The Brexit Effect: The Signals amidst the Noise

There are few events that catch markets by complete surprise but the decision by British voters to leave the EU comes close. As markets struggle to adjust to the aftermath, analysts and experts are looking backward, likening the event to past crises and modeling their responses accordingly. There are some who see the seeds of a market meltdown, and believe that it is time to cash out of the market. There are others who argue that not only will markets bounce back but that it is a buying opportunity. Not finding much clarity in these arguments and suspicious of bias on both sides, I decided to open up my crisis survival kit, last in use in August 2015, in the midst of another market meltdown.

The Pricing Effect

I am sure that you have been bombarded with news stories about how the market has reacted to the Brexit vote and I won't bore you with the gory details. Suffice to say that, for the most part, it has followed the crisis rule book: Government bond rates in developed market currencies (the US, Germany, Japan and even the UK) have dropped, gold prices have risen, the price of risk has increased and equity markets have declined. The picture below captures the fallout of the vote:

While most of the reactions are not surprising, there are some interesting aspects worth emphasizing. 

1. Currency Wars: If this is a battle, the British Pound is on the front lines and taking heavy fire, down close to 10% over the last week against the US dollar and approaching three-decade lows, with the Euro seeing collateral damage against the US dollar and the Japanese Yen.
2. Old EU, New EU and the Rest of the World : The damage is greatest in the EU, but even within the EU, it is the old EU countries (primarily West European, that joined the EU prior to 2000) that have borne the biggest pain, with sovereign CDS spreads rising and stock prices falling the most. The new EU countries (mostly East European) have been hurt less than Britain's other trading partners (US, Australia and Canada) and the damage has been muted in emerging markets. At least for the moment, this is more a European crisis first than a global one.
3. Banking Problems? Though I have seen news stories suggesting that financial service companies are being hurt more than the rest of the market by Brexit and that smaller companies are feeling the pain more than larger ones, the evidence is not there for either proposition at the global level. At more localized levels, it is entirely possible that it does exist, especially in the UK, where the big banks (RBS, Barclays) have dropped by 30% or more and mid-cap stocks have done far worse than their  large-cap counterparts.

While I did stop the assessment as of Friday (6/24), the first two days of this trading week have continued to be volatile, with a big down day on Monday (6/27) followed by an up day on Tuesday (6/28), with more surprises to come over the next few days.

The Value Effect

As markets make their moves, the advice that is being offered is contradictory. At one end of the spectrum, some are suggesting that Brexit could trigger a financial crisis similar to 2008, pulling markets further down and the global economy into a recession, and that investors should therefore reduce or eliminate their equity exposures and batten down the hatches. At the other end are those who feel that this is much ado about nothing, that Brexit will not happen or that the UK will renegotiate new terms to live with the EU and that investors should view the market drops as buying opportunities. Given how badly expert advice served us during the run-up to Brexit, I am loath to trust either side and decided to go back to basics to understand how the value of stocks could be affected by the event and perhaps pass judgment on whether the pricing effect is under or overstated. The value of stocks collectively can be written as a function of three key inputs: the cash flows from existing investment, the expected growth in earnings and cash flows and the required return on stocks (composed of a risk free rate and a price for risk). The following figure looks at the possible ways in which Brexit can affect value:

Embedded in this picture are the most extreme arguments.  Those who believe that Brexit is Lehman-like are arguing that it will lead to systemic shocks that will lower global growth (not just growth in the UK and the EU) and increase the price of risk. In this story, these shocks will come from banking problems spilling over into the rest of the economy or an unraveling of the EU.  Those who believe that Brexit’s effects are more benign are making a case that while it may reduce UK or even EU growth in the short term, the effects of global growth are likely to be small and/or not persistent and that the risk effect will dissipate once investors feel more reassured. 

I see the truth as falling somewhere in the middle.  I think that doomsayers who see this as another Lehman have to provide more tangible evidence of systemic risks that come from Brexit. At least at the moment, while UK banks are being hard hit, there is little evidence of the capital crises and market breakdowns that characterized 2008. It is true that Brexit may open the door to the unraveling of the EU, a bad sign given the size of that market but buffered by the fact that growth has been non-existent in the EU for much of the last six years. If the European experiment hits a wall, it accelerate the shift towards Asia that is already occurring in the global economy. I also think that those who believe that is just another tempest in a teapot are too sanguine. The UK may be only the fifth largest economy in the world but it has a punch that exceeds its weight because London is one of the world's financial centers. I think that this crisis has potential to slow an already anemic global economy further. If that slowdown happens, the central banks of the world, which already have pushed interest rates to zero and below in many currencies will run out of ammunition. Consequently, I see an extended period of political and economic confusion that will affect global growth and some banks, primarily in the UK and the US, will find their capital stretched by the crisis and their stock prices will react accordingly. 

