Significant attention has been focused on the decline of marketing communications budgets, and how that will impact the public ad agencies. As The Wall Street Journal’s Emily Steel reported in mid-December 2008, Publicis Groupe expects U.S. ad spending to drop 6.2% in 2009; WPP and Interpublic Group both expect a decline of about 3%.  Observers outside the industry are less optimistic.  For example, Fitch expects the decline in ad spend to extend well into 2010, with the decrease in the 6%-9% range; Barclays has predicted a decline of 10% for 2009 and have held out optimism for an actual growth of 1% in 2010.  Personally, I think they are all overly-optimistic.

But the large public ad/communications agencies will face major challenges not simply because of likely decreases in their top and bottom lines, but also because their business models are outdated and will not be tolerated by clients looking for efficiency along with creativity.  Here’s my reasons, from the background of someone who has been in all phases of the communications business for four decades:

1. Their revenues are irrationally based primarily on commodities. Agencies generate income primarily for their time, from commissions on media costs and by marking-up production costs, all of which are commodities.  For the agency, the more time spent doing work for the client, the more expensive the media and the higher the production costs, the better; but for the client, exactly the opposite is true.  In the tough economic reality that exists and is getting worse, this approach will prove to be a fundamental flaw that clients are going to reject.

2. They work in silos when clients are demanding truly integrated accounts. Remuneration at large agencies is based on the financial performance of “practice groups” or individual agencies or offices.  That creates silos.  But just the opposite – collegiality – is required for truly integrated campaigns that have been the nirvana of marketing professionals for years.  Agencies talk about how they are trying to get digital and PR and advertising and event marketing, and all their other capabilities (most of which have been acquired) to work as one organic unit, but their very structure preempts their ability to deliver that.  During boom times, clients will deal with the shortcomings.  Now, they will fire the agency.

3. Their good people are going to leave. Investors whose view of the communications business is based on their dealings with senior management have the wrong view of the business.  The work is done, the clients are won and kept, and the reputation is built by a vastly different type of person.  They may like working in a big shop, working on big accounts, and making big salaries and bonuses.  But they also place a very high priority on their quality of life.  Omnicom has announced that it will lay off 3,500 employees in January (so far) and that its CEO will receive a $25 million bonus.  How do you think that is turning on the creative staff?  There are cost controls being implemented in every nook and cranny of every agency.  Resources are shrinking.  At the same time, employees are being pressured to bill more time in response to directives from their bosses as well as pressure arising from their own fear of losing their job.  So the focus is on the time sheet and the culture of the agency isn’t so much fun anymore.  The really good talent, who will be in demand by those few agencies that will be growing, will leave for a much better environment.  The big agencies will lose a load of their really good people.  This will ultimately translate into client problems and the loss of business, which will then translate into an even worse environment.  A momentum will be established in exactly the wrong direction.

4. They are going to move too slowly. Whereas the change in the way people communicate has been the most dramatic manifestation of the technology advances of the past decade or two, the communications industry itself has been remarkably resistant to change.  Yes, they have become aggressive adding digital communications capabilities.  But they are still organized by distribution channel (advertising, PR, interactive, events, etc.) when their clients need them to be singularly organized to use any and all distribution channel to achieve specific results.  When the agencies are too slow providing the change clients are going to demand, the clients will find other agencies.  Some of that business will move from one big shop to another, as has often been the case, but a growing share will go to shops that are not part of any public entity.

5. Growth through earn-out acquisitions will take a major toll. An inefficient structural overhead is a major legacy of the multi-year acquisition binge of the large agencies.  As a result, costs are too high and the ability to change is dramatically mitigated.  But there’s another legacy:  many of the acquisitions still require earn-out payments.  Some of those won’t get paid in 2009 due to bad performance, but some will, and they can be very big.  How will they be paid?  With cash that will become increasingly precious over the year, or with equity that will sink to lower prices, causing greater dilution?

At the same time that clients are going to become more demanding of (and less patient with) the big agencies, they will discover alternatives with different models.  In normal times, clients resist trying things that are too different.  But we’re not going to be in normal times – and with sales sinking anyhow there will be little downside risk for trying something new.  And that will spell tough times for the public entities – dramatically tougher, I think, than currently being projected.