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.

Wednesday, December 8, 2010

Porto's Buy Low, Sell High Strategy

When football fans witnessed Barcelona’s dazzling 5-0 demolition of rivals Real Madrid, they would have been forgiven for assuming that this was an unprecedented performance, but they would have only had to look back three weeks for a similar exhibition in Portugal, when Porto crushed Benfica 5-0 at the Dragão Stadium. The country’s most successful team of recent times thrashing its celebrated capital city opponents? Check. Inspired by a South American phenomenon? Check. Guided by a progressive young coach? Check.

After finishing a disappointing third in the Portuguese League last season, Porto replaced their coach Jesualdo Ferreira with André Villas Boas, a protégé of José Mourinho. Although this is his first coaching role at a leading club, the 33-year-old has already stamped his authority on the team, which has played some beautiful, free-flowing football this season. So much so that Porto are unbeaten in the league, which they lead by an astonishing eight points after 13 games, and are very much favourites to regain the title.

Their inspiration has been a young Brazilian striker named Givanildo Vieira de Souza, better known to the football community as Hulk, largely due to his powerful physique. His presence was badly missed by Porto last season, after he was suspended for a few matches for his part in a post-match brawl following an ill-tempered match against Benfica, when he was found guilty of attacking match stewards in the tunnel. His goals might have made all the difference to Porto in the championship run-in and would almost certainly have avoided the ignominy of failing to qualify for the Champions League for the first time in living memory.

"Andre Villas Boas - remind you of anyone?"

This represented a slap in the face for a club that has become accustomed to filling its trophy cabinet in the past few years. Before 2009/10, Porto had been victorious in the Portuguese championship four consecutive times, which meant that they had collected six Primeira Liga titles in seven seasons. Their history in the last decade also features two European successes under the guidance of the Special One, when they beat Celtic 3-2 to secure the UEFA Cup in 2003 and triumphed 3-0 against Monaco to win the Champions League the following year.

Unfortunately, during this period the club was also tainted with the whiff of scandal for its involvement in the so-called “Golden Whistle” investigation, when it was claimed that referees were offered bribes before two of their matches during the title winning campaign in 2004. They were subsequently docked six points and fined €150,000, though some thought they had got off rather lightly. Importantly, they were still allowed to compete in the Champions League, even though they were initially banned, as on appeal the authorities ruled that the time limit for dealing with the match fixing allegations had passed.

All in all though, the “noughties” has been a highly enjoyable era for Porto. Their success on the field of play has been matched by their performance off the pitch, as the club has reported profits in each of the last four years, which is very good going in these difficult economic times. Although the club tends to make sizeable operating losses, it more than compensates for the shortfall by making equally large profits on player sales.

This is a hugely important activity for Porto’s business model, which can most clearly be seen in 2006, which was the last time the club made a loss, almost entirely due to the club’s decision to retain players that year in order improve their chances of winning. Similarly, the 2010 profit of €0.1 million was €5 million lower than the previous year, which is more or less the reduction in profit on player sales.

The other key driver in Porto’s finances is revenue from the Champions League. Indeed, the €10 million reduction in 2010 revenue was largely due to the team’s earlier exit from that competition. However, Porto are very skilled at balancing their books, so they compensated for most of the decline in revenue by cutting their costs by €7 million, mainly in the wage bill, though they were also helped by €3 million lower interest payments, due to the reduction in interest rates.

Porto’s cash flow from operations (EBITDA) is fairly healthy, averaging €33 million over the last four years, once non-cash items like player amortisation and depreciation are added back, but this is again very reliant on the profit made from player sales. If this were excluded, then EBITDA would be slightly negative.

Although president Jorge Nuno Pinto da Costa has been criticised by some supporters for the club’s policy of selling their best players year after year, a cursory glance at the financials is enough to understand why this approach is necessary. The relatively low revenue, combined with wages high enough to remain competitive, mean that Porto need to make money in the transfer market to survive. They have been remarkably consistent in the profits they have managed to generate from this activity in recent years: 2008 €35 million, 2009 €40 million and 2010 €35 million. They are well on course to repeat the trick in 2011 following this summer’s sales of Bruno Alves to Zenit St. Petersburg for €22 million and Raul Meireles to Liverpool for €13 million.

