David Stern, NBA Commissioner Interview: The Labor Deal, The Business Model, and What a Franchise is Worth

Over the weekend, NBA Commissioner David Stern sat down with Judy Woodruff of Bloomberg TV to discuss a variety of topics. You may have missed this, since usually Bloomberg TV is only showing in hotel rooms and airport lounges, the better to help you zonk out for a while. You can find the entire interview here:

NBA's Stern Interview with Judy Woodruff | Bloomberg TV

I have excerpted some of Stern's responses and followed them with a little bit of my own commentary. I also took the liberty to re-frame the questions to help better understand Stern's answers. I've placed the times his answers begin in the interview in parenthesis. In these excerpts below, I delve heavily into the financial language Stern uses to explain the league's position. 

The Business Model

Question: Is the financial model broken? 

(1:05) Stern: I think that we have a model in place that was put in at an earlier time when the costs that were producing the revenue weren’t as high as they are now. Our revenue generation capacity is really very good. Our prospects are very bright, but we currently have a deal that pays out a percentage to the players that is too high...and when you consider the cost of producing the revenue that we have...it’s a system that needs an adjustment.

Ms. Woodruff jumps right into the crux of what ails the NBA. Here is an illustration that will help you understand the league's dilemma, if it's a little murky for you, because it probably seems like a contradiction when Stern says revenue generation is good but the players are making too much.

Imagine that you're freshly out of college and have a nice new job with a decent company. You decide to take the plunge and buy a home using the standard 30 year mortgage. What you have now is a classic dilemma in something that financiers call "duration mismatch." Your mortgage is fixed; assuming you never sell your home, you will end up paying a fixed amount of money every month of every year until the loan is paid off. You are contractually and legally obligated to do it. However, the source of the money with which you will pay this loan, your job, does not have a guaranteed 30 year life span. In fact, it could change tomorrow. If it does change tomorrow,  then you have either a problem or an opportunity. If you lose your job or have your wage cut, you now have less money to spend on everything after your mortgage (because it's a fixed cost), which in turn restricts your ability to buy other stuff like NBA League Pass and Ramen noodles. If your wage increases, you have a greater capacity to buy those fun things, because your mortgage is still a fixed cost. The point is, the relationship between income and expense is sensitive to changes specifically due to the mismatch in the duration of each. 

In the NBA, the same problem exists. The players sign contracts that make the team legally obligated to compensate them a specific amount of money for a specific amount of time, kind of like your mortgage. However, the league's operating income is subject to the whims of the overall economy. Things like ticket sales, merchandise sales, gas prices, airline fares, security, and the like are extremely price-sensitive to overall economic changes. The result is a mismatch; income changes quickly while expense does not. If the income goes up, the league benefits disproportionately. If income goes down, there is not much the league can do recoup its losses in the immediate term, because those player salaries, which comprise the majority of expenses, are fixed.

The entire point of reducing salary and shortening contract terms is to better match the income with the expense so that the league can adjust accordingly on the fly to changes in the economy. 

Question: What are the odds that the labor issue can be resolved?

(1:57) Stern: Our agreement expires on June 30. And that gives people of good will a lot of time to get their dancing and prancing and posturing out of the way, and we hopefully sit down and do our best to make a deal.

This is a classic David Stern answer; it is shrewd, subtly condescending, and specific in his motive. Stern knows how to negotiate through the public lens and his opponents do not. He also knows that much of what is going to be said in the public by both the players union (NBAPA) and the team owners will be precisely about posturing before the public eye. Ultimately though the NBAPA knows or should know that they have a losing hand; the ownership has too much leverage. Fans, at the end of the day, will sympathize to a degree with NBA players when they get treated unfairly. However, because the NBA way of life is so far removed from the lifestyle of middle-America, fans will only care about whether the NBA is on TV or not. As we learned from the last lock-out, if the NBA goes away for a time, the players will be hurt more than the owners. The players will acquiesce. 

Question: Is it a contradiction to say that the current model does not work, and yet, franchises are being bought for huge sums by billionaires like Mikhail Prokhorov who just bought the Nets?

(2:33) Stern: Stop there – he just did [buy the Nets], and the previous ownership lost several hundred million dollars on that transaction. 

