Whenever you hear that a company is a "growth-through-acquisition story," you should be cautious. Investors tend to shun these types of stocks, as acquisitions bring plenty of risk. The acquired company may not generate the revenue growth that management had been banking on, or hoped-for cost cuts or other synergies may simply never materialize.
But a knee-jerk dismissal of these types of companies is a mistake, and investors instead need to differentiate between the two types of deal-making.
[block:block=16]Some companies do deals just to grow larger, while others do them to fill holes in their business model. It's this latter focus that actually can yield major gains, and where you should be focusing.
Filling in the gaps in its platform has been the key driver for Toronto-based MDC Partners (Nasdaq: MDCA [2]), North America's third-largest advertising agency behind Omnicom (NYSE: OMC [3]) and Interpublic (NYSE: IPG [4]). Publicis, WPP and Havas are also larger than MDC, but are domiciled in Europe. (Please note that many investors mistakenly look up MDC Holdings (NYSE: MDC [5]), which is a home builder.)
MDC Partners went through a solid growth spurt before the economy headed south in 2009. (Sales rose from $247 million in 2004 to $583 million in 2008.) The company was able to snag a number of key accounts from the industry's bigger players by a tight focus on online media advertising. Yet management realized that further gains would be hard to come by as MDC lacked several key services and offerings that clients expect from an ad agency. MDC has recently completed several small deals to round its platform, but those deals have soured investors who shun deal-making companies.
Yet MDC is now in a position to again take share from rivals and also generate more sales from existing customers. The company is on track for more than $1 billion in sales this year, which finally puts its name in discussions when Fortune 500 companies are looking to award major accounts.
Despite the company's newfound heft, shares are off 22% in the past six months, even as Interpublic and Omnicom's stocks have risen more than 35% in that time frame.
As a result, MDC is now the most inexpensive stock in the group -- but it is also the fastest-growing. While Interpublic and Omnicom are expected to boost sales 3% this year, MDC's sales are expected to rise in the low teens to around $1.06 billion.
Sure, the company has done some minor acquisitions in the last few quarters (and just announced another one this week), but the bulk of that growth is coming from new client wins. In just the first quarter of 2012, MDC landed new accounts with Arby's and Applebee's, as well as Target's (NYSE: TGT [6]) grocery business. Equally important, the company's broadened suite of offerings is enabling MDC to move deeper into client account relationships, which is boosting pricing and profit margins.
The company expects to generate 10.5% profit margins in 2012, roughly 100 basis points higher than in 2011. That's leading to an estimated $1.45 a share in free cash flow, which works out to a free cash flow yield of more than 13% ($1.45 FCF / $11 stock price = 13%).
This helps support an annual dividend of $0.56 per share (good for a 5.4% dividend yield).
I had been waiting to see how MDC's quarterly results looked, but management just pre-announced solid projections for the first quarter and the full year. Look for first-quarter sales to rise roughly 7% from a year-ago to around $233 million, and full-year sales to rise more than 10% to around $1.06 billion. Though the company is expected to be unprofitable on a GAAP basis due to a high level of amortization, cash flow should be quite strong, as noted above.
Strong top and bottom-line momentum, a robust dividend, and low valuations help explain why I'm adding this company to my $100,000 Real-Money Portfolio [7].
The Downside Protection --> Ad agencies derive a high degree of recurring revenue thanks to multi-year contracts, so a fall-off in business is unlikely unless the U.S. economy hits a big air pocket. Meanwhile, shares are washed out, trading near a two-year low and sporting a double-digit free cash flow yield. It's hard to see this stock falling much below $10.
Upside Triggers --> Management understands that the recent spate of acquisitions must help bolster the bottom line as well as the top line. The company has been rightly criticized for neglecting free cash flow in the past as it invests in acquired businesses and extends its broad sales platform. Management's 2012 free cash flow [8] targets show that it gets the message. Assuming few new major acquisitions this year, you should expect to see free cash flow surge even higher in 2013 as the era of internal investments winds down.
This is also a play on GDP growth. As the U.S. economy creates 200,000 jobs each month, corporations will respond by boosting spending on advertising. A handy rule of thumb is that ad spending moves at two to three times the direction of GDP growth, so MDC should see a 5% to 10% boost to growth, even before assuming any further market share gains that come from the company's recently expanded service offerings.
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