Winning at a Loser's Game? Control, Synergy and the ABInBev/SABMiller Merger!

I have been a long time investor in ABInBev, though I became one indirectly and accidentally, through a stake I took a long time ago in Brahma, a Brazilian beverage company . That company became Ambev in 1999, which in turn was merged with Interbrew, the Belgian brewer, in 2004, and expanded to include Anheuser Busch, the US beer maker, in 2008 to become the largest beer manufacturer in the world.  I made the bulk of my money early in my holding life, but Amber has remained in my portfolio, a place holder that provides me exposure to both the beverage business and Latin America, while delivering mostly positive returns. It was thus with trepidation that I read the news report in mid-September that ABInBev (which owns 62% of Ambev) had approached SABMiller about a takeover at a still-to-be-specified premium over the the latter's market value. While it is entirely possible to create value from acquisitions, I have argued that creating growth through acquisitions is difficult to do, and doubly so when the acquisition is of a large public company. Since ABInBev's control rests with 3G Capital, a group that I respect for its investment acumen, it would be unfair to prejudge this deal without looking at the numbers. So, here we go!

The Fog of Deal Making: Breaking down an acquisition

The first casualty in deal making is good sense, as the fog of the deal, created by bankers, managers, consultants and journalists, clouds the numbers. Not only do you see "control" and "synergy", two words that I include in my weapons of mass distraction, thrown around casually to justify billions of dollars in premiums, but you also see them used interchangeably. When you acquire a company, there are three (and only three possible) motives that are consistent with intrinsic value. 

1. Undervaluation: You buy a target company because you believe that the market is mispricing the company and that you can buy it for less than its "fair" value. In effect, you are behaving like any value investor would in the market and there is no need for you to either change the way the target company is run or look for synergy benefits. 
2. Control: You buy a company that you believe is badly managed, with the intent of changing the way it is run. If you are right on the first count and can make the necessary changes, the value of the firm should increase under your management. If you can pay less than the "changed" value, you can claim the difference for yourself (and your stockholders). 
3. Synergy: You buy a company that you believe, when combined with a business (or resource) that you already own, will be able to do things that you could not have done as separate entities. Broadly speaking, you can break synergy down into "offensive synergies" (where you are able to grow faster in existing or new markets than you would have as standalone businesses and/or charge higher prices for your products), "defensive synergies" (where you are able to reduce costs or slow down/prevent decline in your businesees) and "tax synergies" (where you directly take advantage of tax clauses or indirectly by being able to borrow more money). 

The key distinction between synergy and control is that control does not require another entity or even a change in managers. It can be accomplished by the target company's management, if they put their minds to it and perhaps hire some help. Synergy requires two entities coming together and stems from the combined entity's capacity to do something that the individual entities would not have been able to deliver. Note that these motives can co-exist in the same acquisition and are not mutually exclusive.  To assess whether these motives apply (or make sense), there are four numbers that you need to track: 

1. Acquisition Price: This is the price at which you can acquire the target company. If it is a private business, it will be negotiated and probably based on what others are paying for similar businesses. If it is a public company, it will be at a premium over the market price, with the premium a function of the state of the M&A market and whether you have other potential bidders. 
2. Status Quo Value: This is the value of the target company, run by existing management and based on existing investing, financing and dividend policies. 
3. Restructured Value: This is the value of the target company, with changes to investing, financing and dividend policies. 
4. Synergy value: This can be estimated by valuing the combined company (with the synergy benefits built in) and subtracting out the value of the acquiring company, as a stand alone entity, and the restructured value of the target company. 

Connecting these numbers to the motives, here are the conditions you would need for each motive to make sense (by itself).

Motive	Test
Undervaluation	Acquisition Price < Status Quo Value
Control	Acquisition Price < Restructured Value (Status Quo Value + Value of Control
Synergy	Acquisition Price < Restructured Value + (Value of Combined company with synergy - Value of Combined company without synergy)

Which of these motives, if any, is driving ABInBev's acquisition of SABMiller, and whatever the motive or motives, is the premium being paid justified? To make that assessment, I will compute each of the four numbers for this deal.

Setting up the ABInBev Deal

The first news stories on ABInBev’s intent to buy SABMiller came out on September 15, 2015, though there may have been inklings among some who are more connected than I am. While no price was specified, the market’s initial reaction was positive, with both ABInBev and SABMiller’s stock prices increasing on the story. The picture below captures the key details of the deal, including both possible rationale and consequences:

There were two key reasons provided to rationalize the potential deal. The first is geographic complementarity, since these two companies overlap in surprisingly few parts of the world, given their size. ABInBev is the largest player in Latin America, with Brazil at its center, and SABMiller is the biggest brewer in Africa. SABMiller’s Latin American operations are outside of Brazil, for the most part and while ABInBev has significant North American operations, SABMiller's North American exposure is entirely through its Coors Joint Venture. While no specifics are provided, the basis for synergy seems to be that after this deal, ABInBev will be able to expand sales in the fastest growing market in the world (Africa) and that SABMiller will be able to increase its revenues in the most profitable market in the world (Latin America). The second is consolidation, a vastly over used term that often means nothing, but  if it tied to specifics, relates to potential costs savings and economies of scale. While the absence of geographic overlap may reduce the potential for cost cutting, ABInBev can use the template that it has used so successfully on prior deals (especially the Grupo Modelo acquisition) to cut costs in this acquisition as well.

There are also negative consequences that follow from this deal. The first is that when anti trust regulators in different parts of the world will be paying close attention to this deal, and it seems likely that SABMiller will be forced to sell its 58% stake in MillerCoors and that Molson Coors, the other JV partner, will be the beneficiary. The second, and this adds to the pressure, ABInBev has agreed to pay $3 billion to SABMiller if the deal falls through.  In summary, though, the challenge is a simple one. ABInBev is paying a $29 billion premium to acquire SABMiller. Is there enough value added to ABInBev's stockholders that they will be able to walk away as winners?

