Another day, another asset-rich Chinese conglomerate or obscure Chinese businessman buying up an English football club. Since the start of 2015, Chinese tycoons have invested an estimated $4 billion in European football clubs. The common reasons put forward in the newspapers are (not in any order of significance):-
- A keen desire to fulfill President Xi Jinping’s ambition to turn China into a football powerhouse. An investment in a club can help the growth of the sport in China via the sharing of knowledge, expertise and best practice as well as obvious commercial opportunities;
- Use of overseas acquisitions to take money out of China in the face of Renminbi devaluation;
- The increasing riches of English Premier League (“EPL”) clubs due to new mega TV deals for broadcasting rights to their matches. After all, 9 of the top 20 richest football clubs in the world (in terms of yearly revenue) are from the EPL, and the EPL’s total annual revenue of €4.4 billion is nearly twice that of second-placed Bundesliga of Germany with total annual revenue of €2.39 billion (see chart below); and
- The ownership of a successful European club has long been seen by many as a global trophy asset, providing owners with an enhanced business profile, political influence and access to important relationships.
Source: Deloitte’s Annual Review of Football Finance 2016
Consider this quote from Xue Feng, the CEO of Everbright Securities, after they partnered with Chinese technology company Baofeng to buy a 65% share in MP & Silva, a leading international sports media company, back in May 2016. “China owns billions of sports fans and its sports industry has been one of the hottest investments recently,” Feng said. “We hope to seize the unprecedented opportunities brought by the rapid development of the sports industry in China.” In other words, they see the opportunity to make money.
However, as I am not one to just take things at face value, and since this question has not really being answered in the newspapers or social media with satisfactory analysis, I decided to ask and research on the question which I have always being curious about: IS AN EPL FOOTBALL CLUB SUCH A CHEAP AND ATTRACTIVE ASSET FOR THE BUYER? For my case study, I have decided to use Liverpool Football Club (“Liverpool” or “LFC”) as an example because (i) there are ongoing reports that the China Everbright Group (“Everbright”) has tabled a bid for a (minority) stake in LFC; (ii) Liverpool is ranked as the 9th richest club in the world by annual revenue (which prima facie makes it an attractive target); and (iii) it is my favourite football club.
HOW DO FOOTBALL CLUBS EARN THEIR MONEY?
In my analysis, I start by studying a football club’s business model and how it earns its money. I started with the latest annual financial statements of Liverpool for the financial year ended 31 May 2015 (“FY2015”), which I found on the internet even though Liverpool is not a listed company.
As you can see, the basic sources of revenue for Liverpool, and any professional football club, are threefold:-
(I) Match-day revenue (19.8% of Liverpool’s total revenue)
This is essentially ticket sales which in turn depend on (i) the average price per ticket; (ii) the seating capacity of the club’s stadium; and (iii) the number of matches played by the club which in turn depends on how successful the club is in knockout cup competitions.
(II) Broadcasting revenue (41.2% of Liverpool’s total revenue)
This refers to TV money received from broadcasting companies (e.g. Sky Sports, BBC, etc) for rights to broadcast the matches. There will be additional broadcasting and match-day revenue if the club’s end-of-season EPL standing in the previous season allows it to participate in the following season’s European competitions, i.e. the UEFA Champions League (“UCL”) or UEFA Europa League (“UEL”). The following diagram illustrates the money flowing to EPL clubs from selling TV rights to EPL matches both domestically and overseas. As you can see, 50% of domestic rights money is shared equally among the 20 EPL clubs, 25% is determined by the club’s final league position, and the remaining 25% is facilities fee for televised matches.
Depending on how far a club progresses in its European competition, it may earn additional broadcast and match-day revenue of £20 to £50 million for that financial year —- as a proxy, please read page 8 of Manchester United’s annual report for the financial year ended 30 June 2015.
(III) Commercial revenue (39% of Liverpool’s total revenue)
This is a broad category and includes mainly money from sponsors, playing in exhibition matches, sale of club merchandise etc.
SO MUCH REVENUE, SO LITTLE PROFIT?!
