I Owe You Nothing

Swiss RamblerContributor IMarch 5, 2010

In a period when most English football clubs seem to be lurching from one financial crisis to another, culminating in Portsmouth going into administration last week, Arsenal’s recent half-year results shone like a diamond in a dustbin. While most have focused on fans protesting at the mountain of debt constructed at Manchester United, the Glazer family’s plaything is by no means the only team that is leveraged to the hilt, as evidenced by the recent UEFA report which stated that 56% of all the football debt in Europe was held by 18 clubs in the English Premier League. And this figure excluded basket cases Portsmouth and West Ham, who did not even qualify for a UEFA licence, so it’s fair to say that English football is grappling with a major debt problem.

Therefore it was hardly surprising that the media reacted so positively to Arsenal’s results for the six months ended 30 November 2009, which included a dramatic £129.2m reduction in net debt from £332.8m to £203.6m. Moreover, profit before tax of £35.2m rose an impressive 44% from £24.5m in 2008 on the back of turnover of £196.8m (up from £156.8m the previous year). This is an impressive performance by anybody’s standards and is fair reward for a club that has consciously tried to manage its business in the right way. However, contrary so-and-so that I am, whenever I see the media universally applaud anything, I am always a tad sceptical, so thought it worth digging a little to see if everything is indeed as wonderful as it appears on the surface.

"Peter Hill-Wood - Old Skool"

The first obvious point to note is the impact of property development, which was acknowledged by Chairman Peter Hill-Wood, the original Eton Rifle, who stated that, “This has been a particularly strong period for our property business with Highbury Square making a significant contribution to the results”. You can say that again. Property development accounts for almost half of the turnover with £96.6m, compared to football revenue of £100.2m. Even more striking is that just about all of the Group’s year-on year revenue growth of £40.0m comes from the property arm (£38.2m), while the football segment barely grew at all with a miniscule increase of £1.8m. The huge importance of property development is further emphasised when looking at operating profit (before player trading, depreciation and finance charges). At a Group level, this actually dropped £0.5m to £29.3m and this was again a “game of two halves” with property rising £5.0m to £11.3m, while football fell £5.5m to £18.0m – that’s nearly a 25% decrease.

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The press release made great play of the fact that the pre-tax profit from the “core business of football” increased to £25.8m from £19.7m, but again this is a little misleading, as it includes £20.8m from player trading, primarily the sales of Adebayor and Toure to Manchester City, up from “only” £8.0m in 2008. Excluding this £12.8m increase, as you would not expect (or hope) for similar big money sales every season, the football operating profit was actually £6.7m lower than the prior year. Not only that, but the profit margin on the real core business, assuming that Arsenal are not a selling club, was slashed by almost 60% from 11.9% to 5.0%, which has to be a cause for concern. In fact, the reported increase of £10.7m in Group profit before tax to £35.2m would also have been more than wiped out if this factor were excluded.

"Ivan Gazidis - facing the future"

Let’s be very clear about this: even if the once-off profits from property development of £9.4m and player trading of £20.8m were to be excluded, Arsenal would still have made a profit, but it would have been considerably lower at just £5.0m. This argument may remind some of the old saying, “if my aunt had balls, she would be my uncle”, but I do think that it’s worth exploring the underlying fundamentals, as Arsenal will exit the property business in the foreseeable future and no fan wants the club to sell their best players every summer.

So, why has the football business become less profitable? You don’t have to look too far for the main reason, which is a “significant increase” of £10.1m in operating costs to £101.4m, largely due to the £8.6m rise in player wages, despite the departure of Greedy-bayor and Toure, who were on pretty high wages. This reflects the re-signing of 17 first-team players on long-term contracts, which the Chairman described as an “investment in a very talented group” and as the “best means of protecting the value of one of our most important assets”. That may well be true, but it still goes against the grain to reward these players for: (a) not winning any trophies for five years; (b) spending lengthy periods in the treatment room with assorted injuries and ailments. This level of investment implies an annual growth of around £20m in player salaries, on the assumption that the increases were spread throughout the period, which is a lot of additional cost to carry, especially as Cesc Fabregas’ new contract will inevitably mean even higher costs.

"Businessman of the year"

Such an increase in the cost base is clearly worrying, but would not be that big an issue if the revenue were rising at the same rate, but the problem is that it only grew by an insignificant £1.8m (less than 2%). Gate and match day revenue is still the highest portion of football revenue at £41.4m, but this was £3.0m lower, though to be fair this is simply a reflection of one less home fixture against the comparative period last year. Commercial revenue also fell – by £0.9m to £23.4m, due to “recessionary factors”. On the other hand, broadcasting revenue grew by an impressive 23% to £35.4m, mainly due to the extended run in the Champions League.

