On Bubbles (and I don’t mean that dude from The Wire)

A Navy buddy of mine named Billy Gamble recently asked if I thought there would be a lockout that would affect the 2011 season.  He couched the question in terms of his own outrage with paying $8 for a beer, and I think that's a fairly common and reasonable fan reaction:

I spend a lot of money on football, so what the hell is the problem?  Why would there even be talk of a lockout?  Isn't there enough money coming in right now for everybody to get a fair piece?  I mean, come on, 8 freaking dollars for a beer?

The short answer is, no, I don't think there will be a lockout that causes any games not to be played.  It's possible-to-likely, though, that a lockout occurs which delays the start of the new NFL year, and makes things which are normally orderly, like free agency and offseason workouts, a bit chaotic.

I decided that I'd talk extensively today about NFL economics, and move from that into a discussion about the real issues in this collective bargaining negotiation.  As usual, my assumption is that my readers are smart enough to understand all of this, but I realize that there may be some detailed questions which you may have. I'll be glad to answer those in the comments.

First, let's talk about some accounting concepts, at a really basic level.  This is obviously what I do for a living, and it can get very complicated, but, for now, I'm only going to touch on stuff which frankly everybody should understand, and which a shocking number of people misunderstand.

The first key term is revenue, which is the top line of any income statement.  Revenue simply means gross income received for goods and services.  The $8 for the beer, the $200 for the ticket, and the $1 billion that DirecTV pays each year for Sunday Ticket rights all end up as revenue.  All current-term and future cash inflows related to business operations become revenue.

Next, we have operating expenses, which are just what they sound like.  Any cash cost of doing your business is an operating expense.  The major operating expense is player and coach salaries, but we're even talking about things like office supplies, and re-painting the lines in parking spaces.  All current-term and future cash outflows related to the business, in other words, are operating expense.

Finally, we come to operating income, or as it's sometimes alternatively called, earnings, or operating profit.  The very simple equation is Revenue – Operating Expenses = Operating Income.  It gets a bit more complicated than that, and we'll necessarily circle back to it eventually, but for now, just understand it as R - O E = OI.

This may seem basic, but almost no sportswriter from the journalist wing seems to really understand any of this.  They also seem to fail to grasp that corporations mostly own sports franchises, and, in the legal sense, not the individual people who own those corporations.

On Saturday night, SI baseball writer Jon Heyman tweeted the following:

I replied back “Future Revenues?” to his question of “wheres (sic) $300M for albert coming from?”  (I pronounced “Future Revenues?” roughly as  “you f$%ing idiot!”)  Of course that’s the answer.  For one thing, when a team signs a guy to a 10-year, $300 million contract, they don’t have to have $300 million in cash on hand today.  That’s really basic, and even Heyman should know that.  Even if the Wilpons eventually don’t own the Mets, a well-managed baseball team in a 19-million-person metro area can afford a $30 million player, if they decide that that’s the direction that they want to go in.

For another thing, Heyman seems to totally misunderstand what’s going on, which isn’t really new.  The Wilpons, personally, and their Sterling Equities real estate company, are getting sued by the trustee in the Madoff case.  The thrust of it is that they invested with the crook for years, and the fact that they made a net $48 million in the scheme could make them liable to those who lost money, for amounts which could ultimately be many times that.  (I don’t know how that makes any sense, unless it can somehow be proven that they were bad-faith actors, and were complicit in the scheme, but the law is the law.)  The trustee can’t directly sue Sterling Mets, Incorporated, because that corporation wasn’t an investor in the Madoff fund.  In any case, the Wilpons and their affected companies are apparently negotiating a settlement with the trustee, which is presumably the reason that they're liquidating some of their equity in the team.

It’s better to get some cash together now than to have to try to do it quickly next year, under duress, because they need to come up with $300 million in cash tomorrow.  In the first article I linked to in the last paragraph, the writer, Mike Lupica (who I can't stand) makes the salient point that the Wilpons will still own 75% of the team if they sell 25%, and that that would bum them out.  The Steinbrenner family only owns 32.9% of the Yankees, just like nasty old George did.  It's all a matter of perspective, really.

Sterling Mets is a separate legal entity, with its own revenues and expenses, and if its management deems it prudent to pay Albert Pujols $300 million over 10 years, as part of a $150 million-or-so annual player salary budget, then that has absolutely nothing to do with the Wilpons’ personal cash situation, unless the revenues of the team suddenly take a massive nosedive, and they have to start making additional cash contributions to the team.  In other words, under present-day circumstances, they’re in the business of taking money out of the team, not putting any more in.  If you’re getting $220 million in revenue, and spending $190 million in total expenses, (which are probably both in the right ballpark), you’re making a fairly nice profit, for a baseball team. 

For the record, as a Mets fan, I’m all for the incompetent Wilpons selling some/all of the team, and separately, I highly doubt that the team’s current baseball management would deem such a large Pujols contract to be prudent. That’s not close to the same thing, though, as Heyman saying that they can’t afford Pujols because the Wilpons want to sell a 25% stake in the team.  If anything, judging from some of the names flying around, like Glaceau founder/billionaire Mike Repole, the new minority partner makes the organization more financially stable, and more capable of paying out big contracts, not less.  But hey, this guy is using logic, and the rest of us are the idiots, right?