The Players in the Deal
To make a value judgment of this deal, we have to begin by looking at ABInBev and SABMiller, as stand alone companies, prior to this deal. In the picture below, I start with a snapshot of ABInBev:

Capital Mix		Operating Metrics		Geographical Mix
Interest-bearing Debt	$51,504	Revenues	$45,762	Latin America	$18,849.00	42.03%
Lease Debt	$1,511	Operating Income (EBIT)	$14,772	Africa	$-	0.00%
Market Capitalization	$173,760	Operating Margin	32.28%	Asia Pacific	$5,040.00	11.24%
Debt to Equity ratio	30.51%	Effective tax rate	18.00%	Europe	$4,865.00	10.85%
Debt to Capital ratio	23.38%	After-tax return on capital	12.10%	North America	$16,093.00	35.88%
Bond Rating	A2	Reinvestment Rate =	50.99%	Total	$44,847.00	100.00%

Looking past the numbers, it is worth noting that not only does ABInBev has a history of growing successfully through acquisitions but that its lead stockholder, 3G Capital, is considered a shrewd allocator and steward of capital.

On the other other side of the deal stands SABMiller, and the picture below provides a sense of the company's standing at the time of the deal:

Capital Mix		Operating Metrics		Geographical Mix
Interest-bearing Debt	$12,550	Revenues	$22,130	Latin America	$7,812	35.30%
Lease Debt	$368	Operating Income (EBIT)	$4,420	Africa	$6,853	30.97%
Market Capitalization	$75,116	Operating Margin	19.97%	Asia Pacific	$3,136	14.17%
Debt to Equity ratio	17.20%	Effective tax rate	26.40%	Europe	$4,186	18.92%
Debt to Capital ratio	14.67%	After-tax return on capital	10.32%	North America	$143	0.65%
Bond Rating	A3	Reinvestment Rate =	16.02%	Total	$22,130	100.00%

This table, though, misses SAB's holdings in the MillerCoors JV and its other minority holdings in associates around the world, and the numbers for SAB's shares of these are summarized below:

SAB Share of Other Associates
Operating Metrics		Geographical Mix
Revenues	$6,099.00	Latin America	$-	0.00%
Operating Income (EBIT)	$654.00	Africa (mostly South Africa)	$2,221	36.42%
Operating Margin	10.72%	Asia Pacific	$2,203	36.12%
Effective tax rate	25.00%	Europe	$1,675	27.46%
After-tax return on capital	11.00%	North America	$-	0.00%
Invested Capital	$4,459	Total	$6,099	100.00%
SAB Share of MillerCoors JV
Operating Metrics		Geographical Mix
Revenues	$5,201.00	Latin America	$-	0.00%
Operating Income (EBIT)	$800.00	Africa (mostly South Africa)	$-	0.00%
Operating Margin	15.38%	Asia Pacific	$-	0.00%
Effective tax rate	25.00%	Europe	$-	0.00%
After-tax return on capital	11.05%	North America	$5,201	100.00%
Invested Capital	$5,428	Total	$5,201	100.00%

The numbers reinforce my earlier point about geographic complementarity at least at the parent company level, with ABInBev getting a large percent of its Latin American sales in Brazil and SABMiller getting most of its Latin American sales from countries other than Brazil.

Is SABMiller a bargain?

The first step in this analysis to a valuation of SABMiller, as a stand alone company and with its existing management in place. Based on the numbers, this is a conservatively run company (both in terms of use of debt and reinvestment for growth) and the valuation reflects that:

	SAB Miller	+ 58% of Coors JV	+ Share of Associates	SAB Miller Consolidated
Revenues	$22,130.00	$5,201.00	$6,099.00
Operating Margin	19.97%	15.38%	10.72%
Operating Income (EBIT)	$4,420.00	$800.00	$654.00
Invested Capital	$31,526.00	$5,428.00	$4,459.00
Beta	0.7977	0.6872	0.6872
ERP	8.90%	6.00%	7.90%
Cost of Equity =	9.10%	6.12%	7.43%
After-tax cost of debt =	2.24%	2.08%	2.24%
Debt to Capital Ratio	14.67%	0.00%	0.00%
Cost of capital =	8.09%	6.12%	7.43%
After-tax return on capital =	10.33%	11.05%	11.00%
Reinvestment Rate =	16.02%	40.00%	40.00%
Expected growth rate=	1.65%	4.42%	4.40%
Number of years of growth	5	5	5
Value of firm
PV of FCFF in high growth =	$11,411.72	$1,715.25	$1,351.68
Terminal value =	$47,711.04	$15,094.36	$9,354.28
Value of operating assets today =	$43,747.24	$12,929.46	$7,889.56	$64,566.26
+ Cash				$1,027.00
- Debt				$12,918.00
- Minority Interests				$1,183.00
Value of equity				$51,492.26

 I am adding in my estimated values for SAB's share of the Coor's JV and other associates to arrive at the total value of the operating assets. In valuing each piece, I have estimated equity risk premiums that reflect where each one operates, using a 6% mature market premium for the Coors JV, since it generates most of its revenues in North America, and much higher premiums for the other two parts. At least based on my estimates, the value of equity is $51.5 billion, well below the market capitalization of $75 billion on September 15. (This may be cynical of me, but if used (wrongly in my view) a 6% equity risk premium for SABMiller, based on its UK incorporation, I get a value of $76 billion for its equity.)

Bottom line: To me, SABMiller does not look like it is priced to be a bargain, even at the pre-deal price, and definitely not at the deal price.

The Value of Control

Is SABMiller ripe for a restructuring? It is tough to tell from the outside but one way to measure room for improvement is to compare the company on key corporate finance measures against both the acquirer (InBev) and the rest of the alcholic beverage sector:

	SABMiller	ABInBev	Global Alcoholic Beverage Sector
Pre-tax Operating Margin	19.97%	32.28%	19.23%
Effective Tax Rate	26.36%	18.00%	22.00%
Pre-tax ROIC	14.02%	14.76%	17.16%
ROIC	10.33%	12.10%	13.38%
Reinvestment Rate	16.02%	50.99%	33.29%
Debt to Capital	14.67%	23.38%	18.82%

This comparison may be simplistic, but it looks like SABMiller lags the sector is in its reinvestment rate and return on capital, and that it earns a profit margin that match up to the sector. It also has a debt ratio that is not far off from the sector average. ABInBev has a much higher profit margin than the rest of the sector and pays a lower tax rate. I revalued SABMiller with the return on capital, debt ratio and reinvestment rate set equal to the industry average. (I considered using ABInBev's operating margin but much of that comes from Brazil and it is unlikely that SABMiller can match it in South Africa or the rest of Latin America.

