A hard rain's a-gonna fall

Formula 1 is facing the biggest financial storm in its history. The sport must adjust, or face being washed away
By Joe Saward

There is no doubt that history will recall recent events in the financial world as ‘The Crash of 2008’. We still do not know just how bad the effects of this will ultimately be, nor what implications it will have for the world. And this is the worry for motor sport, which can only ever be described as ‘a luxury item’. It has become an important industry in some countries, but there is no fundamental need for the sport to exist, beyond the fact that it provides entertainment for the man in the street. In times of war the sport has been set aside, but at the same time mankind has proved over and over that as long as there are ‘bread and circuses’ the world can go without upheaval. Formula 1 is the ultimate circus.

The International Monetary Fund says that the world economy is now entering a major downturn in the face of “the most dangerous shock in mature financial markets since the 1930s”. The question in F1 circles is not whether the financial crisis will hit the sport, but rather how much damage will be done.

Honda’s bombshell

When Honda announced on December 5 that it was terminating its involvement in Grand Prix racing and would close the team down if it was not sold within three months, the F1 world was shocked. The Japanese car company has been badly affected by the global financial crisis, particularly in the key US markets, where the latest monthly sales reveal a drop of 32 per cent compared to a year ago. Honda’s share price was nearly 60 per cent down on the start of the year. Honda chief executive Takeo Fukui said that getting out of F1 was a necessity “in light of the quickly deteriorating operating environment facing the global auto industry, brought on by the sub-prime problem in the United States, the deepening credit crisis and the sudden contraction of the world economies”.

“Honda must protect its core business activities and secure the long term as widespread uncertainties in economies around the globe continue to mount,” said Fukui. “A recovery is expected to take some time. Under these circumstances, Honda has taken swift and flexible measures to counter this sudden and expansive weakening of the marketplace in all business areas. However, in recognition of the need to optimise the allocation of management resources, including investment regarding the future, we have decided to withdraw from F1.”

There were hopes that a buyer would be found in the time available and the team’s chief executive Nick Fry was optimistic. “This is a completely different situation from prior F1 teams stopping,” he said. “This team is one of the best funded, has the best assets, the best resources in the pitlane, a fantastic group of people, and a car designed by Ross Brawn, who has won many World Championships, and is ready to go next year. I think we are going to be a desirable asset for somebody. We are very hopeful that this team is going to take a big step upwards, so it is a big opportunity for somebody.”

Will other teams follow?

The decision by Honda to quit F1 came as a shock to the F1 community and there was much speculation in the days that followed about other teams leaving as well. But one by one the other teams came out and said that they would be staying on.

Toyota, which dropped 34 per cent in US sales in November, said that Honda’s decision was “a pity for us as a Japanese team” but added that: “Toyota is currently committed to succeeding in F1, and to reducing our costs. We are contributing to the Formula One Teams’ Association activities, which will achieve significant cost reductions while maintaining the spirit of the sport. We hope FOTA’s proposals and activities will be given the widespread support they deserve as they provide the sound, stable base F1 requires at this time.”

BMW lost 26.7 per cent of its US sales in the same month, but board member Klaus Draeger said there is no better platform than F1 for demonstrating BMW’s brand values. “It is with regret that we learnt of Honda’s decision,” he said, “but it has no bearing on BMW’s involvement in F1. BMW makes targeted use of the F1 project as a technology accelerator for series production. With the BMW Sauber F1 Team, we have from the start focused on high efficiency and have achieved our successes with a compact and powerful team. The cost-benefit ratio is commensurately positive. The measures now proposed by FOTA for significant cost cuts starting as early as 2009 are a further important contribution.”

Mercedes-Benz, which had to deal with a drop of 30 per cent in US sales, said Honda’s decision to pull out was sad but highlighted the need for cost-cutting. Norbert Haug, the company’s motor sport chief, said Mercedes’s involvement in F1 was “built on financially solid foundations and is in large part financed by our sponsoring partners. Mercedes-Benz’s contribution is cost-efficient; the resonance in the media and with the public which Lewis Hamilton’s win generated last season was worth many times our financial investment”.

He added that the sport needs to halve its costs in the next two years.

