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April 30, 2007

The Ledger Domain

Q&A with Vince Gennaro

by Maury Brown

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When Michael Lewis wrote Moneyball, a larger audience became aware of Doug Pappas and his groundbreaking metric, Marginal Payroll/Marginal Wins, published here at Baseball Prospectus. The metric placed an economic value on how much a club was spending to earn wins, and how much a club was spending in the overall in terms of marginal payroll. It placed the value of a win into perspective, and was seen as a way for clubs to better valuate how they spent, not how much they spent.

To the loss of us all, Doug passed away in May of 2004, and wasn't able to continue his tremendously valuable work on the business and economics of baseball. In his wake, baseball economics have been a topic for greater study, as those of us who have tried to follow him try to expand upon that work on valuating wins, and develop better metrics analyzing club revenues. What was once the speciality of a very few commentators and academics has become a broader topic covered by a number of authors at Baseball Prospectus, doing research in the field online and in print.

That said, Baseball Prospectus isn't alone in this. There are others covering the economics of baseball with objective analysis. One analyst who has come forward recently with a book of his own on this subject is former Pepsi Co. executive Vince Gennaro, a consultant for at least one MLB club. Gennaro has an MBA from the University of Chicago, and his book Diamond Dollars discusses a broad variety of valuations, including Win-Curve, a method for valuating the win-revenue relationship for clubs.

We decided to sit down and talk with Vince about the book, how it came about, and some of the finer details within it.

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Maury Brown: When did you first decide to write Diamond Dollars, and how does your background factor in?

Vince Gennaro: The seeds of Diamond Dollars were planted way back when I was a grad student at the University of Chicago in the late 1970s. I developed a set of statistical models to estimate the way a team’s revenues are affected by their on-field performance. The analysis and its implications on the dollar value of players became the topic of a feature article in The Sporting News, which caught the attention of several teams and player agents. However, it became clear to me that baseball was not ready to embrace a new way of looking at player value nearly 30 years ago, so I put my work aside and pursued my business career. When I was president of one of PepsiCo’s divisions, I was involved in various sports sponsorship deals and came to appreciate the ways in which sponsors can create tangible value from affiliating with a winning team. Several years ago, after I left PepsiCo, I decided to take a serious run at analyzing MLB team economics. Jim Walsh of Maple Street Press was intrigued with my work, and convinced me that it could make for an interesting book.

MB: Diamond Dollars is really a look a placing valuation–-both player and club revenues-–into perspective. Explain the “Five-Tool Formula,” and how that fits into the overall picture of the book.

VG: The “five tools” refer to the kind of decision tools an MLB team draws on to balance the tension between winning and financial performance. In some ways, it’s a blueprint for taking an analytical approach to running a baseball organization. The “tools” also represent the way in which Diamond Dollars is organized, as each has its own section in the book. The first tool centers on a team’s need to understand the relationship between winning games and its local revenue. The second tool gets at the ability to place more than an intuitive dollar value on a player, by using the win-revenue relationship as an input into the valuation decision.

The third section focuses on the financial impact of a high-performing scouting and player development system. Everyone knows it’s cheaper to develop talent than buy it in the free agent market, but how much cheaper? I come up with a way to quantify the difference in the cost. If a team knows its true cost of developing marginal wins versus the cost of buying wins in the free agent market, they may allocate resources differently.

The fourth tool is all about branding. How can teams better understand the attitudes and the makeup of their fan base, and use those insights to build a true emotional connection between the team and their fans? The fifth tool is about making a commitment to a management model that relies on using analyses which get at the critical bits of information to help teams make a go/no-go decision about allocating more international scouting resources, or a free agent signing, or an innovative ticket-pricing plan.

MB: Tell us about Win-Curve, and how it differs from the value over an additional win that Nate Silver talks about in Baseball Between the Numbers?

VG: It’s important for a team to have a detailed understanding of how their revenues will vary, based on their on-field performance. Teams are constantly making decisions to balance the tension between winning and financial performance. Even clubs that are not overly focused on making a profit still need to estimate the amount of revenue they’ll generate from improving the team. Each team’s win-revenue relationship is unique, based on the size of the market and the loyalty of its fans, among other factors. Fifteen years ago, when free agent salaries and team revenues were a fraction of today’s level, teams could get by with some back-of-the-envelope math. Today the stakes are too high to make a $100+ million contract decision without considering the player’s potential impact on all of the team’s revenue streams. The win-curve is an attempt to quantify a team’s win-revenue relationship, and give a team one important additional input into any spending decision intended to improve the team, including player acquisition decisions.