I like the question's intention (listen to it for the full effect) and it makes me wonder if Ms. Woodruff really means what she is asking, or understands the deeper situation that she's about to uncover. I'll give her the benefit of the doubt here. 

On its face, the question is asking about the optics of the situation. Stern says that the league is distressed, yet teams are being sold for hundreds of millions of dollars ($450 million for Warriors, $556 million for Wizards, $200 million for Nets). When a fan turns on the TV or goes to a game, the fan values the game by what he sees: the players, coaches, referees, the arena, the dancers, etc. "Fan X, how much would you pay for all this awesomeness?" And we then come up with some dollar figure that seems like a fair tradeoff. It might be the cost of our season tickets or the price of our cable package, but somehow, we use what we know to assign a value to what we are consuming. So when we hear that the Wizards (the Wizards!) are being purchased for over half a billion dollars, and we think about the Wizards for more than 5 seconds (a dangerous proposition), we are both shocked and disgusted because the two ends of wealth and financial distress do not meet.

Ms. Woodruff might be shocked at this dichotomy, but I honestly don't think so. The deeper issue that I think she is alluding to is the request for Stern to explain how it all works. And that's what he answers, at least in part. the numbers we attach to franchise sales seem astronomical, but in reality they are merely representative of what in the business world would be considered either a micro-cap or small-cap company. In other words, small potatoes. It seems big though, which is why on its surface the question is an appeal to optics. In reality though it is a question of value. What is an NBA franchise worth?

Stern counters with stating that, yes, Prokhorov bought the Nets for a large sum of money, but the previous owners took a loss on the sale. How much value did Prokhorov really acquire? There are a few ways that you can assign a franchise's value:

  1. Book value (assets minus liabilities)
  2. Operating Income
  3. Revenue streams
If you really care about the mechanics of these valuation measures, you can peruse this lovely abstract. The thrust of it is a franchise typically doesn't own very much other than leases, licenses, and of course lots and lots of basketballs. The real value is in the money the franchise generates. If you do read through that abstract, you can see a good analysis as to why one franchise is: a) worth more than another franchise and b) worth more to one person than another. A franchise is worth much more money to a man like Ted Turner or Rupert Murdoch than the man who just won $500 million in the state lottery. Why? Because Ted Turner has access to revenue streams (TV, radio, Internet) that lottery man does not, and the possession of those revenue streams is what makes the franchise more valuable to him because he can exploit them. Ergo, Turner will pay more for a franchise than lottery man, and it has little to do with ego and everything to do with opportunity available to him.

 

Question: If the model is flawed and teams are losing money, why does the marketplace make ownership look so attractive?

(3:01) Stern: We do have a limited number of franchises and people want to get in. But I would tell you that most of those purchases are based on the assumption that the model will be changing. And that is what’s going on in the marketplace. 

Here is the second part of the value equation, and it has to do with demand. If we are to believe Stern (and I do) there are a number of parties interested in getting into the NBA franchise game. There is always some sort of bidding war that arises when a franchise is in play. The more people want something, the more it is worth. Consider this example as the alternative: last August, Newsweek Magazine, a national stalwart for 80 years, was sold for $1. Why? Because its inherent worth was so abysmal that there were nary any realistic buyers who wanted to take on the mess. There are only 30 franchises and a lot of rich people still want them. It could be because of revenue streams (Prokhorov) or it could be because of the ego trip (Mark Cuban). I would be willing to wager though that there are more rich guys that would like to buy an NBA team than a flimsy news mag. Hence, the price goes up.

Now, for this second part of Stern's statement, we're onto our third lesson in valuation. This is the basic premise: when it comes to an item's inherent worth, be it a coffee mug, a stock certificate, or a team, every pertinent piece of information impacts its value, and it impacts it as soon as it becomes known to the marketplace.

