Agencies Decoupled From Ad Revenue Cycle, Says Morgan Stanley

In an industry overview report, the broker advises investors that agencies have become decoupled from the advertising revenue cycle. This is a result of changes in the way contracts are paid and of the deflationary effect on prices of extensive agency consolidation. It says continued market consolidation means that the mega-agencies can no longer rely on the mid-tier to provide growth and are now competing head to head for business.

However, these agencies all have the same global reach, provide a full service offering and are capable of delivering creative strength. Consequently, Morgan Stanley believes that they will become involved in a tussle for market share between one another, which analysts describe as a ‘deflationary pass the parcel’. As a result, the broker has lowered its revenue forecasts for European agencies, even though advertising expenditure forecasts are left unchanged.

A changing model The report says the agency business model has changed significantly over the last couple of decades and particularly in the last two years. “National advertising forecasts and new business wins are regarded as key underpinnings of agency performance. We believe this no longer true and that the market is in danger of misunderstanding the agency business model. Agencies have a different role today than they did ten years ago, and many radical changes have occurred in just the last two years,” it says.

Advertising clients are demanding more and more accountability from their agencies. The full-service ambitions of the global agencies, coupled with the growing demand from clients for transparency, have led to changes in the way agency remuneration is handled. Many more creative contracts are now ‘open book’ rather than commission-based and this introduces a new level of transparency in negotiations between clients and agencies.

According to Morgan Stanley, open book contracts allow clients to assess the pricing of advertising work by measuring the staff and overhead costs associated with a project and allocating a level of profit. This has led to advertisers requiring prospective agencies to submit salary data as well as details of rent, benefits, electricity, phones, office equipment and bonuses.

As well as open book contracts, there has been an increase in the use of search consultants (middlemen advising on middlemen, as Morgan Stanley has it) and in standard rate books. The broker concludes that these shifts from commission-based to fee-based, open book and consultancy-based negotiations are likely to have a deflationary effect on agency revenues and will effectively decouple agencies’ performance from the cyclical patterns of advertising growth.

“The incidence of new remuneration structures forcing lower levels of revenue on advertising agencies is widespread. But, so too is evidence that agencies have been able to manage these savings by reducing the staff employed on these accounts and by trimming overheads. The question that will determine the revenue profiles of the agencies over the coming year is to what extent competitive pressures between the agencies drive them to adopt discounting,” it says.

Consolidation comes to an end Morgan Stanley’s report also notes that throughout the 1990s agencies delivered premium growth through the acquisition of small, medium-sized and sometimes global agencies. Now though, with 80% of the market in the hands of the top five agencies, the scope for ongoing acquisitions is coming to an end.

So where next, asks Morgan Stanley: “The fact that the largest agencies have fed off the medium-sized ones through acquisition and business wins creates an interesting conundrum for the handful left standing. If growth cannot be achieved through picking at the remains of smaller competitors, then where does it come from?”