Managing Marketing: The changing economics of the advertising agency business

Managing Marketing is a podcast hosted by TrinityP3 Founder and Global CEO, Darren Woolley. Each podcast is a conversation with a thought-leader, professional or practitioner of marketing and communications on the issues, insights and opportunities in the marketing management category. Ideal for marketers, advertisers, media and commercial communications professionals.

Michael Farmer, Chairman of Farmer & Company and the author of the industry best seller Madison Avenue Manslaughter talks with Darren on the changing economics of the advertising business and how the holding company structure and business model has become unsustainable in the face of these changes. So where to for agencies?

Michael_Farmer

You can listen to the podcast here:

Transcription:

Darren:

Welcome to Managing Marketing and again we are at Boca Raton in Florida for the ANA Advertising and Financial Management Conference and I’m joined now by someone who I hugely admire and that’s Michael Farmer, Chairman of Farmer and Company, New York and author of industry best-seller book, Madison Avenue Manslaughter.

Welcome Michael.

Michael:

Darren, thanks so much for having me here, it’s a delight to talk to you.

Darren:

Now I said “someone that I hugely admire”, because I worked in advertising as a copywriter for 15 years and when I left to start my own business, TrinityP3, a piece of advice I was given was, if you’re going to go down this path, the person you’ve got to study and model your business on is Michael Farmer, Farmer and Company out of New York.

I said, “oh really, why’s that?”, and they said that this is a company that’s got the right balance of analytics and data around agency-client performance, but also understands and respects the creative process.

Michael:

Well thank you for that Darren.

Darren:

Well 2004 I started searching and studying your company so it was a real pleasure to meet you.

Agencies are factories for making ads

Michael:

Well thank you so much for that, although I’m going to have to confess that I’m still feeling like a newcomer to the industry because prior to working with ad agencies, which I started in about 1992, almost 25 years ago, I was a straightforward, card-carrying, business school type management consultant with a couple of the big name consulting firms.

I only stumbled into the agency business because someone called me up and said they were having a profit problem, could a strategy consultant help them figure it out.

So almost everything I’m doing today, ironically, is what I had to do in that first study for me to understand their operations because I had never worked around an agency before. I think I made a lucky first guess.

That was an ad agency, despite the fact they’re very creative, they are still factories for making ads. If you can understand them as businesses that are strategic and creative factories for their clients, making ads that have a purpose, then it’s easier to understand them as a business. I still look at them that way and I’m still finding today, the same problems that I found 25 years ago.

Darren:

It’s interesting isn’t it, in that the more things change, the more things stay the same in this business.

Michael:

The first thing was when I explained this whole factory approach to the managing director of my first client which was Ogilvy UK, I was in the UK at the time. He said, “oh that’s wonderful, no one who knew anything about advertising would ever think about doing that because we would never use the word factory”.

I said, well the first thing is, figure out how much stuff you make, you develop and produce and look at the fees and look at the resources and figure out what’s changed in the way you’re making it that’s causing you to lose money.

What I didn’t realise is that they don’t keep records on what they make by client, they sort of operate from crisis to crisis, week to week, what’s hot, what’s in trouble, who are we going to allocate to it and then they move on and if there’s any record of the work that they did it’s in job jackets so that they can….

Darren:

Got to go through manually.

Michael:

So they can pay photographers and production companies and the like. Well, little would I ever guess that 25 years later agencies still do not either keep track of the work they do, forecast the work they do or use expected workloads as a basis for negotiating fees.

Today, they pretty much accept fees as a given, something the client tells them, “this is what we’re gonna pay you this year” and then through a completely separate process, the amount of work they do just occurs and the problem is that workloads have been growing and fees have been reducing so that’s been true for 25 years.

That means that agencies are doing more and more work with fewer people. They have to cut the people because the fees are being cut so they’re doing more work with fewer, more junior people and that’s gotten them into a real quality problem which has been reflected in the terrible way they are treated by their clients.

Darren:

I went from medical research into advertising as a copywriter so that was a huge shift for me career wise.

Michael:

Wow!

