomson Baseline and Wedbush Morgan Securities Risks to digital agencies include a trend to internationalization of services by clients over time and the need for greater investment over time to face new competitors. We would expect some clients to take more of this digital work in-house, so as to better adjust their product and marketing plans to the digital groundswell. To compete in the data-driven side of the market, we believe the agencies may have to spend more in capex in IT and opex (hiring, training, etc.) than appear to be in Street models. When independent, digital agencies like aQuantive and Digitas spent substantially more in capex as a proportion of revenue than the agency holding companies do now.

Figure 39: Comparison Of Capex/Revenue For IPG, Omnicom, WPP, Accenture And GOOG

2008, 2.7%

2008, 1.3%

2008, 2.0%

2008, 1.6%

2008, 10.8%GOOG

OMC

IPG

ACN

WPPGY

2008 2007 2006 2005 2004 2003 2002


Source: Advertising Age and Campaign We estimate that, with a number of exceptions, operating margins of the digital agencies in AHCs are below the group average, in the 9-14% range in more developed markets. That said, the scale of digital campaigns is still on average smaller than those of traditional media campaigns, and there are economies of scale in media creative, planning, buying, and post-campaign analysis. Second, digital marketing services are posting above-average revenue growth, which encourages greater investment of margin to build share and scale. Third, the supply chain of digital media marketing is still relatively inefficient. Agency time costs in managing digital campaigns can consume much of the margin in the original scope of work. One agency exec recently estimated that an agency had to incur 2-3x the labor expense to execute a digital campaign as a traditional campaign. Despite having higher commissions (8-12%) than traditional media buying (2-3%), digital media buying typically has substantially lower margins than traditional media buying, in the 2-10% range, unless the agency has layered in a special compensation arrangement (such as a license fee). One reason for the premium commission for digital is to compensate for the greater complexity of executing and analyzing digital campaigns. We believe that, even now, shifts in spending to digital channels from traditional channels are not substantially hurting AHC margins, and that digital margins may have more upside than traditional. Some reports suggest that higher digital creative and retainer margins are more than offsetting any disadvantage in digital media margins, and that in some markets digital agencies are generating higher operating margins than traditional agencies. Digital agencies likely have more cost to take out of their businesses by improving staffing efficiency. Agency execs tell us that salary increases for certain digital staff have moderated from rates seen in 2007-2008.

Figure 40: Digital Agency Margins Can Be Higher Than Average For More Labor-Intensive Services

2008 Est. MarginMedia Agency 17.6%Web Design Firm 15.0%PR Agency 12.0%Direct Marketing Agency 11.3%Sales Promotion Unit 11.3%Promotion Agency 11.3%Marketing Services Agency 11.3%Event Marketing Agency 11.3%Yellow Pages Agency 11.3%Search Marketing Ad 11.3%Digital Agency 10.6%B2B Agency 10.6%Branding Consultancy 10.0%Recruitment Agency 10.0%Research & Consultancy Network 10.0%Sports Marketing Agency 10.0%Healthcare Agency 9.5%Hispanic Ad Agency, 9.5%African‐American Ad Agency 9.5%Political Ad Agency 9.5%Asian‐Based Agency Network 9.5%Ad Agency 8.5%Lead Network Agency 8.5%Multi‐Discipline Marketing 8.5%

We estimate that operating margins of the digital agencies in AHCs are in the 9-14% range in more developed markets We believe that shifts of spending to digital from traditional channels are roughly margin-neutral for the AHCs


Other Services: Direct Marketing, Market Research and Insights/Consulting We estimate that direct marketing and sales promotion probably generate slightly below average operating margins of ~10%. For example, in the 2009 Willott Kingston Smith review of U.K. agency performance, direct marketing and sales promotion had an average operating profit margin of 8.7%. We believe that analog direct marketing is likely to have decreasing margins over time.

The agencies’ involvement in the collection and analysis of digital data about consumer response to marketing messages gives them more opportunity to give marketing strategy advice. We believe that advertisers are interested in hearing the latest insights into consumer behavior and media usage patterns. AHCs like WPP can capitalize on access to a large quantity of marketing data to win consulting engagements in brand valuation and marketing strategy. For example, brand valuation is one of the agency disciplines that has made progress in competing for consulting business. Indeed, Millward Brown’s consulting unit has hired much of its staff from consulting firms. One advantage for the agencies is that general management consulting firms do not typically make it a priority to compete for this business. Beyond certain specialties, however, we believe the agencies may struggle to build their marketing and brand strategy consulting businesses, largely for wont of a compelling business model. We see margins in market research likely to decrease. We have concerns about the commoditization of market research, unless it is wedded to some need-to-have and/or proprietary data (e.g., ratings currency). We believe that agencies will increasingly rely on offshore labor to reduce costs of producing market research. That said, one advantage of market research is that companies with niches in particular areas tend to have a relatively sustainable advantage.

Figure 41: Agency Efforts To Expand Into Consulting, Consumer Insights And Media Measurement

Agency New Capability InvestmentsCarat (Aegis)

IPG

Publicis

Source: Booz Allen Hamilton and Wedbush Morgan Securities

Building Consulting Services

Integrating Traditional and Below the Line

Developing New Sources of Consumer Insights

DetailsCreating New Engagement Metrics

‐ Objective: to transform into more of a solutions provider /strategic consultant

‐ Offers more comprehensive creative marketing solutions ‐ particularly around digital media

‐ FCB (traditional agency) combined with Draft (direct response/promotions specialist)

‐ Invested $10MM in Facebook (0.5% Stake)‐ Seek to mine Facebook community for research trends and consumer insights

‐ Launched "Fortel rating system" with goal to develop a standard "engagement" currency‐ Leverages hybrid mix rating that captures favorite show, time spent, and frequency of


Source: ESOMAR Global Prices Study 2007

AGENCY HOLDING COMPANY BUSINESS MODEL Overview Agency holding companies serve global clients with the full range of marketing services, including branding strategy, media planning and buying, ATL advertising, direct marketing and CRM, and of course interactive marketing. For multinational clients, holding companies typically create client-specific global teams to provide service, funded by internal cost allocations against the local operations directly involved in working on the account. Ideally, the fees charged the client should cover 1) required local creative and production at local rates, 2) a similar amount for local client service and planning salary costs, 3) local overhead, 4) salary of any global coordination staff assigned to the project, 5) direct out-of-pocket expenses incurred by the agency, and 6) a profit margin. The reality of the agency business is that margins are best analyzed on a client-by-client basis, as agencies negotiate fees with major clients on an individual basis, organizing their operations to most profitably provide the scope of work that is ultimately agreed on, while building in the organizational flexibility to respond to the almost inevitable changes in scope of work over the course of client engagements. Alas, AHCs do not provide margin information by client or client type, which leaves analysts to pursue other approaches to understanding agency profitability. Agency holding companies may be able to improve on this structure by having more senior strategy consultants take the lead on solving problems related to global and local brand growth, and fewer local client service and planning staff. In general, the agency is better able to manage its margins by focusing on the client as a profit center, rather than the local offices as profit centers. A challenge here is convincing the local offices to accept this structure, without losing potentially valuable local talent, in particular senior local managers who could see a shift of power to the global client heads.

Figure 42: The Cost Of Market Research Projects Varies Substantially By Region

Market Research Industry Overall Price Comparison (index = 100)

220

204

202

181

176

90

60

56

46

United States

France

United Kingdom

Germany

Japan

China

India

Egypt

Bulgaria

AHCs typically create client-specific global teams to provide service, funded by internal cost allocations against the local operations servicing the client


Based on work done by IBM, we believe agencies continue to shift their mix of services to consumer-centric marketing from traditional advertising. However, we believe that traditional media are a permanent part of the mix. Marketers are exploiting increased data on consumer media usage and purchase habits to improve their return on marketing investment. This requires agencies, as the principal outside firms involved in devising and executing marketing plans, to offer better insights on consumer media usage and purchase habits. Marketers and agencies currently believe that integrated campaigns – involving traditional ATL media, BTL marketing services, and digital channels – offer the most potential for ROI improvement. Despite the theoretical lure of ‘hyper-targeting’ – where a marketer presents its product or service to the consumer just at the point of purchase - we believe that marketing plans will continue to involve a mix of traditional media and digital media, as the costs of such targeting will outweigh the benefits. Prediction of consumer behavior will always be imperfect, and thus marketing will always involve waste. Classifying a particular message as “wasted” will always involve some approximation and uncertainty. At the agency level itself, we see several challenges with the current business model. These include: • Too much management time spent in the account review/pitch process (up to 50%). We believe that

marketing the agency and pitching account for 20-25% of many agencies’ time, which is probably a higher percentage than for most service businesses. However, there is some evidence that the time, and the budgets, allocated to new business pitches has been dropping. According to a survey by the AAR, the percentage of top-20 U.K. agencies with a non-staff budget of more than GBP 500,000 for new business dropped to 17% in 2008 from 40% in 2006.

• The reliance of many client procurement departments on paying agencies on a cost-plus model. Although some agency execs would like to move more agency compensation to incentive-based models - to capitalize on the more granular digital measurement of the impact of marketing campaigns, for example - there appears to be no industry consensus on whether widespread pay-for-performance models are practical or even desirable.

• Too many resources not being monetized in a disciplined way, such as where research is given away as a “value-add” to obtain other business and “scope creep,” where the agency takes on additional tasks during an engagement without receiving adequate compensation. For example, an important differentiator among media agencies can be how they handle changes – this year, usually cuts – in client spending. Although agencies have contracts specifying the media spending contemplated, whose term is typically one-year but which is often cancelable on roughly 90 days notice, the client will often propose cuts in this spending if its own business deteriorates. Because much agency compensation in media planning and buying is still tied to a commission based on media spending, media spending cuts directly affect agency compensation and profit on the engagement. In one extreme, the agency may simply accept these spending cuts and accompanying fee reductions. In other cases, the agency may look to be compensated for the time and costs potentially incurred in making these spending cuts (e.g., canceling upfront buys and exiting other previously placed media buys). Another approach is to reduce

Figure 43: Evolution Of Advertising Business Models

Insights

ROI‐Driven Advertising‐ Direct Digital messaging to micro level

‐ Granular audience profiling, targeting, and measurement

Consumer‐Centric Marketing‐ Integrated, contextual campaigns

‐ Bridges advertising and marketing formats‐ Enables addressability, measurement,

interactivity for desired consumer

Impression

s Traditional Advertising‐ Legacy processes, brand, and transactional

structures‐ Siloed sales and delivery‐ Traditional Measurement

Cross‐Platform Reach‐ Integrated broad portfolio of marketing and

advertising assets‐ Enhanced consumer engagement‐ Breaks through traditional clutter

Single Platform Integrated Cross‐Platform

Source: IBM Institute for Business Value

Level of G

ranu

larity

Degree of Integration

Agencies continue to shift their mix of services to consumer-centric marketing from traditional advertising

Challenges to the current AHC business model include: too many resources spent on the account review/pitch process, compensation on a cost-plus model, scope creep, and inefficient media planning and buying processes driving up costs


the scope of work in other areas of the engagement – such as studies or analytics – to offset lost profit from the reduced media spend.

