The Trouble with the Ad Agency Industry: Organizational ADD and Bad Incentives

The world of advertising agencies is clearly in trouble. Or, more accurately, the industry is in a potentially existential crisis, threatened by ever higher client demands, new competitors and the power of digital platforms. If agencies don’t change the way they do business, things could get very ugly, very soon.

Over the past 12 months, the stocks of the top 4 ad agency holding groups have fallen between 3% (IPG) and 25% (WPP). The power in digital advertising has shifted to the dominant online platforms — Google and Facebook above everybody else. And more recently, new formidable competitors like Accenture have started entering the already competitive market of ad buying services. [1]

Guess which of these stocks belong to more technically inclined companies.

Furthermore, clients have become very critical of their agencies, and many major budgets have changed hands over the last couple of years. Activist investors are forcing the large CPG companies to drive down costs, and since advertising is such a major part of the cost base, agencies are suffering from enormous pressure to reduce fees and margins. Clients are also up in arms about transparency in media buying — or rather, the mindboggling lack thereof. The times when agencies were able to quietly line their pockets with media arbitrage and kickback schemes are soon going to be over.

The people who run these agencies are not in an enviable position, to put it mildly. That’s a dramatic change. The industry enjoyed three decades of growth and handsome financial results after the now disgraced Sir Martin Sorrell invented the modern ad holding company at WPP in 1985. Aggressive acquisition strategies and financial engineering helped squeeze out ever higher margins at greater scale from what once was a glamorous but, for the most part, badly managed cottage industry. Financially driven media buying took over as the dominant part of the industry, leaving the creative side as not much more than a feeder of client money to the buying side of the house. This change was good for financial results, but it hollowed out the deep and special relationship that agencies traditionally had with clients. In the end, the shift to a more transactional relationship made agencies vulnerable, and their new competitors are taking advantage of it.

Agency executives are doing their best to save their businesses, and some want to instill radical change. For example, the new Publicis CEO Arthur Sadoun announced last year that his agencies won’t attend industry events anymore, including the prestigious Cannes Lions festival. Instead Publicis wanted to invest into an AI platform to make its inner workings much more efficient. First results of this process have been heavily criticized, and some employees are resisting change very openly.

The difficult transformation process at Publicis and others hints at a fundamental organizational trait that calls the survival of the modern ad holding groups into question. In a way, agencies suffer from organizational attention deficit disorder (ADD). By their very nature, agencies are organizations that are short-term oriented. Everything in the world of agencies works at the pace of ad campaigns that are often only a few months long. Staff rotates in and out of accounts and between agencies all the time. Tenures are typically short.

Even more importantly, incentives are stacked against long-term strategies. In agency land, you get rewarded for winning the next piece of new business or for increasing the client’s spend levels this quarter. Deep skill development, the creation of real intellectual property and the building of efficient infrastructure are all things that take years, and agencies’ attention spans are simply not that long.

That’s why, to exaggerate just slightly, most agencies still run on Excel sheets and lunch meetings, not modern software infrastructure. It’s very rare to see real proprietary technology at a traditional agency. Many pretend to have something like AI-driven buying and reporting tools, but these are rarely more than hastily assembled piles of off-the-shelf software components.

While most agencies are profitable businesses with decent margins, they don’t nearly produce enough cash to finance long-term R&D projects. Compare this to the time scale and financial wealth at which Google, Amazon and Facebook operate. The tech giants have research projects that will only pay off in many years or even decades, if ever. Their annual budgets for R&D and computing infrastructures are in the many billions, while agencies rarely even have a dedicated R&D line item in their financials. And the tech giants can hire top talent to work with their advertising clients, often providing much deeper insights and more advanced services than agencies can.

At the same time, the tech companies are still able to move quickly, which most dramatically was illustrated by Facebook’s rapid shift to mobile a few years ago. Agency groups on the other hand are difficult to change due to their highly decentralized organizational structure. The holdings are really just a collection of individual agencies with high degrees of operational autonomy. The leaders of the individual agencies typically get compensated on the short-term results of their business. They couldn’t care less about the grand strategic plans that come from the top. Smaller independent agencies on the other hand have less structural complexity, and that’s why many of them have been much better at adapting to new market realities than the big groups.

