Did the Yankees engineer themselves into unprofitability?

My last post talked about how the New York Yankees, baseball's richest team, is actually losing money in part because it makes large revenue sharing payments to help out the other teams.

In the comments, "Johnmeister" responded by arguing that the Yankees' reported earnings are understated, because they don't include local TV revenue. That's a fair point. In fact, I had forgotten that I had posted about that a few years ago. Back then, I had made the same argument -- that if you include the TV money, now the loss turns into a profit.

However, that may not be right. The New York article on which I based my previous post counts the $60 as part of Yankees revenues, which implies that the $60 million is already taken into account in computing the team's bottom line. So their $28 million loss in 2006 really *was* a loss.

But, after thinking about the TV situation a bit, I realized: the Yankees really *are* highly profitable, at least in the sense that really matters.

In 2001, the Yankees created YES, and sold it the rights to broadcast games for 15 years. At the same time, they sold 63 percent of the newly-formed network to Goldman Sachs for (as near as I can tell) about $535 million. (The Yankees kept the remaining 37 percent.)

So, basically, they sold about 2/3 of the TV rights to Yankee games. Those broadcast rights are a huge revenue generator, bringing in even more cash than the revenues from ticket sales. Effectively, the Yankees sold off a large chunk of the business.

Now, that sale wouldn't necessarily have to change the profitability of the team. The Yankees could just take the $535 million, invest it in some other business of roughly equal risk, and earn profits that might be about the same as the profits from YES. It's like when you sell one stock in your investment portfolio, and buy a different one. Your overall return should be about the same.

But: what if, instead, owner George Steinbrenner just took the $535 million and, instead of reinvesting it in the team, he just paid it to himself as a dividend? That's perfectly legitimate -- it was his team, after all, and he could do what he wanted.

But: by taking assets out of the Yankees, the team becomes less profitable. If the Yankees' 37 percent share of broadcast revenues was worth $60 million, that means the other 63 percent, the portion belonging to Goldman Sachs, was about $100 million. With a profit margin of 60 percent of revenues (according to the New York Times), that's a perennial $60 million in profits (as of 2006 -- it's probably more now) that the Yankees sold off.

If you add Goldman Sachs' $60 million back in, you get that the Yankees' baseball operation didn't really lose $28 million: it made a *profit* of $32 million!

Indeed, if Steinbrenner had wanted to, he could have make the loss even larger. For instance, he could have sold the remaining 37 percent of YES. He could have sold his concession profits by telling Goldman Sachs (or any other group of investors), "look, I made $5 million in concession profits last year -- make me a one-time payment of $50 million, and you can have those profits yourself, forever." He could even get rid of his entire gate receipts, by telling the world, "if you give me $1.5 billion in cash, you can take over ticket sales and keep every penny." And so on -- securitizing every stream of revenues he could think of -- luxury boxes, merchandise profits, and so on and so on.

Then, Steinbrenner would have paid himself a huge dividend of all the money raised.

If he did that, then the Yankees would have a massive loss every year. The team's expenses would have stayed the same, but all its revenues would be gone, sold off to others. The Yankees would still have had to pay all those salaries, and all those stadium expenses, and so on -- but they'd have no baseball revenues to pay them with. The result, year after year, would be a massive loss, maybe $300 million or more.

Steinbrenner would then have had to pay off the Yankee losses out of his own pocket. That wouldn't have been a problem, because he'd have pocketed at least a couple of billion dollars out of the sale of all those revenue streams, which he'd have invested elsewhere.

But the fact is that the Yankees would still be losing big money -- because almost all the assets of the team had been sold off. The *business* of Yankees baseball would still be profitable. But most of that business would no longer belong to the Yankees themselves.

What Steinbrenner did was just a small part of that. He didn't sell his ticket revenues, or his merchandise revenues, or his concession revenues. He just sold 63 percent of his local TV revenues. But that was enough to turn the profit into a loss.

To summarize: when you ask if the Yankees are making money, those can be two different questions:

1. If you take all the Yankees' baseball revenues, and subtract all the Yankees' baseball expenses, is there money left over?

2. If you take all the Yankees' baseball revenues *except for 63% of the TV money, which you've voluntarily sold to someone else*, and subtract all the Yankees' baseball expenses, is there money left over?

Question #1 is the one that makes the most sense, and shows the Yankees are profitable. Question #2 is not particularly relevant, but it seems to be the one the media cares most about, and the answer gives the impression that Yankees Baseball is an unprofitable business.

I'm not sure if George Steinbrenner arranged this just to make it look like the Yankees were money-losers. My guess is that was a side effect, and that the real benefit was that, by selling $100 million in annual revenues for a lump sum, it was sheltered from MLB's 31 percent revenue sharing "tax".