This is a key concept to take away for the rest of the discussion.  Corporations generally own sports franchises, and the money that gets spent to operate these businesses is typically not paid by personal check from the owner of the corporation.  It’s not literally coming out of Pat Bowlen’s pocket, as much as the Denver Post would have you misunderstand otherwise.  The Broncos, or any other NFL team, are taking in more money from their discrete football-related operations than they are paying out.  If they aren’t, in a rare month or year, they’re almost certainly drawing against cash reserves that they retained from prior periods, or borrowing the money short-term with commercial paper.

How Much Is My Lemonade Stand Worth?

Let’s  think for a minute about the value of a business.  How do you know what to pay when you want to buy one? Well, the answer is that in every industry, there's generally a standard multiplier based upon a measure of earnings called EBITDA, which we'll come back to.  (There are other approaches based on Free Cash Flow, as well, and you'd ordinarily look at valuation several ways, but in this case, I don't have the information necessary to calculate FCF.)  This is assuming that the business has earnings, of course.  (Sometimes money-losing businesses are practically given away for free, in exchange for the assumption of liabilities by the acquirer.  You even sometimes see the seller paying out cash to the acquirer to make a deal, which is kind of wild, if you think about it.)

In any case, every team in the NFL is currently operationally profitable on an ongoing basis.  I can tell that from reading the last few years of Forbes' annual valuation of the 32 teams.  There's been some propaganda put out by the league which obliquely suggests otherwise, and that has been parroted without investigation by credulous hacks like SI's Dom Bonvissuto, but it's almost certainly based upon an accounting trick.

To illustrate this, we have to get deeper into the income statement, and explain what EBITDA means.  It stands for Earnings Before Interest, Taxation, Depreciation, and Amortization.  It is literally Operating Profit, and the reason you strip out those other elements is that valuation only matters to selling an asset, and Interest, Taxation, Depreciation, and Amortization aren’t germane to a potential buyer’s decision to purchase the assets or not.

Interest is a function of the way that the business is financed, and that will vary widely based upon corporate strategy, and other factors.  When a business is sold, it’s often as an Assets Transfer, and the seller’s debt doesn’t generally go with it; the proceeds of the sale are used to retire the existing debt, and the seller keeps the leftover cash.  The buyer then borrows new money (or not) as part of their own financing scheme.  (It should be noted that sellers mostly prefer stock deals, where liabilities do go with the assets, as it's often favorable from a tax perspective for them.)

Taxation is very manipulatable, and ends up being wildly variable across different companies, based on their strategy, and whether they have other money-losing units, to bury their earnings against.  I’m nowhere near an expert on tax, but just take my word for it.  There are a lot of smart nerds out there getting paid a lot of money to figure out how to best avoid paying taxes, or defer paying some to next year, to the maximum extent possible.  In general, the marginal tax rate is 40%, with 35% going to the federal government, and 5% to the state.

Depreciation and Amortization are the expensing over time of long-term assets, and with non-public companies, there are a lot of ways to do this favorably in your financial statements.  For example, there’s a method that’s allowable for tax purposes called Modified Accelerated Cost Recovery System, usually abbreviated as MACRS, which is pronounced like Makers.  Under MACRS, if you have an asset with a 5-year life, you would depreciate 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76%, respectively, over six accounting years.  That doesn’t make sense in the context of how the capability of an asset degrades over time, but it’s allowed for tax purposes.  That’s in contrast to the straight-line method, which does make sense, and depreciates 20% per year for five years, period.  (That’s how publicly traded companies are required to book depreciation and amortization for SEC financial reporting, but they can use MACRS on their tax books.)

The point is, with all this stuff, you can do things to either maximize or minimize your expenses, and thereby manipulate your reported net income.  When you’re doing your taxes, you want your net income to be low.  When you’re reporting to your investors, you want it to be high.  Nearly all large companies, therefore, keep two sets of books, for that reason.  (Yes, it’s legal, and in some cases, it's required.)

So, if businesses are mostly valued as a function of EBITDA, and EBITDA is what Forbes is publishing for each team every year, how can a team best cry poverty when it wants the union to make concessions?  They can use accruals and reserves, and I’m sure that these teams do so pretty liberally. 

Let’s go back to our friend Operating Expense.  You pay out player and coach salaries, and a check gets written, which is a reduction in cash on hand, and an increase in expense.  You get your electric bill in the mail, and you have 30 days to pay it, and that’s an increase in a liability (money you owe, and will pay in the future), and an increase in expense.  That’s pretty simple, right?

An accrual is used for situations where you know that an expense has been incurred in the current period, but you haven’t received an invoice yet, and you may not know what the exact amount is, so you estimate.  You haven’t received your electric bill yet, but it was $50,000 last month, and you expect that it will be roughly the same this month.  You accrue a liability of $50,000, and increase expense by that amount.  When the bill comes in next month, you reverse this month’s accrual against the actual expense, and it should net out close to nothing, depending on how accurate your estimate was.  Every accrual-based business does this as part of their financial close exercise, every month.

