Sunday, February 16, 2014

Oh When The Stock... Kept Marching Down (Manchester United & the Economics of Sports Teams)

Last May, Sir Alex Ferguson announced he was retiring as manager of Manchester United (MUFC) after 26 years in charge. While the timing was unexpected, it was of course no shock that the 71 year-old had decided to step down at last. A favourite game among fans (well, me and my friends, at least) was to speculate on who would eventually replace him. After all, what's better than making bold claims about things you cannot possibly control, especially after a few drinks? My personal preference was Carlo Ancelotti, who struck me as a cultured man with a proven pedigree at major clubs. I would have taken Pep Guardiola in a heartbeat but he'd recently agreed to take over at Bayern Munich. Other popular picks were Jose Mourinho (too egotistical for my liking, not to mention the small matter of once poking a rival manager in the eye), David Moyes (perennial over-achiever at Everton, though with questions about his ability to actually win trophies) and Jurgen Klopp (his Dortmund side were playing some very attractive football at the time, but he had something of a "Flavour of the Week" feel, even though he appears to be doing a great job there). I'm not sure if Ancelotti was ever really in the running, but was heading to Real Madrid anyhow. It was somewhat controversial, though, when the club's management opted for Moyes over Mourinho. Chatting with my friend Cory, I said I hoped it wouldn't matter too much if Moyes hadn't won any major trophies because Fergie had instilled a culture of excellence at the club. I think I paraphrased Warren Buffett who said he "liked businesses that are so wonderful that an idiot can run them - because sooner or later, one will."

No such luck. As I write this, MUFC sit seventh in the Premier League. Galling as the league position is, it's the manner of the performances that has drawn heavy criticism from the fans. The team has been shaky in defence, timid in midfield and lifeless in attack. The debate over whether Moyes is the right man for the job has only grown more heated.

My hope that MUFC would succeed with or without Moyes has proven unfounded, but to be fair, that was the hope of a fan, and not the unbiased assessment of an analyst. In my day job as a financial analyst, I had been asked in March 2013 to evaluate MUFC as a business given its recent IPO. I'm not a specialist in valuing sports teams, but it seemed to me that they didn't make very good businesses. To quote Buffett again, "The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down." The same goes for sports teams. The last I looked, MUFC was actually doing a pretty good job in generating revenue from three streams: (a) commercial revenue (sponsorship deals, retail, merchandising & apparel sales, and new media & mobile), (b) broadcasting revenue, and (c) matchday revenue. My major concern, though, was on the costs side. Players' wages and transfer fees continue to march upwards, being subject to the economics of superstars. And if you want to continue driving revenues, you've got to continue spending on top-notch players, meaning that the free cash flow wedge is incredibly hard to maintain.

That still left me with the question of how to actually value the stock. Like airlines in the old days, elite sports teams are trophy assets whose owners are rarely focused on a financial return. This means that the valuation of sports teams contains a hugely speculative component, which is the "glamour premium" - something that's more susceptible to the vagaries of the market than I'd like as a common equity investor. (Not the first time I'd made this point - when I was in college, I took a class on Financial Booms and Busts, and we had to write a paper on an asset class of our choice that was a bubble. I chose Premiership football teams. That was 2006, so I guess I could have had my pick, but it was more fun writing about football as a subset of LBOs.) Furthermore, given the predominance of Middle Eastern and Russian investors who set the prices for these assets, I was concerned that private market valuations were much more closely tied to the global commodity cycle and world economy than ever before. My conclusion was that the stock was certainly not a buy, and possibly an outright short. I felt a little stupid as the stock climbed from $17/share to $19/share. But then, of course, Fergie retired, since which the stock is down 20% (which should perhaps make me feel stupid again, since I wasn't actually short the stock).

I promise the point of this isn't to tell you how smart I am (and perhaps you can laugh at this 2 years from now when Moyes rights the ship, and MUFC stock is much higher. I haven't analyzed the financials closely in about 9 months, and so don't have a strong view on valuation, but the stock trades at $14.84/sh at last close). Instead, I want to make three points on how the economics of elite sports teams are even worse than I thought.

1) Even a club like Manchester United is not a self-sustaining institution, but what's worth remembering is how quickly even the best can go off the rails. Sports fans know this. Financial analysts, mmm, not so sure. I'm not suggesting that MUFC is going to enter a long period of decline a la Liverpool, and I'll save comments on the Moyes era for my next post. But it does mean that sporting fortunes can change pretty quickly, and when free cash flow is already so hard to come by, there is a lot of implicit operating leverage.

2) It's a cliche but this is one of those businesses where your best assets walk out of the door every night. Yes, they're signed to long-term contracts, but we all know those aren't worth much. Last year Robin van Persie was hugging Fergie and embracing the little boy inside him on the way to his first Premiership title. This year we're hearing rumours that he's disaffected with the Moyes regime and looking for a way out. True or not, it's a stark reminder how quickly things can change (linked to point 1).

3) The rise of the nouveau riche clubs (I don't mean that in a pejorative way... oh, who am I kidding, yes, I do) shows just how hard it is to sustain a competitive advantage in this business. If you gave me $2b, I couldn't create the next BMW or Louis Vuitton. By comparison, while Chelsea and Manchester City don't have the same history as MUFC, you can't scoff at results and the very attractive football they've been capable of playing. Basically, you CAN buy success, or some modicum of it.  

So there you have it folks. Sports clubs are wonderful playthings for the rich these days, but probably unsuitable for the retail investor unless valuations are extremely favourable. It kind of reminds me of that old joke: "What's the best way to make a small fortune in oil? Start with a large one."  

In my next post, I want to analyze what's going wrong at MUFC by drawing a parallel between the club and the middle income trap. Because what's sexier than football and growth empirics??