What Stan Kroenke’s takeover of Arsenal might tell us

After years of jostling between American businessman Stan Kroenke and his Uzbek rival Alisher Usmanov, the deteriorating health of Danny Fiszman looks like it has broken the log jam in the control of Arsenal.

The price paid by Kroenke of £11,750 per share,  values  the club’s equity at £731.05m. To read across from this valuation however we have to take into account the debt on the club’s balance sheet.

The last reported balance sheet figures are for 30^th November 2010 (the 2010/11 interims). This showed the following debt and cash structure:

If we add this £147.4m net debt to the value of the equity offer we get the “Enterprise Value” (“EV”) of the business.

In the case of Arsenal however, a simple EV calculation is not appropriate because the club is still selling off development properties at its old ground. The interim accounts showed the remaining properties were valued (at the lower of cost or realisable value) at £28.2m. I have assumed that these will convert into cash at a 50% premium to this carrying value and have thus adjusted the EV calculation to take this into account:

So Kroenke is acquiring control of Arsenal at an Enterprise Value of c. £836m (adjusted for the remaining property) to £878m (unadjusted).

This is a pretty hefty valuation on any measure. In 2009/10, the club generated EBITDA from its football business of £57.4m (excluding volatile profits on player sales). This implies historic adjusted EV/EBITDA multiple of 14.6x and a historic adjusted EV/Sales (football only) of 3.8x.

Comparing the valuation to Liverpool

In contrast to the Arsenal deal, Fenway Sports Group paid an EV of £300m for Liverpool last year, a historic EV/EBITDA multiple of 8.6x. At face value on that basis either FSG got a bargain or Kroenke is overpaying hugely. So what’s going on?

I think the answer here is that FSG actually paid a higher multiple for Liverpool, and Kroenke is probably getting a slightly better deal than the headline numbers imply.

The multiple of 8.6x is calculated using the £35m of EBITDA generated by Liverpool in the 2008/09 season. We do not have numbers for 2009/10 yet, but it was a poor year for the club. Having finished third in 2008/09, Liverpool only managed 6^th in 2009/10 and exited the Champions League at the group stage. The failure to qualify for the Champions League in the current season will of course significantly impact profits in the current financial year too. It seems likely that it will take several years to bring Liverpool’s EBITDA back to the £35m level seen in 2008/09 and FSG’s £300m takeover should be compared to a depressed level of profitability, possibly as low as £25m which would take the multiple paid to around 12x.

Arsenal’s depressed profits and the shirt deal opportunity

In the case of Arsenal, it is possible to argue that last year’s profits of £57.4m were quite depressed. The previous year the football side of the company made EBITDA of £66.3m. The club played fewer home games in 2009/10 compared to the prior year, and this will partially reverse this season (28 played vs. 27) adding c. £3.5m to turnover and perhaps 75% of that to profits. The new overseas Premier League TV deal will also add around £5m to the club’s income this season. Even with player costs continuing to rise, EBITDA should bounce back close to 2008/09’s £66m in the current season, reducing the multiple paid to c. 12.6x:

Arsenal is also “structurally” underperforming on its Commercial side due to the (at the time prudent) decision to sign a very long stadium naming rights and shirt sponsorship deal with Emirates in 2004. The shirt element which runs to 2012 is reportedly only worth £5.5m per annum compared to the c. £20m Aon and Standard Chartered pay United and Liverpool respectively and the c. £25m pa Barcelona are to receive from the Qatar Foundation. Arsenal “should” be able to earn a similar sum to its domestic rivals from the next deal creating a step change in profitability.

Taking the expected bounce back in profits into account (and even ignoring a on better shirt deal in the future), the multiple Kroenke is paying for Arsenal looks closer to 13x than 15x EBITDA, more in line with FSG’s acquisition of a Liverpool missing out on the riches of the Champions League.

Reading across

Takeovers of Europe’s biggest clubs are very rare things, and it is therefore worth taking note when they happen. In the case of both Liverpool and Arsenal, American investors are taking a bet on the continued growth of English football which is in itself interesting. At Liverpool, John W Henry has spoken publically about UEFA’s Financial Fair Play being a key factor in buying the club and it seems reasonable to think that Stan Kroenke’s takeover show he is also a believer in the impact of the new rules. Wage inflation is a big problem even at Arsenal, where the salary bill has risen an average 7.5% per annum over the last four years. The move to the Emirates has made this affordable, but with that now complete, it is hard to see significant profit growth without the fall in player wage inflation that UEFA hope FFP will usher in.