	Status Quo Value	Restructured	Changes made
Cost of Equity =	9.10%	9.37%	Increases with debt ratio
After-tax cost of debt =	2.24%	2.24%	Left unchanged
Debt to Capital Ratio	14.67%	18.82%	Set to industry average
Cost of capital =	8.09%	8.03%	Due to debt ratio change
Pre-tax return on capital	14.02%	17.16%	Set to industry average
After-tax return on capital =	10.33%	12.64%	Result of pre-tax ROIC change
Reinvestment Rate =	16.02%	33.29%	Set to industry average
Expected growth rate=	1.65%	4.21%	Result of reinvestment/ROIC
Value of firm
PV of FCFF in high growth =	$11,411.72	$9,757.08
Terminal value =	$47,711.04	$56,935.06
Value of operating assets today =	$43,747.24	$48,449.42
+ Cash	$1,027.00	$1,027.00
+ Minority Holdings	$20,819.02	$20,819.02
- Debt	$12,918.00	$12,918.00
- Minority Interests	$1,183.00	$1,183.00	Value of Control
Value of equity	$51,492.26	$56,194.44	$4,702.17

Bottom line: Changing the way SABMiller is run adds about $4.7 billion to the value, but even with that addition, the equity value of $56.2 billion is still far below what ABInBev paid on October 15. That suggests that control was not the primary rationale either.

The Value of Synergy

This leaves us with only one option, synergy, and to value synergy, I valued ABInBev as a standalone company and put it together with the restructured value of SABMiller to get a combined company value, with no synergy. I then assumed that the synergy (from geographic complementarity and consolidation) would manifest itself in a higher operating margin, higher reinvestment and a higher growth rate for the combined company:

	Inbev	SABMiller	Combined firm (no synergy)	Combined firm (synergy)	Actions
Cost of Equity =	8.93%	9.37%	9.12%	9.12%
After-tax cost of debt =	2.10%	2.24%	2.10%	2.10%
Cost of capital =	7.33%	8.03%	7.51%	7.51%	No changes expected
Operating Margin	32.28%	19.97%	28.27%	30.00%	Cost cutting & Economies of scale
After-tax return on capital =	12.10%	12.64%	11.68%	12.00%	Cost cutting also improves return on capital
Reinvestment Rate =	50.99%	33.29%	43.58%	50.00%	More aggressive reinvestment in shared markets
Expected growth rate=	6.17%	4.21%	5.09%	6.00%	Higher growth because of reinvestment
Value of firm
PV of FCFF in high growth =	$28,732.57	$9,806.49	$38,539.06	$39,150.61
Terminal value =	$260,981.86	$58,735.57	$319,717.43	$340,174.63	Value of Synergy
Value of operating assets =	$211,952.80	$50,065.35	$262,018.16	$276,609.92	$14,591.76

It is possible that I have been too pessimistic about the potential cost savings or growth possibilities, but given the history of synergy in big deals, I think that I am being optimistic. Based on my estimates at least, the value of synergy in this deal is $14.6 billion (and that is assuming it is delivered instantaneously).
Bottom line: If synergy is the motive for this deal, a great deal has to go right for ABInBev to break even on this deal, let alone create value.

The Disconnect
The history of 3G Capital as successful value creators predisposed me to give them the benefit of the doubt, when I started assessing the deal. After looking at the numbers, though, I don't see the value in this deal that would justify the premium paid. It is possible, perhaps even likely, that there is some aspect of the deal, perhaps taxes or other benefits, that I am not grasping. If so, I would encourage you to use my template, change the numbers that you think need to be changed, make your own assessment and enter them in this shared Google spreadsheet. It is also possible that even the smartest investors in the world can sometimes let over confidence drive them to over react. Time will tell!

YouTube version


Data Attachments

1. ABInBev Annual Report (2014)
2. SABMiller Annual Report (2015)

Spreadsheets

1. SABMiller: Status Quo and Control Value
2. Value of Synergy 
3. Google Shared Spreadsheet for Deal Analysis

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The Ride Sharing Business: Playing Pundit

This is the third and final post in a series of three on the ride sharing business. In the first, I valued Uber and looked at the evolution of its business over the last 18 months. In the second, I valued Lyft and looked at pricing across ride sharing companies. In this one, I look at the future of the ride sharing business from the perspective of an outsider with no expertise in this business.

In my last two posts, I first valued Uber, with its expansive narrative, and then looked at putting numbers on Lyft's less ambitious storyline. In my Uber post, I argued that the ride sharing market was proving to be bigger, broader and growing faster than I had estimated it would be in June 2014. In the Lyft post, I examined how VCs were pricing ride sharing companies. In this post, I want to complete the story by looking at the current state of the ride sharing market and for scenarios for the market over time, with consequences for investors, car riders and drivers. 

The Ride Sharing Market: The State of the Game

In my posts on ride sharing, I noted that the ride sharing market has grown exponentially in the last two years, drawing in new users and redefining the car service business. That growth can be seen  in multiple dimensions:

1. Anecdotal & Qualitative evidence: I am usually wary about using anecdotal data but I have been keeping tabs on Uber usage in my travels and I have been amazed at the company's global reach. This summer, I did seminars in São Paulo, Moscow and Mumbai, and in each venue, a significant proportion of the attendants had taken Uber to the event. In fact, my children talk about Ubering to destinations unknown, rather than taking a cab, just as xeroxing and googling became synonyms for copying and online searching. 
2. Operating metrics at ride sharing companies: The operating metrics at the ride sharing companies individually, and in the aggregate, back up the proposition that this is a high growth business.

Company	Revenues in 2014	Revenues (2015)	Growth Rate (2015)
Lyft	$125	$300	140.00%
Uber	$400	$2,000	400.00%
Didi Kuaidi	$30	$450	1400.00%
Ola	$50	$150	200.00%
GrabTaxi	$15	$50	233.33%
BlaBlaCar	$30	$72	140.00%

3. Investor expectations: The increases in the values attached to ride sharing companies indicate that investors are also scaling up expectations of future growth in this business. Using Uber's estimated value of $51 billion in its most recent VC funding to illustrate the process, I estimated imputed revenues of $51.4 billion in 2026, which, if you hold its revenue slice share at 15% (my assumption) yields an imputed gross billing of $342.8 billion in 2026. If I repeat this exercise with the other ride sharing companies, the collective revenues being forecast by investors may exceed attainable revenues, an example of what I termed the big market delusion.

