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Dec 2018: Formula 1 – Economies of scale

December 20, 2018

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Formula One (FWONK) – Economies of Scale

Dec 2018 ($31)

 

“Content, you know, content is where the money is…and content will always be where the money is…but content distribution magnifies the value of content” – Warren Buffett[1]

Regular readers will know our affinity for so-called Dream businesses; those businesses that offer high returns, good growth prospects and a low capital-cost of growth. Many content businesses are Dream businesses. Take three such businesses; WWE, Disney and F1 – all are playing the same game to some degree – monetising a growing audience via a scalable global platform of sorts.

We are drawn to these businesses because they:

  • Enjoy unique wholly-owned, sought-after video content and IP portfolios
  • Are late starters in taking advantage of the ‘new economics’ of global distribution
  • Those ‘new economics’ are leading to increased operational leverage

Fig.1: As content business increase their scalable businesses, margins expand

  Source: Holland Advisors

We’ve written at some length about Formula One, the business taken over by Liberty Media in 2016. Our work has highlighted the under investment, the untapped market opportunity and the track record of the new management team which we referred to as “the best media/Sports rights value extracting team on the planet”. We are positive on both the outlook for substantial improvement’s in F1 the sport and FWONK, the stock which trades on 16x 2018 FCF earnings. But, that’s a valuation struck before any operational gearing kicks in!

In this note, we will not regurgitate our previous work on the F1 business’ fundamentals – work that we think has aged well. We think F1’s prospects are undimmed. Rather, we take a different tack and focus on the evolving business of content monetisation in the 21st century. In particular, we look at the new scope for operational gearing in content businesses under new direct to consumer distribution opportunities.

There is a well-trodden path. Sport content business globally have all evolved from selling predominantly match stadium tickets – i.e. events with a finite, local audience to selling video content of those events to a more global audience. Manchester United (an early beneficiary) and WWE (more recent) are great examples of these trends.

Fig.1 shows that as content becomes more scalable (via broadcasting or indeed as it’s now called: “Narrowcasting[2]”), operational gearing follows. As a truly global sport F1’s scaleable revenues look low at 46% of total sales vs Man Utd at 81% and WWE soon to be at 78%.

In time we expect this to change. It is our contention that F1’s proportion of scalable revenues (i.e. revenue such as broadcasting and advertising) could increase materially from today’s c.46%. Additionally, as the owner of the league rather than the producer of the content per se, the marginally profitability of this increase we would expect to be substantial. Our previous and current attempts at modelling F1’s earnings power did/do not explicitly take this into account. In other words, based on peer studies, even though we have assumed some margin expansion our earnings power now may looks conservative. This note expands on this possibility.

Were F1 to realise c.4m new subscribers (at an average $80/year subscription) to its OTT service by 2021 (below the 5m management have said is realistic), this alone would meaningfully improve the mix of scalable revenues from 46% to over 60%. The marginal profitability of which we suggest would be substantial. Note that 4m subs is less than 1% of the F1 viewership!

We address three issues in this note:
  1. A recap on why F1 is a premium asset
  2. A look at the Economics of Content
  3. Thoughts on why the stock market narrative on FWONK has become increasingly negative
1. F1 is a premium global media asset (with potential for op leverage)

We have written at length[3] on why we think that F1 is another classic ‘rare bird’ investment opportunity. It has all the ingredients: rarity, barriers to entry, a global brand, low capital needs, multiple growth opportunities and is very likely to be under-earning.

Fig.2: A recap on F1’s traits as a ‘Rare Bird’

  Source: Holland Advisors, 2017

More specifically:

  • Formula One is unique. Most sports leagues are owned by teams or are non-profit. For example, the FA Premier League, which reported GBP3bn of revenues last year, is 100% owned by the football teams who share its pricing power. Nascar/ISC[4] is another but is very US-centric sport and does not offer the global appeal/ opportunity of F1.