The numbers are simply incredible for a club of Porto’s size. Since that Champions League win in 2004, the club has raked in almost €350 million revenue from player sales, though its net surplus is “only” €190 million, as it also spent €160 million on buying players in the same period. Looking at this another way, Porto have spent a lot on buying players, but have made even more on selling them. In fact, in the last 11 years, only twice have Porto had a (small) net spend in the transfer market and that was way back in 2002 and 2004.

They are absolute masters at selling two or three players every season for big bucks, interestingly often as bulk purchases, e.g. three players to Dynamo Moscow and two to Chelsea, though the latter sales were obviously partly down to Mourinho raiding his former club. The list of players transferred for over €5 million since 2004 is an extensive one:

The club has demonstrated the enviable knack of buying players relatively cheaply, benefiting from their prowess for a couple of seasons, then selling them for a very good price to richer European teams. As the annual report explains, “We clearly bet on the training of talents and the early detection of the best players.” That’s a fine objective, but it would be to no avail if they could find no buyers, but even in a subdued transfer market, Pinto da Costa boasted, “our assets were again the most requested on the international scene.”

Much of this is down to Porto’s world-class scouting network, which is especially formidable in South America. They need to search far and wide for promising prospects, as they cannot afford to pay top dollar for foreign players, though they address this financial weakness in an innovative way by sharing the player’s rights with an agency, which means that they do not have to fund a transfer in one fell swoop.

For example, in April 2005, Porto bought 50% of the sporting rights of Lisandro Lopez (from Racing Club) and Lucho Gonzalez (from River Plate) with the remaining 50% only acquired in season 2007/08. Clearly, this type of deal is a double-edged sword, as it means that any future profits are shared proportionally with the agency, but it does reduce Porto’s initial outlay and de-risks their activities in the transfer market.

"Bruno Alves - To Russia With Love"

Even though Porto cannot afford to pay very high wages, they still have much to offer South American players. Not only is Porto itself a very successful club, their regular participation in the Champions League provides a perfect platform for emerging talents to display their wares. Moreover, players can easily obtain work permits and embark on the path towards a EU passport, which makes them a more attractive prospect to clubs in countries with more restrictive regulations. Finally, Brazilian players do not have to struggle with any language issues.

On the flip side, Porto are forced to reinvent themselves every season with no player being considered irreplaceable. In this way, when Carvalho left for England, he was replaced by Pepe, whose exit was compensated by the emergence of Bruno Alves. Even with this massive turnover of players, the club has managed to maintain its successful record, consistently winning the Portuguese league, though arguably the departure of three key players to France in the summer of 2009 was a bridge too far.

In the same way that Porto often buy a percentage of a player’s rights, they sometimes also sell part of a player in order to raise cash. There was an example of such a trade only last month, when the club sold percentage of three recent arrivals for a total of €8 million (37.5% of Joao Moutinho, 35% of James Rodriguez and 25% of Walter).

"Falcao - no, not that one"

They also often structure their transfers in a way that they can share in a player’s future development, e.g. Aly Cissoko’s deal with Lyon included a 20% sell-on clause, while the agreement with Lyon for Lisandro Lopez could be worth an additional €4 million depending on sporting achievements. While hesitating to use the phrase “wheeler dealers”, Porto are definitely very nimble on their feet in the transfer market, leaving many of their more illustrious (and staid) peers in the shade.

Ironically, given the vast sums that Porto received from Lyon in 2009, the French club is often considered to operate a similar business model, sharing many of the characteristics of their approach to the transfer market. Up until the last two years, that was certainly the case, before Lyon embarked on a spending spree of their own recently, though their president has promised that they will revert back to type in the future. Furthermore, in relative terms, Porto are even more reliant on money made from player sales, due to the fact that Lyon enjoy a far higher turnover.