Company	Estimated Value (Price)	Revenue Share	Operating Margin	Failure Probability	Imputed Revenue(2026)	Imputed Gross Billing (2026)
Lyft	$2,500	15%	25%	10%	$2,800	$18,665
Uber	$51,000	15%	25%	0%	$51,418	$342,787
Didi Kuaidi	$15,000	15%	20%	0%	$20,044	$133,629
Ola	$2,500	15%	20%	15%	$3,927	$26,183
GrabTaxi	$1,500	10%	20%	15%	$2,392	$23,923
BlaBlaCar	$1,600	12%	20%	10%	$2,392	$19,935
Total	$74,100	NA	NA	NA	$82,974	$565,123

The growth in ride sharing has been accompanied with more intense competition and rising costs, as can be seen in the large and growing operating losses reported by the companies in this business. The reasons for these losses are manifold, as I noted in my Uber post. Some of the costs come from intense competition for drivers and customers, with companies following the Field of Dreams model, that Amazon has used to such effect in the last decade. Some costs come from outside, higher insurance costs and employee expenses, as ride sharing companies go from being fringe players to larger businesses. Some costs flow from legal fights with regulators, licensing agencies and other rule-writers, whose desire to control the business clashes with the market-driven imperatives of ride sharing. The optimistic view is that these costs will become smaller as companies scale up, but will they? As revenues scale up, the number of drivers will increase proportionately, and unless the competition disappears, the costs of fighting for drivers and customers will continue. In brief, the existing ride sharing model looks like a long term money loser, unless something fundamental changes.

 Future Shock

At the risk of playing market prognosticator in a market where I am a novice, I see four possible scenarios that can unfold in this market, all possible, but perhaps not equally probable.

1. Winner-takes-all: The big prize in many technology businesses is that there is a tipping point, where the winner ends up capturing much of the market. That is the template that Microsoft used two decades ago with MS Office to capture the business software business and that Google used to scale the heights of online advertising. The payoff to such a strategy is that you not only control the dominant market share but that you get pricing power (and higher profits). It does seem to be the strategy that Uber is following in the ride sharing business, but there remain three road blocks that may get in the way. First, you have to remove your competitors from the playing field and while Uber had the cash buffer and capital raising upper hand last year, that advantage has narrowed as a result of partnerships and new capital flowing into other ride sharing companies. In a perverse way, Uber's best chance of succeeding at this strategy is if there is a hitch or stop in the flow of capital to tech companies, though that may work against its objective of going public in the near future. Second, you have to navigate your way through the anti trust and monopoly questions that will inevitably follow, not an easy or an inexpensive task, as Google and Microsoft have discovered over the last decade. Third, while technology remains a focal point for ride sharing companies, the car service or logistics business needs physical infrastructure, making it more difficult to preserve global networking benefits.
2. The Losers' Game: While the winner-take-all is alluring, its logical conclusion, if you have multiple players pursuing it, and none winning, is that you can make the business a loser's game, one in which the market grows as promised and companies generate high revenues, but make very little in profits. A big business can sometimes be a bad one, as I noted in this post on bad businesses and why companies in these businesses continue to invest and grow in them.
3. The Divide and Rule Game: As the old colonial empires discovered a few centuries ago, and the Sicilian crime families realized in the late 1920s in the United States, the most profitable end game, when competition is cut-throat (literally), is to negotiate a truce, where the spoils are divided up and each competitor is given control of a segment. In the ride sharing market, if the business boils down to two or three large players, they may be able carve up the global market and each player will get a free run in their carved up portion . This will be, of course, terrible news for drivers and customers and may attract regulatory or legal scrutiny, but for investors collectively, it will be most value-adding scenario. There are two potential weak links. The first is that this truce, by its very nature, will not be a friendly one and small violations can lead to it unraveling. The second is that it rests on the premise that there is no outside party that is powerful enough to step in and take advantage of the soft spots in the market.
4. The Game Changer: I believe that the existing ride sharing model is an unstable one. As I argued in my post on Uber, the very strengths of the models (bare bones infrastructure, drivers as independent contracts and no car ownership) makes it unsustainable in the long term, since ride sharing companies have to compete for drivers on a continuous basis, offering them incentives to switch from competitors, and customers, with special deals. It is therefore likely that a new model will emerge, though it remains an open question of whether it will come from one of the players in the game, or from an outsider. Thus, Uber's hiring of robotics engineers may be a precursor of a different ride sharing game, with driverless cars and infrastructure investments, or it may be Google or Tesla who enter the picture with a different way of operating this business. 

If these scenarios remind you a little little of the prisoner's dilemma, where two rational individuals are given a choice between cooperating and competing, there are parallels. Consider one possible version, where the ride sharing companies globally boil down to two competitors: Uber, as a global ride sharing behemoth, and the Not-Uber, an alliance of  national ride ride sharing companies (Ola+Didi Kuaidi + GrabTaxi + Lyft..). The box below captures the possible outcomes of this game, which will get infinitely more complicated if there is an outsider player lurking on the fringes.

Based on my very limited knowledge of the companies in this space, I would give the highest odds to the ride sharing business becoming a loser's game, attach about equal probabilities to it becoming a winner-take-all or a game changer emerging, and see the least chance that the ride sharing companies will collude to maximize profits and value. There are others, who know more about this business than I do, who see this game evolving differently over time. Mark Shurtleff at Green Wheels Mobility Solutions, the ride sharing expert that I referenced in my last post thinks that I am being too pessimistic on some counts and perhaps too optimistic on others and feels that there are small start ups that are finding a better business model than the big players. There are some who believe that I am underestimating the pull of the familiar and that ride sharing companies, once established, will be difficult to displace. 