Renault sources made the same noises. But it was clear that the message had got through. Cost-cutting was no longer an optional extra. It had become a necessity.

A FOTA meeting in London agreed a series of proposals, described by Ferrari’s Luca di Montezemolo as “decisions with short-term and mid-term impact, for the years 2009 and 2010”, and a proposal for a new engine starting in 2011.

“We gave further input as far as cost reduction is concerned to help especially the smaller teams over the upcoming season,” he said. “It’s a huge effort from all of us, which is important for two reasons: firstly because it wasn’t planned, considering what had been planned a few weeks ago, and secondly because it happens in a very delicate overall economical situation.

“The aim is to reach unanimous decisions which satisfy all our requests, while we don’t touch Formula 1 as a sporty and technological competition among teams.”

The FOTA proposals were presented to the FIA in Monaco on December 10 and an agreement was reached. To read the details of the new rules turn to GP News on page 12.

The sponsor reaction

The immediate problem has gone away but the financial turmoil is going to have an effect on F1. “Our budgets come from the advertising budgets of the companies that support us,” said McLaren’s Ron Dennis. “Inevitably advertising budgets get slashed, or at least are significantly trimmed in times of economic strife. We know we have to reduce our costs to cater for the inevitable downturn in income that is coming in 2010 and 2011. We predict that our turnover will drop from £280 million a year to as low as £175m a year.”

Elsewhere several large F1 sponsors have taken big hits. Williams sponsor AT&T announced 12,000 job cuts in an effort to significantly reduce costs. Another Williams backer, Philips, has warned that it will be making less money because of the economic downturn and there have been similar profit warnings from its rival Panasonic, sponsor of Sony and Toyota. BMW Sauber sponsor Credit Suisse has announced that it is axing 5300 jobs. It’s not clear whether the cuts will affect F1 sponsorship. Even the oil companies, which were booming a few months ago, are now under pressure as prices tumble. The price of crude oil was down to $40 a barrel as I write, compared to a high of $147 in July. Merrill Lynch is predicting that reduced demand caused by the recession will push the price down to $25 a barrel next year.

“F1 is fortunate in that the established teams typically have partnerships that have three- to five-year horizons,” says McLaren’s Martin Whitmarsh. “Unless the companies involved go belly-up, the teams are slightly isolated from the economy.”

Adam Parr, chief executive of Williams, agrees. “What is important, as with any business, is to prepare,” he says. “We need to get on and identify ways to reduce our costs. We need to work with the commercial rights holder to continue to grow the sport. I think that in spite of the global environment we are in rude health. But we will only stay in rude health if we prepare for the future, because the world is changing very, very fast right now.”

Williams is unique in F1 in that it exists solely to go racing. All the other teams are marketing tools for car manufacturers or owned by billionaires. Williams survives on sponsorship and on the money that arrives from the rights sales managed by the Formula One Group. There is no billionaire in the background.

It is therefore worth looking closely at the Williams situation to analyse the threats. The team’s primary sponsor is the Royal Bank of Scotland, which has suffered badly in the crash and has been rescued by the British government. Former banker Stephen Hester has been put in charge and has instigated an in-depth review of all RBS’s operations, a process that will probably result in job losses and asset sales. Williams F1 has two years to run on its RBS contract and while the bank may legally be committed to paying, it may seek an immediate settlement for a reduced amount of money to help cut its commitments. Ironically, this could end up being a windfall for Williams, although it would still then need to go out and find more money for 2010 and beyond.

It does not help that Baugur, which provides sponsorships through a number of brands including Hamleys, Mappin & Webb and mydiamonds.com, is also in trouble because of the economic problems in Iceland.

Bernie Ecclestone, boss of the Formula One Group, has always argued that downturns in the economy are not a problem for F1 because what he calls “the price-to-performance ratio” of F1 is better than other sports, and because there will always be a sufficient number of companies able to support the teams.

Conversely, the high profile of F1 can be a problem if large companies have to lay off workers and do not wish to be seen pouring money into a luxury sport at such a moment.

