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January 22, 2009

Cut Out

Why Players Won't Be Getting a Piece of the MLBN Pie

by Shawn Hoffman

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After just three weeks on the air, the MLB Network is already the most successful cable station ever built by a major American sports league. Thanks to some nifty maneuvering in the spring of 2007, MLBN reaches approximately fifty million homes, making it the biggest launch in the history of cable television. It will also be lucrative from day one: MLBN is expected to bring in $200 million in revenue this year, and $300 million by 2012.

Bud Selig deserves a lot of the credit for this denouement. For all of his public faux pas, Czar Bud has steered MLB through its greatest (and longest) period of financial expansion. In 1993, his first year as acting commissioner, the sport took in $1.8 billion in revenues. This past season, MLB reached $6.5 billion, and is quickly closing the gap between itself and the NFL. The expanded playoffs, the stadium boom, and MLB Advance Media have all been tremendous growth engines, and MLBN could be the next profit center in that lineup. As Maury Brown detailed on Monday, the benefits to the owners are pretty wide-ranging: cash, equity, increased borrowing capacity-all in all, the network should be a very solid business for the foreseeable future.

All of which is great for the owners, but what will it mean for the players? And, more specifically, how will it affect future free-agent markets? Conventional wisdom says that player salaries are simply a function of industry revenues; as the teams go, so go the players. Scott Boras, for one, has latched onto this theory in the past few months, arguing that this year's free-agent market shouldn't be affected by the greater economy. "I always look at baseball revenues, and in the last seven years they have gone from $3 billion to $6.5 billion," he said. "If baseball revenues drop off, that's something we'll look at, but if there is a drop-off, it is not going to be dramatic."

If this is true, MLB Network should be a boon for the players, as well. After all, if incoming cash flows determine outgoing payments in anything resembling a linear fashion, the players should end up taking their share of the pie. One way we can test this is by determining how correlated Opening Day payrolls are to different revenue streams. Using data published at Forbes.com last spring, we can separate gate receipts (i.e. ticket sales) from non-gate revenue. Non-gate income accounts for about two-thirds of the sport's total intake, and includes national media contracts, local media contracts, corporate sponsorships, merchandise, and dividends from MLB Advanced Media (among other things).

Based on the individual team data from 2002-2008, there is a .71 r-squared coefficient between a team's gate revenue in one year and its Opening Day payroll the next. This means that 71 percent of the variation in Opening Day payrolls can be explained by gate receipts alone. Needless to say, this is a very significant number, although it shouldn't come as a surprise. Spending money on player payroll generally helps teams win, and when a team wins, its attendance and ticket prices will rise. The two are inextricably linked, both in theory and in practice.

On the other side, non-gate revenue shows a .20 r-squared value, which is, at best, barely notable. Keep in mind, several of the items within this class are positively correlated to gate receipts, particularly merchandise and sponsorship sales. So if we only accounted for items that are completely unrelated to attendance (i.e. national media, MLBAM, etc.), that figure would likely be even lower. (On a side note, this experiment doesn't work well on a league level, since gate and non-gate revenues have moved pretty proportionally. Therefore, the correlation and r-squared coefficients will always be nearly identical. On a team-by-team basis, there is much more variation, which allows us to get a better view of causation, and not just correlation.)

So what does this mean? Well, it actually confirms what we would expect from basic economic theory: players are paid to help their teams win games, so their salaries are based on marginal revenue per marginal win. When a team raises its ticket prices or moves into a new stadium, their earning potential rises. In turn, the value of each additional win moves higher, and players will get their proportionate share. But if a new revenue stream doesn't raise its MR/MW ratio, player payrolls won't be greatly affected. MLBN falls into this latter category, as does MLB Advanced Media. On a more practical, granular level, this means that the Dodgers can probably increase their 2009 gate receipts and merchandise sales by re-signing Manny Ramirez, but their income from the network and BAM will stay the same regardless, and his salary should reflect that.

Remember that, like any other employer, a baseball team will only hire players until marginal revenue equals marginal cost. If signing Manny brings the Dodgers an extra $15 million in revenue, that is his marginal revenue product (MRP), and the team should only be willing to sign him at or below that number. So even if the Dodgers are sitting on $100 million in cash, the value they place on Manny should still be based solely on the future earnings that he will add. Now, could an individual team with a cash surplus act irrationally? Of course. But if the league as a whole does this, it's a bubble. And as we've seen in the not-so-distant past, these bubbles tend to pop quickly.