• High costs from a planning/buying process that is convoluted and inefficient in some channels (e.g., integrating a buy across online video and TV).

• Scarcity of premium brands in the various agency disciplines that can demand a pricing premium (particularly in a recession).

Basic Revenue Model We believe that, for agencies of all sizes, the trend has been for client tenure to decrease. For agencies, clients with shorter tenure have tended to be less profitable. The typical client engagement is for a one-year term, although many large client relationships have gone on for decades. Project engagements (e.g., assisting in staging an event at a trade show) can be for a shorter period, while some research (such as access to panel data) can involve multi-year contracts. Clients typically only commit revenue in advance on some of the longer-term research contracts. From a revenue perspective, the business of large agency holding companies is more predictable than that of most media companies - management typically has good visibility into roughly 90% of its expected annual revenue at the beginning of the year. When rolling over existing relationships, agencies and clients often discuss in 4Q material changes in marketing plans, to facilitate agency planning and staffing for the coming year. For accounts paying a labor-based fee, the agency will coordinate its expected scope of work for the upcoming sales year of the client. By the end of December each year, agencies typically establish their budgets for the following year. Because most of the agency groups’ revenue is fee-based, it is less volatile than the media spending underlying its clients’ campaigns. Even for work where compensation is commission-based, there is a fair amount of visibility. For example, for a media campaign, the client will typically commit to spending 80-90% of the allowed media budget on a campaign, releasing the full amount if the campaign appears to be on track to achieve its objectives, and cutting the last 10-20% if the campaign is not generating an adequate return. Some agencies claim to have fairly good quarterly visibility on organic growth, often able to guide organic growth within 100bps. Others, however, noting in particularly the difficulty of predicting project-related spending (for example, even some ‘evergreen’ projects have been canceled this year), suggest that quarterly revenue growth visibility is not that good, even in a normal business climate. Agency revenue typically skews seasonally to be the highest in 2Q and 4Q. As agency fees generally follow marketing budgets, which in turn follow sales growth, inflation tends to favor the agency business model more than deflation. In general, there are four ways clients pay agencies: by a labor/project-base fee; by commission; by retainer; or based on reaching performance targets. We estimate that the major agency holding companies now generate over 75% of their revenue from fees determined in advance on a project basis or by hourly rates. The agencies recognize revenue when the service is performed and when collection from the client is reasonably assured. Most agency work is done pursuant to scopes of work that can change over time, resulting in changes in fees paid. • For most projects, the agency and client negotiate a scope of work and a fee for that work. We

estimate that 80% of agency fee-based compensation is determined on the basis of estimated labor inputs. Fees tend to reduce volatility in operating margins, as the predetermined rates typically incorporate a margin component. In traditional marketing, there are public relations projects, creative projects (e.g., shooting a Super Bowl ad), and other event-based projects. In these cases, the agencies may agree to a set fee for completing the project, which may include payments (pass-throughs) to third-party vendors. In addition, much digital creative work (e.g., creation of online micro-sites) is handled on a project fee basis. For digital work, we believe there is more variety in compensation schemes, even those which are nominally fee-based.

We believe that the trend has been for client tenure with agencies to decrease … … but agency revenue visibility is still substantially greater than for media companies

Inflation is better for the agencies than deflation Agency compensation models include: Fees …


• Another stream of revenue, which we estimate is typically under 10% of the total for the agency holding companies, is commission-based, earned on performance in accordance with client engagements. Commissions account for a higher proportion of agency compensation in media planning and buying. Over time, commission levels have been dropping, to ~12% gross for full service, including media planning and buying. Commissions for exclusively traditional media buying services are close to 3-4%, while they can be over 8-12% for digital media services. In estimating the revenue impact from data about billings, we distinguish between:

1. engagements where the agency acts primarily as an agent, such as in media buying, and where the agency generally records revenue net of pass-through charges – one should reduce the estimated billings by the estimated pass-through charges, and 2. engagements where the agency acts primarily as a principal, such as in sales promotion, event, sports and entertainment marketing – here, one should estimate revenue as the estimated gross amount billed, and include as office and general expense associated costs.

• Retainers, less common than they used to be, can be used for estimated scopes of work that involve

regular, low-intensity work by the agency over the course of a longer-term relationship. • Compensation on a pay-for-performance basis could involve agreed amounts for achievement of

specific metrics, such as agency evaluation metrics, marketing communications metrics (e.g., brand), or business performance metrics (e.g., client sales or market share).

New Focus on Pay-For-Performance and Licensing Models Where fees predominate, but are closely challenged by procurement, the only significant additional revenue is from a pay-for-performance (“p4p”) incentive or bonus. The more an agency can makes its case in terms of impact on sales and market share, the less its compensation will be seen as a fixed cost under continuing pressure from client procurement executives. As client CEOs increasingly measure CMO performance primarily in terms of revenue growth and market share gains, CMOs may increasingly measure agencies in terms of how much the agencies measurably contribute to these two goals. Rarely if ever does an agency base all of its compensation on performance. More typically, performance-based criteria apply to ~20% of the total fee. In its value-based compensation system, Coke typically sets the performance-based maximum at roughly 30% of the base fee (the base fee includes no agency profit), so that a full payout would make the p4p component ~23% of the total fee. Failure to earn a performance-based component usually makes an engagement at best a break-even proposition for the agency. Agencies typically resist attempts to convert base fees into variable payments based on performance. For example, as reported in the trade press, MediaCom apparently balked at Nokia’s request to revise payment terms to replace a portion of commission-based payments with payments linked to Nokia’s performance. Agencies are looking for new revenue streams, many of which are based on licensing models. One solution to the tension between more traditional cost-plus billing and the need to increase upfront investment in capabilities is incorporating an intellection property-licensing model into agency compensation arrangements. This topic was one of the presentations at this year’s 4As annual conference this past March. In particular, staffs at digital agencies are increasingly looking to develop applications and programs that can generate licensing revenue from multiple clients. Agencies are also looking increasingly to own the digital data created in the course of their clients’ campaigns, to better be able to monetize the insights that can be gained from this data, especially as the data is aggregated across multiple campaigns.

Commissions … Retainers and … Pay-for-performance

Pay-for-performance may be the only way for agencies to substantially increase their potential compensation



Figure 44: Comparison Of Organic Growth, % Change In Headcount, And Operating Margin For IPG, Omnicom And WPP

IPG ‐ Organic Revenue Growth vs. Operating Margins vs. Headcount Growth

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Expense model The current AHC model is built on top individual agencies generating ~20% operating margins, being integrated into agency networks that generate ~17-19% margins, which results in all-in holding company operating margins of roughly 13-14%. In recent years, a U.K. consultant has said that a well-run independent agency should be able to generate an overall operating margin of at least 15%. Although specifics vary by agency size and discipline, this benchmark generally squares with other industry sources we have seen and discussions we have had with agency execs. The best-run agencies have been able to sustain operating margins in the low 20s. However, pressures from client procurement consultants looking to cut outlier compensation levels, on the one hand, and agency talent seeking higher salaries and incentive compensation, on the other, have tended to limit operating margins to these levels. Within the holding company structure, a good agency network (combining many individual agencies and locations) can achieve 17-19% operating margins. We believe that the top-tier of agency networks has been relatively constant in membership and margin. After allowing for a typical share of agencies performing below par, as well as regional and corporate overhead, international agency holding companies have been able to sustain roughly 13-14% operating margins in recent years. As an agency’s primary cost is salaries and related expenses, the key driver of margin performance is the ratio of staff costs to revenue, which is typically 50-60%. An agency with a staff cost ratio of 50-55% typically generates a 10-15% operating margin, while an agency with a staff cost ratio over 60% may generate no more than a 5% operating margin. Per a 2009 survey in Campaign, the average operating margin was 20% for agencies which had a staff cost ratio below 55%, but only 7% for those which did not. Severance expense for headcount reductions is a substantial expense in the ordinary course of business, as agencies manage their margins to the ebb and flow of marketing spending and new business wins and losses. Not all the agency groups consistently break out severance expense separately, although they may provide color on severance during times of major headcount reductions. We estimate than in a typical year severance is roughly 0.5% of revenue, but in a recession can rise to 1.5%-2.0% of revenue. The typical agency cost structure is roughly 50% for overhead, 20% for client service and planning, 20% for creative and 10% for production & traffic. We believe that the 30% or so of cost associated with creative and production is relatively variable, while the client service and planning cost has historically been more of a fixed cost. It may be possible for agencies to improve margins by reducing the amount spent on client service and planning and overhead. We believe continuing pressure to reduce cost structures to maintain margins in the face of client fee reductions will hasten agency initiatives to right-size and ‘right-shore’ its creative and production operations. For example, access to web development talent in South America and India can substantially reduce the cost of executing digital campaigns. The cost of producing TV commercials is now much lower using computer software-based editing systems.

NEW BUSINESS We believe tracking net new business trends back to the beginning of 2008 likely captures most of the important trends for purposes of our 2009-2010 forecasts. We track new business wins and losses to get a sense of future organic growth trends. We believe that trends in new business can provide a meaningful indicator of relative revenue trends over the next 6-9 months. New business wins and losses usually start to have an impact on revenue growth within roughly 90-120 days of the awarding of the business, and typically ramp up to their run-rate impact on organic growth within roughly six months, although this can take longer during a recession. We generally estimate organic growth from net new business as ~10% of the trailing four-quarter amount of net new business wins, although the impact on agency revenue is a greater percentage of billings for certain business (like interactive creative) than others (traditional media buying). In normal economic conditions, new business activity is usually slightly lower in 4Q, because of the year-end holidays. We also monitor new business trends to spot positive momentum or negative stress at particular agency subsidiaries/networks. A string of client losses can threaten the survival of an agency or one of its major offices, and thus lead to a larger impact than implied simply by mere amount of billings at stake. Conversely, talent can be drawn to an agency that has positive new business momentum, facilitating recruitment and possibly increasing the upward slope of the growth curve.