A reserve can similarly be set up, and is conceptually like a long-term accrual.  It’s typically called a contingent liability reserve.  If a company is being sued, for example, and they think they might lose, they’ll often set up a reserve in the amount that they think their financial exposure is.  If they think they’re liable for $10 million, and that it’s likely that they’ll have pay it out in a year’s time, they’ll reserve $833,333 per month for 12 months.  That becomes Operating Expense, and it reduces EBITDA.  If, a year later, they ultimately win the lawsuit, their expense is reduced by $10 million to clear the reserve, and their EBITDA goes up by that same $10 million.

Reserve accounting is very tightly controlled in publicly traded companies, if you’re talking about any serious amount of money, to prevent any monkey business with it.  You can read Statement of Financial Accounting Standard No. 5, published in March 1975, if you want to get into the arcane details.  See you in about 100 pages.  Basically, if you make these reserves of contingent liabilities in a public company, you have to disclose a lot of information about them in the footnotes of your financial statements, and you have to justify the reasoning behind your assumption around the probability of loss that you’re reserving for.  Auditors look really hard at these reserves, and there’s no great way to use them to manipulate earnings, if a real, demonstrable contingent liability doesn’t exist.

Think, for a moment, though, about a professional football team.  They are not publicly traded, and therefore, don’t have to follow Generally Accepted Accounting Principles (GAAP).  They can basically set up a reserve for anything they damn well please, and reduce their reported earnings accordingly.  I could give you outlandish examples, but how about a Reserve for Potential Losses Due to a Future Work Stoppage? 

A team could decide at the beginning of a CBA that they’ll potentially lose $100 million at the end of the period, if there’s a lengthy work stoppage.  Over a 5 year period, if they reserve $20 million per year, their EBITDA goes down by that amount.  They still have the cash, of course, but they’re not reporting earnings on it.  If they were public, they’d have to reserve based upon a defensible probability of that stoppage happening, and they’d have to disclose everything.  If there’s a 5% chance that they’ll lose $100 million, they can get away with reserving $5 million.  As a private company, they can treat the probability as 100%, and reserve the whole $100 million, and not tell anybody about it.  I’m speculating on this, obviously, but I’d be shocked if it wasn’t going on in a widespread way.

The teams can then go cry poverty to the union, and say that they’re barely making any profit, and the union has to just accept that statement, or not, because the NFL doesn’t make any of its books available to the union or to the public.  (The Packers’ books are available to the public every year, because they’re publicly owned.)  It’s clear, if you read the Tweets of people like George Atallah or Joe Briggs, the union isn’t buying it, and I don’t blame them.

For this purpose, we’re going to have to assume that the NFL is being completely honest about what they’re telling Forbes that each team’s Revenue and EBITDA are.  We’re going to trust all of their numbers, because it’s clear that Forbes does, and that publication has some credibility, for the moment, until I raise some questions below, regarding their analysis. Of course, nobody would buy a team that wasn't audited by a reputable firm, but that costs money.

NFL teams are certainly not losing money, they’re just not making enough.  This will surely be the most incendiary section of this article, but somebody who really understands finance needs to say what I’m going to say, and I’ve never seen anybody else put this thought in writing, so here goes. 

NFL teams are tremendously overvalued, based upon their reported earnings.  There’s no question about this, as much as NFL people are going to strenuously object to me saying so, if/when they come across this article.  (I suspect that they will; for having always written for small/growing blogs, my work seems to have a way of finding its targets.)

As I briefly mentioned about an hour ago, (depending on your reading speed, and how much you’ve been getting distracted), businesses are generally valued at between 5 and 15 times last year’s EBITDA, depending on the industry they’re in, and some other factors.  If there’s a reason to think that EBITDA will be more flat, year-after-year, you’ll get less of a multiplier.  If there’s a reason to think that it will grow rapidly, over a 5-7 year horizon, you’ll get a higher multiplier.  (Example:  EBITDA was $10 million last year.  A reasonable forecast shows it being $20, $25, $40, $40, and $50 million over the next 5 years.  For that kind of expected growth, you could get something like 15 time last year’s EBITDA.)  This is oversimplified, on purpose, but generally, you’re looking for a realistic path to paying back the purchase price, with operating earnings, in 7 years or less.  If you can’t do so at the market price, you don’t make the purchase.

Check this out, and get ready to be shocked:

The whole NFL, as represented by its 32 teams, has a value of almost $33 billion, according to Forbes.  It had an aggregate EBITDA of $1.07 billion last year, also according to Forbes.  That means that it’s being aggregately valued at 30.54 times EBITDA.  The column on the right is my simple analytic for each team’s EBITDA multiplier, and some are more reasonable than others, obviously.  I had never analyzed this before, at a macro level, so I was shocked when I ran these numbers.

