How Ferrari NV Would Profit From An F1 Budget Limit (NYSE:RACE)

Formula One Group (FWONK) is said to be considering a budget limit for teams competing in the Formula 1 world championship, the world's most prestigious motorsports series. Reportedly the proposed budget limit would start at $200 million (according to other reports $175 million) for the 2021 season and would be set to gradually decrease to $135 million until 2023. The cost of engine leasing and maybe the expenses for employing drivers might be excluded from these figures.

However, the teams also have a say in such decisions. For years, Ferrari NV's (NYSE:RACE) racing division Scuderia Ferrari has been one of the fiercest opponents of a budget limit. This is understandable given that it is the team with the highest budget. From a financial perspective, however, I believe that a budget limit would be advantageous for Ferrari as a company - and thus for its shareholders.

First, let's have a quick look at the status quo in formula one. Several teams are either majority or entirely owned or supported by manufacturers. Daimler AG's (OTCPK:DDAIF) is the majority shareholder of reigning champion Mercedes AMG F1, in which senior executives such as team principal Toto Wolff and deceased Chairman Niki Lauda hold minority stakes, while Renault SA (OTC:RNSDF;OTCPK:RNLSY) and Ferrari own their respective teams entirely. The McLaren team, while being a customer of Renault power units, also has manufacturer backing of sorts due to its sister road car division.

Red Bull Racing is owned by the closely held eponymous Austrian beverage company but has exclusive support by engine partner Honda Motor Co. Ltd. (HMC). The team's official name is "Aston Martin Red Bull Racing," yet the British car maker Aston Martin (OTCPK:AMGDF) is merely a title sponsor.

There are also junior teams like Red Bull's Toro Rosso and (de facto) Alfa Romeo, which while being operated by Swiss Sauber Group with Fiat Chrysler Automobiles NV's (FCAU) Alfa Romeo brand being the title sponsor, does closely cooperate with Ferrari and reserves one seat for a driver of the Italians' junior program.

The remaining teams are privately owned. Williams Grand Prix Holding plc, the parent company of the Williams F1 team, is listed on the Frankfurt stock exchange (ticker symbol: WGF1) but majority controlled by the founder Sir Frank Williams and his family.

The top three teams - Scuderia Ferrari, Mercedes-AMG F1 and Red Bull Racing - have considerably higher budgets than the rest of the field which have led to an effective two tier competition in recent years. McLaren and Renault have smaller budgets than the top teams but still considerably more financial resources at their disposal than the private teams. It becomes obvious why Ferrari has had a keen interest in preserving that status quo, at least in a financial sense. However, for the company as a whole there would certainly be something to gain from a budget limit. I will explain my thinking below.

Scuderia is the most successful team in the history of Formula 1 by a great margin. It is therefore in a unique position to attract sponsors willing to pay to have the red race cars sport their logos (in one case not even that). High profile sponsors include Philip Morris International Inc. (PM) - they are the ones without the logo on the car due to anti-tobacco legislation, Royal Dutch Shell plc (RDS.A;RDS.B;OTCPK:RYDAF;OTCPK:RYDBF), United Parcel Services Inc. (UPS), Lenovo Group Ltd. (OTCPK:LNVGF;OTCPK:LNVGY), Weichai Power Co. Ltd. (OTCPK:WEICF;OTCPK:WEICY), EssilorLuxottica SA's (OTCPK:ESLOF;OTCPK:ESLOY) RayBan brand, Advanced Micro Devices Inc. (AMD) and LVMH SE's (OTCPK:LVMHF;OTCPK:LVMUY) Hublot.

Ferrari reported net revenue from sponsorship, commercial and brand - which includes Formula 1-related revenues but also those generated through brand utilization, including merchandising, licensing and royalty income - of €506 million for 2018. This does not include income from leasing Formula 1 engines to customer teams (Haas F1 and Alfa Romeo/Sauber).

Scuderia Ferrari sponsors and suppliers; source: Ferrari NV

According to Forbes estimates, Ferrari collects about $220 million in sponsorship revenue annually. Motorsport Total - which tends to have insightful information regarding Formula 1 - estimates that Ferrari receives around €141 million of sponsorship income.

On top of that come the bonus payments that Ferrari receives from the shared media revenue pot that is shared between the teams. The team receives around €97 million in fixed bonuses (part of which as a previous winner of the constructors' championship; the other - larger - part as a "tradition bonus" for being the longest standing competitor, i.e. a payment simply for being Scuderia Ferrari). Depending on a year's sporting performance there will be additional income of up to €70 million or more (depending on the size of the bonus pot and other factors).