So what do agencies need to do to survive? From my (armchair) point of view [2], the following points come to mind:

1. Invest in real talent and pay great people properly. Under all the financial pressure of the recent past, agencies have systematically started to hire ever cheaper staff, obviously at the expense of quality and competence. The amount of money that junior agency staffers make for their very, very long hours is ridiculous. It’s not surprising that the agency industry is not a very desirable employer for top talent anymore [3]. This is just leading to a downward spiral. Clients notice that they’re not getting the best talent, and of course they will want to cut fees even more.

2. Automate and invest in technology, not office space. The amount of manual labor that is still being done in agencies is mindboggling [4]. Madison Avenue media agencies often have hundreds of badly paid junior people sitting around in expensive mid-town Manhattan buildings, creating media plans by hand. Buys are typically executed by e-mailing Excel sheets around. Some TV buyers are rumored to still uses faxes. Why in the world can media buying not be done in, say, New Jersey instead? It seems to be good enough for pharma and much of finance. And why aren’t agencies investing more in process technology that drives real efficiencies long-term?

3. Root out corruption. Yes, there is a lot of it, on all levels. If an ad tech vendor wants to get anybody’s attention on the agency side, free lunch is about the minimum price of entry. Expectations go up from there. It’s not unusual to have senior agency execs point out pretty openly to vendors that they expect a kickback scheme out of any deal, and if there is an “advisory board” position with stock options or advisory fees in it for them personally, that would really help close the deal. Spoiler alert: Clients won’t like this if they find out (and they’re finding out more and more). Anybody who can offer real transparency will win these clients over. It’s not a coincidence that Accenture’s recently launched programmatic media buying offering is fully based on transparent fees.

4. Build real partnerships with tech vendors and publishers. Agencies complain bitterly about brands treating them just as expendable vendors instead of long-term partners. But guess how agencies treat their tech partners and publishers? Exactly. As soon as the next guy comes along and offers lower fees by half a percentage point, all loyalty goes out of the window. Again, it’s a case of organizational ADD and rampant short-termism. In my experience, the most productive and financially successful relationships between service providers and tech vendors are those that are developed over years, strategically on many levels, not just over a glass of rosé at Cannes. Shared business plans, aligned financial and strategic interests, mutual investment in technology and training, and tight feedback loops on multiple organizational levels are key.

5. Innovate the way the tech industry does. The agency business model doesn’t lend itself to longer-term innovation. But if agencies want to survive as something more than a glorified body shop for cheap white-collar labor, they won’t have a choice: They need to come up with real differentiation through innovation. And yes, there has to be actual substance to it. Just slide decks with buzzwords won’t cut it when you compete with Google and Accenture. Real innovation requires two things. First, decouple innovation budgets from the operational business, but still measure them against tight goals. Second, think in portfolios of innovation investments, like every VC does — and, for example, Alphabet/Google as well with its many “other bets”. Some bets will pay off, some — probably most — won’t. That’s just the nature of innovation. Agencies way too often try to finance innovation from their day-to-day cash flow, and that makes them very risk averse. That’s a guaranteed way to fail.

6. Treat innovation as a core activity, not a hobby. While innovation budgets should be decoupled from operational businesses, the results of innovation projects should not. A frequent mistake is to set up a centralized “innovation department” that independently (and typically with a negligible budget) toys around with new technology, often without real business goals. Buzzwords and fun demos abound, but the business value is rarely clear. The hardworking client-facing people hate these departments and often do their best to ignore or even hurt them. They are right: An innovation unit that isn’t held accountable for its longer-term business impact will be useless and unfocused. The key is once again in setting the right incentives: Guide innovation people to create real business value but avoid the trap of short-termism.

Now, these are all lovely points, but obviously there are two big obstacles in the way: Traditional organizational agency culture (with its ADD tendency) and the established business model of agencies, which often feels like the corporate equivalent of living paycheck to paycheck.