“Why do we like the business? It’s pretty rare, it’s almost impossible to buy a global sports franchise of the scale of Formula One. You can’t buy the Olympics, you can’t buy FIFA. This is about as broad and wide as you can get, with a huge competitive moat in our judgement. Unique scale, massive reach, five continents, 21 countries, 21 events in 2016, over 400 million fans, and a very attractive demographic for sponsors and advertising, and a very attractive financial profile. Greg Maffei, Liberty Media CEO

  • Re scale: F1 now cites over c500m unique global viewers each year (vs >650m for Man Utd and c.60m for WWE). That means that F1 only derives c.$4 per year on average from each fan. That looks like under-monetisation to us.
  • F1 offers Prestige. This brings in celebrities and sponsors alike that chase such spectacles. This point alone shows why Nascar is the wrong comparator for it. Cities such as Vietnam (and possibly Miami) are willing to pay-up for the prestige that a F1 weekend brings them. Bernie Ecclestone suggested in a recent interview that the Vietnam deal alone was likely worth c.$50m of incremental profit per year – i.e. 10% of group OIBDA.
  • F1 is under-earning. Under Eccelstone, F1 was run as a fiefdom.

“As a business, (F1) felt like the small-scale, family-owned NFL of maybe 30 years ago. Just putting out a single product” – Chase Carey interview

A Premium Asset with Pricing Power

The last point mentioned above – under earning – is key to us. As a starting point, we remind readers that F1’s promoters and broadcaster contract clauses typically allow for significant rate rises in broadcasting and promoter deals.

When first looking at the company’s financial prospects this insight underpinned our assumption of revenues that would likely grow 5-7% annually as pricing escalators and the occasional extra race in the calendar would inevitably bring.

However, we also think the OTT monetisation opportunity is another way of unearthing the untapped pricing power inherent in this media business. Based on our work on WWE, the monetisation opportunity is many-fold. Initially, it might likely manifest in material rate-hikes in TV broadcast deal renewals, but in time, a broader advertising base and ultimately the direct selling of content to consumers will drive sales growth.

We should add here that currently F1 in engaged in a delicate balancing act in maximising short-term revenues (via pay-TV contracts) vs. wanting to rebuild its brand and fan base via free-to-air. This has been notable in Italy this year where F1 gave exclusivity of live races (except the Italian race) to Sky Italia. Italian Free to Air channels get delayed access. Trade press reports suggest the Sky Italia deal was reportedly worth cGBP100m, an increase of +c.50%. In light of this the UK rights renewal in 2019 (F1’s largest market) will be interesting to watch. On the point of fanbase re-engagement we think two areas will be key for Formula One.

The first being changes to the races themselves to make the sport more exciting to watch, the second will be the online engagement with fans over social media/YouTube and other platforms.

US sports media peer, WWE showed in its recent renewed TV rights (with a 170% rise in value) that unique live content is still highly sought-after. But we don’t need to go across the Atlantic to see this – live sports content has always been sought after. UK Premier League broadcast rights have inflated from £50m/yr in the mid 1990s to c£1.8bn/yr most recently. That’s a 20% annualised inflation rate. And yet, in spite of this, the primary buyer Sky, still thrived! Understanding how buyers of content can thrive – in spite of such inflation – is important and it is something we address later in this note.

“the single – most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business” – Warren Buffett[5] (emphasis ours)

Fig.3: A Dream business (old-school pricing power in action)

  Source: Berkshire Hathaway annual reports

A Premium Asset with optionality

Expanding F1’s presence in digital media is central to the monetisation efforts. This can happen in lots of ways via an increased social media presence in YouTube etc. We think the WWE precedent is highly relevant here. WWE built a highly successful following on YouTube and this was instrumental in increasing its global brand presence. Specifically, WWE’s success on YouTube (for what might have been seen initially as low return) was a direct reason why Saudi Arabia chose to license an annual Wrestlemania event for $50m per year. Saudi Arabia has a very high young population and has the highest consumption of YouTube content per capital anywhere in the world.

In that context, F1’s recent foray into Esports Series[6] is interesting. Started as a side-line in 2017 (led by commercial director Sean Bratches) the online Grand Prix series drew a record audience of 1.2 million across selected TV networks and 3.2 million people on a dedicated live stream[7]. This is surely a reflection of the newly-found commercial nature of the F1 management. Esports is a market that is reported to approach $900m in value this year from a global audience of c.200m gamers. The opportunity for F1 here is around brand awareness, reviving interest in Grand Prix’s and excitement about the sport. Advertisers and commercial distributors of different shapes and sizes will then pay up for this level of customer engagement with the sport.