The Bigger Lessons

It is easy to get caught up in the crisis of the moment but there are general lessons that I draw from Brexit that I hope to use in molding my investment strategies.

1. Markets are not just counting machines: One of the oft-touted statements about markets is that they are counting machines, prone to mistakes but not to bias. If nothing else, the way markets behaved in the lead-up to Brexit is evidence that markets collectively can suffer from many of the biases that individual investors are exposed to. For most of the last few months, the British Pound operated as a quasi bet on Brexit, rising as optimism that Remain would prevail rose and falling as the Leave campaign looked like it was succeeding. There was a more direct bet that you would make on Brexit in a gamblers' market, where odds were constantly updated and probabilities could be computed from these odds. Since Brexit was also one of the most highly polled referendums in history, you would expect the gambling to be closely tied to the polling numbers, right? The graph below illustrates the divide.
   
   While the odds in the Betfair did move with the polls, the odds of the Leave camp winning never exceeded 40% in the betting market, even as the Leave camp acquired a small lead in the weeks leading up to the vote. In fact, the betting odds were so sticky that they did not shift to the Leave side until almost a third of the votes had been counted. So, why were markets so consistently wrong on this vote? One reason, as this story notes,  is that the big bets in these markets were being made by London-based investors tilting the odds in favor of Remain. It is possible that these investors so wanted the Remain vote to win and so separated from this with a different point of view that they were guilty of confirmation bias (looking for pieces of data or opinion that backed their view). In short, Brexit reminds us that markets are weighted, biased counting machines, where if big investors with biases can cause prices to deviate from fair value for extended periods, a lesson perhaps that we learned from value investors piling into Valeant Pharmaceuticals.
2. No one listens to the experts (and deservedly so): I have never seen an event where the experts were all so collectively wrong in their predictions and so completely ignored by the public. Economists, policy experts and central banks all inveighed against exiting the EU, arguing that is would be catastrophic, and their warnings fell on deaf years as voters tuned them out. As someone who cringes when called a valuation expert, and finds some of them to be insufferably pompous,  I can see why experts have lost their cache. First, in almost every field including economics and finance, expertise has become narrower and more specialized than ever before, leading to prognosticators who are incapable of seeing the big picture. Second, while economic experts have always had a mixed track record on forecasting, their mistakes now are not only more visible but also more public than ever before. Third, the mistakes experts make have become bigger and more common as we have globalized, partly because the interconnections between economies means there are far more uncontrollable variables than in the past. Drawing a parallel to the investment world, even as experts get more forums to be public, their prognostications, predictions and recommendations are getting far less respect than they used to, and deservedly so.
3. Narrative beats numbers: One of the themes for this blog for the last few years has been the importance of stories in a world where numbers have become more plentiful. In the Brexit debate, it seemed to me that the Leave side had the more compelling narrative (of a return to an an old Britain that some voters found appealing) and while the Remain side argued that this narrative was not plausible in today's world, its counter consisted mostly of numbers (the costs that Britain would face from Brexit). Looking ahead to similar referendums in other EU countries,  I am afraid that the same dynamic is going to play out, since few politicians in any EU country seem to want to make a full-throated defense of being Europeans first. 
4. Democracy can disappoint (you): The parallels between political and corporate governance are plentiful and Brexit has brought to the surface the age-old debate about the merits of direct democracy. While some (mostly on the winning side) celebrate the power of free will, those who have never trusted people to make  reasoned judgments on their futures view the vote as vindication of their fears. In corporate governance, this tussle has been playing out for a while, with those who believe that shareholders, as the owners of public corporations, should control outcomes, at one end, and those who argue that incumbent managers and/or insiders are more knowledgeable about businesses and should therefore be allowed to operate unencumbered, at the other. I am sure that there are many in the corporate world who will look at the Brexit results and cheer for the Facebook/Google model of corporate governance, where shares with different voting rights give insiders control in perpetuity. As someone who has argued strongly for corporate democracy and against entrenching incumbent managers, it would be inconsistent of me to find fault with the British public for voting for Brexit.  In a democracy, you will get outcomes you do not like and throwing a tantrum (as some in the Remain camp are doing right now) or threatening to move (to Canada or Switzerland) are not grown-up responses.  You may not like the outcome, but as an American political consultant said after his candidate lost an election, "the people have spoken... the bastards".

