Tuesday, December 14, 2010

Newcastle United's Finances In Black And White

Just when Newcastle United fans could be forgiven for thinking that their club had abandoned its frequent attempts to act as the setting for one of football’s longest running soap operas, their rotund owner Mike Ashley struck again, sacking the likeable Chris Hughton, who had guided the team to promotion last season on a shoestring budget, and replacing him with Alan Pardew, a man whose track record provides little support for his boundless confidence. In their first season back in the Premier League, Newcastle were handily placed in mid-table, having demolished local rivals Sunderland 5-1 and securing away victories against the likes of Arsenal and Everton, not to mention an impressive win at Chelsea in the Carling Cup.

For some inexplicable reason, Ashley suddenly decided that Newcastle needed a manager “with more experience”, even though more rational observers might point out that Hughton had obviously acquired more experience than when Ashley settled on him as permanent manager at the beginning of last season. As the local paper, the Evening Chronicle, wrote, “To say the appointment of Alan Pardew is bewildering and perplexing to Newcastle United fans is an understatement.”

Of course, Ashley is no stranger to putting his foot in it and on occasions it has felt like he is on a one man campaign to demonstrate that the Premier League’s fit and proper person test is equally useless for English owners as those arriving from foreign shores. Since June 2007, when Ashley bought the club, his tenure has been an almost textbook example of how to alienate supporters with a series of embarrassing episodes being gleefully reported across the media.

"No, thank you, Chris"

The signs were far from promising right off the bat, as Ashley’s purchase bore all the hallmarks of an impulse buy, when he failed to perform the standard due diligence on the club’s books. In fairness, he might have felt that he had to move quickly, but businessmen who fail to look before they leap often end up in a dangerous place. Caveat emptor. He then compounded this error by bringing in the “Cockney mafia”, but their origins weren’t the real issue, rather this was a management team that possessed virtually no experience of running a football club.

Although chairman Chris Mort was popular with fans, his replacement Derek Llambias was previously director of three London casinos, while Tony Jimenez, briefly appointed vice-president responsible for player recruitment, was a director of a small sports agency. To add insult to injury, the man with the most inappropriate surname in football, Dennis Wise, was then recruited as Executive Director of Football. This is the man famously described by Sir Alex Ferguson as a man capable of starting a fight in an empty room, though he’s also proved to be pretty tasty outdoors, as evidenced by his conviction for assaulting a taxi driver.

Wise’s appointment undermined the then manager Kevin Keegan, most obviously with the signings of players such as Xisco and Ignacio Gonzalez, which “King Kev” had not approved. This led to Keegan’s acrimonious departure and a legal case in which the club’s explanation of the circumstances behind his exit was described by the tribunal as “profoundly unsatisfactory.”

"You don't know what you're doing"

Then there was the ill advised plan to sell off the naming rights to St James’ Park, which was guaranteed to upset the Toon Army. As was the brilliant idea to put the club up for sale on its website, when bidders were invited to send applications to an e-mail address, which was only a small step away from those humorous eBay auctions of any football club languishing in the doldrums. In fact, Ashley has tried to sell Newcastle United twice, only to withdraw the club from the market on each occasion. Potential purchasers were presumably put off by the tagline, “One careless owner.”

Of course, the lowest grade on Ashley’s report card must be reserved for over-seeing relegation from the Premier League after 16 seasons in the top flight, when the club enjoyed one of the highest budgets in the league. This was hardly surprising after a series of frankly baffling managerial appointments, starting with the overly sentimental choice of Keegan, followed by Joe Kinnear, who had been out of the game for four years, and culminating in local hero, Alan Shearer, who arrived straight from the Match of the Day sofa confident of keeping the club up, but proceeded to win only once in his eight matches in charge.

This managerial merry-go-round was all the more surprising, as Ashley had pinpointed this as one of the factors behind Newcastle’s perilous state when he arrived, “One of the reasons that the club was so in debt when I took over was due to transfer dealings caused by managers moving in and out of the club. Every time there was a change in manager millions would be spent on new players and millions would be lost as players were sold. It can't keep on working like that. It is just madness.”

