If Nick Grouf wanted to impress his new financial backers, he probably outdid himself. At a meeting late last year with top executives from WPP, the global marketing services titan that had taken a stake in Grouf ‘s Los Angeles-based startup ad agency, Spot Runner, the young entrepreneur wanted to show off the cheap and easy service that his agency provides for small firms wanting to run ad spots on local cable TV. As his audience looked on, Grouf, using just a few stock photos to hand, whipped up an ad for a client on his PC and then logged on to the Internet to plan and place the client’s campaign, all in a matter of minutes.

When Sir Martin Sorrell, WPP’s CEO, asked Grouf if Spot Runner could do the same for big advertisers, the answer was, Sure, why not? “You could see the blood draining away from the faces of the people who run our businesses,” Sorrell recalled a few weeks later to a nervously tittering audience at an industry conference in New York City.

Anything to do with Web 2.0 — the sequel to the 1990s dotcom boom — seems to be getting similar reactions from big ad executives these days. Many industry experts believe Web 2.0 will change the $1 trillion-a-year industry beyond recognition, and sparky young agencies like Spot Runner are just a small part of it.

Though still in its early days, any company that has been paying attention is already aware that Web 2.0 is all about consumer-controlled, on-demand marketing that now takes place over a vast array of digital channels, from interactive TV to viral marketing to popular Internet sites such as YouTube. Indeed, there’s evidence that the big advertisers are rapidly following their consumers in this direction, moving their ad budgets from old, costly media, such as mainstream TV networks, to anything to do with Web 2.0.

According to “The Future of Advertising and Agencies,” a new report from the Institute of Practitioners in Advertising (IPA), a U.K. trade body, the big question is what the old-line advertising companies — particularly industry leaders like WPP, Omnicom, Publicis, Interpublic, and Bolloré Group — must do to keep from being rendered obsolete. “In the future, low barriers to entry — especially in the online world — mean that agencies are not just competing with other agencies (though there is still that, too), but also fighting off threats from new ‘mutant’ competitors,” warn the report’s authors.

But beyond the basic fear of change, there’s another school of thought that is more upbeat. In a paper published last month, Bear, Stearns & Company analysts say the marketing services oligarchs haven’t had it so good in a long while. After the Internet bubble burst in 2000, most survived and then thrived, chopping and changing their business models to move into advertising’s fast-growing side businesses, such as direct marketing over digital channels. The good news, Bear Stearns analysts argue, is that these companies not only have the balance sheets, but also the size and diversity to attack Web 2.0 on all fronts, and “continue to garner more of the advertising pie.”

Same, but Different

Fortunately for Sorrell, this plays to the strengths of his trusted finance chief, Paul Richardson. Having resigned from his deputy treasury post at Hanson, the U.K. building materials firm, in 1992 to join WPP as treasurer (the company’s third in four years), Richardson has been WPP’s group finance director since 1996. Widely respected by industry watchers for his financial management of the company while also being one of Sorrell’s closest advisers, Richardson, 49, can take much of the credit for the strength of WPP today.

His take on Web 2.0? For one thing, this is no case of dotcom déjà vu, says Richardson, who remembers all too vividly how close WPP came to becoming a casualty of the market boom-to-bust just a few years ago. He lists a convergence of factors — from better technology to more sophisticated, tech-savvy consumers to impatient corporate clients, which in WPP’s case includes more than 300 of the Fortune 500 companies, tired of seeing their ad spend spiral upwards — to explain why he believes “Web 2.0 is much more significant” than the previous digital euphoria.

It’s also much more complex to manage, particularly for companies like WPP. “If I were a $150m company and I only had digital marketing, you’d say, ‘You’re brilliant at it.’ But guess what? Companies like that are probably only in two or three markets,” says Richardson, sitting in WPP’s cramped, workaday London office, which serves as one of his two base camps (the other being in New York City, just around the corner from Madison Avenue, the old ad capital of the world). “As for a $10 billion company — yes, we’re trying to change. Yes, we’re finding it difficult to change fast enough…. Nobody is coping with this; nobody can go at the speed that the market is demanding.”

