Over the past two months Formula One’s share price has crashed by 43.9% as the coronavirus pandemic put the brakes on many of its races. It has fueled speculation that the sport could be a takeover target but actually it is F1’s debt, not its equity, that could hold the keys to its future.
F1 is owned by the investment firm Liberty Media and listed on the Nasdaq with the ticker FWON. However, perhaps surprisingly, its stockholders don’t own a stake in the lucrative commercial rights to the auto racing series.
Liberty took over the wheel of F1 from the private equity firm CVC in 2017 and listed it on the Nasdaq. It is what is known as a tracking stock as it reflects the financial performance of a group of assets which are wholly owned by Liberty.
FWON tracks the performance of the Formula One Group which doesn’t just include F1’s parent company Delta Topco, but also a 33% stake in event promoter Live Nation and 15% of the Atlanta Braves baseball team as well as tiny shareholdings in other companies.
Crucially, as we reported in 2017, Liberty’s filings confirm that the group is not a “separate legal entity and therefore cannot own assets.” This is what prevents it from owning F1’s commercial rights which remain under Liberty’s ownership regardless of who buys the shares. This structure protects the assets from hostile takeover bids but it doesn’t mean that Liberty couldn’t be forced to relinquish them.
At close of trading on Monday, the stakes in Live Nation and the Braves were worth a total of $3.3 billion. Deducting this from FWON’s $6.1 billion market capitalization gives F1 an equity value of $2.8 billion. As shown on the graph below, it is just $800 million more than F1 was worth when CVC itself bought it from a consortium of banks way back in 2006. By the time Liberty acquired F1 11 years later its equity value had accelerated to $4.6 billion but that was just the start of the story.
F1 had $700 million of cash in the bank and $4.1 billion of loans to repay when Liberty bought it. Subtracting the cash from the loans gave $3.4 billion of net debt which came with the company. Combining this with its $4.6 billion of equity gave F1 an enterprise value of $8 billion which was widely trumpeted as the amount that Liberty paid. The debt boosted it to this total and CVC was the driving force behind it.
Private equity firms are famous for using loans to get deals across the finish line and this is exactly how CVC structured its acquisition of F1 in March 2006. CVC funded the takeover with $965 million of its own money and a $1.1 billion loan from the Royal Bank of Scotland (RBS) but it didn’t stop there.
Once CVC owned F1 it was able to get an even bigger loan as this time it could secure it on the sport’s operating companies. As we revealed in British newspaper the Daily Express, in November 2006 RBS and Lehman Brothers lent F1 $2.9 billion which was used to pay back the original $1.1 billion loan and CVC’s share of the purchase price. So not only did CVC get its money back just eight months after it bought F1, it left the sport on the hook for the loan that it used to buy it.
Over the following decade, F1 boosted its borrowings and used the money to make turbocharged payments to its owners. This drove up F1’s loans to $4.1 billion by the time that Liberty bought it and since then they have gradually reversed. Liberty has refinanced the debt and paid it down with cash that F1 had in the bank. At the end of last year F1 had $402 million of cash and $2.9 billion of loans. They come with crucial conditions.
Known as covenants, these conditions restrict F1’s subsidiaries from doing a number of things such as paying dividends and selling key assets. Doing the former would leave F1 with less money to repay the loans whilst the latter would reduce the security on them.
Other covenants concern F1’s earnings and are similar to the salary warranties that borrowers need to give when they get a mortgage for a house. Someone’s salary establishes how much they can borrow whereas a company’s profit determines the amount a bank will lend it. So if its profit plummets below a certain threshold it is a red flag to lenders because it could prevent the company from being able to repay the loan.
The threshold is different for every company but it is usually calculated in the same way. First the bank determines the company’s net debt by deducting its cash reserves from its total outstanding loans. Subtracting F1’s $402 million of cash from its $2.9 billion of loans gives it $2.5 billion of net debt. F1’s loan covenant states that its net debt mustn’t be more than 8.25 times its operating profit which gives it a threshold of $303 million. It has never been at risk of slipping below this level until now.
