Manchester United is a largely saturated brand facing structurally irrational competition that is using a one-off step-up in broadcasting and shirt sponsorship revenue and a depressed base to pretend it is a high growth enterprise. Thanks to this, an opaque corporate governance and an IPO in the U.S. it is currently enjoying a high-growth multiple.

The key elements to the short thesis are:

• Bull case on leveraging commercial revenues is flawed
• High capex inflation depressing cash flow
• Revenue growth will plateau next year
• FY14 guidance will disappoint
• Sky-high valuation due to misperception of MANU as a high-growth under monetized franchise

Background

Manchester United, an English football club that is 135 years old and was previously publicly traded in the U.K., chose to list its new shares last years in the U.S. as an ‘emerging growth company’ under the JOBS act, which loosened compliance requirements for smaller companies seeking to raise capital to fund their growth. The Glazer family maintains control through a dual share class structure and related party transactions are plentiful.

Football clubs have become the real world, adult version, of Championship Manager - in case you are unfamiliar, it is the most successful football club management video game - with the caveat that in the video game version a team’s budget for acquiring players and the level of wages being offered to those players is set and so the manager has to manage within the limits of the club’s budget. In the real world version the only budgetary constraint is the wealth of the owner and how much of it is pumped into the club. Key examples of this are Chelsea FC, Manchester City and more recently Paris Saint Germain and Monaco. These clubs are spending well beyond their intrinsic means to build top teams in order to better compete for trophies domestically as well as on the European scene. There appears to be no intention to ever turn in a profit and given the size of the recurring capital layouts a positive IRR seems impossible. These are MANU’s competitors.

The bull case appears relatively simple. Analysts (based on the company’s guidance) split revenues into 2 buckets. Common and uncommon revenue.  Common revenue includes matchday (mostly ticket sales) and broadcasting. These are common because the big clubs have similar size attendance and TV broadcasting revenues are split close to evenly among English Premier League (EPL) clubs. Most football clubs are not run for profits. They are run for break-even at best. Therefore, those clubs are willing to reinvest all their revenue into acquiring and retaining high quality players and technical staff. Players tend to absorb the club’s financial success through increased wages and bonuses. Those clubs that are publicly listed and hence supposed to be run to maximise profits for their shareholders have the choice between deteriorating performance on the pitch or keeping up with the other clubs by offering similar (or higher) player wages and bonuses, i.e. sacrificing profitability. Given that deteriorating performance is not an option for a franchise built on results and performance, any increase in that revenue bucket is passed on entirely to players.

This is why people focus on the so called uncommon revenues. These are the commercial revenues derived from sponsorship deals. Investors believe that MANU has the ability to generate uncommon revenue levels that exceed its competitors by a sufficiently large amount that will enable the club to both perform on the pitch and rapidly grow profits. They focus on the notion that the monetization of MANU’s globally recognized brand is still in its infancy. MANU’s global base of fans/sympathizers is unparalleled among its English peers.  Therefore, any incremental revenues generated from new sponsorship deals will not be absorbed by players as it is ‘above’ the competition’s budget, i.e. it cannot be competed away by not-for-profit competitors.  Given the fixed nature of the cost base, these uncommon revenues flow straight to the - currently negative - bottom line.

Leverage of commercial revenue nowhere to be seen

There are several problems with this analysis. Firstly, history claims the contrary. Over the past 2 years MANU’s commercial revenues have increased by nearly £50m and its EBITDA has remained flat. In fact, over the past 4 years MANU’s overall revenue has increased by £69m and EBITDA has barely grown.

Capex inflation

And let’s not forget that EBITDA excludes the cost of player transfer fees. There is major inflation in the cost of player transfers around the world. Since 1995, the European player transfer market has increased 7x in value! This year alone, the market increased double digits (final data not entirely out yet as transfer window closed last night). In its quest for top quality players, MANU is not only competing with EPL clubs against whom it theoretically has a slight financial advantage (though most of that is eliminated by capital injections from wealthy owners as is the case with Chelsea, Manchester city, and others). It must also compete against international clubs such as Real Madrid and Barcelona whose commercial revenue opportunity is no less than MANU’s. A fresh example of that is Real Madrid’s signing of Gareth Bale for c.€100m, a player that MANU was keen to sign. This means capital expenditures are rising as a % of earnings and hence cash flow is deteriorating. MANU’s recent average net spend spent on player capex (excluding FY09 when they had a large inflow by selling their best player to Real Madrid) is £31m. For this year (FY14 which started in July) analysts are expecting ~£28m. We think this estimate is far too low. Last night MANU singed Fellaini from Everton for £27m, exhausting the entire capex analysts budgeted for year and received major criticism and a ‘failed transfer window’.  Keep in mind that press criticism matters a lot here because the entire business model is about image and perception. They will have to spend far more in the future simply to keep the franchise intact.