Let's pretend for example (just pretend!) that you're a huge Kobe Bryant fan and you really want to buy a collector's edition of his bobble-head doll. Let's also pretend that just now, Kobe announced that after this season he is retiring. Now, the important aspect of this announcement is that Kobe is retiring in a few months; that is what matters. However, does the market price for Kobe bobble-heads wait until he actually retires before a demand for the doll spikes? No, of course not. The market price jumps immediately, because the new information is signaling that the doll is suddenly worth more now because of an event that has not yet happened. The new information is digested, and then the market moves forward. This concept is what Stern means when he says that these purchases are based on the assumption that the business model will be changing. If the model changes the way Stern and the owners want it to, the franchises will be able to retain more money and control their expenses more fluidly (see above re: duration). This information is available to prospective buyers now, and so is automatically priced into the valuation model. Ergo, the bid goes up. The value today is calculated in part on what we know the franchise might be worth tomorrow.

Question: While the NBA has been more open with its books than some other sports, why do players say the figures being quoted are unreliable due to the inclusion of hundreds of millions in depreciation and interest?

(3:54) Stern: Our numbers are what our numbers are...You could argue about interest payments or not. Depreciation, when you buy a scoreboard for $10 million dollars, you have to take it one way or the other. You’re not allowed to expense it so that you have five years of $2 million a piece, for example...The interest is real interest. So, if we’re arguing between the players’ numbers between whether we’re losing between 370 mill as a league or 200 mill as a league, that’s an argument we’d love to have.

This topic is a bit wonky, although showing up on a financial news TV show is probably where it belongs. Here is the assertion that Woodruff is stating: players are arguing that the losses are so bad because they include such accounting elements as depreciation and interest expense. If you're not familiar with these terms, this is what they mean in normal language, followed by the argument being made:

Depreciation: A way of calculating how much of a thing is used up over time.

When a franchise buys something expensive, such as stadium chairs, an electronic scoreboard, or a team bus, those items are meant to be used over a course of time; they won't immediately get used up within the first year of ownership. Because of this long-term plan of usage, U.S. accounting standards require that the financial accounting reflect this term of usage. I think that Stern gets his language mixed up a bit here, because if we use his example of a $10 million scoreboard, the cost of it does get spread across a number of years. So let's pretend that this scoreboard has a useful life of five years. Accounting standards say that, rather than allow the cost of it to hit the accounting books all in year one, it has to be spread across its useful life. In other words, the expense has to show up as $2 million per year for five years. Even though the scoreboard may be paid for after year two, its expense is still going to impact the bottom line for another three years. Players say, "Hey! that's not a real expense because there's no cash leaving the franchise, so you're artificially inflating how much you say you're losing due to this accounting gimmick." 

The players' assertion is, of course, true. Stern's point though is that even if it is true, the franchises are still bound by accounting rules. If they make a large purchase that is meant to be used over a course of time, the correct way to account for it is to spread that cost over a term of years. It's still real money that has left the door. The only difference is, in real time it left the door in year one, but in accounting time it's leaving the door bit by bit.

Interest expense: What it costs when you borrow money.

I'm sure most are familiar with interest expense if you own something as simple as a credit card or a mortgage. It is the cost of borrowing. As we've previously discussed on Loud City, a lot of teams have borrowed a lot of money. They borrow that money in order to perform their business operations, such as building a new practice facility. If a business is borrowing responsibly, the financing (borrowing) directly goes towards the investing (building stuff for the team). Players might argue that the interest expense paid on these loans isn't an actual operating expense; it doesn't count toward player salaries, security detail, or printing costs, so therefore it shouldn't be included in calculating how well a franchise is doing. As you can see though, interest expense is a very real measure as to how a franchise is going about building itself up. It has a lot to do with operations, even if it isn't included in the operating income calculation (the reason why it isn't included is primarily due to tax purposes). 

When Sterns says that the "interest is real interest," he's alluding to the above fact, as well as the reality that unlike depreciation, interest expense is actually cash leaving the door in real time. It may not be included in operating income, but as noted above, it does play a factor in how a franchise operates, and it does impact the final bottom line.

Question: Why do owners continue to overpay middle of the road players? 

(5:02) Stern: The answer to that is simple: that this is very competitive. Our teams want to compete. And they pay salaries that are competitive to what other teams pay. And when the top tier is gone, and there’s competition for the next tier, that tends to get bid up as well. 

