Second Opinion: Zuffa Finances Come Into Focus

November 1, 2007

Tom Berryman has experience in corporate finance and offers the following second opinion on Behind the Curtain: Zuffa’s Finances Come Into Focus:
There has been some debate about the health of Zuffa according to a recent series of S&P reports. One thing is clear, Zuffa’s revenues are growing. The decrease in 2007 operating margins is misleading because the EBITDA margin went from 40% in 2006 to 20% in 2007 due to a readily identified one-off impact (that is, the increased international marketing effort). While they claim the margin will be pressured by increasing fighter wages, I find it hard to believe that this will not be a function of increasing revenues. Consequently, the sustainable margin will lie somewhere in the middle (I have assumed a 25% margin for my analysis, which I feel is conservative given the 40% margin in the year without the one-off expense).

Additionally, the credit downgrade only signifies that S&P views the company as risky. This term should not be over-analyzed. Yes, the UFC is a new business with unproven cash flows. No, this assessment of risk does not indicate that it is “high-risk.”

Some other points of clarification:

  • EBITDA margin is paramount – this, although an accounting measure, is the closest measure of cash from operations generally available and barring any unusual accounting policies indicates the “operating margin” of the business.
  • Interest on $325m might seem high, however, we are talking about a financeable corporation, and we need a figure to determine if this is the case here. Assuming a pretty high rate of interest (and here is where I am completely out of my area – the work I do is entirely UK or Europe based and generally specialized to one industry area. To be honest I don’t have a feel for what this rate might be) of 14%, roughly the rate on a risky piece of subordinated debt, the interest payable every year on a balance of $325m is around $45 million. I think this is surely at the top end of what the expense might be. Assuming historically moderate growth in revenues of 50% over the next 5 years and a sustainable operating margin of 25% (probably conservative business forecasts for such a fast-growing sport), the amount payable on the debt is exceeded by operating cash flows by at least 30% (a fair premium for the high cost of debt assumed)
  • Debt/revenue and debt/equity ratios are not that meaningful. Debt/EBITDA can be revealing, and this appears to be in the range 4.0x – 6.5x – this is not unusual.
    The reason the company might have negative equity is due to the large distribution that may have been paid from retained earnings. However with no detail on the mechanism of the distribution nor the state of the accounts prior, this is a structuring issue only, one which I’m sure Zuffa has hired sufficient accountants to solve.
  • There is an empirical argument here: very few people screw the bank. A lender who specializes in making sure their money is safe has lent to Zuffa—therefore it’s probably a good deal!
  • Regarding the notion that the Fertittas and Dana White have “cashed out:” This is no less than they deserve for piling in investment at a time when the company was about to collapse. Do not forget that it has been significant quantities of their money at risk for the last six years and they deserve to be rewarded for that. Obviously we don’t know the details, but a few simple assumptions about how the business will perform indicate that this structure might not only be not risky, but potentially financially prudent.

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