Three weeks ago F1 was forced to give the red light to its season-opener in Australia after a member of the McLaren team was diagnosed with COVID-19. Since then it has postponed or cancelled the first eight races leading to the momentous crash in its stock price. F1 has never dropped this many races in a single season over its 70-year history and the casualties even include the historic Monaco Grand Prix which will not be held this year for the first time in more than six decades.
F1 is particularly at risk from the coronavirus pandemic as it travels to more than 20 countries in only eight months every year with each race attracting an average of 198,331 spectators. Not only have many governments banned mass gatherings in order to stop the spread of the coronavirus, but they have locked down their borders too. No one knows when these restrictions will end and it has sent F1 into a spin.
Following the cancellation of the Australian Grand Prix, F1 announced that the 2020 season would start at the end of May but this was pushed back even further last week. F1’s chief executive Chase Carey didn’t give a revised start date and simply said that racing will begin “at some point this summer.”
F1’s filings state that if races are not held, the “fees under the relevant advertising and sponsorship contract are likely to be reduced” and corporate hospitality tickets have to be refunded. Together they comprised around 19.4% of F1’s $2 billion revenue last year and join the $602.1 million that it received from race promoters. This is also under threat as Carey told analysts last month that if races are not held “we would not receive the promotion revenue.”
F1’s single largest revenue source is the $762.8 million paid by broadcasters such as ESPN in the United States. According to the filings, “broadcast contracts include a provision to reduce the fee payable to Formula 1 if there are fewer than 15 Events.” F1 hasn’t fallen below that number in the past four decades but it could be on track to do it this year.
Last week Carey signalled that investors could be in for further shocks as he said “there is significant potential for additional postponements.” Despite this, he brazenly forecast that F1 will still hold “between 15-18 races” this year which left many observers shaking their heads.
Taking the summer start as being the middle of August, one race would have to take place every weekend until the middle of December in order to fit in 18. That doesn’t just require 18 countries to be free of coronavirus but also the UK, Italy and Switzerland as the teams are based there.
Race hosts probably won’t take any chances after the debacle in Australia, where F1 was seen to have brought a case of coronavirus into the country. This means it is likely that the teams’ home countries will have to be completely clear which suits F1 too as it took just one infection for the Australian Grand Prix to grind to a halt. However, given that the UK, Italy and Switzerland currently have more than 109,866 active cases it could take far longer than the middle of August for them to be completely clear.
This view was recently echoed by Jan Lammers, sporting director of the Dutch Grand Prix, which is one of the races that has been postponed.
Talking to Dutch broadcaster NOS, Lammers questioned whether it would be possible to resume racing in August. “How realistic is that, and should you as a fan even want it?” He added, “that means we have to get this virus out of the country and the world by July. We want people to come to us with a good feeling. Can we expect that in August?”
The problem for F1 is that for every race it cancels, it loses an average of $48.1 million in revenue. This comprises $28.7 million in race promotion fees, $14.3 million in sponsorship and $5.1 million of hospitality ticket sales.
F1 saves money by not travelling to the races that are cancelled but it hasn’t announced any other cut backs such as moving to cheaper premises, slashing executive pay or scaling back staff numbers which surged 26% to 456 under Liberty.
In contrast, IndyCar’s owner, Penske Corporation, warned of lay offs and announced pay cuts for senior management last week. Its chairman Roger Penske and company president Rob Kurnick will forego their salaries throughout the COVID-19 crisis whilst NASCAR has also slashed salaries of senior management by 25% with all other employees taking a 20% pay cut.
F1’s combination of reversing revenue and high-octane costs could drive it perilously close to breaching its $303 million debt covenant. Although there is no evidence it has hit the wall yet, a recent report suggested that it could be heading in that direction.
Last week we revealed in British newspaper the Daily Telegraph that according to JP Morgan, F1 might breach its debt covenant if it misses too many races.
In a recent research note the investment bank said that F1’s credit facilities have “a maximum allowable net leverage of 8.25x (relative to 5.1x at year-end). While Formula 1 could conceivably breach this level with an extended shutdown, we believe it would likely receive a waiver, and in an absolute worst-case scenario, note that Liberty does have cash and liquid assets at the FWON tracking level that it can send down to F1.”