The End Game

I have not bought or sold anything since the Brexit results for the simple reason that almost anything I do in the midst of a panic is more likely to be counter productive than helpful. To those who would argue that I should move my money away from Europe, the markets have already done that for me (by marking down my European stocks) and I see little to be gained by overdoing it. To those who assert that this is the time to buy, I am not a fan of blind contrarianism but I will be looking at UK-based companies that have significant non-European operating exposure in the hope that markets have knocked down their prices too much. Finally, to those who posit that this is a financial meltdown, I will keep a wary eye on the numbers, looking for early signs that the worst case scenario is playing out. In my view, bank stocks will be the canaries in the coal mine, and especially so if the damage spreads to non-UK banks, and I will continue to estimate equity risk premiums for the S&P 500 and perhaps add the UK and Germany to the list to get a measure of how equity markets are repricing risk.

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Nottingham Forest - From The Ritz To The Rubble

Nottingham Forest have enjoyed a glorious past, albeit largely relating to one magical period under the legendary Brian Clough and his assistant Peter Taylor. After gaining promotion from the old Second Division in 1977, Clough’s Forest become Division One champions at the first time of asking in 1978 and then proceeded to win the European Cup two years in succession. In the same purple patch, they also picked up two League Cups.

This was a remarkable achievement for a club of Forest’s size and was testament to the genius of the manager, as the team featured few superstars. These successes have been wonderfully chronicled in the superlative documentary and book, “I Believe In Miracles”, which is well worth the attention of any football fan.

However, recent history has not been so kind. Next season will be the 18th that Forest have spent outside the Premier League, which is a shocking indictment for a club that once scaled the heights . Chairman Fawaz Al Hasawi agreed with this downbeat assessment in his review of the 2014/15 season, which he described as “a time of missed opportunity”.

The Al Hasawi family purchased the club in July 2012 from the estate of former owner and lifelong fan, Nigel Doughty, after his sad and premature death. Initially, the Kuwaiti businessmen talked a good match, “We know there are challenging times ahead of us to bring the club back to its glory days and we look forward with excitement towards a new successful future.”

"Until I learn to accept my Jamie Ward"

The new owners were also boosted by Doughty’s estate only taking a £20 million repayment against the outstanding £86 million of loans, thus enabling the club to move forward with a relatively clean slate.

However, it is fair to say that the Al Hasawi era has not been a glittering success. While it is true that they have made a substantial investment into the club, amounting to £67 million of loans as at 31 May 2015, Forest are no nearer securing a return to the top flight, as they continue to struggle in the Championship.

Indeed, one damning statistic is that their league position has deteriorated every season under Al Hasawi: 8th in 2012/13, 11th in 2013/14, 14th in 2014/15 and 16th in 2015/16. In other words, they are now closer to League One than the Premier League, which is particularly disappointing, given that they reached the play-offs two seasons in a row as recently as 2009/10 and 2010/11.

The constant managerial upheaval surely cannot have helped matters. In the four years since the new owners took charge, Forest have had no fewer than eight people coaching the team, despite Al Hasawi claiming, “I don’t like to change managers. I like stability.”

"Do your best and don't worry"

They started as they meant to go on, i.e. shambolically, with four different managers in their first six months, as noted in a magnificent paragraph in the 2012/13 accounts: “The year started with Steve Cotterill as football manager. He was replaced in July 2012 by Sean O’Driscoll, who himself was replaced in December 2012 by Alex McLeish. Alex was only in the position until February 2013, when he was replaced by the current manager Billy Davies.” And breathe.

After alienating most people with his somewhat abrasive style, Davies was sacked after a year with Gary Brazil taking the role on a caretaker basis (though arguably that’s the only valid description of the position), before the arrival of fans’ favourite Stuart Pearce. After a promising start, the team’s form collapsed, so “Psycho” also failed to last a season.

Next on the chopping block was another former Forest player, Dougie Freedman, though he was given his P45 in the dreaded February/March period with coach Paul Williams stepping up to the plate until the end of the season. Incredibly, Forest are currently without a manager, though many would understandably think twice before accepting this poisoned chalice.

There has been similar turnover in the important Head of Recruitment role, while the brief experiment with an experienced chief executive ended with the resignation of Paul Faulkner, after the former Aston Villa man claimed that he was not allowed to do his job.

The owners’ strategy has essentially been to throw money at the problem, resulting in much higher wage bills and increasing debt. To be fair, the issue has not so much been a lack of investment, but the seeming absence of any sort of strategic plan, which has resulted in the money being largely wasted.

"Vaughan in a storm"

This impression has been reinforced by numerous financial glitches, including late payments to suppliers, failures to pay football clubs transfer fee installments (e.g. to Peterborough United for striker Britt Assombalonga) and five (yes, five) winding-up orders, including two this year alone for non-payment of tax.