Turning to United, the other major club around which takeover speculation always swirls, today’s benchmark doesn’t really help the Glazers. The c. 13x “normal” EBITDA multiple Kroenke is paying would value United at c. £1.3bn. Unlike Arsenal the commercial side is already highly developed, meaning there is less “upside” to go for. Unlike Liverpool, there is no new stadium growth story to hang onto. If 13x EBITDA really is the “market valuation” for a major English club and with the Glazers reportedly looking for a £1.5bn+ price tag, it doesn’t look like much will happen soon.

LUHG

Financial Fair Play - crunching the numbers

This is the first in a series of posts looking at the challenges faced by English clubs in complying with UEFA's Financial Fair Play ("FFP") rules. Next season (2011/12) is the first year when clubs' "break-even result" are calculated. The tables below shows what "break-even result" the seven English clubs that played in Europe this season would have achieved on last year's figures (Liverpool numbers are for 2008/09 as they have not yet published 2009/10 results).

Relevant income

The "relevant income" calculation is the simplest bit of the FFP rules. All football club revenue (which I have divided into the common matchday/media/commercial and retail split) is of course included. In addition, the profit from selling players is included too. Profit in this sense means the difference between a player's selling price and the book value of his registration on the club's balance sheet. Players that come through a club's youth system have a zero book value and thus any sale proceeds are 100% "profit" in the FFP calculations.

Income from non-football operations is excluded, except where they are based at or close to a club's ground (such as hotel or conference facilities). Chelsea's hotel would therefore be included in the income calculation, as would Manchester City's "Sportcity" redevelopment around Eastlands. Arsenal's property income from the re-development of Highbury would be excluded.

The other major exclusion, and one no doubt likely to cause controversy, is revenue received from "related parties" (effectively the owner or people/corporations connected to them) in transactions that are carried out "above fair value". This rule (described in Annex X B 1j) says that transactions with a related party must be compared to the "fair value" that would have been achieved if the transaction was done as a normal commercial deal. Any income above this "fair value" is disregarded when calculating a club's income. This rule is designed to prevent owners subsidising their club by, for example, paying £50m per year for a box that would normally cost £250,000.

Relevant expenses

The expenses element of the FFP is more complicated and less intuitive than the income side. Staff costs are included and are by far the largest element, indeed it can be argued that the whole aim of FFP is to bear down on staff costs across European football. Other cash operating expenses are included (the basic costs of running a football club), but depreciation of fixed assets is not included. This means that there is no account taken under the FFP calculation of any costs from investing in stadiums or training grounds. Owners can finance such capital expenditure without limit under FFP.

Finance costs such as interest payments are included, but not if they relate to borrowing taken on to construct "tangible fixed assets" such as stadia, training facilities etc. In the table above, I have deducted the c. £14.5m of Arsenal's £20.8m of interest costs that relate to the club's financing of the Emirates.

The interest figure for United excludes the significant one-off refinancing costs the club recognised in 2009/10. My understanding is that such costs would not be included under FFP. On an ongoing basis, United's bond interest will be around £44.5m per annum.

A vital element of the expenses calculation is the inclusion of the "amortisation of player contracts" charge, which is how the cost of transfers is accounted for.

The accounting treatment of transfer spending is one of the least intuitive elements of finance for most football supporters. In the UK, the treatment is covered by "Financial Reporting Standard 10: Goodwill and Intangible Assets". In a transfer, the asset that is being bought and sold is not of course the player himself but the player's registration. This "asset" has a finite length of course, being the length of the player's contract with the acquiring club and FRS 10 says that the cost of buying the registration must be "recognised" over that life.

So when a club "buys" a player on a five year deal for (say) £20m, the cost is recognised over the 5 years at £4m per year, this is the "amortisation charge" for that player that appears in the profit and loss account. The timing of cash payments is irrelevant. The money could be paid up front or in agreed stages but the "cost" is recognised evenly over the contract. If after (say) three years the player negotiates a new five year deal, the remaining value (£8m in this example) plus any costs of negotiating the new contract (hello Paul Stretford et al) are added together and then recognised over the life of the new contract.

