May 2019: Omnicom (OMC)

Time is a Friend

I like the company Omnicom (OMC). I understand the business model: an advertising agency that helps large clients run advertising campaigns. OMC is currently a member of the S&P 500 index. The perspective I use with OMC is the way I would evaluate a long-term business partner to manage an important venture for me, by looking at the 30-year history of OMC’s financial performance. OMC pays out a significant portion of earnings as dividends, so dividends are an important topic to discuss in order to understand this company. I don’t try to predict OMC’s stock price or forecast OMC’s future financial results. I have no special secret knowledge about OMC. Everything I like about OMC is based on information out in the open.

OMC is one of the most consistently improving companies in the S&P 500 based on 30 years of history, although it has experienced a few setbacks in recent years. Let’s start by looking at the diluted earnings-per-share (EPS), my favorite metric:

Figure 1: Diluted Earnings-Per-Share (EPS)

Time is the friend of the wonderful business, the enemy of the mediocre.

Warren Buffett, Berkshire Hathaway Letter to Shareholders, 1989

I like to start with the diluted EPS because it provides a clean look at the earning power of the business from a shareholder perspective. Diluted EPS takes into account the effect of stock options, which may dilute the shares outstanding in the future, while also accounting for the benefits of stock repurchases (shrinking the shares outstanding). OMC has a strong history of profitability each year going back 30 years to 1989 (as far back as I have data). The history of profit growth had a few minor hiccups: note various dips in diluted EPS growth: 2017, 2010, 2009, 2001, and 1993. Most of the dips correspond to broader recessions (with the exception of 2017), which suggests that the OMC has cyclical traits. A cyclical company performs well when the overall economy performs well, but struggles when the overall economy struggles. However OMC has 2 strong traits: (1) strong EPS performance after the recessions, and (2) strong and steady increasing dividend history.

Dividends: A Tale of Two Lemonade Stands

Evaluating a dividend-paying company is different than evaluating a non-dividend-paying company. Let’s go through each scenario by imagining a simple business: running a lemonade stand for 3 days. The lemonade analogy was used in this book and this book to illustrate a different point (on how to build an economic “moat”). By understanding a simple analogy of dividend-paying companies, this perspective can be applied to OMC.

Day 0: Two brothers open two lemonade stands at the same time with the following product names: “Fancy Lemonade” and “Simple Lemonade”. Each brother starts with a $100 initial investment from their parents (the money buy a table and chair, water, lemons, sugar, pitcher, ice, paper cups). Both owners start out with exactly the same recipe and approach.

Day 1: After one day of operation, “Fancy Lemonade” and “Simple Lemonade” earn $10 each (great business!). The $10 profit could also be called “earnings” (or “net income”). Here is where the capital allocation strategies diverge. Fancy decides to spend $6 of his profit to re-stock supplies (water, lemons, sugar, ice, paper cups), and he spends $4 to make a really beautiful sign for his business. Fancy believes the beautiful sign will attract additional customers to his lemonade stand. Simple also spends $6 to re-stock supplies but pays $4 back to his parents/investors as a “dividend”. In accounting language, we say that Fancy retained 100% of his earnings in the business; we say Simple retained 60% of his earnings in the business (known as “retained earnings”) and had a dividend payout ratio of 40% ($4 dividend out of $10 earnings).

Day 2: Fancy’s “beautiful sign strategy” works on the second day! His beautiful new sign attracted new customers, and Fancy’s profit on Day 2 was $12 (compared to $10 the previous day). Simple earned $10 on Day 2, the same as what he earned on Day 1. Again the two brother decide upon different capital allocation strategies. Fancy takes his $12 profit from Day 2, spends $6 to re-stock supplies, but pays $6 to buy additional folding chairs so his customers can sit around the store. Simple once again spends $6 to re-stock supplies and again pays $4 back to his parents/investors as a “dividend”. Fancy retained 100% of his earnings in the business; Simple retained 60% of his earnings in the business and had a dividend payout ratio of 40% ($4 dividend out of $10 earnings). Investors might describe Fancy’s business as a “growth company” because his earnings are growing from the extra retained earnings; Simple’s business is a “dividend company”.

Day 3: Fancy’s “customer chairs strategy” worked! Now that customers can linger around the store, some of them decide to buy extra lemonade while they are talking with their friends. Fancy’s profit on Day 3 was $15 (compared to $12 on Day 2 and $10 on Day 1). Simple stuck to his steady business and earned $10 on Day 3, the same as Days 1 and 2. At the end of Day 3, Fancy and Simple sit down with their parents/investors to discuss the business (“earnings call”). Fancy decides he has lots of good ideas on how to grow the business, so he will continue to retain 100% of the earnings in the business. Simple decides to continue his steady strategy, pays another $4 dividend to his parents/investors, but won’t be making any changes to the business.