With top individual agencies generating ~20% operating margins, and integrated agency networks generating ~17-19% margins, AHCs have been able to generate ~13-14% all-in operating margins

An agency’s salary and related expense is typically 50-60% of revenue Severance expense can range from 0.5% of revenue to 1.5-2.0% of revenue

We believe that tracking net new business back to the beginning of 2008 likely captures most of the important trends for purposes of our 2009-2010 outlook


Clients often put accounts up for review when there is an important change in the business, which can include change in senior management, M&A, launch of a new product or service. A change of CMO is a typical early-warning sign that an account could be coming up for review. For those agency incumbents successful in retaining an account, account reviews can be a mixed blessing. Even before the current recession, a primary driver of many large account reviews was to reduce media costs and/or agency fees. However, account consolidations are more likely to offer incumbents some margin upside, due to potential overhead reductions from having fewer agencies servicing the account. If an agency has a strength in a particular discipline or region that is in high demand, the agency can have an important edge in winning new business. For example, digital media offerings have become more important in winning new business. In addition, offerings in faster-growing overseas markets can be more important to winning global pitches, as advertisers look to have the best resources on hand to exploit the higher growth expected from these regions. We base our analysis of new business trends primarily on data from resources such as the World Advertising Research Council (WARC), trade publications like Adweek, Advertising Age, and Campaign, discussions with industry executives, and company data where provided. New business reported in the trade press typically includes little of the flow of business in disciplines like PR and marketing services, and often misses even media new business in smaller countries. In addition, these reports often include estimates, and thus are subject to error. We do note that IPG’s YTD 2009 net new business totals are skewed negatively by the loss of some business to Publicis with Unilever in an account consolidation, which was reported by WARC. We have we included the estimated size of the entire account’s annual billings based on this data for completeness. However, we are cautious about attributing much revenue impact to this figure, as we have not been able to confirm it.

Figure 45: Comparison Of Net New Business By Quarter For IPG, Omnicom And WPP, 2008-Present IPG ‐ Net New Business Wins OMC ‐ Net New Business Wins WPP ‐ Net New Business Wins($ millions) ($ millions) ($ millions)

Period Wins Losses Net Rev. Period Wins LossesNet Rev. Period Wins Losses Net Rev.1Q08 1,500 ‐845 655 33 1Q08 375 ‐523 ‐148 ‐7 1Q08 446 ‐365 81 42Q08 215 ‐440 ‐225 ‐11 2Q08 1,567 ‐896 671 34 2Q08 930 ‐805 125 63Q08 115 ‐349 ‐234 ‐12 3Q08 1,129 ‐642 487 24 3Q08 787 ‐115 672 344Q08 544 ‐732 ‐188 ‐9 4Q08 1,815 ‐325 1,490 75 4Q08 993 ‐505 488 242008 2,374 ‐2,366 8 0 2008 4,886 ‐2,386 2,500 125 2008 3,156 ‐1,790 1,366 68YTD09 349 ‐1,747 ‐1,398 ‐70 YTD09 1,148 ‐406 742 37 YTD09 927 ‐217 710 36

Billings Billings Billings

Source: Company presentations, World Advertising Research Council, and Wedbush Morgan Securities estimates

Events at a marketer that can trigger an account review include change in senior management, M&A, and launch of a new product or service


CLIENT BASE

Figure 46: Mix Of Revenue By Advertising Category For IPG, Omnicom And WPP

WPP Revenue Mix by Category

Category MixCumulative

TotalFood & Drink 16% 16%

Personal Care 13% 29%

Other 11% 40%

Automotive 10% 50%

Healthcare 10% 60%

Financial Services 9% 69%

Technology 8% 77%

Telecommunications 8% 85%

Consumer Products 7% 92%

Travel & Entertainment 4% 96%

Retail 3% 99%

IPG Revenue by IndustryCategory 2007 2008

Tech & Telecom 26% 25%Health/Personal Care 19% 19%Automotive & Transportation 14% 13%Food & Beverage 14% 12%Packaged Goods 8% 8%Financial Services 7% 8%Other 7% 9%Retail 5% 6%

OMC Revenue Mix by Category

Category MixCumulative

TotalFood & Beverage 16% 16%Automotive 14% 30%Pharma & Health 12% 42%Consumer Products 11% 53%Other 10% 63%Telecom 10% 73%Technology 9% 82%Financial Services 8% 90%Retail 5% 95%Travel & Entertainment 5% 100%Source: Company reports and Wedbush Morgan estimates


Perhaps the best thing that can be said about auto advertising is that agencies derive less of their revenue from auto-related compensation, 10-15%, than do many media platform owners or broadcast television networks. We estimate that auto marketing spending is tracking down roughly 30% this year in the U.S. GM is the only one of the Big Three automakers to work with two holding companies (IPG and Publicis), which could somewhat soften the blow to either from continuing reductions in GM marketing spending. Over the longer term, of similar importance to the agencies as the current collapse in auto sales and marketing may be the large-scale migration of marketing spending by all auto advertisers to online marketing. One senior agency exec at Advertising Week 2008 said that automobiles were becoming a largely online purchase path. Only as recently as 2006, however, auto advertisers only spent roughly 4% of their marketing budget online. There is evidence that the auto industry has been ill-served by agencies advocating large marketing budgets for traditional media down through the years. The long-term CAGR of marketing expenditures by the auto industry has been well above its revenue CAGR. This was fun while it lasted for media sellers and marketing services providers like the advertising agencies. That party could be coming to an end.

Figure 47: Auto, Financial and Retail Advertising Particularly Hard Hit in 2009

Top Ten Advertising Categories: 1Q 2009 vs. 1Q 2008$ in millions

Rank Category 1Q09 1Q08 % Chg 1 Automotive $2,309 $3,225 ‐28.4%

Manufacturers 1,665 1964.2 ‐15.2%

Dealers 644 1260.5 ‐48.9%

2 Telecom 2,078 2017.8 3.0%

3 Financial Services 1,968 2402.4 ‐18.1%

4 Local Services 1,867 2188 ‐14.7%

5 Direct Response 1,636 1980.1 ‐17.4%

6 Miscellaneous Retail 1,575 1929.8 ‐18.4%

7 Food & Candy 1,501 1605.6 ‐6.5%

8 Restaurants 1,416 1381.1 2.5%

9 Personal Care Products 1,246 1318.4 ‐5.5%

10 Travel & Tourism 1,140 1331.4 ‐14.3%

Total $16,736 $19,379 ‐13.6%Source: TNS and Wedbush Morgan Securities estimates

AHCs derive roughly 10-15% of their revenue from spending by auto makers


Source: CNW Research, TNS Media Intelligence / CMR Agencies may in fact have lower operating margins on engagements with larger clients, and the recession may cause more margin pressure on media agencies dependent on large accounts. Agencies can rely on large accounts to pay for a large share of annual overhead, to provide cash on which interest can be earned, and to be a reputation lever to win smaller, more lucrative accounts as well as hire talent. Larger accounts are pushing more for fee reductions and reduced media buys to cut costs. Smaller accounts may feel that current levels of spending are less discretionary, so that they can at least maintain their market position during the recession. Although agencies with rosters skewing to smaller accounts must manage the risk of those clients failing or having liquidity issues, so do agencies with larger accounts (e.g., IPG and Publicis with GM).

Section 1.01 AGENCY HOLDING COMPANY COMPETITIVE POSITION IN KEY GEOGRAPHIES

To conclude our discussion of the agencies’ competitive position, we discuss geographic trends, which we believe are the most useful way of forecasting revenue trends and, to a lesser extent margin trends, for the agency holding companies. The driving principles behind the AHCs’ geographic strategy are that global brands should gain share, these brands are shifting to more global marketing campaigns, and AHCs with international scope are best able to serve their clients and benefit from this share shift. Our baseline assumption is that, during the recession, in the more mature markets of the U.S., Western Europe and Japan, agency organic growth should be down 50-75% of the percentage drop in advertising and marketing spend. In less mature markets, media and marketing spending growth can exceed GDP growth substantially, helping to pull AHC revenue growth up along with it. As a starting assumption, we

Figure 48: Comparison of Auto Media Mix to Media Impact on Consumer Purchase Decision, 2003

Auto Advertising Mix vs. Purchase Decision

Television, 27%

Newspaper, 12%

Newspaper, 30%

Magazine, 35%

Magazine, 17%

Radio, 4%

Internet, 22%

Television, 50%

Radio, 2%

Internet, 1%

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Allocation of Advertising Spending by Car Companies(2003)

Impact on Consumer's Car Purchase Decision (2003)

Agencies may have lower operating margins on projects for larger clients

We believe geographic trends are the most useful way of forecasting revenue trends and, to a lesser extent margin trends, for the AHCs


assume that operating margins are higher in more mature markets than in emerging markets, reflecting increased investments in infrastructure and personnel in emerging markets to build market share. Over the next couple of years, the profit growth of the AHCs should depend more on how they exploit the shift in spending to interactive media in mature markets than on how the AHCs position themselves for the faster growth in the emerging markets. On the one hand, the emerging markets will be the place for growth in 2009. We expect positive, but slower, media spending growth in the BRIC countries in 2009, with the possible exception of Russia. As the world economy pulls out of recession, however, we would not necessarily expect the premium of media spending growth to GDP growth in China and Brazil to reach pre-recession levels. In addition, the agencies generally have higher margins in North America, Europe and Japan than in the rest of the world, so that managing their business model to adjust to shifts in marketing spend in these markets will have a greater impact on their consolidated profits. Finally, while the media mix in the faster-growing emerging markets is still quite TV-centric, we expect interactive media to begin to gain share in these markets. The business model lessons that the AHCs learn – or do not learn - from the more mature markets will affect agency profitability in the emerging markets when that shift occurs. IPG and Omnicom are more exposed to the U.S. advertising market than WPP, and thus are plays on media and marketing spending (or at least the share of this spending which goes to the AHCs) recovering faster in the U.S. than in the rest of the world when the recession ends. In 2008, IPG and Omnicom were over twice as dependent on North America for their revenue growth as WPP.


