Tuesday, October 5, 2010

How Manchester City Could Break Even


Just a week after Arsenal reported record profits of £56 million, the other side of the football finance spectrum was seen when Manchester City announced a massive loss of £121 million for the year ending 31 May 2010. This is not quite the worst loss ever reported in Premier League history - that dubious honour belongs to Chelsea, who lost £141 million in 2004/05, the first full year after the acquisition by their Russian benefactor Roman Abramovich. However, to put this into context, City’s deficit is more than the combined loss for every other team in the Premier League if you exclude Chelsea (or Liverpool).

This is also the first full financial year since Sheikh Mansour’s Abu Dhabi United Group bought Manchester City and it is no coincidence that the club has made huge losses ever since the takeover, as it is striving for rapid sporting success. Last year’s loss of £93 million was the largest by far in the Premier League and it will surely be no different for this year’s loss.

As chief executive Garry Cook explained, once again dipping into his tried-and-trusted book of corporate clichés, “Manchester City football Club is undergoing a significant transformation and our financial results for 2009/10 reflect the pace of that process through rapid and ongoing investment in our infrastructure, facilities and professional capabilities.” English translation: we’re spending loads of money, so we’re making big losses.

Hidden among all the financials is Manchester City’s fifth position, which is their best ever finish in the Premier League, and represents some justification for this heavy expenditure. There is no doubt that the club’s prospects look brighter than they have done for some time, but it’s certainly cost them a lot to get here. When looking at the accounts, two areas in particular stand out: the huge transfer spend and the growing wage bill.

Since Sheikh Mansour’s arrival, the club has splashed out over £350 million in transfer fees, averaging more than £100 million each season. This marks a sea change for City, which had been a bit of a selling club in the preceding years, but there have been few signs of this outlay slowing down. In fact, this summer City spent around £128 million on new players, though they did recoup £28 million from the sale of Robinho, Stephen Ireland and others.

As surely as night follows day, transfer expenditure of this magnitude will also result in a significant increase in the wage bill and this has certainly been the case at City. Wages grew by 61% last season from £83 million to an incredible £133 million. This is still lower than Chelsea’s £149 million, though that should now be reduced after high earners like Joe Cole, Michael Ballack and Ricardo Carvalho all came off the payroll this summer. However, City’s wage bill has now overtaken three clubs: Manchester United £123 million, Arsenal £111 million and Liverpool £90 million. Incidentally, it’s also more than twice as much as Spurs (£59 million), the team that edged City out for the final Champions League qualifying place last season.

Actually, wages have been growing apace for the last few years (49% in 2008, 52% in 2009), but there’s still no end in sight, as the £133 million does not include the impact of this summer’s incoming players (Yaya Toure, Mario Balotelli, David Silva, James Milner, Jerome Boateng and Aleksandar Kolarov).

In fact, the wage bill alone is now higher than the club’s revenue of £125 million, leading to a wages to turnover ratio of 107%, which is considerably higher than UEFA’s recommended maximum limit of 70%. Just two years ago, the club had managed to stay below this guideline with a more reasonable ratio of 66%. Needless to say, the current ratio is the highest (worst) in the Premier League and far higher than Manchester United 44%, Arsenal 50% and even Chelsea 68%.

Off the pitch, the situation looks no better with the number of staff working in commercial or administrative activities also increasing by more than 50% from 146 to 223. The highest paid director, presumably Garry Cook, received a whopping £1.8 million, up from £1.4 million a year ago. This is exactly the same amount that Arsenal paid their chief executive, Ivan Gazidis, but the former MLS deputy commissioner managed to bring in a very healthy profit, while the Gunners once again qualified for the Champions League.