Moreover, in regards to MLBN and BAM, the owners will have limited access to the cash coming in. They will have greater borrowing capacity due to their increased equity, and BAM has paid small dividends the past two years, but the great majority of the revenue will remain "hidden" on the subsidiaries' books. Short of spending borrowed money, the teams won't be able to funnel much of this cash to the players, even if they want to.

Don't be surprised if this turns into a collective bargaining issue at some point down the road. The network and Advanced Media will likely bring in $700-800 million in revenue this year, and the players are mostly being shut out. But for the time being, these companies are pure cash cows for the owners (or equity cows, if there is such a thing). Winning games is often a very low-margin business, particularly toward the end of a team's success cycle. But leveraging powerful, existing brands into a widely distributed cable network can yield high margins, and create huge ROIs off of a small amount of seed capital. It's no wonder sports leagues are moving in this direction, and it's to MLB's credit that they've succeeded where others have failed.

Note: Financial data taken from Rod Fort's indispensable Sports Business Data Pages.

---

Shawn Hoffman writes about business and baseball at Squawking Baseball.

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

Related Content:  Revenue,  Marginal Revenue

7 comments have been left for this article. (Click to hide comments)

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Darsox64

It's ludicrous to conflate the "irrational" decision of teams to spend money above the marginal returns for a given player with bubble formation. Players aren't traded in the same way that stocks or real state is; there needs to be a positive feedback mechanism in place within the prices for each player for the situation to inflate out of control. While it does make it easier for players to cite other contracts in arbitration or negotiations when one owner gives out an "irrational" contract, this does not cause owners to want to bid up the prices simply to sell them off later. Without this, no speculative bubble can form.

Owners, even the bad ones, are still baseball fans. The extent to which they are baseball fans and not businessmen can be measured by how much they are willing to spend against "fixed" revenues. Such spending may not be rational in the naive profit-maximizing sense, but it may be for them as human beings.

While the r-squared data you gave does mean something, it isn't especially compelling. What were the coefficients and p-values attached to gate receipts and non-gate revenue? A lower r-squared value must be weighed against the practical effect of the coefficient. Most importantly, the lack of explanatory power found in the non-gate revenues can easily be explained away by the relative lack of variation amongst teams in contrast to the variation amongst them in gate receipts. It says NOTHING as to whether a substantial, exogenous increase for all teams, such as the possible effect of MLBN, will have on the league's payroll as a whole.

Jan 22, 2009 11:23 AM
rating: 1
 
Steve D.

"I have no idea what you said, but I LOVED hearing you say it!"

Jan 22, 2009 12:00 PM
rating: 3
 
SFC B

"What's a battle?"

Jan 23, 2009 13:45 PM
rating: 1
 
hunter

Well, let's clarify the phenomenon where the team owner spends more than the marginal financial benefit on a player in order to win games. That owner has two goals: then. 1. Make money, 2. Feel good about winning. The owner derives a benefit from both, though the financial benefit is much more equal to quantify. Then, for the owner to be satisfied with the situation, financial outlay + emotional outlay < financial gain + emotional satisfaction. Otherwise, the owner is not satisfied. If you like, feel free to stick coefficients in front of those terms to represent that some owners are rabit fans and some owners only care a little, but it's not worth being so absurdly pedantic about it.

Anyway, people do this kind of back of the mental envelope cost-benefit analysis all the time, even if it's not noted as such. We all do it between 50 and 50 thousand times a day.

Jan 25, 2009 18:21 PM
rating: 0
 
goodwine10

The owners don't want to give the players any money? That's shocking. Baseball owners have always been so fair when it comes to paying players.

At least we all know that if some of these wealthy owners who cry poor all the time get a salary cap, they will put the money in the fans' pockets. What? That won't happen? Oh.

Jan 22, 2009 12:08 PM
rating: 0
 
gabbymatt

Baseball revenues will be affected this year and for the next few years. It will really kick in for the 2010 season and advertising this season. The cycle of excess should reverse. No one is immune in 2009.