I called my dad, who’s a longtime defense industry executive, because before I made this bold statement, and got some people mad at me, I wanted to be sure that I was thinking reasonably.  Your dad is always the guy who will tell you when you’re not, especially when he knows a lot more about this stuff than you do.  I asked him, is this crazy, that Forbes is saying that these teams are worth this much, and that buyers seem to be willing to accept these valuations?  I didn’t get the sense that he realized how these numbers look, offhand, but he quickly said it was complete lunacy, and the more I’ve thought about it, I just can’t imagine how it could be anything other than that.

Ponder this.  Where is there room for significant revenue growth with the NFL?  They’re as saturated as they can possibly be in the United States, and they’ve been failing for years at materially growing interest in the game beyond this country.  Their advertisers are all from fairly stagnant retail sectors like beer, jewelry, and automobiles.  It’s not like the networks can squeeze them that much more for higher fees, and thereby pass significantly more revenue through to the NFL.  The NFL can get some of their current customers to pay for new services (I’d be all over coaches film being made available online, for example), but that’s not going to be nearly significant enough to justify a 30X multiplier.

Like every retail sector in the United States, they’re being hurt by the fact that inflation-adjusted household wages have been pretty stagnant declined since 1980, (h/t to Chibronx) despite an ever-rising cost of living.  For a generation, families adjusted to this by sending mom to work, and letting kids grow up in day care, and then work the latch-key, but now there’s nobody else they can send to work, and people’s ability to spend money on non-essential goods and services is being squeezed.  They can’t grow their earnings through normal operations, and neither can discretionary service-providers like the NFL.

We can’t ostensibly do much for NFL revenue, at least under the current operating model, so what about the other part of the income statement?  On the expense side, there’s limited opportunity as well.  You can’t offshore your production to Guatemala or Malaysia, so you can pay your workers $3 per hour in this industry.  You can fire your website guy every couple years, as he starts to get paid too much, and you can go lean on secretaries, and ticket staff, and do less with less, (nobody actually does more with less), but those measures don’t make a major dent.

To a large extent, given an unchanged operating environment, your revenues and expenses can only be forecasted to stay relatively stable, and therefore, your EBITDA will also be relatively stable.  I’d never pay more than seven times EBITDA for a business that profiles like that.  A buyer is certainly going to make some operating income, but it’s not going to be nearly enough to justify what Forbes says the team values are. 

Over-Levering (No - It's Not In The Kama Sutra)

Some of you are no doubt thinking that there are intrinsic, nonfinancial side benefits at play, which raise the value beyond what the earnings profile says it should be.  Everybody thinks it would be cool to own a football team, and you get to be a Big Swinging Richard around town when you do.  You have a good chance of getting your name in the paper all the time, and that’s fun.  Fame has value, right?

I say it doesn’t have all that much value.  Maybe it gets a "reasonable buyer" to go to 10 times EBITDA, at the absolute most.  I’ll put it to you like this.  Let’s say that Pat Bowlen decides to sell the Broncos in the next few years.  He has to get $1 billion for the team, because Forbes says that’s what they’re worth.  If he can’t get that price, it will fundamentally affect the valuations of the other 31 teams, so he can’t take a discount.  It’s kind of like how you get pissed when somebody sells their house 25 grand too low, two doors down from you.  Your house value just dropped, and it’s like, thanks a lot, jerk!  Well, in the NFL, nobody is going to get pissed; they’ll just decline to approve the sale, as required by the NFL charter, and probably leak a hit piece about the owner to Jason La Canfora, saying that the selling-low owner is senile.

Bowlen wants $1 billion, and he’ll probably get it, and be a winner, but that buyer is a sucker.  The aggregate NFL-wide debt-to-crazy Forbes value ratio is presently 17%.  The New Guy will probably lever up to 30%, which is as much as the NFL allows for a buyer of a new team.  (The word leverage, and other forms like lever, simply means debt.)  That means he’ll borrow $300 million.  Let’s say he has to make bond payments of 7.5% of that per year.  That’s $22.5 million per year, and remember, that comes after EBITDA in the income statement. 

The Broncos’ EBITDA was only $22 million last year, and we expect it to be relatively flat, so suddenly, by dramatically overpaying for this football team, the New Guy is actually losing money.  The company isn’t making enough income to pay its debt obligations.  Even beyond that, let's say that the Broncos improve their EBITDA to something like $35 million, which seems like it could be feasible.  When the $22.5 million goes away, and you pay 40% income tax on the leftover $12.5 million, you're left with After-Tax Net Income of $7.5 million.  If you divide that $7.5 million into $700 million of equity ($1 billion of value minus $300 million debt), your return on equity is only 1%, which is unacceptable to any business.  If you pay 45 times EBITDA, that’s what you get, sucker. 

I live in Cleveland, and this is what happened to the Cleveland Indians.  Cleveland is definitely a Browns town first, and people mostly only go to Tribe games when they’re competitive.  Throughout the 90s, the Indians did a good job of developing and keeping young talent on reasonable deals.  This is a mid-sized market, with about 3 million people in the metro area, so it should support a mid-sized payroll, and it did during those good years, when people saw a product worth going to games for. 

Dick Jacobs (the winner) had bought the team in 1986 for $35 million, and he sold it in 2003 for $323 million to Larry Dolan (the sucker).  Larry is part of a tremendously wealthy family, and his nephew James owns the New York Knicks and Rangers, but Larry wasn’t really all that personally wealthy, and he needed to lever way up in order to overpay for the team. 