Of course, there was some good news in the accounts, notably City reporting revenue over £100 million for the first time in the club’s history with a 44% rise in turnover from £87 million to £125 million. Although chairman Khaldoon Al Mubarak said, “We are encouraged by the growth in the club’s capacity to generate revenue from various sources”, it is clear that the vast majority of the £38 million increase has come from commercial revenue, which rose £30 million from £23 million to £53 million. Much of this has come from “corporate partnerships” after new agreements were signed with a number of what could be reasonably described as “friendly” partners, including Etihad Airways, Etisalat, the Abu Dhabi Tourism Authority and Aabar.

This growth might be fairly impressive, but it still leaves City’s revenue way behind the traditional Big Four. Manchester United’s £279 million is more than twice as much, while Arsenal’s £223 million and Chelsea’s £206 million are £100 million and £80 million higher respectively. Even Liverpool’s recent disappointments have not prevented them generating £60 million more revenue than City.

Of course, none of this financial weakness matters too much while the owners are supporting the club and covering the losses by pouring in substantial funds. Their generosity went a stage further last year, as explained by Graham Wallace, the chief financial officer, “The financial foundations upon which the club operates have been strengthened with the conversion into equity of £305 million in shareholder loans.” A further demonstration of commitment from the owners came when they purchased an additional £189 million of shares, taking their total investment in the club to nearly half a billion.

It should be noted that City are not quite debt-free yet, as they still have £36 million of outstanding loan notes and bank loans plus £39 million provided for future stadium rent, giving gross debt of £75 million. If cash balances of £35 million are taken into consideration, the net debt is only £41 million, which is still very low, though the accounts also reveal that City owe other football clubs an amazing £81 million, most of which falls due within one year.

"What have I let myself in for?"

Manchester City’s strategy is eerily reminiscent of the one adopted by Chelsea, namely to invest heavily in new players with the objective of gaining success on the football pitch, thus generating significantly higher revenue that will ultimately be enough to cover the growth in costs. As celebrity City supporters Oasis would no doubt say, “it’s all part of the master plan.”

The CFO confirmed this, “the club’s overall financial performance for 2009/10 is in line with the Board and management team’s long-term financial and operating strategies and consistent with expectations at this stage of the financial process.” That’s all very well, but keen observers of football finances will have noted that Chelsea are still nowhere near self-sufficiency, even though they have been telling us for years that they are on course to break-even. Although they have in fairness been reducing their losses year after year, they still made a large loss last year of £47 million.

To be honest, this probably would not have mattered much without the advent of the UEFA Financial Fair Play Regulations, which aim to “introduce more discipline and rationality in club finances and to decrease pressure on players’ salaries and transfer fees.” Under this regime, clubs will have to balance their books and operate within their financial means. In other words, they will be required to break-even by spending no more than they earn.

"The only way is up"

UEFA have explicitly stated that clubs like Manchester City cannot continue making huge losses, even if they are supported by a wealthy benefactor. Although this initiative has no impact on domestic leagues like the Premiership, clubs that fail to make profits will ultimately be excluded from European competitions. Given the magnitude of City’s losses, it will be a major challenge (at the very least) for them to reach break-even, though Garry Cook said, “The plan is to grow the revenues further, control costs and have young players coming through to replace some senior players. We want to be sustainable and intend to comply with financial fair play.”

The first season that UEFA will start monitoring clubs is 2013/14, but this will take into account the losses made in the two preceding years, namely 2011/12 and 2012/13, so the accounts need to be in far better shape in just two short years.

However, they don’t need to be absolutely perfect by then, as billionaire owners will be allowed to absorb aggregate losses (so-called “acceptable deviations”) of €45 million (£39 million) over the three-year monitoring period, as long as they are willing to cover the deficit by making equity contributions. The maximum permitted loss then falls to €30 million (£26 million) from 2015/16 and will be further reduced from 2018/19 (to an unspecified amount). Of course, this is still a much smaller loss than City are currently reporting, so it’s hardly going to be a walk in the park to get down to the initial, softer definition of “break-even”.

