Dentsu Group — Simplification to boost growth and margins

While Dentsu is commonly bracketed with the other global marketing services holding companies, the range of activities is broad across media activation, creative, data analytics, systems integration, sports and entertainment. It has a particularly strong position in data analytics and digital transformation, based on the 2016 acquisition of US-based Merkle. 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 in the summer as the accelerated transformation plan. The objective is to simplify the business and make it fit for purpose, reducing structural overheads and allocating capital to growth and innovation. Digital activities accounted for 54% of FY20 group revenues, with Customer Transformation & Technology representing 28%. Management targets this latter category to grow to 50% of group revenues.

Dentsu’s share price has risen 20% since the start of the year. This partly reflects the improving global outlook for advertising spend (the global sector holding company peer set is ahead by 14% ytd). We would suggest the outperformance reflects moves that Dentsu has made to improve its financial performance and prospects and to strengthen its balance sheet. The intention to have a progressive dividend policy and buy back shares when appropriate will also have contributed. The rating is now roughly on a par with peers for FY22 (beyond the transitional year) on EV/EBITDA. A DCF on a range of terminal growth and WACC assumptions suggests possible further upside.

FY20 figures reflect the impact of the COVID-19 pandemic, with revenues less passthrough costs down 11.1% and a slight dip in operating margin from 15.0% to 14.8%. This was very slightly ahead of previous Q420 market estimates. The FY20 restructuring charge was ¥80bn and an impairment loss of ¥145bn was also taken. This predominantly reflects a diminution in the carrying value of DI assets, reappraised in light of the pandemic impact. Management is targeting revenue less pass-through costs growth of 3–4% CAGR over FY21–24. Our modelling is at the lower end of this range. The group also anticipates a steady improvement in underlying operating margin across the period. Our published forecasts only extend to FY22 but show operating margin broadly level at 14.7% in FY21, climbing to 16.7% in FY22 as the restructuring benefits start to flow through. As described above, the balance sheet has been strengthened by the disposal of the Recruit shares. The objective now is to maintain an efficient balance sheet with a medium-term leverage target of 1.5x net debt /EBITDA (0.6X in FY20). This should allow for continued investment in organic and inorganic growth (M&A) and a progressive dividend towards 35% of adjusted EPS over the next few years. Additional shareholder returns through further buybacks may follow exceptional asset sales.

The key sensitivity to our forecasts is successful implementation of the group’s transformation plan. The economic backdrop should improve through FY21, although globally levels of advertising spend are unlikely to recoup all the losses registered in FY20. Dentsu’s weighting towards customer experience management (CXM) and digital transformation should help it outperform the broader advertising market. If the Tokyo Olympics do not proceed as planned, advertising spend will be affected. The group also has standard industry sensitivities regarding client retention and reputational risk, along with regulatory risks on matters such as data security.

Dentsu Group is a global marketing services holding company, headquartered in Japan. It has a full range of services to support its customers’ brands, with a particularly strong position in data analytics. It has two reporting segments, DJN and DI.

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. In this interview, CFO Yushin Soga gives a brief overview of the group, along with a high-level description of the transformation that management has put in place to simplify the group and improve integration. The objective is to make the group easier to navigate for its clients and help them achieve growth using consumer insights, technology and analytics and in digital transformation.

The group reports in two segments, representing its Japanese business and its business outside Japan, now known as DI. The dynamics of these two are different and in the past have been effectively managed separately. DJN is a leading player and has historically enjoyed high operating margins. DI (previously Dentsu Aegis Network) has been built through a fairly aggressive acquisition programme, leaving it with 160 agency brands that it now intends to consolidate into six global leadership brands within two years.

Before documenting and commenting on the restructuring programme, we briefly describe some of the group’s main agencies with key clients where appropriate and links to the relevant websites.

DJN has a prominent position in the Japanese marketing services landscape, with an estimated market share of around 30%. Historically, the Japanese market had been relatively slow to adapt to digital media and DJN was broadly aligned with its market. In FY20, 34.8% of its DJN revenues were derived from digital, compared with 67.5% of those at DI, giving an overall group level of 53.8%. Revenues from customer transformation and technology programmes are around 25% of the division, approximately equal to the proportion in the international business. Until recently it provided services falling into eight broad segments: marketing; digital marketing; creative; promotions; media; content; PR; and global. It is now reframing that offering into four domains: advertising transformation; business transformation; customer experience transformation; and digital transformation.

