Author: Jeremy Chia

Sea Ltd (NYSE: SE), which I will refer to as Sea from here on, reported its 2021 third-quarter financial results on 18 November. The parent company of Shopee and Garena saw its total revenue grow 122% year-on-year to US$2.7 billion, while gross profit surged 148% to reach US$1 billion.

Here’s how its three segments of e-commerce, digital entertainment, and digital financial services fared.

1. E-commerce

Triple-digit growth

E-commerce revenue surged 134% year on year to US$1.5 billion. This was driven by an 81% increase in gross merchandise value (GMV) to US$16.8 billion and an uptick in the take rate from 6.7% to 8.6%. 

Forrest Li, CEO and founder of Sea Ltd, said in the earnings conference call that the stronger monetisation was due to growth across value-added services, transaction-based fees, and advertising revenue. I’m keeping my eye on future comments from Sea’s management on advertising revenue as this is a relatively higher margin item and should be an important contributor to Shopee’s long-term profitability.

On a sequential basis, GMV grew an impressive 12%. 

Li and his team are providing more tools for merchants to succeed on the platform to create a more comprehensive ecosystem. He said:

“We are helping sellers be more competitive. For example, we have rolled out more features, tools and services to help them build engagement with their customers and grow their businesses. We recently launched Seller Missions, an incentive program that rewards sellers with privileges as they complete certain tasks. The program gamifies the experience of sellers as it guides them through features and tools on Shopee they can use to become better sellers. We also introduced tools like Listing Optimizer which helps sellers identify listings that can be improved and how to improve them. These initiatives help sellers grow on the Shopee platform and create better experiences for our buyers too.

We also recently celebrated the first anniversary of Shopee Premium, a dedicated space on Shopee for select brand partners in the luxury segment. Since launch, we have doubled the number of Shopee Premium brands. Through a more immersive shopping experience, Shopee Premium helps brands share their stories and build deeper personalized relationships with buyers.”

Global ambitions

Li also hinted that Sea’s e-commerce ambitions lie beyond its current core markets of Southeast Asia, Taiwan, and Brazil.

In recent months, Sea has launched in Poland, France, Spain and India, gradually creating a truly global presence.

Although each new market poses its own set of challenges, Shopee’s competitive edge lies in its ready-base of sellers who are looking to sell abroad and expand their global reach. This should provide the initial seller base for Shopee to enter into new territories. 

E-commerce profitability improving

One of the main risk-factors I’m watching for Sea is the cash burn rate for its e-commerce segment. However, there are encouraging signs in the quarter as the e-commerce gross margin is now 16%, up from just 6.4% in the corresponding period in 2020. 

The gross margin even reached 18.3% in the second-quarter of 2021. The last two quarters show signs that Sea’s e-commerce segment is heading in the right direction in terms of profitability as scale-effects and the ability to offer sellers advertising becomes more relevant over time.

I believe Shopee is on track to increase its take rate to above 10% over time (comparable with other marketplaces which may have take rates above 15%) and help e-commerce gross margins to widen substantially.

Deep pockets

Sea’s strategy to grow its e-commerce business is to spend heavily on sales and marketing, often at the expense of near-term profitability and resulting in extremely heavy cash burn.

But this is a well-calculated strategy. Sea has two sources of cash that other e-commerce companies may not have. First, the gaming business – which I will touch on shortly – is a cash machine. 

Second, investors love Sea. The company has already taken advantage of this by raising US$1.35 billion in 2019, US$2.6 billion in 2020, and more than US$6 billion in its latest stock and bond offering announced in September this year.

As such, Sea exited the third quarter of 2021 with a war chest of US$11.8 billion. This is up from US$5.6 billion at the end of the second quarter of 2021.

2. Digital Entertainment (Gaming)

Free Fire growth slowing but outlook still bright

Sea’s gaming segment, Garena, delivered explosive growth over the last few years as one of its self-developed games, Free Fire, became a global hit. Free Fire is a phenomenon as it has the second-highest average monthly active users among mobile games on Google Play in the quarter.

But growth has started to slow. Quarterly active users only inched up by 0.5% sequentially to 729 million users from 725 million.