By including the amortisation charge in the expenses calculation, FFP captures transfer spending over an extended period. Even if a club stops spending after a period of heavy investment, the amortisation charge will stay high for a prolonged period. The chart below shows my estimate of Manchester City's charge over the next five years assuming no further purchases or sales (other than those players currently out on loan).

Dividend payments are captured in the calculation (in order to ensure debt is not disguised as equity). If the Glazers exercise any of their dividend rights (currently around £95m), such payments would have to be included in the FFP calculation.

As with the income calculation, transactions with "related parties" not done at "fair value" are adjusted for in the relevant expenses calculation. This is to prevent owners subsidising their clubs through taking on club costs (such as directly paying players for example).

The final major adjustments in the expense calculation relate to spending on youth development and community activities. Both are excluded from the FFP numbers, meaning clubs can spend as much as they wish on these areas. I have estimated figures for all seven clubs as they are not separately disclosed in the accounts.

Income minus expenses = "break-even result"

Subtracting "relevant expenses" from "relevant income" gives us the all important "break-even result". This is the key figure under the new regulations. In the first two "monitoring periods", seasons 2011/12 and 2012/13, clubs are not permitted to make a loss greater than €45m (c. £39.5m) over these two years combined if they are to receive a licence to play in Europe in 2013/14.

As you can see from the table above, only three or the seven English clubs would have made a profit under the break-even calculation last year, and Spurs' profit was only due to profits on player sales. United would have shown a loss if the exceptional financing costs were included. The losses at both Chelsea and City stand out. The figures for Liverpool are misleading, because they include significant finance costs relating to the debt Hicks and Gillet loaded on the club which have now been cleared.

Enforcement and exemptions
Meeting the new rules is going to be hard for many clubs across Europe. A key question is the extent to which  UEFA actually enforce their new rules. The credibility of Michel Platini and UEFA as an organisation are clearly on the line, and I believe they will be enforced, although that may well mean banning a major club from European competition.

The rules do give one notable exemption to the calculations I have outlined for the first two seasons in which the rules apply (2013/14 and 2014/15), set out in Annex XI 2, the final page of the regulations. If a club breaches the "break-even" target in the "monitoring periods" for either of these seasons because of a loss in the 2011/12 season caused by wages paid to players under contracts signed before 1st June 2010 (when the FFP rules were published) the club will be let off (as long as losses are reducing over time). That is quite a big get out, and may well mean that City and Chelsea do not face the imminent prospect of a European ban. The exemption is only temporary however and the principle remains the same, if UEFA enforce FFP, many clubs are going to have to cut their wage bills and/or radically boost their revenues in the next few years.

LUHG

Arsenal’s 2009/10 results: overall business in excellent shape but industry headwinds persist

Arsenal Holdings plc today published preliminary results for the year to 31^st May 2010 (full accounts will be available in due course). This is my initial take on the figures.

Overview

The business is in very good shape overall. The strategy of borrowing to finance the building of the Emirates and the redevelopment of Highbury into apartments has clearly paid off. Net debt has fallen to £135.6m (2.4x football EBITDA) compared to a peak of £318.1m two years ago. All the debt incurred to redevelop Highbury has now been repaid and the Emirates financing is on a fixed rate of 5.3% with a maturity of around 20 years. The Highbury Square development generated operating profits of £15.2m, almost double last year's £7.8m. Now the property business is debt free, it should provide a useful fillip to cash flow in the next two years after which all sales will be complete.

Football profits (before player sales) are down because of rising costs and flat turnover. Higher profits on player sales compared to the previous year means profit before tax is up.

On these figures Arsenal will comfortably meet the new UEFA Financial Fair Play rules, in fact in this area it is probably the best placed of all the major English clubs.

Football revenue

All general admission and "Club Tier" season tickets sold out for the current season. The stadium brings in almost £3.5m of revenue per home game which is almost as much as Old Trafford (£3.6m per home game in 2008/09) despite the latter having a capacity 26% higher. This impressive sales performance is only part of the story of course. The further a team progresses through competitions the more income is generated and matchday income actually fell 6% in 2009/10 due to fewer home games being played (there was no CL semi-final for example).

Reflecting the improved Champions League TV deal that began in 2009/10 (and despite being knocked out a round earlier than the previous season), broadcasting income rose 15% to £85m. Arsenal significantly underperform United on media income due to a smaller share of the important CL "market pool" (Arsenal received €16.4m to United's €28.8m last year). The division of the pool is determined by the relative performance of clubs from each country and finishing places in the domestic league. Next year (in common with every other PL club), the new overseas rights deal means PL media income will rise by an estimated 10%.

