It’s not over till it's over!

Company description: A leading German football club

Borussia Dortmund has been a major force in German football for decades. Second only to Bayern Munich in terms of Bundesliga titles over the last 25 years, it was the first German club to win a European competition (the European Cup Winners’ Cup in 1966) and the Champions League in 1997. Last season was typically successful: narrow runners-up in the Bundesliga and group stage winners in the Champions League. The club’s fabled stadium (the Westfalenstadion, now formally Signal Iduna Park) has long enjoyed the highest average football attendance (over 80,000) in the world. Borussia Dortmund was formed as Ballspielverein Borussia 09 e.V. Dortmund in 1909 (hence the BVB 09 logo) and was listed on the Frankfurt Stock Exchange in 2000.

Borussia Dortmund has the lowest rating among listed peers, based on prospective EV/EBITDA and EV/Pre-transfer revenue. An EV/EBITDA rating of 7x FY19e does not, in our view, reflect the long-term potential of powerful brand development, valuable media rights and sustainable positive cash flow, backed by freehold property, substantial subscription revenue, and hidden reserves from player investment. EV as a share of resilient and growing revenue is barely 2x prospective. The company’s transfer policy continues to generate significant hidden reserves in player values. Despite a positive balance of transfers since 2013/14, the surplus of market value, estimated by www.transfermarkt.de, to net player assets is c €300m.

Financials

Borussia Dortmund’s turnaround has been remarkable. The company was at risk of bankruptcy in 2005, broadly attributed to extravagance, notably on foreign players, after Bundesliga success. New management (the current CEO and CFO) implemented a reorganisation programme, which included the restructuring of liabilities through a long-term, fixed-interest loan from Morgan Stanley, cost-cutting, and a strategy of revenue development and sustainable investment in players. Key initiatives included the repurchase of the stadium, eliminating high rental costs, and early repayment of the loan via a long-term agreement with marketing partner Sportfive, while early extension of flagship contracts endorsed the advertising strategy. Jürgen Klopp’s appointment as coach was in tune with management’s approach to player investment. A c €140m fund-raising in 2014, backed by key sponsors and new partnerships, was a strong endorsement of strategy.

Rich pedigree: Since its formation in 1909, Borussia Dortmund has become one of Germany’s most successful football clubs, having won eight national championships, four DFB Cups and six DFL-Supercups, as well as the Champions League in 1997 and the European Cup Winners’ Cup in 1966.

During the 56 seasons of the Bundesliga, the club has achieved top six status (the benchmark for UEFA competition qualification) on 25 occasions (including the recent season when it was second) in addition to its five titles. Indeed, as shown in Exhibit 2, Dortmund’s performance in the Bundesliga has been second just to dominant Bayern Munich as the only other club to have won multiple titles in the last 20 years or so. The prolonged decline between 2003 and 2008 reflects financial troubles under previous management, while the 2015 dip proved short-lived (change of coach) and still allowed successful international participation as Europa League quarter-finalists.

Head coach: Lucien Favre joined Dortmund in May 2018 after two years as head coach at Nice. He took Nice to their highest league position for 40 years (third, with Champions League qualification) in his first season with the club but European competition was narrowly missed in the following season (8th in Ligue 1). Over the previous decade he gained valuable Bundesliga experience as coach both at Hertha Berlin (fourth in 2008/09) and then at Borussia Mönchengladbach (third in 2014/15). This followed a long and successful association with Swiss football, both as a player (regular international with 24 caps and a Swiss league title with Servette) and as a manager (two league titles with FC Zürich). He is 61 and his contract at Dortmund runs until June 2020.

Sporting director: Michael Zorc has spent his whole career at Dortmund, first as player for 17 years (Bundesliga appearance record), culminating in the Bundesliga and Champions League success of the mid-1990s and then as sports director since 1998. Aged 56, he is under contract until 2021.

Participation in the recent season by matches started is shown in Exhibit 3, which also highlights key changes for 2018/19 (acquisitions shown in bold).