Darren:

But, people say, well how did you end up at TrinityP3? All I did was bring the same analysis and curiosity that you have in medical research to advertising and one of the things that frustrated me as a Creative Director was seeing this iteration after iteration after iteration of work until either the time ran out or the money and time is money.

Michael:

Right.

Darren:

And so I kept saying to myself, there must be a way to understand this system and optimise it better. That was the whole purpose.

When agencies were money machines

Michael:

Well you are so right about that. I think those bad habits occurred before you joined. I mean, really, in the 50s and 60s when agencies were paid on commission, on the media spend of their clients.

That was a very high level of remuneration and at the same time, they weren’t making that much stuff, they weren’t making that many TV, print or radio ads. And so, if a campaign ran into a second year, the agency was collecting money for it and doing no work.

Darren:

Yeah.

Michael:

So, agencies were money machines then. In fact, they spent money in order to hide how profitable they potentially could have been. So they got in the business of saying, look, the client wants three ideas for now, let’s give him 10 and if they gave him 10 they’d go through 5 rounds of rework.

They could afford it and they thought it was a way of showing their stuff. So, all of these bad operational habits that existed at a period of time when remuneration was exceptionally high relative to work load are the things that plague them today.

I think many of the senior leaders of agencies today feel like there was something right about those days and there’s something really wrong about these days and what they need to do is to try harder to get back to where they were.

But what they don’t understand is the economics were non-duplicable, they can’t go back to a time when they were paid a small fortune to do a little bit of work. Today they’re paid a little bit of money to do a huge amount of work and you can’t get back there by over-servicing the client.

So, the rework is a huge problem. So is agreeing with clients, when the clients say, you know, “Darren, I’ve got another idea for a campaign. I don’t have any money for it but you can handle it right, in the existing relationship?” and you say, “But of course! You know, we’re good service providers”.

That’s what today’s client heads or account people, their leads are saying because they don’t want to lose the client, that would be catastrophic and they feel it’s kind of in line with what the agency is supposed to do. Now, it’s completely wrong today.

Darren:

Yeah, absolutely and in fact, we’re going through a process at the moment on a regional basis of moving a client in the agency from a cost resource recovery model, the traditional retainer to an outputs based deliverable value model.

Michael:

Totally correct and unusual I might add.

Darren:

Now, we are having conversations with the agency where the client will have a scope of work, we’ll then present to the agency and say this is the scope of work from the client’s perspective in the next 12 months. You’ve got 24 hours to look through it and come back with what else you do.

They often come back with a long list you know like, you may want us to run another 2-day workshop on digital technology or what about on-boarding new staff? And the client goes, “but that’s part of your cost of business” and they go “well it’s a cost to us” and all of these things were built in to that cost recovery model.

Michael:

They were assumed to be part of the…

Just because you give something for free, doesn’t mean it has value

Darren:

Yeah, they were assumed. And what I’d point out to the agency is just because you give something to someone for free, if there is no value attached to it, monetary or otherwise, then it has no value.

There are lots of things that they do for the client to, in some ways, justify their retainer but it has no value because when you pull it out and start putting a price to it the client largely says “I don’t really want it because it’s of no value to me”.

Michael:

So true, and I think again, the old commission system encouraged this kind of stuff because agencies certainly couldn’t compete on the basis of price. Everybody got paid the same thing, 15% commission on media, 17.5% mark-up on production so they competed on creativity, who won awards?

They competed on who could provide the greatest amount of service. That was their distinguishing feature.

Since no one has told them that it’s a different ball game today or cricket match or whatever, they take their cues from the past and think, we offer service and creativity and, you know, that’s the mantra of what agencies offer. That’s what is on their websites.

BBDO says it’s the work, the work, the work which means we work it till we get it right. And all of those things run counter to the actual economics of the agency and the business. Now it’s the business where you can only afford to get it right the first time.

You can’t afford to rework things over and over again so you need to put more thought into it upfront. Creativity itself is not a product, it’s an input and clients won’t pay an extra dollar for creative, the fact that an agency has won a lot of creative awards.

So, creativity doesn’t really sell. What clients are looking for ever since the days when they said shareholder value is what we’re all about, what they’re looking for are results.