Newspaper headlines like to highlight how rich EPL clubs are based on their top-line revenue. But real investors like to see how much that revenue translates into the bottom-line. In the case of EPL clubs, the answer seems to be “not much”! As can be seen from Liverpool’s P&L above, the club only made pre-tax profit before player trading (commonly called “operating profit”) of £7.4 million and £6.2 million for FY2015 and FY2014 respectively, figures that are easily exceeded by even some medium-sized enterprises in Singapore. The reason for such a low profit margin is the high level of wages and bonuses paid to players, which is not surprising when we regularly read about top players being paid in the magnitude of £100,000 to £200,000 per week, while even lesser lights take home five figures per week! These translate to an EPL-average wages-to-revenue ratio (“WTRR”) of 58% and 61% for seasons 2013/15 and 2014/15 respectively. Liverpool’s WTRR for 2014/15 season was 56%, lower than Chelsea’s 68%, which was still lower than Tony Fernandes’ Queens Park Rangers’ 85%!
Source: Deloitte’s Annual Review of Football Finance 2016
TRADING OF PLAYERS: THE BIG P&L SWING FACTOR
Having paid the players their wages to cover their Bugatti Veyrons and their WAGS’ (wives-and-girlfriends) shopping bills, the biggest swing factor on the “pre-tax profit” is the club’s P&L on buying and selling of players. The profit on player trading is the difference between the transfer fee receivable less the net book value of the player on the balance sheet at the date of sale (i.e. what is left of a player’s value after amortising his acquisition fee over the number of years of his contract with the club) and less any direct costs of transfer (which include signing-on fees paid to players and hefty fees paid to the influential players’ agents).
For FY2015, Liverpool reported a £60 million pre-tax profit which was attributable primarily to the £56.2m profit on player sales (mainly that of star player Luis Suarez). While this has not been an entirely uncommon item, with the club having significant player trading profits in FY2011, FY2015, and likely again in FY2016, it should be considered an “extraordinary item” when characterizing operating results, i.e. non-recurring item in accounting terminology. The sales of their best players like Torres, Suarez and Sterling were each somewhat unique situations and for prudence, an investor cannot always expect such profit from player sales to recur consistently in the future. Ironically, with (hopefully) better performance on the field under the new manager Jurgen Klopp and thus (again hopefully) better ability to hold on to its best players, it will not be prudent to count on player trading gains when making one’s investment decision on Liverpool.
If we conservatively work solely off the £7.4 million of operating profit instead of pre-tax profit which is distorted by P&L from players trading, then the oft-touted £800 million valuation of Liverpool will translate into a historical price-earnings multiple of over 100 times — hardly of good value by this commonly used valuation measure.
HOW TO GENERATE MORE SHAREHOLDER VALUE FROM A FOOTBALL CLUB?
To possibly justify a £800 million valuation of Liverpool, the management will have to achieve a combination of the following, ranked from the least to the most controllable option:-
Increase ticket sales: Firstly, the owners of Liverpool attempted to raise ticket prices less than a year ago, but this was quickly put off after protests and walk-offs by the fans. Raising ticket prices will become an even more sensitive topic given the increased TV revenue to the club, who will be expected to share this additional revenue with the fans by not hiking ticket prices. Secondly, Liverpool has just expanded seating capacity by nearly 20% from 45,500 to 54,000. However, this is still less than the 75,000 seating capacity at Old Trafford, the home ground of rival Manchester United (“MU”). The increased seating capacity at Anfield may boost yearly match-day revenue by £12 million to £70 million, but this is still less than the £90 to £100 million of yearly match-day revenue generated by MU in each of its last few financial years. Adding further seating capacity is not always an easy and quick solution, due to structural constraints and time taken for planning, seeking government approvals, and reclamation of land from surrounding residents, etc.
Increase broadcasting revenue: The bulk of broadcasting revenue is from EPL’s deals with both domestic and overseas broadcasting companies. Such deals are typically renewed every three years and are not fully within the control of the individual football clubs. As stated on page 7 of the aforementioned MU annual report, contracts for these media rights and certain other revenue for competitions (both domestically and internationally) are negotiated collectively by the EPL and the Union of European Football Associations (“UEFA“) respectively. The clubs are not party to the contracts negotiated by the EPL and UEFA. Furthermore, the clubs do not participate in and therefore do not have any direct influence on the outcome of contract negotiations. Nevertheless, the level of broadcasting revenue has been on a strong uptrend since the EPL’s inauguration in 1992.