"Welcome to the madness"

Maybe that way of thinking explains Ashley’s apparently crazy decision to go “all in”, rather than hedging his bets, by handing Pardew a five-year contract, which is surely the longest in the Premier League. Certainly, Pardew was singing from the same song sheet as his new boss during his first press conference, “I intend to focus on developing exciting young players through the club’s excellent academy and development squad, and I know the board here at St James’ Park is very committed to that too.” They sure are, having drawn up a five-year plan with the objective of breaking-even by the 2015/16 season.

Part of this strategy is for the club to “buy clever”, rather than rely on expensive signings. Ashley outlined his vision a couple of years ago, “My plan and my strategy for Newcastle is different. It has to be. Arsenal is the shining example in England of a sustainable business model. It takes time. It can't be done overnight. Newcastle has therefore set up an extensive scouting system. We look for young players, for players in foreign leagues who everyone does not know about. We try and stay ahead of the competition. We search high and low looking for value, for potential that we can bring on and for players who will allow Newcastle to compete at the very highest level, but who don't cost the earth.”

This approach is evidenced by the purchases made in this summer’s transfer window, when Hughton had to largely make do with a series of free transfers and loans, as the club could not afford to spend big money on new players. Dan Gosling and Sol Campbell arrived on free transfers from Everton and Arsenal respectively, while James Perch cost only £1 million from Nottingham Forest. However, Newcastle’s frugal policy can still work, the best example perhaps being the impressive midfielder Cheick Tiote, who cost just £3.5 million from Twente Enschede, while the loan signing of the skilful winger Hatem Ben Arfa from Marseille was looking inspired before his unfortunate injury.

Joe McLean, partner at accountants Grant Thornton, praised the new strategy, “It’s eminently sensible. It’s not a message that supporters want to hear, but I think it’s a sensible statement if you’re concerned about the long-term future of Newcastle United.” Indeed, the fans appear to be taking a much more realistic stance these days, understanding that the club faces some difficult financial challenges.

These are evident when you look at the club’s accounts, where they have reported large losses for the last four years. The last time Newcastle made a profit was back in 2005 – and that was a very small one of £620,000. Since then, the club has registered pre-tax losses of £12 million in 2006, £34 million in 2007, £20 million in 2008 and £15 million in 2009. Unfortunately, we don’t yet have the 2010 accounts (Newcastle tend to publish these quite late), but the loss will certainly be even larger following relegation to the Championship.

Although operating profit, defined as EBITDA (Earnings Before Interest, Taxation, Depreciation and Amortisation), was positive for many years, it has been steadily declining and actually turned into an £8 million loss in 2009, due to the lack of revenue growth and the explosion in the wages. It is obvious that the club has been living beyond its means, which has been exacerbated by the rise in non-cash expenses, mainly player amortisation, and a raft of exceptional items. Once these are taken into consideration, the 2010 loss rises to £38 million, though this has been partially compensated by £23 million of profit on player sales, mainly James Milner, Shay Given and Charles N’Zogbia.

Profit from activity in the transfer market has been an important driver of Newcastle’s financial performance, so that the very high loss of £34 million in 2007 was mostly due to the £2 million loss on player sales that year, primarily arising from Jean-Alain Boumsong’s move to Juventus.

"Not just Andy Carroll's landlord"

Actually, the 2007 loss would have been even higher without a positive contribution from exceptional items. These included the usual substantial payments for changes in management £1 million plus £2 million compensation to directors for the loss of office and £3 million of costs relating to an aborted financing project and takeover bids that had to be written-off, but were mitigated by £7 million of compensation received following Michael Owen’s injury at the 2006 World Cup.

By far the largest reason for these exceptional charges is the severance payments made to departing managers, which amount to a staggering £17 million over the last five years, including £5.3 million to Kevin Keegan, £4.6 million to Sam Allardyce and his team, £3.2 million to Graeme Souness and £1.1 million to Glenn Roeder. It may be a nerve-wracking experience managing Newcastle, but it’s also a lucrative one. Rumour has it that Big Sam bought a villa in Spain with his pay-off, naming it “Casa St James”. In fact, give the regularity of these payments, it is difficult to argue that they are exceptional in any way, shape or form.