Fancy grew his earnings stream from $10 to $15, a notable achievement. Undoubtedly, Fancy’s business is more valuable now given it’s increased earnings stream. Simple kept his earnings stream at $10, but he paid $4 in dividends for 3 days (a total of $12).

Here is the key takeaway: investors should not evaluate these two business in the same way. Fancy is reinvesting 100% of the earnings back into the business, thereby enabling future growth in earnings. Fancy’s growth in earnings should also drive an increase in the “price” in the business. Simple has steady earnings (no growth) so the “price” of his business should be flat. Or stated another way, a company that pays dividends (i.e. does not retain 100% of earnings) will not see the stock price rise as much as another company that doesn’t pay dividends.

Hardy Dividend Growth

The below chart shows the dividend history of OMC. If you have been a long-term shareholder of OMC, this dividend chart should make you want to stand up and clap. The most recent year (2018) had a $2.40 dividend per share, compared with $0.60 ten years ago in 2008. That represents a 4x increase in dividends in 10 years! Ten years prior to that, the dividends were $0.26 in 1998, representing a 2.3x increase. Nine years earlier in 1989, the dividends were $0.06, representing a 4.3x increase.

Figure 2: Dividends per Share

The percentage of earnings paid out to shareholders as dividends is referred to as the “dividend payout ratio”. Companies with a high dividend payout ratio typically don’t have high internal capital requirements, don’t spend much money buying other companies (M&A strategy), and are not using the capital to buyback own stock (the other way of returning capital to shareholders). OMC has a history of high dividend payout ratios, as seen in the below chart.

Figure 3: Dividend Payout Ratio (dividends-per-share/basic-EPS)

Buffett Ratio (aka “RORE”)

I want to take a moment to show a simple calculation that shows OMC’s use of retained earnings to drive EPS growth over the long-term. This calculation shows the cumulative retained earnings over a period of time, and compares that figure to the growth in EPS over the same period of time. In plain language, by retaining the shareholders capital (instead of paying out as a dividend), management team exhibits the ability to increase annual earnings per share. In short, OMC has an impressive 30 year record of growing earnings with relatively smaller retained earnings (given dividend payouts):

  • Cumulative Retained Earnings 1989-to-2018: $42.278
  • Cumulative Basic EPS 1989-to-2018: $63.804
  • Cumulative Dividends per Share 1989-to-2018: $21.526
  • Basic EPS in 1989: $0.23
  • Basic EPS in 2018: $5.85
  • Growth in basic EPS 1989-vs-2018: $5.62
  • Growth in basic EPS as % of cumulative retained earnings: 5.62/42.278 = 13.29%

This simple calculation tells us that in exchange for holding onto $1 of shareholder capital (in the form of retained earnings), the OMC management team was able to increase the annual EPS by 13 cents. This 13.29% illustrates how well the management team is able to grow earnings. This metric is followed by Warren Buffett, according to his former daughter-in-law, although I should note that Mr. Buffett does not endorse those 2 books (he was asked about them on multiple occasions at shareholder meetings, for example this video clip, where both Buffett and Munger avoid mentioning the books by name … personally I only found out about these books from a recommendation by Dr. Michael Burry … worthwhile reading both books as there is different content in each, although they share similar titles). In my own head, I refer to it as the “Buffett Ratio”, but it is known as the “Return on Retained Earnings (RORE)” online at this article and this article. At a later time, I may go into this metric in greater detail, and compare the ratios at different companies.

Figure 3: Annual Retained Earnings (EPS minus dividends-per-share)

OMC Not Looking for Big Deals

Other advertising agencies have been busy on the mergers-and-acquisitions front, but OMC isn’t looking for big deals. In a way, I like this attitude, because it shows that the management team is being prudent with shareholder capital, instead of imitating what competitors are doing. From the WSJ:

“If I or the team felt threatened in any way, we’d look for the appropriate acquisitions to complete our offerings to our clients,” Chairman and Chief Executive John Wren said during Omnicom’s earnings call. “I simply don’t feel that way right now.”

Omnicom doesn’t need another creative agency like Droga5 because it already has “good agencies,” he said. The company has similar feelings about the Epsilon transaction. “They don’t have anything from what I can observe that’s unique or so proprietary,” Mr. Wren said.

While Omnicom continues to invest in data capabilities, in most cases it would rather rent than own data, said Jonathan Nelson, chief executive of Omnicom Digital, during the call. The company expressed similar sentiments after IPG’s Acxiom deal.

