Monday, August 31, 2009

Is a Hamilton NHL team worth as little as Andrew Zimbalist thinks?

I've just finished reading Andrew Zimbalist's sworn submission to the courts with regard to the Phoenix Coyotes situation (hat tip to blogger James Mirtle for posting the entire legal document), and there's lots in it I don't agree with. It could be that I don't understand the antitrust or economics issues, which, of course, are Zimbalist's specialties. I'll list my issues and maybe someone can explain.

First, a quick summary of the situation, as I understand it.

The Phoenix Coyotes are bankrupt. Jim Balsillie wants to buy the team and move it to Hamilton, Ontario, a hockey-mad city 45 miles from Toronto. The NHL doesn't like the idea. First, it believes that it, not the courts, have the right to decide where a team plays. Second, it seems to want to protect the Toronto Maple Leafs from competition. And, third, it doesn't like Balsillie, who is being combative with the NHL rather than cooperating with it.

Zimbalist's written testimony, written at the request of the Balsillie team, argues that

(a) a franchise in Hamilton is worth only $12 million more than if the bankrupt franchise was left in Phoenix, at $175 million versus $163 million;

(b) the effect on the Toronto Maple Leafs would be minimal;

(c) the price Balsillie is offering to pay for the team, $212 million is therefore more than the team is worth, and the difference is "Picasso value," the price Balsillie is willing to pay for the consumption pleasure of owning the team;

(d) the Hamilton expansion opportunity does not "belong" to the NHL.

Maybe there's something about the economics I don't understand, but I don't see it the same way. I'll deal with (b) and (d) in a future post, but for now, let me concentrate on (a) and (c). I think the team is worth substantially more than $175 million, and I think the "Picasso value" is huge, much more than the $37 million that Zimbalist thinks it is.

First, doesn't it seem strange that a hockey team in Hamilton, so close to the best hockey market in the world, would be worth only 7 percent more than the same, bankrupt team in a non-hockey market in the desert? The way Zimbalist gets his numbers is to multiply gross revenue by 2.4. That's based on Forbes Magazine's estimates of team revenue and market value (Zimbalist doesn't justify the 2.4 figure separately).

That seems strange to me, valuing a team by its revenues rather than its profits. It would kind of make sense in comparing "normal" businesses, companies of different sizes in the same industry. Suppose you have two widget manufacturers; Acme sells $10 million worth of widgets a year, and Consolidated sells $100 million worth. You'd expect Consolidated to be worth about 10 times as much as Acme. After all, Consolidated probably has 10 times as many employees, and 10 times as many machines, and 10 times the bill for raw materials, and 10 times the shipping costs, and so on. All else being equal, Consolidated should make 10 times the profit.

But that's not the case in the NHL. With the salary cap, you could argue that team expenses are roughly the same, whether the team is in Glendale or Hamilton. Most of the expense is salaries, and those are now fixed in the range of $41 to $57 million. Forbes has the Coyotes at revenue of $68 million, meaning that if they paid $50 in player salaries, that would leave only $18 million for other expenses and profit. On the other hand, a team like Vancouver, with $107 million in revenue, has $57 million left for other expenses and profit.

For both teams, it looks like those "other expenses" are around $30 million: because Forbes has Vancouver turning a profit of $19 million, whereas Phoenix *lost* $10 million. Vancouver is a profitable enterprise, whereas Phoenix would struggle just to break even. Profits are much less proportional to revenues in hockey than they are in a "regular" business. So why use revenues as your measure?

As a verification, I ran a regression to predict team value based on revenues. The results:

Market Value = 3.2 * annual revenue - $73 million

or, rephrased,

Market Value = 3.2 * (annual revenue - $22.8 million)

The correlation coefficient was .965.

So the value of a team isn't a multiple of revenues: it's a multiple of revenues *above $22.8 million*. Suppose the Coyotes make $68 million revenue, and the Hamiltons twice that. Hamilton won't be worth twice Phoenix, then: it'll be worth two-and-a-half times. Apparently you need at least $22.8 million in revenue to make the team desirable even at $0. Only revenue after that translates into market value.

If you look at Forbes' chart, you can see that: the top 6 teams have a little less than twice the revenues of the Coyotes: and they're worth a little less than 250% as much.