When he did, he had to immediately and dramatically cut costs to pay his debt service, and the team has resultingly gone to hell, except for one playoff season.  Nobody goes to the games, and the franchise is a big loser, whose only hope to making any money is developing a bunch more young, cheap indentured servants within MLB’s draconian arbitration-driven system.

Dolan’s solution was to slash payroll, and go all baller on a budget.  He had, and has, that option, but the New Guy in Denver really wouldn’t.  Because the NFL shares so much of its revenue, it has had both minimum and maximum player payroll expense thresholds since 1993.  The two amounts aren’t generally all that far apart, so being a cheapskate isn’t a very viable option, over any long-term horizon.  It’s a bit like being Greece (or Ireland… or Portugal… or Texas).  You’re struggling financially in a massive way, but you don’t have your own currency, so you can’t devalue it to drive exports, and prop up your economy.  You’re hostage to a larger system that would be good for you, if only your circumstances were better.  Unfortunately, you’re over-levered, and there’s no very good answer for what to do, when your revenue and expense streams are pretty much fixed.

If you look at this chart, several teams appear to be in this losing-money-after-interest situation right now.  The Giants and Jets are buried under a bunch of debt because they had to self-finance their new stadium, and I would speculate that these numbers don’t necessarily reflect what future years will look like.  I suspect that both teams probably took a lot of stadium-related expenses to current-period income, rather than creating a depreciable long-term capital asset from them.  I’ll be curious to compare next year’s Forbes numbers against this year’s, but if they’re each going to be losing something on the order of $50 million per year, after interest, they’re in a world of ongoing financial trouble.

The Lions are unusually heavily leveraged, and they also have an operating loss, which appears to stem from having the lowest revenue in the whole NFL, at $210 million.  Detroit’s player expense was about $1 million below average, and their total operating expense was middle-of-the-road, as well.  The Vikings and Raiders show minimal losses, with the Raiders having a higher-than average player cost, by $16 million.

The Dolphins are most applicable to our Broncos example, because their sale from Wayne Huizenga to Stephen Ross was the most recent NFL team to be sold to a new owner.  (Stan Kroenke was a longtime minority owner in the Rams, with a 40% stake, and he bought the rest of the team from Chip Rosenbloom and Lucia Rodriguez in August 2010.)  Ross paid a total of $1.55 billion for a 95% stake in the Dolphins, along with ownership of the stadium, and the land surrounding it.  It’s a little bit opaque exactly  how much was paid for the team, and how much went for the stadium and land, but we know from Forbes that the team is carrying $400 million of debt, which is about $50 million more than any team that didn’t just build a stadium in New Jersey.

It’s clear that the Dolphins are significantly over-levered, and the simple reason why is that Stephen Ross overpaid greatly for the team.  The earnings from operations don’t support the debt service obligations, and probably never will.  Wayne Huizenga is the winner, and Ross is the sucker.  Everybody who presently owns an NFL team would undoubtedly like to someday find their own sucker.  As the Dolphins continue to fail to make enough money to be profitable after interest expense, the word is going to get out to that effect, and team values are going to be viewed much more pessimistically.

The NFL is, today, the functional equivalent of the California real estate bubble of the early to middle 2000s.  Do you want to know how you know if your home is overvalued?  There’s a really simple way to figure it out.  Find out how much you could rent it out for, per month, and then multiply that number by 12 to get annual gross rentals.  The rule of thumb is that you should buy a house at 10 times annual gross rentals, and sell it at 20.  The houses in some parts of California, like Los Angeles and San Francisco, were trading at 35 to 40 times gross rental, right up until the crash in 2007.  That is lunacy, just like buying a modest-growth business at 30 times EBITDA is lunacy.

Shilling and Zinfandeling

I’m far from the only guy who understands this, of course.  There were a lot of people who understood that California (and Nevada, Arizona, and Florida) real estate was obscenely overpriced, and a precious few even said so publicly.  They were drowned out by the raucous sounds of all of those people enjoying the party.  Americans are suckers for happy stories

Forbes is supposedly a journalistic enterprise, but in this case, I can’t see how they’re acting as anything more than a propaganda tool for the NFL.  If you want to sell a new line of yacht, you advertise it in the Robb Report, and wealthy people will hopefully want to buy it.  The NFL wants suckers to believe that its average team is worth $1 billion, so they’re essentially advertising in Forbes.  The magazine benefits from being the only source which annually receives and reports these numbers.  There may very well be some financial data that Forbes is looking at, which I don't have, that justifies their valuations, but if that's the case, why aren't they sharing that data?  Forbes is saying that 32 teams which clear EBITDA of $1 billion are worth a total of $33 billion.  At the most simple level, I can say that that is patently ridiculous.

Simply put, the NFL needs to generate more profit to narrow the gap between what the franchises are really worth, and what Forbes says they’re worth.  That is the one sentence distillation of this whole CBA negotiation, and the NFL’s reason for the obvious urgency behind it.

