Q1 2013: IIBB, GFH and the curious partial sale of Leeds United

We are now through our first full financial quarter of GFH's ownership. The first quarter of 2013 has been quite active with GFH selling a stake to IIBB, a fellow Bahraini investment bank. Now with the first publication of both GFH and IIBB's results we can see how this purchase/sale has been reported by both institutions and how it has changed the ownership structure. A few things are worth noting which I detail below:

Value of the investment in Leeds United

As can be seen, in US$ terms, the value of Leeds United fell by $3.2m over the quarter. However, this fall was driven by currency movements rather than any depreciation in the value of the investment. The value of a 10% stake (roughly £2.8m) is broadly in line with the £2.5m which IIBB state that they have paid for their stake.

Nature of Investment

Now this might get a bit technical, but here we go. Typically, an investment would be structured like this:

This would have the following benefits:

• The investment is ring-fenced from the rest of the group
• It provides an easy structure for investors to be able to acquire a stake
• A new investor gets "clean" exposure to the performance of Leeds United rather than if a stake is acquired through GFH for example.

Comments in the IIBB accounts suggest that their stake is held indirectly through an investment in GFH. GFH also control 100% of the company and it is fully consolidated on their balance sheet, therefore suggesting that the structure is something like this:

Now, for an investment bank to hold an investment in this structure is quite odd for a lot of reasons.

1. Any investment is exposed to GFH's financial performance, at least indirectly.
2. Who controls the exit from the investment? If GFH own 100% of Leeds United, it would suggest that any other investors are effectively dependent on GFH to decide when the exit is.
3. An investment structure as per the above would be a difficult structure for most investors to get comfortable with, unless they could get very comfortable with the GFH business model. This could limit the potential pool of future investors and perhaps ties in with comments from the IIBB annual report about GFH targeting other "regional players" as investment partners.

IIBB's annual report also provided a few more comments on their strategy for this investment: 

"IIB anticipates capital appreciation over the medium-term, therefore we are currently taking the approach to hold the 10% investment in its portfolio, with a consideration to offer it once the club’s financial position is solidified."

To me, this sounds relatively short-term, and would suggest that IIBB would look to exit as and when an appropriate offer was tabled. Much work is to be done in stabilising the club's financial position still (see my previous blog), but with the building work complete and the final season of season ticket forward sales to Ticketus now upon us, one would hope that with some recovery in attendances, the cashflow of Leeds United should improve over the short-term. This would suggest that IIBB's ownership is not likely to being long-term.

Timing of investment

My final point relates to the timing of the investment. The inclusion of the investment in the IIBB 2012 annual report; comments that IIBB were introduced to the investment in December 2012 and as mentioned in previous blogs, the positive revaluation of the investment in the FY2012 GFH accounts, would suggest strongly to me that the sale of 10% of Leeds United actually occurred in December 2012 before the year end rather than at the time of the announcement at the end of March. If this was true, why then was this announcement delayed by 3 months?

Conclusion

The continuing theme of an opaque ownership structure of Leeds United continues, and the strategy for sourcing further investment is open to question as is the assertion that any investment is for the "long-term" when you have a co-investor stating that it will look to exit once the club's financial position is "solidified". In my opinion, the acquisition by IIBB muddies the waters and I see a majority sale over the short to medium term as the most logical step forward.

Time will tell however, and a lot more will become clearer over the early part of the summer and the club's attitude to backing McDermott's strategy, alongside the retention of key personnel such as Byram. If Byram for one is to be sold for a significant sum (which may occur), then whether these funds are then re-invested into the squad is an important metric as to how GFH will be judged as owner of Leeds United. As has been seen in my previous blog, there has been a pattern over the past 5 years of excess transfer profits being diverted to fund ancillary projects rather than being reinvested in the squad. A break from this negative feedback loop would be a positive step forward, that said, I would much prefer Byram to stay.

The Mythology of Ken Bates - Leeds United 2008-12

The Oxford English Dictionary defines a myth as:

A widely held but false belief or idea:

·         an exaggerated or idealized conception of a person or thing

One of the largest myths in association with Leeds United concerns the argument that Ken Bates has created a “well run” football club. A cursory glance at the accounts indicates that this is far from the case.

Stepping back to the original takeover, it can be argued that at that critical juncture there was no one else with neither the will nor ability to step in and take over Leeds. Maybe so, but that doesn’t explain the chronic misallocation of capital away from what should be the primary objective of a football club, the playing squad.

My analysis has focussed on the accounts from the period 2008-2012. 2008 coincided with the exit of Leeds from the latest period of administration, a deduction of 15 points and effectively a business facing a new start. Bates’ consortium had taken control of the club following a payment to shareholders of 11.2p in the pound and whilst numerous creditors lost out, Leeds was effectively debt-free. On that basis, and with the highest turnover of any club in the lower leagues, then Leeds should have been ideally placed to grow from a sustainable base. What therefore happened? One of the main parts of the Bates mythology surrounds his assertion that he established a well-run football club. A simple analysis of the cashflow, the starting basis for whether a business is in a healthy state or not suggests otherwise:

 

As can be seen above, the cashflow of Leeds was largely supported by player sales throughout the post-2008 era, with the exception of 2011 where the net outflow was £1.25m on player transfers. If we look at the entire period, income from player sales contributed £8.4m to Leeds United’s cashflow over the period, and as can be seen from above, this has played a crucial role in keeping Leeds United operating as a viable concern over the period.