The approach taken by Nate Silver in Baseball Between the Numbers bears some resemblance to my win-curve. The primary difference is that Nate’s “marginal economic value of one additional win” is not differentiated by team or market, whereas my win-curves are team-specific. Also, my win-curves incorporate an estimate of the broadcast revenue that flows to a team-owned Regional Sports Network (RSN).

MB: You use regression models to define team revenues, but one of the more difficult aspects in defining revenues for the clubs deals with how television territories factor into what is deemed a “local market.” As television becomes a growing factor with RSNs, and expanding territories that overlap, it can be difficult to address the issue. How did you approach this, and where do RSNs sit in terms of team economics?

VG: Regression analysis can be especially helpful in estimating some aspects of team revenues, particularly attendance and other revenues that move hand-in-hand with attendance, such as concessions. Broadcast revenues are an entirely different story. In the case of the “traditional” broadcast arrangement—a team is paid a fixed rights fee from a regional Fox Sports type of affiliate—there can be a very weak relationship between winning and broadcast revenues. In the short term, the upside from winning can be limited to a bonus (beyond their rights fee) for reaching the postseason. Another factor that needs to be considered is the term of the rights agreement. Building a winning team may not pay off at the broadcast revenue line until three or four years down the road, when a team’s contract is up for renewal.

Team-owned RSNs are an entirely different breed. Even though a team is still paid a rights fee, it’s important to get at the other financial benefits that accrue to a team from their RSN. To estimate the true revenue impact of winning, it’s best to create “transparency” between the team and the broadcast entity. For example, if the Red Sox win 96 games and return to the postseason this year (versus last year’s disappointing third-place finish), their viewer ratings on NESN will improve over last year’s ratings. Ultimately these higher viewer ratings can be converted into increased ad revenue. Even though it’s NESN who benefits, the Red Sox own 80% of NESN, so we can impute 80% of the increase of the revenues attributable to winning to the Red Sox, and incorporate it into their win-curve. Add to the revenue impact the reality that team-owned RSNs are separate assets with tangible value. If a team’s improved performance generates $3 million in extra ad revenue, it may also translate into $15 million of increased value for the asset—the RSN. Team-owned RSNs are dramatically changing the face of baseball’s economics, and it’s not simply because they may shelter a few revenue-sharing tax dollars.

MB: Team brand is an interesting theme in the book. How do teams approach building their brands, and is it unified?

VG: Building the team brand is all about creating a deep emotional connection between a team and its fans, which breeds loyalty and pays huge financial dividends that endure, whether a team is winning or losing. In the good times a strong brand has many benefits, including giving a team extra “pricing power,” while in the lean years it cushions the decline in attendance. Even some of the strongest team brands in MLB have taken different paths to building their brand. For example, take the Yankees and Red Sox. The one common thread is their playing in a historic ballpark, but that’s where the similarities end. The Yankees brand is built on the pillars of winning and tradition. Winning is not just an outcome, it’s part of Yankees’ identity, reinforced by Steinbrenner’s public apology for last year’s early exit from the playoffs. On the other hand, the Red Sox' deep emotional connection to their fans has a lot to do with their long history of near-brushes with greatness—1967, 1975, and 1986—and their fallibility. There’s even a marked difference in how the players shape the perception of the brand. Yankee players often come across as aloof and formal, but when you think of the team’s place in baseball history, that may actually fit with the vaunted image of the team. On the other hand, Red Sox players are much more “accessible”, highly quotable, and open with their comments and feelings, allowing the average fan to get to know them on a more personal level—and by doing so, they personalize the Red Sox brand.

MB: Let’s do some pretending… the Mets and Yankees have the exact same payroll, exact same Win-Loss, have the exact same television audience size, and the exact same physical territory in terms of DMA. Why would the Yankees have a higher brand loyalty factor?

