WPP ads up to momentum

In lots of business sectors, recovery has a habit of happening quicker and lasting longer than you might expect; and often continuing long after share valuations look full. So it is with the advertising industry now, where a rebound looks likely to last right through the first half of this year and beyond. And what better way to play this momentum theme than via shares in the world's biggest advertising agency WPP, which covers everything from advertising, media buying and public relations.

True, its share price has already had a decent run, up from 610p at the start of the year. It could also be argued that a rating of 14 times forecast earnings is no bargain; nor is the dividend yield anything to get excited about. Yet that would be to underestimate the powerful effect of a turnabout in investor sentiment on a share price.

After a “brutal 12 months”, during which profits fell 16 per cent, it is not surprising that WPP's chief executive, Sir Martin Sorrell, took a curmudgeonly stand on prospects earlier this year. He steered the City's expectations towards a muted 2010 and complained of WPP's clients that “the fact that you cannot cost-cut your way to prosperity has not been accepted as yet". Perhaps he should have been more sympathetic since WPP axed 14,000 jobs last year to protect its own profits.

But WPP has perked up since as the full extent of the shift in the advertising landscape has become clear. Better-than-expected Q1 figures last Friday showed flat year-on-year revenue growth, after stripping out exchange rates and acquisitions, and importantly gave the company confidence to predict a return to growth through the rest of the year and start hiring again. This means a fresh prospective on WPP's shares is required since we labelled them fairly priced when writing up the 2009 results (). The group has been bolstered by strong dollar-earning advertising in the US so far this year. In the first quarter of this year, Omnicom, Publicis and Havas - all global agencies - reinforced the positive trends first spotted at Google and Yahoo and showed sound organic growth. As a result, analysts at investment bank Goldman Sachs have been raising their profits forecasts across the media sector.

WPP is pinning its hopes on the World Cup in South Africa, the World Expo in Shanghai and the US mid-term elections to release the advertising purse strings later this year. While business is likely to remain tricky in Europe, a key for WPP’s ongoing recovery will be emerging markets, which are expected to make up a third of group revenues within five years, up from 27 per cent currently. Direct marketing and digital are also expected to provide other key engines for growth, and most of WPP's £100m war chest for bolt-on acquisitions. Last month it snapped up a stake in retail-led ebusiness consultant eCommera, although it kept the price under wraps.

On forecasts from investment bank Nomura, WPP's shares are rated at 14 times this year's earnings (see table), falling to 12 times earnings for 2011 (EPS: 58.2p). This begs the question, can paying that prospective earnings multiple be justified? WPP shares have regularly traded on a PE ratio of 15 to 18 times in the past; and reasonably so - after all, in the five years 2004-08 revenues, profits and EPS all averaged percentage growth in the mid teens. Go back 10 years and the rating was over 30 times. That was inflated by the dot-com boom and won't recur, but it illustrates how a sudden switch in investor sentiment can drive a share price far beyond what might seem logical. By contrast, reclaiming a PE ratio of 17 times for WPP's shares looks quite feasible during the next six months, implying a share price of over 800p.

This is backed up by technical analysis, with The Trader flagging WPP as likely to give “repeated buy signals” just a few weeks ago (). Further out, a return to typical percentage EPS growth in the mid teens would further justify a re-rated PE ratio, and imply a share price chasing £10 towards the end of the year.