Figure 49: WPP Has Most Geographic Diversification, But More Exposure To Europe And U.K.










IPG OMC WPP


The profit growth of the AHCs could depend more on how they exploit the shift in spending to interactive media in mature markets than on how they are positioned for the faster growth in the emerging markets


Source: Company data and Wedbush Morgan Securities estimates In the U.S. and particularly in Europe, because the internet now leads television as the driver of media spending growth, we would expect the AHCs to focus on interactive marketing expertise as their spearhead for winning new business and developing existing accounts in those regions. In Western Europe, Internet spending has contributed over 50% of media spending growth for 2006-2008. In 2008 in Western Europe, the internet contributed almost 70% of media spending growth, while television contributed under 20%. In North America, the Internet has contributed roughly 50% of annual media spending growth since 2005.

Figure 50: IPG And WPP Had The Biggest Growth Contribution From Emerging Markets In 2008

Revenue Growth Contribution Mix by Geography, 2008




United Kingdom, ‐10.3% United Kingdom, ‐4.0%

Continental Europe, 19.6%Continental Europe, 41.4%



IPG OMC WPP

North America United Kingdom Continental Europe Other

Because the internet now leads television as the driver of media spending growth in the mature markets, we expect the AHCs to use expertise in interactive marketing as their spearhead for growth


Figure 51: North America: Internet Now Rivals Or Surpasses TV In Contribution To Media Spending Growth


North America: Contribution to Overall Media Spending Growth, TV vs Internet, 2002‐2008

59%

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Figure 52: Western Europe: Internet Has Made Most Dramatic Gains In Growth Contribution Here


Western Europe: Contribution to Overall Media Spending Growth, TV vs Internet, 2002‐2008

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Of the BRIC countries, we believe that the agencies have more near-term upside from Brazil and China, which appear to have made more progress to a broad-based consumer economy than India and Russia. This should favor WPP, as it has relatively greater exposure to Brazil and China. First, media and marketing spending is already over 1.0% of GDP in China and Brazil, while it still lags substantially in India and Russia. Second, media spending growth has been substantially outpacing GDP growth in Brazil and China, while it has been more in line with GDP growth in Russia, and consistently lagging GDP growth in India. Media and marketing spending growth in the BRIC countries was 10-20% in 2008.

Source: Aegis and Wedbush Morgan Securities estimates

Figure 53: BRIC Media And Marketing Spending Is Still Relatively Small, But Growing Fastest

Source: GroupM, "This Year, Next Year" Win 2008

2008 Media and Marketing Spending and Growth, Selected Countries

$246.1

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Figure 54: Media & Marketing Spending is Near 2.0% of GDP for Developed Economies

2007 Media & Marketing Spend % of GDP

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WPP should benefit in the near-term from its greater exposure to China and Brazil, which we expect to provide the most growth of the BRIC countries


In many emerging markets, media and marketing spending has been growing substantially faster than GDP, which in turn has been growing faster than world GDP. One reason for the over-indexing of media spending growth to overall growth is the outsized growth of the middle class expected in the emerging markets. We heard at Advertising Week last fall the expectation that roughly 2/3 of the growth in the middle class in the next 20 years would be from China and India. On the flip side, the potential for relatively slower development of the middle class in Russia could reduce its media spending growth premium. Certain sources indicate that advertising and marketing spending in China continues to grow at least 30-40% faster than GDP, while others indicate it is growing 2-3x the rate of economic growth. As a result, although China may become the largest economy in the 2030s, it may become the largest advertising market roughly 10 years earlier. From 1979-2008 Chinese real GDP grew at a roughly 9% CAGR. From 1997-2006, the Chinese advertising market grew at a roughly 70% CAGR. In Asia Pacific and Latin America, TV continues to drive media spending growth. Thus, we would expect agencies to focus on strength in this traditional discipline in this fastest-growing region.

Figure 55: Media Spending Has Been Growing Faster than GDP in Latin America, Emerging Europe and North America

Media Growth Relative to GDP Growth 2006 2007 2008 Mean '06‐'08

RegionsLatin America 124 115 113 117Central & Eastern Europe 105 124 101 110North America 121 90 117 109Asia Pacific (All) 84 101 109 98Middle East & Africa 89 106 78 91Western Europe 87 91 74 84

CountriesBrazil 188 158 174 173China 158 96 132 129Russia 100 138 95 111North Asia 103 95 123 107United States 116 90 114 107ASEAN 57 89 75 74India 58 68 70 65

World 93 94 116 101

Source: GroupM, Wedbush Morgan Securities estimates

In many emerging markets, media and marketing spending has been growing substantially faster than GDP


Figure 56: Asia Pacific: Television Remains the Primary Driver of Media Spending Growth


Asia Pacific: Contribution to Overall Media Spending Growth, TV vs Internet, 2002‐2008

100%

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Figure 57: Latin America: Television Remains the Dominant Medium


Latin America: Contribution to Overall Media Spending Growth, TV vs Internet, 2002‐2008

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For the AHCs over the next 2-3 years, we expect the majority of profit growth to come from the more mature markets, as the lower margins in the emerging markets somewhat offset their faster revenue growth. First, in the near term, we believe the agency groups will be less likely to trim staff in the emerging markets than in the more mature markets in North America and Europe, even though they are cutting their growth outlooks across the board. We assume that agencies have lower margins in faster-growing markets, as they are more willing to build staff in advance of revenue, so that they are not forced to turn down new business in a growing market. For example, trade reports indicate that major agencies have been reducing headcount in Hong Kong more than in mainland China. Second, over the medium term, fast growing geographies will probably have lower margins as the companies invest to build market share. Third, in certain emerging markets, such as China, there are a large number of local agencies competing for business, which can reduce margins on work for locally-based clients in particular. Fourth, in some more mature but still faster-growing markets like Korea, in-house agencies take a greater share of the business than they do in Western markets. Over time, we would expect agency margins to converge across geographic markets. First, emerging market margins should increase. Second, we believe margins in more mature markets may be under pressure as the AHCs continue their transition to interactive marketing. AHCs may have to increase their investments to deal with less-traditional competitors for this business, such as the Big 4 online companies. Finally, increasing coordination of campaigns globally should prompt some convergence in margins by geography.

GROWTH AND MARGIN TRENDS

Source: Wedbush Morgan Securities, Magna, and Bureau of Economic Analysis Some agency execs broadly view overall advertising and marketing spending as tracking GDP growth, with the AHC organic growth rate normally increasing 100-200bps faster than marketing spending through the economic cycle. We note that advertising agency organic revenue growth has generally followed a similar cycle as U.S. GDP growth, despite the fact that the AHCs have global businesses. During recessions, agency industry organic revenue has usually dropped in the range of 5%. Although the AHCs have substantially easier growth comparisons in 2009 than they did in 2001, their growth outlook is substantially worse now. Comparing the year prior to each of the last two recessions, the growth and operating margins of the major agency holding companies were lower in 2007 than 2000. In 2000, the agencies were growing organically in the range of 10%, with some of the larger holding companies growing

Figure 58: Comparison of Advertising Agency Industry Organic Revenue Growth to US Advertising Spending, US Nominal GDP and World Real GDP Growth, 1980-2009E

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1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

U.S. Advertising YOY Growth Agency Industry Growth

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We expect the majority of AHC profit growth to come from the more mature markets over the next 2-3 years

Although the AHCs have substantially easier growth comparisons in 2009 than they did in 2001, their growth outlook is substantially worse now


in the mid-teens. In 2007, agencies were growing organically at ~5%, with leaders like Omnicom growing a bit faster, at 7%. On balance, agency operating margins were roughly 100bps lower in 2007 than in 2000. In addition to the anomalous dot.com boom, 2000 benefited from some quadrennial events missing from 2007. Large-scale events – typically, the Olympics, the U.S. presidential elections, and the World Cup (coming next in 2010) – can contribute 1-2 percentage points to global media and marketing spending growth in certain years. In 2008, IPG closed the gap between its organic revenue growth and that of Omnicom and WPP, on the basis of both 1-year and 2-year CAGRs. IPG’s turnaround has made more progress in North America than internationally, however. Over the past three years, of the three companies we cover, IPG has the most often been the slowest-growing of the three internationally, for 9 of the last 13 quarters in fact. In the U.S. over the past three years (1Q06-1Q09), Omnicom’s organic growth has been on average almost 5%, roughly 200bps higher than IPG’s, and almost 300bps higher than WPP’s. Of the three, Omnicom has been the fastest growing organically on a rather consistent basis. Over the last 13 quarters, Omnicom has had the highest U.S. organic growth for nine, IPG three and WPP just once. Outside the U.S. over the past three years, Omnicom’s international organic growth has been on average almost 6%, roughly 100bps higher than WPP’s, and over 300bps higher than IPG’s. Omnicom has been the fastest growing organically on consistent basis, but WPP has been close behind, largely because it has rarely been the slowest growing in a quarter. Over the last 13 quarters, Omnicom has had the highest international organic growth for 8, IPG 3, and WPP 2. We see again that IPG edged out Omnicom for the fastest international growth in 2008, this time because of strong growth in both 2Q08 and 3Q08. One issue for Omnicom is that it has posted the slowest international growth for 3 of the past 5 quarters, including 1Q09, although in these quarters the difference among the three companies was a little lower than average.


