Dentsu Group — Set for a stronger H223

Dentsu Group is a holding company, headquartered in Tokyo, Japan, and operating globally. It provides communications services, media and digital services to a client base diversified by geography and by scale. Over the past few years, the group has undergone considerable change from being a traditional media holding company to one with a strong emphasis on data driven business solutions, known in the company’s terminology as ‘Customer Transformation and Technology’, or CT&T. Since the start of FY23, the group has been run as one unified organisation, having previously been a combination of the domestic Japanese group and the international operations. It is now focused around six core agency brands, detailed below.

Dentsu Group is the fifth largest quoted agency holding company globally, after Publicis, Omnicom, Interpublic and WPP, with one smaller Japanese peer, Hakuhodo. All have performed well so far this year, as the worst fears of recession in major developed economies have receded, with Dentsu’s share price up 7% and peers up 4%. With distortions regarding the definitions of appropriate revenue lines (gross or net of pass-through costs, etc) and variations in tax affecting the flow through to EPS, we regard EV/EBITDA as the least-worst comparison metric. Dentsu currently trades at a 33% discount to FY22–24e average EV/EBITDA multiples, which likely reflects lower levels of market familiarity, particularly when compared with the US-based Omnicom and Interpublic. Parity would imply a share price of ¥5,403, while our discounted cash flow (DCF) analysis (WACC 9.0%, terminal growth 2%) returns a value of ¥6,137.

The biggest factor affecting top-line progress is the state of the underlying economies in which the group does business, with advertising revenues highly correlated to GDP. Operating in many countries and with growing levels of off- and near-shoring, Dentsu is exposed to both transactional and translational currency impacts, reporting financial results in Japanese yen. Competition is a perennial sensitivity, with new business levels highly scrutinised. The shift further toward CT&T in the mix increases the degree of recurring revenues and improves the visibility of earnings. The group has been undergoing an extended period of major structural and cultural change, which can have destabilising effects. It can also reinject energy and focus. The advertising industry comes with high levels of reputational risk. This has happened to Dentsu recently regarding the Tokyo Olympics, when the group was indicted on a number of charges, with some sanctions imposed by the Japanese authorities as a consequence (which has a negligible impact at the group level). The situation was examined at the company’s behest by a highly qualified independent review panel, resulting in recommendations that we believe should ensure no repetition.

Dentsu Group is a global leader in media and digital communications, founded and headquartered in Japan and now operating in around 145 countries and regions globally. Dentsu was founded on 1 January 1901 and has therefore a vast heritage on which to draw. It listed on the Tokyo Stock Exchange in 2001, as an international advertising and PR business, growing since that date through a combination of organic progress and considerable M&A activity.

The business emphasis shifted markedly in 2016, when Dentsu bought Merkle in the US. Merkle’s objective is to ‘use data, technology and analysis to help the world’s best brands make their advertising more addressable, their experiences more personal, and manage relationships over time’. The changes to the underlying marketing communications market with the growth in importance of Google and Meta have necessitated a pivot to data-centricity, making it a central element of Dentsu’s client service proposition. Fuller descriptions of the group agencies are given below.

Digital activities accounted for 54% of FY22 group revenues, with CT&T representing 32% (33% of H123 revenues). Management targets this latter category to grow to 50% of group revenues.

Having grown through an extensive acquisition programme to diversify beyond its Japanese home market, the organisation had become unwieldy and inefficient. An integration programme, One dentsu, was initiated in early 2020 and was progressed that summer as an ‘accelerated transformation plan’. The objective was to simplify the business and make it fit for purpose, reducing structural overheads and allocating capital to growth and innovation.

In the video below, CFO Nick Priday provides an overview of the One dentsu initiative.

With the FY21 results published in February 2022, management set out its strategy for the FY22–24 period, focused around four themes, which is summarised below.

Leadership targets:

How is it going?

A reminder – why CT&T?

It is worth reiterating the key reasons why Dentsu’s management has identified CT&T as its preferred area for investment:

Leadership targets:

How is it going?

