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Last week, our Russell Carleton posted an excellent review of the new Collective Bargaining Agreement between baseball owners and the players’ union. As Russell explains, the CBA, which already had a soft cap on the domestic draft, establishes a hard cap on the international bonus pool. In addition, escalating luxury taxes and a new draft pick penalty on high payrolls–for which the thresholds are moving up less than three percent per year, creating “bracket creep”–could, Russell maintains, create a de facto (if not de jure) cap on major-league salaries as well.

One of the reactions you’ve probably heard is: “Well, if the owners have a cap on the amateur draft, and a cap on international signings, and a cap on player salaries, where are they going to spend their money?”

That’s the question I’d like to answer here. For years, I was a financial research analyst. I reviewed publicly traded companies’ financial statements, listened to company conference calls to discuss earnings reports, and made financial projections, updated quarterly or more frequently. So I’ve had experience with companies experiencing better-than-expected or improved cash flows.Their resultant actions, I think, can inform how baseball’s owners might direct enhanced profits.

Here are ways companies typically deal with augmented earnings:

Capital Spending

Capital expenditures, or “capex,” are purchases of long-lived assets like buildings and equipment. Companies with extra cash might upgrade manufacturing plants or buy new software or (red flag!) build a fancy new corporate headquarters. They might refurbish properties or invest in a big research project. A company I followed once spent several million dollars “relamping”–i.e., replacing incandescent bulbs with LED bulbs throughout its network of hundreds of properties.

The thing about capex, though, is that it isn’t something you generally associate just with good times. “Hey, the money’s rolling in, so let’s put new carpets and beds and bathroom fixtures in all of our hotel rooms.” It’s commonly an ongoing expense that companies incur in order to remain competitive. It’s often more a case that companies going through lean times have to cut back on capex than companies having good years go on spending sprees.

Relevance to Baseball: There aren’t a lot of opportunities to do capex in baseball. Yes, you can upgrade your computer systems, but that’s not going to set you back tens of millions of dollars. You can upgrade your ballpark, but that may be partially on the taxpayer’s dime, not yours. Certainly, you can do things like provide translators and healthier food choices and nicer buses throughout your minor-league system, but those aren’t big-ticket items. Build an analytics team or expand the front office in general? Everybody’s already done that, and besides, it’s often done on the cheap. Excess profits aren’t going to get soaked up by capital spending.

Mergers and Acquisitions

Companies can seek to combine with other companies to increase their market share, gain efficiencies, and/or enter new markets. That’s evident in some of the larger deals of 2016. Protection 1 bought ADT to increase its share of the home and commercial security market. Three finance companies, NorthStar Asset Management, NorthStar Realty Finance, and Colony Capital merged, gained operating synergies. Microsoft bought LinkedIn, grabbing a leading role in professional social networking. Strong financial results can accelerate companies’ appetite to get bigger.

Relevance to baseball: None. The teams already own their minor-league affiliates, and they’re not about to go out and buy teams in the Korean Baseball Organization or something like that. In fact, the biggest M&A deal in baseball this year wasn’t an acquisition, it was a sale: The $1 billion the Walt Disney Company paid for a 33 percent stake in BAMTech, the leading part of MLB Advanced Media.

Debt Retirement or Refinancing

Just as you might use a $1,000 year-end bonus at work to pay down some credit card debt, companies can use extra cash to repay creditors. Often, companies flush with cash will keep their debt outstanding—given current interest rates and the tax treatment of debt, it’s a low-cost way for companies to finance their business—but they’ll refinance it at lower rates.

Now, you might think: “Why do they need higher income to take advantage of lower rates? I’ve refinanced my mortgage three times in the past 10 years, and I’ve barely gotten raises.” Well, your mortgage lender cares about your ability to pay, but ultimately knows that if you default, it gets your house. That’s called secured debt, because it’s secured by an asset (your house). Companies generally get unsecured debt, in which the lender is investing entirely on the credit-worthiness of the borrower. And the best way for a borrower to increase its credit-worthiness is by making more money. As my grandfather, a small businessman, once complained after meeting with his bank: “The bank will loan you money only if you can prove you don’t need it.”