You sure don’t want to be the guy who recently paid 40 times gross rental or 30 times EBITDA when the bubble bursts.  There are undoubtedly smart people working for the NFL who recognize what’s happening here, and I’m here to tell you, that’s 100% what this upcoming labor fight is about. 

After All That, Finally, Talk About The Lockout

Some of you may have been looking forward to this article, just based on the current events discussion around the possible impending lockout.  Like Ford Fairlane told his two blonde lady-friends, you got the bonus plan.  To set the stage, we’re going to talk now about the NFL and the Player’s Association, and how this is not the typical Labor vs. Management situation, that many of us have been part of, on one side or the other.

First, let’s talk about the operating structure of the NFL.  The NFL operates as a cartel, which is a business term that has come to have a decidedly negative connotation, due to its prevalence in the illicit drug trade.  Many people actually think that the word cartel means ”gang of thugs who sell drugs”, but that’s not the case.  

A cartel is a formal agreement between competing firms to fix prices, marketing, and production, and generally, to compete in a cooperative manner, as counter-intuitive as that is to Americans raised on free market concepts.  Along with the drug organizations from Colombia and other places, another prominent example of a cartel is OPEC.  They meet regularly, mainly to set production levels, and thereby, to manipulate oil pricing by controlling supply within a forecasted demand environment.

In America, this sort of collusion is more than frowned upon; it’s patently illegal, per the Sherman Antitrust Act of 1890.  Since 1914, only two industries have had blanket antitrust exemptions.  The more famous one, professional baseball, lost its full exemption in 1998.  The other, the health insurance industry, still idiotically and unnecessarily has its blanket exemption, to the clear detriment of consumers, even after the passage of the Affordable Care Act last year.  (The House of Representatives voted to rescind it, but there were too many Senators, both Republican and Democrat, in the industry’s pocket for the Senate to be able to do the same.)

So, I know what you’re thinking.  If cartels are illegal in the United States, how do sports leagues get away with it?  Well, I took HR Management in my MBA program at Cleveland State University’s James J. Nance College of Business last semester, and this is something that I learned during that class.  My professor, Egdilio Morales, is a longtime labor relations attorney on the employer’s side, and I asked him what the noise around the NFLPA electing to decertify was about, and if that was a feasible strategy for other unions.

He explained that the way that the NFL, and other sports leagues are able to legally operate as cartels is due to a Non-Statutory Labor Exemption, which was judicially derived from the Statutory Labor Exemption, as passed in the Clayton Act of 1914.  It’s a bit complicated, but the one-sentence version of this is that collective bargaining agreements between unions and management can’t be scrutinized for antitrust violations, provided that negotiations between the two parties were conducted in good faith by both sides.

The implication is that a sports league and its associated union are partners, and by agreeing to conditions which form monopolistic practices, the unions actually allow the leagues to operate as cartels.  Again, exemptions are granted to the unions, not to the management, and in effect, the unions agree to share those exemptions with the management entities. 

The Supreme Court held in 1997 that contract-based exemptions continue after the expiration of collective bargaining agreements, and through all labor actions, while a new negotiation is conducted.  The sports union’s ultimate weapon, in the case of an impasse, is to simply decertify their union, thus taking away the league’s ability to legally operate as a cartel.  The union’s existence is specifically what allows for things like player drafts, salary caps, franchise and transition tags, and restrictions on free agency, so the NFL, or any league, has no appetite for a decertification fight, which could plunge their business model into chaos.

The leverage that this gives sports unions is unlike anything in regular trade unions in the United States.  If you’re an assembler at a Ford plant, and your union strikes, Ford is permitted to replace you with new employees, and you’re not necessarily entitled to ever get your job back.  (You get preference for rehiring, if your replacement ever leaves.  If they don’t, you’re SOL.)

For that reason, and others, you never really see long labor actions anymore in America.  The field has basically been tilted dramatically toward management over the last 40 years or so, and union membership has shrunk across the country, due to a confluence of pro-business legislative changes, very successful (and always illegal) union-busting activities, and anti-union propaganda campaigns.

In this case, it's my expectation is that negotiations are going to heat up very soon, in advance of the March 3rd expiration of the current CBA.  The posturing by both sides is definitely already ratcheting up, with the NFLPA having produced a commercial to be run during the Super Bowl, preemptively putting the blame for any work stoppage on the NFL, and CBS having now rejected the ad

The NFL, or a sympathizer, is leaking stuff about how DeMaurice Smith isn’t acting in the best interests of the league to Pro Football Weekly.  It’s all about his political career, apparently.  (PFW is notorious for letting its friends shamelessly (and anonymously) grind axes, but still, people read it.  And yes; I went there.  Parentheses within parentheses.  That’s what’s up.)

Posturing in advance of serious negotiations is standard in all CBA expirations, of course, and I’m not reading anything into any of it.  It’s also standard that neither side particularly wants to negotiate for real, until close to the last minute.  This is a zero-sum game, and both sides are going to take some small wins and small losses.  The union is going to claim victory, as always, once an agreement is reached, and the NFL is going to be silent and let them do so, like all management entities always do.  (The agreement reached by the union’s negotiators still has to be ratified by its 1,500 or so members, and it’s a lot easier to negotiate on behalf of 32 people, and feel confident that they’re satisfied, than it is for 1,500.)