Increase commercial revenue: This is by far the biggest differentiating factor between the successful and not-so-successful clubs, and also the one that can be most “worked on” by the club’s management. A comparison between Liverpool and MU for FY2015 (see MU’s operating results below) reveals that the former’s commercial revenue lags the latter by £80 million, i.e. Liverpool’s commercial revenue was only 60% that of MU’s in FY2015 or roughly equal to where MU was 5 years ago. This is a shame as Liverpool has arguably just as rich a history and as strong a global following, if not more, than MU. Liverpool’s management in the past decade or two has clearly dropped the ball on being market leaders in generating commercial revenue by tapping on the club’s strong global branding. And this is where one hopes that if a bulge-bracket, politically-connected Chinese state-owned buyer does take up a minority stake, it can use its connections or “guanxi” to help Liverpool tap into China’s sports and retail market to help bridge that £80-100 million gap in commercial revenue. Of course, apart from tapping the corporate sponsors and fan base more creatively and effectively, commercial revenue is also dependent on the club’s success on the football field within a self-reinforcing circle.
Source: Manchester United’s annual report for the financial year ended 30 June 2015
SO HOW CAN I MAKE SOME PROFITS?
An optimistic scenario for a potential buyer involves achieving all of the following inter-related operating conditions:-
- astute management and marketing by the owners working closely with the new Chinese co-owners to double commercial revenue over 2017-2019;
- strong on-field performance producing a top-six EPL placing and regular participation in European competitions over the next few seasons;
- maintenance of a steady WTRR at current levels i.e. not more than 60%; and
- not paying absurdly high transfer fees which will increase the annual amortisation charge on transfer fees as well as increase the likelihood of incurring extraordinary loss when selling the same player.
If the abovementioned conditions are executed or achieved, then Liverpool may financially receive an additional yearly (i) £12 million from match-day revenue; (ii) £30 million of broadcasting revenue; and (iii) £80 million of commercial revenue by 2019 — boosting its total revenue from £298 million in FY2015 to £420 million by FY2019. All these will likely help the club to achieve annual operating profit of approximately £50 million, which is similar to that generated by MU during FY2011-2014 (before the unsuccessful reigns of David Moyes and Louis van Gaal). Incidentally, £50 million of annual operating profit is also the same figure for the average operating profit for each EPL club as projected by Deloitte in their “Annual Review of Football Finance 2016” — see page 20. An annual operating profit of £50 million will translate into a prospective FY2019 price-earnings ratio of 16 times, which to a value investor is still not attractively cheap especially for a non-controlling, minority stake in such an unpredictable business.
THE SUN ALWAYS SHINES ON TV: CAUSE FOR OPTIMISM?
Dan Jones of Deloitte’s Sports Business Group, which publishes the “Annual Review of Football Finance 2016”, believes that due to the new TV deals paying a record £5.136 billion (up from £3.018 billion in 2013-16) for rights to broadcast EPL matches live over 2016-19, “Premier League clubs have turned the corner, and are entering a new era of sustained profitability. Clubs are now attractive propositions to investors, and not merely as vanity projects….For the first time, the Premier League leads the football world in all three key revenue categories – commercial, match day and broadcast – and this is driving sustainable profitability.”
Although the WTRR has increased for the EPL clubs, Mr Jones does not see this as cause for concern. He said, “In fact, in the last two years, only 30% of revenue increases have been consumed by wage growth, whereas in the five years to 2012-13 this figure was 99%.”
An investor must surely hope that EPL clubs are able to maintain a financially rational WTRR and not pay exorbitant transfer fees for eventually unproductive players (i.e. conditions (c) and (d) ), particularly when the lust for glory or pressure to win matches to survive in the lucrative EPL gets to the managers and their owners.
IS IT SUCH A WONDERFUL BUSINESS AT A FAIR PRICE?
The great investor Warren Buffett focuses on buying great businesses trading at fair prices. However, Buffett does not say to buy great businesses at any price. He said, “For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favourable business developments.”
In the decade to the 2012/13 season, EPL clubs had accumulated combined pre-tax losses of over £2.5 billion, with ever-increasing broadcasting revenues being consumed by players’ wage inflation. At the end of the 2011/12 season, only 11 and 8 out of 20 clubs reported operating profit and pre-tax profit respectively (see chart below). However, the substantial revenue increase brought about by the 2013-16 broadcast deal, coupled with the continued application of financial fair play regulations, have led to a long-awaited improvement in the financial balance of EPL clubs. At the end of the 2014/15 season, 17 and 14 out of 20 clubs reported operating profit and pre-tax profit respectively — a huge improvement from 2011/12. Clubs now seemingly have another great opportunity to increase profitability further when the even larger broadcast deals commences in 2016/17.
