Sunday, January 03, 2016

Barclays Center bombshell: arena lost $9 million in FY 2015, revenues behind estimates; arena sale price below book value (document buried on New Year's Eve)

Note: Forest City Ratner takes issue with my conclusions. Here's my response.

The Barclays Center had a terrible year financially in the fiscal year ending June 2015. Net revenues plummeted, to less than half the total once projected, and the arena lost some $9 million in what was (roughly) its third year in operation.

A hint of the news emerged in a bond rating document released upon the arena sale Dec. 22, then was detailed in a financial statement--Consolidated Statement of Operations for Brooklyn Arena LLC--released at 4 pm on New Year's Eve, seemingly timed to bury the news.

The arena's net operating income (NOI) fell well behind expectations, to $38 million, due to declines in event and related revenues, while operating expenses remained high.

In contrast with the previous year's results, which were also behind expectations, the arena suffered a loss loss after financing expenses were subtracted, according to the document (bottom), aimed at bondholders. It was released by Barclays Center developer Forest City Enterprises via the Municipal Securities Rulemaking Board.

Below, I annotate key pages from the FY 2014 and FY 2015 reports.



Update: I recognize that depreciation has long led to a paper loss, but arena developer Bruce Ratner has long sought to frame the financial results as including financing expenses, to quote a May 2011 profile in the Real Deal:
He estimated the arena will generate annual net income of about $110 million to $120 million, cost $30 million to operate, and require about $45 million to $50 million a year to pay off financing, leaving the company with about $35 million a year in profit.
New perspective on arena results

The lagging NOI and overall loss pose a significant contrast from both original expectations and more modest recent results.

It suggests that the arena's much-ballyhooed statistics--high-rankings internationally in tickets sold and overall revenue--were stunningly incomplete, given the failure to translate revenue into profit.

It also suggests, as I explain below, that the investment-grade rating for the arena bonds--key to a relatively low interest rate and thus savings for the developer--was premised on either faulty prognostication or misinformation (or both).

The lowered NOI also explains why, when Forest City last month sold 55% of the arena operating company it controlled to Russian oligarch Mikhail Prokhorov (who had owned the other 45%), it did not receive a premium, as the developer once predicted.
From Barclays Center Official Statement, 2009

Rather, the $825 million arena valuation was some $60 million below book value, even after factoring in depreciation from construction cost.

That valuation surely would have been lower had not arena NOI been expected to recover somewhat thanks to the arrival this fall of the New York Islanders hockey team.

Still, it has a long way to rise. Remember, in 2009, potential bond buyers were told (see document at right) that net operating income was expected to reach $81 million by 2015.

Now NOI is $38 million, down $8 million from FY 2014, with the $46 million that year still below expectations. Ultimately that year the arena made a slight profit, nearly $1 million, after financing expenses were subtracted.

It suffered a paper loss of $32 million only after factoring in depreciation. In the past year, however, arena losses on paper hit $42 million, adding $33 million in depreciation to the previously cited $9 million.

(In calendar year 2014, as reported--though not as clearly--by Forest City Ratner in annual operating results, the arena lost $3.5 million after interest costs. See p. 52 of this 10-K report. Calendar 2015 results are not out yet.)

Looking more closely

The graphic below combines pages from the FY 2014 and FY 2015 financial statements, with annotation I added.

As the documents show, the arena in 2014 earned more than $120 million in revenues, which in 2015 took in less than $113 million. While sponsorship and suite revenue rose slightly in one year, revenues regarding events, tickets, and concession all declined, a sign of softness in the concert and event business.

Meanwhile, given a slight uptick in both operating expenses and finance costs, the arena went in the red, before depreciation.



Calculating arena value

When Forest City Enterprises on 12/22/15 announced the sale of the 55% share of the arena operating company that it controlled, and the 20% of the Brooklyn Nets, it stated that the arena, for the purposes of the transaction, was valued at $825 million.