Speculative Analysis (Is That An Oxymoron?)

This is all very predictable, but what isn’t as predictable is what package of conditions ultimately gets an agreement done.  I have some thoughts on it, but of course, I’m doing what we’ll call speculative analysis.

Currently, the NFL publicly claims that the players get about 60% of all revenues.  That’s demonstrably untrue, as George Atallah pointed out in his letter to NFL reporters.  They get less than 60% of some revenues, after some credits for defined expenses are backed out.  Atallah says those credits total around $1 billion per year, and while I have no way to verify that, based on my analysis, I find it very plausible.  We refer back to our Forbes numbers, and we find that the players got 56% of all team-based revenues.  I would venture to guess that the NFL, as a separate and distinct operating unit (in the form of NFL Network, NFL Properties, and other businesses) had another $1 billion in revenue on top of the $8.016 billion that the teams made from their operations.  That takes us down to right around the 50% of total gross revenue that Atallah said went to the players.

The NFLPA isn’t likely to get any real wins in this round of negotiations, in terms of percent of revenue.  The NFL is determined to grow their revenue, by adding two regular season games to the schedule, and getting rid of two preseason games.  Remember how I asked how the NFL increases revenue?  That’s the only way they can do so in the short-term, by increasing quantity.  I expect that they’ll soon add one more playoff game in each conference, too, by adding a third wildcard qualifier.  Playoff games are very profitable, because the players get very little extra pay for playing in them, and incremental gate receipts are very high for the teams playing in the games.

The 2 extra playoff games and the 32 extra regular season games are going to have to be added to the NFL’s existing TV contracts, which will undoubtedly add more revenue for the NFL, since the networks can ultimately sell more advertising.  The NFL is going to want to keep as much of that incremental revenue as possible, so that it can flow straight through to Operating Income.  (They were going to play preseason games anyway, so the logistical expenses that go with holding a game, and travelling to it were already going to be realized.  Actually, travelling 53 or so players rather than 75 or 80 is likely a minor money-saver.)

I’m sure that the NFLPA knows that they’re going to eventually have to accept the additional games, because finding more profit is an absolute must for the NFL, as we’ve discussed.  The union is clearly in a defensive posture, and their challenge will be getting all that they can of the incremental television and gate revenue for the two games, while maintaining the status quo on the other 16.  (On Monday, Judy Battista of the New York Times wrote a similar thought, that the NFLPA has quietly accepted the 18 game schedule.  Her article is pretty solid, and worth reading, although it's over-focused on short-term issues.)

Chances are, whatever incremental revenue that the NFLPA gets will come in the form of additional roster spots, to make up for injury-based attrition during the longer season.  I could see rosters move from 53 to 57 players, and active rosters go from 45 to something like 48.  NFL players actually miss a much smaller percentage of games due to injury than the players in any other major sport, so I don’t get too worked up about the rhetoric around increased injuries.  I basically consider it to be posturing, in the interest of taking some of the new revenue on the deal.  In the case of Peter King constantly worrying about it in print, I consider it to be him being a credulous fool, as usual.  (Good Heavens!  What if Tom Brady is hurt during the extra two games?  Again… What do you mean the NFL went on just fine without him last time?  And that he was injured in the first quarter of the first game of the season?  That’s not how I remember it!  Where’s my microbrewed maple nut crunch black and tan venti cream ale grande stout latte to take with me on the Acela?)

I suspect that a rookie wage scale will almost certainly be part of the deal, because both sides want it.  The only constituency which doesn’t is the agent community, and they’re not represented in these negotiations.  It will probably be something like what the NBA does, where the first 2 years are guaranteed at specific slot-driven salaries, with no signing bonus, and the team has options for years 3 and 4.  After the 4th year, or if a team declines years 3 or 4, the player is an unrestricted free agent, and eligible to sign for real money, once they prove they can play. 

You know who’s going to love that?  The largest free agent class ever, who will hit the market once a new deal is signed, and who suddenly will have more total money available to them, since much less will have to be encumbered to pay rookie contracts.

Agents will hate it, because it basically makes them worthless until after a guy has been in the NFL for 4 years.  If I were a rookie coming in under such a system, I wouldn’t even bother to hire an agent until I was getting ready to hit free agency.  Why the hell pay somebody 3% of my contract when he has nothing to do with getting me paid?   If I was really big-time, I’d hire an entertainment agent, and let them take commission on endorsements, but nothing would be coming out of my rookie football contract.  I consider agents to mostly be non-value-adding drains on the football economy, so I’m sorry about their luck. 

The rookie scale is something that the NFLPA can claim as a victory for their side, because their current constituents are the veterans, who stand to appropriately benefit.  The NFL wants it too, for risk management purposes, but remember, PR-wise, the union always has to be able to claim that it won.  The NFLPA will almost certainly succeed in getting offseason workouts and training camp reduced, as well, which they’ll also call a huge victory.  Owners will kind of smirk at that, too, because to them, cutting down those activities reduces costs on non-revenue generating activities.  Coaches would squawk, and say that they were being handcuffed, but if everybody is limited to the same extent, their kvetching would be meaningless.  It sucks being middle management, doesn’t it?