Still, all things considered, I'm sure MLB is not unhappy that the world thinks the Yankees are significantly less profitable than they actually are.

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?

An economist predicts the Olympic medal standings

Daniel Johnson is an economics professor who, according to Forbes magazine, makes "remarkably accurate" predictions on how many Olympic medals each country will win. But I'm not sure, based on the description given, that the predictions are all that remarkable.

From the article, it sounds like what Johnson is doing is running some kind of regression, on "per-capita income, the nation's population, its political structure, its climate and the home-field advantage for hosting the Games or living nearby." He doesn't consider anything specific about the sports or athletes.

How accurate are Johnson's predictions? I'm not really sure. Forbes says,

"Over the past five Olympics, from the 2000 Summer Games in Sydney through the 2008 Summer Games in Beijing, Johnson's model demonstrated 94% accuracy between predicted and actual national medal counts. For gold medal wins, the correlation is 87%."

What does that mean? From the word "correlation," my guess is that those numbers are the correlation coefficient, or "r". But an r of .94 doesn't mean that the predictions are 94% accurate. It just means that the *best fit straight line* is 94% accurate. It's possible to be wrong, perhaps badly wrong, in every guess, but still have an r of 1, which means 100% correlation. For instance, if you underpredict every below-average country by 50% of the difference, and you overpredict every above-average country by 50% of the difference, you'll get a perfect correlation, but really crappy guesses. For instance, here's an example of how that might happen:

Country A: estimate 80, actual 65
Country B: estimate 60, actual 55
Country C: estimate 40, actual 45
Country D: estimate 20, actual 35

Regressing estimate on actual (or is it actual on estimate? I forget which way the word "on" implies, but never mind) gives a 100% correlation, but the actual guesses aren't spectacular in the least.

Anyway, it might be some other method that Johnson uses to compute the accuracy percentage, but it's hard to evaluate the claims without an explanation.

(UPDATE: as this blog post was going to press, I found Johnson's website, which confirms that it *is* correlation. It still could be that it's some kind of method that doesn't have the flaw of my example above. The site contains a media release, but no actual copy of the paper, which was published in "Social Science Quarterly" in December, 2004.)

More importantly, you can't tell how impressive a set of predictions is without something to compare it to. At Forbes, commenter "Doubter" points this out, and tries using the results of the previous Olympics to predict the current one. For the top five countries, he gets an 85% accuracy rating, and correctly points out that "include a bunch of countries with stable medal counts (Jamaica, Japan, Nigeria, Kenya, most European countries) and I am sure it gets much better."

I'm pretty confident that if you were to just use a weighted average of previous Olympics results and adjust for home field advantage, you'd come pretty close to what Mr. Johnson was able to do. Forbes should have realized that the results probably aren't "remarkably accurate" -- just "accurate".

Also confusing is the estimate of home field advantage. There were no results given for the Winter Olympics, but for the summer games, the host team "typically garners 25 additional medals compared with its expected performance, 12 of them gold." It doesn't really make sense that the home field advantage should be a fixed number of medals. Shouldn't it be a percentage increase? Canada won 11 medals in 1976 in Montreal, none of them gold. That was a few more medals than usual, probably because of home field. Should they really have been expected to win minus 14 medals in 1988 in Seoul, of which minus 12 would be gold? Or, on the other hand, were they just unlucky in Montreal, where they should have won about 30, when they were in the single digits in 1968 and 1972?

Or, if Pakistan were to host the Olympics, would you really expect them to jump from (say) 1 medal to 26?

Oh, and one more thing: in his 2010 predictions, Johnson has the top 13 countries winning 250 medals, but only 57 golds. Overall, gold are 33.3% of medals, but for those 13 countries, Johnson has them winning only 22.8% golds. How come? An eyeballing of the 2006 chart shows about 1/3 golds for those countries then ... I wonder why the drop?

Why don't reporters consult sabermetricians?

Here's a completely misguided article about baseball production and salary. It's from Forbes magazine, which should know better.

The piece tries to figure out which players are the most overpaid in baseball. To get a measure of production, they compare a player's raw stats to the average at his position. The article doesn't give an actual formula, but it says that

"we compared the major offensive stats--batting average, home runs, runs batted in and OPS ... of each player to the league average for starters at his position. Then we did the same with salaries."

The idea being, if player X hits .300, and the league average is .270, player X's salary should be 11% higher than average.

That's just plain wrong -- a .300 hitter is a lot more than 11% more valuable than a .270 hitter. You have to measure from replacement value. If the best available minor-leaguer would hit .240, then you can see that the .300 hitter is actually twice as valuable as the .270 hitter -- he gains 60 points over replacement, as compared to 30 points. (This doesn't mean his salary should be double; only the part of the salary above replacement level should be double.)