But Omnicom hasn’t sworn off deal making entirely. “We’re going to continue to pursue deals,” Chief Financial Officer Philip Angelastro said. “We’re pretty disciplined about it.”

The company in 2018 and early 2019 sold various assets, including sales support businesses MarketStar and Sellbytel. Omnicom wasn’t prepared to keep investing what was needed for the future of those businesses, and was able to find buyers that made more sense for them, Mr. Angelastro said.

Omnicom will continue to seek operational efficiencies from real estate, back-office services, procurement and IT, he added.

“Amid Ad-Industry M&A, Omnicom Says It Isn’t Looking for Big Deals” by Alexandra Bruell, Wall Street Journal, April 16, 2019.

Warren Buffett Investment

Back in 2002, Warren Buffett purchased shares in OMC via Geico. I do not know whether he still owns these shares now (17 years later). But back in the 1960s, Buffett acquired stakes in 2 advertising agencies: McCann-Erickson and Ogilvy & Mather. According to the WSJ article by Kenneth Roman:

As Warren Buffett explained his strategy: “I like royalty-based businesses.” At that time, ad agencies were still compensated by commissions on media purchases.

“Warren Buffett’s Brief Career as an Ad Man” by Kenneth Roman, Wall Street Journal, March 27, 2017. Mr. Roman, a former chairman of Ogilvy & Mather Worldwide, is author of “The King of Madison Avenue” (St. Martin’s Press, 2009).
Article available at: https://www.wsj.com/articles/warren-buffetts-brief-career-as-an-ad-man-1490655634

On a personal note, I have my own affinity for the advertising agency industry from 3 situations. In high school, to earn extra money over summer vacations, I used to work with a temp agency and often found myself doing random office work for advertising agencies. The people I met were always very pleasant and nice to deal with, so I always had a positive impression of the industry. Later in college, I read the beautiful book “Ogilvy on Advertising” by David Ogilvy. The book made a huge impression on me at the time. Even if you have no interest in the industry, this book will delight and inspire you. Finally, someone I once knew (a late-executive at one of the my former employers) got his first job out of college working directly for David Ogilvy … one day over lunch he told us the funniest and most unbelievable personal stories of interactions with Mr. Ogilvy … those “Mad Men” stories over lunch represent the fondest and sweetest memory I have of that late-executive. All-in-all, I have a positive impression of the advertising agency industry.

We subscribe to the philosophy of Ogilvy & Mather’s founding genius, David Ogilvy: “If each of us hires people who are smaller than we are, we shall become a
company of dwarfs. But, if each of us hires people who are bigger than we are, we shall become a company of giants.”

Warren Buffett, Berkshire Hathaway Letter to Shareholders, 1986

In fact, in Berkshire Hathaway’s 1977 Letter to Shareholders, Ogilvy & Mather is prominently listed as one of the firm’s top equity holdings. During the 1970s, the U.S. experience high rates of inflation which eroded the real returns in many investment classes. I remember reading that back then Buffett invested in advertising agencies because they were “royalty” businesses, that grew with inflation. I try not to get too clever in my micro-economic analysis of particular industries. For those interested in this topic, here is an article that claims advertising agencies no longer follow this business model. Instead, my approach is to follow the numbers, specifically the 30-year financial histories of public companies.

Investment Institutions Who Might Like This

This is a side-note … but for fun I like to look at this great website that tracks the top holdings are large institutional investors. Here is a list of the 100 largest institutional owners of OMC. I ignore most of these institutions and only look at firms where it is a Top 10 holding in the portfolio. This is a fun way to learn about investment firms that might care about OMC. Although I usually find that most investment institutions are so broadly diversified that even a Top 10 holding is rarely more than a few percentage points of the overall portfolio.

History of Buybacks

OMC has a reasonably good history of stock buybacks, as seen in the below chart. Since 2010, OMC has purchased over $500M per year in stock repurchases, with over $1.2B in 2010. OMC seems to have gap years where it doesn’t purchase much stock (2009, 2003, 2001).

Figure 4: Annual Stock Buybacks

A simple way to evaluate buybacks is to look at the ratio of annual earnings to annual buybacks. In other words, what percentage of OMC’s annual profits does the management team allocate towards shrinking the shares outstanding? Although the history is somewhat erratic, OMC clearly shows a long history of significant stock repurchases.

Figure 5: Annual Stock Buybacks as % of Annual Earnings

The recent history shows annual share counts peaks in 2001 at 405M shares, with 227M shares as of last year in 2018, representing a shrinkage of 43% over 17 years. The buybacks shrunk the share count by approximately 3.34% per year every year for 17 years.

