December 16, 2016

Flu-Like Symptoms

Will the Owners Actually Spend Their Money?

by Rob Mains

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.

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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.

Rob Mains is an author of Baseball Prospectus. Follow @Cran_Boy
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