The scale of Fenway’s challenge at Liverpool becomes clear

Andy Green, of Anders Red Blog, provides an excellent analysis of Liverpool’s finances following the publication of the club’s accounts this week.

Liverpool are a club in transition on and off the pitch. The financial results published overnight show just how great is the challenge facing Fenway Sports Group (“FSG”). We can now see that the American owners spent £261m acquiring and refinancing Liverpool. Of this figure only £30m has actually flowed into the club, the rest was spent on the purchase itself.

I think Liverpool will turn the corner financially, the commercial opportunity is still there and there is clearly the scope to occupy a far larger/more profitable ground. The challenge is getting far more sporting success out of a very expensive squad of players, and that isn’t really down to money at all….

FSG’s ownership structure

The primary operating company of Liverpool Football Club is “The Liverpool Football Club and Athletic Grounds Limited” which the the main entity I will focus on. Since 15th October 2010, 100% of this operating company has been owned by a new vehicle “UKSV Holdings Company Limited”. UKSV is in turn owned by NESV I LLC, a US company also (and commonly) known as “Fenway Sports Group”. The accounts of UKSV only run from 1st October when it was established to 31st July 2011. The accounts of the operating business, which I’ll refer to as “Liverpool” or “the club” for ease, run for the year to 31st July 2011 (i.e. last season).

Ian Ayre’s spin

Before the club’s accounts were available at Companies House, Managing Director Ian Ayre gave a lengthy interview to the club’s website and to the Liverpool Echo. Without making the accounts available, Ayre threw around various numbers and in particular blamed the £50m pre-tax loss on a write-off of work on the abandoned stadium plans. Whilst the write-off had a big impact, he was being pretty disingenuous by not mentioning a pretty exceptional profit (£43.3m) on the sales of Fernando Torres and Javier Mascherano. This profit largely offset the stadium write-off (£49.2m) and that meant that the underlying results were very poor.

Ayre is not alone in spinning his club’s financial figures before they come out (hello Chelsea) or not being straight with his supporters (hello United and many, many others), but it is still pretty poor. The club is in transition and there is surely no need for such spin.

Revenues and costs

Football clubs are simple businesses. There are three revenue streams (matchday receipts, media income and commercial deals) and two main operating costs (wages and the costs of operating the club day to day). The difference between these numbers is “EBITDA” (earnings before interest, tax, depreciation and amortisation), effectively cash profits before any investment or the servicing of debts. After EBITDA come depreciation of the stadium, training ground etc, “amortisation” which is how transfers are accounted for, then interest and (rarely in football) corporation tax.

Liverpool’s results for 2010/11 show what happens when costs run ahead of revenues; profits collapse. This is of course the curse of football finance. Success brings income so clubs invest in player wages in the pursuit of this success. Fail to do well on the pitch and the costs are still there but not the income.

Liverpool’s revenue was effectively flat last season (down 0.5%). Matchday income fell 4.6% despite the same number of home games, reflecting a small fall in average attendances (40,224 vs. 41,940) more than offsetting ticket prices rises and must imply a fall of in corporate hospitality too. Media income was down 18% as the club failed to qualify for the Champions League (losing £25m of income). This was partly offset by £5m of Europa League income and the £6m increase in PL TV money from overseas rights. Commercial revenue was the star area with the Standard Chartered deal driving it up £15m or 25%. The Warrior kit deal will not impact the accounts until 2012/13.

Although revenues were down a fraction, there was significant cost growth as the club spent heavily in an attempt to break back into the top 4. Pre-exceptional staff costs rose a very punchy 12.7% year-on-year. This wage growth is more down to contract increases than transfers in my opinion. Although the club signed Cole, Poulsen, Konchesky, Meireles etc, Mascherano, Riera and Benayoun all departed and the January flurry of transfers will not have impacted the full year numbers significantly.

Total operating costs (pre-exceptionals) rose 9.3%, driving EBITDA before players sales down by 63% to only £9.8m, a margin of 5.3%. The graph below shows how the club’s EBITDA has fallen very sharply since 2009 revenue despite growing slightly. Liverpool are overspending.

The issue of rampant wage inflation is not of course unique to Liverpool. The graph below shows that Arsenal, Everton, United and City all saw wages rise faster than turnover last season. The problem for Liverpool is however more acute than at other clubs, fundamentally because Liverpool are operating a squad with a Champions League cost base without Champions League income.

Liverpool’s wage bill is quite competitive in Premier League terms, fourth behind City, Chelsea and United but the dreaded wages/turnover ratio is rising sharply (up to 70% from 62%). That puts Liverpool much closer to Chelsea (76%) than Arsenal or Everton (55% and 56% respectively).

Amortisation and depreciation

Amortisation is the method by which transfer spending is recognised in the profit and loss account. It reflects the level of transfer spending a club does, spread out over the life of player contracts. Importantly it forms part of the UEFA’s FFP calculation. At Liverpool the amortisation charge has been quite high, reflecting steady transfer spending under Benitez and Hodgson. The charge fell from £40m to £36m in 2010/11.