Can complacency, if not arrogance, be partly to blame? Some industry observers reckon so. “For a long while, I think the traditional agencies thought they could deal with [Web 2.0] by simply subcontracting the production aspect [of making interactive and Internet ads] without investing in the technical know-how themselves,” says Robert Willott, editor of Marketing Services Financial Intelligence, a U.K.-based industry newsletter. “That view has been changing rapidly over the past 18 months and all the traditional agencies are rushing around trying to find the quickest and most effective way to bring digital skills in-house to avoid losing business to specialists or more advanced competitors.”

Advanced competitors? That would include the big search engines, notably Google. Having built its business around search advertising, the Silicon Valley darling has been muscling in on Madison Avenue and striking deals over recent months to sell adverts for the mainstream media. It’s already running an experiment with around 70 newspapers in the U.S., it has hooked up with BBC Worldwide, the commercial arm of the British state broadcaster, to run ad-sponsored content on its YouTube channel, and it’s said to be very close to an agreement with U.S. network TV and broadcasting giant CBS to handle its radio advertising. “The long-term fantasy is we walk up to you and you give us, say, $10m and we’ll completely allocate it for you across different media and ad types,” Eric Schmidt, Google’s CEO, told The Wall Street Journal late last year.

That sounds like WPP’s territory. And while it’s too early to know the significance of the threat that Google poses, WPP, for now, has decided to look at the dominant search engine as both friend and enemy — or, employing the awkward neologism, a “frienemy,” as Sorrell has taken to calling it lately. Indeed, on the one hand, says Richardson, “Schmidt regards his company as a technology-innovation company and he’s not averse to coming into the marketing services sector and attempting to take a significantly larger market share.” On the other hand, Google can’t crack the mainstream media without the involvement of the likes of WPP, which incidentally is Google’s largest customer in terms of purchasing search and media ads.

As Richardson explains, “[Schmidt’s] methodology and techniques apply extremely well to the smaller and medium-sized corporations, but he hasn’t had, at this stage, any traction with the multinationals. That door is harder for him to open than he would have probably originally thought.” That’s where WPP comes in. “What he’s realized is that our relationship with multinationals is very valuable,” says Richardson.

Stay Tuned

What’s clear is that traditional advertising — primarily prime-time network TV — will account for an ever smaller portion of multinationals’ advertising. Richardson, for his part, says that the TV networks have only themselves to blame. “My view is that [the large network TV stations in the U.S.] have abused their privileged position and jacked prices up to a degree that has made clients extremely unhappy,” he explains. “The media price inflation that’s been going on for a decade, running considerably greater than consumer price inflation, and the fragmentation into other channels are why experimental dollars are being pushed to other mediums.”

The Internet, of course, is one of those mediums. According to PricewaterhouseCoopers, global Internet advertising has been increasing steadily, from $66 billion in 2001 to $145 billion in 2005. By 2010, PwC predicts it will reach $266 billion.

The Internet’s appeal from an advertiser’s perspective is easy to understand: it’s cheaper and more targeted, making monitoring consumer behavior more feasible. It’s equally attractive for the advertising holding companies. Bear Stearns analysts say that the cost for the holding companies to handle a non-traditional media account should be lower than that for a traditional media account. According to their calculations, an interactive agency keeps around 35 percent of a client’s ad budget, compared with around 10 percent that clients allocate to a creative agency to develop a broadcast TV ad. “Since operating margins are about the same in both businesses, the interactive agency actually collects more profit dollars than the traditional creative agency,” they write in January’s report. However, they add, “these [non-traditional] businesses are still relatively small, but over time we expect they will become a more meaningful contributor to holding company profits, both from volume of business and from increasing economies of scale.”

It’s anyone’s guess as to when the Internet will indeed become a meaningful contributor. But in the meantime, TV — network, cable or interactive — will continue to be a force to be reckoned with. After all, the 30-second slots during the U.S.’s Super Bowl game earlier this month sold for $2.6m each. Bear Stearns estimates that TV accounted for nearly 25 percent of all advertising spend in 2006, compared with the Internet’s 3 percent.

Ad Ons

And don’t let any of WPP’s “frienemy” hand-wringing fool you. “WPP isn’t an outsider in any of this,” says Alexia Quadrani, a media analyst at Bear Stearns. “It’s very much in the flow.” Last year alone, in fact, it bought stakes in, or acquired outright, nearly 30 small and medium-sized businesses, a third of which are involved in Internet or digital media, according to Zephyr, an M&A data provider. Its 3.2 percent stake in Spot Runner is a case in point.