In FY20, Dentsu set in motion a plan to dramatically simplify the organisation, built through years of acquisitions but not necessarily followed through with integration. The aim was to structurally and permanently lower operating costs; to improve the efficiency of the balance sheet; and to improve shareholder value. This involved reducing the number of non-Japanese agency brands from over 160 to six, and focusing the Japanese operations into four domains, with a much greater emphasis on digital. Cross shareholdings in other Japanese corporates were unwound and the iconic Shiodome headquarters building in Tokyo sold and leased back.

In September 2022, Dentsu announced a further fundamental restructuring, which has done away with the differentiation between the Japanese and international operations, with the resultant organisation described as ‘One dentsu’. There is now a unified board, headed by President and CEO Hiroshi Igarashi and with the group’s first non-Japanese CFO in the appointment of Nick Priday to the role.

The group is now organised in four regions: Japan, Americas, EMEA and Asia-Pacific (APAC). It has established a new client support platform to enhance the client experience at the global level, alongside promoting Integrated Growth Solutions, which bring together the diverse capabilities within the group. Dentsu is integrating its corporate functions to build a common management platform. Further details on the main operating brands is given below.

Normalised operating margin was 18.2% in FY22 (18.4% if Russian operations were excluded). We had previously modelled that the additional investment in CT&T and in the One dentsu initiative would press on the normalised operating margin, estimating the impact as a reduction to 17.6%, with a bounce to 18.4% for FY24.

Management has now downgraded guidance for FY23 from a normalised operating margin of 17.5% to 17.0%, with most (unquantified) of this downgrade attributable to the DACH cluster issue, with the balance reflecting softer revenues in the Americas and APAC. All of the repercussions of the DACH cluster issue have been accounted for in Q223 and there should be no further impact. Normalised operating margin for the quarter was 8.7%, down from 13.9% in Q222 (H123: 11.5%, H122: 17.7%).

The 18.0% target for FY24 now looks like a stretch (our revised modelling assumes 17.3%), but is, in our opinion, achievable in FY25.

Leadership targets:

How is it going?

Capital spend in FY22 was ¥18.5bn, although this was offset by disposals totalling ¥13.9bn, so only shows up as a small net spend our model. We have modelled fairly modest amounts for FY23 and FY24 of ¥11bn in each year, giving a total across the planning period of ¥41.5bn, but this only includes the physical elements of property, plant and equipment. Additions to other intangibles in FY22 were ¥38bn and we currently model investment of ¥15bn and ¥11bn for FY23 and FY24, respectively. The total net investment across the period is therefore ¥69m, so very much on target.

On the M&A front, spending in FY22 was ¥40.9bn, with deferred consideration built into our modelling of ¥15.0bn in the current year, and ¥27.8bn for FY24. Payment for Tag was made before 30 June as the net debt figure provided at the H123 results was post payment. The acquisition of Tag was announced in March 2023 and it has contributed to revenues from 1 July. While not officially disclosed, the purchase price has been reported in the press at £533m, which translates to ¥98.9bn at current rates (August 2023). The total spend outlined currently is therefore running at ¥186.7bn, meaning that there is still considerable scope for further M&A. The intention is that any acquisitions should further bolster the group’s exposure to CT&T and help drive it toward the target of 50% of net revenues in the medium term.

There were six acquisitions in the 12 months to March 2023, five of which (Pexlify (UK/Ireland), Extentia (India), Aware Services (Australia), Omega (Spain) and Shift7 (US)) now form part of Merkle. The other was Ignition Point in Japan. Aware and Omega both step up the in-house expertise in Salesforce.

The announcement of the intended acquisition of Tag was also made in March, with the expectation that it would complete late Q323/early Q423. This was the third largest acquisition in the group’s history and significantly steps up the group’s capability in personalisation at scale and boosts the proportion of revenues derived from CT&T further towards the 50% goal. Completion was quicker than expected and the results will be consolidated as of 1 July 2023. The price paid was undisclosed, but press speculation put the figure at £533m, or ¥98.9bn at today’s exchange rate (¥185.6/£). Further information on Tag is given in the Key group agencies section below.

Leverage at the half-year was 0.2x net debt/underlying EBITDA post payment of the Tag consideration on the last day of the period. This is clearly well below indicated limits, suggesting that further M&A could be possible.