This is the essence of Porto’s problem, for the club is a big fish in a small pond. The Portuguese market is a small one with many clubs struggling financially, so the only realistic way for Porto to keep up with Europe’s elite from the wealthier nations is to sell the players that they develop. In that way, they can just about find enough money to fund a wage bill that will allow them to be competitive.

We can see the magnitude of the problem by examining the Deloittes Money League for 2008/09. There’s not a Portuguese name in sight among the top twenty listed, which is no surprise given that Benfica is the only Portuguese club to make an appearance on this august list, back in 2006 (in 20th position). Porto’s revenue of €68 million in 2008/09 leaves them miles behind wealthier clubs. To place that into context, Real Madrid’s revenue of over €400 million is almost six times as much. Even a club like Newcastle United, which was relegated at the end of that season, generated 50% more money.

This highlights the enormous financial challenges confronting clubs from outside the Big Five countries (England, Spain, Germany, Italy and France). By a strange coincidence, Porto’s revenue is almost exactly the same as that of Ajax, who face the same sort of issues. In terms of Premier League clubs, the nearest revenue equivalent is Stoke City, who have made a lot of progress recently, but, with the greatest respect, their record is nothing compared to Porto’s. From that perspective, there is no doubt that Porto have been punching well above their weight in Europe, regularly reaching the last 16 of the Champions League.

At this point, I should probably clarify that this analysis is based on Porto’s consolidated accounts, which include the following companies: PortoComercial (sponsorship, licensing and merchandising, 93.5% owned), PortoEstadio (stadium, 100%), PortoMultimedia (70%) and PortoSeguro (insurance, 90%). That said, the results are still very largely based on the operations of the football club.

The importance of player trading to Porto’s business can be seen very well in the above graph. If profit on player sales is considered as “revenue”, its contribution has been notable in the past few years, averaging around 60% of normal turnover. Put another way, the club makes three times as much from the transfer market as gate receipts. This would be very worrying if Porto had not shown that they are capable of maintaining this “revenue stream” year after year, with the exception of 2006, when, of course, the club made a big loss.

It is imperative that Porto continue along this path, as the revenue growth in other areas has been very limited. Gate receipts are actually down 17% in the last five years, while television, the impetus behind revenue growth in many countries, has only risen €5 million in the same period. The star performer has been commercial income, which has doubled to €24 million. Although total revenue growth of 24% has outpaced cost growth of 19%, the absolute growth is smaller, meaning that the operating loss has slightly grown over this time. Whichever way you look at it, the club needs to buy and sell.

As we have seen, broadcasting is not as important for Porto as other leading clubs with the 2010 revenue amounting to only €20 million, comprising €8 million from the domestic deal and €12 million distributions from UEFA for the Champions League. Even with the boost of European revenue, which represents over half of their total TV revenue, this is fairly pitiful compared to the major leagues. If we compare Porto’s revenue with the clubs that earn most from broadcasting income in those other leagues, we can see that they earn between four and eight times this amount.

The total value of the Portuguese Liga TV rights is only around €50 million a season, which compares very unfavourably to others: England €1.2 billion, Italy €900 million, France €700 million, Spain €500 million, Germany €400 million. That might be expected, but the Portuguese contract with Olivedesportos (matches shown on SportTV) is also behind Turkey €250 million, Holland €100 million and Greece €54 million. This is not a collective deal, so the lion’s share of the TV revenue (about €24 million) goes to the traditional big three clubs in Portugal: Porto, Benfica and Sporting Lisbon.

From that perspective, Porto’s €8.4 million is not too bad (up from €7 million in 2008), but to put this into context, Arsenal also finished third in their league and received around €62 million, which is nearly eight times as much - and the Premier League TV money will further increase this season. In fact, Arsenal on their own received more than all of the 16 clubs in the Portuguese Liga combined.

That’s why the Champions League money has been so important to Porto’s finances over the last few years. This is most evident in 2004, the year when they won the tournament and received €25 million, which was almost 40% of their turnover that year, but even this year when the revenue was down to €12 million, that was still worth 20% of their income - and that excludes gate receipts and sponsorship increments.