Jan 22, 2009 19:37 PM
rating: 0
 
nicholj

I enjoyed the article but have a couple of issues. Firstly, I think you are abusing the term "Revenue" - probably a result from the Forbes data that you are using. Revenue is merely income without reference to cost. A better metric to use would have been "Profit", which is income net of cost. While $700M sounds like a big number, if it costs MLB $699M to generate the $700M then all of a sudden it isn't such a big number. I would guess that in the first year of operation MLBN would probably operate at a loss (maybe breakeven) - that is the cost will be equal to or greater than revenue. Once established, I would expect such a venture to have a "profit margin" of around 20% - the percentage of profit from every dollar of cost.

Secondly, your quote "the great majority of the revenue will remain 'hidden' on the subsidiaries' books" is highly misleading in that it implies that the owners are illegally hiding profits from the players. It is more likely that the profits are being retained to repay the start-up capital or fund future growth, commonly referred to as "retained earnings". I would expect the "start-up capital" - the amount money spent before the first dollar of revenue is received - to run a television station would be quite significant and would take at least 2 years to repay. As you alluded the actual cash received by the owners for operating these businesses is probably insignificant in the grand scheme.

Thirdly, the owners make the vast majority of their money not by operating the business but when they monetize their equity, usually by selling the business. Unions in all industries, would love to have a fair share of those "capital gains" instead of just the operating profit margin but to do so would be incredibly complex because increases in equity are merely paper profits until the equity is monetized. The union would either have to agree to sit and wait to receive their share when the business is actually sold (unions because of their revolving membership are not usually so patient) or create a complex arrangement where increases in equity are monetized systematically by leveraging off the equity by using it as collateral in a borrowing (you did make a couple of references to this kind monetization). Unions though, because their members are on fixed incomes, normally do not tolerate the risks involved in such arrangements. Ask any pension fund manager what happens when the income generated by the pension fund suddenly evaporates.

To further explain the risks involved in the second approach, lets use the simple example of home equity. You own a home. You made a down payment (start-up capital) and regularly make your mortgage payments. The equity in your home is the sale value of your home less the outstanding principal on your mortgage. This equity typically increases in three ways. 1. by making your mortgage payments you are slowly decreasing the principal portion of your loan, 2. by making home improvements, eg. renovating the kitchen, you increase the sale value of your home or 3. by market inflation. You can routinely monetize these increases in equity in your home without selling by increasing the amount of your mortgage also known as a second mortgaging. And, let's say you immediately share the proceeds from your second mortgaging with your family members who you have no intention of ever paying you back. All is well and good, as long the equity in your home is increasing. But market inflation is beyond your control. It does not always go up, it can also go down, as many homeowners are currently experiencing. When the sale value of your home goes down, so does the value of the collateral supporting your mortgage. When the value of the collateral supporting your mortage becomes less than the value of the mortgage itself, you may be forced to sell your home for less than the value of the mortgage in order to repay the lender. All of a sudden, you have no equity and no home. All the money you spent on the down payment, mortgage payments and home improvements is lost. And, to make matters worse, your family is none to happy with you because they depend on the income you gave them through second mortgaging arrangement and have no means to pay you back.

This is why owners do not typically share the potentially lucrative capital gains with unions (aside from stock options and the like). The owners are assuming all of the risk, there are no guarantees for them and their business may be doomed by something completely beyond their control. Not only could they lose their income stream, they could also lose their investment as well. Player contracts on the otherhand are guaranteed. Regardless of the economy or the players performance, they get paid. A fundamental principle for cpaitalism to be effective is that the risk taker gets the spoils.

Lastly, the idea that baseball is "recession proof" is born out of simple supply and demand theory. The supply of baseball franchises is extremely small (30 total) compared to the demand (I would assume that millions, maybe tens of millions of people would like to own a MLB team) and therefore baseball franchise resale values will always be relatively stable. Unlike other industries,where if you cannot afford to buy a company, you can always start and grow your own and compete. in baseball, if you cannot afford to buy an MLB franchise, there is no opportunity to start your own franchise and compete against the other teams (paying an expansion fee is essentially the same as purchasing an existing franchise). Baseball being "recession proof" it is not based on the stability of a baseball teams operating profit margin. Those profit margins should fluctuate based on the broader economy like any other business (every business reacts differently to various economic times, bankruptcy specialists do far better in a bad economy than a good one, a gold company does far better when the gold price is high, etc.) and thus average player salaries should fluctuate along with those profit margins. The guaranteed nature of player contracts means the swings in average player salaries will be slightly delayed and somewhat smoothed out over time but they will parallel fluctuations in profit margins.

Jan 22, 2009 20:07 PM
rating: 6
 
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