Relevance to baseball: Now we’re getting somewhere. Refinancing debt doesn’t spend money, of course. If a team has borrowed $100 million and reduces its interest rate by half a percentage point, it now has another $500,000 in its pocket every year.

But debt retirement can mop up money. And per this Los Angeles Times story by Bill Shaikin, the Dodgers are under pressure to reduce their borrowings. MLB rules at the time of Dodgers’ ownership change in 2012 gave teams five years to comply with a limit of borrowings of no more than 12 times revenues less expenses. Forbes estimates that the Dodgers have debt of $400 million. There are a lot of ways the Dodgers could work around this conundrum, but paying back some of its creditors would be part of the solution.

But that’s the Dodgers, whose $2 billion sale price annihilated the $845 million the Ricketts family paid for the Cubs in 2009 as the costliest team acquisition in baseball history. Most teams don’t have to repay debt, and they won’t.

Increased Dividend/Share Repurchase

These two strategies are related, as I’ll explain later. Dividends are payments companies make to owners of their stocks, expressed in cents per share. For example, McDonald’s shareholders receive a dividend of $3.76 per share–equal to about three percent of the share’s price–and the company has raised its dividend for 40 straight years. Dividends are an easy way for companies to transfer profits to their shareholders (although in a non-tax-efficient manner).

Companies also may use excess cash to buy back shares. This is a less direct way of transferring profits to shareholders, but it has the same goal. Say a company whose stock is selling for $40 per share has 10 million shares outstanding. If it spends $80 million to buy back two million shares, its share price, in theory, should rise to $50 ($40/share x 10 million shares = $50/share x 8 million shares).

NYU professor of finance Aswath Damodaran estimates that from 2011-2015, companies paid out 35 percent of their earnings in dividends and devoted an additional 54 percent to share repurchases. So dividends and share repurchases absorb a lot of profits.

Relevance to baseball: One of the reasons dividends and share repurchases are so popular with publicly traded companies is that shareholders clamor for them, since they put money in their pockets, either physically (via dividend payments) or on paper (via a higher stock price). Baseball teams, though, aren’t publicly traded. They don’t have to please fund managers and pension fund administrators and individual investors.

But that doesn’t mean they don’t care about their shareholders. They care about them a lot! It’s just that their shareholders are, well, themselves. Share repurchases aren’t really relevant here, and dividends can be tricky unless the tax consequences can be mitigated, but the idea of getting profits into the pockets of the shareholders is as relevant here as it is for publicly traded companies. If the clubs make more money, you can bet that ownership will work on ways to keep it for themselves, just as public companies work on ways to get higher earnings to their shareholders.

***

Note that in this discussion I didn’t include one possible use of excess profits: higher wages for employees. You and I can make a pretty good case that Mike Trout is worth something around $75 million per year, but that doesn’t mean Angels owner Arte Moreno is going to fork it over. He has no reason to. Nobody else is going to swoop in and lure Mike Trout away, so nobody has to pay him that kind of money. Similarly, Moreno can’t just hire a bunch of additional ballplayers; he’s limited by the 40-man roster and the 25-man active roster. And if for some reason baseball goes into an economic nosedive, Moreno doesn’t want to find himself in the same situation as his neighbors in Chavez Ravine. So there’s no impetus to raise salaries or headcount.

It’s true that when public companies experience higher-than-expected profits, their salary expense often goes up, but that’s often because the value of their employees’ profit-sharing and stock option plans goes up commensurately with profits and/or share price. But that can’t happen in baseball. Players and managers are not allowed to have a financial stake in the clubs that employ them. So there is neither the imperative for ownership to transfer cash directly to their employees, nor the profit-sharing vehicle to transfer profits to on-field personnel indirectly.

So what will the owners do with all the money they’re likely to make as a result of the new CBA? The same thing public companies typically do with a windfall: Tweak operations a little here, make some capital investments there, but for the most part, seek to enrich their shareholders who are, after all, the owners of the companies. For a company like Apple, for example, the shareholders are all sorts of entities, from grandmas to plutocrats, including the company’s biggest owners, which are index funds and pension funds that will help provide retirement income for millions of Americans. For baseball teams, they’re … well, the owners aren’t grandmas or index funds or pension funds. But you can count on baseball management being just as eager to enrich its shareholders as is Apple’s management.