Construction Costs

Looking at the cashflow, a total of £18.6m was spent over the 5 years on alterations and fixtures/fittings, which we can see is related to the improvements made to Elland Road (this ties in broadly with the £20m that Bates said had been invested in Elland Road in the Daily Mail article in December). To put this amount into context, the total amount of cashflow generated from operating activities by the club, plus the player sales over the 5 year period totals £19.25m. This is quite astonishing, and for a business whose primary revenue generator isn’t real estate (especially one which doesn’t actually own the real estate it is investing) it is the equivalent of betting the house on black.

Now, there are two reasons why investing this amount may have been necessary/desirable:

1.       Elland Road was unsuitable to host Championship football: Whilst Elland Road may have been requiring modernisation in an ideal world, this wasn’t something that was strictly required. If there had been some legislative or structural requirement to improve the stadium, then under most circumstances this would be the responsibility of our landlord (whoever they may be...).

2.       The investment would produce an attractive and sustainable return which can be reinvested in the playing squad: Given the cost of investing such a large amount involved diverting funds and weakening the playing squad, one would expect that the business would have to receive a substantial return over a short timeframe in order for this to justify the outlay.

To my mind, neither point is valid in this case and certainly not to the detriment of investment in the playing squad. £18.6m which could have been invested in the playing squad was instead diverted to a spurious building project which has done little to enhance the bottom line of the business and by diverting funds at crucial points over the past 5 years, may have prevented Leeds United securing promotion at an earlier stage. This is further proved when looking at the growth in turnover components over the period. For this I have excluded central distributions and TV income which are largely outside of the control of the football club business and instead focussed on gate receipts, merchandise revenue and other commercial revenue. If we assume that corporate hospitality falls into other commercial revenue which is its most logical location, we can see that it has broadly flatlined over the period;

What therefore was the justification for investing a huge component of the cashflow for what looks like quite meagre returns to date?

Administrative Expenses

Another component which stands out when looking through the accounts is the amount of administrative expenses. As can be seen below, whilst wage growth has been relatively constrained, and I have assumed that rent has grown by 3% per year from a base of £2m (as per Swiss Ramble’s blog: http://swissramble.blogspot.co.uk/2012/05/leeds-united-marching-on-together.html), the growth in other costs has been huge, growing from £5.5m to a total of £10.6m, in effect doubling. It is hard to see what significant other costs would be due to be paid by a club which has outsourced its catering services and does pose some questions. As ever, given the lack of clarity in the accounts it is very hard to see where the costs have been accrued.

 

Given the comments during the Levi case where Harvey referenced the huge legal costs that the club had incurred, one can only presume that a significant component of the other costs must relate to some of these legal costs.

Wage growth has remained constrained throughout the period, as can be seen from the chart below:

Leeds have consistently kept the ratio of wages/turnover between 49-56% over the 5 year period which, as Swiss Ramble stated in his blog, puts Leeds at the bottom of the pile compared to other Championship clubs. Whilst sustainability is obviously important (as we have seen over our recent history) it does suggest that there is room for further investment in wages to be made, especially if there can be some cost control of some of the other costs within the business.

 

Conclusions

"We are one of the most stable clubs in the country, we will not take any risks, and we will not spend money that we haven`t got in the hope that we will go up." – Ken Bates 28/12/11

Looking at the 2008-12 period and Bates’ claim of building a “well-run club”, one which takes no risks and doesn’t spend money it doesn’t have doesn’t quite stack up. For a start, investing the vast majority of the operating cashflow of the business whilst also funding the remainder by selling the only valuable assets of the business (the playing squad) to fund an investment which to date has failed to produce any form of reasonable return for the outlay strikes me as the exact opposite of not taking risks.

When the cashflow started to run out in 2011/12, Bates had to rely on raising capital by forward-selling income from season tickets and taking loans from other spurious sources. Forward-selling season ticket income it should be remembered was exactly the strategy that got Leeds into trouble during the Ridsdale era, an era Bates likes to refer to as an example of bad management.

Ultimately 2008-12 represents an opportunity missed. Had the operating cashflows been invested sustainably in the playing squad, had the club taken a more active approach in keeping some of the promising League One squad together by perhaps increasing its wage/turnover ratio and reducing some of the other costs, then the dream of Premier League status could have been realised. Instead we have shiny new corporate facilities, another season of mid-table Championship football and a club which has a significant amount of its future cashflow sold onto other companies. Turning around a troubled business is like turning around an oil tanker and therefore GFH or whichever other party becomes involved with Leeds over the near future will require time and investment to do this. Ultimately the rhetoric and mythology that Bates has sought to create belies the reality of a club which has gone backwards rather than forwards over the past 5 years.