So how does a club go from making a small profit in 2005 to a large loss in 2009, especially in a period when the money from television has significantly increased? The step graph above clearly shows that Newcastle’s TV money has indeed increased in that period by £10 million, but all of that has been wiped out by falls in both match day income of £6 million and commercial revenue of £4 million, meaning no revenue growth at all. Despite that, player costs have shot up: wages by £21 million and player amortisation £6 million. The deficit has been mitigated to some extent by lower interest charges £4 million and higher profit from player sales £10 million.

At this point, I should emphasise that these figures relate to Newcastle United Limited, but the loss is even larger in the club’s parent company, St James Holdings Limited. This was £23 million in 2009 with the only substantial difference being £7 million amortisation on the goodwill arising from the takeover. The divergence was larger in the 2008 accounts, resulting in a £34 million loss in St James Holdings Limited, but that is only because that year’s accounts covered the period since the holding company’s incorporation, which was 13 months.

Even though Newcastle’s revenue has not grown over the last few years, it was still the seventh highest in the Premier League in the 2008/09 season at £86 million, though the gap has widened since then with Manchester City and Tottenham increasing their revenue to £125 million and £113 million respectively. It was already a long way behind the so-called Sky Four with Manchester United generating more than three times as much revenue at £279 million, followed by Arsenal £224 million, Chelsea £206 million and Liverpool £185 million.

It is perhaps surprising then that Newcastle still managed to feature in Deloitte’s last Money League, which ranks the top twenty football clubs in Europe by turnover, albeit in 20th position, especially as they are the only club in the list that did not compete in European competition. That said, Newcastle have featured in every single edition of the Money League since its inception in 1997, though they will slip out of the rankings next year, due to their (brief) sojourn in the Championship. Of course, to become a permanent fixture in these rankings, Newcastle will have to step up to the next level and qualify for the Champions League, which is probably a bit unrealistic in the short-term.

Although the magnitude of the revenue could be higher, the revenue mix offers more encouragement, as it is reasonably well balanced: media 44%, match day 34% and commercial 23%. In other words, they are far less reliant on TV money than many other clubs in the Premier League, half a dozen of which collect more than 70% of their total turnover from Murdoch’s empire.

Having said that, the vast majority of Newcastle’s TV revenue of £38 million in 2008/09 did come from the Premier League central distribution, which worked out at £36 million. This money is allocated as follows: (a) domestic rights – 50% equal share, 25% facility fees based on number of times a team is broadcast live and 25% merit payment based on the final league position; (b) overseas rights – 100% equal share. So, even though Newcastle’s allocation was adversely impacted by finishing 18th, this was mitigated by the club being shown live 20 times, the third highest in the division, demonstrating its enduring box office appeal.

Clearly, the TV allocation in the Championship in 2009/10 was much lower at just over £2 million. Although the impact of relegation was partly cushioned by the £12 million parachute payment, this still meant a drop in media revenue of around £23 million. Conversely, in 2010/11 Newcastle will again benefit from the Premier League’s riches, more so, in fact, as the new three-year deal kicked-off this season. Thanks to a healthy increase in overseas rights, this will be worth considerably more and it is anticipated that teams will receive at least £40 million. The last time that the Premier League deal was increased was in 2007/08, when Newcastle’s media revenue rose from £26 million to £41 million, so the importance of growth in this revenue stream is readily apparent.

Of course, like many other clubs, Newcastle’s TV revenue pales in comparison to the Sky Four, who have boosted their income with Champions League qualification. This was worth an average of £30 million for the four English clubs last year, not including additional gate receipts or uplifts in sponsorship agreements. To place this into context, in 2003/04, the year after Newcastle last reached the Champions League, their total revenue was only £2 million lower than Liverpool’s, but the clubs are now separated by almost £100 million.

Where Newcastle do score very highly is in gate receipts, thanks to their impressively large and loyal support. Although this has fallen from £35 million in 2005 to £29 million in 2009, this was unbelievably still the tenth highest of the Money League clubs, superior to Milan, Inter, Lyon and Borussia Dortmund among others.

Part of the decrease was due to the lack of European competition, which boosted revenue in 2005 and 2008 thanks to 6-7 home matches in the UEFA Cup, but average attendances have also declined, falling from 51,800 in 2005 to 48,800 in 2009. Despite season ticket prices being cut by an average 9% in the Championship, attendances unsurprisingly fell further to 43,400, but that was still the fourth highest in England, ahead of Liverpool, Chelsea and, yes, Sunderland.