On dividends, the payout ratio increased from 30% in FY21 to 32% in FY22. Our modelling shows a further uplift to 34% for FY23e and 35% for FY24e.

4. Social impact and ESG

Leadership targets:

How is it going?

In April 2023, Dentsu Group established a Group Sustainability Committee, with participants drawn from across the group. It will be responsible for formulating group strategy on environmental and social matters, as well as the reporting of progress on those initiatives to a wider audience.

Post the group restructure, Dentsu is now technically a ‘company with three committees’, indicating that it now has fully operational audit, remuneration and governance committees. There is now in place a chief governance officer (Arinobu Soga, previously group CFO) and a chief culture officer, plus chief sustainability officers for the Japanese and the ex-Japan parts of the business. Miho Tanimoto was recently appointed as chief HR officer across the entire group.

Executive compensation is linked to organic growth, operating margin and total shareholder return versus a subset of agency peers and other media companies. On the ESG front, it is also linked to CO2 emissions and female leadership targets. Scope 1 and 2 emissions have reduced by 53% from the 2019 baseline (2022 = 16,039 tCO2e, 2019 = 33962 tCO2e). Renewable electricity now accounts for 37% of Dentsu Group’s usage (International = 100%, Japan = 0.4%).

The satisfaction score from the employee engagement survey remains at 68% for 2022, with no improvement from 2021 (also 68%).

The target for female leaders was upgraded at Q123 to 45% from 30%. For the International business, the current level is 37% (level 55+), and for Japan it is 13.8% (level 35+).

As part of the group restructuring, there has been a substantial reduction in the number of operating subsidiaries and legal entities, which, apart from deduplicating overheads, should allow for a more coherent service offering to large, global clients. Key Dentsu group brands include:

Merkle is a key element of the CT&T delivery. It is a global performance marketing agency with a 32-year track record of helping the best brands in the world create personalised experiences at every stage of the customer life cycle, describing itself as a customer experience transformation business partner. It has over 16,000 employees globally and operates in more than 30 countries, with over 400 leading brands as customers; a small sample is listed below.

In FY22, Merkle generated net revenue of $1.7bn, which is 19% of the group total, so, by implication, was just below 60% of the total CT&T net revenue.

Carat is an award-winning media, content and branding agency that ‘uses its peerless understanding of the passions, motivations, and behaviours of real people to bring brands and their customers together’. It has an impressive client roster, some of whom are highlighted below.

Carat was founded over 50 years ago and was a pioneer media agency. It now employs or uses the services of over 12,000 people in more than 100 countries globally. As well as traditional media agency work, Carat’s work covers business planning for growth, audience analysis, customer experience mapping, designing and optimising cross-platform media experiences, performance marketing, retail marketing and marketing effectiveness monitoring. It is also well known for its thought leadership pieces and its regular monitoring and forecasting of global ad spending, with the latest version available to download here: dentsu Global Ad Spend Forecasts 2023 Carat.

Dentsu Creative (www.dentsucreative.com) is a recent construct (Q322) that brings together Dentsu’s existing global creative network, which was previously spread across numerous standalone agencies within the wider Dentsu group agencies, including in Japan. It describes itself as transforming ‘brands and businesses through the power of Modern Creativity’. In many instances, it works alongside Merkle and other elements of the CT&T offering as well as Dentsu’s media interests. It works with around 9,000 creatives globally ‘to deliver ideas that Create Culture, Shape Society, and Invent the Future’. The new logo represents a meeting of East and West, as well as the initials of the segment. It won the 2022 Cannes Lions Agency of the year, a highly coveted industry accolade.

Dentsu X is a global integrated marketing agency network providing communication and media planning services, content creation, technology, data and behavioural insights. It describes itself as helping ‘brands create memorable, personalised marketing solutions that meet rapidly changing consumer demands to deliver ‘Experience Beyond Exposure.’’

Dentsu X has over 3,500 staff spread across 47 markets.

iProspect is a global digital-first, end-to-end media agency. It combines media strategy and storytelling with digital expertise and audience knowledge to promote performance-driven brand building.

The iProspect team comprises a network of more than 8,000 media and performance specialists spread across 93 global markets.