Gross bookings also came in flat quarter-on-quarter. With Free Fire already such a big hit in its key markets, it is no surprise that growth will taper off over time. On a brighter note, Garena is still highly profitable and continues to help fuel the growth of Sea’s e-commerce business.

Engagement levels for Free Fire also still remained strong and the signs are that Free Fire will be a long-lasting global franchise that acts as a stable source of cash for Sea for many years to come.

Garena is focused on building the Free Fire franchise with Li reiterating in the latest earnings conference call:

“Given Free Fire’s growing global popularity, we see significant opportunity to provide our community with many kinds of ways to enjoy the Free Fire platform, and we continue to invest in building towards a long-lasting global franchise.”

Gaming options beyond Free Fire to drive growth

Sea is looking to develop other games beyond Free Fire.

With Garena’s global reach and the success of Free Fire, the company can now attract the best talent and form partnerships with renowned game developers to try to build the new big thing. It also helps that Sea’s share price has been on a tear of late, which should be a big pull factor for top talent.

Li summed it up by saying:

“We are also very focused on growing our global reach and building a games pipeline that ensures we can capture the most promising and valuable long-term trends in online games. Our growing global presence across diverse high-growth markets gives us important local insights and strong local operational capabilities. And our in-house development team is tapping into this as they work on both existing games and new ideas. Moreover, given our proven global track record, we have received more interest from studios keen to build strategic relationships with us. As such, our pace of investments in and partnerships with games studios worldwide has stepped up.”

3. Digital financial services

Lastly, Sea’s digital financial services segment, which includes its digital wallet offering and payment services, saw continued growth. Total payment volume for Sea’s mobile wallet was US$4.6 billion for the quarter, up 111% from a year ago.

Quarterly paying users also increased to 39.3 million, up 120% compared to a year ago. SeaMoney has a large potential to grow in Southeast Asia where many people are unbanked. The company is doing an excellent job in tying up with merchants both online and offline to offer users ways to pay with SeaMoney.

Parting thoughts

It was another excellent quarter for Sea as its e-commerce business surged and showed signs of improving profitability. The gaming unit continues to generate healthy profits and Sea’s balance sheet has been strengthened by the recent cash injection from its secondary offering.

The only blip was the slowing growth in its digital entertainment bookings and active users on a sequential basis. But the signs point to Free Fire being a long-lasting global franchise that will rake in tonnes of cash for Sea for years to come. With Sea’s e-commerce business scaling nicely, and financial services growing at triple-digit rates, the future looks bright for Singapore’s home-grown tech giant.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, I currently have a vested interest in Sea Ltd. Holdings are subject to change at any time.

Not much has gone right for The a2 Milk Company recently. 

In its fiscal year 21 (FY21), which ended on 30 June 2021, the infant milk formula and fresh milk specialist suffered a 30.3% decline in revenue to NZ$1.21 billion from the previous financial year. Gross profit dropped even more, falling 47.4% to NZ$509.7 million, because of write-downs from inventory overload at resellers and a big decline in a2 Milk’s high margin English-label infant milk formula products.

And things are not likely to improve in the next fiscal year with management providing some bleak remarks on the overall outlook for FY22. 

As an investor with a vested interest in a2 Milk since July 2020, watching its share price slide 67% has, to put it mildly, not been a pleasant experience. The fact that the S&P 500 index has risen 47% over the same time makes it even more depressing.  

So what went wrong?

1. Flat industry growth

Although a2 Milk is a company based in New Zealand, the bulk of its revenue is driven by Chinese consumers. As such, China is a big part of its growth. But in FY21, the China infant milk formula market’s growth rate fall from a high level in previous years to flat year-on-year. Moreover, total infant milk formula volume declined.

Part of the reason was due to a decline in newborns in China. The chart below shows the number of newborns in China from 2015 to 2020 and the forecast for the next 5 years.

2. International brands losing market share

There is also a change in consumption patterns among Chinese parents. Local brands have been winning market share against multinational corporations over the past few years. The chart below shows the decline in market share among multinational corporations. 

From 2008 to 2018, Chinese consumers had a preference for international brands due to the 2008 Chinese milk scandal. In 2008, some Chinese suppliers added melamine to powdered milk to artificially boost protein levels. An estimated 54,000 victims were hospitalised and 50 babies died due to the contamination.