The latter might be easier to change than the former, but they are closely related. Most agency groups have a mindset of financial extraction, not of long-term value creation, and that’s driven from the very top. A fun illustration (and I apologize in advance for the somewhat populist perspective) is the level of CEO compensation compared to the size and profitability of a business (Details in footnote [5]).

In terms of the percentage of a company’s operating income that went to CEO compensation, the CEOs of WPP and Omnicom made 4.6x and 2.8x as much as their peer at Accenture, which is bigger and grows faster. It’s good to be an ad executive, particularly considering they are running smaller, less profitable, largely stagnant and underperforming (in terms of stock price) businesses. Obviously, CEO compensation is just a minor cost block in the grand scheme of things, but it’s a symbolic and telling one.

The more technical advertising becomes — and it doesn’t look like this trend will change anytime soon — the more difficult life will become for traditional agencies. Historically the agency business was driven by creative excellence and personal relationships, both things that lose importance in a world of fast-moving, data-driven, AI-powered marketing, for better or worse. It doesn’t look like the agency industry is particularly well prepared for this change.

As so often with these things, there are not easy solutions. It’s probably a safe bet that we’re going to see a few of these groups getting restructured massively, getting acquired at a low valuation or even going out of business altogether in the next few years. That’s not a bad thing for the industry overall.

Advertising is a fundamental component of a modern economy. Information is abundant, but attention is more and more scarce. Advertising, when done right, channels potential customers’ attention towards the best products, and that’s an essential building block of a well-functioning market.

Advertising trades in consumer attention, and the scarcer attention becomes, the more lucrative it will be to do this effectively. It’s not a coincidence that Google and Facebook are so profitable, because they are better traders of attention than anybody else.

Media and the way we spend our time and attention has changed very fundamentally over the last two decades. It’s time for the ad agencies, which once were the stewards of brands’ communication to consumers, to adapt to this change. And they better to it quickly.

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Footnotes:

[1] Nowhere was this change more visible than at the Cannes Lions festival, which once was an annual celebration of creativity in advertising. Now it’s mostly a huge deal-making circus with a clear hierarchy of participants: The big online platforms like Google, Facebook, Microsoft and Twitter are the only ones who can still afford to rent a part of the beach. The cabanas behind them on the Croisette boardwalk are mostly reserved for the largest media agencies and ad tech vendors. The yachts next door are rented by consultancies and smaller ad tech vendors. If you’re looking for creative agencies, they most likely can only afford a hotel suite across the street, if even that. Cannes is a micro-geographical manifestation of the power structure in advertising.

[2] Disclaimer: I have personally never worked at a traditional ad agency or holding company. But I have been involved for many years in companies that compete with agencies on the digital side or that sell technology to them, so I can say that I have some pretty deep insights into the inner workings of agencies, both in Europe and the US.

[3] A very, very senior agency executive with a very, very long tenure once told me that back when he joined the industry in the late 70s, it was not unusual for top graduates to pick their career between banking, consulting, technology and the ad agency world. Agencies were still considered a top career choice, and maybe the best one for the more adventurous graduates. Those times are over. It’s hard to imagine that a MIT computer science graduate, Stanford data scientist or Harvard MBA would have ad agencies even on their list of potential employers nowadays.

[4] This is also a function of ineffective management incentives and broken work culture. A senior agency exec once told me — after I pitched him on a workflow tool that could have saved his media buyers tons of time — “Look, I don’t have the money to spend on workflow optimization, and I don’t need this stuff anyway. I pay these kids $35,000 a year, and I can just make them stay two hours longer at night.”

[5] Here’s the compensation data:

Accenture Revenue: $36.7B
Operating Income: $4.6B
CEO compensation: $18.5M

WPP Revenue: $27.4B
Operating Income: $3.4B
CEO compensation: $63.9M

Omnicom Revenue: $15.2B
Operating Income: $2.1B
CEO compensation: $23.6M

(and just for fun:)
Alphabet, Google’s parent company
Revenue: $110.8B
Operating Income: $26.1B
CEO compensation: $1 (yes, one buck, but no reason to feel sorry for the guy)

Originally published at innospective.net on June 18, 2018.