I said before that the union is in a defensive posture, and the reason why is that the NFL did a great job of planning ahead for this situation.  The deal they signed with DirecTV pays the NFL $1 billion this year, whether there are games or not.  The NFLPA currently has a challenge to the legality of that before a Special Master, because it causes management to have significantly less financial pain than the labor force.  I put this chart together last year to illustrate that:

Implied Income Statement, Average NFL Team

  Operating Team Locked Out Team
TV Revenue 128 31
Gate Revenue 53 0
Other Revenue 66 13
Total Revenue 247 44
Player Expenses 135 0
Other Expenses 69 41
Total Operating Expenses 204 41
Operating Income 43 3
Interest Expense 18 18
Pre-Tax Profit 25 (15)

all figures in millions of dollars

That uses last year’s averages, and please note, it’s nothing more than a generalization based upon averages, but it makes the point that if a whole season were lost to a labor action, the DirecTV deal means that the owners mostly wouldn’t lose very much money at all.  The NFL still gets revenue from DirecTV, and I'm factoring in some advertising and merchandise-driven revenue, as well.  Expense-wise, I'm actually being pretty conservative, and not assuming any layoffs of support staff.  The $28 million savings I'm factoring in is for stuff like travel to games, feeding players, and renting facilities for training camps.  

In any case, you get the point, that while a lot of reporters are saying that the teams will each lose hundreds of millions of dollars if games aren't played, that's a bunch of nonsense.  They'd forego $150 million in revenue, and they'll also not pay out about that same amount in player salaries and other football-related expenses.  The NFL set themselves up brilliantly here, by any measure.

Of course, the real cost of missing games is an intensely negative fan reaction that will definitely materialize.  The social networking era has made intolerable fans ubiquitous, and now every random guy feels like they should harangue the commissioner about topics that they clearly have little understanding of.  Then the random guy becomes a local hero, striking a blow for the little man, according to the Denver Post.  Of course, Woody and The Dullards joined with/co-opted the angry/ignorant Twittersphere to run Josh McDaniels out of town before he could get his program fully implemented, so you’d have to say that they’re all on the same team.

In any case, customers are going to get vocally upset, and both the NFL and NFLPA are going to have to read, watch, and listen to it constantly.  Pat Bowlen obviously capitulated to this sort of relentless negativity, and both sides in this negotiation will as well. 

The media intelligentsia (LMAO) is going to immediately start treating a March 3rd lockout as a catastrophe, even though it’ll be 5 months away from even affecting preseason games.  The pressure from Cletus303, JimBob6969, SIlverAndBlackOnCrack, YinzerAHole412, and Cutie4You4EvaInNJ will start flooding NFL Twitter timelines then, because a meaningful work stoppage will seem…  immediate… even though it really isn’t.  Neither side wants to meaningfully anger its customers, and deep down, to those customers, this is millionaires fighting with billionaires, jeopardizing the ability of (mostly upper-middle-class) working stiffs to go pay $8 a beer like my boy Billy Gamble did at the Dallas-Atlanta game.

I don’t think there’s any way that this goes past the Draft, because to even have a Draft, the NFLPA would have had to decline to use their decertification option.   I simply don’t expect them to allow the process to go past the league’s second biggest weekend, from both a fan interest and TV revenue perspective, without holding it hostage to a sincere threat of decertification.  This is literally the NFLPA’s only serious bullet, and they’re not going to let it go unfired because they lack the will to use it.  The NFL knows that, the same as I know it.

No, I’m not in the posturing business, unless somebody wants to pay me to be, so I’m going to predict that a deal gets reached by April 1st.  That will allow free agency to start before the Draft, and teams will be able to approach their player acquisition processes in the same order that they always did in the past, despite a possibly shortened time frame.

Both sides will win some battles and lose others.  We’ll have a deal that increases the regular season to 18 games, and the playoff field to 7 teams on each side.  There’ll be a rookie salary scale, and more roster spots.  Non-revenue offseason activities will be reduced, and amazingly, the quality of the game will not suffer noticeably.  There will probably be a minor amount of help given to the needs of the retired and retiring players, because that’s a major soft target, in a PR sense, for both sides of the negotiation.

The NFL’s teams will increase their earnings numbers some, and it will help, but it still won’t be nearly enough to make them intrinsically worth an average of $1 billion each, in what will continue to be a modest-growth environment.  The bubble will go on, and when enough suckers lose their asses buying teams for way too much money, the bubble will burst.  I only wish there was a way to short-sell assets like this, that are so clearly and hopelessly overvalued, because there’d be a killing to be made there, over a multiyear timeline.  Watch, somebody will create a derivative security out of it, once this all gets substantially more obvious, and I won’t even get credit for the idea.  All of y’all will know it was me, though, and I can at least take some solace in that.

1.  I’m not in the arguing business, I’m in the saying what I think business.
2.  I get my information from my eyes.

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