In summary, JP Morgan believes that even if F1 breached the covenant, it wouldn’t actually default on the loan because the lenders would allow it to miss payments and if they didn’t, it could use cash to make the payments.
The loan incurs interest at 4.3% annually and F1 paid a total of $142 million in 2018. That comes to $11.8 million per month so F1’s $402 million of cash would cover instalments for nearly three years. This assumes that F1 wouldn’t need its reserves for anything else which seems unlikely in practice. In contrast, it’s not unlikely that the lenders would allow F1 to miss payments. We gave Liberty the opportunity to comment but it declined to respond.
F1’s filings clearly state that its $2.9 billion loan “is secured by share pledges, bank accounts and floating charges over Formula 1’s primary operating companies.” In other words, if it defaults on the loan, the lender becomes the new owner of F1.
That may sound appealing but in reality, who wants to own the rights to a race series that isn’t allowed to race? Lenders don’t usually want to become asset owners, they want their money back with interest and the easiest way to do that is to help the borrower get their business back on its feet.
However, lenders don’t usually allow payments to be missed continuously and their tolerance may depend on how likely it is that the company can recover. In this regard, it could be worth noting that JP Morgan’s warning about a covenant breach was made before even the Australian Grand Prix had been cancelled. Since then a total of eight races have skidded off track so the outlook for F1 is likely to be even bleaker now. We asked JP Morgan if it wanted to provide an update but it didn’t respond.
A bleaker outlook might not be the only spanner in the works for F1. Although RBS and Lehman originally provided F1’s debt, it was later syndicated meaning that the right to repayment was sold. It can be bought by investors and this gives an insight into the financial health of the sport. The higher its price, the more confidence there is that the loan will be repaid.
At the end of last year the debt was priced at 100 Cents in the Dollar, according to Markit Group, which charts credit pricing. It means there was no likelihood of the debt not being repaid but by the end of last week it had reversed to 86 Cents putting the level of risk at around 14%. At this price, the right to repayment of the $2.9 billion could be bought for only $2.5 billion and the risk F1 runs is that this debt could be acquired by a group which is far less benevolent than a bank.
Whilst banks may be looking to get their money back, debt investors might have their eye on the assets and may not be comfortable with F1 missing many payments. According to F1’s filings, it may even have to repay its loan in full under certain circumstances and if it doesn’t have enough cash in the bank, this could drive it into default.
F1’s filings state that it may “be required to repay its credit facilities upon the occurrence of certain events and Formula 1 cannot give any assurance that it will be able to finance such a repayment. Failure to comply with an obligation to repay the credit facilities would result in an event of default which could have a material adverse effect on Formula 1 and the Formula One Group.” There is no suggestion this will happen though as F1 has some tricks under its hood to swerve around the danger.
Its loan is non-recourse which means that Liberty wouldn’t be obliged to bail F1 out, though it may do so anyway. One source points out that Liberty could issue new shares to cover the cost and says that it “could easily raise $2 billion for F1.” It could also get a helping hand from F1’s regulator, the Fédération Internationale de l’Automobile (FIA).
In 2001, F1’s operating companies paid the FIA $313.7 million to buy a 100-year license to run the auto racing series. According to F1’s filings, the FIA can terminate the license if some of F1’s “subsidiaries party to the 100-Year Agreements become insolvent.”
It raises the question of whether the debtholder would actually get F1’s lucrative commercial rights if it defaulted and crashed into insolvency. There is no doubt that the tracking stock structure protects these crown jewels from hostile takeovers though Liberty could of course decide to sell F1 voluntarily. Even that wouldn’t require approval from the owners of FWON shares.
Liberty’s filings state that it “requires stockholder approval only for a sale or other disposition of all or substantially all of the assets of our Company taken as a whole.”
This clearly wouldn’t apply to F1 as its equity value comes to just 16.8% of the total market capitalization of Liberty’s three tracking stocks which also include the Braves and satellite radio broadcaster SiriusXM. There is no evidence that Liberty has reached the end of the road with F1 just yet but there is no doubt that it faces a very bumpy road ahead.