A premium asset with Operational Gearing prospects

The scope for root and branch reform at F1 remains significant. As a symbol for how this business used to be run, bear in mind that under Bernie Ecclestone, this was effectively a $2bn revenue per year fiefdom which was run out of the his Knightsbridge townhouse. The repositioning of the F1 management culture by the Liberty Media team should have significant potential.

The aforementioned Sean Bratches worked at ESPN for 27 years prior to joining Liberty Media post the acquisition. Here is what he said earlier this year:

“We acquired F1 for three primary reasons. Firstly, this is a fantastic brand, a global brand, with a pretty good balance sheet. Secondly, in the world we live in with tech continuing to disintermediate the consumer experience the thesis is that live sports is going to be [one of] the last bastion of platforms, brands, genres that can aggregate large audiences at a given point in time. And thirdly they felt it was an under-managed business. The 21st century leadership opportunity to grow the business is pretty significant… In the broadest sense we are trying to reposition F1 from a motorsport company to a media and entertainment brand”[8] – Sean Bratches, F1 Commercial Director, March 2018 (killer quote emphasis ours!)

Case in point, F1 had just five sponsorship deals under previous owner Bernie Ecclestone, and Bratches contrasted that to a Premier League football team like Manchester United, which has 96 sponsors. Fig.1 puts F1 business revenue streams into the context of some other global brands. Importantly, we suggest it shows the potential for margin expansion as ‘scalable’ revenues increase as part of the mix as shown in Fig.3b.

Fig.3b: Many strings to the bow are being created

Source: Liberty Media

The FA Premier League generates about 2x the revenue of F1. Having discussed pricing, we do need to add an important caveat here re content ‘volume’. Not all content is equal in the eyes of broadcasters in terms of volume (aka ‘time’). Broadcasters want content that is ‘live’ in order to draw consumer to their channels and thus their advertisers. But it is important to note that F1 has just 21 live events per year. Excluding qualifying races, that’s about say 60 hours of live content per year (albeit with huge – c85m unique – viewers per race). The Premier League by contrast has 380 premiership fixtures this season. So the Premier League offers about 10x the magnitude of live sport that F1 does. Additionally, other sports such as American Football lend themselves to increased frequency of ad breaks than others (esp. motor racing).

F1 TV is key to the margin expansion prospects

F1 launched its OTT[9] service (‘F1 TV’) earlier in 2018 – it debuted at the 2018 Monaco Grand Prix. Streaming live sports in real time to a global audience is not trivial (delays are not acceptable) and there were teething problems on the launch which necessitated customer refunds.

Few companies escape such teething problems. In terms of pricing, F1 has taken the approach of a two-tier OTT service: a cheaper version with delayed races costing c$30/year and a ‘pro’ service with live races and feeds costing c$200 per year. Press interviews with F1 management earlier this year suggest that the ambition is to have 5m F1 TV subscribers in due course, though this seems to be an informal target and we note that Liberty Media has not really engaged in offering specific targets to investors (unlike WWE did in 2014).

“Frank Arthofer, F1’s head of digital and new business, believes that around five million dedicated fans worldwide who could be converted into subscribers. Firstly, it’s for fans who don’t have cable, but who are F1 fans in a given market where it’s available on a pay TV basis, and they’d like to subscribe directly. “And then I’d say the second demographic are the super hardcore fans. “We have by our estimates around 500 million fans in the world, which is quite a number. “If even, conservatively, one percent of that customer base is a super avid hardcore fan, that’s a five million addressable audience to sell this product to.” (Asked by Motorsport.com if five million was a realistic target, he said: “I wish that the total addressable potential base would all subscribe). I think that’s probably a big number in the short term. “I’m not sure that we’ll convert all of those in the first year or two. That’s a marketing and product challenge that we’ll be addressing.” – Motorsport.com[10]

F1 TV is clearly crucial to F1’s profit growth, so let’s do a sense check in this regard. Our base case (from earlier work) is that F1 ought to compound revenues by c6% per annum through to 2021. In that model, we had not made any explicit assumptions on the take-up of F1 TV so it now seems to us that might have been conservative.