Although the club described these problems as “purely administrative”, this sort of incompetence is never a good sign. One reason offered for slow payment of wages was “a national holiday in Kuwait”, which is only one step above “the dog ate my homework”.

Even if Al Hasawi wanted to spend more on the club, he would not have been able to do so, as the club’s losses resulted in Forest breaching the Financial Fair Play (FFP) regulations, thus being placed under a transfer embargo in December 2014.

This catalogue of woe means that it is not overly surprising that the owners are looking for others to come on board. Indeed, there are strong rumours that Greek shipping magnate Evangelos Marinakis, the owner of Olympiacos Piraeus, is poised to buy 80% of Forest.

Although Forest might seem like an attractive proposition, any new investor would discover a club in a fairly poor financial position, as seen by the 2014/15 accounts, which featured a loss of £21.5 million.

This actually represented a £2.5 million improvement over the previous season’s £24.0 million loss, though that included a £1.1 million restatement following the cancellation of a  sponsorship agreement with the Al Hasawi family (for the shirt and areas around the City Ground).

The main reason for the lower loss was a £4.3 million increase in profit on player sales to £6.1 million, largely due to the sales of Jamaal Lascelles and Karl Darlow to Newcastle United.

Revenue also rose by £2.1 million (14%) to £17.4 million, which Al Hasawi ascribed to “the dedication of the supporters and the work of the commercial department”. This was reflected in match day income increasing by £1.0 million (14%) to £8.2 million and commercial income rising by £0.5 million (18%) to £3.1 million.

However, another important factor was income from player loans climbing £1.0 million to £1.5 million, as a remarkable 12 players were loaned out, including Radoslaw Majewski, Jamie Mackie, Greg Halford, Dan Harding and Djamel Habdoun (amongst others). On the other hand, broadcasting income dropped by £0.4 million (8%) to £4.6 million.

There was another “significant increase” in the wage bill, which rose £2.5 million (9%) from £27.2 million to £29.7 million, while player amortisation was up £0.7 million (13%) to £6.4 million. Other expenses slightly increased to £8.2 million, while interest payable was £0.5 million worse, as the previous year included a credit after interest previously charged by the holding company had been waived.

Despite the improvement to the bottom line, only two Championship clubs reported larger losses than Forest in 2014/15, namely Bournemouth £39 million and Fulham £27 million. In fairness, hardly any clubs are profitable in the Championship with only six making money in 2014/15 – and most of those are due to special factors.

Ipswich Town were top of the pops with £5 million, but that included £12 million profit on player sales. Cardiff’s £4 million was boosted by £26 million credits from their owner writing-off some loans and accrued interest. Reading’s £3 million was largely due to an £11 million revaluation of land around their stadium. Birmingham City and Wolverhampton Wanderers both made £1 million, but were helped by £10 million of parachute payments apiece.

So the only club to make money without the benefit of once-off positives were Rotherham United, who basically just broke even – and ended up avoiding relegation to League One by a single place.

Of course, losses are nothing new for Forest, as the last time they made a profit was back in 2005 – and that was only £1.1 million. Since then the club has suffered a decade of losses, amounting to an extraordinary £126 million.

This was all meant to change with the arrival of the Al Hasawi family: “From the club’s perspective the new ownership represented the end of a period of uncertainty and has allowed the club to once again stabilize its finances.”

In reality, the deficits have increased with £63 million of losses being accumulated in the last three years, averaging £21 million a season. This is more than double the average annual loss of £9 million over the preceding seven seasons.

As we have seen, part of the 2014/15 improvement was due to profits made from player sales. These can have a major impact on a football club’s bottom line, but it’s not an enormous money-spinner outside the Premier League with the most profit made by Norwich City £14 million, followed by Ipswich £12 million, Leeds United £10 million and Cardiff City £10 million.

Forest made £6 million from this activity, which was boosted by the way that player values are accounted, as the major sales (Lascelles and Darlow) were both homegrown products, so had no value on the balance sheet (as no transfer fees had been paid). Against that, the club would have absorbed losses for the large number of players released on free transfers.

Over the years, Forest have made very little money from player sales. In fact, the last time that they registered a profit above £2.5 million from this activity (before last season) was 2005, when the £5.1 million (plus an exceptional £1.5 million gain on finance leases) helped produce the club’s last overall surplus.

In the nine years between 2005 and 2015, the club only generated a total of £11.5 million profits from player sales, i.e. just £1.3 million a season. In some cases, this can be considered a positive, as it means that a club is retaining its best players, but here it is more likely to be because Forest have not had many players that others clubs would want to buy.

