Once more unto the breach. Nine thoughts on what lies ahead

Once more unto the breach. Nine thoughts on what lies ahead

It seems as though the second quarter reporting season has just ended, at least in the UK (a number of media companies, including Informa and Reach, reported their results near to the end of September, and M&C Saatchi missed the deadline) yet this week sees the start of the Q3 reporting season. I will try and avoid the obvious points and highlight what I thought were a number of interesting take-away points with implications both for upcoming results and future trends.

1. Advertising might be about to get a step up 

Advertising is intangible capex i.e. just as firms invest in plant for future growth, so advertisers should invest in advertising for the same reason. An apt summary for the performance of advertising in Q2 was Apocalypse Not Now. Generally, advertising-exposed names either did better than expected when it came to their results or, at least, were not as bad as expected (another feature was that the United States generally did better than international markets). This was pretty much across the board: most of the holding agencies beat expectations (Interpublic, Publicis and, to a degree, WPP) or at least generally met them (only Omnicom, with its heavy events and sports-related businesses, was seen as disappointing). Facebook snapped expectations and several US broadcasters also performed better than expected – AMC saw its US national TV ad revenues down 15% in Q2 vs analyst expectations of a 27% to 40%. Even in Europe, advertising declines while steep (e.g. ITV saw its total advertising revenues, down 43% yoy with RTL down 40%), generally they were not worse than expected.

The consensual view from the results was that Q2 represented the trough for advertising and that Q3 is seeing improving trends. Facebook stated it expected Q3 ad revenues to be c. 10%, similar to Q2 while Alphabet reported Search revenues had returned to flat by the end of the Q. Jeremy Darroch, Sky’s CEO, recently made remarks that Q3 advertising trends for Sky were significantly better than Q2 and that has been mirrored pretty much across the board in commentary.

It is worth focusing on what the companies say about Q4, as it is almost certain all companies will give a view on what they are seeing now and what they expect to see in the coming months. Do not expect too much from the Agencies who are likely to say they have little visibility on December (Q4 is their most important quarter for profitability and is heavily weighted towards the back end, because of ad-hoc project work and Media buying). Generally, the later a company reports, the more it can talk about what is happening in Q4. Do expect much commentary over the level of uncertainty given the rising wave of pandemic infections and the growing likelihood of mass unemployment, already a presence in the US and likely to hit Europe as Government-funded support schemes to protect jobs end.

However, advertising is likely to benefit from three longer-term trends. One is that while the crisis will cause many firms to collapse, it is also likely to see the rise of new advertisers who will need to advertise to take advantage of changing consumer trends such as the growth in e-commerce and D2C. In fact, for the latter, a study by iSpot, had already shown that D2C US TV ad impressions had risen 13.7% yoy in 1H. A second is that FMCG groups in particular may need to spend more to promote themselves to protect themselves from the mass shift towards e-commerce (see Point 6).

A third is that advertising spending may be boosted structurally as established advertisers shift money into it from areas that are likely to see a secular decline in spending such as property, travel and entertainment and related expenses. This was a point made by Mondelez, whose CFO made this point in relation to his company’s advertising plans. This makes sense: advertising is intangible capex and it is far better to spend your money on something that helps grows a business than merely “maintaining” it. If others take the same approach as Mondelez, then this could mean some very interesting implications for advertising numbers.

2. The Online companies’ striking differences in advertising performance may be the start of something more fundamental

One of the more interesting features of the Q2 results was the wide divergence between the advertising results of the Online platforms (I have left out their non-advertising services from the comparison). It was even more striking because in the case of Alphabet (Google) and Facebook, the two major global powerhouses, the consensual view was that, given both were heavily exposed to Small and Medium Businesses (SMBs), that they should probably both suffer relatively equally as SMBs pulled back on their advertising spending in the wake of the pandemic, although it was recognised that Search had exposure to sectors such as Travel that would get disproportionately hit. In fact, the gap between the two was huge, with Facebook posting 10% year on year advertising growth in Q2 and Google’s Search revenues actually down 10% yoy. However, that was mirrored across the performances of the Online groups.

Q2 advertising revenues, Online companies, Year on Year growth / (decline) (%)

Source: company reports, Ian Whittaker / Liberty Sky Advisors

A couple of things were happening here. Bar the specific things such as Travel, there appeared to have been some more fundamental shifts happening as well. One was an upsurge in Direct Response advertising, as advertisers tried to generate short-term cashflow to keep their businesses going. This is what both Facebook and Snap referred to in their results presentations as well as Alphabet when it was discussing YouTube’s growth. Again, that makes sense given the crisis.