Its prominent agencies include:

Dentsu, Inc, the largest unit within the Dentsu Group. Founded as an advertising group, it now works across the range of marketing communications, including digital marketing, creative, media, PR, promotions, events, sports and content development. It also works with clients on business and digital transformation and on e-commerce projects and CRM implementations. Activities are increasingly based on advanced data and technology platforms, sometimes collaborating with partners inside and outside the group.

iSiD (61.8% owned and separately listed on the Tokyo Stock Exchange: 4812) is an advanced IT solutions provider, supporting client digital transformation backed with solid technological and creative capabilities. It has particular strengths in fintech, smart enterprises and manufacturing innovations. It also provides the Dentsu group with its underlying marketing platform. It helps drive its clients’ programmes with solutions in finance, business, manufacturing and communications/IT. Among other developments, iSiD is also accelerating its service development with cutting-edge technologies such as location based and sensing.

Dentsu Digital (100% owned) is a digital marketing company established in July 2016. It supplies a wide range of services to be a digital partner to its clients in digital marketing IT platform and data infrastructure and digital transformation. Dentsu Digital employs 1,500 people and is based in Tokyo, working with around 600 clients. Its approach is summarised in the phrase ‘People Driven Marketing’, driven through data and analytics.

As explained above, DI is a global agency network. It has strong working relationships with key technology partners, in particular Salesforce, Adobe, AWS, Microsoft, Google and Facebook, which are key to building its CXM offering. A fuller discussion of DI is contained in the interview with its CEO, Wendy Clark (Exhibit 14). Wendy joined the company in September 2020 and has brought a clear vision to the business and its potential. She is also committed to the importance of strong ethics in the relationship between the business and all its stakeholders, internal and external, and the need to be mindful of the group’s environmental impact. It is proposed that Wendy will be joining the main group Board at the March General Meeting.

Merkle is a data-driven and technology-enabled global performance marketing agency with a 32-year track record of working with brands to create personalised experiences through each stage of the customer lifecycle. Merkle joined with Dentsu in 2016 (purchase of 66%) and has since continued to acquire digital marketing and data analytics companies to complement its offer and widen its geographic reach. The outstanding shares were acquired in FY20, taking Dentsu to 100% ownership, with payment in FY21. Merkle employs over 9,600 employees globally. Its FY19 revenues were $1.1bn (¥120bn), over 11% of the group total. It is the fastest growing area of DI and its continuing development is central to the group’s ambitions as the market moves further towards greater personalisation.

In the interview below (Exhibit 6) Merkle’s global CEO, Craig Dempster, provides further information on how Merkle has built its offering and how it is positioned within the shifting privacy landscape.

Isobar describes itself as a digital experience agency that transforms businesses by integrating creativity and technology to create meaningful customer experiences. It is a global agency employing 5,500 people across 85 offices in 45 countries. Its activities fall across both agency work and consultancy, encompassing digital marketing through to experience-led transformation programmes for clients.

Carat was founded over 50 years ago and was the world’s first media agency. It has a brand-first approach, using its ‘understanding of the passions, motivations and behaviours of real people to bring brands and their customers together’. It employs over 12,000 people in over 100 countries and has a very strong client roster, including those listed in Exhibit 7.

dentsu X is an integrated agency network combining best-in-class communication and media planning services, content creation, technology, data and behavioural insights. It employs c 3,500 staff across 47 markets. Working with the tagline ‘experience beyond exposure’, the agency looks to deliver fully integrated solutions, working alongside clients’ other agencies. These clients include Jaguar Land Rover, LVMH, Kao Corporation and Netflix.

iProspect (now including Vizeum). Announced in November as part of the brand rationalisation programme, the formal merger between iProspect and Vizeum is set to be concluded by end March 2021. iProspect employs around 8,000 people in 126 offices across 93 markets, with the largest number in EMEA. The agency focuses on performance-driven brand building, describing itself as an end-to-end digital-first media agency, with Vizeum adding media strategy and planning.

Dentsumcgarrybowen is a global creative agency, focused on brand transformation, combining the dentsu agency and mcgarrybowen. The newly-merged entity has around 3,000 employees at 33 locations in 24 markets. The nature of the marketing services industry makes it important the larger providers are able to put choices in front of potential clients, particularly in creative.

MKTG is a global lifestyle marketing agency that works to connect brands and people through sports and entertainment marketing, live experiences, digital and social media, retail marketing, enterprise/B2B engagement and sponsorship marketing. Although severely affected by the restrictions enforced by governments worldwide to counter the spread of COVID-19, sports and entertainment is an increasingly important element in the global marketing mix as traditional channels to reach audiences are diluted by the breadth of contact points between content and audiences. MKTG has around 1,300 employees and 7,000 brand ambassadors based in 29 offices in 16 countries across the Americas, EMEA and APAC.