There are a few signs that this might be changing, as the 2015/16 accounts will be boosted by the £7 million sale of Michail Antonio to West Ham, though accounting losses will also be incurred for the release of the likes of Jamie Mackie. In financial terms, this might be seen as “running to stand still”, as the reasonably good profits from player sales in 2014/15 did not prevent a thumping great overall loss.

This is because Forest’s underlying profitability is getting worse. Most clubs use EBITDA (Earnings Before Interest, Depreciation and Amortisation) as an indicator of financial health, as this strips out once-off profits from player trading and non-cash items. This has been consistently negative at Forest, but has plummeted from minus £2 million in 2005 to minus £20 million in 2015.

This was one of the worst in the Championship, only better than Bournemouth, whose minus £25 million was heavily influenced by large promotion bonuses. In real terms, Forest had the lowest EBITDA, which means that they are the least profitable club in the division.

To be fair, only three clubs had a positive EBITDA in the 2014/15 Championship (Wolves, Birmingham City and Rotherham) and none of those clubs generated more than £1.5 million. In stark contrast, in the Premier League only one club (QPR) reported a negative EBITDA, which is testament to the earning power in the top flight.

Revenue has only grown by £2.8 million (19%) in the three seasons since Al Hasawi arrived and even that is a bit misleading, as it includes £1.5 million of player loans income. This has only been included as gross income since 2013, as it had previously been netted off against expenses.

Excluding the effect of this accounting restatement, the real revenue growth is just £1.2 million (8%), which is a long way from the increases implied by the owners’ 3-5 year plan.

Part of the problem was actually highlighted by the club in the 2012 accounts, as it explained one of the reasons for the revenue reduction that year as being “the lower performance of the first team”.

Even after the rise in Forest’s income to £17.4 million, this is still on the low side and clearly bottom half of the table in the 2014/15 Championship. Although Blackpool and Bolton Wanderers are yet to publish their accounts, we can safely say that their revenue was higher than Forest, as they both received £10 million parachute payments.

Therefore, Forest only had the 16th highest revenue in the Championship, only above eight clubs, though one of these (Bournemouth) did manage to get promoted. To further place this into perspective, four clubs enjoyed revenue higher than £35 million (more than twice as much as Forest): Norwich City £52 million, Fulham £42 million, Cardiff City £40 million and Reading £35 million.

Of course, these revenue figures are distorted by the parachute payments made to those clubs relegated from the Premier League, e.g. in 2014/15 this was worth £25 million in the first year of relegation.

However, if we were to exclude this disparity, Forest would still find themselves back in tenth place. The revenue differentials would be smaller, though they would be behind different clubs, e.g. the top three would then be Norwich City £29 million, Leeds United £24 million and Brighton and Hove Albion £24 million.

The most important revenue stream for Forest is match day, which contributes 47% of total revenue, followed by broadcasting 26% and commercial 18%. Player loans accounted for as much as 9% of 2014/15 revenue.

In fact, no club has a greater reliance on match day revenue in the Championship than Forest’s 47%, ahead of Charlton Athletic 43%, Brighton and Hove Albion 42%, Millwall 41% and Ipswich Town 40%.

Forest’s match day revenue actually rose by £1.0 million (14%) to £8.2 million in 2014/15, even though they hosted four fewer cup games, as the average attendance increased from 22,630 to 23,492, largely due to having Forest legend Pearce at the helm.

This meant that Forest’s match day revenue was the fourth highest in the Championship, only behind Norwich City £10.7 million, Brighton £9.8 million and Leeds United £8.8 million.

In terms of attendance, it was a similar story, as Forest were the fifth highest, though it would have been somewhat galling to see that the league leaders were local rivals Derby County with 29,232.

However, to add to Forest’s concerns, attendances fell by a massive 3,800 (16%) in 2015/16 to 19,676, even though season ticket prices were frozen, due to a combination of several factors:  unhappiness with the owners, the poor football on display and high ticket prices.

Whatever the reasons, this is the first time that attendances have dipped below 20,000 since the club was in League One in 2007/08, which is clearly bad news, given how important gate receipts are to Forest’s business model.

Indeed, Forest have decided to cut ticket prices by 5% for the 2016/17 season with Al Hasawi explaining the rationale thus, “With loyal supporters making a financial commitment to support this club I feel it is our duty to extend the (early bird) offer.” Fair enough, but it could just as easily be a straightforward acknowledgment of the need to do something to prevent the crowds falling any further.

Of course, in the Premier League, the vast majority of all but the elite clubs’ income is derived from broadcasting, but this is not the case in the Championship. Here, most clubs receive just £4 million of central distributions, regardless of where they finish in the league, comprising £1.7 million from the Football League pool and a £2.3 million solidarity payment from the Premier League.