However, I suspect one thing we are also seeing here is advertisers deciding to concentrate more and more of their advertising firepower on the platforms which they think add value (Facebook, Snap etc) and take money out of platforms that are seen as “second tier” advertising properties, such as Twitter and Spotify. That makes sense. Brand advertising thrives on mass and neither platform has the mass scale of a Facebook or a YouTube (for the likes of Snap, its youth focus makes it appealing to advertisers). Also, Spotify’s focus is to grow its premium paid subscriptions while Twitter has had its own issues.

Therefore, look out for whether there is a similar divergence in the Q3 results. The likelihood is these trends accelerate. One general feature of crises like these is that advertisers tend to take money out of the weaker players, and even weak #2s, and concentrate on the leading platforms. This happened, for example, in the newspaper industry post the 2008/9 Global Financial Crisis, and it seems like we may be seeing the same sorts of trends appearing here as well. If so, then Twitter and Spotify are likely to see sub-optimal growth when we come out of the crisis. Q3 results could give an indication whether this is happening.

3. Search might be on the wane

One point I had made previously in a separate post is that there are very good reasons to believe that a lot of Paid Search is wasted, that its share of the overall advertising market is too big and, therefore, there was significant wastage in shareholder value. Without getting into the full details of that post, the central premise is that Paid Search is essentially Yellow Pages for the digital age and that, like Yellow Pages, while Search could be effectively for particular items, it is not a brand-building tool. This is why, for example, Yellow Pages (or Classified Directories as they officially called), only made up 6% of total UK advertising spending in 2000, less than a fifth of the share of Paid Search in 2019, which stands at 31%.

As mentioned above, Paid Search has been disproportionately impacted by the collapse in Travel. Nevertheless, the underperformance vs. Facebook and other platforms was striking and it raises a question as to whether firms are starting to question whether they need Paid Search as much as they thought they did, and how that behaviour continues moving forwards. Some have said so already (e.g. the now well known comments from Adidas’ CMO that he realised Paid Search made no difference to their sales when the function went down for two days and there was no impact on traffic or sales) but others may follow. Therefore, it is worthwhile looking at how Paid Search did in Q3 compared with other Online platforms and the outlook for Q4.

4. Streaming – back to the future

A big focus will be on the results of the streaming companies, in particular the likes of Netflix and Disney. Will Netflix see the slowing in growth in subscriber numbers that it has guided to for 2H? Will Disney+ continue to show stellar growth or will some of the momentum fade? Can AT&T’s HBO Max service start to see improved momentum? What we will see from the likes of Comcast’s Peacock or ViacomCBS’ Pluto TV? What also will the “skinny” platforms such as FuboTV (which has just gone through an IPO) or Roku produce?

One thing is clear: streaming is probably the major battleground in global Media today. It is rare for an activist investor to call for less cash to be returned to shareholders but Daniel Loeb has called for exactly that with Disney, calling for it to axe its dividend and double its investment in Disney+. That represents a view that there is still plenty of growth for which to attack. Ampere Analysis (which I highly rate as a research outfit) estimated that 2019 ended with 642m paying streaming subscribers worldwide but that up to 3 billion more subscriptions could be handled (the premise is that households will take multiple streaming services).

Another opportunity is in Advertising Video on Demand (AVOD) with subscribers paying a lower fee (or maybe no fee in the future) in return for watching adverts. Some streaming platforms already use this hybrid model (e.g. Hulu) where subscribers can choose to go advertising free and pay a higher fee, or take advertising and pay a lower one. This flexibility is likely to be advantageous to the hybrid platforms at a time of rising unemployment when many households are looking to reduce expenditure. It also raises the ongoing question (again) of whether Netflix will start to offer a model that includes some advertising in order to appeal to more price-sensitive customers. If Netflix goes down the advertising route, though, it will need to disclose more on its viewing habits.

However, there is another alternative where consumers become increasingly confused about the packages on offer and start to chafe at having to pay for so many services to watch their favourite shows. In effect, they start clamouring for an old-fashioned bundled service which has everything. This is what Sky (part of Comcast) is banking on with Sky Q, as a go-to place with all the apps in place where people can watch multiple streaming services. There are advantages here for both sides. For the streaming services, some of which may have limited brand recognition outside the US, it offers a somewhat guaranteed source of revenues and without having to spend on expensive marketing campaigns to establish your service (and which may not work). For the likes of Sky, it means a reduction in fixed programming costs as the model shifts to more of a share of revenue pass-through agreement (as has happened with Disney+) which also brings greater flexibility into the model.    