To avoid this F1 needs to be seen to be taking steps so that big companies can justify their involvement. For the banks that have been saved with public money that may not be possible, but there are other companies that will come into F1 if the rate card is a little lower.

The right new rules

Everyone agrees that Formula 1 needs to continue to have high technology in order to differentiate itself from other series. FIA president Max Mosley has argued for the standardization of parts but wants areas of new technology to be free – particularly environmentally-friendly ideas which will help automobile manufacturers to reduce emissions. The current engine freeze in F1 has achieved little for the manufacturers in terms of development or publicity but in the short term it has been agreed to extend the life of these engines. The next step is to find a new engine formula, better suited to the modern world than are the gas-guzzling 2.4-litre V8s of today. This will be an expensive exercise, but should make the sport more relevant for the car industry.

A year ago researchers at the Massachusetts Institute of Technology (MIT) developed a new engine configuration that can match the performance of modern hybrids at a fraction of the development cost. This was achieved by using small turbocharged engines fitted with direct fuel injection, using an ethanol-gasoline mixture. With direct injection into each cylinder fuel economy improves dramatically, while the turbochargers use wasted energy from the exhaust gases to produce more power. The smaller engines not only lower emissions, but also improve fuel consumption because they reduce the weight of the cars and thus the amount of fuel needed to move them.

There are a number of manufacturers in Europe that are keen to add models with this kind of engine in order to reduce their fleet average CO2 emission by 2012, when stringent new European Union rules are adopted.

As these discussions continue, the sport also needs to look at other effects of the financial crisis. The banks are important trackside advertisers and users of VIP hospitality, and these are areas where it is easier to make savings. This means that the Formula One Group will make less money. Television companies are also going to struggle for advertising and thus will want to pay less for the rights to broadcast Grands Prix.

The cash-hungry owners of F1

CVC Capital Partners, the company that owns the Formula One Group, has no great passion for the sport and looks at F1 simply as an investment vehicle. It leaves F1’s chief executive Bernie Ecclestone to run things on its behalf. The financiers do not understand the issues and the history of the F1 world, and they do not care – unless it is going to affect the profits.

What is clear is that the CVC investment in F1 is not going to last forever. Typical investment funds exist for five to 10 years. These buy stakes in businesses which have an established market position with strong cash flow, a plausible growth strategy and clear exit potential. The fund managers help to grow the business and when this process begins to bear fruit the funds cash in, either selling the company to the public, to a bigger company or to another private equity fund. The CVC European Equity Partners IV Fund, which owns the F1 investment, was launched in 2005 with $13 billion to invest. Logically, this fund will exist only until 2015. Thus far it has produced a dramatic 52.9 per cent rate of return, largely thanks to F1 and the financial juggling that has gone on since.

CVC bought into F1 in March 2006 in what was, in effect, a leveraged buyout. It paid around $1.35bn to acquire a majority stake in the group from three investment banks – JP Morgan, Lehman Brothers and Bayerische Landesbank – and an offshore trust controlled by the Ecclestone family. The funding came initially from RBS, which provided $1.1bn. Of this, $865m was used to buy SLEC, the rights-holding company, and another $305m went to acquire Allsport Management, which dealt with trackside advertising and hospitality. These loans are understood to have been ‘payment in kind’, which means that rather than paying interest a borrower agrees to pay a larger lump sum at the end of the term of the loan. This was followed by a re-financing process which saw RBS and Lehman Brothers loan CVC a total of $2.95bn to allow it to take out money and to tidy up the loan structure.

CVC expects that it will be able to pay back around $1bn within five years, at which point a similar loan can then be taken out to pay off the remaining debt – and this will provide another payout to CVC and its shareholders in its European Equity Partners IV Fund. This would then be followed by a sale of the business. All things considered, when the fund closes in 2015 F1 may have produced as much as $7.5bn, an impressive return on the investment made.

The now-defunct Lehman Brothers acquired a shareholding in Delta Topco, the ultimate holding company of the Formula One Group, during the re-financing process but with only 16.8 per cent of the company, this will not have any serious influence on the business. CVC remains the dominant partner with 69.6 per cent of the business and may acquire the Lehman shares to strengthen its position.