Source: Deloitte’s Annual Review of Football Finance 2016
In my conservative opinion, in spite of the revenue boost from the new TV deals till 2019 and surely beyond, it is still highly doubtful if an EPL football club is such a wonderful business to own, given the narrow margin for error if the club wants to earn £50 million of annual operating profit steadily from year to year — please assess the probability of achieving all of the aforementioned operating conditions (a) to (d). The EPL’s history since 1992 has shown that players’ wages and transfer fees are constantly on an inflationary trend every few years. In particular, conditions (b) and (d) are highly unpredictable even with an elite football manager at the helm — Sir Alex Ferguson and his steady track record is an exception. It is little wonder that for the financial year ended 30 June 2015 (after Ferguson’s retirement in May 2013), MU reported an operating profit of only £7.99 million (a sharp fall from the previous year’s £60.0 million) when broadcasting revenue and match-day revenue fell due to poorer on-field results while players’ wages remained a ‘sticky’ high fixed cost in the medium term. From Buffett’s book, you really want to own a business which franchise is so secure and competitive that even your idiot nephew (and not only an exceptional Harvard-lecturing manager) can run it with constant profitability. Such businesses are like a needle in a haystack.
Other elite managers like Jose Mourinho and Pep Guardiola will demand a big transfer kitty to buy the best players at expensive prices, no doubt to the chagrin of a club’s financial controller. Such fat transfer fees paid to buy star players will either have to come from the three sources of revenue and/or profitable player trading, or the owners will have to pump additional capital into the club. Again, from Buffett’s book, a wonderful business cannot be one that has to go back to its owners now and again for additional capital. You may already have noticed that there is potentially a conflict between building a strong team under an ambitious manager that produces great on-field results that supporters are happy with, versus building a profitable club that its shareholders are happy with. Alternatively, an elite football manager that can deliver results on the football field may not be the same manager who can deliver results on the P&L statement to shareholders. It is for this reason that Arsene Wenger has stayed in his job at Arsenal for so long, because of his ability to balance and marry these two potentially conflicting objectives of fans and owners of the club.
MONKEY DANCING ON A RAZOR BLADE
Given the economic challenges and little margin of safety at current valuations, the real non-political, non-sporting, commercial reasons I see as to why Chinese buyers are still so keen to buy an EPL club (apart from diversifying from Renminbi exposure) may instead be:-
- To join the herd and make quick profits by buying underperforming clubs with a large fan base, turn them around and sell it off at an even higher price to the next greater
foolbuyer over the next few years; or
- To make quick profits by injecting an unlisted football business into a China-listed company to capitalise on the latter’s higher valuation.
With the exception of financially well-endowed, politically-connected enterprises like Everbright, Dalian Wanda and China Media Capital who may really be able to generate marketing synergies between their football investments and their mainland China businesses, the other smaller Chinese tycoons or entrepreneurs may wish to be reminded of a recent “it-won’t-make-you-money” warning from Wang Jianlin (China’s richest man and owner of Dalian Wanda who recently bought a stake in Spanish club Athletic Madrid), and the story of one Simon Jordan who tells the story of how owning a football club can go terribly wrong.
Jordan amassed a fortune of £75 million in the early days of the mobile phone revolution. In 2000, he paid £10 million to take control of Crystal Palace Football Club, becoming the youngest football club chairman at the age of 32. He was warned by many not to do it, but having being a fan of the club since his childhood, he could not resist. After 10 years, the club was in administration with Jordan’s personal wealth largely wiped out. Even though Jordan stated he tried to run the club as a hard-headed business, ambition was irresistible and in football, success comes at a high price to the owners.
Simon Jordan is not alone in this regard. The cash-draining experiences of Randy Lerner (former owner of Aston Villa), Mike Ashley (owner of Newcastle who is also looking to sell his club), Bill Kenwright (former owner of Everton), Sir Alan Sugar (former owner of Tottenham Hotspurs) and Mohamed Al Fayed (former owner of Fulham) should make any prospective club owner aware of the need to constantly re-invest significant earnings in new players and managers, while managing the expectations of the fans, trying to boost revenue and cover their financing costs. It is an exercise not unlike a monkey dancing on a razor blade. Don’t be surprised to see more than a few calculative and impatient new club owners, or even reports of promised but delayed payments from owners into their clubs, emerging over the next few years.