In terms of attack, the loss of exceptional goal scorer Aubameyang to Arsenal in January 2018 (21 goals in all competitions in the first half of 2017/18) was mitigated by remarkably effective finishing by Barcelona signing Alcácer. His Bundesliga goal tally (18) was second only to that of Bayern’s Lewandowski and achieved mainly as a substitute (his record goals-per-minute ratio was, for example, double that of 2018/19 Premier League’s three joint top scorers). This was complemented by a resurgent Reus, whose most prolific Bundesliga season for five years (17 goals) reflected renewed fitness (27 starts against only 11 in 2017/18). Sancho came of age with a dozen goals (the youngest Dortmund player to reach double figures in a season) and the second-highest number of assists in Europe’s five major leagues. Impressively, he started all but two of Dortmund’s last 28 games. There was also a significant contribution from Götze, especially in the second half of the season; his seven goals marked his most successful campaign since returning to the club in 2016.

As for midfield, summer arrivals, Witsel and Delaney, proved immediately a robust, creative and stable partnership, with a pass completion rate of over 90% and seven goals. In particular, Witsel started all but five of BVB’s 45 competitive matches. In defence, the absence of veterans Sokratis (now at Arsenal), and Schmelzer and Toprak (largely through injury) was made good by the rapid integration of Diallo and Hakimi (on loan from Real Madrid) alongside Akanji.

At the start of the season, the 2018/19 squad of 25 had an average age of 24, compared with 26 for Bayern and 23 for Leipzig and 25 for Leverkusen, its closest Bundesliga rivals. Key contributors such as Sancho, Hakimi, Diallo and Akanji were well below this average, while seasoned Götze and Reus were only 26 and 29 respectively.

In what was expected to be a transitional season with a target simply of a top-four finish, Dortmund markedly outperformed. After a troubled 2017/18 (29 points behind champions Bayern and Champions League qualification only on goal difference), taking the title race to the very last day with the club’s third-highest points total (up 21 y-o-y and 10 ahead of third-placed Leipzig) was no mean feat. Indeed, for five months and 18 games (more than half the season) BVB topped the table, at one point (Matchday 15) by a striking nine points. There was then a sudden dip in form in February (see Exhibit 4) as successive draws, including the late concession of a three-goal lead vs Hoffenheim, and only the second defeat of the season, coincided with exits from the Champions League and DFB Cup. This allowed Bayern to close the gap by Matchday 25, but to Dortmund’s credit for the rest of the season a clear pick-up (average of 2.1 points per game) saw the champions being all but matched and Champions League qualification achieved as early as Matchday 30.

Results in European competition were also positive, if ultimately disappointing. A Champions League group win with 13 points was in stark contrast to just two points in 2017/18. The highlight was an impressive 4-0 win over Atlético Madrid, the heaviest defeat in seven years under coach Simeone. By mid-February, Dortmund’s form had dipped (see above), reflected in disappointing losses (0-4 on aggregate) to Tottenham in the round of 16.

After its financial troubles (see page 2) Dortmund has successfully concentrated on developing core revenue sources such as broadcasting, advertising, match operations and merchandising. Management is similarly intent on maximising success on the field without taking on new debt, while achieving a balance between financial and sporting interests.

Dortmund’s positive reconciliation of conflicting interests is further highlighted by the disparity in its net transfer balance (amount received less paid) with those of certain fellow Champions League regulars. Exhibit 6 shows last five seasons. The comparison with Bayern is telling as Bundesliga performance is also noted. While Dortmund has ensured European football with a net positive balance and easily outpaced other domestic rivals (over the last five years 16% more Bundesliga points than the nearest, Bayer Leverkusen), there is a glaring 22% points inferiority to Bayern.

Management aims to monetise this, as follows:

The company’s senior management (see below) is backed by highly experienced members of the non-sports businesses and coaching staff.