UEFA have provided some assistance, as their break-even calculation excludes any costs incurred for what they term sensible, long-term investment like improving the stadium, training facilities, youth and community development. In this way, City’s starting point in UEFA’s template is £6.7 million better than their published loss, as it excludes £4.5m depreciation on fixed assets and £2.2m stadium finance lease charges, giving a revised loss of £115 million. OK, a little better, but still a long way to go.

Nevertheless, Manchester City appear confident of meeting the new requirements. As Cook said, “The last thing we want is not getting a licence to appear in the greatest league.” However, many appear sceptical, especially as City have not provided any details of exactly how they are going to achieve this minor miracle. Indeed, many believe that this will prove impossible, unless the club somehow discovers some loopholes in UEFA’s regulations.

I’m not so sure.

Having taken a close look at the financials, I believe that City could legitimately be in line with the guidelines over the next few years and have prepared a 10-point plan to show how they could make it.

At this point, I should emphasise that the actions I suggest are by no means the only way of reaching break-even, but they should demonstrate that this objective is not as unfeasible as some believe. This plan assumes that the club’s owners would not be overly concerned about investing even more capital, nor about making lower profits in some parts of their organisation. In other words, this would not necessarily be the best use of their resources, but this would not be an issue, as the primary objective would be to get down to the elusive break-even target.

1. Wages

The first thing to say is that the financials will get worse before they get better, as the impact of the new players arriving this summer is reflected in the accounts, though this is partially offset by players leaving. We do not know exactly how much each player is paid, but we can make some reasonable estimates.

My assumed weekly salaries for those coming in are as follows: Yaya Toure £200k, Mario Baolotelli £150k, James Milner £130k, David Silva £120k, Jerome Boateng £100k, Aleksandar Kolarov £100k. That would increase the wage bill by £42 million a year.

"Yaya Toure - does my bum look big in this?"

Against that, City sold Robinho, Stephen Ireland, Valeri Bojinov and Javier Garrido, while they also released Benjani, Sylvinho and Martin Petrov. We know that Robinho was a high earner (reportedly £160k a week), while I would expect Ireland to be on around £70k. The others were recruited during a less spendthrift era, so let’s assume an average £40k here. All of this would mean £22 million coming off the payroll.

The net impact of these movements is an increase of £20 million in wages to around £153 million. This year’s accounts also include a severance payment to former manager Mark Hughes and his team, which may or may not be repeated next year, depending on Roberto Mancini’s ability to survive, but it’s immaterial in any case.

Of course, City might bring in even more players in January, though not to the same extent, if you believe Garry Cook, “It is safe to say that player acquisitions on the scale we have seen in recent transfer windows will no longer be required in the years ahead now that we have such a deep and competitive squad.”

Another possibility that would help reduce the wage bill is offloading players who are no longer wanted, either via loans (like Craig Bellamy to Cardiff City and Nedum Onuoha to Sunderland) or selling them at a loss. We can anticipate the club selling the likes of Roque Santa Cruz and Jo at generous prices in order to get them off the books.

"Robinho flying off to Milan"

Such sales have a triple whammy effect, as they also reduce amortisation and potentially bring in a profit on sale (if the price is higher than the remaining value in the accounts). If we take Robinho as an example: he was bought for £32.5 million in September 2008 on a four-year contract, so annual amortisation was £8.1 million. He was sold after two years, so cumulative amortisation was £16.2 million, leaving a value of £16.3m in the books. Sale price to Milan is reported as £18 million, so City will report a profit on sale of £1.7 million in the 2010/11 accounts. Therefore, City will show an annual profit improvement of £18.1 million after this deal: £8.3 million lower wages + £8.1 million lower amortisation + £1.7 million profit on sale.

In my plan, I have assumed that there will be negligible profit on sales, effectively maintaining the £10 million that was booked in 2010, which is a relatively low figure for a top club, but seems a reasonable estimate in the specific case of Manchester City.