Figure 59: Comparison Of Organic Revenue Growth For IPG, Omnicom And WPP, 2000-2010E

Organic Revenue Growth

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009E 2010E

IPG OMC WPP Market Growth

Over the past three years, Omnicom has consistently had the highest organic growth, both in the U.S. and internationally, while IPG has closed the gap with its peers



Figure 60: Comparison Of 2-Year CAGR Of Organic Revenue Growth For IPG, Omnicom And WPP, 2001-2010E

2‐Year Organic Revenue CAGR

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2001 2002 2003 2004 2005 2006 2007 2008 2009E 2010E

IPG OMC WPP Market Growth

Figure 61: Comparison Of Organic Revenue Growth By Geography For IPG, Omnicom And WPP, 2006-2010E

2006 2007 2008 2009E 2010EIPG ‐ North America 0.6% 6.3% 3.2% ‐8.0% ‐1.9%IPG ‐ International 1.4% 0.7% 4.6% ‐4.7% 0.2%IPG ‐ Consolidated 1.0% 3.8% 3.8% ‐6.5% ‐1.0%OMC ‐ North America 7.2% 7.6% 1.7% ‐6.2% ‐1.6%OMC ‐ International 8.1% 6.5% 4.3% ‐4.8% 2.7%OMC ‐ Consolidated 7.6% 7.1% 2.9% ‐5.5% 0.3%WPP ‐ North America 4.6% 3.8% ‐0.3% ‐7.0% ‐1.2%WPP ‐ International 5.9% 5.8% 4.4% ‐5.7% 2.3%WPP ‐ Consolidated 5.4% 5.0% 2.7% ‐6.2% 1.2%Source: Company reports and Wedbush Morgan Securities estimates


We expect AHC margins to decline roughly 100bps in 2009. Before the recession, operating margins for Omnicom and WPP were relatively flat, while IPG increased its margins by over 300bps in each year from 2006-2008 as its turnaround effort gained traction. In 2010, even assuming a slight organic revenue decline, we expect IPG’s margins to resume their upward move. We assume that, outside of picking up the low-hanging fruit on the turnaround tree, a major AHC like Omnicom and WPP is going to be hard pressed to show net margin expansion over the next 2-3 years. We do not believe that foreign exchange swings have a material impact on the operating margins of the AHCs. Forex swings have reversed dramatically in the past year, with the strengthening of the U.S. Dollar against most major foreign currencies. This can substantially affect our reported revenue estimates (e.g., this year, the GBP-denominated income statement of WPP should show a large positive revenue impact, while the USD-denominated statements of IPG and Omnicom should show a large negative impact).

Figure 62: Comparison Of Organic Revenue 2-Year CAGR By Geography For IPG, Omnicom And WPP, 2007-2010E

2007 2008 2009E 2010EIPG ‐ North America 3.4% 4.7% ‐2.6% ‐5.0%IPG ‐ International 1.1% 2.6% ‐0.2% ‐2.3%IPG ‐ Consolidated 2.4% 3.8% ‐1.5% ‐3.8%OMC ‐ North America 7.4% 4.6% ‐2.3% ‐4.0%OMC ‐ International 7.3% 5.4% ‐0.3% ‐1.1%OMC ‐ Consolidated 7.3% 5.0% ‐1.4% ‐2.7%WPP ‐ North America 4.2% 1.7% ‐3.7% ‐4.1%WPP ‐ International 5.8% 5.1% ‐0.8% ‐1.8%WPP ‐ Consolidated 5.2% 3.8% ‐1.8% ‐2.6%Source: Company reports and Wedbush Morgan Securities estimates

Figure 63: Comparison Of YoY Change In Operating Margins For IPG, Omnicom And WPP, 2006-2010E YoY Change in Operating Margins (bps) 2006 2007 2008 2009E 2010EIPG 337 354 322 ‐129 81OMC 26 3 ‐42 ‐72 31WPP ‐ Operating Margin ‐17 43 ‐135 ‐175 38WPP ‐ Headine Margin w/o Assoc. Income 50 43 ‐1 ‐199 34WPP ‐ Headline Margin 49 46 ‐5 ‐210 35

Source: Company reports and Wedbush Morgan Securities

We expect AHC margins to decline roughly 100bps in 2009


2009 GROWTH COMPARISONS

Source: TNS Although we typically examine quarterly growth comparisons on a company-by-company basis, there are a few industry-wide items affecting the 2009 quarterly outlook. First, Olympics-related marketing spending creates the toughest monthly growth comparison of the year for the global advertising market in August. Second, it may be more difficult than usual for the AHCs to put a tight range on their outlook for 4Q09. We have heard some agency execs say it may not be until they start having discussions with clients about 2010 marketing plans that they will have a clear indication of what 4Q09 spending plans will be. We also note that, even as late as the end of 3Q08, many agencies had not seen much budget-cutting by clients. Thus, the pacing comparisons for 4Q09 might not be as easy when the agencies give their 4Q09 outlook as might be inferred from the ultimate 4Q08 results, which showed a sharp deceleration in global advertising spending in each month of the quarter.

CYCLICAL TRENDS

Source: Carat, GroupM, ZenithOptimedia and Wedbush Morgan Securities estimates

Source: Carat, GroupM, ZenithOptimedia and Wedbush Morgan Securities estimates

Figure 64: After Olympics, Global Advertising Spending Growth Decelerated Dramatically

2008 Global Ad Spend YoY Growth by Month

4.7%5.3%

2.6% 2.6%

0.0%

3.3% 3.5%

6.5%

0.3%

‐1.0%

‐2.3%

‐4.8%

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Full Year Average

GLOBAL+1.5%

Figure 65: Comparison of 2009 U.S. and Global Advertising Spending Forecasts of Aegis (Carat), Omnicom (ZenithOptimedia), and WPP (GroupM)

2009 Ad Spending Forecast Carat ZenithOptimedia GroupM (WPP)

US ‐9.8% ‐8.7% ‐4.2%Global ‐5.8% ‐6.9% ‐4.4%

Figure 66: Comparison of 2010 U.S. and Global Advertising Spending Forecasts of Aegis (Carat), Omnicom (ZenithOptimedia), and WPP (GroupM)

2010 Ad Spending Forecast Carat ZenithOptimedia GroupM (WPP)US ‐2.7% ‐1.7% ‐6.8%

Global 0.7% 1.5%


Source: Magna, Bureau of Economic Analysis and Wedbush Morgan Securities estimates How Agency Revenue Trends Vary During the Economic Cycle Although we expect the ultimate declines in AHC organic revenue to be less than those of overall marketing and media spending, past experience suggests that the recovery in AHC organic revenue growth will lag the economic cycle. One dynamic that generally reduces agency revenue volatility is the large proportion of agency revenue from hourly fees, as opposed to a straight commission based on the volume of media purchased by the agency. However, media and marketing spending typically lags six months behind the economy, so that even if economic activity hit its bottom at mid-year, marketers would be unlike to see the impact until 2010. Thus, agency fundamentals tend to move somewhat later in the economic cycle, as larger advertisers, whose spending drives the majority of agency compensation revenue, typically do not restore marketing budgets until the economy is clearly recovering. On balance, we have sensed in our discussions with agency execs 1) more pessimism than optimism about 2Q, 2) a view that we are in more widespread, deeper downturn than in 2001-2002, and 3) a view that an improvement in ad spending is more likely at year-end than at mid-year. There is concern that weak 2Q results for key client categories could lead to another round of marketing budget cuts at mid-year. Thus far this year, most marketers have simply been cutting budgets, as opposed to shifting spending to new media from traditional media. Agency execs describe the situation as “fluid,” which we believe means growth trends could turn up or down on relatively short notice. Because of the fluidity of client marketing plans, we believe the visibility of the AHCs on their likely quarterly organic growth is lower than usual, largely because of the potential impact of project cancellations or restorations. Thus, we would estimate that quarterly organic growth guidance with a 300bps margin for error is more likely this year, as opposed to the roughly 100bps level that is more typical for, say, Omnicom. Two particular growth headwinds for the AHCs in this recession are 1) client pressure for reduced fees, putting pressure on the agencies to become more efficient, and 2) liquidity problems at clients leading to greater-than-average cuts in marketing spending. On the first point, many marketers are asking their agencies for fee reductions outside of a formal account review. According to a February ANA survey, 72% of marketers planned to reduce advertising-campaign production budgets; 68% planned to "challenge" agencies to reduce internal expenses and/or identify cost reductions; and 48% were looking at reducing agency compensation at that time. We expect that the agencies are trying to broaden the discussion to scope of work and compensation structures, so as to better manage their margins. We believe that agencies likely continued to bill under existing agreements on many

Figure 67: Comparison of Growth of US. Advertising Spending as Share of GDP, 1930-2007

Advertising Spending as a % of U.S. GDP and Past Recessions

1.00%

1.20%

1.40%

1.60%

1.80%

2.00%

2.20%

2.40%

2.60%

2.80%

3.00%

1930 1937 1944 1951 1958 1965 1972 1979 1986 1993 2000 2007

Ad Spend % of GDP

1937 1953 1945 1948 1957 1960 1969 1973 1980 1981 2001 1990 1937 1953 1945 1948 1957 1960 1969

Although AHC organic revenue should hold up better than overall media and marketing spending, its recovery will likely lag the upturn in the economy

We sense more pessimism than optimism about 2Q and a view that an improvement in ad spending is more likely at year-end than at mid-year

Many marketers are asking their agencies for fee reductions outside of a formal account review


engagements in 1Q, and that they will have to make some concessions as these agreements are revised in 2Q. Thus, we would expect a greater level of fee reductions in 2Q than 1Q. On the second point, some large advertisers have company-specific reasons for cutting marketing more than usual, such as GM and Chrysler, because of their bankruptcies, and Anheuser-Busch, which is reducing costs to achieve merger synergies. Even before GM and Chrysler made their bankruptcy filings, executives were concerned about the potential impact on marketing spending. On the other hand, easing liquidity concerns could indirectly boost marketing spending. New business activity – the life blood of agencies in economic expansions – can recede in importance during recessions. In addition to the revenue cycles broadly associated with the economic cycle, agencies have a cyclical overlay from the win and loss of substantial new business. In recessions, marketers typically cut back on account review activity at first. Many CMOs would prefer to avoid compounding the business uncertainty of a recession with the uncertainty of a potential change in agency. This reluctance to make major changes in agency rosters gives the larger agency groups some stability in their client base. Organic growth declines from existing business will likely overwhelm positive increments from new business this year. New business activity was substantially lower in 2008 than at the beginning of the 2001-2002 recession, when online and technology companies were spending heavily until the crash. In addition, we have heard that agencies are seeing increased pressures in many new business pitches to reduce costs. And for agencies winning new business, the revenue lift from new business wins typically takes longer to ramp up in recessions. On the other end of a recession, investors need to be wary of “false dawns” when new business activity picks up. Revivals in new business do not necessarily signal the end of the marketing downturn. For example, new business activity picked up in 1Q02, but agency growth for full-year 2002 still decelerated sharply from 2001.