That's both more and less than expectations.

In October 2014, as I wrote, Sports Business Journal suggested that, given the low revenue flow, the arena was worth only $750 million.

But the Wall Street Journal, quoting Forest City executive Ashley Cotton, soon reported that the developer was "expecting any new investor will pay a price that values the arena substantially above its cost," given an an expected increase in revenue.

That didn't happen.

On 12/1/14, the New York Post reported that Anschutz Entertainment Group (AEG) was willing to spend up to $500 million on the arena, based on a 12x multiple of the roughly $40 million in expected net operating income. Forest City didn't bite.

Yes, the $825 million value does exceed the previously floated figures of $750 million, and $500 million. But it's still below the cost of the arena, rather than, as Cotton said, "substantially above." That reflects the poor financial results over the rest of the fiscal year after October 2014.

According to the most recent Consolidated Statement of Operations, as of 6/30/15, the Barclays Center was worth $908.2 million, including the building and land, furniture and equipment, while factoring in depreciation.

If another half-year of depreciation were calculated, the arena, as of the time of the sale in December, should have been worth about $892 million . (That assumes depreciation at an annual rate of some $33 million, the last reported figure.) But the transaction valued the arena at $825 million.

Expected NOI goes from $81M to $55M (still a stretch?)

The most recent net operating income figure, $38 million, is well below expectations, even those tempered after the (now) clearly unrealistic expectations in the Official Statement released in 2009 by the bond underwriters, Goldman Sachs and Barclays Bank.

The Official Statement predicted NOI at $81 million by 2015 and $83 million by 2016--see document below left. Dialing back after recognizing how much it cost to staff the Barclays Center arena and the cost to launch the arena with superstars, Forest City in October 2013 predicted $70 million in NOI by 2016.

From Official Statement; click to enlarge
That too was way overoptimistic. By December 2013, Forest City further lowered expectations, saying NOI would stabilize at $65 million by 2016.

In May 2015, the company downgraded the net operating income projections to $55 million, a 34% drop from the $83 million estimate made six years earlier.

That still may be a stretch, since it implies that the increased revenues from Islanders games would help close a $17 million gap from the current $38 million..

Surely revenue will rise, given that the Islanders mean the arena hosts more events that have a reasonable floor of attendance. Still, the Islanders have performed below expectations, with the second-to-lowest attendance in the league. And the unusual deal with the Islanders--in which the arena guarantees the team a payment while keeping overage--also poses risks.

At least one thing has changed regarding arena financial reporting: the 2015 results no longer include the category of "other payable," which in 2014 referred to "ticket sale proceeds from events that are remitted to the promoter/artist when the event occurs." Such an arrangement could allow total revenues to seem impressive while diminishing net revenues.

Implications of lowered profits

If the most recent projection of $55 million wasn't realistic, well, Forest City Enterprises no longer controls the arena operating company. The projections to bondholders--and bond rating agencies--are now Prokhorov's problem.

Tight finances also suggest an impetus to hold down costs. That may make the arena less likely to accommodate the ongoing push by SEIU 32BJ to ensure that part-time workers have a better chance to accumulate hours and thus qualify for benefits like health care.

It also means the arena has less incentive to spend money to be responsive to the concerns of neighbors impacted by operations--such as trash, noise, and parking--and more incentive to cut corners.

As a reader suggested, it also means the arena might cut corners in seeking revenue wherever possible, such as through branding of locations (note ads on bollards), accepting sponsors of dubious ethical provenance (along with the rest of sports, they've embraced fantasy leagues), and accepting potentially problematic events.
Overblown financing cushion (DSCR) deflates

The amount of cushion available to pay back the $511 million in tax-exempt bonds, which have been rated barely investment grade, has declined significantly.

The arena in FY 2015 paid $33.3 million described as the "financing lease obligation" and other payments. The total included $29.3 million to service the tax-exempt bonds, with the rest put in escrow to maintain a cash cushion.