Fig.3c shows a simple 2021 scenario whereby 1) Track promotion and Paddock revenues are conservatively not assumed to grow. TV rights and advertising ought to benefit from a step-up in brand awareness and commerciality – we assume +40% vs 2017 (or an equivalent of 8% cagr). Finally we look at OTT potential. Assuming 4m subscribers by 2021 (of which 3m pay only $40 per year with the remaining 1m being ‘pro’ subscribers (paying $200/yr) would, combined, contribute c$320m of revenue. Such a tailwind would increase the ‘scalable mix’ of revenues to c.61% of revenues (and overall revenue cagr of 8%). As we outlined above revenue increases from such sources, particularly once early setup costs stabilise, should be very beneficial to margins.

Fig.3c: Back of the envelope OTT scenario

 Source: Holland Advisors

2. Content Economics for Dummies (a guide for the rest of us!)

“The question is: Is the cable business going be a great business; who is going to make the money? It may well be that the Disney’s of the world make the money and cable and video continue to get squeezed. But I think at least for now they’ve got enough pricing power in broadband to make up for that…The key to future profitability and success in the cable business will be the ability to control programming costs through the leverage of size.” – John Malone[11]

Regarding Malone’s point above – how can it be that companies like Sky can tolerate 20% compound inflation on a core part of its cost of sales (i.e. Premier League rights)? The answer, we suggest, is down to the economics of content. Put simply, “content wins eyeballs” and is scalable. Given critical mass, the marginal cost of adding another consumer of your content is close to zero. We have spent time recently looking at a number of global content creators and their distribution customers to better understand the economics of content. One of our conclusions is that content distribution is a highly fixed cost business (the main costs – depreciation of infrastructure and content – are largely fixed). Thus the content aggregator, you would think, ought to have operational gearing. In fact, what actually happens is that the spoils of that gearing gets passed up to the content companies as many aggregators fight for the product that wins eyeballs. This is just reflecting contents value in the supply chain of course. Yet, it is still a good deal for the aggregators like Sky, Comcast et al who are able to retain strong and stable operating margins and grow their customer base in spite of the inflating content cost.

A simple Content Economics model

Post our studies of different content and aggregation players we built a small generic model to test this theory (admittedly backward looking) based on the US cable company Comcast as a proxy and using some simplistic growth assumptions. This is shown in Fig.4 (assumptions in blue font). This simplistic model shows why, in spite of content P&L costs growing at 11% cagr, and increasing as a percentage of sales, overall group margins for the aggregator can be maintained.

Fig.4: Content providers and distributors can co-exist despite lofty inflation

 Source: Holland Advisors

We would highlight the following:

  1. Even though content costs inflate at 2x the rate of cable bundle inflation (in this case 11% vs 6%), the economics of such a distribution model are still sufficiently attractive for both sides.
  2. It goes without saying that the best content is still needed to draw-in or retain those subscribers.
  3. This also explains why traditional distributors are evolving into content producers themselves (and why, when choosing a content company to invest in, it is now best choose the ones with rare or branded content WWE, Disney and F1).

There are other conclusions we might make too:

  • As content distribution costs fall for the aggregators (via OTT), it seems logical that
    • Customers will get offered more value (because previous wholesale prices can become retail prices – see our ESPN work). Thus customers can afford to buy more and have greater choice.
    • Consumers can opt for more personalised content which in turn drives the need for more niche content brands. Star Wars, F1, UFC etc.
    • For aggregators, scale will matter greatly.
    • Cable pricing power thus will rely heavily on high speed broadband provision (Virgin Media) – as per Malone’s point above.
  • Additionally
    • A technology change (OTT) that means content producers can more cheaply reach more customers should result in the value of their product being greater than in the past, all things being equal.
    • Content producers can now have a more direct relationship with the customer. In some businesses this may have a limited benefit (say Football), but in companies where content is produced to appeal to customers its effect could be significant. Via ‘big data’ insights, WWE has bought back wrestlers from retirement that Network customers were searching for and Disney we think will learn from which of its old movies get watched and by whom. The benefit to F1 in this area might come from fan feedback on changes it makes to the racing/cars in the future.
3. What is Mr Market thinking (aka Devil’s Advocate)?

So, you may rightly ask: if F1 is such a formidable brand with exemplary commercially minded management team and prospects – why are the shares languishing at 2017 levels?