5. Agencies – Tankers vs. Speedboats

Just as the Online companies had a very varied performance in advertising in Q2, so did the Agency groups. As was explained above, the Agencies generally did better than was expected (significantly so in the case of Interpublic and Publicis) and, even with Omnicom, there were firm-specific reasons why its performance lagged. One trend that was noticeable, however, was the variance in performance between the legacy Agency groups and “newer” agency networks such as S4 Capital. (Next 15 – which we characterise as one of the “newer” groups - is out of this because it 1H year end is the end of July but its 1H organic net revenue decline was -6.6%, at the better end of the agency scale; also note there are slightly different definitions for the Agency groups).

 Q2 organic net sales declines year on year (%)

Source: company results, Ian Whittaker / Liberty Sky Advisors

There are several reasons for this. Mixture of clients is one – for example, Next 15 is heavily weighted towards technology clients (40% of its revenues are Software and IT Services and the company said 67% of its sector revenues had been “positively impacted” by the crisis as opposed to 9% that had been negatively affected). Another is that the newer agency groups do not have the legacy businesses that, in many cases, have also held back the major agency groups (areas such as Media buying focused on traditional platforms). There is also, no doubt, that groups such as Next 15 and S4 benefit from being seen by advertisers as much cutting edge and so more attuned to the new media environment. That is now starting to be reflected in account wins such as S4’s win of BMW.  

One thing the performance has shown is that the fear that Agencies will be disintermediated, prevalent a few years back, is overblown (a more likely reason for the pressures they faced pre-crisis was both pressure on fees and a greater focus on their profitable Media buying and planning businesses). Another fear that has been unmasked is that consultancies will take significant business from the Agencies (it hasn’t happened and is unlikely to happen). Clients still very much want to use Agencies, which makes sense. An in-house team (and there is no doubt in-housing is growing but in-housing encapsulates a range of behaviours) brings extra costs and does not mean necessarily a better service.

However, for the major Agency groups, the rise of players such as S4 Capital and Next 15 mean that they now face more credible competitors. That is specially in areas that are potentially lucrative growth areas such as e-commerce. What makes it even more challenging is that they are also trying to restructure their businesses internally both the effects of the pandemic and because of more structural issues. This creates a great amount of opportunity, particularly on the staff side to flex the cost base to match revenues (see below). The pandemic has also accelerated massively the use of technology and new ways of working. However, it also means that the major Agencies can no longer rely on a landscape of effectively competing against each other while they are trying to fix their problems. It is likely the likes of S4 and Next 15 will continue to take share.

6. The growth in e-commerce may not be a great thing for Amazon (Part 2)…

A permanent feature of the pandemic will almost certainly be a significant structural step-up in the size of the e-commerce market. As highlighted in the earlier piece “Five reflections on a bloodied quarter”, the growth in e-commerce may not be so great for Amazon because it meant that e-commerce had been moved centre stage to retailers’ strategy in a far more sudden and dramatic fashion than expected. That meant Amazon is likely to face more competition in the e-commerce space more quickly than it anticipated. That is likely to mean that Amazon’s dominance in e-commerce is eroded more quickly than anticipated.

Bear in mind Amazon does not have an overwhelming dominance of the e-commerce market. Yes, its 37% share means it had over 6x market share than the #2 player in the US e-commerce market. However, that share does not lock in the overwhelming network effects that would mean that Amazon’s position would be unchallengeable.

2019 share of US retail e-commerce sales

Source: eMarketer, Shopify

Moreover, there are signs Amazon is losing share. In Q2, Amazon’s e-commerce growth rate was at the lower end of the scale, although still very impressive. While that reflects its much bigger size, it is also a reflection of the greater focus put by others into growing their share of the market.

Q2 net sales growth year on year (%) for e-commerce sites

Source: company results, Ian Whittaker / Liberty Sky Advisors * eBay FX neutral; Amazon are results for International / North America, may reflect certain non-e-commerce revenues

However, what should truly worry Amazon, which is what he highlighted after Q1, is the growth of the e-commerce operations of the established retailers such as Wal-Mart, Target and Tesco’s and how e-commerce has leapt to their of those companies’ strategies. That now means that Amazon faces far more competition at this stage than it would have imagined. e-commerce grew 97% in Q2 at Wal-Mart and was the main contribution to the comparable sales growth of 9.3%, providing 2/3 of that growth at c. 600bps. The retailers are starting from much smaller bases but, if growth rates continue, the absolute gaps will narrow quickly. Target saw e-commerce sales rise 195%. To show how important e-commerce has suddenly become to retailers, look at Best Buy: Q2 online revenues grew 242% yoy and now contribute 53% of domestic US revenues vs 16% in Q2 2019.