Understandably, Chinese mums lost confidence in local brands and began looking for alternative infant milk formulas from respected international companies. a2 Milk was one of the companies that benefited from this shift.

But with Chinese companies improving their products and finally regaining trust among consumers, local brands are starting to win back some market share in the last few years. In addition, there is a growing corner of the Chinese population who prefer to buy local brands simply because of rising patriotism in the country.  

a2 Milk’s marketing team has likely seen a surge in this consumer-group – the company felt a need to include them in its recent Investor Day presentation.

The two new types of customers that the company showcased – the “Value-seeker mum” and the “China Pride mum” – are both consumer-groups that prefer to shop for local brands.

3. Poor channel inventory management

a2 Milk sells its infant milk formula to China via (1) a Chinese-label brand that is sold in China and (2) an English-label brand that is sold in Australia to Daigous and directly to consumers through cross-border e-commerce. (Daigous are Chinese resellers who purchase goods abroad to bring back to China for re-sell to Chinese consumers.)

In FY20, around 58% of a2 Milk’s revenue came from its English-label brand, the bulk of which likely ended up with Chinese consumers via Daigous and cross-border e-commerce. 

But in FY21, it seemed like everything went wrong for a2 Milk for its English-label brand. During the year, its English-label infant milk formula revenue declined by a whopping 52.1%.

One of the major reasons for the decline was because resellers and Daigous had too much inventory. This was ultimately the fault of poor foresight and channel inventory management by a2 Milk’s previous management team. In essence, a2 Milk sold way too much inventory to Daigous and other resellers in the prior year who, in turn, could not move inventory fast enough as the COVID pandemic dragged on. As a result, the resellers and Daigous were left with ageing inventory and were forced to offer discounts to try to offload their expiring inventory.

Understandably, a2 Milk had to take initiative to reverse the situation and to stabilise pricing. First, the company offered to write down some of its reseller’s old inventory and even swapped out some of its distributors’ inventory. The company also restricted sales in the fourth quarter of FY21 to stabilise pricing and improve inventory flow. 

All these actions resulted in lower sales for its English-label brand, lower margins due to write-offs and expensive swapping of products to resale channels, and a loss in market share in both cross-border e-commerce and Daigou channels.

What’s in store in the future?

Over the past fiscal year, a2 Milk’s management had to lower the company’s forecast for the year multiple times as some of the above factors seemed to have blindsided them. I think the company’s current management team has learnt a hard lesson and has declined to give specific guidance for the next fiscal year. However, it did provide an update to say that the first half of the year is going to be choppy.

In its trading update, a2 Milk said that its China-label infant milk formula sales are expected to be “significantly down” the first half of FY22 versus the comparable period in FY21. The company also said that its English-label infant milk formula sales are expected to be down in the first half of the fiscal year. 

But can a2 Milk turn things around in the medium to long term?

In a2 Milk’s recent Investor Day event, a number of the company’s C-suite executives came together to explain their plan for the next few years. 

1. Medium-term goal to hit NZ$2 billion in annual revenue

Management has set a target of achieving NZ$2 billion in revenue in five years. This is a 66% increase from FY21, but just 15.6% above a2 Milk’s peak revenue in FY20. As an investor who first gained exposure to the company just before things turned sour, I was hoping for more lofty ambitions by the company. But this is a start. The company provided this chart to show the areas they are targeting to achieve this goal.

From the chart, we can see that management is targeting broad-based growth across its current core geographies and to enter into emerging markets such as Southeast Asia.

Management also mentioned that they are targeting an EBITDA margin in the low to mid-twenties range. This is significantly lower than the 31% EBITDA margin achieved in FY20, but higher than the meagre 10% margin seen in FY21. The margin outlook is slightly disappointing, given the heights a2 Milk reached in FY20. But it is understandable as the high-margin English-Label brand is not expected to hit the highs of yesteryears in the next five years. The bulk of revenue growth will come from the lower margin China-label brand.