Commercial and retail turnover declined year-on-year with both areas seeing falls of c. 9%. The club blamed this on their "...sensitivity to the recessionary climate". Arsenal are miles behind United, Real, Bayern and Barca when it comes to commercial revenue and recruited a new Chief Commercial Officer a year ago to improve in this area.

Overall, the increase in media income was not sufficient to offset weak commercial sales and the impact of fewer home games to leave football turnover down marginally.

Football costs

On the cost side, Arsenal have a good reputation for controlling wage costs with the move to the Emirates transforming the club's wages/turnover ratio, but these figures show the significant pressures still evident across football. Total wage costs (for all staff not just players) rose 6.5% and the club warns that there is more to come because "the full cost of a number of the new and revised player contracts entered into in the last 18 months has not yet fully translated into the reported wage cost". The ratio of wages to (football) turnover increased to 49.7% from 46.2%, still very good compared to a number around 80% at Chelsea and over 100% at City. In words that should concern all football clubs and supporters, Arsenal say:

"...there continues to be very strong upward pressure on players' wage expectations."

Football profits and margins

The wage pressure and slightly weaker turnover meant that EBITDA (before the impact of player sales) fell 13.5% year-on-year (a decrease of 375bps in the margin to 25.7%). The player amortisation charge rose by a moderate 4.8% to leave football EBIT down 34% at £20.4m.

Thankfully for the club, the sales of Adebayor and Kolo Toure to the ever generous Manchester City generated a profit of £38.1m vs. £23.2m in the prior year. This allowed EBIT including player sales to actually rise 8.5% to £58.5m. Football interest costs (the Emirate bonds) were down 1.7% to leave football PBT up 12.1% at £45m.

What we should take from this

Arsenal is a very well run club. Debt is totally under control, the business is profitable and cash generation is strong. Industry pressures (and underperformance on the pitch) means,  however, that there is little growth in the business.

These results also tell us quite a lot about the current economics of English football.

For those clubs with large modern stadiums, matchday still remains the most important element of turnover but growth in this area is hard to come by and revenue is of course highly dependent on the number of home games played.

The current growth cycle from media is clearly illustrated in these figures with Arsenal showing an increase year-on-year despite a weaker performance on the pitch as the new CL deal kicks in. But media growth is not a one way street and at 37% of media income the importance of CL qualification is obvious. I remain sceptical about ongoing football rights inflation. The domestic PL rights for the next three years have declined in real terms compared to the last deal perhaps showing early signs of maturity. International growth has been phenomenal, but may also be nearing a peak with some broadcasters now paying more per capita for PL rights than Sky/ESPN in the UK!

Commercial and retail revenue is obviously under pressure from the recession and with the prognosis for the UK economy dull at best, this trend seems likely to continue. Arsenal are determined to catch up with the best in class performance of United and the major Spanish clubs.

Whilst revenue for Arsenal and for most large English clubs looks to be stagnating, cost pressures remain very pronounced. Many hope that limits on squad sizes and the new UEFA Financial Fair Play regulations will moderate transfer and salary inflation, but there is no evidence of that from these figures.

Along with other big English clubs, Arsenal rely quite heavily on profits and cash from player sales (excluding the sale of Ronaldo the top seven English clubs reported an average profit on player sales of £19m in the 2008/09 season). The sharp decline in transfer activity over the summer means this year this source of profits cannot be relied upon. Arsenal say:

"There has been very limited player sale activity during the summer transfer window. As a result, in contrast to each of the previous three years, we do not have a significant profit on disposal of player registrations on the books at this stage of the new financial year. Subject to any transfer activity in the January 2011 window this may impact the final level of profits to be reported for the financial year 2010/11."

The flipside to lower receipts from sales may in the longer run be lower amortisation charges for clubs, but in the shorter term the impact may well be negative.

These results show what a prudently financed, well managed football club should look like. The sharp decline in net debt (debt taken on only for the purposes of investment, not to finance an LBO) stands in stark contrast to position of Manchester United and Liverpool.

Finance does not of course win trophies, and it has been five years since Arsenal has won one (and that was totally undeserved), but in a difficult world Arsenal look financially well placed.

LUHG