The biggest risk for CVC is not that the teams will demand a bigger share of the money when it comes to renegotiating the commercial contracts in 2012, but rather that the FIA might try to cancel the 100-year deal if there is a change of ownership.

F1 teams stand united

The establishment of FOTA in the summer seemed to be a move to create a union to demand more money from CVC in the future. The stated aim of the new organisation is “to work with the FIA and FOM to agree upon regulations and commercial conditions which will provide a framework for a strong and dynamic sport”. In the past the teams have almost always been divided by their own self-interests and they have thus been weak, but the emergence of FOTA suggests that there is a strong new force in F1. The concept is not unlike the Formula One Constructors Association (FOCA) that emerged in the 1970s and was led by Ecclestone and Mosley. This helped the teams to win the right to exploit the commercial rights to the sport. FOCA was transformed into Ecclestone’s personal fiefdom, while Mosley moved on to become FIA president, leaving the teams with no collective representation.

CVC clearly recognises that it needs to make more money and has now started working to build up new revenues, from global partnership programmes similar to those enjoyed by the International Olympic Committee and FIFA World Cup soccer. The announcement that Korea’s LG Electronics is to become the official Consumer Electronics, Mobile Phone and Data Processor of Formula 1, beginning in January 2009, is expected to the first in a number of such deals. The figures produced by the IOC and FIFA suggest that such deals could add as much as $400m a year to the F1 revenues, which would give CVC the chance to give the teams more money without disrupting the financial model that has been created.

At the moment the teams get 50 per cent of all revenues, and while some want as much as 85 per cent, a substantial increase in cash makes it hard to argue in favour of a breakaway series. As it is, F1’s revenues are growing at around 10 per cent a year – or have been up to now.

The pressure of promotors

There are increasing signs that race promoters are struggling to keep up with the annual fee increases in their contracts. This has led to the sport moving away from its traditional markets in Europe and to pressure to have such new ideas as night races to make sure that racing in Asia is shown on TV in the sport’s key European markets.

Promoters say that they cannot afford to go on with the numbers now being asked. The Formula One Group believes that local governments should be involved in the funding of events, as they are with other major sports, notably the Olympic Games, arguing that cities that host the Olympics also lose money but that the prestige that comes from such events gives them the potential to earn much more from increased investment and tourism in the years that follow. It also argues that F1 is an annual event and not a one-off. This is true, but the counter-argument is that F1 is less exclusive an event than the Olympic Games and thus does not warrant the same level of investment. The feeling in F1 circles at the moment is that the sport is increasingly marginalised to countries where there are no traditions in the sport and no real interest, and that F1 should remain in its core markets. Others argue that to ensure long-term growth F1 needs to be building interest and audiences in new regions. That is a lengthy process. The downside of this policy is that F1 has now priced itself out of the North American markets, which are of key importance to the big sponsors and car companies. Getting back into America is clearly crucial.

Is F1 safe from the financial woes of the world? It’s too early to say. “No one knows if it is going to get better or worse,” said Max Mosley on the day of his meeting with the teams. “No one knows what is going on. It is essential to plan for the worst case, to have a contingency plan.”

Formula 1 has done that. Now we must watch what happens next.

Martin Whitmarsh
McLaren chief operating officer

There is no doubt that the world is radically changing, but the driving force behind all economies is consumer confidence, and the more we talk of recession and slowdown the more we accentuate the lack of confidence.

McLaren is fortunate in having a group of very strong primary partners in Daimler, Vodafone, Mobil, Diageo and Santander – all of whom manage their affairs well and all of whom will be responding to the demanding climate in which they find themselves. But I believe all these businesses will survive the volatility and that they will continue their long-term relationships with the sport.

I do not accept, and never have accepted, the notion that Grand Prix racing somehow has the right to exist and that we live in a world of our own. We will have to cut costs, and we must be both prudent and realistic going forward.

We remain optimistic, and we remain ambitious. For the first time, with the creation of FOTA, all the teams are now having good conversations and we are working together to keep costs under control. For FOTA to be successful is a challenge for all of us and I am optimistic that the association can grow into a strong force for the benefit of all the teams.