2. Chinese-label brand initiatives

To achieve their NZ$2 billion revenue target, a2 Milk’s management is targeting to double the company’s Chinese-label brand sales in China from NZ$390 million to NZ$800 million. The Chinese-label brand has been one bright spot for the company in FY21. While all other segments declined, the Chinese label brand grew in FY21 and won market share via both offline channels through its distribution network of mother & baby stores in China as well as direct online channels.

There are a few key ways to drive growth.

First, the company is looking to win market share in lower-tier cities where it is under-indexed. Lower-tier cities make up 84% of the total sales value of China’s infant milk formula market but only 61% of a2 Milk’s sales come from these lower-tier cities.

In fact, there is a large dispersion in market share between a2 Milk’s market share in upper-tier cities and lower-tier cities. In upper-tier cities, the company holds a 5.8% market share from mother and baby stores but in lower-tier cities, the company only commands a share of 1.8%. 

There is a lot of room to grow in these cities and the company plans to increase its mother and baby store footprint in these areas. At the moment, a2 Milk’s products can be found in 18% of mother and baby stores, which account for 38% of total infant milk formula sales.

To win market share in lower-tier cities, the company is planning to get its product on the shelves of more mother and baby stores. The target is to be in enough mother and baby stores in China such that these stores, in aggregate, account for 50% of total infant milk formula sales in China.

In addition, there seems to be room for a2 Milk to grow its direct online channels.

Around 81% of the Chinese-label brand sales came from mother and baby stores compared to just 19% from direct online channels. While the online channels did grow by 18% from a year ago, there is still room to expand as other brands drive much more sales from online channels. The graph below on the right shows that a2 Milk’s direct online sales for its Chinese-label brand makes up only 19% of the total sales of its Chinese-label, much lower than other international players.

The key to driving direct online commerce growth is brand awareness. a2 Milk is planning to invest more in digital marketing, which should improve brand awareness in important online channels such as Tmall and JD.com.

Lastly, the company is planning to expand its product portfolio to increase its customer reach. It only has a single China-label brand that is in the ultra-premium range, the highest category for infant milk formula. To reach more consumers, a2 Milk wants to have a variety of brands at lower price points.

3. English-label brand recovery plan

As mentioned earlier, the English-label infant milk formula was the hardest hit in FY21. The pandemic affected commercial Daigou businesses hard and they ended up with excess inventory on their hands.

As Daigou lost momentum, the cross-border e-commerce channels were also hit as Daigous previously acted as social influencers who promoted a2 milk infant formula sales online too. Moreover, the shift toward local brands in China has likely led to both a near and medium-term impact on the popularity of a2 Milk’s English-label brand.

Although the company tried to paint a picture of recovery for the English-label brand, it seems like years will be needed before the brand reaches its glory days of yesteryears. a2 Milk is targeting to win back merely NZ$300 million in revenue in the medium term. For perspective, in FY20, the English-label infant formula revenue was NZ$1,081 million. The company is now targeting annual revenue of just NZ$820 million after five years. 

Still, a2 Milk outlined some initiatives to win back sales. The first is to increase reseller support by upgrading brand awareness and to try to place English-label products in offline channels as a “showroom” for the brand.

Better inventory management should also better support prices over the longer term. And lastly, management highlighted an opportunity to expand its English-label infant milk formula portfolio. Like the Chinese-label brand, a2 Milk only has a single brand of infant milk formula at the premium to super-premium category. Expanding the product portfolio can allow a2 Milk to capture a greater portion of the market.

4. Diversifying to new products and geography

Another initiative mentioned was the opportunity to expand the a2 brand. The company is looking to leverage the a2 brand to launch new products. In October 2020, the company launched UHT in China with some success.

In addition, a2 Milk has already expanded into other geographies such as Canada and South Korea recently. There has been some success in South Korea too where the company started selling in December 2019. Monthly infant milk formula volume has steadily increased since then, albeit from a low base.

a2 Milk has also prioritised Vietnam, Indonesia, Malaysia, and Singapore as expansion opportunities, targeting NZD$100 million in sales from the growth of these new markets over time.

5. Growing the ANZ and USA liquid milk market

I won’t spend too much time on these initiatives as ANZ (Australia/New Zealand) is a mature market and the room for growth here is limited. Meanwhile, the USA is still a small market for a2 Milk. Between the two countries, the company hopes to grow revenue by around NZ$200 million in the medium term through market share wins by expanding its footprint in the USA and increasing its product portfolio there. 

