Analysis: Income is up despite low margins

Despite this, percentage growth income across the digital sector was higher than any of the other individual marketing disciplines. Income has increased by more than a third across the top 20 digital agencies.

"The significant increase in income across the digital agencies surveyed indicates that specialist digital marketing is still a very high growth area. However, in the scramble to win market share in this space, are agencies able to charge the premium fees their expertise ought to command? Margins would indicate the answer is no," says Esther Calder, partner at WKS.

On further analysis, however, the margins are slightly more encouraging. Three agencies posted large operating losses and made a significant distorting effect on the margins. Interestingly, all three of these - AKQA, Deal Group Media and Green Cathedral - were group-owned or listed agencies. Once these are removed from the list, margins improve to a much healthier 13.8 per cent.

"But it is still disappointing that average margins in the digital sector were not higher than their more traditional counterparts," adds Calder. It is interesting to note that last year, Calder was optimistic that 2007 would yield stronger margins as more markets planned to invest in digital.

Revenue grew across all the agencies surveyed except Green Cathedral, which saw losses of 35.8 per cent. Four agencies increased revenue by more than 50 per cent, including LBi (formerly Framfab), Avenue A/Razorfish, Dialogue DLKW, and Poke London.

Autonomy

Within the top 20 agencies included in the survey, independent agencies showed a higher average gross income growth (39 per cent) than the group-owned and listed agencies (26 per cent). According to WKS, this can largely be attributed to greater autonomy in independent agencies, allowing them to respond quickly to market changes and demands.

Digital agencies faring well this year include Poke London, Profero, Dare and Glue. Pure digital shops have a great opportunity to attract clients with their specialist knowledge and skills, but will fare best when they understand integrated marketing techniques. Poke, for instance, works closely with Mother to provide an integrated offer.

"We do well when collaborating with other agencies," says Nick Farnhill, managing director at Poke. Farnhill has noticed that most of the brands he works with are shifting a 'vast majority' of their budget and focus into digital. Poke has picked up several good consultancy-related jobs over the past year, especially in the US.

Orange and BBC Worldwide have both worked with Poke as they move further into digital. The agency's largest recent piece of work was for an Orange Unlimited campaign, at www.unlimitedorange.co.uk. While Wunderman handles the DR for digital, press and print for Orange, Poke is the sole digital agency for branding, and Farnhill points out that the relationship is growing.

As the scope of digital channels rockets exponentially, moving beyond classic online advertising to experiential marketing and other business functions, the work that agencies can take on also broadens. Agency GT won a pitch for Adviva, beginning work at the start of 2007. GT has gone as far as to develop an online self-service strategy with the client, moving its core customer service away from call centres.

Marc Giusti, partner at GT, believes some digital agencies are now doing consultancy and brand positioning work in weeks that would have previously been done by Accenture over a period of several months.

"In six weeks, we developed an application that is now channelling £28 million a month for one client," Giusti says.

Agencies have never been this close to business processes before, but have been producing advertising rather than restructuring client business (which has traditionally been carried out by firms such as Accenture and McKinsey).

Clients such as Audi and Microsoft conduct a large proportion of their business decisions and financial infrastructure through the online environment. The majority of Adviva's insurance customers, for example, reach the brand via online aggregators and comparison sites.

Adviva operates within an ever more consumer-driven market, in which users visit review sites and forums, and spend time discussing brands and products with each other before committing to purchases.

If WKS had focused on digital performance in 1998, it would probably have discovered massive margins. Everybody was throwing money at digital to become an online player, according to Russell Marsh, managing director at Agency.com.

Now, clients are generally channelling more of their budgets out of traditional towards online. But when budgets aren't necessarily increasing, it is reallocated - and clients demand value for money.

Nobody can deny that growth is good for an industry. But the rapid growth of digital means agencies are still catching up with themselves. Margins in this survey were 13.8 per cent with the loss-making agencies discounted - Calder says that agencies should be making 15 per cent as a minimum.

Rapid growth may actually be suppressing the margins revealed in this study, as agencies pay out for recruitment fees and new, larger offices, for example. Calder suggests that as growth plateaus, and agencies become more mature, the industry should see higher margins.

On the other hand, increasing competition over time could see more competition in the form of new digital agencies and traditional agencies catching up with integrated digital offerings. Calder suspects that one will counteract the other, to level margins out somewhat.

Simon Latarche is finance director at LBi (formerly Framfab), which counts BT Business, Comet, Orange and Procter & Gamble among its clients, and ranked highest for gross income in this year's survey as well as last year's.

He says that you have to factor in huge investment by all companies in the digital space to develop staff and software. "As the industry matures over the next few years, and our clients are clearer about what they want, margins will go up," he predicts.

Latarche adds that margins are generally good, comparable with above the line but not quite as strong. "We can expect that to really ramp up over the next five to ten years," he says.

More broadly, the sector has evolved through two web phenomena, and is now entering a third generation. Agency propositions to clients are likewise constantly changing, which makes it difficult for the industry as a whole to nail pricing.

Staff crisis

One of the biggest financial drains agency side is recruitment and retention, a problem repeatedly cited by agency heads for some years now. Calder notices with this year's sample that the pressure lies in keeping an eye on staff costs. The agencies with a lower proportion of staff costs (below 60 per cent of gross income) generally managed better margins.

This year's survey revealed that the average operating profit per head within digital (£5,640) was significantly lower than in media buying (£18,939) and PR (£14, 607).

A huge frustration for agencies is winning new business and not having the talent to do the work. Play recently pulled out of the BBC digital services pitch citing staff shortages. A climate of headhunting is seeing smaller independent shops lose out to networks. Also, a lack of staff in the marketplace means that skilled digital folk can demand hefty salaries.

Marsh says that after the dot com crash, people left the industry and, seven years on, the mid-level tier simply isn't there. "We need more youth coming into the industry," he says.

Calder says that with digital talent so costly, hiring lots of junior staff drags down employment costs per head. The flipside is that income generated per head can also slip as graduates are less likely to bring in the most lucrative clients.

Integrated agencies that have built a strong digital team are bound to succeed in today's digital landscape. Aegis has made a series of acquisitions, and now has Glue, Deconstruct and mobile company Marvellous Ideas within its group.

Calder says digital agencies should be able to charge a premium for their services as clients demand specialist skills: "Digital performance was lacklustre this year, but the survey included a mixture of younger agencies. Overall, margins were dragged down by high growth, recruitment costs and office moves. I hope to see an improvement next year."