The Dance of the Disrupted

In a post from a few months ago, I looked at the the dark side of disruption, i.e., the businesses being disrupted, both with the intent of identifying the businesses most at risk and to look at the stages, at least as I see them, of how the disrupted business deal with the chaos of seeing established business models being upended. Using that five stage process, it seems to me that the taxi cab business is now at an advanced stage:

Stage of disruption	The Taxi Cab Business
1. Denial and Delusion	This is long in the past, but in the first year or two of Uber’s existence, there were many in the conventional car service and taxi cab businesses, who were convinced that not only was this a passing phase, but that no customer in his right mind would want to miss the comfort, convenience and safety of a yellow cab experience. (Irony alert!)
2. Failure and False Hope	With each misstep by a ride sharing company (and Uber in particular), whether it be an employee with a loose tongue or a assault by an Uber driver, the hope that this misstep will put an end to the ride sharing business rises among taxi operators and regulators. However, only the most delusional among these hold on this hope.
3. Imitation and Institutional Inertia	In the mistaken belief that all that separates the ride sharing companies from conventional car service is an app, taxi operators have turned to putting apps in the hands of drivers and customers. At the same time, any attempts to introduce flexibility into the existing car service business are fought by politicians, regulators and some of the operators who benefit from the current structure.
4. Regulation, Rule Rigging and Legal Challenges	This seems to be the place where car service companies are making their stand, aided and abetted by regulators, courts and politics. By restricting or even banning ride sharing, they are slowing it’s growth but as I see it, the fight is on its way to being lost, since it is the customers who ultimately will determine the winner in this game, and they are voting with their dollars.
5. Acceptance and Adjustment	It may be slow in coming, but a portion of the conventional car service business is adjusting to the new reality, sometimes because they realize that it is a fight that is unwinnable and sometimes because the financial hill is getting steeper to climb. This is especially true for cab operators who have borrowed much or most of the money that they used to buy medallions and are discovering that they cannot pay their debt.

So what does the future hold? Will there be no taxi cabs left on the streets of New York, London and Tokyo in a few years? I think that the taxi cab business will shrink, but not disappear, and that it will retain a portion of its business in those public spaces where regulators have the most say, airports, train stations and public arenas. If this is the future, it is also clear that there is more pain to come and it will take the form of continuing decline in taxi cab revenues and market capitalization at these companies. As for the private car service business, it will either adapt and share revenues with the ride sharing companies  (which still needs cars and drivers) or focus on corporate relationships (offering discounted and on-demand services to companies that do not want their employees using multiple ride sharing services). 

Coming soon to a business near you?

As I watch the traditional taxi cab business flailing and ride sharing companies grow at their expense, and am tempted to pass judgment on the inability of those in the business to adapt to the world that they live in, there are two general lessons that come to mind. From the disruptor's standpoint, I think that the success of Uber and its peer group in changing the car service business is a reminder that existing business models can be disrupted in short order by new technologies, but the collective losses reported by these companies are also a reminder that making money on disruption is much more difficult.

Looking at the same process from the perspective of the disrupted, it is a reminder that the pain inflicted on the car service business could very easily be coming to the business that you are in. If you are in the financial services business,  the entertainment business or the health care business, all of which are deserving of disruption, I wonder whether you would react any more rationally than the London cabdrivers who went on strike to stop Uber, and ended up getting many of their customers to try Uber for the very first time. I operate in the education business, a large and extraordinarily inefficient business, and there is no group more resistant to change and more unprepared to adapt than tenured professors at research university. I cannot wait to see this group, convinced of its intellectual superiority and attached to unreal perks (minuscule teaching loads, research assistants and sabbaticals),  go through the throes of disruption.

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Ride Sharing Series (September 2015)

1. On the Uber Rollercoaster: Narrative Tweaks, Twists and Turns
2. Dream Big or Stay Focused? The Lyft Answer!
3. The Future of Ride Sharing: Playing Pundit

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Manchester City - The Modern World

Most football clubs would be very satisfied if they ended up with a second place Premier League finish and qualifying for the knockout stages of the Champions League, but not Manchester City. In fact, chairman Khaldoon Al Mubarak said, “it is hard to look back on the 2014/15 season without a degree of disappointment”, as there was no title to show for their efforts.

However, he did point out, “The fact that we consider last season to be below par for Manchester City is a testament to how far we have come in the last seven years”, adding “this is a level of ambition that we should not shirk or shy away from.”

Although City may not have met all the owners’ demanding objectives in terms of filling the trophy cabinet, they certainly performed off the pitch. As chief executive Ferren Soriano said, “The 2014/15 season marked a historical step in Manchester City’s journey. The club delivered an annual profit for the first time since its acquisition in 2008.”

In fact, City reported a pre-tax profit of £10.4 million (£10.7 million after tax), compared to the previous year’s loss of £22.9 million, a year-on-year improvement of £33.3 million. Revenue rose by £5 million (2%) to a record £352 million, marking the seventh straight year of revenue growth, with commercial income up £7 million (4%) to £173 million and broadcast revenue up £2 million (2%) to £135 million, though match day revenue was £4 million (9%) lower, largely as a result of the stadium expansion works.

Profit on player sales was £14 million higher, but the main driver of the better figures in 2014/15 was a reduction in costs, as the wage bill was cut by £11 million (5%) to £194 million and player amortisation was £6 million (8%) lower. Against that, other expenses rose £8 million (12%) to £76 million and depreciation was £2 million higher.

This year also benefited from having no exceptional items, while 2013/14 was adversely impacted by the £16 million settlement with UEFA for failing to meet Financial Fair Play (FFP) regulations, though this was partly offset by £7 million insurance proceeds. Finally, there was a £2 million loss on disposal of fixed assets, while other operating income was £1 million lower.

Of course, these days the Premier League is a largely profitable environment, largely thanks to the ever increasing TV deals, with City being one of just five clubs in the top flight to lose money in 2013/14. Only three clubs have to date published their accounts in 2014/15 with both City and Arsenal reporting healthy profits, though Manchester United’s absence from the Champions League contributed to them slipping into the, ahem, red with a £4 million loss.

Once-off profits on player sales can also be very important to the bottom line. While City made less than £200,000 from this activity in 2013/14, this rose to £13.8 million last season, helping the club’s return to overall profitability. This was largely due to the sales of Matija Nastasic to Schalke 04, Jack Rodwell to Sunderland, Javi Garcia to Zenit Saint Petersburg and Gareth Barry to Everton.

This has not been a great money-spinner for City recently, but next year’s accounts will benefit from a number of players leaving the club, which has generated sales proceeds of around £48 million (Alvaro Negredo to Valencia £24 million, Rony Lopes to Monaco £9 million, Karim Rekik to Marseille £3.5 million, Scott Sinclair to Aston Villa £2.5 million and Dedrick Boyata to Celtic £1.5 million) and £5 million of loan fees (including Edin Dzeko to Roma £2.9 million and Stevan Jovetic to Inter £2 million). Dzeko’s loan was made permanent in October, bringing in an additional £8 million.

After deducting accumulated amortisation, all those deals could bring in over £40 million of profits in 2015/16 with a further £10 million due if the other loan deals are made permanent (though that might only hit the 2016/17 books).