The bottom line: Uncertainty ahead

Shareholders of a2 Milk have been taken on a wild ride in the past few years. The company’s share price climbed from just A$2.00 five years ago to A$19.83 at its peak in 2020 as the company grew revenue quickly from FY16 to FY20. But the past year has been tumultuous for a2 Milk as its share price has since dived to less than A$6.50.

It seems like whatever could go wrong for the company in the last year has gone wrong.

But there are still a few bright spots worth highlighting. First, the company is financially robust and is still generating positive free cash flow despite the fall in revenue and profits.  As of 30 June 2021, a2 Milk had NZ$875 million in cash and short-term deposits, equivalent to about 18% of its current NZ$ 5 billion market cap.

Management has outlined what seems to be a sensible plan to get the company back on firmer footing. The Chinese-label brand also seems to be doing well and is winning market share against the larger trend of international brands losing market share to local players.

Moreover, if a2 Milk reaches its goal of NZ$2 billion in revenue and margins in the mid-twenties range, I believe its share price will rebound strongly. But that’s still a big if.

There are still many unknowns going forward and the company is in unprecedented territory at the moment. Although a2 Milk has overcome challenges in the past, its future remains littered with uncertainty. 

I’m expecting another rough interim report for FY22 and will be keeping an eye on further company updates throughout the year.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, I currently have a vested interest in The a2 Milk Company. Holdings are subject to change at any time.

I first wrote about Twilio in this blog in January 2020. Since then, Twilio’s stock price is up by more than 150%. Although Twilio is a big winner over that time frame, its stock price did fall by more than 17% last Thursday (28 October 2021), a day after it announced its 2021 third-quarter earnings report.

With the recent dive in its price, I think Twilio’s shares are back at a valuation that could give joy to the long term shareholder.

What the numbers say

The headline numbers for Twilio in the recent report were actually really solid. Revenue rose 65% year-over-year to US$740 million. Organic growth, which excludes one-off revenue and revenue from recent acquisitions, was a solid 38%. On a quarter-on-quarter basis, Twilio’s core business also grew by 2.7%. 

The dollar-based net expansion rate, a metric that shows how much more existing customers spent on Twilio’s core business, was 131%.

This is clearly a company that is still growing. For the fourth quarter of 2021, management expects revenue of between US$760 million and US$770 million, implying year-on-year growth of around 45% to 47% after excluding one-off traffic in the year-ago period that’s related to the US presidential elections.

More importantly, Twilio’s management is still very confident of its long-term prospects. Twilio’s current CFO and new COO, Khozema Shipchandler, shared the following during the latest earnings conference call:

“When we look to 2022 and beyond, we remain very confident about our ability to deliver 30%+ annual revenue growth over the next three years.

Overall, we delivered very strong results in the third quarter, and we are well positioned for a strong close to the year. We’re excited about the large opportunity ahead as we continue to help companies around the world and across industries reimagine their customer engagement.”

Lapping its Segment acquisition

Twilio has also made important acquisitions in the last couple of years. Segment, a customer data platform that helps organisations collect, clean, control, and organise their customer data, is one of Twilio’s key acquisitions in the past year.

Segment is growing even faster than Twilio’s core business. In the third quarter of 2021, Segment delivered US$52 million in revenue, up an impressive 12% sequentially. If Segment can keep that up, it will be growing revenue at more than 50% annually. 

Twilio does not include Segment in its calculation of organic growth as Segment was only acquired in late 2020. But by the first quarter of 2022, Segment will be included in the organic growth contribution and should accelerate Twilio’s organic growth starting next year.

International growth

Twilio’s business outside of the US is also growing significantly faster than in the US, a good sign that Twilio is gaining traction beyond its core markets. International revenue in the third quarter of 2021 contributed 33% of revenue, up from just 27% in the third quarter of 2020.

I think Twilio’s growth outside of the USA is a testament to the company’s execution in its go-to-market strategy internationally.

As Twilio’s international revenue scales, it should become a bigger driver of growth for the company over the long term.