Posterscope is a leading global out-of-home (OOH) communications agency and location expert, with over 1,000 people in 49 offices located in 30 countries worldwide. It books over 30,000 OOH campaigns every year, with billings of over $3bn (¥327bn). OOH is increasingly sophisticated and digital. Posterscope’s market proposition includes a leading technology platform with advanced planning tools, strong data and analytics capabilities, an advanced automation programme and a broad and diverse physical offering.

In August 2020, Dentsu’s management announced the group would be carrying out a restructuring, which it called an accelerated transformation plan. The group is now to be focused on a global client service model, as is employed by other agency holding companies such as WPP and Publicis. There are already relationships with 95 of the world’s top 100 advertisers. This gives a clear opportunity to drive deeper and more substantial penetration to build scale and grow the top line. DI is now organised into three lines of business: creative, media and CRM across the Americas, APAC and EMEA. DI is realigning its 160 agency brands into six global leadership brands.

M&A will be focused on the high-growth areas of data, analytics and digital transformation, building on existing strengths and taking advantage of opportunities presented by the structural shift in the market toward first-party data. Deals are likely to be fewer in number but of more significance (Dentsu’s average deal size over recent years was around $30m). Merkle’s strong positioning in the US makes expansion in other geographic regions more likely.

The culture of encouraging innovation prevalent within DJN is to be emphasised, with more JVs and start-ups with tech companies in areas such as marketing technology, virtual reality and AI.

Dentsu’s accelerated transformation plan is underway and progress is on track. The key objectives are to deliver the following:

Dentsu’s management regards the group’s social impact as a core element of its responsibility. As Wendy Clark points out in her interview above, acting with environmental and social respect is increasingly effectively a social licence to operate. Consumers are ever more vocal in their demands that the companies they buy from act responsibly and Dentsu is part of that supply chain. Being on the front foot in this respect can translate into a commercial advantage over other suppliers with less of an ESG commitment.

The group has resolved to implement a 46% absolute reduction in CO2 usage and be 100% net zero by 2030, with the balance offset by certified green gas. The COVID-19 pandemic will have had a marked impact on the carbon footprint in 2020, with travel obviously curtailed and office occupancy reduced globally. While some of this will resume as restrictions lift, we would not expect levels to revert to pre-pandemic volumes.

Restructuring programmes are inevitably unsettling and staff relations are more of a focus than they may have been historically. Improvements in employee engagement are a key part of the group’s revised positioning, along with a commitment to gender diversity across all levels.

Global advertising spend has a correlation with GDP, as shown below. The US market is the largest by value (see Exhibit 16, below) and Dentsu forecasts it will have outperformed global markets over FY20 with a decline of 7.6% versus the market at -8.8%. This reflects the prevalence of digital in the mix and the acceleration of growth of e-commerce in the face of the COVID-19 pandemic and its impact on consumer behaviour. The fastest growth over the next couple of years is forecast to come from Central and Eastern Europe as their economies shift further to digital, albeit off a much lower base.

The Japanese advertising market is still far behind the digital transition curve, with TV prominent at a 26.8% share (FY19, source: Dentsu). The digital share of the Japanese market is slightly ahead at 33%. Japan had a very difficult year in FY20, with the postponement of the planned Tokyo Olympics contributing to a year-on-year decline of advertising spending of 16.6%. Forecast recovery in ad spend of 5.3% in FY21, broadly in line with the global GDP growth assumption, is based on the delayed Olympics taking place as currently scheduled.

The marketing services industry remains heavily influenced by the large global agency holding companies, listed below. 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 has drawn attention to the companies’ relative cost bases in terms of payroll-related costs but also for property costs, where historically flagship premises were part of the client marketing effort.

We briefly outline some of the key issues that may affect financial performance.

The exhibits below show how Dentsu’s shares trade compared to their historical ranges since 2015. As can be seen, across the key valuation metrics of EV/revenue, EV/EBIT and P/E, the trend has softened with current levels close to historical lows.

The strong rise in Dentsu’s share price year to date has more than recouped the fall that it suffered in 2020. Our view is that reflects several factors, but notably the stronger balance sheet post the partial sales of the Recruit holding, buoyed by expectations regarding the potential sale and leaseback of the headquarters building (now confirmed as under consideration). We appraise Dentsu’s valuation compared with the other key holding companies and its largest Japan-based competitor.

On an EV/EBITDA basis, Dentsu’s shares are valued broadly in line with its peers for calendar 2022. For 2021, viewed by management as a transition year, it is trading ahead of the pack.