In the long-term, City would hope to progress their youth players into the first team, replacing some of the expensive imports. This was explained by Brian Marwood, the exotically titled chief football administration officer, “For both financial and strategic reasons, it makes sense for Manchester City to develop and draw upon as much talent as we can from within our own academy and development squads in the future.”

Finally, once the club establishes itself as a regular presence in the Champions League, they should no longer have to pay players over the odds in order to attract them to the blue half of Manchester.

"Super Mario"

2. Amortisation

As we have seen in the Robinho example above, when a player is purchased, his cost is capitalised on the balance sheet and is written-down (amortised) over the length of his contract. Importantly for Manchester City, this means that the cost of their recent purchases will have an impact on their accounts over the next few years via the amortisation charge.

We can see this effect over the last four seasons, as amortisation has grown significantly from £6 million in 2007 to £71 million in 2010. To place that into context, the next highest in the Premier League is Chelsea at £49 million, though they did get as high as £83 million in 2005 after their own version of supermarket sweep. Even big spending Barcelona and Real Madrid have lower player amortisation than City at £61 million and £55 million respectively.

Like salaries, any calculation here involves a degree of guesswork and is influenced not just by the players coming in, but also those leaving the club. The Guardian estimated £75 million for the 2011/12 season, but I’m going to be more conservative and assume that it increases by £10 million to £81 million.

"In good Kompany"

3. Premier League

Although City’s television revenue has been partially influenced by cup runs, notably £6m in 2009 for reaching the quarter-finals of the UEFA Cup, the vast majority of their money comes from the Premier League central distribution. City received £50 million this season, which was a £10 million improvement on the previous year, thanks to a higher merit payment (after finishing fifth compared to tenth) and more matches broadcast live on television. Next season, like other clubs, they should receive a further £10 million increase, as the new Premier League 2010-13 deal kicks, following the much higher sale of overseas rights.

4. Champions League

A key element of City’s business plan is to qualify for the Champions League, which has been so beneficial from the financial perspective to the Big Four. Last season, Chelsea earned £28 million for reaching the last 16, i.e. qualifying from the group stage, which would be a reasonable aspiration for City. Prize money will slightly increase, so this should be worth at least £30 million in the future. Of course, reaching the Champions League would also bring in higher gate receipts (assume £3 million) and trigger higher payments from sponsorship agreements (assume £5 million).

"Hart of gold"

5. Commercial Revenue

The real success story in the accounts was the 125% increase in commercial revenue. City signed new marketing deals with Etihad and Umbro, replacing Thomas Cook and Le Coq Sportif as shirt sponsor and supplier. These contracts are reportedly for much more money, so Etihad’s deal is worth £25 million over the next three seasons, compared to Thomas Cook’s £2.3 million annual payment, while Umbro have entered into a ten-year strategic partnership for more than £50 million, which helped retail sales and merchandise revenue rise 60% to £8 million.

This is the area where those fans who have not bothered to plough through UEFA’s regulations (and who can blame them?) see an easy way to reach the target. Why doesn’t the Sheikh sign a £200 million sponsorship deal? Or pay £50 million a season for a super-VIP executive box?

Unfortunately, that simply will not fly, as UEFA have introduced the concept of “fair value” so beloved of tax authorities when reviewing inter-company transactions. In short, if an owner over-pays for services, this will be adjusted down to market value, i.e. what the club would have received if the transactions were conducted on an “arm’s length” basis. Obviously, there is still some scope for manipulation, but the most blatant excesses should be prevented.

"Garry Cook - a lot to think about"

Having said that, even within these limitations, there is still scope for improvement, as City could point to much higher shirt sponsorship deals with other Premier League clubs. For example, the Etihad deal is worth £7.5 million this season, compared to the £20 million received by Liverpool and Manchester United from Standard Chartered and Aon respectively, so there’s a potential £12.5 million increase right there.

My plan assumes that City could easily justify an increase in their commercial revenue to the same level as Manchester United, which should be around £80 million this season. City’s current revenue here is £53 million, but I have already added £5 million for Champions League qualification, so that implies further growth of £22 million.