Valuation

Despite strong third quarter results, Twilio’s stock price plummeted, as I mentioned earlier. Although I can only speculate on the reasons, I believe the lower organic growth projection for the fourth quarter, and the low sequential growth in the third quarter, are the main culprits for the sell-down. The announcement – released concurrently with the earnings report – that Twilio’s long-time executive, George Hu, would be stepping down as COO, may also have been one of the factors. 

These said, the sell-off has made Twilio shares much more attractive. Twilio now trades at a market cap of around US$50 billion. The customer engagement company has a revenue run-rate of US$3 billion (based on the revenue for the third quarter of 2021) and thus trades at around 17 times annualised revenue.

Twilio’s management is projecting revenue growth of at least 30% per year over the next three years. At the low end of the forecast, this should already lead to revenue more than doubling to US$6.6 billion by the last quarter of 2024. 

Given its gross margin of around 57%, I think Twilio can achieve a steady-state free cash flow margin of around 20% eventually. And as a high-growth software company, I expect Twilio to trade at more than 50 times normalised free cash flow by then, which should give it a market cap of more than US$65 billion.

Bear in mind that these numbers above are based on 30% annual revenue growth, which is at the bottom of management’s expectations. I believe Twilio should grow even faster than 30% as Segment is growing at 50% and Twilio’s core business dollar-based net expansion rate is still above 130%. 

In addition, the market can easily give Twilio a much larger valuation multiple if Twilio is still projecting healthy growth then.

Final thoughts

With the recent drop in Twilio’s share price, the stock looks attractive again. Jeff Lawson, the founder and CEO of Twilio, is a great operator and technical leader and appears to be skillful with capital allocation. For instance, he has made excellent decisions to grow the company through astute acquisitions and to integrate these services with its core offering (Segment is a good example).

Lawson described his vision for the company in the recent earnings conference call:

“The customer journey is a conversation, from when a customer first meets a company, all the way through becoming a customer, buying, repeat buying, returning, getting support or whatever else the customer needs. All of that is one conversation between the customer and the company. Our platform provides the tools for companies to manage every part of that journey, with Twilio Engage, Frontline, Messaging X, Flex and more. One conversation on one platform to unlock endless possibilities. That’s the Twilio customer engagement platform.”

Given this vision, I think Twilio is in the early innings of its long-term mission and should be able to grow for years to come.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, I currently have a vested interest in Twilio. Holdings are subject to change at any time.

When news that Manchester United re-signed Cristiano Ronaldo broke a few weeks ago, the football club’s stock price climbed by 10% in just a few hours.

As a big football fan, this got me curious on the economics of a football club. I decided to do some research to find out if a stock like Manchester United (NYSE: MANU) is really worth considering.

This article is about what I found out. For full transparency, I should state that I am a Liverpool fan. But don’t worry, I didn’t let that influence (I hope) my analysis of Manchester United’s stock. So let’s begin.

How Manchester United and other football clubs make money

Football clubs like Manchester United boast a huge and international fanbase. The fans are the reason behind the club’s ability to generate hundreds of millions of pounds in revenue. Football clubs earn money directly from fans by selling merchandise to these fans.

The fans are also what drive the commercial appeal of a football club. Sponsors pay tens of millions of pounds to have their logo on Manchester United’s kit. This makes sense, as sponsors know that fans will be watching the team play and having their brand on a big-name club like Manchester United is a great avenue for brand marketing.

Manchester United also competes in some of the biggest football competitions in the world, which fans around the world want to watch. These competitions -such as the Premier League and the UEFA Champions League – negotiate massive broadcasting deals with broadcasters. Some of the money from these broadcasting deals are distributed to the football clubs who play in these competitions. 

Lastly, clubs also earn from matchday revenue, which are derived from ticket and other matchday-related sales to attendees. Old Trafford, Manchester United’s fully-owned stadium, can seat 74,140 fans and is one of the largest football club stadiums in the United Kingdom. In the pre-COVID days, Old Trafford was consistently 99% full during matchdays. 

The chart below shows the revenue breakdown of Manchester United in the financial year ended 30 June 2020 (FY2020).

Costs of running its business

With its massive fanbase, and as one of the most popular clubs not just in the UK but across the globe, Manchester United has no problem generating revenue year after year. But the cost of running a club like Manchester United is the real sticking point if you are looking at it as an investor.