After its redevelopment, St James’ Park is the third largest club stadium in England, only behind Old Trafford and the Emirates, with a capacity of 52,400. While it is true that Newcastle struggle to fill the ground, their crowd figures are still pretty remarkable, especially in the midst of an economic recession which has hit the north-east of England particularly hard. Indeed, the average attendance is up to 46,000 so far this season, which is only surpassed by Manchester United, Arsenal and Manchester City. In terms of the fan base, this is undeniably a big club.

Given that reputation, the club’s commercial revenue of £19 million might be considered a touch disappointing, especially as it dropped by £7 million in 2009, though much of this was because of the decision to outsource the club’s catering operations and some might be due to fans boycotting the club’s merchandise as a protest against the unpopular owner. In fact, commercial income might fall even more, as the four-year extension to the shirt sponsorship deal with Northern Rock is now only worth £2.5 million a year, only about half of the previous agreement of £4.8 million. Even this is not guaranteed, but depends on Newcastle remaining in the Premier League.

"What have they done to deserve this?"

This was one of only two Premier League shirt sponsorship contracts to decrease this season (Sunderland was the other one), but in fairness Newcastle were caught between a (Northern) Rock and a hard place and the deal is still the tenth most lucrative in the league, albeit miles less than Manchester United and Liverpool, who both receive £20 million per annum. At least, cash from this extension is not front-loaded, as was the money from the previous deal, which was reportedly used to fund Michael Owen’s transfer.

There is a new kit deal with Puma, who have replaced long-standing partner Adidas, which runs two years until 2012, though no financial details have been disclosed. At least this means that the ludicrous custard yellow away kit can be jettisoned.

It is still possible that the thorny issue of stadium naming rights will be raised again, though this is a tricky thing to get right, unless a club moves to a new ground where there is no history or tradition. That said, even Ashley’s fierce rival, local businessman Barry Moat, who unsuccessfully tried to take over the club, has admitted that he would look at naming rights in order to bridge the financial gap with wealthier clubs.

All in all, there’s room for improvement in Newcastle’s revenue, but it’s really not too bad. However, the club’s expenses are shocking, especially the wage bill. In four years, wages increased by more than 40% from £50 million in 2005 to £71 million in 2009, while the revenue stagnated, producing an unsustainable wages to turnover ratio of 83%, way above UEFA’s recommended upper limit of 70%. Only three Premier League clubs (Manchester City, Blackburn Rovers and Wigan Athletic) had a worse ratio in 2008/09.

Furthermore, in the year that Newcastle were relegated, they had the sixth highest wage bill in the league. Invariably, the level of wages bears a close correlation to success on the pitch, so it’s fair to say that Newcastle have massively under-performed. Put another way, their wage bill was more than twice that of the clubs they were battling for relegation.

Since dropping into the Championship, the club has significantly reduced its payroll, as many high earners have departed, including Owen, Mark Viduka, Obafemi Martins, Damien Duff, Geremi, Nicky Butt and Habib Baye, but many of the squad that was relegated have remained. As Llambias explained, “We didn’t fire sale. We purposefully kept a nucleus of the team that we felt could take us up.” This was an expensive gamble, but one that worked out in this instance.

In a way, Newcastle’s rapid return was only to be expected, given that their lower wage bill was still the highest in the league with Llambias admitting that the wages were “down to an acceptable level in the Premiership, but not in the Championship.” The cut might have been deeper if the club had inserted relegation clauses into the players’ contracts, but apparently the previous owners did not consider this a possibility. Nevertheless, it has been estimated that some £25 million was chopped off the wage bill, reducing it to around £45 million. Some other large contracts are apparently coming to an end next summer, so there will be an opportunity to further address the wages at that point, either by selling those players or offering them reduced terms.

There has also been a steep increase in player amortisation, namely the annual expense of writing down the purchase price of new players, which has doubled since 2005, rising from £10 million to £20million, though it is still on the low side compared to clubs known for being big spenders in the transfer market, e.g. Manchester City £71 million, Chelsea £49 million.

The concept of amortisation confuses many people, but it is simply how accountants handle player transfers. Instead of booking 100% of the player’s transfer price as a cost in the year of purchase, accountants treat players as assets, so the cost is capitalised and written-down (amortised) over the length of his contract. At the end of the contract, the player is considered to have no value, because he can then leave the club on a free transfer.