However, the clear importance of parachute payments is once again highlighted in this revenue stream, greatly influencing the top eight earners, though it should be noted that clubs receiving parachute payments do not also receive solidarity payments.

Nevertheless, it should be noted that these payments are not a panacea, so Middlesbrough secured promotion last season, even though their broadcasting income of £6.2 million in 2014/15 was less than half the size of those clubs boosted by parachutes.

Looking at the television distributions in the top flight, the massive financial chasm between England’s top two leagues becomes evident with Premier League clubs receiving between £67 million and £101 million, compared to the £4 million in the Championship. In other words, it would take a Championship club more than 15 years to earn the same amount as the bottom placed club in the Premier League.

The size of the prize goes a long way towards explaining the loss-making behaviour of many Championship clubs and to some extent justifies Forest’s profligacy. This is even more the case with the astonishing new TV deal that starts in 2016/17, which will be worth an additional £30-50 million a year to each club depending on where they finish in the table.

As an example, I have (conservatively) estimated that the club finishing bottom in the Premier League next season will receive £92 million, which is £87 million more than a Championship club not receiving parachute payments. Forest might well be a big club, but the TV deals in the Premier League have risen to stratospheric levels since they last graced the top flight, so they now have to compete against the realities of the modern footballing world.

From 2016/17 parachute payments will be even higher, though clubs will only receive these for three seasons after relegation. My estimate is £75 million, based on the percentages advised by the Premier League (year 1 – £35 million, year 2 – £28 million and year 3 – £11 million). Up to now, these have been worth £65 million over four years: year 1 – £25 million, year 2 – £20 million and £10 million in each of years 3 and 4.

There are some arguments in favour of these payments, namely that it encourages clubs promoted to the Premier League to invest to compete, safe in the knowledge that if the worst happens and they do end up relegated at the end of the season, then there is a safety net. However, they do undoubtedly create a significant revenue disadvantage in the Championship for clubs like Forest.

Surprisingly for a club of Forest’s admirable tradition, their commercial income of £3.1 million, up from £2.6 million the previous season, was one of the smallest in the Championship in 2014/15, way behind Norwich City £12.8 million, Leeds United £11.3 million and Brighton £8.9 million. In fact, it was only ahead of four clubs: Charlton Athletic £2.5 million, Brentford £2.4 million, Millwall £1.9 million and Wigan £1.5 million.

Forest’s commercial income is made up of sponsorship, royalties and advertising £0.8 million, match day hospitality, events and catering £1.8 million and merchandising £0.6 million.

One of the reasons for Forest’s low commercial revenue is their merchandising deal with Kitbag, though this ended in June 2015, so next year’s accounts should see some upside. That said, there is considerable room for improvement in the commercial arena when you consider that local Midlands rivals, Derby County and Wolves, both generate around £8 million a year from this activity.

"Shout, shout, let it all out"

For the past three seasons Forest’s shirt has been emblazoned with the name of one of the owner’s companies, namely Fawaz Refrigeration & Air Conditioning. Although the chairman described this as a “lucrative” deal, he did admit that he would have preferred to secure an external sponsor, and he has now done so. From the 2016/17 season, Forest will have online betting firm 888 Sport as its shirt sponsor.

It remains to be seen whether some of the sponsorship areas around the stadium will be continued to be utilised by companies controlled by the Al Hasawi family at no charge. Either way, it feels a long way from the days when Fawaz claimed that Forest’s revenue issues would be addressed in the form of new sponsorship from several companies in Kuwait.

The current three-year kit supplier partnership with Adidas runs until the end of the 2016/17 season.

Forest’s wage bill rose by 9% (£3 million) from £27 million to £30 million in 2014/15, which means that wages have increased by a staggering 69% (£12 million) in the three years since Al Hasawi arrived, while revenue only grew by 19% (£3 million) in the same period, thus pushing the wages to turnover ratio up to an awful 170%.

As the club observed, “the owners gave significant support to football management in an effort to support the promotion bid.” In a way, that is laudable, though it is unclear how much is included in the wage bill for pay-offs to all the sacked managers (and their backroom staff).

This is the price Forest have paid for their frequent changes at the top, perhaps the worst example being Billy Davies being sacked just six months after being awarded a four-year contract.

In any case, the last time that Forest had a wages to turnover ratio below 100% was back in 2009. Of course, wages to turnover invariably looks terrible in the Championship with no fewer than 10 clubs “boasting” a ratio above 100%, but Forest’s 170% was the third highest (worst), only behind Bournemouth 237% and Brentford 178%.