These are to be joined with the latest sizeable acquisition, Tag, being bought from Advent International. The corporate narrative around this is that the original acquisition of Aegis back in FY10 brought the group significant scale; the purchase of Merkle in FY16 gave the group its strategic shift into CT&T through its focus on digitalisation; and Tag brings it all together through integration and simplification.

Tag describes itself as an omnichannel content production partner, working in 29 countries, with over 2,700 employees. Tag has benefited from over €100m of investment, so this is not a case of an asset having been milked for cash in Advent International’s seven years of ownership.

Its service portfolio has three core elements: Creative Production (including digital video, high-end CGI, moving image, AR/VR and post-production), Technology (focused on UX design, website & platform development, managed services and digital interact) and Channel Activation (comprising strategic advisory and omnichannel content delivery).

The client roster is blue-chip (some notable names are listed above), working with 38 of the world’s leading 100 brands, and the average client relationship is over seven years long. The revenue synergies should come through quite quickly as the client rosters are scoured for immediate opportunities. A key attraction for Dentsu is Tag’s Digital Interact, an end-to-end proprietary production and marketing execution tool. This has the potential to be efficaciously utilised across Dentsu group agencies. The benefits from the dynamic content production within Digital Interact, for example in mass personalisation, could be significant and will certainly bring some currently subcontracted activity back in-house.

The new corporate structure of One dentsu was accompanied by a reconfiguration of the board and the group management team. At board level, there are now 10 directors, of whom two are female and four are non-Japanese nationals.

The group management team is now integrated, having previously been run as two distinct operational teams for Dentsu Japan Network and Dentsu International. There are 36 in the team, of whom 21 constitute the executive management team.

Fuller details of the team are given here: 2022074-1114en.pdf (dentsu.com)

Global advertising spend has a correlation with GDP, as shown below, with advertising spend generally exaggerating the changes in underlying GDP (ie underperforming in times of downturn and outperforming in stronger periods). The US market is the largest by value (see Exhibit 7, below) and Dentsu’s latest edition of Global Ad Spend Forecasts (downloadable here: dentsu Global Ad Spend Forecasts 2023) shows a very strong performance in 2022 at +12.9%, compared with global growth of +7.9%. The anticipated progress for the current year is for growth of 2.6%, against global growth of +3.3%. The fastest growing markets are India (+14.5%), Brazil (+5.4%) and China (+5.1%). North American market growth is set to rebound in FY24, with forecast growth of 5.5%, ahead of Asia-Pacific at +5.1%.

Japan remains the world’s third largest advertising market. 2022 turned out better than had been anticipated with 4.4% growth (Dentsu had predicted 3.6% in its December 2022 Global Ad Spend Report). Some of this was due to the timing of the spend of advertising budgets, though, and estimates for FY23 have retreated from +1.5% to +1.0% to $54.1bn. The Japanese ad market remains well behind the curve on digitisation and is markedly overweighted to television, which is forecast to decline 2.4% in FY23 before staging a slight comeback to +1.4% in FY24. The different dynamics are at least in part attributable to the country’s demographics, with an older population favouring more traditional media, although the ‘digital natives’ will obviously be moving up the age range bands over time.

The marketing services industry remains heavily influenced by the large global agency holding companies, listed below in Exhibit 11. Over recent years and as digital transformation has become a central theme, the traditional industry heavyweights have been joined by the large global consulting companies. In the more data-led, tech-driven space, key competitors would commonly include Accenture Interactive, Deloitte Digital and PWC. Of these, only Accenture makes partial disclosure of its marketing-based activities. WPP, Omnicom and the others (as listed below) are all keen to push their digital credentials, with the range of activities and direction of travel highlighted below.

As an industry, marketing services has traditionally been ‘people heavy’, although with a degree of flexibility through the extensive use of freelancers. The pandemic drew attention to the marketing service companies’ relative cost bases in terms of payroll-related costs but also property costs, where historically flagship premises were part of the client marketing effort.

Looked at across an extended period, back to 2015, Dentsu’s valuation is at or near lows to long-term average across the standard metrics of EV/revenue less cost of sales, EV/EBITDA and P/E, as is shown in the three exhibits below. The disruption from the impact of the pandemic is particularly clear to see in the EV/EBITDA.