Of course, this is still a long way short of the astonishing £136 million commercial revenue earned by Bayern Munich, which is made up of numerous commercial deals, so there is possibly even more capacity for revenue growth here. It might be difficult for UEFA to argue against a club securing many £5 million deals, which could add up to a tidy sum.

"Would you Adam and Eve it?"

6. Loans

Interest charges have already fallen considerably from £17 million to £4 million following the conversion of shareholder debt to equity, but the club could presumably also pay off the remaining bank loans early to completely remove interest payments. This might not be the best move financially, as it would almost certainly involve penalty payments, but remember that our objective is to reach break-even.

7. Cash

Similarly, the club could generate interest income if the owners are willing to tie up capital in the club’s bank account. As we all know, interest rates are very low at the moment, so that means a lot of capital would be needed to produce relatively small amounts of interest. I assume that UEFA’s fair value review would also more than raise an eyebrow if the cash balances were ridiculously high for the club’s operational requirements. However, Manchester United’s last accounts included £151 million of cash (albeit boosted by the £80 million received for Ronaldo), while Arsenal’s cash balance stands at £128 million. Therefore, I think City could get away with, say, £167 million which would generate annual interest of £5 million at a rate of 3%, which should be achievable.

"Room for growth"

8. Stadium

Although ticketing revenues increased by £3 million to £18 million in 2009/10, thanks to extended runs in the FA and Carling Cups, City’s gate receipts are still extremely low compared to other Premier League clubs. As a shocking comparison, their neighbours Manchester United trouser £109 million from match day revenue.

Unfortunately the club is restricted in its ability to greatly increase its match day revenue by the fact that it does not own the City of Manchester Stadium, which is rented from the council on a 250-year lease. The rental payments are based on a formula whereby the club retains receipts up to the 34,000 capacity of Maine Road, their old ground, but has to pay 50% of any revenue above that to the council This means that City do not fully receive the benefit of higher attendances, as it just means more rent paid to the council.

There has been some talk that the club would seek to buy the stadium from the council, but recent reports indicate that it is more likely that they would try to renegotiate the terms of the lease to a flat fee. This would be higher than the current payments, but would allow the club to get more benefit if they expand the capacity. This has certainly been discussed as part of England’s bid to host the 2018 World Cup - possibly to 75,000, but more realistically to 60,000, including more corporate hospitality facilities.

"Born offside"

City’s average attendances have been continually rising over the past few seasons from 40,000 to 45,500, which is now the third highest in the Premier League, though worryingly this is still short of the 48,000 capacity. Clearly, there must be some doubt about City’s ability to fill a new stadium, but if the team is successful on the pitch, you would have to assume that this would draw higher crowds.

In any case, given that Liverpool earn £43 million of match day revenue from the 45,000 capacity Anfield, it does not seem unreasonable to assume that City could at least match that, which would imply an increase of £25 million from the current £18 million.

9. Naming Rights

I would be surprised if any discussions with the council about the stadium did not include the possibility of renaming the stadium. It’s not quite the same as Arsenal naming their ground The Emirates, as this was a brand new ground, but it’s not as if there’s an enormous amount of football tradition associated with Eastlands, so I would not anticipate much (if any) resistance from the supporters. It’s difficult to put a price on naming rights, as there are very few comparatives available, but I don’t think £15 million a season is totally unrealistic.

10. Sportcity Development

Manchester City are planning a £1 billion development for the area around Eastlands stadium. Described as a world class sports and leisure complex, Sportcity will include training facilities for a number of sports, conference halls, a luxury hotel and restaurant. Although there will obviously also be high costs associated with this project, it should still provide very healthy profits.

As a rule, revenue from non-football operations is excluded from the break-even calculation, but clause B. (k) in Annex X allows clubs to included revenue (and associated expenses) from “Operations based at, or in close proximity to, a club’s stadium and training facilities such as a hotel, restaurant, conference centre, business premises (for rental), health-care centre, other sports teams”, so long as these are closely associated with the club. Sound familiar?