So, the funny thing is, agencies, which think of their business as a creative, service-oriented business need to actually become more consultative so that they can deliver brand results and that requires a lot of analytical capability, not necessarily creativity in the way that they think about it. Yeah…

Darren:

Sorry, sorry Michael but it absolutely goes back to what you mentioned before about being a factory, you know, manufacturing. I know that every time I’ve raised that issue with an agency, and even some clients, they go “no, no, it’s not manufacturing” and I point out to them the automotive industry is the best example.

Look at the time and effort they put into building a prototype and testing it and then they immediately put it on to the production line and optimise the hell out of the production of that.

Now, in advertising, for me, especially on the creative content side but also on the media side, there is the big idea, the strategic and creative idea, that’s the prototype. But as you say, no one has actually been paying for that, it’s largely being given away for free because when you look at the splits in the fees paid, it’s actually less than 10%.

Michael:

Absolutely, it’s a small part of the hours…

Darren:

Right, right, 7-8% of the total revenue is for the big idea, the time and effort to create an idea that all the money goes into then, the implementation across multiple channels and that, is the production line.

Michael:

You know, I like your analogy of the automotive business because Toyota, which is the world’s most successful car company instituted a thing called “The Toyota Way” which has been written about.

Part of The Toyota Way said that you need to engage your suppliers in such an intimate process from beginning of product through production that mistakes are eliminated.

In fact, a Toyota supplier that, let’s say they supply axles or brake assemblies or something of that sort, is involved in designing the product and ensuring that there are no more than 25 parts per million defects.

In other words, they have to design and produce a product that’s nearly perfect, that can be delivered to the assembly line just in time to be put on the car and off it goes and there’ll never be any warranty claims. Well, there’s no rework in that process.

Darren:

No.

Clinging to what made them successful at a time that doesn’t exist

Michael:

The car companies prior to The Toyota Way had a lot of rework, well rework is a warranty claim isn’t it? It means, the axle failed, the brakes failed, go back for millions and millions of dollars of repairs and maybe liabilities for people that are killed.

The agency world thinks that a certain amount of rework is inherently a good thing. Whereas I think if they put more time in upfront they could eliminate it and put together scopes of work and do creative work that really hits the nail on the head and delivers brand results because both sides have confidence in it.

So I can hardly think of a part of the agency business that has not been turned on its head by the changing economics meaning fees being brought down by procurement and workloads growing which requires a different way of working.

The problem with our friends in the agency world is they’re clinging to what made them successful at a time that doesn’t exist. Not to poke too much fun at our British friends but it’s a little bit like the Brits who clung to the idea of Empire long after the Empire was gone and that might be very true of the American Empire as well you know.

Darren:

The sun may have set.

Michael:

Yeah, the sun may have set on certain parts of it and it’s hard for people to cope with living a more modest lifestyle or role than one they had in the past. There’s always a desire to go back to it.

But real leaders recognise that, IBM went through a major transformation in 1990 from being a hardware and software producer to really being an integrated service provider. They went from a computer company to a consulting firm, and that was done under the strong leadership of a new chief executive and I think the agency world today needs that kind of leadership.

Not with leaders that are going to enhance creativity, win more awards and win more business under the current unfortunate circumstances of today. But instead to say, we need to operate in a very different way to create success for today’s market.

Darren:

Reinvent the business model.

Michael:

Absolutely.

Darren:

To actually meet the needs and expectations of their clients.

Michael:

It’s a leadership challenge. I don’t think at conferences like this, at ANA, that an awful lot can be improved. I think we need chief executives who understand the problem.

Holding companies and consolidation

Darren:

Well the other thing we’ve seen in the last 30 or 40 years has been the consolidation through holding of agency ownership through the holding companies and what we’ve seen is first of all the consolidation of the 8 traditional agency brands and then those holding companies diversifying by growing through acquisition.

Now that’s had a huge impact and I ended up working for most of my career for a WPP agency and saw the cultural change that happens there. But what do you see as being the legacy that we’ll look back on of this holding company trend?

Michael:

Now that’s a very interesting case because that has its own story.