Figure 6: Annual Shares Outstanding

Long-Term Debt as % of Earnings

Many companies finance growth by borrowing heavily, so it is important to check on the growth in long-term debt, and monitor levels as a multiple of earnings. Or stated differently, how many years of profits would be required to payoff the long-term debt?

Figure 7: Long-Term Debt including Capital Lease Obligations

Since a company with increased earnings can support a larger debt, it is useful to compare the ratio of debt to annual earnings. A very conservative balance sheet has debt that can be paid off with 3-5 years of annual earnings. OMC currently has long-term debt equivalent to 3.3 years of annual earnings.

Figure 8: Long-Term Debt as Multiple of Annual Earnings

Current Ratio (Short-Term Liquidity)

A final check on financial liquidity is to compare current assets (assets that can be liquidated within 1 year) to current liabilities (liabilities that are due within 1 year). OMC has a manageable current ratio of 0.9.

Figure 9: Current Ratio (Current Assets / Current Liabilities)

Interest Rates, Valuation, Yield Curve

When evaluating investment opportunities, one of the most important considerations (if not the most important) is the current benchmark interest rate, for example 10-year treasuries. The simplest investment strategy would be to invest in “risk free” 10-year U.S. government bonds. The US Treasury Bond is considered a “risk-free” investment, because the US Government can raise funds through many sources such as taxation. Before we examine the current level of interest rates, here is an interesting quote by Charlie Munger about opportunity cost as an investment filter:

I would argue that one filter that’s useful in investing is the simple idea of opportunity cost. If you have one opportunity that you already have available in large quantity, and you like it better than 98% of the other things you see, why you can just screen out the other 98%, if you already know something better. So people who have a lot of opportunities tend to make better investments than people that don’t have a lot of opportunities. People who have very good opportunities, and using a concept of opportunity costs, they can make better decisions about what to buy. With this attitude you get a concentrated portfolio, which we don’t mind. That practice of ours, which is so simple, is not widely copied. I don’t know why. Now it’s copied among the Berkshire shareholders, all of you people have learned it. But it’s not the standard in investment management, even at great universities and other intellectual institutions. It’s a very interesting question: if we’re right, why are so many eminent places so wrong?

Charlie Munger (Vice Chairman of Berkshire Hathaway), 1997 Annual Meeting.
Available at: https://www.youtube.com/watch?v=5ioeNrmn4eY

The 10-year treasury bond is currently yielding 2.39%, so a good investment opportunity with a “margin of safety” would yield at least twice that level at 4.78%. According to Yahoo Finance, OMC has a PE Ratio (TTM) of 13.55, which taking the reciprocal implies an “earnings yield” of 7.38%. Moreover, Yahoo Finance projects a forward dividend of $2.60 which implies a “dividend yield” of 3.25%. OMC’s earnings yield provides a margin of safety above U.S. treasury yields, and the dividend yield alone is greater than treasury yields.

Figure 11: OMC quote on Yahoo Finance

Yield Curves are important because they reveal the current stage in the short-term economic cycle (aka short-term credit cycle). Various parts of the yield curve are inverted: the 10-year yield is near-or-below the 3-month yield, and the 5-year yield is near-or-below the 2-year yield. It is important to note that the 30-year yield is still well above the rest of the yield curve. But when the “long-end of the yield curve” inverts (i.e. the 30-year yield falls below the rest of the yields) that will be an important early possible-early-indicator of a recession.

Figure 12: Graph Comparing Treasury Yields in May 2019

My favorite long-term view of the yield curve is to pick a single relationship and plot over time, e.g. 30-year treasury minus 3-month treasury. I am looking to compare the level of this relationship relative to prior recessions (2008, 2001) in order to provide guidance on the possible future timing of the next recession. The current reading of the 30Y-3M is approximately 0.43, and the last time we were at this level (on a downward slope, not upward slope) was back in 2006 and 2000. So that is why I feel like the next recession might be 1-2 years from now.

Figure 13: Yield Curve: 30Y-3Month,
(Source: https://stockcharts.com)

Conclusion

Omnicom (OMC) is one of my favorite companies in the S&P 500. OMC is the third company I have chosen for a monthly article on this new blog. OMC has shown consistent growth over the past 30 years, with a strong history of dividends and share buybacks, conservative liquidity management, and modest use of debt. OMC’s current valuation (earnings and dividend yield) is relatively attractive relative to benchmark interest rates, and I believe there is still 1-2 years remaining in the short-term economic cycle. For long-term-focused investors, OMC is worthy of further study.

Disclosure: I own shares in Omnicom (OMC) as of publishing this article (May 2019). I have no intention of selling my position in the near future. This article is not a recommendation. Investors should make their own determination of whether or not to buy or sell this stock based upon their specific investment goals, and in consultation with their financial advisor.