How Different Disciplines Respond During the Economic Cycle The speed with which marketing spending changes affect agency revenue depends on the nature of the marketing discipline. Agency disciplines more dependent on non-recurring business, like projects and events, tend to be more economically sensitive. Project spending tends to be more volatile. Marketers find it easier to cut project spending to preserve margins in a downturn, and similarly find it easier to restore some project spending if they become more optimistic about their marketing plans. Cuts in projects can have a proportionately greater impact on agency compensation, as agencies typically capture a larger portion of project revenue as compensation – at least as a pass-through to third-party contractors. On the other hand, some project work – such as for events – is lower margin and thus the cuts have proportionately less impact on the bottom line. Thus, in this recession, BTL agency fees, where budgets for activation (e.g., a promotional campaign to drive sales) are largely concentrated, appear in fact be falling faster for some agencies than ATL fees. In its June update at the time of its annual shareholders’ meeting, WPP said that organic growth for from its advertising and media investment management business (i.e., advertising creative and media planning and buying) has been least affected by the recession this year. In this recession, many marketers disproportionately cut projects when the financial crisis deepened. Anheuser-Busch InBev this year eliminated the payment of agency retainers and introduced a system of paying agencies based on a scope of work set at the beginning of the engagement. Such shifts in the mix of work to being more project-based could introduce more volatility into the agency model over time. Even digital marketing services have been subject to project cuts, and WPP noted that direct, internet and interactive growth has been more affected this year than advertising and media investment management. As a specific example, Microsoft’s Razorfish reportedly saw $2-3m online projects put on hold in 4Q08. Media planning and buying units tend to feel the impact of a downturn after some delay. For a traditional TV-centric campaign, 3-6 months before launch, the agency will typically begin work on the creative and execution, including related web execution, such as the creation of micro-sites. Media spending plans for large-scale (e.g., nationwide) launches of products with extensive distribution through dealers or larger retailers (e.g., Wal-Mart) are more difficult to scale back quickly. For example, a manufacturer launching a new vehicle model will need to buy a certain amount of media exposure to coordinate with the delivery of the vehicles to and marketing plans of the dealer network in support of the launch. Similarly, media plans coordinated with major retailers are less subject to change at the beginning of a downturn. Given the leverage of major retailers in the distribution channel, manufacturers are leery of making major changes to established marketing plans. Retailers may respond by dropping their support for that product or other

New business activity – the life blood of agencies in economic expansions – can recede in importance during recessions

Agency disciplines dependent on projects and events tend to be more economically sensitive

In this recession, BTL agency revenue appears to be falling faster than ATL revenue

Media planning and buying units tend to feel the impact of a downturn after some delay


products of that manufacturer. As a result, agency work on such campaigns generally continues, although the scope of work may be reduced. Alternatively, advertisers can reduce expenses by reducing the scope of work on a project (e.g., fewer actors or cameras on a commercial shoot), rather than cutting it entirely. We believe that the impact of some fee cuts typically happens with a lag and has yet to be fully felt, given that marketers began asking agencies to cut fees in earnest only in 4Q08. As these clients typically asked the agencies to provide the same or greater level or service, these cuts will put pressure on margins. Once the client does cut its media spending, any of the agency’s commission-based compensation – for media buying services, for example – drops at the same time. Marketing services disciplines (e.g., direct marketing), to the extent they do not depend on spending on discrete projects, should be less affected by the recession, benefiting from client budget shifts in search of measurable sales results. For example, we expect digital disciplines to grow in 2009, but at a substantially slower pace than in 2008. For example, AKQA has said it expects 10% growth in 2009, down from 22% in 2008 and 40% in 2007. In digital channels, however, spending on activation appears to have been cut less than spending on branding. We believe that digital agency revenue has outperformed in the recession, reflecting not just spending trends on targeted digital channels, but also spending on projects to understand new, rapidly growing areas like social media. For marketing spending, we believe one sign of a turn will be selective release of budgets to defend market share, or perhaps opportunistically steal share from a napping competitor. The most likely source of upside in near-term agency organic growth would be an increase in project spending. At the onset of a recession, marketers can follow a herd instinct, cutting spending to preserve profits, not fearing market share loss as they believe that competitors are likely cutting marketing spending as well. At some point, marketers will look to pick up share on the cheap by increasing spending while others continue to cut. Procter & Gamble, for example, has been known to look to pick up share in recessions, as it can be cheaper to do so at this time. Indeed, increases in marketing spending by major marketers (e.g., P&G in 1993) can be more relevant than increases in TV upfront spending commitments (e.g., in 2002) in leading the cycle of marketing spending cuts to stop and reverse.

How Agency Margins Vary During the Economic Cycle Thus far in this recession, the AHCs seem more confident in their ability to preserve margins than in past recessions. Agencies have more sophisticated cost management systems in place now than during the last recession. Based on early results, it seems like the agencies are safe from repeating the disastrous margin contraction of some prior recessions. In the 1991-2 recession, margin declines were up to 50% at the larger agencies. In the U.K., operating profit margin for the largest agencies was 9.8% in 1991. In the three subsequent years, they recorded overall operating losses. Some of the better performers actually tended to be smaller agencies with strong creative departments. Typically, as organic growth goes negative, industry operating margins contract, as the cost of administrative staff is relatively inflexible and, in the near term, much office and general expense is relatively fixed. An agency has some incentive to moderate headcount reductions at the beginning of a down cycle so that it can maintain levels of client service and have capacity in case the downturn is less severe than expected or in case it picks up market share from new business wins. For this reason, creative agencies, especially those dependent on project work and work on secondary brands, often see margins drop first, as clients cut this spending to preserve margins. Only over a 12-18 month period can agencies meaningfully reduce overhead costs like lease expense. Thus, cost-cutting – and reinstatement - typically proceeds as follows. First, discretionary items like T&E are cut, although in the medium term there is some pressure to restore spending levels for morale and recruiting reasons. As new business activity falls in a recession, this naturally leads to less T&E spending. Second, temporary staff and consultant services are cut, along with accruals for incentive compensation (up to ~50%). Third, staff salary increases and then headcount are cut. As marketing spending begins to increase, the process of adding to the AHC expense base proceeds roughly in reverse order to how expenses were cut. Ultimately, staff is the largest component of agency overhead, and thus contributes the largest share of cost reductions in a recession, although the associated opex reductions are somewhat offset in the near-term by severance costs. There is just so much mileage the agencies can get from their “shock absorbers” (to quote WPP) to cushion fee reductions absent reductions in headcount, simply because the increasing use of procurement directors to negotiate agency fees has left less fat to cut at the agency. Throughout, staff specifically associated with projects that have been cut or clients with reduced or eliminated scopes of work

Marketing services disciplines that deliver measurable sales results should be less affected by the recession

We believe one sign of a turn in marketing spending will be selective release of budgets to defend or steal market share

In this recession, the AHCs seem more confident in their ability to preserve margins than in past recessions

As organic growth goes negative, industry operating margins contract, as the cost of administrative staff and office overhead is relatively inflexible and in the near term


are more subject to being severed. In this recession, the events business and associated headcount has had a higher beta than other businesses and staff. Down cycles also tend to turn working capital into a net user rather than contributor of cash for the AHCs. One sign of stress in the agency business model in the current recession is Omnicom’s proposal earlier this year, since withdrawn, to pay production houses only once the agencies had been paid by clients. Of course, prior to filing for bankruptcy, GM shifted its agency payment terms to 120 days from 30 days, putting pressure on its agencies’ cash positions. Anheuser-Busch InBev this year eliminated the payment of agency retainers and introduced a system of paying agencies based on a scope of work set at the beginning of the engagement. We tend to believe that margin recovery may be more difficult after this recession, which will make preserving margins now all the more important. We believe clients are looking to impose less profitable terms of trade that could make agency margin expansion more difficult during a recovery. These terms include a greater mix of work done on a project basis, greater use of value based compensation or similar systems, and a greater client procurement focus on reducing expenses in interactive marketing. We believe that AHCs may ultimately have to sacrifice some margin to achieve satisfactory post-recession growth. That said, we do note that many AHC execs think margins will recover as fast as or faster than in prior economic recoveries. As the economy improves again, the agencies will seek to hold headcount growth below organic revenue growth, beginning the cycle of margin expansion again. The agency industry is even more consolidated than it was coming out of prior recessions, presumably giving it more pricing power to resist fee cuts now, and to push for fee increases when business conditions improve.

How Agency Performance Varies by Geography in the Economic Cycle Media and marketing spending is tracking down in the high single digit percentages in the US and Europe for 2009. 1H has been worse than expected, in both the U.S. and Europe, as cuts that hit in December have carried through thus far this year. Recent forecasts now suggest that media and marketing spending declines could be greater in the United Kingdom than those in the U.S. in 2009. For example, GroupM in early June revised its U.K. media spending growth forecast to down 14% - this compares to the down 5% forecast in its semi-annual global forecast in December. Earlier in the year, there were signs that the media and marketing spending decline might be less in the U.K. than the U.S., reflecting in part a skew in these forecasts to measured media – the traditional ATL ad vehicles like TV, radio and print – which seemed to have less fat to cut at this point. Traditional measured media have already lost substantial market share in the U.K., which has among the highest shares of online ad spending in the world. Thus far in 2009, Continental Europe has had the strongest growth in Eastern Europe and Russia, moderate declines (less than the U.S.) in the largest economies of Germany and France, and the greatest declines in Italy and Spain. We expect modest positive media and marketing spending growth from the BRIC countries in 2009. Although China and India still appear to be on track for modest, single-digit percentage growth this year, spending in Russia is falling, reflecting the YoY decline in oil prices and the devaluation of the ruble. Led by Brazil, Latin and South America should grow in 2009. Generally speaking, AHCs with a greater mix of business from local clients, as opposed to multinational companies, appear to be faring better, because the recession has had less of an impact on spending by local companies. In the Asia Pacific region, Japan is shaping up as 2009’s big albatross. Per trade press reports, overall media spending in Japan was down ~20% in 1Q09. We believe that declines in South Korea could be even greater, although this market is usually a smaller contributor to revenue for the AHCs. The biggest risks to marketing growth in Latin America are the impact of the recession from the U.S., political instability, and now the aftermath of the swine flu outbreak. Some smaller markets, like Turkey, could be up as well, but not enough to move the needle for the agency holding companies.

