Why are the Yankees willing to give up so much profit?

Last week, someone leaked the financial statements of several Major League Baseball teams. It turned out that two of the worst teams in baseball, the Pirates and Marlins, regularly turned a profit. They did that, in part, by pocketing MLB's revenue sharing payments, and simultaneously keeping their payroll very low.

Actually, the leaked statements didn't tell us a whole lot that we didn't already know. Every year, Forbes magazine comes out with their estimates of baseball teams' financials, and every year there is some criticism that the Forbes estimates are inaccurate. But if you compare the Forbes revenue figures to the teams' numbers on the leaked statements, you'll find that Forbes is pretty close -- in a couple of cases, they're right on. Forbes' *profit* numbers, as opposed to revenue numbers, aren't quite as accurate, but that's to be expected: a 5% discrepancy in revenues can easily lead to a 100% difference in profits.

(Forbes 2010 numbers are here; for other years, Google "forbes mlb 2009" (or whatever year you're looking for)).

Previously, I argued that the small-market teams will never be able to compete with teams like the Yankees and Red Sox, simply because their revenue base is too small. A win on the free agent market costs somewhere around $5 million (Tango uses $4.4 million, which may be more accurate), but brings in a lot less than $5 million in additional revenues for he Pirates or Marlins. And so, they maximize their profit by keeping their payroll down. Long term, teams like those aren't able to compete.

One obvious solution to this problem of long-term competitive imbalance would be to share all revenues equally, and force each team to spend roughly the same amount on payroll. However, that solution has its own problem -- the Yankees have double the revenues of most of the other teams in both leagues. Why should they suddenly be willing to share?

That is: suppose you bought the Yankees for $1.5 billion, thinking you'll pull in $400 million in revenues and make $50 million in profit (numbers made up). If MLB suddenly decides all revenue has to be shared, then, suddenly, you're pulling in only $200 million in revenues. You have to stop signing free agents, and, after everything shakes out, you now have only $25 million in profit.

Since businesses are valued on profits, and your profits are permanently cut in half, your $1.5 billion investment is now worth only $750 million. No matter how rich you are, you won't want to take a bath of $750 million even if it does make baseball better. Seven hundred and fifty billion dollars is just too much money.

Or is it?

The thing is, revenue sharing has been around in MLB for almost a decade now. It's not full sharing, which is what I described in the above example, where every team winds up the same. It's just partial sharing. Every team contributes 31% of its revenues to a common pool, which then gets split among all 30 teams. Effectively, if you're above average, you lose 30% of the amount by which you're above average (you pay 31%, but get 1% back as your 1/30 share). If you're below average, you gain 30% of the amount by which you're below average.

That's still a lot of money, then, that the Yankees are losing. In 2009, according to Forbes, the Yankees had revenues of $441 million, as compared to the league average of (I'm estimating just by eyeing the chart) about $200 million. However, I think that $441 million is *after* revenue sharing payments. (Why do I think that? Because in the cases of the actual leaked statements, the Forbes estimates are significantly closer to the revenue statements *after* adjusting for revenue sharing.)

So, the Yankees probably had about $549 million in gross revenues; they then paid $170 million into the pool, and received $62 million back, leaving $441 million.

That is: revenue sharing cost the Yankees $108 million in cash last year.

That's still very large. Forbes values the typical large-market team at 2.5 to 3 times revenues (the Yankees are above 3, almost 4). Assume the Yankees' market price really is 3x their annual revenues. (I'm not convinced -- I prefer a valuation based on profit -- but never mind). That means that, if they continue to consent to the MLB revenue sharing plan, and if they continue to spend the way they do, the Yankees have effectively agreed to hand $324 million to the other 29 clubs.

Looked at another way: according to Forbes, the Yankees have lost money every year from 2002 to 2008:

2009: $24.9 MM profit
2008: $ 3.7 MM loss
2007: $47.3 MM loss
2006: $25.2 MM loss
2005: $50.0 MM loss
2004: $37.1 MM loss
2003: $26.3 MM loss

If you added back in the Yankees' revenue sharing payments for those years, that would probably turn every loss back into a profit. And, in 2009 alone, without revenue sharing, the Yankees would have made *five times* as much money -- $133 million instead of just $25 million.

So what's going on? Some possibilities:

1. George Steinbrenner is so rich that he doesn't mind subsidizing the other teams. He was old enough when revenue sharing came in to being that he knew he'd never spend his wealth before he died. And so, he figured, whatever is best for baseball was fine with him, regardless of cost, so long as he could keep winning.

2. The Yankees believed that, without revenue sharing, competitive balance would be so bad, and the Yankees so much better than the other teams, that the fans would stay away and the Yankees would wind up being worse off. There may be something to that: according to Forbes, the value of the Yankees doubled since 2001, while the other teams increased in value by only maybe 50% (eyeballing again). So maybe revenue sharing is bad for the Yankees bottom line in the short term, but better in the long term.

That is: maybe by creating a league where teams like Tampa Bay might be able to compete once or twice every 20 years, fan interest rises to the point where the Yankees' investment in revenue sharing pays for itself, by increasing interest not just in the Yankees, but in baseball in general -- resulting in more revenue from the website, a bigger TV contract, and so on.

3. Maybe the Yankees (and Forbes), know that the operating losses are temporary, caused by Steinbrenner's desire to win at any cost. Maybe they figure, correctly, that they can cut down their free agent spending whenever they want, and start making significant profits.

That's in keeping with standard models of business valuation: you assess the value of a business on its *future* earnings potential, not its past.

4. Maybe revenue sharing drops the price of free agents enough that, in combination with some of the other factors, it makes revenue sharing profitable.

Suppose a free agent will increase the Yankees' revenue by $10 million. Then, if the guy costs less than $10 million, the Yankees will sign him. But, with revenue sharing, the Yankees only get to keep $7 million of the $10 million. And so, they're only willing to sign the player if he costs $7 million or less.

With the 31% revenue "tax", every team is in the same position. That depresses demand for free agents, which keeps prices down. And since the Yankees are the largest consumers of free agents, they get the largest benefit from the price decrease. The question: is the effect enough to pay for itself? I bet the answer is no -- it helps, not enough to make up for the tax. But that's just a gut feeling. Any economists out there able to estimate the size of the effect?

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My guess is that it's partly desire to win at any cost, and part rational economic calculation. That is, part of it is Steinbrenner's willingness to spend part of his fortune on fame. The other part is numbers 2, 3, and 4: the Yankees are doing what they have to do to make MLB attractive to fans in general, and are willing to lose money temporarily to be winners. I'm not so willing to believe #1, that George Steinbrenner is willing to give away half the value of his team just like that.

If that's correct, my prediction is that, eventually, when the new owners of the Yankees decide they're not as willing to spend their entire profit, and more, to make the playoffs every year, they'll cut down on their player spending. Instead of winding up in a class by themselves, with a payroll 50% higher than the average of the next seven highest-spending teams, they'll join those other teams, and wind up looking more like the Red Sox and Cubs. They'll still be highly successful, but not so much so that they make a mockery of the rest of the league.

Or not. There could be other, better explanations for what's going on. Any other ideas?