Of course, batting average isn't a very good proxy for performance; OPS is much better (although there are other measures evan even more accurate). And if you're going to include OPS, like the Forbes article does, why bother including the other statistics anyway?

And, since we're already shooting fish in a barrel ... why would you evaluate a hitter by his RBI? We've known better than to do that for, what, around 30 years now.

----

This brings up a question, which Tom Tango asks on "The Book" blog: How did this article make it into print? Shouldn't Forbes, which is a pretty sophisticated business magazine, know better than to run a financial analysis that's wrong on so many levels?

The answer, I think, is that writers and editors' don't care as much about accuracy when it comes to baseball. I can think of several reasons, off the top of my head. Feel free to suggest more in the comments.

1. People don't think of sabermetrics as a formal field of knowledge, one with subject-matter experts who should be consulted. Forbes would never have dabbled in this kind of layman analysis in the field of, say, engineering. Can you imagine an article on which bridges are most overpriced, based on dividing the price by the total length of the bridge compared to the average length of bridges? That would never happen. Forbes would consult an engineer, who would tell them that there are many, many factors affecting how much it costs to build a bridge, and that their analysis was simplistic, silly, and very wrong.

2. My perception is that among most of the media (the Wall Street Journal among the notable exceptions), sabermetricians are seen as fringe researchers, nerds with the "blogging out of their parents' basement" stereotype. Certainly a veteran financial reporter should be more expert at player valuation than a unpaid 24-year-old blogger? Well, no. In this field, it turns out that the experts are among those with the fewest formal credentials. And that might be difficult for the mainstream media to accept.

3. It's only baseball. Remember when Bill James, in the 1991 Baseball Book, reamed out David Halberstam for some awful inaccuracies in "Summer of '49". James wrote,

"It is frightening to think that Halberstam, one of the nation's most respected journalists, is this sloppy in writing about war and politics, yet has still been able to build a reputation simply because nobody has noticed.

"What seems more likely is that Halberstam, writing about baseball, just didn't take the subject seriously. He just didn't figure that it *mattered* whether he got the facts right or not, as long as we was just writing about baseball."

I think that's what's happening here. Baseball is frivolous, Forbes probably thinks, and so it's not worth caring about getting it right. It's easy to forget, when you're dealing with a subject you don't take seriously, that there are other people who do. Freakonomics thought it was the first to talk about baby-naming trends, and was criticized by serious experts whom it would have been good to consult. I've done things like that myself, assuming that the subject is so trivial that I must be just as much an expert as anyone else. It's usually not the case.

4. Sabermetrics is a field composed more of logic than fact; sabermetric analysis sounds like opinion, not science. What treatments work for Hepatitis? I don't know, and Forbes reporters don't know; it's a question of medicine, a question of fact. We can't even guess. You have to ask a doctor; they know.

But when it comes to evaluating a player's performance ... well, if you don't think about it too deeply, it seems like you don't need to know anything. Sure, just divide the salary by the numbers ... it seems reasonable and logical, doesn't it, that if you drive in 20 percent more runs you should make 20 percent more money? It doesn't seem like there's an underlying fact there, something that an expert has to tell you. You can come up with something plausible in your head.

And if someone tells you you're wrong, so what? It doesn't look like it's a question that has a right answer. If you can find two financial analysts, one who says a stock is worth $30, the other who says the same stock is worth $10, and it's OK to stick them on consecutive pages of Forbes ... then who's to say that figuring out the value of a player is any different? It's just one opinion instead of another.

This isn't a problem just in sabermetrics ... a few years ago, I read an economist (I think it was Steven Landsburg) with the same complaint. He said (and I'm paraphrasing) that economics is such that everyone thinks they understand it as well as people who have studied it for years -- people who wouldn't dream of having an opinion on a medical issue will confidently come forth with solutions -- wrong solutions -- to whatever economic problem is on today's agenda.

And, again, I think that's because a lot of it is logic. And logic is hard -- it's hard to reason through an argument than to memorize a fact. There are lots of arguments that sound plausible, but are, in fact, flawed. It takes work to figure out which is which, especially when you don't have enough background to be able to avoid the common fallacies, when you might be too proud of your own flawed logic to accept that you might have left something out, and when you might, ignorantly, be rejecting certain principles that sound silly to you but that the field has empirically found to be correct.

It's funny, too, because reporters will be willing to publish their half-baked theories without a second thought -- but when it comes to a specific mathematical calculation, they'll often cite a source, even when the calculation is simple enough to state as fact. It's as if they know their math *facts* might be shaky, but believe their mathematical *arguments* are beyond error.