Ad Firms Hurting the Cause?

Tech-Buying Binge Is Raising Prices -- And Red Flags

By AARON O. PATRICK
September 6, 2007; Page C6

Advertising agencies are buying up technology companies, and tech companies, in turn, are snapping up ad firms. The result: Price tags are rising.

Investors should be wary.

A recent spate of acquisitions in the ad industry has driven up targets' sale prices relative to their profits to levels reminiscent of the 1990s tech-stock boom. Analysts say more acquisitions could be on the way.

That is raising red flags. Prices are so high now that the ad industry may struggle to make its tech investments profitable, some analysts say.

In July, WPP Group PLC bought Internet ad-broker 24/7 Real Media Inc. for $649 million, 44 times earnings before interest, taxes, depreciation and amortization, or Ebitda. In January, Publicis Group SA paid $1.3 billion for Digitas Inc., an Internet marketing agency. The price was 29 times Ebitda, which is a pretax-income figure that some companies use to indicate their ability to service their debt.

A survey two years ago by AdMedia Partners Inc., a boutique investment bank in New York, found that Internet-marketing firms were typically selling for just five to seven times Ebitda.

Driving the deals is the boom in Internet advertising. Global spending on Internet ads rose 92% from 2004 to 2006, when it hit $32 billion, according to PriceWaterhouseCoopers.

Much of that money is bypassing the established global ad networks and instead going to tech companies. By selling millions of short online ads, Google Inc. will this year generate more revenue than WPP or Omnicom Group Inc., the biggest ad groups, according to analyst forecasts. Google and Microsoft Corp. have spent a combined $9 billion buying ad companies this year. Online ad broker BlueLithium Inc., of San Jose, Calif., this week agreed to be acquired by Yahoo Inc. for about $300 million.

Unwilling to cede a lucrative new market, traditional ad companies are fighting back. Over the past year, WPP has bought or invested in 17 tech companies, in addition to 24/7 Real Media.

"These assets aren't cheap, to put it mildly," WPP Chief Executive Officer Martin Sorrell said in announcing the 24/7 Real Media deal. "But I think in the long term they will prove to be the right thing to do."

Some investors agree. "In the short term it's very, very expensive, but it is important to be in these sectors because they have growth," says Bruno Vacossin, a portfolio manager at Palatine Asset Management in Paris, which has about €1 billion ($1.36 billion) in funds under management and owns 140,000 WPP shares, according to regulatory filings.

That said, Robert Willott, a former accounting professor who publishes investment reports on the ad industry, estimates that 24/7 Real Media will need to increase revenue at 50% a year for the foreseeable future to give WPP a 10% return after paying tax.

Revenue at 24/7 increased 43% last year, but "even in the digital market such a long-term growth rate sounds too rich to be true," Mr. Willott says.

WPP executives say 24/7 Real Media should continue to expand quickly by selling services to WPP's existing clients. They also say Internet companies have higher profit margins than traditional advertising agencies, making them more valuable.

Some forecasters see the growth rates in Internet advertising starting to slow. Publicis's Zenith Optimedia ad-broking unit predicts the global Internet ad market will increase 18.8% next year compared with 22.2% this year. Simon Wallis of London broker Collins Stewart Ltd. downgraded WPP to a "hold" from a "buy" after Sir Martin gave a presentation at Collins Stewart's offices in May. Mr. Wallis wrote in a report that he is concerned "there are going to be further expensive strategic acquisitions" by WPP.

One online ad company seen as a takeover candidate is Stockholm-based TradeDoubler AB, which turned down a $900 million offer from Time Warner Inc. early this year.

So far, WPP's tech investments aren't big enough to be a drag on the company if they go bad, analysts say. A spurt of advertising spending expected next year on the Beijing Olympics and the U.S. presidential election should benefit WPP and the other ad groups, they say.

According to financial-data compiler FactSet Research Systems Inc., 14 analysts currently have a "buy" or "overweight" recommendation on WPP and one has a "neutral" call. There are no "sell" recommendations.

WPP's American depositary shares are up nearly 4% this year to $70.43 on the Nasdaq Stock Market (and up 0.5% in London). On the New York Stock Exchange, Publicis is down 0.1% to $42.19 (and down 3.7% in Paris).

Publicis, a smaller company, has spent more on tech firms relative to its size. In addition to the Digitas deal, in June it agreed to buy French Web agency Business Interactif for €137 million, 43 times the firm's Ebitda.

Two big ad companies are sitting out the buying spree. Omnicom hasn't made any big digital acquisitions recently. And Fernando Rodés Vilà, chief executive of Havas SA, says the Paris-based advertising company isn't looking to make any large investments in ad-technology companies, preferring to expand its own Euro 4D and Media Contacts digital units.

"It's hard to see how valuations of these companies can be justified by the profit they are making," Mr. Rodés says.