Other clubs have been generating sizeable profits from this activity, as can be seen in 2013/14: Tottenham £104 million (largely Gareth Bale to Real Madrid), Chelsea £65 million (David Luiz to PSG), Southampton £32 million (Adam Lallana to Liverpool) and Everton £28 million (Marouane Fellaini to Manchester United).

After years of heavy spending in order to build a squad and the facilities required to compete at the highest level, City’s losses have been steadily reducing since the record £197 million peak posted in 2011, effectively halving each year (2012 £99 million, 2013 £52 million and 2014 £23 million) before reaching profitability in 2015.

Al Mubarak described the transition to profitability as “a long planned milestone”, being part of “a strategy predicated on long-term sustainability and the ongoing development of momentum year-after-year.” The figures certainly seem to support this viewpoint, marking out an almost perfect v-shaped recovery.

Another impressive aspect of these results is that they have not been enhanced by some of the fancy footwork that has been seen in previous years, most notably in 2013 when the sale of intellectual property lowered the loss by £47 million.

Against that, City would actually have been close to profitability last year without the £16 million UEFA fine.

The other side of player trading is obviously player purchases, which is reflected in the accounts via player amortisation, as transfer fees are not fully expensed in the year a player is purchased, but the cost is spread evenly over the length of the player’s contract. City’s initial spending spree saw player amortisation shoot up from just £6 million in 2007 to a peak of £84 million in 2011, before falling away in the last three years to £70 million in line with less frenetic transfer activity.

In addition, City have frequently extended player contracts, so any remaining written-down value in the accounts for those players has been amortised over the term of the new contract. This has had the advantage of reducing the annual amortisation charge in recent years, but has the disadvantage of extending the period for which these players’ transfer fees are amortised.

Clubs that are regarded as big spenders logically have the highest player amortisation charges, so United’s massive outlay under Moyes and van Gaal has driven their annual expense up to £100 million. The next highest in the Premier League is Chelsea £72 million (2013/14), followed by City £70 million, while Arsenal’s relatively restrained spending has left them with £54 million of player amortisation in 2014/15.

The accounting for player trading is horribly technical, but it is important to grasp how it works to really understand a football club’s accounts. The fundamental point is that when a club purchases a player the costs are spread over a few years, but any profit made from selling players is immediately booked to the accounts, which helps explain why clubs like City can spend so much and still meet UEFA’s Financial Fair Play targets.

As a result of all this accounting smoke and mirrors, clubs often look at EBITDA (Earnings Before Interest, Depreciation and Amortisation) for a better idea of underlying profitability. In City’s case this metric clearly shows their improvement, as it has steadily risen from a negative £71 million in 2011 to an impressive £83 million in 2015.

This is only behind Manchester United, whose amazing ability to generate cash is reflected in their EBITDA of £120 million (and they are projecting an astonishing £165-175 million for 2015/16 following their return to the Champions League and their new kit deal).

However, to better place City’s £83 million EBITDA into context, it is still a third higher than Arsenal’s £64 million, while the next best are Liverpool £53 million, Chelsea £51 million and Tottenham £39 million (all 2013/14 figures).

City have increased their revenue by over 300% (£265 million) since 2009 from £87 million to £352 million. The majority of the growth has come from commercial income, which has surged £155 million to £173 million, so is almost 10 times as much as the £18 million in 2009.

In the same period, broadcasting income has nearly tripled from £48 million to £135 million with £54 million coming from improved Premier League TV deals and £33 million from Champions League participation. Match day receipts have more than doubled from £21 million to £43 million.

That’s very impressive, but the growth in 2014/15 was only 2% (£5 million), which is less than analysts had anticipated and also worse than Arsenal, who grew by 10% (£31 million). However, it was better than Manchester United, whose revenue fell by 9% (£38 million), due to their failure to qualify for Europe.

This should not be overly concerning for City, as there is more to come in every revenue stream: TV – through higher Premier League and Champions League deals; commercial – from renegotiating the shirt and kit sponsorship; and match day – after expanding the stadium.

Despite United’s decline, they still have the highest revenue in the Premier League in 2014/15 with £395 million, which is £43 million more than their “noisy neighbours”. However, City are the second highest in England, ahead of Arsenal £329 million, Chelsea £320 million and Liverpool £256 million (the latter two being 2013/14 figures).

City’s 2013/14 revenue of £347 million placed them 6th highest in world football as per the Deloitte Money League, though Real Madrid continued to lead the way with £460 million, followed by United £433 million, Bayern Munich £408 million, Barcelona £405 million and Paris Saint-Germain £397 million.

In their annual report City claim to have “the highest annual growth in revenues of the top 10 clubs”, but this does not automatically mean that they will overtake the leading contenders, as they too are making good progress. For example, both Spanish giants have announced good revenue growth in 2014/15: Real Madrid up 5% to €578 million, Barcelona up 16% to €561 million. Against that, their revenue in Sterling terms will be impacted by the weakness of the Euro.

Furthermore, United are estimating revenue of £500-510 million in 2015/16 following their return to the Champions League and the record Adidas kit deal, which would make them the first English club to break through the half-billion pounds barrier.

If we compare City’s revenue to that of the other nine clubs in the Money League top ten, we can immediately see where their largest problem lies, namely match day income, where City are substantially lower than their rivals, e.g. they were £61 million behind United (£47 million compared to £108 million).

On the plus side, City look to be fine on broadcasting and pretty good on commercial. City’s spectacular commercial growth means that they are ahead of most clubs, though are still lower than those that have traditionally been successful in monitising their brand: Bayern Munich £78 million, Real Madrid £28 million and Manchester United £23 million. The £108 million shortfall against PSG is largely due to the French club’s “friendly” agreement with the Qatar Tourist Authority.

Unsurprisingly, commercial income is the largest revenue stream, accounting for around 50% of total revenue, followed by broadcasting 38%. Match day income contributes only 12%, following the 2014/15 reduction.

City have grown commercially at a far faster rate than all their domestic rivals (861% since 2009) with their revenue rising to £173 million in 2014/15, but they are still behind Manchester United, whose commercial juggernaut produced £197 million – and that is before United’s blockbuster new deal with Adidas that commences in 2015/16.

However, City are miles ahead of all other English clubs commercially, e.g. even after Arsenal reported 34% growth last season, their £103 million was still £70 million lower than City. It’s a similar story at the other English clubs: Chelsea £109 million, Liverpool £104 million, then a big drop to Tottenham £42 million and Aston Villa £26 million.