The share price performances of the major global marketing services groups have been good so far this year, posting gains averaging 4% as the worst fears of Q422 have failed to come to fruition through the FY22 and Q123 reporting seasons. Dentsu’s share price performance had been better up until the Q123 figures, but even post the correction has gained 7% year-to-date as the market starts to appreciate the value being built with the growth of CT&T in the mix and the greater coherence in the group strategy. This has narrowed the discount of the rating to peers, which now sits at 33% when measured on EV/EBITDA across FY22–24e and averaging 32% on a P/E basis.

If parity were to be achieved against peers across an average of these metrics, the share price would be ¥5,403, compared with the current price of ¥4,165.

As a sense check, we also carried out a DCF, using a WACC of 9.0% and a terminal growth rate of 2.0%. These are fairly standard assumptions for stocks that Edison follows but may be overly conservative in the case of Dentsu, given that the bank lending rate in Japan is currently sitting at 1.30%.

This exercise produces a figure of ¥6,137, reflecting significant potential upside to the current share price.

The relevant top line for Dentsu and its peers is that of group revenue less pass-through costs, and we will refer to this simply as revenue.

We show here the longer-term record, separating out the regional reporting, which was previously agglomerated as Dentsu International. Immediately obvious from this exhibit is the impact of the COVID-19 pandemic on revenues, most notably in FY20, with a significant bounceback in FY21 and FY22. For the period FY16–FY22, the revenue CAGR was 3.2% for Japan, which is actually a strong showing against the underlying GDP performance of -0.07% over the same interval, although not all this growth was organic.

The US results have been very much shaped by the acquisition of Merkle, where a majority stake was acquired in 2016 and sole ownership achieved in 2020. The revenue CAGR for the US operations is 12.1% over the period FY16–22. For EMEA, the CAGR is 6.4%.

Looking at more recent periods, the prior year comparators have a distortive effect, particularly in Q322, with Q321 having been the period with the Tokyo Olympics. We discussed the Q123 figures in our May update note, again pointing out the impact of demanding Q122 comparators. The Americas’ performance was restrained by weak demand from the major tech companies.

This has continued into Q223, with Japan the only region to deliver organic growth of 1.4% in the quarter, as group organic growth fell by 4.7%. The positive performance in Japan was driven by double-digit growth in the CT&T business, with robust levels of client spend in the financial, transportation and household products sectors. Advertising spend was down year-on-year given strong prior year comparators as a cautious approach from clients continued. Given the weaker Q123 period in Japan, H123 organic revenue growth was 1.4%.

Weak demand from tech companies in the Americas in Q123 continued through to Q223 as organic revenue dropped by 7.4%, resulting in an H123 organic growth decline of 6.2% against tougher comparators. Dentsu appointed Michael Komasinski as CEO of dentsu Americas in June, from his position as CEO of CXM International Markets and previously as global CEO of Merkle, in order to put further impetus on executing on the integrated growth strategy.

Denstu flagged a one-off financial impact in Q223 in the EMEA region, relating to a complex transformation issue within the DACH cluster. This resulted in a 12.7% organic revenue decline in the region in Q223, which fed through to an H123 fall of 5.2%. Management noted that without this impact, EMEA would have reported positive organic revenue growth for the first half. The region reported a number of new client wins in Q223, including Carlsberg and Netflix UK, across Media, CXM and Creative.

Performance in APAC continued to be hindered by a weak macroeconomic environment in China, in which Dentsu has a greater client weighting towards more cyclical companies. India was weaker due to client losses in Media in the quarter, although the appointment of a new leadership team, Anita Kotwani in Media and CEO Harsha Razdan, has resulted in more recent client wins. Performance in South-East Asia continues to be held back by a weak Indonesia, despite a strong quarter in Vietnam.

A summary of the quarterly organic growth rates is shown in Exhibit 19 below.

In February, management guidance for the current year was for organic revenue growth of 4% and an underlying operating margin of 17.5%, below the prior year to reflect the additional investment in the One dentsu initiative and in systems and operations to support growth in the CT&T areas of the group. This was to translate into underlying basic EPS of ¥461 and a dividend payout of ¥157.

