Monday, August 30, 2010

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?

-----

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?



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13 Comments:

At Monday, August 30, 2010 6:22:00 PM, Blogger David Pinto said...

The Yankee need opponents in order to actually pay games. Part of the money fans spend is to see the other team. I think 31% is actually rather low for the work the other teams perform.

 
At Monday, August 30, 2010 10:56:00 PM, Anonymous JB H said...

There's probably long term benefits to having a dynasty. I would guess there's a lot more life-long-to-be obsessive Yankee fans born in 1980 than 1970. Building a TV network and getting other people to pay for part of your fancy new stadium is easier when you're winning all the time too

 
At Monday, August 30, 2010 11:00:00 PM, Blogger Ken Dynamo said...

could steinbrenner also be making money through other sources indirectly related to the Yankees? How much of the YES Network profits go directly to him versus the ball club's operations? is it reflected in Forbes' data? if the arrangement is YES "pays" the team for broadcast rights but then as a whole makes well above what is paid to the Yankees for their content (and presuming the other content on YES doesn't cost much to produce) that could provide plenty of cusion for the steinbrenner family to "lose" money with the Yankees.

I actually have no idea if that's what's going on, but that or something similar could explain how the luxury tax is tolerated.

 
At Tuesday, August 31, 2010 11:08:00 AM, Blogger Hank Gillette said...

I don't know when you originally wrote this article, but it's a little jarring to have you refer to George Steinbrenner as though he were still alive.

As far as the substance of the article, I think Ken is on to something. There are a lot of accounting tricks that you can play when you own two separate businesses that make payments to each other. Remember that in Hollywood, very few films or television shows ever show a profit, at least according to the accounting.

Another consideration is that so far, nearly every owner has made large capital gains when selling a baseball team. Look at the current estimated value of the Yankees vs. what Steinbrenner bought the team. If you are rich enough to be able to buy a baseball team, it may be good business to run the team at a break-even point or even take losses (if you have other income that you can write the losses off against) while effectively converting income to lower taxed capital gains.

Assuming the tax laws are the same for the ownership structure of the Yankess as they are for stocks (IANAA), the Steinbrenner heirs will not have to pay any taxes on $400 million or so in capital gains accrued during Steinbrenner's ownership, because the tax basis is stepped up to the value on the day he died. And because George was gracious enough to die in 2010, they won't have to pay a penny in estate taxes on their inheritance either.

 
At Tuesday, August 31, 2010 11:12:00 AM, Blogger Phil Birnbaum said...

Sorry. I am indeed aware that Mr. Steinbrenner is dead. Not sure why I phrased things the way I did. Maybe because the financials only go to 2009?

The thing is, where do the capital gains come from? Normally, they come from increased expectation of future earnings. But if there are no earnings, then what's going on?

Part of it might be the "Picasso Value" representing the consumption value of owning the team. But, still, why be willing to forgo so much money by agreeing to share more than 100% of profit with the other teams? The forgone profit is forgone profit, even if you are hiding a bit of earnings with accounting tricks.

 
At Tuesday, August 31, 2010 11:57:00 AM, Blogger Hank Gillette said...

The thing is, where do the capital gains come from? Normally, they come from increased expectation of future earnings. But if there are no earnings, then what's going on?

I don't think we know enough to assume there are no earnings, just because there aren't for tax purposes.

Take player depreciation, for example. Baseball teams are allowed to write off some amount of money for their players for a certain number of years. That lowers their reported profit, but that money is still there.

Are there any owners who draw a salary from their baseball team? That would be deducted directly from profit, but again, it would be money that the owner can spend.

I wish Doug Pappas was still with us to help make sense of all of this.

The fact that rich people see enough value in owning a sports team accounts for the capital gains, whether it's cash flow they can take out that is not reported as income or something else.

There is certainly an intangible value to being one of only 30 owners of a baseball team, at least for a certain type of personality. George Steinbrenner was rich before he bought the Yankees, but who had ever heard of him? When he died, virtually everyone in the country knew who he was. I think he reveled in being well known.

As far as their willingness to share, I think you covered some valid reasons. If baseball got to the point where everyone believed that no one could ever compete with the Yankees, attendance and interest in baseball would decline precipitously. I think the Pirates are flirting with this precipice, especially in light of the revealing of their financials, where the conclusion can easily being drawn that they are not even trying.

 
At Tuesday, August 31, 2010 12:07:00 PM, Blogger Phil Birnbaum said...

Good point: if the owners are taking money out as salaries, then there is definitely profit there that won't show up in the bottom line. I'm not sure that's happening. There's not much evidence of that in any of the leaked financial statements: all the operating expenses are broadly similar, in the 10-15 MM range.

Florida does have a $2.8MM expense for "Management fees - related party."

Also, I think depreciation of players happens only after a team is bought/sold. In the leaked statements, Texas's is the only one that has that explictly, at $13MM.

 
At Tuesday, August 31, 2010 12:09:00 PM, Blogger Hank Gillette said...

Phil,

Sorry for hogging the conversation, but a couple of points:

1. I grossly underestimated the capital gains that Steinbrenner accrued during his ownership of the Yankees. Steinbrenner and some minority investors bought the Yankees for $8.8 million in 1973. Forbes now estimates the franchise value at $1.6 billion.

2. Here is a link to an article that explains the depreciation of players, although the example given is for basketball. http://seattletimes.nwsource.com/html/localnews/2002911235_ownertaxes05m.html

 
At Tuesday, August 31, 2010 12:10:00 PM, Blogger Phil Birnbaum said...

Hog away! You raise some good points.

 
At Tuesday, August 31, 2010 5:05:00 PM, Blogger Johnmeister said...

The key is the TV revenues that I don't think get calculated with the baseball revenue since it is a separate corporation.

Also, the Yanks just teamed up with the Cowboys to start yet another corporation that would deal with the food sales at the Stadium. So that is another source of profit for the ownership that doesn't need to be reported as baseball revenue.

 
At Tuesday, August 31, 2010 9:39:00 PM, Anonymous Cliff said...

Because George died in 2010, his heirs don't get a step-up in basis, so if they sell the team, they'll have to pay tax on the gain using the price he paid in 1973.

 
At Tuesday, August 31, 2010 10:20:00 PM, Blogger Hank Gillette said...

Because George died in 2010, his heirs don't get a step-up in basis, so if they sell the team, they'll have to pay tax on the gain using the price he paid in 1973.

Good point. I'd forgotten about that little clause in the elimination of the estate tax (for 2010). On the other hand, if George had died last year, his heirs would have owned something like 45% estate tax (after a $3.5 million exemption). They might have very well had to sell the team simply to pay the estate taxes.

 
At Wednesday, September 01, 2010 12:03:00 AM, Blogger Phil Birnbaum said...

Johnmeister,

Good point about the TV issue. I'm not sure if Forbes includes that or not, but, if not, it's a huge omission. I've posted about that before:

http://sabermetricresearch.blogspot.com/2007/06/do-yankees-lose-money-not-if-you.html

 

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