Candidly, I have no idea what this could be worth to City, so I have included a notional £150 million turnover, which might produce £30 million profit (at a 20% margin). As Bruce Forsyth would have said in “Play Your Cards Right”, it could be higher or lower, but I don’t think City would invest so much time and money in such a development if the returns did not justify it.

So there we have it – how to turn a £121 million loss into a £4 million profit in ten easy steps. Of course, this plan includes lots of ifs, buts and maybes, but it should at least prove that City’s task is not completely out of the question.

"Roque fights on"

Some of the actions, like developing the stadium and Sportcity, are longer-term in nature, but my guess is that UEFA might make an exception for these, so long as City could demonstrate that the plans were very advanced, especially as they would bring a lot of benefit to the surrounding community with the continuing regeneration of East Manchester.

If this argument is not approved by UEFA, then at least this exercise highlights how much City would have to improve by growing revenue and reducing wages and player amortisation, if they want to meet the target.

The cynics among you would no doubt suggest that all of this is unnecessary, as City will just employ an army of lawyers and accountant to locate the loopholes. Call me naïve, but I would like to think that clubs would not resort to such subterfuge. In any case, UEFA are clearly no mugs, as they have addressed some of the more obvious ways of getting around the new regulations.

For example, many clubs these days have an intricate inter-company structure and there were fears that a club might argue that the football club itself was profitable, while large expenses such as interest payments were paid out of a different company. Clearly, that does not make sense to any reasonable man and UEFA have caught that one, “If the licence applicant is controlled by a parent or has control of any subsidiary, then consolidated financial statements must be prepared and submitted to the licensor as if the entities were a single company.”

"The flying Dutchman"

Others, including the venerable David Conn and the bearded Martin Samuel have suggested some accounting trickery, whereby City would choose to book all the huge transfer spend now as a cost, so that it would not impact future accounts. It is true that UEFA's regulations do allow football clubs to choose "an accounting policy to expense the costs of acquiring a player’s registration rather than capitalise them", but this must be "permitted under their national accounting practice."

This is highly technical, but in my view this is where their argument falls down. Ever since the introduction of IFRS (International Financial Reporting Standards), in particular FRS10 on Goodwill and Intangible Assets, major clubs have used the capitalisation and amortisation method to account for player transfers, so it would be difficult for City to argue that the "income and expense" method had suddenly become appropriate.

In fact, this discussion may now actually be redundant, given that City did not change their accounting policy this season, unless they decide to book a massive impairment provision in 2010/11 (the last year where the accounts are excluded from UEFA’s calculations), dramatically reducing the value of their players in the accounts and reducing future expenses.

In my opinion, this would be blatant earnings manipulation and would not be accepted by UEFA. Ultimately, they will look at the intention of such operations. People often say that the devil is in the detail, but sometimes it's worth stepping back a little and applying some good, old-fashioned common sense. I know that doesn't always work, especially in the legal world, but that's surely the intention.

"That's the spirit"

But will the regulators have the bite to go with their bark? Expelling teams from European competitions works fine on paper, but it might never happen in reality, especially when you consider that Europe’s most indebted teams are among those that attract the largest television audiences. Would UEFA really bite the hand that feeds?

Yes, if you believe Gianni Infantino, UEFA's general secretary, who said, “There may be intermediate measures. We would have to ask why, maybe there would be a warning, but we would bar clubs in breach of the rules from playing in the Champions League or the Europa League. Otherwise, we lose all credibility.”

We shall see, but it need not come to that for Manchester City. As we have demonstrated, it is perfectly possible for them to reach break-even. Of course, this is in no way a fait accompli, but it can be done. Frankly, it would beggar belief if City’s management did not already have a plan in place, but if by some chance they haven’t, mine is available for the usual fee. I’m sure they can afford it.