Q2 online sales growth year on year (%) for retailers and compared with Amazon

Source: company results, Ian Whittaker / Liberty Sky Advisors * Amazon are results for International / North America, may reflect certain non-e-commerce revenues

More worrying for Amazon is that retailers have a major advantage over Amazon in that they have physical stores where consumers can pick up their goods and that this physical presence is a facilitator that Amazon does not currently has. Target summed this up on their Q2 conference call:

“When you look beneath the surface of the reported numbers, you find that our stores actually drove more than 90% of our second-quarter growth given that they enabled more than three-quarters of our digital sales and an even higher percentage of our digital growth. “ (Target Q2 2020 results conference call)

Others have reported this already (Wal-Mart said in Q1 that 60% of its customers who ordered online picked up their goods from the stores). The established retailers may therefore have a major advantage over Amazon in the fight for customers. Aligned with an uplift in delivery capabilities, as companies such as Uber and Delivery Hero focus more on the delivery of commerce items, together with the loyalty of existing customers, Amazon may have a problem. In fact, there are signs the established retailers are looking to gatecrash Amazon’s key events such as Prime Day to generate sales (Wal-Mart is leading with offers Oct 11-15th)

The question therefore becomes does Amazon feel as though it needs to heavily expand its high street presence to counter this effect. That is probably a question going through the mind of Amazon’s management.

7…but this growth also raises questions for the FMCG groups in particular

It is not just Amazon who might be at risk from the growth in e-commerce at the retailers. It also has worrying implications for the FMCG groups. When a shopper goes to a store, brands benefit from consumers’ recall of products and the values associated with them. The retailers have some control over this and it is why shelf placement is such an important issue because where a product is placed has an impact on whether it sells (so, if a product is on the bottom shelf tucked out of sight, it is at a major disadvantage). However, a consumer walking around can take in literally hundreds of products as they shop.

However, if major retailers such as Wal-Mart, see more of their sales move online, then a greater percentage of brand’s sales are going to come from an environment where retailers have more control over which brands are seen and not. This is particularly relevant if brands are competing against a retailer’s own label, which they are in many cases. Target (again) pointed out on its Q2 call that sales from its Good and Gather own label had risen to over $1bn in less than a year, growing more than 30% so far this year and taking market share. It has expanded that range and

This will be a particularly problematic if a new concept takes off, namely that of Q-commerce, which has been flagged by Global food delivery company Delivery Hero, which recently acquired a Middle Eastern online grocery provider called InstaShop. Their view is of consumers picking from a small selection of curated goods held in a series of small warehouse-style locations where delivery drivers deliver the products in less than an hour:

Source: Delivery Hero

If Q-commerce does take off, then the threat to brands, and particularly smaller brands, is abundantly clear. If only a small selection of products is available, then many brands are likely to be squeezed out of the equation. It will be survival of the fitness. One positive for the brands, though, is that, as the above shows, Q-commerce is likely to be more aimed at single person households, not families. That might be small comfort though.

How can brands protect against this? One obvious answer is advertising to boost sales and brand. Therefore, one defensive strategy that brands should be considering now is to boost their advertising spend now so that, if Q-commerce does take off, they are in a better position to be one of the chosen brands. More radical solutions could include setting up D2C outlets (although that has the problems of (1) consider tend to buy goods as part of an overall shop and (2) it ends up with the brand effectively competing against the retailer) and / or setting up their own Q-commerce operations.

8. Media companies’ cost bases may become more variable in future 

There is no doubt that many countries are facing an upcoming unemployment crisis. In the UK, the base case unemployment rate in the forecasts published by the Government’s financial watchdog, the Office of Budget Responsibility, is 11.7%, levels not seen since the 1980s. The US has seen a slowdown in the reduction of weekly unemployment claims. Some companies have been explicit in stating that this unemployment will help their cost base by increasing supply of willing employees. Lyft would be an example of this.

It is also clear that companies are using the pandemic to push through structural changes that will not reverse when the pandemic eases. companies using the crisis to simplify their management structures and take out effectively several layers of managers. Job cuts from the likes of BP, Shell, Centrica and many others highlight the disproportionate numbers to be cut from the managerial ranks and / or head office. This makes sense. In a world where there is increasing automation, more working from home and more productivity tools than ever (a hot category in the world of IPOs), there is less need for highly paid managers. In this case, automation has become a facilitator of job reductions.