Given that, it might come as something of a surprise then to see that Forest’s wage bill of £30 million was actually only the seventh highest in the Championship, behind Norwich City £51 million, Cardiff City £42 million, Fulham £37 million, Reading £33 million, Bournemouth £30 million and Blackburn Rovers £30 million – though it was almost £10 million more than Watford, who were promoted that season.

Stop me if you’ve heard this before, but this was once again because most of these clubs enjoyed the benefit of parachute payments. If we look at clubs who did not receive such payments, then Forest had the second highest wage bill, only £700k behind Bournemouth, whose wages were significantly inflated by substantial promotion bonus payments, but £8 million above Derby County. In other words, Forest's wages were effectively the highest of any club not receiving parachute payments - and by some distance.

It is likely that the wage bill will fall in 2015/16 following the departure of some high earners (and  lower termination pay-offs), but it will still be a real challenge for the club to control this while giving themselves the best chance of promotion.

Another aspect of player costs that has been steadily rising at Forest is player amortisation, which is the method that football clubs use to expense transfer fees. In line with the higher sums spent on bringing players into the club, player amortisation has grown under the current ownership from £2.5 million in 2012 to £6.4 million in 2015.

As a reminder of how this works, transfer fees are not fully expensed in the year a player is purchased, but the cost is written-off evenly over the length of the player’s contract via player amortisation. As an illustration, if Forest were to pay £5 million for a new player with a five-year contract, the annual expense would only be £1 million (£5 million divided by 5 years) in player amortisation (on top of wages).

Although Forest’s player amortisation might not seem a huge charge, it was actually the fourth highest in the Championship, only surpassed by those clubs relegated from the Premier League in recent times, i.e. Norwich City, Cardiff City and Fulham. Of course, this expense should have come down in 2015/16 following the transfer embargo and release of many players.

The other side of that coin is that player values on the balance sheet have also increased, more or less tripling from £3.1 million in 2012 to £9.2 million in 2015. That is the accounting value in the books, but the actual market value would obviously be much higher if Forest were to sell any of its players, as homegrown players have zero value in the accounts.

It will not have escaped the supporters’ attention that the performances on the pitch have actually worsened as both wages and player values have increased, which is not how these things generally work. As The Blow Monkeys once sang, “It doesn’t have to be this way.”

In fairness to Al Hasawi, one thing that he cannot be accused of is failing to back his managers in the transfer market. Even with the impact of the transfer embargo, Forest have made gross purchases of £23 million in his four seasons, compared to only £9 million in the preceding four seasons.

On the other hand, there has also been an increase in player sales from virtually nothing between 2008 and 2012 to £17 million in the last four years, so net spend has overall decreased.

Clearly, Forest have had to act smarter since the embargo was put in place, so they have made some astute free signings such as Matt Mills, Jamie Ward and Daniel Pinillos. They have also dipped into the loan market with good contributions from the likes of Nelson Oliveira, Ryan Mendes, Bojan Jokic and Gary Gardner.

As a result of the transfers of Antonio, Lascelles and Darlow, Forest had £4 million of net sales over the last two seasons. This meant that they were comfortably outspent by the likes of Derby County £29 million, Middlesbrough £23 million and Burnley £14 million.

In fact, the two automatically promoted clubs and the four that qualified for the play-offs filled six of the seven top places in the net spend league, which underlines how much Forest have been hit by the transfer embargo, so it is good news that the chairman has confirmed this has recently been lifted (though there is nothing to this effect on the Football League website).

Forest’s net debt significantly increased in 2015 from £52.0 million to £82.1 million, as gross debt rose by £29.5 million from £52.6 million to £82.2 million and cash fell £0.5 million from £0.6 million to just £0.1 million.

Virtually all of the debt is owed to the club’s owner, either directly to the Al Hasawi family (£67 million) or indirectly via the loan from the parent company, NFFC Group Holdings Limited, £14.9 million. No interest is charged on these loans, which are only repayable when the club “is in a position to do so”, so this could therefore be considered “soft” debt. Other football club owners have gone a stage further by converting much of their debt into equity, though last month Al Hasawi did convert £8 million into capital.

Indeed, after the takeover the estate of Nigel Doughty allowed £66 million of their outstanding debt to be capitalised. As the club said, that represented a “considerable and significant improvement to the balance sheet.” The remaining balance of £20 million was repaid using funds provided by the parent company. However, just three years later, Forest’s debt is back up to the pre-capitalisation levels.