Darren:

Yeah.

Michael:

It’s clear that Publicis, Havas, IPG, WPP, Omnicom, they all started for different reasons. But in the end they put together portfolios of agencies that had the potential back in the 80s to be a lot more profitable than they were.

Uh, example, WPP bought JWT in 1986 at the height of the media commission time. JWT should’ve made a fortune, they were making a 4% margin.

Darren:

Yeah, crazy.

Michael:

A couple of years later they bought Ogilvy and Mather, which was then earning an 8% margin. Now, prices for agency services then were 3 times as high as they are today and yet those agencies are making 15-20% margins.

So, the Martin Sorrell’s of the world recognise that they could buy underperforming assets with borrowed money, squeeze them to make them perform, get out all the surplus costs, run them on a discipline basis, give them tough budgets that they had to meet and as their profits would rise, so would the share price of WPP.

Then WPP could use and enhance share price to go out and make cheaper acquisitions. That is the old financial holding company game from way back. In the 60s and the 70s we had the same thing happen with what were then called conglomerates.

Darren:

Yep.

Michael:

They used borrowed money to buy undervalued assets, they’d squeeze them to perform better, the share price of the conglomerate would go up, it would make more acquisitions.

The problem was that they had to make more and more and more at an accelerated pace and they had to squeeze harder and harder and harder. Now, by my calculations from 1985 to 2005, that 20-year period, agencies had surplus costs that could be squeezed out that did not affect their operations.

They were, at that time, allocating excess number of creative teams to work. They were putting 3, 4, and 5 creative teams to work. They were developing 10-12 ideas for every brief. They were doing a whole bunch of rework and none of that was really adding value.

So, Martin Sorrell and John Wren and the others that were running holding companies that were putting a squeeze on the ad agencies, it didn’t really hurt them, they took the cost out, they downsized.

Darren:

Well that’s good business.

Michael:

That was good business and they were rewarded very well. Their share prices went up, I don’t have the figures in front of me but if you look at WPP performance up to 2005, it was probably very substantial and the share price was high, they were getting a good multiple on their earnings per share but the problem is, they had to keep it going.

Now, what they didn’t know but my analysis shows are that 2005 was the last year that agencies had surplus resources. So WPP and the others had to keep the earnings growth machine going but from 2005 onwards, as clients were cutting agency fees, agencies were downsizing and they were cutting muscle out.

Darren:

Yeah.

How it all came to this

Michael:

They were firing senior people. They were hiring junior people at incredibly low market rates. They were using too few people to do the work and to be quite frank, the work was kind of crappy and it has been for the last 10 years.

So, the holding companies who did the right thing up to 2005 by putting the squeeze on and benefiting from it, have had to continue that strategy and they have weakened the agencies and their portfolio.

They will never admit it. They will never say that’s the case but the evidence says that now the holding companies, who probably don’t feel that their agencies are quite up to the job that they used to be, are creating holding company relationships and Martin Sorrell and the others are themselves going out to sell relationships drawing on the best resources from the individual agencies.

To me, it is the best evidence that there is a recognition that the agencies have been very weakened by the holding company’s squeeze.

Now, the holding companies have to continue this. If they don’t show continued earnings per share growth their share price is going to take a huge dive. All there has to be is a slight change in the growth rate of earnings as we’ve seen in Apple and Apple got punished. The share price dropped by 10% for a slight decrease in sales of Iphones.

If the holding companies go through that same thing there will be a decline in the share price, investors who didn’t unload their shares are going to feel like they’ve been bamboozled, the security analysts are going to rush in and say “wait a minute, what’s going on here? I thought this was an earnings machine that was going on forever”.

What they’re going to find, and I’ve certainly documented it in my book, is that for the last 10 years, agencies have been squeezed to the point of ill health.

Darren:

It’s a hollow shell.

Michael:

So when the holding company earnings reports are going out, in my view, those are low quality earnings. Every year, the quality of earnings is going down because the agencies themselves are starved for resources.