It’s probably easier to understand with a real world example. Let’s take Fabrizio Coloccini, who was bought for £10 million in 2008 on a five-year contract, meaning that the annual amortisation is £2 million. After two years his net book value in the accounts is £6 million (the original cost of £10 million less two years amortisation at £2 million per annum).

The increase in amortisation therefore suggests that they have spent big in the transfer market and that was indeed the case – right up until Mike Ashley arrived. In fact, most of the rise occurred back in 2006, before the new owner’s era, when the club also wrote-off substantial sums in impairment of player values.

Details of transfer activity over the last decade show the changing approach quite clearly. In the six years since the turn of the millennium Newcastle had net spend of £82 million, but in the last four years there has been a surplus of £18 million. Even when the new board sanctioned higher spending of £30 million in 2008/09, this was matched by sales of £32 million. That is an almost perfect example of balancing the books, whereby the manager has to sell before he can buy.

This cautious, but sensible, approach is epitomised by the first risk listed in the club’s annual report, “the acquisition of players and their related costs are one of the most significant and high profile risks facing the Group.” In fact, only three Premier League clubs spent less on bringing in new players than Newcastle this summer: Everton, Blackburn Rovers and Blackpool.

In spite of this, the club’s previous excesses have resulted in significant debt of £282 million, though only £150 million is held in the books of the football club with the remaining £132 million held in the holding company. The vast majority of this debt represents loans from Mike Ashley of £243 million, but there is also a bank overdraft of £36 million, which is a significant increase on the prior year balance of £1 million. Since the 2009 year-end, Ashley advanced a further £25.5 million to keep the club ticking over in the Championship, so his total investment in the club now stands at £268 million, represented by £132 million to buy the club, £70 million to repay loans and £66 million working capital.

Because most of the loans are from the owner, instead of banks, some commentators have argued that the club is effectively debt-free, though it should be noted that Ashley’s loans are now repayable on demand, whereas they were previously only repayable on demand in the event of a change of control (ownership). That said, it is clear that it is better for the football club to borrow money from the owner, as these loans are unsecured, which means that Ashley has no guarantee of repayment, and non-interest bearing. This has been important to the club’s finances, as the net interest payable has been reduced by £5 million a year.

More to the point, Ashley’s loans have been critical to the club’s survival, as it is far from clear that they would have managed to secure refinancing from the debt market. For example, Barclays Bank has insisted on securing its lending on assets and cash from transfer fees, while the last loan obtained by the previous regime under chairman Freddy Shepherd was at the prohibitively expensive interest rate of 11.72%.

In fact, it is fair to say that the previous ownership had mortgaged the club to the hilt, securing loans on virtually all the club’s assets (training ground) and future income streams (TV, sponsorship), though they would argue that this was used to fund the stadium development. Whatever the reasons, when Ashley bought the club, the holders of the loan notes invoked a change of control clause, forcing the new owner to immediately repay the £45 million outstanding, as opposed to the annual installments until 2016 that he had anticipated.

Despite his crass behaviour, there is no doubt that Mike Ashley has put his hand in his pocket to keep the club going. The unpalatable truth is that Newcastle United are heavily reliant on the support of their charmless owner. In the last two years, he has put in £111 million of new loans, initially to repay £70 million of expensive bank loans, but also providing £41 million of working capital on top of that (plus the £25.5 million subsequent to the books closing). Looking at the 2009 cash flow statement, his backing was required to help fund a £24 million loss from operating activities plus £17 million of net spend on new players, many of which were signed in previous periods, though most of the shortfall was financed by the increase in the overdraft.

The club’s deteriorating financial position is also evidenced by the balance sheet, which shows a swing from net assets of £17 million in 2005 to net liabilities of £52 million in 2009, though the players’ value in the accounts is under-stated compared to the price that they would receive in the market.

In contrast to Ashley, the former owners did very nicely out of their investment in Newcastle United, thank you very much. In fact, they absolutely coined it with the Halls (Sir John and Douglas) receiving a total of £95 million over the years, while the Shepherds (Freddy and Bruce) had to make do with £55 million. The Halls’ money comprised £55 million from the sale to Ashley, £20 million from previous share sales (to NTL and the club itself), £15 million from dividends and £5 million in salary payments, while the Shepherds’ money came from £38 million Ashley sale, £7 million dividends and £5 million salaries.