Forest’s was by no means the largest debt in the Championship, being lower than six other clubs. In fact, four clubs had debt over £100 million, including Brighton £148 million, Cardiff City £116 million and Blackburn Rovers £104 million. Bolton Wanderers have not yet published their 2015 accounts, given their much-publicised problems, but their debt was a horrific £195 million in 2014.

That said, the vast majority of this debt is provided by owners and is interest-free, so the amounts paid out by Championship clubs in interest is a lot less than you might imagine.

In addition to the financial debt, Forest owed £2 million in transfer fees, while they also had quite high contingent liabilities of £6.6 million, up from £4.3 million, for player purchases and first team management changes.

The accounts state that the club “relies on the continued support of the Al Hasawi family for its day to day funding and funds its working capital requirements through a facility provided by the Al Hasawi family.” This is clearly seen in the 2015 cash flow statement.

Even after adding back non-cash items such as player amortisation and depreciation, then adjusting for working capital movements, Forest made a substantial cash loss from operating activities of £23.9 million. They then spent a net £5.7 million on player recruitment and £0.5 million on capital expenditure. This was funded by an additional £29.7 million loan from Al Hasawi.

One other point worth noting is the increase in creditors in 2013 and 2014, which meant that the club was effectively funding some of its expenditure by the old trick of paying suppliers later.

Of course, it is nothing new for Forest to rely on their owner for financial support, as it was much the same story under Doughty with the only real source of funds being additional shareholder loans. In fact, since 2005 around £127 million has been provided by the club’s owners with almost 70% (£88 million) of that money being used purely to cover operating losses.

Only £14 million was used for player purchases (net), while over £18 million went on sorting out the finances: reduction in overdraft £9.8 million, loan repayments £6.7 million and interest payments £1.8 million.

What is striking is how little money (only £6.6 million) has been spent on infrastructure investment, so there have been virtually no improvements to the stadium or the academy. This is in stark contrast to clubs like Brighton and Brentford where the owners have also provided ample funding, but large amounts have been invested in their long-term future.

It is also true that there has been an increase in financial dependency under Al Hasawi with the family needing to pump in £67 million in just three years. As a comparison, Doughty had to stump up a similar sum (£65 million) over the preceding eight years.

"It looks like Daniel"

As we have already noted, Forest’s 2013/14 loss meant that they breached the Financial Fair Play regulations, resulting in a transfer embargo. The Football League simply stated that the club had “exceeded the maximum permitted deviation of £6 million – consisting of a maximum adjusted loss of £3 million plus a further maximum of £3 million of shareholder investment.”

It should be noted that FFP losses are not the same as the published accounts, as clubs are permitted to exclude some costs, such as youth development, community schemes, promotion-related bonuses and infrastructure investment (such as stadium improvements and training ground). That said, this does not really  help Forest’s FFP calculation that much, as they have spent so little in these areas.

Instead, this will remain a major issue for the owners, as they noted in the accounts: “Preparation to meet the challenges of FFP also adversely affected the season as management worked tirelessly behind the scenes to thrive in the changed environment.”

That may be, but it is somewhat surprising that they took so long to wake up to the realities of FFP, given that the 2012 accounts explicitly stated that this “will be a challenge for the new owners.”

From the 2016/17 season the regulations will change to be more aligned with the Premier League, so that the losses will be calculated over a three-year period up to a maximum of £39 million, i.e. an annual average of £13 million. This will likely encourage clubs to “go for it” even more.

"Many Happy Returns"

Any renewed spending may well be under new ownership, as Al Hasawi has tired of the criticism: “If people are pushing and always negative, and there is no appreciation, why should I continue? Maybe there are some people better than me and I am doing it wrong.”

The obvious answer would be that few could do worse, but it might be a case of “out of the frying pan and into the fire” if the rumours are true about Olympiacos owner Evangelos Marinakis buying into the club. He is currently banned from any “football activity” in Greece with the public prosecutor’s dossier containing a lengthy list of allegations, including blackmail, fraud and bribery.

In any case, Forest fans would not have seen the last of Al Hasawi, who would like to stay on as chairman: “Whatever happens, it is not going to be a sale of the club. I want this club to win promotion and I want to be here when it happens.”

Even after all the misadventures on his watch, Al Hasawi is still optimistic, “I hope this will be a positive summer, because I want to do things right. I want this to be the time we get it right.” On the plus side, key players like Assombalonga and Chris Cohen are returning from lengthy injuries, but the lack of a manager does not exactly inspire confidence.

Realistically, the chances of  a return to the Premier League appear further away than ever. The Championship is a tremendously competitive league and Forest seem ill-equipped to mount a serious challenge against those clubs benefitting from hefty parachute payments – or even those with wealthy owners who have a good understanding of the game. Unless, of course, you do believe in miracles.

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