We suggest there are three or four main reasons:

  1. F1 has a lot of debt – frankly, more than we would like – and indebtedness is somewhat out of favour in recent weeks to say the least (!). But, this is a John Malone business – and like all Malone businesses, debt is a tool to be taken advantage of. There are very very few managements around the world we trust to use the loaded gun of leverage but if there is an exception then John Malone is it. We note the long tenure of the debt, that the bulk of it is as fixed rates. We also not the stable and contracted revenue stream that F1 has and the huge (c.90%) EBITDA to Free Cash conversion.
  2. The revival of F1’s commercial operations is taking more time than might have been expected and uncertainty abounds re the Concorde agreement with the teams. E.g. the odd rumour that a team like Ferrari might leave if they do not get the deal they want.
  3. We suspect, there might be a perception that F1 is out of touch with the era of electric cars and political correctness and that this is causing falling audience figures.
  4. Finally, FWONK is a tracking stock. In light of Michael Dell’s recent financial engineering with VMWare and the new Dell tracking stock etc, investors are not keen on these types of securities.
3a) Over indebtedness vs careful financial engineering

“Our skills here, internally, are very much in financial engineering. Entrepreneurs will always be able to take an asset, leverage it up, operate it tightly and make it worth money to them and get good equity returns. You can borrow money against a growing cash-flow stream, and as long as your growth rate’s faster than your cost of money it’s a wonderful business…The cable industry created so many rich guys. It was the combination of tax-sheltered cash-flow growth that was, in effect, growing faster than the interest rate under which you could borrow money. Inflation lets you raise your rates and devalue your liabilities” – John Malone

Fig.5: F1 Leverage

Source: Liberty Media

F1’s debt is a subset of the Liberty Media group debt as shown in Fig.5 above. That said, the magnitude of F1 debt is (a still hefty) $2.9bn versus EBITDA of c.$438m last year or a 6.5x leverage ratio. This ratio is above the guidance of 5-6x to which the company has recently recommitted to reaching in 2019. This is more than we would like but is not uncommon in Malone-controlled entities. The debt is entirely bank loans – not imminently maturing bond debt and has covenants of 8.75x Net Debt/EBITDA.

3b). The slow pace of transformation

“we decided to run Formula 1 like a private company for the last few years focusing on building long-term value and having a thick skin to deal with the market’s short-term demands, and we think it was the right decision” – Chase Carey (emphasis ours)

We can see why investors are getting a little impatient with F1’s progress. We show CEO Carey’s stated objectives – notably to be achieved by 2020. In particular, investors are very focussed on number 4 – the agreement with the teams.

As a reminder, F1 CEO Chase Carey’s stated five priorities for 2020:

  1. Change a culture of “no” to a culture of “yes,” allowing teams and partners to take advantage of entrepreneurial and other opportunities
  2. Make every Grand Prix a weeklong experience in the host city
  3. Grow F1’s presence on social media
  4. Create a financial structure for the sport that allows smaller clubs to compete
  5. Increase F1’s impact and importance in the United States and China

Priority 4 above really refers to the renegotiation of the Concorde Agreement. F1 pays-out roughly 50% of revenues to the twelve teams that comprise the Formula Championship. Actually it is based on a % of the EBITDA profit of the business as was contractually agreed in what is known as the Concorde Agreement which is the infamous agreement between F1 and the teams.

The pending renegotiation of this agreement (due by 2020) obviously IS central to incentivising teams and determining the residual profits available to the shareholders of F1. As you would expect there is much posturing on both sides and we suspect there may be a little WWE-like drama intentionally created to ensure a media buzz and fuss around the issue too. That said, we think Chase Carey and his team appreciate the significance of this renewal:

Notably:

  • Liberty’s Ross Brawn has been on the other side of the negotiating table including as team chief at Ferrari and Mercedes – a substantial advantage for Liberty team.
  • F1 has already taken the sensible step of issuing equity to the teams thus more aligning interest- maybe there is more of this to come
  • Ferrari talks tough in the media about the possibility of leaving F1 for a break away championship yet in its own regulatory filings, Ferrari says something much different:

“The prestige, identity , and appeal of the Ferrari brand depend in part on the continued success of the Scuderia Ferrari racing team in the Formula 1 World Championship. The racing team is a key component of our marketing strategy and may be perceived by our clients as a demonstration of the technological capabilities of our Sports and GT cars which also supports the appeal of other Ferrari-branded luxury goods. We have focused on restoring the success of our Formula 1 racing team as our most recent driver’s championship and constructors’ championship were in 2007 and 2008, respectively. We are focused on improving our racing results and restoring our historical position as the premier racing team.