Critics will argue that City’s commercial success is built on friendly deals with Arab partners, but the fact is that City are now signing up many other deals not linked to their owners with 22 additional partnerships last season alone, including Nissan, SAP, City and Coco Joy (the official coconut water partner, oh yes).

Al Mubarak argues that the commercial growth “is also in large part due to the City Football Group strategy that has been rolled out over the last two years…(that) creates global scale.” This involves joint initiatives with New York City FC, Melbourne City FC and Yokohama F Marinos.

There is obviously some truth in that, but it is also down to the fact that sponsors simply like to be associated with success on the pitch. Either way, Brand Finance have rated City as the fourth most valuable football brand globally and the second most valuable in the Premier League.

In any case, the groundbreaking 10-year £400 million deal with Etihad Airways, covering shirt sponsorship, stadium naming rights and the campus development, now looks to be behind the market, as other clubs have since raised the bar. It is estimated that the shirt sponsorship element of City’s deal is worth £20 million a season, which would put City’s deal way below their competitors: Manchester United – Chevrolet £47 million ($70 million); Chelsea – Yokohama Rubber £40 million; and Arsenal – Emirates £30 million.

In fact, there has been talk of City renegotiating the Etihad deal upwards to reflect their higher commercial value after two Premier League titles and regular Champions League participation. Some reports have speculated that the value could even double to £80 million a season.

There are also rumours that City are trying to negotiate upwards their £12 million kit supplier deal with Nike, even though their current six-year contract only started in 2013. There is certainly room for improvement, as this is now well behind other clubs’ latest deals: United £75 million (Adidas), Arsenal £30 million (PUMA) and Liverpool £25 million (Warrior).

City’s share of the Premier League television money was £98.5 million in 2014/15, up £2 million from the previous season. This was even before the increases from the mega Premier League TV deal in 2016/17. My estimates suggest that City’s second place would be worth an additional £51.5 million under the new contract, increasing the total received to an incredible £150 million. This is based on the contracted 70% increase in the domestic deal and an assumed 30% increase in the overseas deals (though this might be a bit conservative, given some of the deals announced to date).

The other main element of broadcasting revenue is European competition with City receiving €46 million for reaching the last 16 in the Champions League. Although this was €11 million higher than 2013/14, in Sterling terms this was only worth an additional £2 million (£33 million compared to £31 million), due to the weakening of the Euro.

It is worth noting the importance of the TV (Market) pool to the Champions League distributions. Half of this is based on how far a club progresses in the Champions League, so City benefited from other English clubs not doing so well in 2014/15 as the prior year. The other half is dependent on where a club finished in the previous season’s Premier League: 1st place 40%, 2nd place 30%, 3rd place 20% and 4th place 10%. As City won the title in 2013/14, compared to finishing runners-up the year before, they received a higher percentage in 2014/15.

In addition, there was more money available in the UK market pool in 2014/15, as this did not have to be shared with a Scottish club in 2014/15 (as was the case in 2013/14 with Celtic). The allocation also depends on how many clubs reach the group stage from a country, which explains why Juventus received such an enormous slice of the Italian market pool, as they only had to share it with one other club, while the UK pool was split between four clubs.

The financial significance of a top four placing is even more pronounced from the 2015/16 season with the new Champions League TV deal worth an additional 40-50% for participation bonuses and prize money and further significant growth in the market pool thanks to BT Sports paying more than Sky/ITV for live games. This could be worth an additional €20 million to City.

Match day income fell 9% (£4 million) to £43 million in 2014/15, partly because of temporarily reduced seating capacity due to stadium expansion works, which reduced the average attendance from 47,091 to 45,365, and two fewer home games following shorter campaigns in the domestic cups.

Although this revenue stream had been on a rising trend, City’s £43 million is less than half the money generated by Arsenal £100 million and United £91 million, partly due to City season tickets being among the cheapest in the Premier League.

For the 2015/16 season the Etihad Stadium capacity has been increased by 7,000 seats to 55,000 after adding a third tier to the South Stand and adding three new rows of pitchside seats, which should result in higher match day income. The club sold out its full allocation of more than 35,000 season tickets with a 9,000 waiting list. City have also received planning permission for potential further expansion up to 62,000 by doing the same for the North Stand.

City’s wage bill decreased by 5% (£11 million) from £205 million to £194 million, the second year in a row that wages have been cut. A large part of the decrease was due to smaller bonus payments, as no silverware was secured, with chief executive Ferran Soriano renegotiating a number of contracts with a lower basic salary, but higher bonus payments.

This lowered the wages to turnover ratio to a “healthy” 55%, the fourth successive year that this metric has improved from the peak of 114% in 2011. In fact, this is now one of the lowest in the premier League, better than Arsenal’s 58%, but still higher than United’s 51%.

The magnitude of City’s wages reduction has raised a few eyebrows, especially as the number of football staff was slashed from 222 to 112 in 2014. This is essentially due to a group restructure, where some staff are now paid by group companies, which then charge the club for services provided.

Whatever the rights and wrongs of City’s reported wages, they have been overtaken by United, whose wage bill was £203 million in 2014/15. It is striking how the wage bills at the leading clubs are converging around the £200 million level with Arsenal up to £192 million in 2014/15 and Chelsea £193 million in 2013/14. It should be noted that one of the clauses in UEFA’s FFP settlement with City stated that they could not increase their wage bill during the next two financial periods (2015 and 2016) – though performance bonuses are not included in this calculation.

Of course, there is a big gap to the other Premier League clubs with the nearest challengers (in 2013/14) being Liverpool £144 million, Tottenham £100 million and Newcastle £78 million.

Although there is a natural focus on wages, other expenses also account for a considerable part of the budget at leading clubs, especially at City with £76 million, now ahead of United and Arsenal (both £72 million). These cover the costs of running the stadium, staging home games, supporting commercial partnerships, travel, medical expenses, insurance, retail costs, etc.

In City’s case, there is also the impact of the restructure whereby some staff are now paid by group companies with the costs included in external charges, as opposed to wages. This helps explain the steep growth in external charges, which have risen from £42 million in 2013 to £69 million in 2015.