In order to remain a competitive football club and to win fan appeal, the club has to spend significant dough to sign the top (and most marketable) players. Buying a player from another club can cost tens of millions, and even hundreds of millions, of pounds. In addition, in order to retain and attract talent, Manchester united needs to pay highly sought-after players extremely competitive wages that can go up to hundreds of thousands of pounds a week.

In FY2020, Manchester United’s wages and other employee benefit expenses amounted to a staggering £284 million, or 55% of revenue.

On the income statement, money spent on acquiring players is not immediately recorded as an expense. Instead these expenses are capitalised on the balance sheet and amortised over time, which can significantly distort the profitability of the club. Player sales may also artificially distort operating profits for a particular year. As such, I prefer to look at the cash flow statement to see if Manchester United has been able to generate a growing stream of cash flow over the years. The chart below shows Manchester United’s free cash flow from FY2015 to FY2020.

To calculate free cash flow, I took operating cash flow and deducted capital expenses (the bulk of it is for stadium upkeep) and the cost of player purchases, and added back the amount earned from player sales.

From the chart, we can see that Manchester United’s free cash flow can be fairly unpredictable. This is due to the unpredictability of player purchases and player sales.

Another wildcard is that the club’s operating cash flow is also not stable as some of the broadcasting revenue from certain competitions depends on the club’s progress in these competitions. This creates a further degree of uncertainty. For example, during the 2017/2018 season, Manchester United exited the Champions League in the group stages, which resulted in lower operating cash flow for the year.

To make matters more complicated, Manchester United is also not guaranteed entry into the UEFA Champions League each year – entry into the tournament largely depends on the club’s position at the end of the season in the Premier League. The UEFA Champions League is a major source of revenue for the club. During the 2019/2020 season, on top of a loss of matchday revenue because of COVID, Manchester United also did not qualify for the Champions League and only played in the Europa League, which resulted in lower revenue and operating cash flow.

Balance sheet

Due to the unpredictable nature of a football club’s cash flow, I believe its balance sheet needs to be fairly robust.

Unfortunately, Manchester United again seems thin in this area. The club ended 31 March 2021 with £443.5 million in net debt consisting of around £84.7 million in cash and £528.2 million in debt. Throw in the amount Manchester United paid in July and August this year for signing a few star footballers in Cristiano Ronaldo, Jadon Sancho, and Raphael Varane, and the club’s net debt likely has increased further.

Although the signing of Ronaldo should bring in more commercial revenue for Manchester United, the club’s financial standing still seems risky, given the high cost of running a football club and the unpredictable nature of its cash flow.

My thoughts on Manchester United as an investment

Owning shares of a football club like Manchester United may seem like a novelty and a great conversation starter. But the unpredictability of its business makes it an unappealing investment to me.

The club is in a constant struggle to balance profitability and keeping the fans happy. But its profitability and its fans are inextricably linked as fans are the main reasons for the club’s commercial success in the first place. Upset this balance and the empire comes crashing down.

From a valuation perspective, Manchester United currently has a market cap of around £2.08 billion. To me, this doesn’t seem cheap. In the six years ended 30 June 2020, the club only generated a cumulative £53.3 million in free cash flow or an average of around £8.9 million per year. This translates to a price-to-average free cash flow ratio of 225.

In the nine months ended 31 March 2021, the club had negative free cash flow of £10.9 million. And given the recent player purchases of Ronaldo, Sancho and Varane, I think it will end the year with even more cash burn. 

Although there is always the possibility that a rich businessman may offer a premium valuation to take the club private simply for the media publicity and the novelty of owning a club like Manchester United, the numbers from a business perspective are not appealing. Although I’m a huge football fan, I’m definitely not a fan of investing in Manchester United.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have no vested interest in the shares of any company mentioned. Holdings are subject to change at any time.

In an April 2020 article published in this website, I named Sembcorp Marine Ltd (SGX: S51) as a company that could face a liquidity crisis. 

I wrote,

“Another one of Temasek’s investments, Sembcorp Marine could face a similar fate to Singapore Airlines. Sembcorp Marine is highly dependent on the health of the oil industry and faces major disruptions to its business amid tumbling oil prices (oil prices are near 20-year lows now). 

