Friday, November 24, 2006

Why do NHL teams make so little money?

Last week, Forbes magazine released its annual report on NHL team finances.

In 2004-05, the Toronto Maple Leafs had the highest operating income -- $41.5 million US -- while the New Jersey Devils were the biggest money losers, at negative $6.7 million. These are all Forbes estimates; I believe that the teams don't release their financials publicly. (And for those scoring at home, earnings figures are EBITDA.)

Also interesting are Forbes estimates of what each team is worth. The Leafs again top the list with an enterprise value of $332 million, and the Washington Capitals are at the bottom, at $127 million. The median is $153 million. The Buffalo Sabres were the biggest gainer over the last two years, going from $104 million to $149 million. Forbes attributes the increase to Thomas Golisano, the Sabres' new owner, who cut front-office jobs, reduced ticket prices, and improved his team by telling the coaches to make the players practice shooting more. (Seriously, that's what the article says.)

What strikes me about the numbers is the crappy rate of return the owners are getting on their investment. The average team is worth $180 million, but earned only $4.2 million. That's an "enterprise multiple" of about 43. That's huge. By comparison, Home Depot trades at about 7,
IBM is at 9, McDonald's is at 10, and Coca-Cola is at 14.

Put another way, the owner who invested $180 million and made $4.2 million earned a return of only 2.3%. He could have earned 4%, risk-free, by selling the team and putting the $180 million into government bonds. Or, roughly speaking, he could have bought $180 million worth of IBM stock, and earned 11% instead of 2.3%.

According to standard economic theory, a return of only 2.3% can't persist in the long term, at least if owners are rational. So what's going on? One possibility is that last year's NHL income could have been abnormally low – the league was having a bad year, and owners (and potential buyers of their teams) expect higher earnings in the years ahead. That doesn't sound plausible to me, especially because last year's earnings already include the effects of the salary cap. Also, to pull even with other investments, team earnings would have to at least triple. I don't see that happening, but, then again, I don’t know all that much about the business of sports, and I might be misunderstanding all these numbers.

Another possibility is that Forbes has overestimated team values. But their numbers seem to be close to what teams have sold for recently. For instance, Eugene Melnyk bought the Ottawa Senators in 2003 for $127.5 million Canadian, and Forbes says the team is now worth $159 million US. The Devils were sold for $175 million in 2000, and now Forbes has them at $148 million. (However, Forbes' values include debt, while the sale prices quoted in the press may not.) My feeling is that the numbers are correct – after all Forbes knows accounting, and I don’t.

But I think sports franchises are always going to earn less money than other businesses. Why? Because the people who buy sports teams aren't doing it just for investment purposes; they're doing it for ego and status and fun. A hockey team isn't something you buy and forget about, like a share of General Motors stock. It's partly a consumer good, like an antique car or a Honus Wagner hockey card. A large part of its value is the benefits other than cash earnings.

If you were a billionaire, how would you spend your vast wealth? The truth is, you couldn't. Even if you invested everything in government bonds at 4%, you'd earn forty million dollars a year. That's $109,000 a day, every day, even before touching the principal. If you absolutely had to get rid of that much money, you'd have to spend it on exotic stuff, like trips into space, or Van Goghs, or huge diamonds.

Or a sports team.

Suppose you sold some of your investments to buy the Ottawa Senators at the Forbes price of $159 million. You'd be giving up about $10-$15 million in earnings from your investments. The Senators would earn you only about $4 million. So the cost of owning the team for a season is about $8 million.

The Senators are actually owned by a man named Eugene Melnyk. Eight million dollars is about one-half of one percent of his net worth. For that, what does Melnyk get? A lot. He gets fame – everyone in Ottawa knows him now. He gets his name in the papers, and his face on TV. He gets respect and admiration. He gets the best seat in the house for games. He gets to run a hockey team, or at least select the people who will. He gets to decide how much to spend on players, and maybe even input on who to sigh for how much. Basically, he gets to own a fantasy league team, except that it's no fantasy.

All that is a huge bargain at $8 million a year. Think about it. If you had so much money that $8 million was a drop in the bucket, wouldn't you want to own a sports franchise? I sure would. As soon as I make my first couple of billion, I'm making an offer for my beloved
Toronto Maple Leafs, opportunity cost be damned.

If this theory is true – if sports teams weren't just profit-making institutions, but also consumer goods for people who are extraordinarily rich – what should we expect to see?

1. Teams would be owned by individuals, rather than corporations, because corporations don't have egos and care only about the bottom line.

2. Where rule number 1 doesn't hold, and teams *are* owned by corporations, it would be those where a single individual or family owns most of the voting shares, and where an individual from that family is the face of ownership.