Anyway, if you use this formula for the Coyotes instead of just 2.4 times revenue, you get $145 million, not $163 million. That makes sense, since the regression was based on Forbes data, which values the Coyotes at $142 million. However, Zimbalist did consider subsidies from the city of Glendale, which might make up part of the difference.

As for Zimbalist's Hamilton estimate ... well, he takes Balsillie's own estimate, which assumes revenues would be $73 million. That, to me, seems *way* too low. It would put Hamilton last among the other Canadian teams:

$160MM Leafs
$139MM Habs
$107MM Canucks
$ 96MM Senators
$ 97MM Flames
$ 85MM Oilers

I think an estimate of $100 million would be much more appropriate, given the size of the market. Based on the results of the regression, that would make the new Hamilton franchise worth $247 million -- not $175 million.


Now, Zimbalist also calculates team value another way, a better way: by estimating actual future profits, and calculating their present value. He doesn't do that for Phoenix, which I think is because he can't predict the Coyotes to ever make a profit in the future (in which case, shouldn't its value by this method be zero? But I digress). However, he does it for the proposed Hamilton franchise. Here's how: he starts with Balsillie's own projections of earnings the first five years of the franchise. Then, he assumes earnings will grow steadily for the next 25 years. He then discounts all 30 years' profit into today's dollars.

Zimbalist performs this calculation for five different 25-year growth rates (from 3 to 7 percent) and for three different discount rates (from 8 to 12 percent). He winds up with a franchise value ranging from $70 million to $177 million, with a typical value of $150 million.

This is all quite reasonable, although you have to keep in mind that Balsillie is probably being very conservative in his earnings projections in order to keep his price down. Still, it doesn't seem like this is how other teams are valued, probably because of the "Picasso factor." Looking at the Forbes chart, the market value of teams is much, much flatter than their earnings. The top three teams (Leafs, Rangers, Habs) make an average of about $45 million a year, and their market value is about $400 million -- an earnings/price ratio of about 11%. But the teams in the middle, who look like they make an average of about $3 million a year, are worth about $200 million -- an earnings/price ratio of about 1.5%. And the teams at the bottom are all losing money -- but their market values are still around $160 million.

Why are the values so flat relative to profits, where a team that makes $1 million a year is worth almost half as much as a team that makes $40 million a year? It could be the Picasso effect. I ran a regression to predict market value based on earnings. The results, rounded:

Market value = $200 million + 4 times annual earnings

The correlation coefficient? 0.88. Not as high as for revenues, but still huge.

What that tells us is that, regardless of earnings, there's a value of $200 million dollars to owning a team, even if it only breaks even every year. That might be Picasso value. Or, it might partially reflect the value of the right to move the team if it starts losing money. It might reflect the fact that owners think that earnings will jump soon -- maybe they think a new TV contract will someday be worth a present value of $30 million each, and that's part of the $200 million. But I think it's consumption value, Picasso value.

$200 million does seem reasonable in terms of consumption value. At today's low interest rates of (say) 4%, the opportunity cost of locking up $200 million is only $8 million. Most of these owners are billionnaires -- what's a tiny $8 million a year? Jim Balsillie's own willingness to pay is no doubt much more than $8 million. He likes publicity. He's making much of the fact that he wants to bring the NHL to more Canadian cities, making him something of a hero in some circles. He might have some ambitions beyond NHL owner, ambitions which being in the limelight will further.

Using the regression results puts the Coyotes at $161 million, which is about where Zimbalist has them in his revenue model (he can't use the earnings model because the Coyotes have negative earnings).

So, let's say we use this same regression equation to value the Hamilton team. Balsillie claims that five years from now, the team will be making $11 million. That means it'll be worth about $244 million then. Discounting that to today's dollars, at 4%, gives $209 million today. Adding in $35 million of Picasso value ($40 million discounted) for the next five years takes us back to $244 million.

And, again, that's conservative because it uses Balsillie's own estimates of his profits. Here are the earnings of the six Canadian teams last year, according to Forbes:

$66.4 million (Leafs)
$39.6 million (Canadiens)
$19.2 million (Canucks)
$ 4.7 million (Senators)
$ 7.4 million (Flames)
$11.8 million (Oilers)

Judging by this, I'd say that, for a Hamilton franchise, $11 million five years from now is pretty conservative. Even so, the Picasso value drives so much of franchise valuation that it doesn't matter much: even if the Hamiltons made as much as the Canucks, it would only raise the franchise value from $244 million to $276 million.

