Take the structure of the IPO. Investors will get a stapled security, comprising of a stake in the business and a US$4bn PIK loan note with a 10% coupon that does not mature until 2060. Such a structure is unusual for an IPO, although variations of it are not so rare among private-equity held companies. It’s also motivated entirely by tax savings: the loan note is tax deductable, giving the business an effective tax rate of about 4%.
That sounds clever. But investors need to be sure that the structure is also in their best interests.
The PIK portion is worthy of special attention. The PIK loan note yields a whopping 10% a year for a reason: it is a deeply subordinated and very issuer-friendly instrument. Typically on PIK loan notes, cash payments may be made but are not required, so in lean years the interest payments can be added to the principal. This means the debt may grow, changing the company’s metrics over time, and making comparisons with other issuers difficult.
As for the equity component, Formula 1 is trumpeting the fact that it plans to return 80% of the total benefit from the stapled security to investors each year so that investors will receive an annual distribution of 3.4%-4.7%.
That sounds impressive, but the more eye-catching revelation is how dependent Formula 1’s teams are on Formula 1 for their financial survival. Formula 1 pays out about 63% of Ebitda to racing teams as a prize fund. Many of those payments come with a floor but are fixed to a percentage of the competition’s earnings, and some will even grow if any team dominates over two consecutive years.
Payments are fixed, growth is not
This means that investors’ interests and racing teams’ interests are not totally aligned. Should Formula 1’s revenues rise, the teams will take a chunk of the growth. In years of low Ebitda, meanwhile, shareholders face a potential double blow: the fixed payments to the teams mean shareholders will suffer financially, while the quality of racing will suffer if those payments fall back to their floors, leaving teams not so well financed. Should payments fall below a certain level, some of the teams have the right to break their contracts, leaving the entire sport in jeopardy. Contracts with the teams are also up for renegotiation again in 2020, at which point the business model may change dramatically.
The forensic details of Formula 1’s accounts will only emerge with the prospectus. On the face of things, however, Formula 1 has a good growth story over the next few years with some 70%, or US$4.6bn, of its revenues contracted until 2015 and analysts forecasting revenue growth of above 9% between now and 2016. That’s a rate of growth as fast as a Formula 1 car.
The Formula 1 brand is also remarkably bullet-proof. It thrives despite never being far from controversy. Only a few months ago, Formula 1 faced strong criticism over its cowardly decision to proceed with the Bahrain Grand Prix despite a repressive government crackdown. That did not stop last month’s Australian Formula 1 Grand Prix from attracting its best TV audience in seven years – as if there had been no controversy.
Investors seem to be buying the story, too. Waddell & Reed, BlackRock and Norges Bank Investment Management have joined as pre-IPO investors on incredibly issuer-friendly terms. These pre-IPO investors are locked in for six months after listing, have no voting rights, receive no coupon and – most amazingly – no exit option should the IPO not happen. This suggests that Formula 1 is going out of its way to ensure it enjoys a dominant relationship over its investors.
Formula 1’s tax-efficient structure sounds clever. But investors need to be sure that it is also in their best interests.
Beyond the unusual financing structure lies the matter of what assets Formula 1 actually owns. They are mainly just contracts in an area where contract breaching and re-writing are as common as mosquitoes in a malarial swamp. With few real assets to sell, Formula 1 can only downsize in lean times through the long and torturous renegotiating of contracts. That does not impact the company’s growth story, but it does illustrate just how fragile the company’s asset base actually is should Formula 1 come under financial pressure.
Formula 1, with its fast cars and glamorous locations, also looks suspiciously like a boom-time activity. The problem is that boom times are over – even in super-resilient Asia where the Chinese and Indian economies are looking more vulnerable by the day. Asia is slowing and the only remaining question is: how bad it will be? Television rights are critical to Formula 1’s success, so broadcasters and Formula 1 have an interdependent relationship. The weakness in that, however, is that broadcasting money is directly linked to advertising spend – something that always contracts sharply in a downturn.
Formula 1’s prospectus, due out by June 5, should shed some further light on the company. But with a convoluted structure and history of fractious relationships with both teams and hosts, investors will need to look beyond the numbers.
