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.

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Shawn Hoffman writes about business and baseball at Squawking Baseball.

Shawn Hoffman is an author of Baseball Prospectus. 
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