 For the Media and Digital world, which is more reliant on cyclical advertising revenues, I still think one of the most interesting comments from the Q1 results season was that of John Rogers, WPP’s CFO when he stated:

““(I) think the biggest lever for us will be looking at part-time working. So, moving colleagues to either three or four days at working week. And this gives us maximum flexibility both in terms of taking the cost out and taking the cost out quickly, but also, we are initiating that cost back in as and when markets do recover. So, I think we can build that flexibility into our clients.”

Agencies employee costs as percentage of net revenues 2019 (%)

Source: company results, Ian Whittaker / Liberty Sky Advisors

That would have huge implications for the Agencies, where staff costs make 60%+ of net revenues, as it would not only represent a permanent uplift in their margin potential but also bring greater flexibility into the work model. It would mean the elimination of the cycle of redundancies, and taking restructuring costs, when revenues declined and then having to hire on expensive terms when business improved.

However, there is no reason why this model could not be used elsewhere in the media / digital tech space to help increase the efficiency of the model. It is already being done in other industries. Easyjet mentioned in their recent trading update that their recent negotiations with employee unions meant that “our future UK winter crew cost base has the ability to be flexed down materially in line with demand. “ In future, what we may see in the Media and Online spaces is an environment where there are fewer compulsory redundancies in return for a greater flexibility of employee costs to match revenues.

For employees though, there is an obvious trade off, and shifts the balance of power more towards employers. I mentioned last time Carl Frey’s “The Technology Trap”, which is excellent and suggests we are in an age akin to the Industrial Revolution where technology replaces expensive jobs. Daniel Susskind in “A World Without Work” takes a slightly different view stating that Artificial Intelligence will replace a lot more jobs than expected over the upcoming years. The book that probably reflects where we are going most is Joel Kotkin’s “The coming of neo-feudalism” which talks about an increased polarisation of society with, at the bottom, people enjoy fewer employment rates and less job security and, crucially, less visibility (another analogy would be the old pre-war casual labour dock schemes, where dockers would turn up in the morning, be selected or not for work, be paid (or not) for the day and then have to go through the same process each day afterwards. And certainly with no benefits).

However, for many Media and Digital companies, especially people-intensive businesses such as the Agencies and Broadcasters, it means they become more fundamentally attractive business models than in the past because they are less operationally geared (i.e. they can flex their cost bases more easily to match revenues as opposed to revenues). Thus, it is possible that they are more highly rated by the market and become more attractive takeover candidates.

9.      Towers falling, towers standing

One reference people seemed to like in the Q1 summary was the reference to the Tower in the deck of Tarot Cards which represented sudden change and upheaval, and is meant to show that the Tower is itself a solid structure but, as it is built on shaky foundations, it only takes one bolt of lightning to bring it down. This seemed to be an accurate analogy for a number of companies whose model looked secure but where the foundations were not be as strong as appeared.

As it has turned out, some of the towers turned out to be more resilient than expected. Facebook was one of these, as was pointed out above. The classified portal businesses, such as AutoTrader and Rightmove, also had wobbles but now look to be back on track (in the US, property portal group Zillow smashed expectations, and REA in Australia delivered a solid set of numbers. In the latter cases, relief given to struggling customers seemed to help, although these companies are not out of trouble yet given the economic environment. In the former, the SMB base continued to spend.

However, there are two models where there may be concern. One is Live Events, which have been obliterated by the pandemic. A recovery will obviously depend on what happens with the pandemic and the easing of restrictions. Live Nation Entertainment saw a 97% drop in revenues year on year in Q2 to $74m and instituted a $800m cost reduction programme for 2020. Even here, there is some optimism. Two-thirds of customers for cancelled events have decided to keep their tickets for deferred events. That suggests there is an underlying demand to get back to live events when conditions allow.

Of more concern would be Events and whether there will be a full return to Events even post-pandemic. Already, it is clear the Events industry is running behind schedule (see the charts below for what Informa, the world’s largest Events business stated back in April / June and then its update to the market last month at its Interims). The fear is that, at some point, companies decide that certain Events are not as crucial to their business as they had previously realised and that they can divert the resources into other areas (which links in with the comments from Mondelez about shifting money into advertising from areas such as Travel) and / or that virtual events become more prevalent, for which exhibitors are not willing to pay much and / or see as lower quality (although there is also far lower costs and capacity issues involved). A personal view is that it will not be so drastic – those Events which are seen as “must have” / market leaders in their fields and which are primarily for conducting business are likely to come back strongly. However, weaker players are likely to suffer more as are those Events that are seen less vital for revenue generation (e.g. Cannes) and which represent a sizeable budget to reallocate.

Informa – Events schedule for 2020, guidance April / June

Source: Informa

Informa – Events schedule updated at Interim Results, September 2020

Source: Informa