Like Neo Group, Sembcorp Marine has more short-term debt than cash on its balance sheet. That’s extremely worrying given that credit may dry up during this trying time. As of 31 December 2019, Sembcorp Marine had S$389 million in cash and a staggering S$1.42 billion in short-term borrowings. In addition, the company had S$2.98 billion in long-term debt.

And let’s not forget that Sembcorp Marine also has heavy expenses. In the quarter ended 31 December 2019, Sembcorp Marine racked up S$29 million in finance costs alone and also had a negative gross margin. The company also spends heavily on capital expenditures just to maintain its current operations. Sembcorp Marine was free cash flow negative in 2019 after spending S$316 million in capital expenditures.”

Surviving but at what cost?

Back then, it was pretty clear to me that Sembcorp Marine was in a fight for survival. The company was bleeding cash and had more than a billion dollars in debt to pay in the next 12 months. It didn’t have enough cash on hand to repay its borrowings and was also facing heavy ongoing operational expenses. 

True enough, my guess that Sembcorp Marine would go down the same route as Singapore Airlines has played out. In the year and a quarter since my article, the company has raised a significant amount of cash through two rights issues, massively diluting shareholders. 

On 2 September 2020, Sembcorp Marine closed its first rights issue, raising S$2.1 billion and at the same time, increasing its number of shares outstanding from 2 billion to 11.4 billion. Sembcorp Marine used S$1.5 billion to pay off debt and the rest to shore up its balance sheet but it also diluted existing shareholders massively. Even shareholders who bought up their full allotment of the rights issue would have suffered painful shareholder value destruction.

But this was not the end of it. On 24 June 2021, the company proposed to raise an additional S$1.5 billion through another rights issue of up to 18.8 billion shares. The full allotment will definitely be filled as DBS has underwritten a third of the shares and Sembcorp Marine’s major shareholder, Temasek (one of the Singapore government’s investment arms), has agreed to take its full allotment and any remaining rights. This second rights issue will increase the share count by another 150%.

When the dust eventually settles, the total number of shares outstanding would have risen from around 2 billion before the first rights issue to slightly more than 31 billion. That’s a staggering increase of more than 1,400%. Put another way, initial shareholders who owned the “original” 2 billion shares used to own 100% of the company. Today, these shares represent just under 7% of the company.

A tanking stock price

Unsurprisingly, the market has reacted appropriately to the massive dilution of Sembcorp Marine’s shareholders. Since I first wrote about Sembcorp Marine in April 2020, its share price has plunged by 72% from 33 cents per share to 9.3 cents per share. 

Shareholders who bought into the first rights issue at 20 cents per share are already down more than 50% on that investment, even though the rights were priced at a discount to the “theoretical ex-rights price” back then.

And even after raising a combined total of S$3.1 billion through the two rights issues, Sembcorp Marine still has more debt than cash and is still facing the same old story of cash flow issues.

In the first half of 2021, the company, even with significant one-off working capital tailwinds, had a net cash outflow from operations of S$1.9 million. Excluding working capital changes, Sembcorp Marine had negative operating cash flow of S$479 million. Throw in the capital expenditure of S$23.7 million for the period to maintain operations, and the company is still burning significant amounts of cash.

Though the balance sheet is less leveraged now, the company is still not out of the woods yet. If things don’t turn around operationally, don’t be surprised to see another round of cash injections.

Learning points

Just because a company is “too important to fail” doesn’t mean that shareholders will not face crippling losses. Although Sembcorp Marine seems to be a strategic asset that Temasek will continue to support, survival doesn’t mean shareholders are saved. On the contrary, while the company is in better shape today than in 2019, its shareholders are much worse off.

There were clear red flags for investors. Sembcorp Marine’s worsening free cash flow generation, poor near-term liquidity, and dependence on external factors that were beyond the company’s control (such as oil price movements) were major warning signs that investors should have been looking out for. 

I feel for Semcorp Marine shareholders who have lost a chunk of their investment. But this episode also serves as an important lesson and a handy reminder on what red flags to look out for and how to avoid the next investing mistake.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in any shares mentioned. Holdings are subject to change at any time.