3. Where rule number 2 doesn't hold, and teams *are* owned by widely-held corporations, it will be mostly teams that are profitable, and earn a reasonable return on the market value of the franchise.

4. Sports will have a larger proportion of egoist owners than other corporate fields. Owners will have a larger presence in the community than owners of other businesses. Absentee or reclusive owners will be rare.

5. Different owners will have different priorities. Some owners will concentrate more on making money and less on winning, while others will concentrate more on winning, even taking substantial financial hits to do so.

6. Losses will be widespread and returns on investment will be low. Some owners will make decisions that do not appear to make sense financially, in pursuit of something other than just profits.

7. Because the supply of billionaires increases faster than the supply of sports teams, demand will rapidly bid up the market value of a franchise, even past the point of profitability.

And all these things are roughly true, I think.

So, does this mean that sports teams are a bad investment? Not necessarily. It does mean that teams, as a whole, will never show a profit as good as other investments with equal market value. But it is quite possible that demand for teams is increasing so fast that there's a lot of money to be made buying a team, holding it for a few years, and flipping it to the next bored billionaire. It's kind of like buying the Mona Lisa for a billion dollars. You won't earn much charging admission to see it, but that's OK, because, unlike IBM, its value isn't based on its income stream. Eventually, as society gets richer and richer but Mona Lisas stay rare, the price gets bid up until someone will pay more than you will.

I don't think that sports teams will never earn a full economic profit. They are mostly expensive toys.


UPDATE: Tango coined the phrase "Picasso Effect" to describe this phenomenon. Subsequent posts on this topic can be found by searching for "picasso".

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At Friday, November 24, 2006 10:23:00 PM, Blogger Phil Birnbaum said...

For point #3 ... as I wrote, the average team made about 2.3% of market value. The teams owned by institutions or corporations made 12.5% (Leafs), 5.8% (Rangers), 0.3% (Flyers), and 7.6% (Canadiens).

At Friday, November 24, 2006 10:28:00 PM, Blogger Phil Birnbaum said...

Another thing I should note is that the return on market value seems roughly the same for the NBA, but is a bit higher for the NFL, and much higher for MLB.

Actually, in MLB, the top three teams in market value lost a lot of money, but the small-market teams seem to be earning 6% or so. Is that a result of revenue sharing and payroll tax from the Yankees?

At Saturday, November 25, 2006 12:04:00 PM, Anonymous Anonymous said...

Phil, I've done a good amount of research on this and from what I can glean, it seems that MLB teams are a good investment, but only when their rising value is taken into account. The Yankees might lose $20 million a year, but their value goes up by $50 million, so Steinbrenner is still up $30 million. If you look at the question in this way, I think you'll find they're a good invesment and also the teams that lose the most money generally gain the most in value, balancing things out.

At Saturday, November 25, 2006 12:15:00 PM, Blogger Phil Birnbaum said...

Hi, David,

Thanks. That makes sense, and is consistent with my argument ... which was that any increase in value is less related to actual returns from the business (present value of future cash flow), and more related to an increase in the "collectible value" of a team to someone who wants to pay to be the owner.

At Monday, November 27, 2006 2:39:00 PM, Blogger Tangotiger said...

Yes, the enterprise value increases by 10% every year (as does payroll). In a normal business, this should only happen because the market expects that company to turn a profit, so that a DCF would work. But, this has been going on for a few decades now, and teams don't turn the healthy profits a DCF envisions. The "art collector" aspect can certainly apply, as does being able to leverage that product for other things (like starting a cable network).

At Wednesday, November 29, 2006 10:37:00 AM, Blogger Phil Birnbaum said...


Agreed. I would hope that Forbes would take the leveraging into account when figuring operating profit, though. If the Rogers-owned Blue Jays sell broadcast rights to Rogers Cable for $1, I assume Forbes will see through that and adjust accordingly. I may be overoptimistic, though.

At Wednesday, December 20, 2006 1:40:00 PM, Anonymous Anonymous said...

Regarding Rule #4, I wonder whether this is the case. I would imagine egotism as being common, but an owner can be an egotist and a recluse. I think a another reason (and most likely non-statistically measurable) for owning a sports team is the control that an owner can have. The owner can 'play god' in a way that many of them can't because in their business world because of the interests of other investors, stockholders, regulators, etc.

At Monday, August 31, 2009 2:28:00 PM, Blogger Phil Birnbaum said...

The ego/consumption aspect to owning a franchise I'm calling the "Picasso effect". I think Tom Tango invented that name ... I don't remember where, so I'm adding this comment here.


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