Porto use a slightly strange accounting policy when it comes to reporting Champions League revenue, whereby as soon as they have qualified for the competition, they immediately book the guaranteed element for the following season. So the 2009/10 revenue for participating in the group stage (worth €7.1 million) was already reported in 2008/09, hence the reduction in the 2009/10 accounts, even though Porto actually received more from UEFA that year: €18.7 million in 2010, up from €14.5 million in 2009.

What is certain is that qualification for the Champions League has been fairly lucrative to Porto, €92 million in the last seven years, though they have again been short-changed because of their misfortune in playing in a small country, more specifically a country with a small TV audience.

"Happy days for Varela"

Although Champions League participation fees and performance prizes are the same for every club, the share of the television money from the market pool is dependent on the size/value of a country’s TV market, so the amount allocated to teams in other countries is more than that given to Portugal. For example, last season Porto reached the last 16 and received €5.4 million from the market pool, which was much less than the €18.1 million distributed to Chelsea for reaching the same stage.

Actually, Porto’s share of the 2009/10 pool was higher than they are accustomed to receiving, as the allocation also depends on the number of representatives from a country that qualify for the group stage, and there was only one from Portugal that year, compared to two or even three in previous seasons.

Porto’s bottom line will therefore be adversely impacted in 2011, as they have only qualified for the Europa League, which distributes much less money than the Champions League with the guaranteed fees worth only €1 million. In fact, if Porto were to battle their way through countless matches and win the trophy, they would still only get €6.4 million, though that’s better than nothing.

"25 million for Quaresma?"

Hence, the determination that the club’s absence from the Champions League will last no more than a year. Only first place in the Liga ZON Sagres guarantees qualification, but the runners-up can also get there if they make it through the qualifying matches. The latest UEFA coefficient rankings suggest that Portugal may get a third place from next season, which would give Porto an even better chance of returning to Europe’s premier competition. That would obviously please their fans, but it would no doubt also bring a smile to the face of their bank manager.

And there’s more: as the 2009 annual report stated, “In addition to the direct financial results awarded by UEFA, the presence of FC Porto in the great showcase of European football, where players strongly shine, is essential to their valorization as economic assets of the society.” Not the greatest translation in the English version of Porto’s accounts, albeit scoring high marks for lyricism, but, in short, this means that the Champions League is also the perfect shop window for Porto’s selling policy.

Where Porto have done quite well is in increasing their commercial revenue, especially sponsorship and advertising, which has reached €14 million. They have an interesting shirt sponsorship deal with Portugal Telecom, which features one company tmn (mobile network) on the home shirt and another meo (IPTV) on the away shirt in the same way that Arsenal used to have Sega and Dreamcast on different kits. This is a long-term six-year deal worth €21.45 million and runs until June 2011.

However, this is still on the low side by international standards, equivalent to only €3.6 million a season, while Bayern Munich, Manchester United and Real Madrid all have deals worth over €20 million. It might seem absurd to make comparisons against clubs of this stature, but Porto will have to beat these teams if they want to lift the Champions League trophy again.

Similarly, the kit deal with Nike brings in less than €3 million a season (four-year deal worth €11.1 million, potentially rising to €14.8 million depending on team’s success, for the period 2008-12). Although Porto have been very active in merchandising initiatives, including revoking an agreement with TBZ following poor performance and setting up several club stores (co-branded with Nike), revenue from this source only comes to just over €2 million a year. A similar amount is generated by corporate hospitality, which is contracted out to a company called EuroAntas.

Gate receipts are also nothing to write home about at just €11 million, which is the lowest that they have been in the last six years. The €2 million decline is partially attributed to the earlier Champions League exit with the previous season’s glamour quarter-final against Manchester United bringing in €0.9 million alone, but is also symptomatic of the general economic malaise affecting Portugal, which resulted in the average league attendance falling 14% from 38,800 to 33,500. The poor results probably also played a part, as the average so far in the current successful season has climbed back up to 37,800, which is just behind Benfica, who have the highest crowds in Portugal at the moment.