Darren:

On those particular assets I think they’ve had a little bit of a lifeline with the media and this whole area which is actually propping up all those…

The media cash cow is facing attack

Michael:

Well there’s no question about it because if you think of the holding company as having media assets, creative, traditional agency assets and then research and consultancy in their portfolio, the cash cows have been the media companies and the other stuff and the sort of dogs in the portfolio have been the creative agencies which have been squeezed.

Even the digital companies have been squeezed, let’s not kid ourselves.

So the question is, what happens if what goes on in the media side of the business, which is fear about the media rebates, click fraud, viewability, may be a slight suspicion that digital isn’t all that it’s cracked up to be, and there’s a retrenchment and a decline or attack on the media side of the equation.

Then the holding company is going to have a real problem on its hands because it won’t have the cash cow to sure up the dogs.

Darren:

Yeah.

Michael:

That is my prediction by the way, I just don’t know when it’s going to happen. If I did I’d short them all.

Darren:

It’s like all markets, it’s all in the timing.

Michael:

It’s all a timing thing isn’t it. It’s like the people, the few people who saw the mortgage bubble in the U.S. and shorted, all the banks made billions of dollars provided they had a deep pocket. But I don’t know if that’s really gonna happen.

Darren:

I’m just wondering, sorry Michael, but whether some of those dogs, because I’ve seen the agency brands, the JWT’s and the BBDO’s used almost in an entanglement strategy. That is, get a client in at the basement discount into the agency and then use that relationship to on-sell all of the more profitable areas that they offer as well.

Michael:

That is certainly the intent. I don’t know that they’re taking it deliberately for a low price. I think they’re forced to take it at a low price because that’s where the market is. I then think the desire by the holding company is to squeeze out all competitors and make it a genuine holding company relationship by offering all the different assets including media from an individual holding company.

That has a lot of problems too, you could say that financially that makes a lot of sense but it does mean that the branded agencies have lost their lustre as agencies who each individually stand for something.

They’re not as far gone as representing a typing pool of creatives. Meaning, let’s go get Sally-Anne or Jean Jacques in on this and we will take someone from JWT and somebody else from OLM. But there is a little bit more of that in a holding company relationship than would be the case if JWT were the agency of record.

Consultant’s results driven approach vs the agency’s “creative” approach

Darren:

So, to change the topic a little bit, at the conference today the CMO of Deloitte was presenting and some of the agencies stood up and asked questions about whether their role as consultants and their investment in digital agencies is actually a conflict and she answered quite honestly, “not if it’s not a conflict for the client”.

Why do you think the Deloitte’s, the IBM’S, are acquiring, especially digital agencies and what do you believe will be the impact for the more traditional agency groups?

Michael:

A very good question and because I have a background in consulting, I feel personally attached to this because I can see why they’re doing it and I can see how attractive it is.

The thing to recognise, is that since the 80s all of the consulting firms, including the Deloitte’s who were accounting firms but all of the consulting firms have said, “our purpose is to generate increased profits and growth for our clients”.

They are totally results-driven. They don’t say about themselves, “we’re analytical” in the way that agencies say “we’re creative”. They’ve said, “the only reason we exist, is to make money for our clients, that’s what justifies our very high fees”, because they are paid more than double what an agency is paid for an equivalent amount of work.

So the Deloitte’s, the Bain’s, the Mackenzie’s, the BCG’s, Accenture’s, IBM are all aggressively pursuing a market opportunity where their skills are totally appropriate because what they see happening as media shifts towards digital which is data intensive and allows a great deal of analysis, well look, they’re analysis machines, that’s what they do.

That’s what they did, that’s what they’ve been doing since the 80s, they’ve been doing analysis of businesses and the development of strategies that leads to improved results.

Now that they see everything moving to digital and they see agencies as being weak in providing work that delivers results and they see a huge amount of money being spent on media and they say, “the person that is being ill-served today is the Chief Marketing Officer”.

The Chief Marketing Officer desperately needs brand growth. The agencies are not delivering it. We are consulting firms, we can tack on a creative capability to our already powerhouse analytical resources, client-facing resources and that’s a lot easier for us and that’s almost a natural transition and she did say, “listen, for us that’s like adding an HR capability, an M and A capability, a cost reduction capability, a re-organisation capability and now we’re adding a creative capability in digital media”.