An additional $13.8 million in interest was assigned to service a taxable loan--unrated by ratings agencies and not a bond issue--from a Prokhorov affiliate. (When that financing was expected to be a bond issue, it was rated as "very speculative," or junk bond territory.)

Without mentioning the arena's actual income, the ratings agency Moody's, upon the sale of the arena last month, reaffirmed the investment grade rating, albeit a bit gingerly.

On 12/22/15, Moody's reported that "the decline in concert and events revenue contributed to the lower debt service coverage ratio (DSCR) of 1.29x in fiscal year 2015, which was below expectations and down from 1.62x in fiscal year 2014."

That's a bland way to express some sobering news.

That means the arena operators had only $38 million in NOI to pay back that crucial $29.3 million in bond debt, via payments in lieu of taxes (PILOTs). A cushion that deflated is bad news..

In fact, there was not enough to pay back that additional $13.8 million in subordinate, unrated debt. (I'll write more about how that may have been resolved.) Had that debt been a bond issue and thus calculated as part of the DSCR, the ratio would have gone below 1, a sign of potential default.

Bad prognostication by bond rating agencies

The bond rating agencies have not been good prognosticators.

In 2009, upon the sale of the bonds, the DSCR, according to a 12/1/09 Moody's press release, was supposed to have "10-year average debt service coverage ratios of 2.85x on the senior (PILOT) debt and 1.91x on a consolidated basis (senior plus subordinated debt)."

That ratio of 2.85x was incorporated into the Official Statement issued to potential bondholders, though it did warn that "THE UNDERWRITERS DO NOT GUARANTEE THE ACCURACY OR COMPLETENESS" of any information in the document.

In assessing the arena, Moody's estimated 225 annual events, and Standard & Poor's estimated 220 events. But that was premised on misinformation, a 2005 projection by Forest City-hired sports economist of 225 annual events, which assumed the absence of a rival arena in New Jersey.

(That would have left nowhere for the New Jersey Devils to play, as Gustav Peebles and Jung Kim first pointed out. While the Meadowlands arena has since closed, the Prudential Center had opened in Newark in 2007.)

When addressing other audiences, arena officials were more candid. As I wrote in 2009, a Barclays Center press release just a few months earlier estimated that "the arena will host over 200 events annually." A year later, in a 9/11/13 investor presentation, Forest City said the arena "is expected to host more than 200 cultural and sporting events annually."

DSCR well below guideline ratios

So the debt service coverage ratio was flawed from the start, given the number of events. Add in the cost of operations and the variable concert/event business, and the DSCR declined. So, instead of a DSCR reaching 2.85x on the senior (PILOT) debt, it was 1.29x for FY 2015.

Such numbers set off warning bells. According to the 2010 book The Business of Sports, the Fitch ratings ratings agency sets a minimum total DSCR for a new facility at 2.25, in the "base case," when the arena appears operationally sound.


In a "stress case," when there are more question marks, the minimum pledged revenue for a new facility is 1.75.

With the Islanders coming, management forecasts an improvement in the DSCR to 1.7x in the current fiscal year, which ends June 30, 2016, according to Moody's. That's still below the "stress case" for a new facility but within the wheelhouse for an established facility.

2014 official DSCR; not provided in 2015
Questionable practices

Interestingly, unlike with the 2014 Consolidated Statement of Operations (see right), the arena in 2015 did not break out a separate page with the DSCR calculation, perhaps to avoid calling attention to it.

Moody's seems to be practicing its own version of opacity.

In its press release last month, Moody's affirms Barclays Center Project's Baa3 with stable outlook, Moody's not only predicted a DSCR in "the 1.7x range for the next couple of years," it noted that the rating could go up if "actual performance exceeds forecasts with higher annual DSCRs closer to the initial forecast of 2.0x."