Some investors believe that the new financial fair play rules issued by the international football federation will reduce the ability of wealthy owners to inject infinite amounts of capital into their respective clubs which will bolster MANU’s position. We find this naïve. Club owners can easily find new ways of injecting the necessary capital into clubs. An illustration of that is Manchester City’s recent 10 year $642 million sponsorship deal with Etihad, an entity owned by the UAE government, where Manchester City’s owner is deputy prime minister.

Commercial revenue opportunity and future growth

In FY13 MANU is showing nice revenue and EBITDA growth giving the impression that business is booming. However, as can be seen in the table above this comes off a depressed FY12 (due to early champions league exit and less home games). On a 2 year CAGR, revenues grew 3% and EBITDA declined 1%.

For FY14 analysts are expecting close to 30% top line growth. The market seems under the impression that this is driven by the immense monetization opportunity that is being tapped into with sponsorship deals announced nearly on a weekly basis. The reality is that the revenue growth is entirely driven by the one-off step up in EPL broadcasting rights (deal is fixed until 2018 + is common revenue), the new GM shirt sponsorship deal (fixed for 7 years) and the potential renewal Nike kit sponsorship (more on this below). Excluding these, revenue growth would be mid-single digits at best, which is barely sufficient to offset cost inflation. The reason for this is that all these credit card and the like, franchising deals in random countries are tiny in terms of revenue contribution. The shirt sponsorship and kit supply sponsorship account for the vast majority of the commercial revenue opportunity.

The GM deal

This deal, agreed last year just ahead of the IPO (again great timing), was unique. The annual revenue from this deal will be double what the previous sponsor was paying. While analysts view this as a testament to MANU’s great franchise opportunity, the reality is that GM massively overpaid.  It was widely reported that the exec that completed this deal for GM was fired shortly after. Barcelona, a franchise that is unquestionably at least as strong in the football world as MANU, last week singed a new 3 year short sponsorship deal with Qatar Airways under which it will receive £26m per year. This is the second largest shirt sponsorship in football exceeded only by…MANU’s £45m per year Chevy deal.

Kudos to MANU for getting this, but after the one-off step up that’s it for the next 7 years.

Nike deal

Nike is MANU’s kit sponsor and global retail partner. Its current deal lasts through FY15. However, the sides agreed to an exclusive renegotiation window between February-August 2013. Analysts expected a new deal agreed in that window that goes into effect immediately. The revenue increase is modelled on the GM deal so that revenue is doubled. In addition, they expect MANU to bring merchandise distribution is house which they believe will drive further revenue (all of which is supposed to flow straight to the bottom line). All-in, this revenue segment is expected to grow from £38m this year to £79m in FY14. There are 2 issues here.

1. The window has expired and nothing was announced (though this could still happen)
2. The revenue increase seems unrealistic given the cost to sponsor other teams such as Real Madrid, Bayern Munich, Chelsea, etc is less than half of what analysts project for MANU

Putting all of the together we can make 2 conclusions:

1. Following the step-up from the EPL, GM and possible Nike deals revenue growth will plateau
2. The Nike deal likely hasn’t happened which implies that FY14 guidance might be ~20% below expectations on the EBITDA line

Valuation

50x this year’s ‘adjusted’ earnings according to consensus. There is some benefit from lower debt and refinancing next year as well as the step-up in the 3 deals. This gives the following underlying free cash flow calculation:

If we assume at some point Nike pays £30m more and add that to the £25m step from the GM deal as 100% margin we get £80m in free cash flow on £2.4bn market cap or ~3% yield with little to no growth left. If the Nike deal doesn’t happen this yield nearly halves.

Risks

There 3 key risks to this short:

• The stock is not very liquid so if the thesis is dead wrong for some reason it would take time to cover
• Positive news flow e.g. a Nike announcement that is even larger than analysts expect can cause a rally (seem highly unlikely)
• Takeover: this is a trophy asset and some wealthy oligarch or sheikh might be interested. This is somewhat mitigated by the current $2.8bn market…this would be a very high ticket item even if you have oil in your backyard

• FY14 guidance will dissppoint
• Market realisation that after this year revenue growth is flat