Asset-rich

The share price is at c 20% discount to a simple sum-of-the-parts valuation of €10.75/share (€9.5 before), based on estimated market value of players c €480m, per www.transfermarkt.de, adjusted to exclude Pulisic (sold) and Hakimi and Alcácer (on loan), brand value €481m (at May 2018 per Brand Finance) and financial position (€28m net cash at end FY19e).

This squad valuation necessarily does not allow for step changes in the value of emerging talent, which Dortmund is so adept at identifying and which is attracting the attention of major clubs at ever younger ages. Potential prodigies such as Balerdi and Gómez (Exhibit 5) may emulate the uplift (admittedly unrealised) of estimated €91m attributable to similarly youthful Sancho or the bumper realised returns on Dembélé and Pulisic. There may also be appreciation by established talent, eg last month’s triple signing of internationals (Brandt, Hazard and Schulz), which has already elicited clear upgrades on approval of their Dortmund prospects.

Dortmund’s success at value creation is evident in the 13% rise in value per share from €9.5 in our SOTP exercise in April 2018. At that point, the share price discount was twice the current level, reflecting major sporting uncertainties and a troubled season.

Indeed, the company’s transfer policy consistently generates substantial hidden reserves in player values. The past three years saw average capital gains of c €88m (our estimate), including the ‘exceptional’ Dembélé transaction, and the scope for further gains is high. The surplus of market value to net player assets is c €300m if the reported March 2019 carrying value of €180m is set against www.transfermarkt.de’s adjusted valuation of c €480m.

Beyond this is sustained transfer market buoyancy, shown by a doubling in spend to over €5bn in 2018/19 by the five major European leagues over the last four years (Exhibit 7). Consolidation in the season just ended is understandable after such a heady rise (30% in 2017/18 alone). This comes at a price in terms of player replacement, but Dortmund is a net seller.

Disposals do of course carry the threat of undue sporting detriment. With management’s objective to declare an annual net profit, the scale of intangible amortisation (over €60m pa) and operating cost pressures (we estimate pre-transfer negative EBITDA in Q319 despite 18% higher operating income) risk a disruptive volume of transactions. While we are satisfied, as above, that the company has the resources to meet such financial needs, it is reasonable to be wary about the sporting impact.

Low rated

Among listed peers, there is limited comparability with Dortmund in terms of valuation indicators. By far the largest by market cap, Manchester United offers very limited free float, while Juventus has a majority shareholder and sizeable net debt. Olympique Lyonnais’s renewed Champions League participation may allow a higher outturn this year (H1 EBITDA up 30%), although H218 included substantial transfer profit. Against available peer numbers BVB is rated the lowest in terms of EV/EBITDA and EV/Pre-transfer revenue.

FY19e: H1 was again a tale of two quarters (Exhibit 9). While Q1 lacked a bumper transfer, hence c 70% lower EBITDA y-o-y, the following period was unaffected by transfers and saw a rise in EBITDA (from €2m in Q218 to €31m), which was striking in the face of persistent wage pressure (+11%). Admittedly against a weak comparative, the three months to December saw an impressive 41% increase in pre-transfer revenue, driven by sporting success, ie 10 Bundesliga wins against two and top of the Champions League group table compared with just two points last time, and a favourable y-o-y fixture pattern. This led to a near doubling in TV marketing income from European competition. On-field buoyancy also permeated advertising, up 6% thanks to Champions League knockout bonuses, in addition to the benefit of newly enhanced virtual advertising to international audiences, and merchandising, up 8%. In Q3 the transfer of Pulisic broadly matched that of Aubameyang in the prior period, while Champions rather than Europa League involvement drove 18% higher pre-transfer income. Despite such quarterly volatility, we broadly retain our assumptions for this year (just €5m pre-transfer revenue upgrade) with no allowance for significant end of season dealings.

FY20e: Our forecasts for this period are also broadly maintained (€5m income upgrade is flow-through from this year). Transfer activity is expected to be on a par with the current year, as are operational factors, ie competition and broadcasting.