The really good news in these accounts comes from the property side, where there has been considerable progress over the last few months. The last couple of reports have stressed the risks and uncertainty arising from the property downturn, but now “the position is completely different”. Indeed it is: sales of 261 apartments at Highbury Square increased turnover by 65% from £58.4m to £96.6m, while operating profit was up almost 80% at £11.3m. This means that 524 of the 655 private apartments have now been completed with cumulative revenue of £217m, leaving only 131 units still to sell. The proceeds have been used in repayment of the project’s bank debt, which was cut from £123.6m in May to £35.7m in November and has been further reduced to £12.9m since these accounts were published with Hill-Wood stating, “we can clearly now anticipate the point at which the (Highbury Square) project will become debt free”. Furthermore, the sale of the social housing element of the Queensland Road development site to Newlon Housing Trust means that the Group’s other property activities are now also free of debt.

"How much is my budget?"

The breakthrough in property sales has resulted in a staggering reduction of £129.2m in net debt from £332.6m to £203.6m, which is presumably now down to £180.8m, given the further reduction of £22.8m in the Highbury Square balance. This is a major achievement, which is worthy of the lavish praise from the media, especially when you consider the £716m (and rising) of debt that the Glazers have loaded onto Manchester United. However, I would point out that most journalists have been comparing apples with pears here, as the United figure is gross debt, i.e. ignoring £140m of cash, while Arsenal’s gross debt is actually £305m, before including £101m of cash to produce the net debt of £204m. Even so, it’s clear that Arsenal are prudently managing their balance sheet with new kid on the block, Chief Executive Ivan Gazidis stating, “I think it’s important that clubs act responsibly with respect to debt”. Having said that, it’s all relative. For example, Portsmouth went into administration with debts of around £75m, which is a lot less than Arsenal’s reduced balance, but the point is that Pompey cannot service their debt, as their earnings capacity is much lower and their cost base is too high compared to those earnings.

Enough already with the past, there are some key questions that need to be answered in the future:

1. Can revenue from the football business be increased?

(a) Commercial revenue – this is clearly an area of weakness with revenue lagging way behind the club’s English peers. According to the Deloitte's Football Money League 2010, Arsenal’s annual commercial revenue of £48m is much lower than the other teams in the so-called “Big Four” (Manchester United £70m, Liverpool £68m and Chelsea £53m). The comparisons are even worse against the continental European teams (Real Madrid £119m, Barcelona £96m and Bayern Munich £136m). Understandably, Arsenal tied themselves into long-term contracts with Emirates (stadium naming rights until 2021, shirt sponsorship until 2014) in order to provide security for the stadium financing, but recent deals by other clubs highlight the opportunity, which is probably worth another £20m a year. Gazidis is well aware of this and has recently restructured and strengthened his commercial team to explore new partners and overseas markets.

"That's what I call branding"

(b) Gate and Match Day revenue – partly depends on the number of home games that the club plays, which is in turn dependent on how far the club progresses in the various Cup competitions. Deloittes estimated that 20% of Arsenal’s total revenue came from participation in the Champions League in 2008/09, when they reached the semi-final. It is difficult to see how the club could greatly increase ticket prices, which are already among the highest in Europe. Indeed, demand at the higher end has not been so strong this season, which is important, as those 9,000 premium seats generate approximately 35% of match day revenue. Any continued lack of success in terms of winning trophies might also negatively affect demand.

(c) Broadcasting revenue – this is again partly linked to performance on the pitch, especially in the Champions League. Despite the recession, football continues to be vitally important to television companies. Whatever faults Premier League Chief Executive Richard Scudamore may have (and there are many), he has secured some impressive broadcasting deals, recently increasing the domestic rights contract by 4% to £1.8 bln for the three years from season 2010/11 and overseas rights by a rumoured 70% to £1.2 bln for the same period. However, the top English clubs suffer from the Premier League’s collective bargaining, compared to the Spanish giants, Real Madrid and Barcelona, who are allowed to negotiate individual deals with broadcasters, thus earning almost twice as much (£137m) as Arsenal (£76m).

"More Songs About Buildings And Food"

2. Can costs be controlled?

This is difficult to address, as the accounts do not provide much detail for operating costs, but we do know that players’ salaries have significantly increased as a direct result of the strategy to sign young players to long-term contracts. I can only see this trend increasing, especially if the market continues to be artificially inflated by the arrival of extremely wealthy benefactors. The weakness of Sterling and the harsh UK tax regime also makes countries like Spain more attractive for players, which can only be compensated by increasing gross salaries in England. I don’t think that it is in Arsenal’s DNA to demolish the wage structure, unless the Board suffers a communal fit of madness and appoints Harry Redknapp, but Arsenal’s wage/revenue ratio is currently among the lowest of top football teams, so costs are more likely to increase than fall here.

3. How much money could the club get from property development?

Peter Hill-Wood confidently stated, “It is clear that the next couple of years will see our property activities deliver excess cash”. Ivan Gazidis confirmed, “We will soon be delivering a profit back into the football side of the Group”. We can estimate the value of the 131 remaining apartments at Highbury Square as between a conservative £32.8m (assuming the quoted starting price of £250k) and £54.3m (based on average price for sales to date of £414k), which would produce net proceeds of £19.9m to £41.4m, say £30m, after clearing the outstanding debt of £12.9m. That would be an extraordinary achievement in the current economic climate. Furthermore, the club’s other three property assets (Queensland Road market housing, Hornsey Road and Holloway Road) are now free of debt following the sale of Queensland Road social housing, so any future sales here represent pure profit, generating cash that would be available to use elsewhere in the Group. I have no idea what that could be worth, but let’s say £10m.