However, as we have seen, this does not produce much in cold hard cash with the gate receipts being worse than every club in the Deloittes Money League. There may be some match day income hidden away in commercial revenue, but the harsh reality is that the club’s revenue here lags a considerable distance behind its foreign competition. Manchester United’s match day revenue of €128 million is about ten times higher than Porto’s. It’s difficult to compete with such financial might, especially as this difference accrues every single season.

The club is housed at the Estádio do Dragão (Stadium of the Dragon), which replaced their old stadium, Estádio das Antas, in 2003. It seats over 50,000 spectators and its name is derived from the dragon on Porto's crest, which is also the nickname of Porto fans. The new stadium was built for the European Championships held in Portugal in 2004 and cost €98 million, of which €18 million was contributed by the taxpayer. To further support the funding, naming rights have been sold for each stand, mainly to divisions of the principal sponsor Portugal Telecom, but also to other companies like Coca-Cola.

The stadium is actually owned by EuroAntas, which granted Porto a 30-year lease in 2003 to use the facilities for an annual payment of around €1 million. It is also used for other events like the “Race of Champions” featuring the top drivers in motor sport. In addition, the complex features a multi-sport arena nearby for Porto’s basketball and handball teams.

"Enter the Dragon"

Moving onto costs, even though expenses are higher than revenue, it is clear that Porto strive to reflect any movement in the revenue in the costs line, so when revenue surged 24% in 2009, costs grew by a similar amount 25%. On the other hand, when the 2010 revenue fell 15%, cash costs (excluding player amortisation) were also cut by 14%. This is a tough balancing act, as the wages have to be held at a minimum level in order to attract the right quality of player.

As the annual report explained in its quaint English, “the company bets on the investment of the team with players of high quality … to ensure the best sporting results, which necessarily requires adequate compensation to their status.” Nevertheless, Porto’s wage bill of €39 million is very low by international standards, a long way below big spenders like Barcelona €263 million, Inter €205 million, Real Madrid €187 million and Bayern Munich €165 million. An interesting equivalent would be Celtic, but even their wage bill of €43 million is higher. Of more interest to Porto fans might be the wages of Arsenal, the team that eliminated them from the Champions League last season, which are €130 million – over three times as much.

Wages actually reduced 17% in 2010 from €48 million to €39 million, partly due to worse sporting performances, which resulted in lower bonus payments. Porto have stated that 25% of staff costs are related to the performance of the team, so in a good sporting year, these costs will increase ceteris paribus. The split of this year’s staff costs is: players €23 million, technical and administrative staff €10 million, directors €2 million (on the high side), insurance €1 million, other costs €3 million.

Porto also specifically mention in their annual report the Webster Law having an inflationary impact on salaries. This regulation allows a player to unilaterally terminate his contract after three years (or 2 years if he is over 28) to move to a foreign club, only compensating the club with a sum equivalent to the remaining salary for the time left on his contract. Clearly, that could spell disaster for Porto’s business model and its reliance on money from player sales, hence the decision to raise salaries in 2009.

Given these pressures, the club is justifiably proud of keeping its wages to turnover ratio below UEFA’s recommended upper limit of 70%. This ratio actually fell to 68% last year, which is very impressive if you consider the constraints imposed by the low revenue.

The trend in player amortisation, namely the annual cost of writing down the cost of buying new players, is more concerning, as this has been steadily rising over the last two years. In the four years between 2005 and 2008, it had held steady at around €20 million, but it has now shot up to €27 million. Of course, this can quickly be reduced with the sale of a couple of players that were bought for high fees, so I would expect this trend to reverse in the near future. In any case, it’s still much lower than those sides that have spent really big in the transfer market, such as Manchester City €83 million, Barcelona €71 million, Real Madrid €64 million and Chelsea €57 million.

Like most other Portuguese clubs, Porto have a lot of debt. Given the imbalance between expenses and revenue, this is hardly surprising, but it is exacerbated in their case by the cost of building the new stadium. That said, the debt is still on an upward trend, though it has remained at €84 million for the last two years. This comprises €76 million of bank loans plus a €17 million bond less €8 million of cash.