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morro089
12/15
Does anyone know how arbitration discussions define the salary of a player? Is it just precedence or is cost of living and revenue accounted for?
mainsr
12/15
I'm no expert but my understanding is that it's all based on comparisons to other players. An outfielder is compared to other players, especially outfielders, with roughly the same numbers with roughly the same service time (e.g., a first year arb-eligible player is compared to other first year arb-eligible player, give or take exactly one year). And the numbers that get discussed are pretty basic. Specifically, the financial performance of the club is not admissible. It's all about selecting the appropriate comps. And old but good primer is here: http://www.baseballprospectus.com/article.php?articleid=3732
Grasul
12/15
It seems pretty straightforward that one form of capex for a baseball team is hiring more expensive players. It isn't capex in terms of depreciable assets, but certainly could be considered an intermediate term investment that potentially has revenue tied to it or has a different form of payoff structure (wins on the field). As a business, a baseball team has multiple goals, among them making money and winning games. I would think an analysis of spending decisions would need to account for these different but sometimes related goals, and investments contribute differently to different goals.
brentdaily
12/15
I desperately hope you're right and while it's true that you can't put a price on an eccentric billionaires ego and/or need to win the World Series, the CBA has real teeth for the first time with regard to the salary cap, er, luxury tax. Russel highlighted this in his recap, but the penalty isn't just times over the cap, but the amount you're over as well. And beyond money there are also draft ramifications. The point at which it doesn't make sense to spend the marginal dollar plus penalties effectively plummeted. I'm afraid the MLBPA got woodshedded.
mainsr
12/15
Grasul, I agree with brentdaily's summation of Russell's piece: The increased marginal cost of high payrolls creates an effective cap on payrolls. Certainly, a rising tide of team profits will raise the salary boats of the A's and Rays and Pirates, to pick three teams in the bottom third of salaries, enabling them to sign/trade for more expensive players or keep more of their own. Fair point. But will a high-payroll team like Detroit or Toronto pay more? It sounds as if they're headed the opposite way. And I can't see a team like the Red Sox suddenly bumping up their player salaries (except to lock in their Killer Bs and the like). So while I'm on board with you that the increased revenues will allow *some* teams to spend more, they'll be bringing their spending only up to the level of what their players would get elsewhere (e.g., Padres being able to afford to keep Jon Jay, albeit at about the same $8 million the Cubs are paying him). So I don't know whether overall payrolls would move up a lot.
Grasul
12/15
I don't disagree with you or Russell's base premise (the new CBA has strong disincentives to spending). Where I was going is the notion of capex in Baseball, which you explored some but I think is an interesting notion. When looking at free agent decisions as a theoretical owner, I do think the lens of intermediate length capex is appropriate. I "invest" $XX million for Y years in a player with an expected payout of Z additional wins. Those wins translate to playoff expectations and additional revenue, though of course the projection of these benefits get more tenuous as we pile on the assumptions.
mainsr
12/15
I think that makes sense. My friend @williamnyy suggested that player payroll is part operating expense, part capital expense. In the example you cited, you could almost do an ROI calculation where the numerator is wins (or their dollar equivalent). Good comments, thanks.
mainsr
12/15
Man, I am on a roll with typos. That should be @williamnyy23
Carosella
12/15
I enjoyed this unusual look. As an accountant who loves baseball, this was especially interesting to me and a good education for those without a similar background. However, you need to correct your math: "If a team has borrowed $100 million and reduces its interest rate by half a percentage point, it now has another $5 million in its pocket every year." This would result in a $500,000 a year savings.
mainsr
12/15
Aargh. This is why you CPAs make fun of us CFAs. I'll get that fixed. Since you're an accountant, do you sports accounting? the reason I ask is that I was thinking of Grasul's comment above. I have a vague recollection that when acquiring a sports franchise, long-term player contracts are a depreciable asset. Do you know whether that's correct, and whether they're depreciated for tax purposes or only amortized, like goodwill, for reporting purposes? If it's the former than I suppose there could be an argument that long-term player contracts could be viewed as capex, as Grasul suggests.
mainsr
12/15
*do you KNOW sports accounting
jfranco77
12/15