So I think the team in Hamilton is worth about $250 million. Not only is this substantially higher than its worth in Phoenix, but it's even more than Balsillie has offered. So I bet Balsillie is willing to spend a whole lot more than his $212 million offer, if necessary, to achieve his dream of a team in Hamilton.


So, a summary of our respective market value estimates:

Zimbalist thinks:

-- Phoenix $163MM by revenues
-- Hamilton $175MM by revenues (based on $78MM in revenues)
-- Hamilton $150MM by earnings

I think:

-- Phoenix $145MM by revenues, plus government subsidies
-- Phoenix $161MM by earnings
-- Hamilton $247MM by revenues (based on $100MM in revenues)
-- Hamilton $250MM by earnings

Zimbalist thinks the difference between Phoenix and Hamilton is maybe $12 million at most. I think the difference is close to $100 million.

Am I missing something?

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At Monday, August 31, 2009 4:10:00 PM, Anonymous Eddy Elfenbein said...

Interesting post as always. I'll add two quick thoughts.

Understanding the difference between fixed costs and variable costs is one the most important lessons in business.

The other is the Picasso Value doesn't belong in some netherworld. It's a non-tangible asset and it should be assumed to rise or fall just like any other investment.

At Monday, August 31, 2009 4:30:00 PM, Blogger Phil Birnbaum said...

Agree that the Picasso value will probably fluctuate. Suppose it rises with inflation. The inflation-adjusted interest rate is about 2%, so owning a team costs only $4 million a year, not $8 million.

Good call.

At Monday, August 31, 2009 10:23:00 PM, Blogger KJOK said...

Two quibbles:

1. You should not value the franchise on revenues or profit, but on cash flow (which is obviously a little harder to get at).

2. Per #1, even if the franchise is projected to lose money over several years, there would be a cash flow at the end of the period either with someone willing to purchase the team/assets, or with 'contraction' and the owner selling off the remaining assets, that would need to be figured in (discounted for time of course).

At Monday, August 31, 2009 10:28:00 PM, Blogger Phil Birnbaum said...

1. Actually, Zimbalist was using earnings instead of cash flow, not me. But I assumed that all earnings were taken out of the business every year in cash, and that none of the earnings were used to grow the business. Those assumptions aren't perfect, but they're not too bad for a hockey team, and they have the effect of making earnings = free cash flow.

I should have been more explicit about that.

2. I don't think that's right. What would happen in a situation of perpetual losses is that either the team would be moved, or it could be sold at the regression formula to someone keeping the team in the same city.

Remember, according to the model, the team has value as long as it loses less than about $8 million a year, since that's the amount in opportunity costs (Picasso costs) an owner is willing to pay for.

I think the valuation of the team probably takes into account it being moved eventually if necessary.

At Tuesday, September 01, 2009 4:14:00 PM, Anonymous Rodney Fort said...

Thanks for the post, Phil.

The team is worth the discounted stream of bottom line + tax shelter + cross-over earnings to other endeavors + the actual corporate taking of profits on the cost side.

Any estimate that focuses only on team bottom line could miss as much as 30% of the actual sale price (my paper, International Journal of Sport Finance).

At Tuesday, September 01, 2009 8:41:00 PM, Blogger alan said...

Isn't Buffalo also concerned about a Hamilton team hurting the Sabres' attendance?

At Tuesday, September 08, 2009 11:10:00 PM, Anonymous Hami Lton said...

I think what the NHL is concerned about is more the Buffalo sabres losing at least 2000-5000 seats a game from all the Niagara Region hockey fans who go to the Sabre games. With the border hassles now, all of those fans would go to Hamilton before going to Buffalo, it is only a extra 1/2 hour drive and you get to stay in Canada! As far as the leafs are concerned, they are never not going to sell out, you could put 2 more teams in Ontario and the leafs would still sell out everygame. Buffalo will become unprofitable if a team moves to Hamilton, thats the real concern to the NHL.


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