"Another fine mess he's got into"

And what was the result of these staggering payments? After years of rank bad management, they left the club in an appalling mess: a £30 million loss; £70 million of debt plus £27 million owing transfer fees; extremely limited borrowing capacity, as all assets and income streams had already been used to secure loans; and a bloated wage bill of aging mercenaries on generous long-term contracts.

They also left us the indelible memory of Douglas Hall and Freddy Shepherd being caught by a News of the World sting, when they were recorded in a seedy Spanish bar, laughing about the Toon Army’s gullibility in buying replica shirts and calling Geordie women “dogs”. After this scandal, the gruesome twosome briefly resigned, only to return to the board less than a year later. Somehow, they managed to survive by spouting a lot of nonsense about “fighting for the Geordie nation” and appeasing the fans by making a marquee signing from time to time.

Incoming chairman Chris Mort criticised the old board, “If they had not been successful in refinancing the club by the end of the year, it would have folded like a pack of cards.” Admittedly, he had a vested interest, but his view was endorsed by Vinay Bedi from stockbrokers Brewin Dolphin, “Ashley bought a club that was financially going nowhere with debts increasing as player transfers built up. It was a difficult situation – it was hard to see how the club could be turned round quickly without a huge injection of cash.”

"Newcastle v Sunderland - Cheick Mate"

To be fair to Ashley, that is exactly what he has done. Furthermore, the club’s accounts have only been signed off by the auditors on the basis of assurances from Ashley that he will continue to finance operations in the future. The man himself has said that he is “prepared to bankroll Newcastle up to the tune of £20 million per year, but no more.” The question is for how long he can afford to do this, as his wealth is linked to the fortunes of his company Sports Direct, which has seen fluctuations in its share price and is also the subject of an ongoing investigation by the Office of Fair Trading. Nevertheless, even though his wealth halved in the 2009 Sunday Times Rich List, he is still estimated to be worth £700 million.

Of course, the more fundamental question is whether Ashley will sell the club. He’s had plenty of attempts already, lowering his price each time he puts the club in the shop window, starting at an utterly absurd £400 million, before rapidly changing down through the gears until he reached the most recent price of £80 million, though it is not entirely clear whether or not that includes repayment of the loans made on top of the original purchase price.

It is difficult to understand his intentions. In the past, he’s made all the right noises about selling the club, but when Barry Moat appeared to be edging close to his asking price, he suddenly cancelled the sale. Giving the new manager a five-year contract does not seem to be the act of an owner that is keen to sell, but Ashley is a bewildering figure in many ways.

For the right price, Newcastle United would surely attract a serious bidder. It’s the only club in one of England’s largest football cities, which has a very large following. Not only that, but it is also playing in the richest league in the world with the most lucrative TV deal and has numerous commercial opportunities. More cynically, another attraction to overseas buyers is the lax regulations on takeovers in the Premier League.

"It's really not funny"

Financially, the figures will get worse before they get better, and Newcastle have estimated an operating loss of £32.5 million for the Championship season in 2009/10. However, the club is aiming for self-sufficiency now that it is back in the Premier League, and this should be feasible, especially with the new TV deal and the reduction in wages after the clear out of so many high earners after relegation. My own estimate is for a £5 million profit, which assumes £45 million TV revenue, 10% reduction in match day income compared to the last time in Premier League, commercial revenue reduced by £2 million for the lower sponsorship deal, a £50 million wage bill and £15 million profit on player sales (Sebastien Bassong, Obafemi Martins and Damien Duff).

The tragedy for Mike Ashley is that he could so easily have been a hero to the Newcastle faithful, having sunk so much of his own money into the club, but as Freddy Shepherd acidly observed, “Anybody can buy a football club, not everybody can run one.” Leaving aside the slightly unreliable provenance of the quote, especially as Ashley has had to fix the financial mess that he inherited from his predecessors, the man does have a point. As Ashley himself has admitted, “I tried my best, but I accept that my best was woefully short.” Even after Newcastle’s victory over Liverpool at the weekend, it’s difficult to believe that many of their fans would disagree with him.