The value of a sponsorship derives from the power of the brand and its visibility on the race track. Therefore, I doubt that sponsorship income would decline due to a budget limit.

So all in all Ferrari's Formula 1 operations should be well able to operate at a comely profit even in a year of lower than average success. Even assuming that there might be substantial additional cost for driver salaries - top earner Lewis Hamilton reportedly makes around $50 million a year - there would still be a splendid profit contribution from the racing division.

If we take the low estimates of around €140 million in sponsorship income and let's say a mere €130 million in bonus income (which is a very conservative estimate and assumes a miserable sporting performance), we would arrive at a budget of nearly $300 million even at the current exchange rates (1 Euro = 1.10 USD). With a budget limit of $200 and $70 million in driver salaries ($50 million for whoever is the best pilot in the field and $20 million for a decent number two driver as has been Ferrari's line-up policy most of the time), this would add up to some $30 million in profit.

$30 million of additional profitability is certainly a nice thing to have. At a budget limit of $135 million that figure would come closer to some $95 million. This is where it would begin to really move the needle for Ferrari as a company. There will always be some currency fluctuation of course but based on the company's reported EBIT for the first half of 2019 (€471 million), the potential Scuderia profit could boost the overall EBIT by somewhere near 10 percent on a full year basis. And remember I base this calculation on rather conservative estimates regarding bonus payments and sponsorship income while estimating quite a high cost of driver salaries.

As anyone who read my previous take on Ferrari as a company knows (provided he or she agrees with my assessment), Ferrari is well off even without a profit from the racing division. Given the importance of preserving its brand, it might be argued that it is far more important in the long run to be successful in Formula 1 rather than being profitable. Enzo Ferrari began selling road cars in order to finance his racing operations back in the day. But today, Scuderia is more of a marketing tool for the company. But not just any such tool but the most important that the company has at its disposal. Therefore, it might seem rather unfavorable to sacrifice the sporting advantage of having the highest budget in exchange for a gain in profitability. But would the risk of Ferrari losing ground on track really be that high?

Notably, Scuderia Ferrari already has the highest budget of all teams in Formula 1 (Mercedes-AMG F1 admittedly coming fairly close). However, more than a decade of having the highest budget did not translate to winning the championship (the last constructors' title dates back to 2008 while Ferrari's last drivers' championship was won by Kimi Raikkönen in 2007).

Certainly a budget limit would decrease the performance gap between the top tier and midfield teams, especially if combined with measures such as an easier aerodynamics regime and more standard parts. However, the closer the field gets in terms of car performance the more important the individual drivers will become.

This offers several advantages to Scuderia Ferrari. First of all, the team enjoys a legendary status in the motor sports world. Many legends of the sport drove for the Italian team, including Michael Schumacher, Niki Lauda, Juan Manuel Fangio to name but a few. There are of course some great drivers who did never drive for Ferrari, for instance Jim Clark, Jackie Stewart or Ayrton Senna (the latter however already having been in negotiations for a Ferrari contract when he died in a race in Imola in 1994). Yet for most drivers, it is a dream to be a Ferrari driver at one point in their career. Thus, Ferrari would have a natural advantage in terms of attracting the best drivers, who can make a difference.

If driver salaries were not to be included in the budget limit, Scuderia could also increase this advantage by the ability to offer the highest-paying contracts to its driving personnel given its financial strength (as laid out above).

So all in all, I think Ferrari would still be able to preserve its position as one of the top teams in Formula 1.

A budget limit for Formula 1 teams might increase Ferrari NV's profitability by a significant amount. I do believe that this additional profit would more than outweigh the potential narrowing of Scuderia Ferrari's gap towards the smaller teams. On the contrary, adjustments to the sporting regulations that would reduce the technical complexity and increase the importance of the individual driver might even help the team to win the title once again.

In any case, I believe that it would be a favorable outcome for shareholders as it would increase the already excellent profitability without endangering the brand. So the perspective of a potential budget limit affirms my bullish view of the stock if anything.

This article was written by

Analyst's Disclosure: I am/we are long LVMHF, RACE, RYDBF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Disclaimer: All research contained in this article was done with utmost care. However, I cannot guarantee accuracy. Every reader is advised to conduct his or her own due diligence and research.

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