Down cycles also tend to turn working capital into a net user rather than contributor of cash for the AHCs

We believe that margin recovery may be more difficult after this recession, making margin preservation now more important – some AHC execs disagree

Media and marketing spending is tracking down in the high single digit percentages in the US and Europe for 2009

We expect modest positive media and marketing spending growth from the BRIC countries in 2009


DEAL TRENDS

Compared to its peers, WPP has spent more of its revenue on acquisitions and spent more on later-stage targets. For 2003-2008, WPP spent on average 9% of revenue on acquisitions, and acquisitions have in turn generated roughly 7% of WPP’s revenue. During this same time, Omnicom spent on average 3% of revenue on acquisitions, and acquisitions have generated 1% of Omnicom’s revenue, suggesting that it was acquiring earlier stage companies than WPP. Busy with turning around its core operations – and digesting some prior acquisitions of its own – IPG spent the least on acquisitions from 2003-2008, on average 1.6% of revenue. While digesting its 2008 acquisition of TNS, even with its term loan bridge now refinanced, WPP is unlikely to make any major acquisitions, so that we would expect its acquisition spending as a percent of revenue to decline noticeably in 2009 and 2010. Omnicom has lower leverage, has indicated interest in making acquisitions during the recession, and has suggested that the bid/ask gap is coming down, and thus may be more likely to boost its acquisitions in 2009-2010. We expect IPG to focus on smaller, complementary acquisitions. Although an acquisition of an agency with a major multinational client could complement Lowe’s turnaround plan by giving a combined agency network greater global scale, we are not aware of any likely candidates, or plans by IPG to make such an acquisition. Prior to WPP’s closing its acquisition of TNS in October 2008, there were trade press reports of a potential deal between WPP and Microsoft, in which WPP would acquire the Avenue A/Razorfish digital agency in exchange for cash and 24/7’s publisher ad-serving technology business, Open AdStream. WPP would be able to substantially expand its digital agency business by thus acquiring the second-largest U.S. digital advertising agency, and have the largest digital agency revenue base in the U.S. of the AHCs. Microsoft might prefer to structure a deal for Avenue A as an asset exchange, to mask comparisons to its $5.9bn cash purchase price paid in August 2007 for aQuantive – which primarily consisted of Atlas, DrivePM and Avenue A (~60% of aQuantive’s revenue at the time). Assuming total revenue of roughly $400m, a roughly 20% EBITDA margin, and an 8-10x EV/EBITDA multiple, Avenue A would be valued at roughly $700-$800m. The agency holding companies have been competing for digital media acquisitions with the major online advertising companies for the past few years. Although independent digital advertising agencies once appeared to prefer acquisition by an AHC, they may now prefer not only potentially higher prices which the Big 4 and perhaps even technology-oriented companies can offer, but also the opportunity to expand their offerings with such an acquirer’s technology. In 2006, Publicis was the first AHC to make a substantial acquisition of a digital agency, buying Digitas for $1.3bn, or slightly over 3x revenue. Google then acquired DoubleClick for $3.1bn in April 2007. Partially in response, WPP acquired 24/7 Real Media for $649m in May 2007. That same month, Microsoft announced the acquisition of aQuantive (most of whose revenue came from its digital advertising agency Avenue A/Razorfish) for $5.9bn, or ~11x revenue. Also in May

Figure 68: WPP Has Spent Much More of Its Revenue on Acquisitions than IPG or Omnicom Comparison of spending on acquisitions by IPG, OMC and WPP, 2003‐2008Acquisitions/Divestitures in $ 2003 2004 2005 2006 2007 2008 2003‐08WPP $690.3 $418.6 $1,017.3 $432.0 $1,352.2 $1,908.0 $5,818.5OMC $410.0 $316.0 $294.5 $236.3 $358.8 $441.4 $2,057.0IPG $224.6 $175.4 $2.2 ‐$24.9 $106.8 $113.7 $597.8Acquisitions as % of Total Revenue 2003 2004 2005 2006 2007 2008 2003‐08WPP 8.4% 4.9% 9.4% 3.6% 10.9% 14.0% 8.9%OMC 4.8% 3.2% 2.8% 2.1% 2.8% 3.3% 3.1%IPG 3.6% 2.7% 0.0% ‐0.4% 1.6% 1.6% 1.6%Revenue from Acquisitions/Divestitures 2003 2004 2005 2006 2007 2008 2003‐08WPP $571.7 $608.8 $1,499.1 592.2 378.8 780.9 4431.6OMC $271.7 $163.9 ‐$28.8 25.9 77.7 128.1 $638.5IPG ‐$13.9 ‐$88.0 ‐$107.4 ‐$165.4 ‐$70.7 $87.6 ‐$357.8Acquisition Revenue % of Total Revenue 2003 2004 2005 2006 2007 2008 2003‐08WPP 6.9% 7.1% 13.9% 5.0% 3.1% 5.7% 6.8%OMC 3.2% 1.7% ‐0.3% 0.2% 0.6% 1.0% 1.0%IPG ‐0.2% ‐1.4% ‐1.7% ‐2.7% ‐1.1% 1.3% ‐0.9%Total Revenue 2003 2004 2005 2006 2007 2008 2003‐08OMC $8,621.4 $9,747.2 $10,481.1 $11,376.9 $12,694.0 $13,359.9 $66,280.5WPP $8,227.7 $8,615.4 $10,767.9 $11,838.1 $12,395.4 $13,598.4 $65,442.9IPG $6,161.7 $6,387.0 $6,274.3 $6,190.8 $6,554.2 $6,962.7 $38,530.7

Source: Company reports and Wedbush Morgan Securities

Compared to its peers, WPP has spent more of its revenue on acquisitions and spent more on later-stage targets

In our view, while WPP digests its 2008 acquisition of TNS, it is unlikely to make any major acquisitions, although Avenue A/Razorfish is a possible wild card

The major AHCs have been competing for digital media acquisitions with the major online advertising companies for the past few years


2007, AOL announced its acquisition of Adtech and its online ad serving operations for an undisclosed sum. In July 2007, Yahoo acquired Right Media and its online advertising exchange for $650m. Compared to those of holding company peers Publicis and WPP, the digital media acquisitions of Omnicom and IPG have been more modest. That said, IPG did acquire a 51% stake in web design firm HUGE for an undisclosed amount in July 2008. In the emerging markets, we expect the AHCs to focus on acquiring both traditional and digital agencies. Even in geographic markets where, as we have seen, television may still be the dominant driver of media spending growth, we would expect the AHCs to look to make acquisitions of agencies that add in particular to their digital capabilities, with an eye to future growth. In India for example, the market of digital media agencies is relatively unconsolidated, growing substantially faster than the traditional agency market, and digital media agencies can have operating margins up to 2-3x higher than traditional. A long-rumored merger of Aegis and Havas would further concentrate the top AHC players, and potentially create opportunities for IPG, Omnicom or WPP to pick up talent and/or clients that would leave the combined firm during the integration process. French businessman Vincent Bolloré controls Havas, owns a 29% stake in Aegis, and reportedly has had discussions about merging Havas with Aegis, apparently balking at the price required by Aegis. WPP CEO Martin Sorrell has openly predicted a merger of Aegis and Havas as recently as last year. A merger of Havas and Aegis would strengthen Havas’ offering in media planning and buying and digital marketing. The fallout from such a merger could also make available some businesses (such Aegis’ Synovate unit) and talent to the other AHCs. First, there are client conflicts that could require a merged Aegis-Havas to resign some accounts. Second, there are usually turf battles when two agencies merge, even where, as here, one has a particular strength in one area – Aegis in media – and thus perhaps there is less direct overlap between the two. On the back burner for the foreseeable future in our view is a potential acquisition of IPG by Publicis as an exit at the end of IPG’s turnaround. The trade press has periodic stories on a merger between IPG and Publicis. Still less likely, but possible, in our view, is a deal between Havas and IPG, such as by Bollore’s acquiring a stake in IPG to facilitate a joint venture or an outright acquisition of some of IPG’s businesses by Havas.

TECHNOLOGY AND REGULATORY TRENDS We believe that one of the most important trends for the agencies will be the development of systems to facilitate the planning, execution, and measurement of effectiveness of integrated cross-platform campaigns involving traditional and interactive media. This would involve a combination of technology and the creation of standards and organizations to apply this technology. As IBM has noted in its ongoing studies of the media industry:

“Very few providers can enable cross-platform support to include inventory forecasting, dynamic pricing, packaging, delivery and reporting. Even if enabling tools did exist, many participants have siloed structures that would hamper their use, with separate groups handling digital advertising deals and traditional advertising deals.”

We believe that developments in this area, and how the agencies lead or react to them, could have important consequences for the agencies’ business models going forward. We do not foresee the agencies becoming substantial investors in technology development themselves, however. For one, WPP – the most aggressive acquirer among the AHCs - still takes the view that agencies should stay focused on the application of technology to marketing, not in the development of marketing technology. We consider the agencies’ investments in technology to be relatively modest compared to the size of their operations, and particularly so with what their major “frenemies” in the online marketing sector spend. For example, capex/revenue has averaged 2-3% for our agency coverage universe in the past three years. For IPG, which gives detail on technology-related capex, technology-related capex/revenue has averaged around 1%, in the range of $50-75m annually. In our view, the most important legal issue for the AHCs is the control and use of consumer data in the marketing process. Currently, marketers are trying to set standards through self-regulation. Agencies may be able to benefit if they can establish themselves as honest brokers, although this role is by no means a sure thing.

A merger of Aegis and Havas would further concentrate the top AHC players, and potentially allow IPG, Omnicom or WPP to pick up clients and/or talent

Tools to integrate online and offline campaigns could have important AHC implications

A key legal issue is the control and use of consumer data in marketing


CAPITAL STRUCTURE TRENDS We believe that the AHCs will attempt to maintain investment grade ratings, or at least investment grade credit profiles, opting to avoid the large cash acquisitions or substantial increases in capex that might be necessary if they were to invest more in the development of marketing technology. Omnicom and WPP are investment grade and we forecast IPG’s leverage peaking at ~3x EBITDA during this recession, which would be consistent with an investment grade credit rating. Acquisitions usually set minimum compensation levels for the senior management of the acquired company, and we include an estimate of contingent liabilities such as future earn-outs in the hidden value section of our enterprise value calculation for each of the AHCs. Agency cash levels fluctuate throughout the year more than for most companies, largely because of changes in working capital as a result of the cycle of client billings. Agencies typically have a negative working capital position, which peaks at year-end, typically serving as a source of operating cash during expansions. Agencies collect in advance from their clients the cash needed to make the media buys and pay third-party vendors involved in production. Given that the cash collected can be 5-10x higher than the agency’s revenue, the working capital impact can be substantial. Agency revenue might be 3% of media billings and 12% of creative and marketing services billings. In addition, published billings estimates can be inflated, sometimes by clients wishing to give head-fakes to competitors.