We are currently evaluating the terms and conditions under which we may continue to participate in the Formula 1 championship after the 2020 season and we cannot be certain that we or other racing teams will be successful in negotiating acceptable terms and conditions for continued participation. If we were to withdraw from Formula 1 this would affect our marketing and brand strategies and we currently are unable to predict the consequences on our business, financial condition and results of operations” – 2017 Ferrari annual report (emphasis ours)

Other teams also show their commitment via spending

Analysis of financial statements has revealed that over the past 13 years it has invested more than $1.4 billion (£1 billion) in Red Bull Racing and $900 million (€770 million) in sister outfit Toro Rosso which it bought in 2005 from aviation entrepreneur Paul Stoddart…Red Bull is reported to have spent a combined $223.8 million on both its teams which is apparently comparable with the amount that auto maker Renault spends on F1.

So what is the appropriate level of profit sharing? That is hard to say, Man United pays away about 45% of its revenues on player salaries and no doubt the Teams will use such comparisons in their negotiations. Yet it is also true that F1 has a clear interest in lowering the cost of participating in F1 championship to allow the second-tier teams the occasional chance of a podium and just as importantly to make a profit whilst doing so. Were a lower cost of being in racing to be achieved, it might be accompanied by a lower revenue share to match?

In short we think that, financially, there will be more than enough to go round for all parties in a world where F1 becomes the global spectacle it deserves to be and once was.

3c). FWONK is a tracking stock – is that an issue?

Formula One is a tracking stock – a common tool used by John Malone over the years. Liberty Media Corporation contains three tracking stocks: F1, Sirius XM (satellite radio) and Braves (a baseball team). We discussed this in our original work. Clearly, such securities raise concerns about corporate governance and lack of control for minority holders.

We are not concerned about any potential mis-alignment of interests in the case of John Malone but many others might not be so familiar with Malone’s track record and avoid tracking stocks. The high-profile complaints by Carl Icahn recently towards Michael Dell’s creation of tracking stocks for VMWare and Dell Technologies have perhaps given these concerns more prominence than they would otherwise warrant.

“generally tracking stock discounts having spread for a bunch of factors run arbitrage. Carl Icahn has noted the unhappiness in some corners with how Dell has treated VMware, they’re tracking stock. I won’t comment on this much to say, but we’re in the tracking stock business. We expect to be in the tracking stock business, we’re going to be in the tracking stock business, and we’re not going to mistreat tracking stock shareholders, full stop.” – Greg Maffei, CEO Liberty Media, Nov 2018

We note there is investor displeasure towards some of Liberty Media’s other tracking stocks not realising their supposed full intrinsic value. Here is John Malone from a few weeks ago responding to those concerns (worth reading in their entirety for much long-term thinking is evident):

“the benefit of keeping (the tracking stocks) in, by tracking them is you create an equity motivator, let’s call it, for the guys running the tracked entity, you keep under one umbrella so you don’t have antitrust issues on your inter-corporate dealings. You’re in one set of tax consolidation. And you at least have financial flexibility to move things around. And the way we set up our trackers, the board sort of has the ability to figure when to either suck them back in or totally spin them out. So they’re a tool…

Analyst (re Sirius XM tracking stock): “was wanting to ask about the discount on Liberty Sirius, which a lot of investors I talk to believe that the discount has persisted so long and it’s been so large, that it’s something that hurts your credibility. As you said, you’re in the business of trackers. And so, my question to you is, how do you – do you share that sense that this discount hurts your credibility?

John Malone: “The benefit of control, right, which I try and simplify to the things I’m involved with is patience, deferred gratification… So, if you look at any of the businesses that you saw today, what you will see is patience. If Trip wasn’t a controlled

entity, there would have been a panic in the last two years to monetize it, maybe merge it with trivago on an unfavourable basis or sell it to Priceline. The fact is that because we’re patient, because we love these businesses, we’re able to innovate and take advantage of the cycles.