As shown in the exhibit below, a DCF at various WACCs and terminal growth rates would mostly indicate higher values. Selecting an industry-typical terminal growth rate of 1% and a WACC of 10%, the DCF derives a value of ¥4,199, 14% above the current level.

With the FY20 results, Dentsu’s management set out a clear financial framework to drive shareholder value over the four years from FY21 to FY24 inclusive. This includes three key earnings-based targets:

Q220 was the most difficult trading quarter for the group, with an easing across the rest of the year, albeit with regional variations. At DJN, revenues were supported by strong demand for digital solutions, with both iSiD and Dentsu Digital growing revenues organically by double digits. At DI Americas, the digital and customer experience practices performed well (where investment is being focused, including at Merkle) but there was weakness in media spend and the creative practice. The EMEA performance remained soft as the year progressed with gains in CXM and creative more than offset by COVID-19-related weakness in demand for out-of-home and experiential campaigns. The smaller APAC region varied by geography but again had a good contribution from CXM.

We expect Q121 to continue to be difficult, given stronger comparatives, with like-for-like growth rates then starting to improve. Our modelling suggests revenue less cost of sales growing by 3.6% over FY21, with DI growing slightly faster than DJN. Management guidance is for organic revenue growth at a CAGR of 3–4% over the period FY21–24. Our modelling is slightly more conservative, given the number of moving parts and uncertainty regarding the shape of the post pandemic economic recovery.

As shown in the exhibit below, DJN historically benefited from high operating margins, reflecting its dominant market position and its business mix, with a heavy weighting to television. These margins were self-evidently not sustainable as the Japanese market moves into closer alignment with other markets. Management is now targeting ¥21bn of annualised cost reductions through to FY22, at a cost of around ¥50m, spread ¥24bn in FY20, ¥23bn in FY21 and ¥3bn in FY22 There are two elements to this programme: an HR element, focused on a voluntary early-retirement scheme and other HR initiatives designed to give greater flexibility to the cost base; and a property element that will look to optimise working practices, including at the headquarters in Shiodome, Tokyo. It is this flagship building that is being considered for sale and leaseback.

The restructuring is more substantial at DI, as outlined in the transformation plan published in December 2020. The earlier acquisition programme was designed to build the group’s competencies but was not sufficiently focused on integrating those acquisitions with any coherence. The published plan is to reduce ex-Japan headcount by 12.5%, equating to around 6k people. Annualised savings of ¥55bn from the end of FY21 are expected, at an estimated cost of ¥88bn, of which ¥56bn was taken in FY20, with the balance of ¥32bn falling into FY21. This should enable the underlying operating margins to expand as illustrated below, with our model indicating a broadly flat margin FY21 on FY20 at 14.7% versus 14.8%, increasing to 16.7% in FY22, as the benefits of the cost cutting and the reorientation of revenues toward higher-margin activities start to kick in.

The group remains well capitalised, with a strong balance sheet and a AA- credit rating from Japan’s Rating and Investment Information. While a full balance sheet for FY20 has not yet been published, the group cash flow statement shows a reduction in net debt of ¥155.7bn from ¥209.9bn at end FY19 to ¥56bn at end FY20. Key changes include an adjustment arising from the disposal of the majority of the stake in Recruit Holdings, initiated by the strategy to unwind holdings in non-trading security assets. We have also adjusted intangible assets in our model for the reported impairment charge of ¥145bn, mostly against DI assets.

Full details of the balance sheet will be available when the full accounts are published (expected in March 2021). Our balance sheet and cashflow estimates modelled in Exhibit 27 incorporate the selected figures already published. Although management has announced the intention to buy back shares up to a value of ¥30bn, we will only include this in our modelling when it happens.

The group intends to maintain a strong balance sheet, with a medium-term average leverage target of 1.5x net debt/EBITDA. Our modelling puts this ratio at under 0.7x for the next couple of years but, as indicated, this does not account for the buyback, which would lift the ratio to 1.0x. This implies there is still plenty of potential to increase levels of investment in the business, both to fuel organic growth and drive further acquisitions. We would expect these would be fewer and larger than most of the activity over the last few years in the light of the group’s structural simplification strategy. Given the ambitions to grow Customer Transformation & Technology towards half of group revenues, it seems likely this area will be the focus for transactions.

Management is adopting a progressive dividend policy (to grow the payout ratio to 35% of adjusted EPS over the next few years); our modelling shows a pay-out ratio on this basis of 29% in FY21 and 30% in FY22.

In 2019, Dentsu carried out share buybacks of approximately ¥30bn. The newly announced programme targets the same sum. Additional shareholder returns would be likely to be made after exceptional asset sales, for example in the case of any capital realisation from the sale and leaseback of the headquarter building.