Depreciation (on Anfield and Melwood) was up slightly at £2.9m (vs. £2.1m).

Exceptionals, player sales and interest

Exceptional costs totaled £58.99m in 2010/11. Of this, £49.2m was a write-off of capitalised costs relating to the abandoned stadium project. It is important to stress that this is not a cash cost in 2010/11, the money had already been spent in previous years. Most of the balance of the exceptional charges relate to getting rid of Roy Hodgson. The club spent £8.4m changing managers last season compared to £7.8m getting rid of Benitez the year before.

The interest charge fell very sharply from £17.6m to £2.9m as the burden of Hicks and Gillett’s debts was lifted. It is worth noting that cash interest paid actually rose slightly.

Although not treated as an “exceptional”, the club recorded a huge profit on player sales in 2010/11. Such profits are calculated as the difference between the price at which a player is sold and his “book value”. Torres was acquired for around £20m and probably had a book value of around £10m when he was sold to Chelsea. That means the club recorded a profit on his sale of around £40m. Add in Mascherano and the “profit on player sales” was £43.3m.

Pre-tax loss

Bringing all these numbers together, Liverpool reported a pre-tax loss of £49.3m compared to £20m the previous year. The exceptional charges are unlikely to re-occur, but neither is the enormous profit on Torres. Estimating a “normal” profit on player sales is very difficult (the figure was £23m in 2010, £4m in 2009), but £10m looks a reasonable estimate for a club with Liverpool’s strong youth set-up. Stripping out the exceptional costs and using £10m for a “normal” profit on player sales implies an “underlying” pre-tax loss of c. £23m. The collapse in EBITDA means Liverpool are structurally loss making at these level of income and wages. To change that of course, the club need cheaper players or more revenue.

Cash(flow) is king

Accounting items like non-cash exceptionals, amortisation and player sale profits can often make the profit and loss account of football clubs misleading. It is always important to focus on cash flow as shown in this table:

The collapse in EBITDA (here including cash exceptionals), led to a very sharp fall in operating cash flow at Liverpool. Unlike in the P&L, the transfer spending here reflects actual cash spent and received and with the Carroll spending paid up front but the Torres receipts staggered, there was punchy £40m of cash spending in 2010/11. Deduct interest and the club saw a £42.5m outflow before financing.

It goes without saying that Liverpool need to generate more EBITDA and hence cash flow to be able to compete in the transfer market in the future or will need subsidising by FSG.

Debt and financing

Of the £42.5m cash outflow shown above, £26m came from an injection from new parent company UKSV and the balance from running down the club’s cash balance (which fell from £19m to £2.5m).

The £30m “debt” on the Liverpool balance sheet owed to UKSV/FSG is really equity by another name (it attracts no interest). At 31st July there was a real bank loan of £37.7m (the “stadium finance” part of a larger £92m facility with RBS and Wachovia/Wells Fargo) secured on the club’s assets.

On 30th September 2011, the club entered into a new £120m facility with RBS, Bank of America and Barclays for £120m. The facility runs for three years. £45m is the stadium project facility and £75m for “general corporate purposes”. Whilst with year end debt of only £37.7m there might appear to be plenty of spare capacity, football clubs’ cash positions are highly seasonal and the club will definitely need this facility during the course of the season. We do not know the interest rate on this debt (the old facility was LIBOR +450bps).

Prospects and thoughts

Fenway have a very big challenge keeping Liverpool competitive in the next few years. The Warrior kit deal next season will add c. £13m (7%) to revenue, but there was no Champions League football in the current season and there won’t be any next season. Wage inflation across football remains endemic despite the imminent arrival of FFP. The playing squad needs investment and a new ground is desperately needed.

If all that wasn’t bad enough, the competition for CL places is far fiercer than it was in the good old days of “the big 4”. A £100m+ wage bill used to guarantee qualification for the CL, now it barely guarantees qualification for the Europa.

The great unknown in all this is the willingness of FSG to invest their own money in Liverpool FC. So far £30m has flowed in on top of the cost of acquiring the club. The expansion of the banking facility very much suggests that the business will be debt not equity financed in the next year or two and that is a worry.

Despite all this gloom, I think Liverpool will negotiate these financial risks, for two reasons. Firstly as shown by the Standard Chartered and Warrior deals, the club is a big brand still on the global stage. It is commercial success that has allowed United to compete despite its debt burden and remains a key advantage for Liverpool too. Secondly, there is significant scope to expand matchday income if a new stadium can be developed. Liverpool L4 is not London N5, but Arsenal‘s move to the Emirates gives a flavour of what can be done. Liverpool’s matchday income is only 37% of United’s. FSG need to close some of that gap.

The other thing Liverpool need is for Financial Fair Play to be rigorously enforced. This is the great unknown of course, but FSG have clearly made a bet that it will stick.

Taken together, the Liverpool “project” is a steep, steep challenge.

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