One of the benefits of having a collection of public vehicles under an umbrella, in addition to economic and tax synergies is this ability to watch the equity markets and shrink those that are cheap and utilize equity when it’s strong. So, you could ask and you should ask, why did we decided to do Pandora with Sirius all equity when we could have levered up and done it with cash, and the answer is we’re just playing the equity market. What somebody told me a very long time ago was buy low and sell high, and that’s a consistent way to get ahead over time…” – Liberty Media analyst day Nov 2018

3d). Is F1 out of touch?

Saying F1 is out of touch in the modern era is analogous perhaps to calling the end of heavyweight boxing. We suggest that exotic, exciting and advanced technological sports will not go out of fashion, but we understand the concern.

In any case, Liberty has hedged its bets a just a little. Formula E (an electric-only race series) is an independently run alternative championship also under the auspices of the FIA ruling body. Notably, F1 has taken an equity stake in this series and both Porsche and Mercedes have decided to run teams. Sergio Marchionne (RIP) had previously stated that one of the FCA brands would also race under Formula E (though he ruled out Ferrari). Formula E was setup by Alejandrio Agag and has received equity investment from both Liberty Media and Discovery (the latter also a Malone controlled entity) which are reported to be c.38% in aggregate. We have checked the company accounts for Formula E – it is still early days with just EUR100m of revenue and c.20m of operating losses.

Valuation

Due to the issues we have described above, valuing Liberty Media is not a straight forward exercise. We will be happy to share our spread sheets with those interested. In it we make a few simple assumptions:

  1. That F1 revues grow c 5-7% as an occasional extra race is added to the calendar and the fee escalators kick in.
  2. That by 2021 EBITDA margins rise to c.33%, but this does reflect the aforementioned operational leverage upside in scalable revenues we have addressed in this note just more of the same type growth and cost control
  3. That 90% of free cash is used to pay down debt
  4. That debt costs are assumed to be higher than management guide (we assumes 5% interest cost as opposed to the sub 4% they are currently paying)
  5. That by 2021 F1 is valued at 20x its equity earnings and has a much less geared balance sheet.
  6. That the other external stakes are only worth today’s value.

The result of these crude assumptions is that the shares could compound at 20-25% pa for the Equity investor.

A couple of other observations are also worth making:

  1. That the debt/EBITDA multiple given by the company of 6.5x is only on the debt inside F1. There is other debt at the parent level equating to c.$1.3bn.
  2. However, there are also some very valuable stakes in other business held at the group level too, mainly Live Nation. Interestingly while the Liberty Media share price is unchanged in two years, the Live Nation price has doubled. This means the equity Rump value of F1 investors are buying in to today is $2.6bn. When we wrote on F1 in the summer of 2017 (with the share price also at c.$31 the rump (i.e. implicit F1 value) was then $4.1bn). So F1 Equity value implied is down 36% since then. The rise in the aggregate value of these other equity stakes to today’s level of $4.6bn also suggests they can now act as better security against the remainder of group debt $1.3bn.

The reality of this share is that a franchise/content investor has to accept more leverage than they are used to and more complexity. The equity investor IRR that our simple model throws out is c.20-25% pa to 2021. Crucially, however, this assumes very little benefit from the scalable revenues we have written about above. Each investor will need to study the company’s cashflow characteristics and debt levels for themselves to decide if such returns outweigh the risk, they feel they are taking. As we stated before we are giving more leeway on debt levels than we would usually tolerate, due to Malone’s past successful record with such companies and because of the rarity of the asset we are buying into and the security of cashflows its long-term contracts bring.

The big picture and a conclusion

In conclusion, let’s try not to forget the big picture here (as per Fig.6).

  1. Malone has an awesome record
  2. Liberty Media strategy is carefully thought-out and is consistently employed. Note the reference in Fig.4 (RHS) to ‘protected niches’.

Fig.6: a reminder of the Jockey involved here – Malone compounded returns +30% 1973-1999

Source: Outsiders by Will Thorndike, Liberty Media

F1 is a rare and unique asset that is being reformed and commercialised under the tutelage of an excellent team of media asset managers. High debt and a tracking stock security are not ideal but we think F1 presents a one-off chance to buy a potentially great global asset that is neither priced for its rarity nor the operational gearing that might one day turn up when an improved product that is run in more commercial manner delivers more scalable and growing revenues operational gearing following closely behind.

