Why Ad Agencies Will Not Be Replaced By Google

LinkedIn Article by Tim Williams 
October 15, 2014

Advertising agencies have been walking in fear of the giant tech companies like Google and Facebook ever since these disruptive new players arrived on the scene. And for years, Google and Facebook have been insisting that agencies are their business partners, not their competitors. These complicated relationship dynamics led one high-profile agency executive to famously refer to Google as a “frenemy.”

There are some legitimate reasons for the advertising agency industry to be concerned. Google has been siphoning ad dollars that normally would be spent through media agencies. And because of the growing popularity and effectiveness of search, marketers continue to invest more money there at the expense of traditional paid media campaigns, the bread and butter of most agencies.

But ultimately, agencies need not be concerned that Google wishes to supplant their role in the business world. Google runs an immensely profitable business, turning in average annual profits of 50%. This year, WPP achieved 17%. The average profit for many independent agencies is even lower. Why would Google ever want to be in the agency business? As the Economist recently observed in their excellent Advertising and Technology Special Report, “Perversely, the agencies’ mediocre returns may protect them from being wiped out by nimbler competitors.” As the report points out, companies like Google would have to add significant new staff to replicate the agency model, and for very limited returns.

Another key metric of success

It wasn’t always this way. Back in the days of Don Draper (and before the invention of the agency time sheet) firms benefitted from commissions on big media budgets and turned in average profit margins of 30%. But today, agencies are a people-hungry business with largely flat revenues and low returns. When calculating revenue per employee – a useful metric of success for knowledge work – most independent agencies are in the range of $125,000 per employee. A handful of the very best agencies may turn in twice that number, but it’s a long way from the returns earned by marketing technology companies. Google generates $1,135,000 in revenue for every one employee. At Facebook, revenue per employee is $1,192,000. Craig’s List, a private company, is said to produce a remarkable $3 million per employee.

The virtual reality company Oculus VR was purchased by Facebook recently for $2 billion. Oculus VR has 75 employees. Consider the market value of an advertising agency with 75 people. True, these are very different companies, but the gap in market value is astounding. Unlike the new breed of technology companies, agencies have not leveraged their intellectual capital by inventing new services, new products, and new ways of creating marketing value. Instead, they have mostly been content to just keep harvesting the last of the dollars from the "traditional" marketing ecosystem that is now more than a century old.

Can knowledge work be automated?

Wall Street is now largely automated, with real-time bidding administered in micro-seconds by computers instead of traders on the floor of the exchange. While this technology has no doubt replaced some human traders, Wall Street firms have hugely benefitted because they’ve been able to trade faster and with more precision, earning ever higher margins.

This same type of technology is now being employed in the ad buying world. Called “programmatic buying,” the concept is similar to the financial markets. Media inventory goes on the market, then is bid on and bought in an instant, using the brains of computers instead of human media buyers. The big agencies now even have what they call “trading desks.” But unlike Wall Street, agencies are not really benefitting financially from this leap forward in technology, because most are still mired in the outmoded practice of charging for the time they spend (hours) instead of the value they create. Margins on Wall Street continue to soar, and margins of agencies continue to shrink.

To make matters worse, when agencies place digital media, it involves a host of marketing technology intermediaries who take a larger cut than the agencies do – a “technology tax” of up to 80% of the media spend. Within just a few years, programmatic buying is expected to account for half of all online advertising, and online advertising is on its way to becoming the dominant form of paid marketing on the planet.

If you don’t invest in yourself, who will?

This is one more reason agencies need to get out of the “service” business. Instead of responding to the current needs of advertisers, agencies must invest much more financial and intellectual capital creating new forms of value for their clients. This is no doubt challenging given the razor-thin margins in the agency business right now. But what exactly is the alternative? Even if your firm has been around 30 years, now is the moment to adopt the mentality – and business model – of a start up. If agencies don’t invest in themselves, it appears increasingly likely that no one else will either.