2011 NBA Lockout: Profit Certainty and the Problem With TV

We've been working to piece together more and more information into this lockout rubric, and thus far, the majority of discussion has been on whether the NBA is actually losing real money. Let's put aside that debate for a moment and accept it as a given, and instead ask the question of how it is happening. One element of the league's financial position that I don't think has received enough sunlight is the TV deal that they have had with ABC/ESPN/TNT. As far as I can tell, Ethan Sherwood Strauss at HoopSpeak has been the only guy asking the pertinent questions, and thus far there are no answers forthcoming.

The TV Problem | HoopSpeak

Here is a summary of his argument, along with some commentary:

• As the article linked above states (as well as his post from last week), the NBA is contractually due $930 million per year combined from these three media entities. This TV deal was signed in 2007 and runs through 2016.
• This current deal was a 22% jump in value over the previous deal. This increase in value came despite the fact that before the deal was signed, the NBA was in a ratings lull (think about the championship series that ran. I would argue that only Lakers-Pacers and Lakers-Pistons were in any way memorable).

• The reasons for TV overbidding for the NBA's rights are numerous. Some of the reasons are that there is the economic reality of scarcity, the NBA is appointment viewing (you really have to watch it when it is live), and the fact that to a large degree championship series are network defining, so in essence overpaying for sports is kind of like overpaying for corporate goodwill.
• The league was then locked into an eight year deal for just under $1 billion per year. That likely seemed like a great deal at the time, especially when ratings and revenue sources were dwindling. Furthermore, it ensured that the NBA had constant fixed revenue coming in the door to mitigate their massive fixed costs (player salaries).
• It is also important to note that this deal was signed in 2007, when the US economy was starting to feel some indigestion from myriad of over-inflated assets (housing, for example), but the economy had not yet collapsed (that would come in 2008 and 2009). Coupled with the fact that the NBA was not the hottest ticket in town at the time, it seems reasonable to understand why the NBA would agree to such a long-term deal that fixed its revenue potential. Today though, with technology and entertainment consumption changing by the month, it does seem foolish to have committed to such a long-term revenue cap.
• The NBA has barely made it to the middle of that TV deal and the league has done a 180 in terms of its popularity. The NBA Finals were must-see TV and there is a wide variety of players whom you can love or loathe. Some of the biggest names in the game are in the biggest venues (NY, Chicago, LA), creating further buzz. And yet, the NBA is locked into the same fixed TV revenue, so the league cannot capitalize on any of it in terms of TV advertising.
• To use a simple formula - if profit = revenue minus costs, the NBA is looking at a fixed revenue (TV deal) minus rising player salary costs, which would naturally lead to a steady if gradually shrinking profit. However, if you add into that the fact that other expenses such as energy costs are rising as well, you can see how quickly the league's profit margin can shrink.
• In a normally functioning economy, when the economy grows, prices rise. If the economy contracts, prices fall. This makes intuitive sense, and you can see that there is a strong if lagged correlation between GDP and CPI. However, the NBA has entered into a position where this correlation is halted. Prices of costs like energy, security, and the like continue to rise, but they do not have a matching increase in revenue growth because that TV deal is fixed. Since the teams cannot simply stop paying their gas bill, they are seeking to alleviate the pressure of this profit compression by the only means left, which is by seeking to adjust player salaries.
• In essence, the very thing that the league thought (and probably was) its saving grace in 2008 has become the anchor which is going to crush it over the next five years: the fixed revenue stream from its TV deal. On the other side of the coin, ABC/ESPN/TNT showed better foresight in the negotiation. As long as the popularity of the NBA continues to rise, they can charge whatever they want from their advertisers, but they don't have to pay the NBA a nickel more.

• In a twist of fate, it is as if the NBA is caught in its own little game of SAW. The more they work to increase the value of the game, the less money they will make over the next five years. This is because in order to operate, teams have to endure rising operating costs (fuel, security, etc). And yet, with a fixed TV revenue comprising a huge percentage of their total operating income, the league does not have the ability to see its TV revenues rise proportionately. The league's success squeezes the profit margin.
• TV cut a pretty sweet deal with the league and now essentially they have unbounded profits locked in as long as the NBA continues to thrive. According to Adwatch, the network was predicted to make around $1.25 billion per year, or a tasty $300+ million tidy profit. If nothing changes and the game continues to thrive, that number would likely go up as well, and yet the NBA would not be able to share in any of it.
• One big sign that the NBA has overvalued itself - they keep entering into contracts that are too long. Be it a contract between the league and TV or the teams and their players, unfavorable contracts that last too long have undone the league at both ends of the spectrum.
• To give the NBA the benefit of the doubt, it is easy to fall into such a trap as long as you're convinced your value will continue to increase. However, increase in value is never certain, and it is foolish of any business-type to think that it is. As a result, the NBA may have inadvertently backed itself into an alligator box spread.
• The phrase "profit certainty" takes on new meaning in this analysis. The irony of it all is, the one party that actually has profit certainty is TV. I'm sure that the NBA would love to turn the tables on this dynamic and gain unbounded profits in the same way the networks have. However, it appears as if the NBA was negotiating from a position of weakness in 2007, and I do not think that the NBPA has yet found itself in such a disadvantage.