Buy Formula One/FWONK

Kind regards

Andrew Hollingworth & Mark Power

The Directors and employees of Holland Advisors may have a beneficial interest in some of the companies mentioned in this report via holdings in a fund that they also act as advisors to.

Appendix

Disclaimer

This document does not consist of investment research as it has not been prepared in accordance with UK legal requirements designed to promote the independence of investment research. Therefore even if it contains a research recommendation it should be treated as a marketing communication and as such will be fair, clear and not misleading in line with Financial Conduct Authority rules. Holland Advisors is authorised and regulated by the Financial Conduct Authority. This presentation is intended for institutional investors and high net worth experienced investors who understand the risks involved with the investment being promoted within this document. This communication should not be distributed to anyone other than the intended recipients and should not be relied upon by retail clients (as defined by Financial Conduct Authority). This communication is being supplied to you solely for your information and may not be reproduced, re-distributed or passed to any other person or published in whole or in part for any purpose. This communication is provided for information purposes only and should not be regarded as an offer or solicitation to buy or sell any security or other financial instrument. Any opinions cited in this communication are subject to change without notice. This communication is not a personal recommendation to you. Holland Advisors takes all reasonable care to ensure that the information is accurate and complete; however no warranty, representation, or undertaking is given that it is free from inaccuracies or omissions. This communication is based on and contains current public information, data, opinions, estimates and projections obtained from sources we believe to be reliable. Past performance is not necessarily a guide to future performance. The content of this communication may have been disclosed to the issuer(s) prior to dissemination in order to verify its factual accuracy. Investments in general involve some degree of risk therefore Prospective Investors should be aware that the value of any investment may rise and fall and you may get back less than you invested. Value and income may be adversely affected by exchange rates, interest rates and other factors. The investment discussed in this communication may not be eligible for sale in some states or countries and may not be suitable for all investors. If you are unsure about the suitability of this investment given your financial objectives, resources and risk appetite, please contact your financial advisor before taking any further action. This document is for informational purposes only and should not be regarded as an offer or solicitation to buy the securities or other instruments mentioned in it. Holland Advisors and/or its officers, directors and employees may have or take positions in securities or derivatives mentioned in this document (or in any related investment) and may from time to time dispose of any such securities (or instrument). Holland Advisors manage conflicts of interest in regard to this communication internally via their compliance procedures.

  1. https://www.cnbc.com/id/100716784 ↑
  2. Narrowcasting describes the ability to stream personalised content. Instead of blasting 57 channels at the world, users take their personalised (narrow) pick of preferred sports, entertainment channels. ↑
  3. Holland Views – a winning formula, March 17, Holland Views – Lollapalooza at speed – Nov 2017 ↑
  4. Nascar and International Speedway Corp (the US-specific racing league and promoter/owners of raceways respectively) – a family controlled business – have just announced a merger/take-private deal. http://ir.internationalspeedwaycorporation.com/phoenix.zhtml?c=113983&p=irol-newsArticle&ID=2376581 ↑
  5. FCIC testimony 2010 https://www.dropbox.com/sh/ufck6e0dmytje66/AAAMfpvMM5H4aAtESOnVgfwKa/SCREENED%20Interviews/2010-05-26%20FCIC%20interview%20of%20Warren%20Buffett_1.doc?dl=0 ↑
  6. https://f1esports.com/ ↑
  7. https://www.formula1.com/en/latest/article.f1-new-balance-esports-series-2018-watched-by-4-4-million.2d2JuGmQeYY0a0euOUOoOO.html ↑
  8. https://www.marketingweek.com/2018/03/21/f1s-commercial-boss-transforming-business/?nocache=true&login_errors%5B0%5D=invalidcombo&_lsnonce=9a082d2556&rememberme=1 ↑
  9. Over The Top (i.e. its direct to consumer internet platform) ↑
  10. https://www.motorsport.com/f1/news/f1-tv-five-million-subscribers-ott-1010165/1394013/ ↑
  11. 25 things I’ve learned from John Malone https://25iq.com/2014/11/02/a-dozen-things-ive-learned-from-john-malone/ ↑

Related Posts

June 14, 2020

Jun 2020: Formula 1 – A simpler Formula

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