VG: The Yankees have 60 more years of history than the Mets and a richer tradition, with World Series memories for every generation of fans, and an honor roll of Ruth, Gehrig, DiMaggio, Mantle, et al. They also had a four-year head start with the YES Network, feeding their fans 24/7 Yankee propaganda, dramatizing their glorious history to their fans—all of which deepen the emotional connection and build their brand loyalty.

MB: What are some of the real leverage points, the things a team can do that really make a difference to a team’s financial performance?

VG: One of the biggest drivers of revenue is an appearance in the postseason. When a team reaches the postseason, particularly for the first time after being absent for several years, it can trigger a revenue stream for up to five years. The Tigers have seen a 90% increase in season tickets, coming off last year’s World Series appearance. Even if they fail to get back to the postseason in 2007 and 2008, they will still retain some of those new season ticket buyers. The net result is a revenue stream of about $35 million over four or five years, just as a result of the 2006 World Series appearance. Not all postseason appearances are created equal—if an 85-win playoff team goes three and out in the first round, the financial benefits may be small.

On the cost side, the biggest financial lever is to have a prolific scouting and player development system. It costs two to three times more to buy wins in the free agent market than it does to develop them internally—providing the team has a reasonably productive farm system. The key is farm system productivity. There is no upside in saving money on player development. The relative cost is so low, when compared to the cost of buying wins in the free agent market, that teams should be looking for ways to spend more money to improve the yield from their farm system. A third financial game-changer is to get into the team-owned RSN business. An RSN can be a great investment for a MLB team, providing the team’s broadcast rights are a significant enough asset to form the basis of a network. It probably is a viable strategy for at least half the MLB teams.

MB: In a recent Wall Street Journal article there seemed to be a debate as to whether your marginal revenue approach is a fair way to gauge a player’s dollar value.

VG: I’ve never viewed the marginal revenue a player is expected to generate as the “Gennaro sheet” to a player’s value. The way I think about player dollar value is that it’s a highly complex decision that involves a number of variables. Teams consider the injury history and risk of the player, the duration of the proposed contract, his expected performance, his makeup, his fit with their team, and many other factors. I’m simply a strong advocate for adding the expected revenue impact from the player to the list of variables to consider. But when I say expected revenue impact, I don’t mean, “If we win six more games, we’ll sell about 200,000 more tickets, generating about $4 million in revenue.” I mean thoroughly analyzing the expected revenues from not only attendance, but all sources. Any revenue estimate needs to address the financial impact of reaching the postseason, factoring in the increased probability of reaching the playoffs from improving the team by six wins. There’s a long list of revenue sources to consider, and if a team owns an RSN, it should include the increased viewer ratings and the amount of ad revenue the six wins might generate. In the end, I’m saying that knowing the potential revenue impact of a player should be an input to the decision. If a player is likely to generate $7 million in incremental revenue, but costs $10 million in the free agent market, a team can at least acknowledge that if they choose to sign the player, they’ll be “deficit spending” by about $3 million—which may be the right business decision.

MB: Which teams stand to gain the most revenue from reaching the playoffs?

VG: This varies from year to year. I’ve estimated a value of reaching the postseason for each team, based on their market size, available seats, and several other factors. Even though I have an estimate for each team, the values are not constant from year to year. Once a team reaches the postseason, the value of reaching it in the following year is diminished. Using our earlier example, the 2006 Tigers will generate a revenue stream totaling about $35 million from their first appearance in the postseason since 1987. One component of the $35 million is an increase in 8700 season tickets over the previous season. If the Tigers return to the playoffs in 2007, season ticket sales will likely increase again, but by a lesser amount, generating a much smaller incremental revenue stream. In the 2006 season the Mets took the prize with the biggest postseason windfall, having made their first appearance since 2000. For 2007, the teams that stand to gain the most revenue if they reach the playoffs are the Cubs, the Mariners, and the Phillies. (This is independent of their probability of reaching the postseason.) For those who doubt that the Cubs have any revenue upside, consider the Red Sox were in a similar position prior to the 2003 season. The new ownership group in Boston proved to be highly resourceful and found numerous ways to capitalize on the increased popularity of the team.

Maury Brown is an author of Baseball Prospectus. 
Click here to see Maury's other articles. You can contact Maury by clicking here

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