I think you might find some unexpected places to spend on M&A. I didn't think all MLB teams "owned" their minor league teams in the way that the Braves do. There's also local TV companies that can be acquired, stadium parking lots that can be pretty profitable, and other creative things to buy. If you own your TV station, maybe the money they "pay" for the broadcast isn't counted towards your revenue in quite the same way, for revenue-sharing purposes.
mainsr
12/15
All good points, thanks. The other advantage of owning a lot of separate entities is being able to shift around revenues and expenses in a tax- and operations-efficient manner. As for the minors, all teams own (and pay) the on-field personnel but you're right, nobody's been as good at getting taxpayers to pay for facilities as the Braves.
onegameref
12/18
Where does the cash go when those teams that have to pay luxury taxes pay them? Does MLB get to squirrel it away? Does it get allocated out to the low spenders? Does revenue level affect the allocations? I am curious since I recall a time where the A's and Royals, for example, had to spend more on payroll because the Yankees and Dodgers were cutting them annual checks. Does that continue these days?
mainsr
12/18
Huge caveat up front: I don't know whether what I'm about to say changes under the new CBA. That's a big deal. That being said... Of luxury taxes collected, the first $2.4 million funds current player benefits. Of the remaining amount, another 25% funds current player benefits, 25% (plus accrued interest) is earmarked for the Industry Growth Fund, which develops baseball internationally, and 50% (plus accrued interest) funds player benefits long-term. So this isn't redistributive from big spenders to small spenders. However, the beneficiaries are, ultimately, the clubs, since the programs that the luxury tax funds are obligations that the teams would have to pay anyway. (OK, in theory, maybe not the Industry Growth Fund, but come on, it's not big dollars and with the new international signing rules, there's the potential for a huge ROI.) So the best analogy I can think of is that this is like increasing taxes on the rich in order to give all taxpayers a $100 rebate (including the rich ones). It's not take from the rich/give to the poor, it's take from the rich/give to everybody. Or, if you prefer, it's not from each according to his abilities/to each according to his needs, it's from each according to his payroll/to each regardless of his needs. In theory, then, by defraying teams' benefits and development obligations, it frees up money for other purposes, including player salaries. But it frees up the money equally for all teams.
aussieyank
12/19
Regardless of the categories, I think they could increase the salaries of both minor league players and non-player staff. If you want to compete for athletic talent with other sports, be competitive, don't exploit peoples love of the game or dreams by expecting people to work for minimum wage or less while other sports are offering college educations or overseas contracts. And they seem to have caught on that having quality employees is worth the investment in coaches, scouts, etc., so keep going with that. Or they could make their products more affordable and accessible to their consumers (lowering ticket prices for a start, or better tv watching options). We always hear about how much they want to compete with other sports for fan attention, and they continually add obstacles to watching.
mainsr
12/19
Fair point about minor league player salaries. But is baseball losing out on multi-sport athletes because minor league pay sucks? The best amateurs, of course, get big signing bonuses, and my sense is that there aren't that many multi-sport athletes out there anyway. But yes, if there's a talent drain to the NFL and NBA because of the allure of college scholarships vs. riding buses and eating at McDonald's, I agree with you. Kate and Russell have done a good job explaining why the low salaries (if any) paid for front office positions contributes to a lack of diversity. Basically, the only kids who can take the positions are those who come from money, which is a built-in barrier to nonwhites. I know a guy who used to work for a baseball team, and it's not just the analytical staff and aspiring front office personnel who are underpaid relative to other industries, it's everybody. (If I were, say, a payroll clerk, and had the choice of making $X for a mid-sized business in town or $X/2 for a baseball team, there's not way I'd choose the baseball team, but it appears that there are lots of people who aren't like me.) I think that teams feel that if they can get away with that, great, but they're not considering the consequences of the resulting homogeneity. There is no way that baseball teams will lower ticket prices. As was pointed out on Effectively Wild recently, if a team dropped ticket prices from, say, $50 to $30, people would buy tickets for $30 and resell them on the secondary market for $50, so there'll be no change in price for fans. If the market price for a ticket is $50, it makes more sense for teams to get the full $50 than to share that with scalpers and StubHub. The market determines ticket prices in the end, not teams. (That's the rationale behind dynamic pricing.) The only way ticket prices will go down is if people stop going to games. That's not owner greed, that's economics.