Analyst downgrades advertising stocks over fear of 'mis-leading' payments to agencies

Pivotal Research Group analyst Brian Wieser has downgraded his stock ratings for all of the advertising agency holding companies Pivotal covers - reducing IPG from buy to hold, and WPP, Omnicom, and Publicis Groupe from hold to sell. He cites "emerging concerns among marketers" around "mis-leading" payments and different forms of volume discount rebates that agencies claim in the United States.

As a result, Wieser advises investors in such companies to move to the sidelines or "exit the sector altogether."

Media rebates are one of the most controversial areas of advertising, and are not new: Media companies pay them to agencies to keep client dollars - in the form of ad buys - rolling in, even when those dollars may be more efficiently spent elsewhere.

They exist in a legal gray area. Usually, most client-agency contracts insist that all discounts, rebates and benefits earned by media spending be returned to the client. But if a TV station returns a discount to a media-buying agency there is no way for the client to know about that payment if the agency does not disclose it. Historically, agencies have padded their margins with these payments. Clients haven't bothered to pursue them because it would be complicated and resource-intensive to do so. Critics regard them as bribes or kickbacks. Agencies have defended them as a legitimate way to maintain their profitability, and note that if clients felt they were being ripped off they would go elsewhere.

Grey Global Group was once sued unsuccessfully by its former CFO over the issue of whether rebates were legit.

Recently, former Mediacom CEO Jon Mandel alleged that agency "kickbacks" are still "widespread" and cited them as one of the reasons he left the agency world, AdAge reported. "Have you ever wondered why fees to agencies have gone down and yet the declared profits to these agencies are up?" he said at the time. GroupM (the media division of the WPP group, which owns Mediacom) denied the allegations, saying "In the US, rebates or other form so hidden revenue are not part of GroupM's trading relationships with vendors."

Nevertheless, Wieser writes in a research note published on Monday:

The volume and specificity of allegations by aggrieved media owners, former agency executives and marketers are difficult to ignore. Rightly or wrongly, there is a growing perception among marketers that agencies have been mis-leading, transferring value associated with media volumes without clients' full understanding or support. Between cash rebates, consulting arrangements, vendor-funded staffing or services, inventory banks, equity provided for spending volumes, shifting of inventory from one entity to another and all of the above practices involving volumes in one country shifted in exchange for benefits in another, few marketer-clients in the US fully understand the specific arrangements their agencies undertake with media owners.

Despite its Mediacom business being namechecked in the aforementioned trade magazine reports, Wieser says WPP is probably the most "immunized" holding group in the event that clients decide to do something about the problem.

That's because WPP is the only group to disclose both gross revenues versus revenues net of media trading. Indeed, Sir Martin Sorrell has recently been vocal in both quarterly earnings calls and his appearances at advertising conferences about rival groups not reporting revenues transparently.

Even still, Wieser points out that none of the agency holding groups break out revenue from barter, cash rebates, consulting, media agency research fees, the booking of business from media inventory banks, or trading with equity investees.

Wieser believes that clients' scrutiny of the fees they are being charged by their agencies "will surely expand" as trading practices are explored in greater depth - presumably this means by their own procurement divisions, the press, or trade bodies.

He warns:

All of this may ultimately cause only an imperceptible difference in growth, but as marketers become more vocal about undisclosed rebates and more specific allegations come to light, a drumbeat of negativity will build around the sector over the course of this year. Given this risk, we'd recommend that investors move to the sidelines or exit the sector altogether while it all plays out.

Beyond the rebate issue, the note suggests other risks in the sector include: Squeezing fees from clients, competition from adjacent industries, and reduced competition between marketers and demand for other advertising services.

Here are the specific Pivotal downgrades:

• IPG
• Rating: HOLD (Previous: BUY)
• Target price: $23 (Previous $24)
• Omnicom
• Rating: SELL (Previous: HOLD)
• Target price: $66 (Previous: $71)
• Publicis Groupe
• Rating: SELL (Previous: HOLD)
• Target price:€64 (Previous:€65)
• WPP
• Rating: SELL (Previous: HOLD)
• Target price: 1370p (Previous: 1440p)