Due to the impact of the DACH issue in Q2, at the interim results in August organic revenue growth guidance was revised to a range of flat to down 2% in FY23. Although the operating margin guidance was also lowered by 50bp to 17% due to the issue in the DACH cluster, EPS and dividend expectations were unchanged as benefits from the One dentsu strategy resulted in lower financing costs. As a result, management expects to reduce its interest costs by ¥4–5bn in FY23 and ¥7.7bn in FY24. The implication is therefore that although organic growth will be muted or in decline, net profit expectations are unchanged as the benefits of One dentsu and the Tag acquisition come through.

The Tag acquisition was completed at end June and we have incorporated its contribution into our modelling. We expect Tag would have lifted the contribution from CT&T from 32% to 34% on a pro forma basis for FY22. Our understanding is that it currently earns margins a couple of percentage points below those achieved by Dentsu Group. Management has stated that the acquisition will be earnings accretive.

We have tweaked our FY23 and FY24 expectations to reflect both management’s updated guidance and the Tag acquisition. Our modelling continues to be a little more conservative than company guidance, with the observation that performance will be more heavily weighted to the second half than is usual (although Q4 is the most substantial for the majority of companies in the marketing services industry). We now assume revenue growth in FY23 of 2.6% (previously 3.7%) at an adjusted operating margin close to guidance at 17.0%. We have included the interest cost reduction made in FY23e of ¥4–5bn, which translates to a forecast EPS number of ¥461 with a dividend of ¥156 (a 34% payout ratio).

To extend the modelling into FY24, we have made assumptions of relatively modest revenue (less cost of sales) growth of 4.4%. We model a 30bp improvement in the adjusted operating margin to 17.3% as the various initiatives start to produce returns. This drives a 10% step up in EPS as we model the annualisation of the interest cost reductions into our forecasts, with the dividend lifted to ¥177 given a payout ratio of 35%. This is below the numbers that we published in May 2023 given the expected decline in operating margin (down 149bp vs our previous expectations), when we modelled FY24 EPS of ¥524, a figure now revised to ¥509.

While the short-term cash flow is subject to various vacillations, it is more meaningful to show how the balance sheet has been transformed over recent years through the generation and use of cash. To illustrate this more clearly, we have combined the cash flow statements from the years FY16–22 inclusive, as shown below. FY16 predates the launch of the comprehensive review of business operations, which was launched in August 2020.

By doing this, the scale of the transformation and the key elements become more obvious. The main factors to note are:

Our modelling for FY23 and FY24 contains no further share buybacks but now includes the payment for Tag. We model net cash inflow of ¥35.3bn for FY23, which reflects strong operating cash flow of ¥197.7bn offset by a ¥103.1bn investing outflow (including Tag) and a ¥59.2bn financing outflow, of which ¥41.1bn is expected to be dividends paid.

Leverage at the end of H123 was 0.2x trailing 12-months EBITDA post the Tag acquisition, which is net debt of ¥36.7bn (from ¥71.3bn of net cash at end FY22). The swing from net cash to net debt predominantly reflects the first quarter (end-Q123 net debt: ¥103.3bn), which is typical of the seasonality of Dentsu’s working capital, predominantly relating to the timing of incentive payments. Given the reduction in net debt between Q123 and Q223, we continue to forecast that Dentsu will return to a net cash position in FY23.

The medium-term range for net leverage set by management at 1.0–1.5x clearly gives plenty of scope for further deals and the M&A pipeline is reportedly healthy. The sum outlined for acquisitions across FY22–24 was ¥250–300bn (US$1.8–2.1bn). Spend in FY22 was ¥41bn and the externally reported price for Tag was £533m (¥98.9bn at current rates), leaving plenty still in the pot.

From ¥54bn of debt at end FY20, the cash flow as described above moved the balance sheet to a net cash position the following year of ¥144bn, with returns to shareholders bringing that total down to ¥71bn at end FY22. Our current modelling shows a net cash build over the year to ¥106.2bn, which as mentioned previously includes the Tag acquisition but contains no provision for additional share buybacks.