What initial forecast? Moody's, as far as I can tell, is mixing apples and applesauce. Moody's originally predicted average DSCR of 2.85x on the senior (PILOT) debt, which is the only debt it was rating in the recent press release.

Moody's in 2009 did assess an overall DSCR of 1.91x--which is similar to the recently referenced "initial forecast of 2.0x"--but only on a consolidated basis, including the purported additional subordinated debt. But it is no longer rating the two as a unit, since there was not a second, taxable bond issue.

So the "initial forecast" line does not make sense.

What if the 2009 bond issue came with more accurate projections? Back then, NOI was expected to reach 83.1 million in 2016, which meant a DSCR of 2.85x  applied to $29.2 million required to pay back the tax-exempt arena bonds.

From The Big Short
With net operating income expected to reach $55 million, that means a DSCR of 1.88x. That's within the ballpark in the "stress case"--1.75x to 2x for a new facility--but it's near the low end.

The bonds might have gotten closer to junk, or "high-yield," thus commanding a higher interest rate to make up for the elevated risk, posing more cost to the arena developer. (A DSCR like the current 1.29x surely reaches junk bond territory.)

This raises a question: is the performance of a ratings agency like Moody's reminiscent of that described in Michael Lewis's book The Big Short, now a film?

To quote Lewis's interpretation of money manager Steve Eisman (or, in the film, Mark Baum, played by Steve Carell),  "To judge from their behavior, all the rating agencies worried about was maximizing the number of deals they rated for Wall Street investment banks, and the fees they collected from them...  The surest way to attract structured finance business was to accept the assumptions of the structured finance industry."

Such lack of skepticism continues today. A 12/24/15 article in Money, Is the Shady Stuff From “The Big Short” Era Still Going On?, observed:
However, as the Council on Foreign Relations notes, there are still only three major ratings agencies and they all use an “issuer pays” fee structure—a built-in incentive for the agencies to deliver favorable ratings. As the S&P employee played by Melissa Leo says in The Big Short: “They’ll just go to Moody’s.”
The same incentives were there for the arena. Yes, the investment-grade rating Forest City purchased in 2009 was not glaringly out of bounds at the time, given that recently-built stadia in New York got the same rating.

But it was premised on inaccurate information and--as we now know--poor prognostication. Was this just an "honest mistake" by the ratings agencies? Or did they want the numbers to work?

2 comments:

  1. Anonymous7:12 PM

    Thank you for the updated analysis. It is still difficult to calculate the arena’s actual costs because you don’t know them. The public numbers likely include various other costs that were folded into the arena’s alleged costs (calculations of overhead and administration can include oh so much that isn’t really overhead and administration for that particular project, or at least a greater percentage that would be reasonably justified). It also, still, doesn’t include the various tax benefits for construction of the arena, which include lower cost bonds that cause lost revenues to taxpayers but reduced Ratner’s expense.

    Income was certainly down, which is news, but a comparison of events for MSG vs Barclays would be interesting in terms of days booked and revenues generated (as well as valuation of the facililty).

    Also, there still is multiple revenue streams. If, for example, the stadium is worth less, it still increased the value of the Nets substantially (and not just the move from NJ to NY). Same with the Yankees and other sports teams with new stadiums, virtually all of which demonstrated increased team value. Some might call the stadium a loss leader, but green is green overall especially now that the same owner controls the stadium and the team (just like Ratner did).

    And bond rating agencies being wrong? Old news as you note, but their rating agency payment check cleared so there’s always that.

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  2. Yes, the move to Brooklyn raised the value of the Nets. But Forest City and others all said the arena would be valued at *above* cost for the purpose of the sale.

    Comparison of events between Barclays and MSG is done annually, and MSG is ahead (duh). The key question is not total revenues or tickets sold, but Net Operating Income, because as we have learned, Barclays sold a ton of tickets in first year of operations but didn't make much profit, because (in part) of the deals it struck to get big names.

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