So, it is a natural thing for a consulting firm to add capabilities as marketplace needs change. What they’re always adding those capabilities to is their powerhouse analytical capability.

Now, it’s easier for them to add creative to their analytical capability than for agencies, who have very little money, to try and hire in analysts and try to invent a creative organisation. It just doesn’t fit.

Like, where do we put this analyst? It doesn’t have a home, isn’t respected by anyone, everyone makes jokes about he’s just a spreadsheet person, you know, that sort of thing.

But a creative, a digital creative, coming to a Deloitte or an Accenture, you know something…

Darren:

It just brings it all together.

Michael:

Deloitte is providing higher quality client-service people to the existing creative capability. It’s a very natural fit.

Darren:

Yeah.

Michael:

So, that and they are used to having a different type of dialogue with clients about what their services are. They will say, “our service is to add value, to grow brands through a better exploitation of digital, the digital marketplace.

We will do a better job at creating digital scopes of work. We will do a better, faster job of creating the assets, because a lot of their assets are created in India.

Darren:

Yeah.

Michael:

“We have a single-minded focus on achieving for you what you need”. That’s something you’d never hear from an ad agency. It’s a shame.

It’s a crisis because if they had recognised the intense client interest and need for improved performance, then they might have changed their business but they haven’t changed their business model, they’re still all about, “we’re creative” and “we’re service-oriented and we feel underappreciated by our clients”.

And the clients are saying, “wait a minute! It’s about me, it’s about my need for growth and profitability, are you serving me properly? Are you giving me that? Are you helping me to keep my job and make my bonuses by making me successful?”.

I think agencies have proven to be a little bit too narcissistic for them.

Darren:

Well it comes part and parcel with the creative ego doesn’t it? A little bit?

Michael:

Uh, it need not. I mean listen, I think that there’s an enormous amount of creativity required in identifying the client’s performance problem so that’s kind of a creative thing but you don’t toot your horn about that, you assume it’s what you’re good at.

Darren:

Well let’s look at an industry that has more awards for creativity than any other. I mean, there are so many advertising awards for creativity. I mean, I don’t see consultants having awards for creativity.

Michael:

No it would be awards for analytical brilliance.

Darren:

Or, stockbrokers having…

Michael:

No it is a “me, me, me” thing. Don’t get me going on what a creative award is anyway, that is often a panel of other creatives from within the industry rewarding…

Darren:

I used to be on those panels, so….

Michael:

Ok, so you know. If I get a creative award and it’s in my portfolio that gives me market value so I can leave my current job and get a huge pay rise.

Darren:

Exactly.

Michael:

I’ve seen that over and over again. So, it’s narcissistic to the degree to which the award is something you keep on your resume even if the golden lion sits, you know, at Saatchi and Saatchi or TBWA.

Darren:

Michael Farmer this has been a fantastic discussion and I really enjoyed it. I would absolutely recommend to everyone, if they haven’t read your book Madison Avenue Manslaughter, they should get a copy. It’s available on Amazon.

Madison_Avenue_Manslaughter_book

Michael:

It’s at Amazon. It’s available through Google Books and it’s available through Apple, uh, I don’t know if it’s called Apple Books or iBook or whatever the devil it is.

But it is not available as an Amazon Kindle, it has a fair number of diagrams and tables in it which doesn’t translate well on a Kindle format but it is available, Madison Avenue Manslaughter, an inside view of fee-cutting clients, profit-hungry owners and declining ad agencies.

Darren:

I think you summed it up perfectly. Thanks very much.

Michael:

Thanks Darren.

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About Darren Woolley

Darren is considered a thought leader on all aspects of marketing management. A Problem Solver, Negotiator, Founder & Global CEO of TrinityP3 - Marketing Management Consultants, founding member of the Marketing FIRST Forum and Author. He is also a Past-Chair of the Australian Marketing Institute, Ex-Medical Scientist and Ex-Creative Director. And in his spare time he sleeps. Darren's Bio Here Email: darren@trinityp3.com

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