Acquisitions have long been the foundation of WPP’s growth strategy, transforming the former shopping-basket company — which Sorrell bought in 1985 after quitting his CFO job with the advertising gurus Saatchi & Saatchi in London — into a sprawling empire with more than 90,000 employees in over 100 countries. Its portfolio includes two of the world’s top ten creative agencies by revenue (JWT and Ogilvy & Mather) and three of the top ten media buyers (Mindshare, Mediaedge:cia and MediaCom), the latter being an increasingly important part of the services side of the industry that all of the big holding companies want to capture.

Asia has loomed large on WPP’s acquisition map, particularly in China, where it has bought a number of small, local agencies in recent years. As a consumer culture burgeons across the country, growth prospects are strong for WPP, which is known to turn away business in China because it can’t keep up with demand. By 2009, WPP expects China to be its second largest market, after the U.S.; by 2020, it will be number one. “Our huge advantage is that we recognized very early on the importance of Asia,” says Richardson. “While our competitors say they are going to catch up, we know there is nothing to buy of any scale because we’ve been farming the territory for ten years.”

It’s not just expanding geographically. WPP — like its main rivals — has been moving further and further away from a business model dependent on the cyclical and volatile world of traditional advertising (that is, creating ads and planning ad campaigns) to the less glamorous, but faster-growing “below-the-line” businesses — industry jargon for direct mail, market research, promotional events, Internet marketing and the like. Today, WPP’s revenue is split roughly 50:50 between marketing services and traditional advertising. With diversification providing a cushion for any industry shocks, Sorrell has said that WPP’s revenue mix could eventually shift even more towards below-the-line services.

Marginal Improvements

That mix is working in WPP’s favor. Though third-quarter figures disappointed investors — Merrill Lynch analysts, for example, grumbled that its organic revenue growth, at a smidgen over 4 percent, was lower than the 5 percent they had wanted to see — 2006 was generally a good year for WPP.

Amid growing confidence, WPP pleased investors in October by delivering new long-term margin guidance of 15.5 percent for 2008 and 16 percent for 2009, while maintaining its 14.5 percent and 15 percent guidance for 2006 and 2007, respectively. As “the only FTSE company to give margin growth,” it’s clearly a matter of pride for Richardson that apart from dipping in 2001 and 2002 during the recession, margins have been steadily climbing.

But the CFO reckons the company should strive for even higher margins, closer to 20 percent. He cites several reasons why this isn’t just wishful musing from a CFO’s office. First, the average margin of WPP’s best-in-class businesses in each category is currently around 17 percent; second, the operating margin that WPP’s top 20 clients earn in their own sectors is around 18 percent; and third, external benchmarking shows that other professional-services companies, such as banks or “McKinsey-ish” consultancies, “earn margins of between 20 percent and 30 percent,” he says. “There’s no real difference in my mind when looking at their P&L structure, why we shouldn’t be able to achieve that. It is demanding, but that is what the financial-efficiency goals are for.”

While it’s this type of relentless focus on financial efficiency that makes creative types balk, it’s music to the ears of investors. For the past two years, analysts at Bernstein Research have been saying that ad agencies are “a ‘safe harbor’ relative to traditional ad-based media (that is, print, broadcast TV, radio) that will continue to produce intra-sector outperformance.” In a research note published in October last year, Bernstein analysts wrote: “The strong 2005 organic revenue growth at Omnicom (7.3 percent) and WPP (5.5 percent) are providing strong support that these agencies are benefiting from the move away from traditional media towards agency-owned marketing services.”

Promisingly, a lot of that growth is from business on new campaigns. According to an annual ranking of the advertising oligarchs by media analysts at Lehman Brothers, WPP won $1 billion of the $18 billion of new business in 2006, the second-highest after French rival Publicis Group. Lehman’s report also notes that WPP is starting 2007 with far more new deals in the pipeline than the other five holding companies, including closest industry rival Omnicom.

Richardson feels vindicated. “Two years ago, with the death of traditional media, everyone was saying the advertising agencies were the same, a dying industry,” he says. In 2005, “Omnicom, ourselves, Publicis, all came out with between 5.5 percent and 7 percent organic growth. To me, that is not a dying industry.”



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