I accept that there has not been a good history of Grand Prix teams working together – they are, and always will be, combative and competitive units – but now is the time to leave the guns outside and to focus on the future rather than short-term personal gain and self-interest.

There will be a degree of isolation in the short term and it would be foolish if we did not recognise that McLaren, and the sport itself, have to be in the best possible position to deal with a far more challenging economic environment. There is no bottomless pit and now, more than is normally the case, each department at McLaren will have to fight for its resources. In more general terms, the purpose of FOTA is to develop the sport in such a way as to ensure the health and well-being of each and every team.

Notably, I think Grand Prix teams have failed to maximise their revenue streams from the sport itself, and that is one of the challenges we face in the immediate future.

Adam Parr
Williams chief executive officer

I believe that this kind of global slowdown could actually be very healthy for Formula 1 racing. The sport has become less economically sustainable and more unbalanced over the past 10 years. The kind of cost inflation we have seen simply doesn’t help anyone and we are all – that is FOM, FOTA and the FIA – working together to find a sustainable way ahead. There is a consensus for the need to make changes.

I am genuinely optimistic that all the teams will agree on the changes which are necessary to make F1 economically viable in the long term. We are seeing this already with the reduction of testing and the introduction of three-race engines. The bigger teams will be taking actions that are not simply in their own self-interest, and in some cases they will actually be doing things for the benefit of the smaller, independent teams. We all agree that the sport is not sustainable at current spending levels, and this is very significant. Nothing is off the table at FOTA meetings – in periods of downturn the smart people prepare their businesses for the future and they manage their cost base in line with their revenues. This downturn is an opportunity for F1 to come out the other side looking stronger. There will be pain along the way, no question, but we simply cannot defy gravity indefinitely.

There has been speculation in the media about the continued involvement of the Royal Bank of Scotland in sports sponsorship. I want to make it very clear that we have had no indication whatever of any intent other than RBS honouring its agreement with us for the full term of the sponsorship. We have a very solid group of partners for the 2009 season. It would be unfortunate if speculation like this were to undermine the motor racing sector of the UK economy. We employ 550 people at Williams and in the last three years we have spent £100 million with 2000 UK companies who are our suppliers.

Williams will never give up. There is more passion, and more determination, to survive than ever before. It is not in Frank and Patrick’s nature to give in. I am optimistic – the FOTA meetings thus far have had great leadership from Luca di Montezemelo, and I have seen the best side of Formula 1 people over the past few months.

Ian Phillips
Force India commercial director

No one saw the scale of what was coming. I always thought it was a great shame that, when the financial terms from the commercial rights holder for 2008-2012 were proposed in early ’05, the team owners did not take the opportunity for a radical re-think. The chance was there to put every team on a profit-making basis, but nobody really had the appetite for it…

There are a number of ways in which we will be affected, and sponsorship will be the first area to be hit. Having said that, I am confident that F1 will survive. It is a very good product, the public want it, the sponsors want it and we are lucky because we are riding high on the back of two fantastic championships.

As far as our partnership with McLaren-Mercedes goes, this is extremely positive for Force India and makes us a far more attractive proposition for sponsors. Vijay Mallya has been open about the costs of running this team – last year he spent $120m – but in the long term F1 should not have to rely on benevolent billionaires. That is not sustainable and the FIA, and latterly all the competitors, have recognised as much.

It has been apparent for some years now that F1 teams needed to speak with one voice, and in that sense I see FOTA as being a step in the right direction. But FOTA is not the solution to all the challenges – there will always be those who wish to protect their own positions. A new Concorde Agreement without the current unanimous voting procedure would be a better starting point.

We’ve been here before, and survived. In the recession of the early 1990s sponsorship became a legitimate part of the marketing mix. Later it became clear that, after tobacco sponsorship was banned, there would be less money to go round. Since then there has been no real dominance by one single sector but F1 sponsorship has become an acceptable and effective part of any corporate marketing strategy. In the current climate there may well be fewer offers on the table. But there will always be brave companies who see this as an opportunity to establish themselves across the world. I accept that, in the immediate future, they will need to be mighty brave. Meanwhile F1 must take the opportunity to ensure its own survival.