According to the annual report, “the company managed to relieve the financial pressure by issuing a new bond.” This bears 6% interest per annum and is repayable in December 2012. What was reassuring is that the bond issue was 4.5 times over-subscribed, reflecting the market’s support for the club. This is not the first time that Porto have tapped the debt market, as they issued a similar three-year bond in 2006, which was repaid on schedule in December 2009.

Of more concern is the security provided to guarantee the loans with the accounts listing all sorts of collateral, including Champions league revenue, stadium naming rights, sponsorship contracts and transfer receivables. The club is obviously aware of this issue and stresses that it can service the debt by referring to the net debt/EBITDA ratio. In Porto’s case, this works out as 2.7 (84/31), which is not great, but I’ve seen worse. The ratio effectively indicates how many years’ earnings would be required to pay off all the debt and is considered alarming if it rises above 3-4.

"A special day"

The other aspect of debt that is important to clubs like Porto with their frenetic activity in the transfer market is how much they owe to other football clubs, which stands at €25 million. This is in line with previous years: 2008 €23 million, 2009 €26 million. However, other clubs owe Porto more than twice as much with an incredible €56 million of receivables. This appears to be a vital part of Porto’s transfer dealings, as the sum is unchanged from last year, while 2008 was also high at €46 million. The largest debtors are Lyon €12 million, Marseille €10 million and Inter €6 million. Porto supporters might be surprised to know that the club is still owed money two years after the sale of Quaresma to Inter.

This is one reason why Porto’s balance sheet shows €23 million of net assets with assets of €183 million being higher than liabilities of €160 million. The surplus is partly due to the value of player registrations held on the books, which increased last year from €58 million to €69 million. Of course, this accounting value is significantly below the players’ market value, which has been estimated at €132 million by Transfermarkt. In particular, players developed by Porto’s academy will have zero value in the accounts, but are obviously worth something.

However, there are risks facing Porto’s strategy, as the transfer market has been deteriorating recently, with all clubs affected by the recession, and values of players have plummeted, e.g. Zlatan Ibrahimovic’s price was slashed to €24 million just 12 months after Barcelona paid €70 million, while Diego moved to Wolfsburg for €16 million a year after Juventus bought him for €25 million. The statistics show that Europe’s top five leagues spent almost 40% less on transfer fees in the summer of 2010 than the previous year.

"Meet El Presidente"

On top of the adverse market environment, the advent of the UEFA Financial Fair Play Regulations could also have a detrimental effect. These will force clubs to break-even if they wish to compete in European competitions, so expenses have to be covered by revenue. As a major expense element is the player amortisation arising from transfers, it seems logical that clubs will endeavour to reduce their transfer spend, which might well harm selling clubs like Porto.

Having said that, Porto have managed to beat the odds so far with the transfer of Bruno Alves this summer among the top ten worldwide. Maybe it just means that only those clubs with superb scouting networks and an excellent track record for developing players will thrive in the new world – and Porto certainly fit the bill there. It is clear that they still have many players who would be in demand with Manchester City being only one team linked with a €30 million move for Hulk.

Even so, it makes it even more important for Porto to produce players from their “Dragon Force” academy, as the club may have less money in the future to spend on bringing players in. This is why they have invested substantial funds into improving the Vitalis Park facility, which now features 11 grass pitches and 7 synthetic pitches. There is a risk that players would then be transferred to richer clubs at a younger age, but the financial arguments are pretty compelling.

"The dynamic duo"

The fact is that the Portuguese League does not generate enough money on its own for its clubs to compete in the upper echelons of the Champions League. Many clubs are struggling financially, over burdened with debt, leading to seven clubs from the top flight recently seeking assistance from the LPFP (Portuguese Football Federation). Although this theoretically represents financial aid to improve sports facilities, it looks more like grants are being given out to enable the survival of these clubs.

This is the situation in which Porto operates, so their focus on making money from selling players is perfectly understandable. They have become the ultimate football traders, buying low and selling high with great success, which should be applauded, especially as their results on the pitch have rarely suffered. It’s a delicate balance, however, as seen by their failure to qualify for this season’s Champions League. This year looks much more encouraging though with a very good possibility that the league title will once again return to the Dragons’ Den.

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