After an initial period of major investment following the club’s purchase by Sheikh Mansour, which peaked with £155 million of gross spend in 2010/11, City had been reducing their activity in the transfer market (relatively speaking), as explained in the annual report: “Consistent with the commitment made in 2009/10 that transfers of the scale seen in previous years would be unlikely to be repeated, the club is continuing to benefit from greater stability in the first team squad.”

Well, yes, that may have been the case – until this summer’s £142 million outlay, when City brought in Kevin De Bruyne (£54 million from Wolfsburg), Raheem Sterling (£44 million from Liverpool), Nicolas Otamendi (£28.5 million from Valencia), Fabian Delph (£8 million from Aston Villa) and Patrick Roberts (£5 million from Fulham). These purchases are not included in the 2014/15 accounts.

Interestingly, City’s gross spend in the last five years of £462 million (averaging £92 million a season) is almost exactly the same as the £456 million spent in the previous five years – though most of this (£407 million) was incurred in the three years after the new regime arrived in September 2008.

Of course, there are two sides in a market and City managed to recoup £41 million through player sales, giving a net spend of £101 million. Obviously this is still on the high side and most clubs can only dream of such a level of expenditure, but it’s not quite so dramatic as the gross spend figure widely reported. It is also worth noting that this is the highest annual player sales figure achieved to date by City.

To an extent City have been playing catch up this summer, as UEFA had imposed restrictions on their transfer spending last year. Nevertheless, City still have the highest net spend over the last two season of £151 million, though Manchester United are pretty much at the same level with £145 million, as Moyes and Van Gaal have both endeavoured to reinvigorate their squad following the departure of Sir Alex Ferguson.

Both Manchester clubs are a long way ahead of the other Premier League clubs in terms of net spend with the closest challengers being Arsenal £74 million (around half as much), Newcastle United £62 million and Liverpool £57 million.

City have stated that they are “operating with zero financial debt”, which is true, but their own net debt calculation includes £67 million of debt from finance leases (for future obligations under the lease of the Etihad Stadium). Nonetheless, this is not a problem, especially as it is covered by £75 million of cash to give net funds of £8 million.

However, it is worth noting the impact that the transfer market has had on City’s liabilities. They owe an additional £29 million in transfer fees to other clubs, though this is more than compensated by the £42 million that other clubs owe City.

The really prominent figure is the £113 million that City have included for contingent liabilities (up from £42 million in 2012), which is for “additional transfer fees, signing-on fees and loyalty bonuses… that will become payable upon the achievement of certain conditions contained within player and transfer contracts”, i.e. number of appearances, success on the pitch, etc. To place this enormous sum into perspective, contingent liabilities at other leading clubs are significantly smaller: United £26 million, Arsenal £9 million and Chelsea £3 million.

Where City are doing well compared to their peers is on net financing costs, as their annual payment of £5 million (mainly stadium finance lease charges) is a lot lower than United £35 million and Arsenal £13 million. For context, it’s around the same as Everton, West Ham and Liverpool.

Similarly, other clubs have to carry the burden of sizeable debt, especially United who still have £411 million of borrowings even after all the Glazers’ various re-financings and Arsenal, whose £234 million debt effectively comprises the “mortgage” on the Emirates stadium. There were four other clubs with debt above £100 million in the Premier League in 2013/14, namely Cardiff City £135 million, Newcastle United £129 million, Liverpool £127 million and Aston Villa £104 million.

The turnaround in City’s financial performance n the last two years is underlined in the cash flow statement, which shows that the club is now generating cash. In 2014/15 they generated an impressive £103 million from operating activities, spending a net £66 million on transfers, £62 million on capital expenditure (i.e. infrastructure investment in the stadium expansion and the City Football Academy) and £5 million on interest/lease payments. This produced a cash deficit of £31 million that was funded by issuing £84 million of new shares, leading to an increase in cash balances of £53 million.

Of course, City’s development has been largely funded by Sheikh Mansour, who has put in around £1.2 billion since the takeover in August 2008 through £0.9 billion of new share capital and £0.3 billion of loans (subsequently converted to shares). Most of this has gone into the squad (£679 million) with a further £288 million invested into the club’s infrastructure. Around 10% (£121 million) of the money has been used to finance loans and leases with a further £76 million required to fund (cash) operating losses. This leaves £65 million that has simply increased the club's cash.

City now have a very healthy cash balance of £75 million, but this is still a lot lower than Arsenal £228 million and United £156 million.

Although some might believe that this is evidence that City have bought success, it is in stark contrast to United, whose owners have cost the Red Devils around £850 million in interest payments, debt repayments and professional fees, thus restricting the amount they have been able to spend on improving the squad and the club’s infrastructure.

"Hand in Glove"

As the Manchester United Supporters' Trust said, “If it were a race, then United are dragging their owners behind them like a tractor, while Manchester City's owners are providing rocket fuel.”

Financial Fair Play has obviously been one of the most important challenges for Manchester City, including a €20 million (£16 million) settlement in 2013/14. The failure to meet UEFA’s break-even targets had actually resulted in a €60 million (£49 million) fine, but €40m (£33 million) of this was suspended.

"Captain Sensible"

City would now appear to be out of the woods with Al Mubarak confirming that there are “no outstanding restrictions”, though UEFA have noted that this was “subject to ongoing additional controls and audits”, adding, “the club remains under strict monitoring and has still to meet break-even targets and is therefore subject to some limitations in 2016.”

In any case, City are already looking to the future with the opening of the City Football Academy in December 2014. This has been built on 80 acres featuring a 7,000 capacity stadium and 16.5 pitches with two thirds of the site dedicated to youth football.

Al Mubarak observed, “The signs are all positive. Our Academy enjoyed one of its most successful years to date with accomplishments at every age group.” Importantly, he was keen to note that “ten players from our development system earned first team debuts in 2014/15.”

"Pablo Honey"

It has been a long journey for City, but they have rarely put a foot wrong in executing their Masterplan. As Soriano said, “Manchester City is now a profitable, self-sustainable club competing at the highest level in world football.”

That’s already a fine achievement, but, echoing famous City fan Noel Gallagher (“I'm part of the greatest band in the world. Am I happy with that? No, I'm not. I want more!”), Soriano is eager for further progress, talking of “the potential that exists for Manchester City to reach even greater heights in the future.”

The other elite clubs might have something to say about that, but it is fair to say that this version of City is considerably different from the one that used to suffer from what Joe Royle once called “Cityitis”. They are well placed to win more honours, but it’s now up to manager Manuel Pellegrini to deliver.

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