MANAGEMENT AND GOVERNANCE We see a trend for AHCs to manage global accounts from the holding company level. We see this as part of a strategy to 1) strengthen the agency-client relationship at the most senior, e.g., board, level, 2) increase the agency’s strategic consulting business, by leveraging their existing creative relationships with clients and the company’s substantial global marketing database, and 3) reduce client service costs. AHC company parents typically handle administrative work, hire and manage talent across the group, and can be the focal point of contact and accountability with multinational clients in particular.

VALUATION TRENDS Investors typically rely on three primary methods of valuation for the agencies: discounted cash flow, P/E and EV/EBITDA. Particular advantages of the DCF in agency analysis include the ability to capture: differences between book and cash taxes, working capital swings (positive during expansions, negative during contractions), and adjustments for earnouts and contingent payments for acquisitions (more relevant during times of greater M&A activity). Another check on relative valuation is price to revenue-per-share, on the assumption that agencies should gravitate to similar margins over time. Enterprise value-to-revenue can be used as a metric in evaluating acquisitions, particularly in faster-growing sectors like digital and the emerging markets.

We believe that the AHCs will attempt to maintain investment grade ratings, or at least investment grade credit profiles

We see a trend for AHCs to manage global accounts from the holding company level

In valuing the AHCs, investors typically rely on discounted cash flow, P/E and EV/EBITDA


Source: Thomson Baseline, Advertising Age, Campaign, Wall Street Journal, Company data and Wedbush Morgan Securities estimates

Figure 69: Stock price history of IPG, OMC, WPPGY vs SPX

A WPPGY ‐ 1988: WPPGY listed on the Nasdaq exchange in New YorkB WPPGY ‐ December 1990: WPP profit warning was the critical point in turning off confidence. Stock plunges 82% in two days.C WPPGY ‐ May 1994: IBM fires 40 agencies in 1994 and consolidates its global advertising at OgilvyD OMC ‐ January 1997: John Wren becomes CEOE WPPGY ‐ March 6, 2000 ‐ share price reaches its all‐time high of 1323 pence.F WPPGY ‐ May 2000: Acquires Young & Rubicam for $5.5 bn in stockG IPG ‐ March 19, 2001: First of two earnings warnings. IPG share price falls sharply again on 06/15/2001 with second earnings warning.H IPG ‐ June 1, 2001 ‐ Acquires True North for $2.1bnI WPPGY ‐ September 2001: Acquires Tempus Group for $630m, above Havas' $600m bidJ OMC ‐ June 6, 2002: Rumors of a forthcoming negative Wall Street Journal article�circulate and Omnicom's stock price declines.K IPG ‐ March 2002: Announces accounting/ SEC problemsL IPG ‐ February 19, 2003: Announces suspension of cash dividend. M WPPGY ‐ March 2005: Acquires Grey for $719mN WPPGY ‐ May 2007: Acquires 24/7 Media for $649mO OMC ‐ June 25, 2007: Two‐for‐one stock split P IPG ‐ January 19, 2005: Michael Roth becomes Chairman and CEO.

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Source: Thomson Baseline, Advertising Age, Campaign, Wall Street Journal, Company data and Wedbush Morgan Securities estimates

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Figure 70: Stock Price Appreciation To May 31, 2009 Based On Date Of Purchase For IPG, OMC, WPPGY And SPX

Figure 71: Stock Price Appreciation To May 31, 2009 Based On Date Of Purchase For IPG, OMC, WPPGY And SPX

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Figure 72: P/E for IPG, OMC and WPPGY Compared to S&P

P/E Comparison: S&P500 vs. IPG, OMC, and WPPGY

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Figure 73: Relative P/E vs S&P for IPG, OMC, PUBGY and WPPGY

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Source: Thomson Baseline and Wedbush Morgan Securities estimates Reflecting the increasing similarity of US GAAP to International Financial Reporting Standards (IFRS), the P/E ratios of WPPGY, on the one hand, and IPG and OMC, on the other, have become somewhat more comparable over time. OMC has typically traded at a premium on P/E to WPPGY. The magnitude of the premium is subject to some interpretation, however, given differences between the “headline” earnings figures which WPP reports and the IFRS earnings. The headline figures exclude items such as goodwill amortization and investment write-downs, which would not be excluded under IFRS or under US GAAP. Thus, for example, in the last reconciliation which WPP provided on the topic in 2006, headline EPS was 42p per share, while EPS under US GAAP would have been 28p per share. As for IPG, prior to the investigations of its accounting practices, IPG generally traded at a P/E similar to that of Omnicom. Since 2002, however, P/E has not been a particularly relevant valuation metric for IPG, although IPG’s P/E has moved somewhat more in line with its peers over the past year. Reflecting their cyclical nature, the agencies stocks have generally traded at a trailing P/E premium of 1.0-1.3x relative to the S&P during periods of moderate economic expansion, such as 2003-2007. If growth gets stuck in the mid-to-high-single digit decline ditch we currently expect for 2009, the recent rally in agency

Figure 74: Agency Stock Price Performance Relative to Trough of 2001 Recession

IPG, OMC, and WPP Relative Stock Performance vs. S&P 500 (2001 Recession)

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Figure 75: Agency Stock Price Performance Relative to Trough of 1991 Recession

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shares may fade, just as it did after the post-9/11 surge in the last recession. At the height of the Internet boom in the 1990s, which saw double digit agency organic growth as well as increasing industry consolidation, WPPGY traded as high as 2.0x the S&P P/E. By the end of 2001 and the beginning of 2002, WPPGY was trading at a discount of almost 0.8x the S&P P/E. During the summer of 2002, reflecting both market-wide concerns about accounting practices as well as specific concerns raised about its own accounting practices by the Wall Street Journal, OMC briefly dropped to a discount of roughly 0.7x the S&P P/E. When the U.S. recession officially began in December 2007, OMC and WPPGY were both trading at a slight premium to the S&P P/E on a trailing basis. By the time of the market lows in March 2009, OMC had fallen to roughly 0.6x of the S&P P/E, and WPPGY, reflecting leverage covenant concerns as well as the recession, had fallen to roughly 0.5x of the S&P P/E. Since the market rally, and in WPP’s case the successful offering on convertible debt to refinance outstanding debt incurred at the time of the TNS acquisition last year, by our estimates, OMC has moved up to trade at ~0.7x of the S&P P/E, and WPP up to ~0.6x.

We believe that some, particularly more value-oriented investors look at trends in return on invested capital (ROIC) as well - on this basis, Omnicom has been the best performer. On an ROIC basis, Omnicom has delivered the highest returns of the companies on which we initiate. In 2008, Omnicom's ROIC was 9.0%, compared to IPG's 8.8% and WPP's 7.1%. This compares to 2005, when ROICs for Omnicom, IPG, and WPP were 7.5%, 2.5%, and 7.1%, respectively. Notably, IPG's remarkable ROIC improvement reflects its efforts to divest non-performing assets as part of its overall turnaround effort. Looking forward, we expect that Omnicom will continue to have a higher ROIC, absent any significant acquisitions. On the other hand, the ROIC of WPP is likely to come under pressure, as its average invested capital base now includes goodwill from its 2008 acquisition of TNS.

Figure 76: Omnicom Has Had Highest Return on Invested Capital (ROIC) from 2005-2008

CompoundCompany 2005 2006 2007 2008 2009 2005‐09

OMC 7.5% 8.4% 8.8% 9.0% 8.3% 8.4%WPPGY 7.1% 7.9% 7.0% 7.1% 5.7% 6.9%IPG 2.6% 4.9% 7.0% 8.8% 6.8% 6.0%


Comparison of return on invested capital of IPG, OMC and WPPGY

In December 2007, OMC and WPPGY were both trading at a slight premium to the S&P P/E on a trailing basis

On the basis of return on invested capital, Omnicom has been the best performer


Public Companies Mentioned in this Report (as of close 6/15/09) Company Ticker Rating Current Price Price Target Interpublic Group IPG HOLD $5.65 $5.75 Omnicom Group OMC BUY $31.81 $38.00 WPP plc WPPGY HOLD $34.24 $36.00

WEDBUSH MORGAN SECURITIES

Wedbush Morgan Securities does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Section 1.02 ANALYST CERTIFICATION

I, James Dix, CFA, certify that the views expressed in this report accurately reflect my personal opinion and that I have not and will not, directly or indirectly, receive compensation or other payments in connection with my specific recommendations or views contained in this report.

IMPORTANT DISCLOSURES

INVESTMENT RATINGS STRONG BUY – The stock is expected to return at least 20% over the next 6-12 months. BUY – The stock is expected to return at least 15% over the next 6-12 months. HOLD – The stock is expected to return between -15% and +15% over the next 6-12 months. SELL – The stock is expected to decline by at least 15% over the next 6-12 months. DISTRIBUTION OF RATINGS (as of March 31, 2009) BUY – 43% (2% of this rating category were investment banking clients within the last 12 months). HOLD – 56% (3% of this rating category were investment banking clients within the last 12 months).


SELL – 1% (0% of this rating category were investment banking clients within the last 12 months).

The analysts responsible for preparing research reports do not receive compensation based on specific investment banking activity. The analysts receive compensation that is based upon various factors including WMS’ total revenues, a portion of which are generated by WMS’ investment banking activities. WMS makes a market in the securities mentioned herein. WMS changed its rating system from (BUY/ HOLD/SELL) to (STRONG BUY/BUY/HOLD/SELL) on January 5, 2006. Additional information is available upon request by contacting Ellen Kang in the Research Department at (213) 688-4529, or by email to [email protected], or the Business Conduct Department at (213) 688-8090.

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Agencies 2009.06.16 Initiation

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