"I'll tip my hat to the new constitution"

4. How much money could be available for transfers?

Arsene Wenger has always maintained that he has the funds to compete in transfer negotiations. This was confirmed by Ivan Gazidis when commenting on the results, “We have money available to invest in the transfer market, when we can identify the right players to add into the mix that add something to the squad”, but just how much money could be available? The starting point is £101m of cash, but £22m of that must be maintained on deposit as security against future interest payments, leaving £79m. To that, we could add £30m from the sale of the remaining Highbury Square apartments plus the £10m guesstimate from the other three property assets. The core football business should also contribute £10m, which is calculated based on annualising the £5m profit for the last six months, having stripped out the £20.8m earned from player trading. Against that, the accounts mention contingent liabilities of £11m, which represent further transfer fees payable to other clubs is players make a certain number of first team appearances, play for England, etc. All this gives you a very rough figure of £118m for the transfer pot. Wow. Of course, Arsenal still have to pay a hefty annual interest charge of around £20m (£5m repayment, £15m stadium financing) for many years, so they might want to reserve even more than the specified minimum, unless they can substantially increase commercial revenue. Either way, there will definitely be a lot of cash available.

5. How will the funds be invested?

Well, we already know that Arsene Wenger’s budget not only covers the purchase of new players, but also salaries, so it is likely that some cash will be allocated to improving the contracts of the existing squad, most notably Cesc Fabregas, but potentially also Andrei Arsahavin. Those fans that would prefer to see the club put money into the “Arsenalisation” of the team rather than the stadium, would be comforted by Ivan Gazidis’ comments after the results, “We have delivered a profit before tax of £35m for the first half of the year, but it’s important to note that this isn’t our primary objective. The reason we run a responsible, profitable and self-sustaining business is so that we can deliver success to the club and invest in the club and ultimately deliver success on the pitch”. However, Peter Hill-Wood said, “In addition to investing in the team, I think we will examine investment in club projects and infrastructure … into the next phase of growth”. Might that mean expanding the stadium to 80,000, as per the original design?

"Hands off, she's mine"

6. What will happen to the club’s debt?

The majority of Arsenal’s debt is long-term, a mixture of fixed rate bonds £178m, floating rate bonds £53m and debentures £26m, at an average interest rate of around 5.6%, which is much lower than the exorbitant rates required by Manchester United’s lenders (over 9% on the bonds and an eye-watering 16.25% of the PIK notes). Net finance charges for the last six months actually increased from £7.9m to £9.2m, but that is almost entirely due to lower interest receivable, as interest rates have declined. It’s not clear whether it would be possible for Arsenal to pay off this debt early in order to reduce the interest charges, but my guess is that they are in no hurry to do that, as Gazidis has argued that debt is sometimes justified, “The debt that we’re left with is what I would call ‘healthy debt’ – it’s long term, low rates, very affordable for the club, and it’s effectively a mortgage on our stadium, which generates revenue for the club. Not all debt is bad and I think Arsenal’s debt delivered an asset to the Club that will be an asset for generations to come in our stadium”.

7. Will the financial success have any impact on the club’s ownership?

Some people have claimed that the Board’s desire to reduce the debt is part of some sort of Machiavellian scheme to make the club more attractive to a prospective purchaser like “Silent Stan” Kroenke or Alisher “Fat Boy FatUsmanov. Granted, both Danny Fiszman and Peter Hill-Wood have sold shares to Kroenke, but this does feel like a conspiracy theory too far. For one thing, everything else being equal, increased profits should increase the share price, making any acquisition more expensive. On the other hand, you could argue that this would make selling shares more attractive for the current directors. The real concern is that any take-over would be in the form of a leveraged buy-out (like Manchester united), which would mean that the club would once again be saddled with large debts, but frankly this could happen at any time.

"Of course, we're going to buy"

The Board should be commended for how they have managed the club’s finances over this challenging period, especially as Arsene has kept the team competitive, albeit not actually winning anything. When it became palpably obvious that Highbury was simply too small to provide the revenue required for a major European club and could not be expanded, due to the proximity of local housing and two stands being listed, the club embarked on an ambitious five-pronged strategy: (a) develop and sell Highbury; (b) build a new stadium with a much larger capacity; (c) invest in the youth academy to develop talent; (d) improve and sell players to cover finance charges; (e) not waste money on big money transfers.

This could loosely be described as the Barcelona model, whereby you rely on bringing through young talent, coached to play in the club’s style, and supplement this with a couple of world class acquisitions every season. Arsenal are not quite there yet, and some may argue that they have erred too much on the side of frugality when it comes to the transfer market, but they will soon be able to exit the property business and fully concentrate on football. At that stage, we will see whether the strategy was successful – not just in property development, but also on the pitch.

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