Stern is right to say that the market place for players is extremely competitive. The talent difference between someone like Carmelo Anthony and Luol Deng might be small, but when a team becomes convinced that it is the difference between a sometime All-Star and a cornerstone franchise player, the team will pay a premium for that marginal increase in talent. This relationship is true everywhere in the market place; it is why the bid for talent grows exponentially and not linearly. 

That isn't the problem though. The problem is, the teams have not done a good enough job in evaluating who has that extra marginal talent which would warrant the oversized contract. Case in point: Rashard Lewis. Currently, Lewis is making over $20 million per year. Lewis has never averaged more than 22 points per game, has shot higher than 47% once, and despite being 6'10", never averaged more than seven rebounds per game. Lewis was paid a steep premium by the Orlando Magic to do one thing better than the majority - shoot the basketball. If you look at his career stats, you can see that, not only did he not do that after he signed his contract, he really has never done that his entire career, at least not to the degree that he's being paid for it.

The problem is not that teams compete for talent, be it top tier or middle tier. The problem occurs when they misjudge a talent and then destroy their team's financial structure because of the decision. Most teams don't do nearly enough evaluation in what is called replacement value. I recall a few years back when the Suns were considered a contender, and then lost Amare Stoudemire for the year. Then-coach Mike D'Antoni conspired with his staff and, instead of breaking the bank to try and get another Stoudemire-type player, they asked themselves, "how do we replace his production with lesser parts? This is a better approach and will help mitigate the inflation of middle-tier talent.

Question: Do you think certain teams could survive a round of franchise contraction?

(9:35) Stern:  I think they can make it. I think the fair question is whether they should make it...When we come out of this, we are going to have a better collective bargaining agreement, together with robust revenue sharing, to make sure that all teams that are well-managed have an opportunity to compete.

To channel Bill Simmons a bit, how crazy would it be if the league conducted a franchise contraction, "Bachelor"-style? If teams were brought to the chopping block, I imagine that each one would have to demonstrate a competency to 1) prove financial viability and 2) have a plan for competitiveness. 

Stern's answer is pretty sly though; in effect he is and has been putting team ownership on notice that they have got to do a better job than what they've been doing these past few years. His key phrases:

"Should they make it..." - The implication here is that he doesn't think certain teams deserve to. We can speculate all we want about which teams might fall into that category, but it is notable enough that Grandpa Stern is not pleased with how teams have managed themselves. Mismanagement not only damages individual franchise value, but it effects the league overall. Just like a blighted house in a neighborhood can bring down everyone's real estate property value, so too a broken franchise can negatively impact the value of everyone else. In this sense, revenue sharing can operate like one home owner offering to cut his neighbor's hedges back because the effect is detrimental to both properties.

"Well-managed..." - I do wonder if Stern's ideas on revenue sharing could somehow hinge on a franchise's performance. As I have written before, giving a franchise money for making bad decisions creates moral hazard. The challenge is to give teams incentives to make better decisions. In other words, Stern is saying that owning an NBA franchise isn't akin to printing free money anymore; the teams are going to have to prove their worth in the financial and competitive landscape if they are going to receive any help. My rhetorical question would be whether that incentive comes in the form of a carrot or a stick.

Stern wants teams to think that a Sword of Damocles is hanging somewhere. 

Question: Which teams are the most fragile?

(10:18) Stern: None of them is really fragile because they are all well supported by ownership. But in the context of the transfer of checks for one group of teams to another group of teams, it always comes up in terms of a question: is this really where we should be?

This statement may seem like a backtrack, since previously Stern has stated that a lot of teams are in financial distress. However, he's speaking of something different here; there is a difference between a team not performing well and a team that whose overall structure is decaying. Given enough time, poor performance will result in decay, but Stern is saying here that no team is yet at that point. There is reason for alarm, but the owners can only posture so much before their words begin to ring hollow.

The bigger issue is what he calls the "transfer of checks." This phrase is simply another way of describing the concept of revenue sharing - it is the transfer of one team's success to another's in order to bolster the financial viability of everyone. 

What Stern is getting at here is that, when you're talking about the transfer of wealth from one team to another, the owners who are losing some of their pot of gold are going to want significant input as to where that money goes. It doesn't matter if Stern sees a team as fragile; it only matters if the other owners do, because it is their money being taken away.

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