RSN money and small market risk

Mar 23, 2023 - 4:00 PM

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As Diamond Sports Group starts working its way through bankruptcy, many questions about how we will all watch our favorite teams play baseball have started cropping up. At first, I was excited about the prospect of blackout restrictions on streaming possibly being lifted because it would be very convenient for someone like me who doesn’t have cable and lives within the Royals blackout area around KC. However, now that I have read more on the situation, and considered the implications, the long-term viability of small market teams could be threatened by the loss of consistent revenue streams from cable companies.

I will try to refrain from turning this into a full blown corporate finance lecture, but we are going to need to cover some basic tenets of how that subject works. There is a concept in corporate finance called operating leverage. Basically, companies can be structured along a continuum of how much fixed costs they have. Running a Major League baseball team puts you on the heavy operating leverage part of the continuum. There are a lot of fixed costs associated with running an MLB organization, the first and most obvious being player contracts. The front office salaries and costs associated with keeping stadiums and parking lots functioning are as well. Most of their variable costs are around game day items and staff.

Having guaranteed contracts for players means that your cost structure is fixed going into each season to some extent, and fixed for future seasons already as well. Bigger, longer contracts create even more operating leverage, which is one of the reasons small market teams rarely wade into the deep end of free agency. Unless you get lucky or unlucky, a la Gil Meche and sadly Yordano Ventura, you are paying all of those dollars on each contract, so each year your team has to make enough to cover them before you can break even or become profitable. That is how the concept works, as a bar you have to clear to reach profitability. The higher the bar is, the harder it is to clear. Then, if you think about how revenue streams work, the two concepts can be added together to show how likely a team is to remain solvent. See below:

If your revenues are fairly consistent, like the green line, then you can handle a decent amount of debt/operating leverage, because the dependable revenues will clear the bar to profitability the vast majority of the time. On the other hand, revenues that are not consistent can make high debt service and/or operating leverage untenable. The revenues dipping below the fixed cost amount frequently and occasionally by a lot can make it hard, or even impossible, to sustain the business long-term.

MLB revenue streams are mix of stable and unstable types of revenue. If you look at a breakdown of their revenue sources:

This is a league aggregate number, so it will vary from team to team some, but at least this gives us a basis to work from. Local media, regional television and radio, makes up almost a fourth of revenue for the average team, and that chunk is now being threatened. It is one of the most stable portions of revenue, along with the national media piece and the revenue sharing for small market teams. Gate receipts, sponsorship, licensing, and especially the postseason revenues are all much more variable depending on the quality of the team, bankable stars on the roster, macroeconomic environment, and even things like the Chiefs being good can reduce the amount people are willing to spend on things related to the Royals.

If we move away from fixed contract payments for television rights and into the streaming future, there are definitely some upsides for fans, but now you are changing the nature of up to a quarter of the revenue for a lot of teams. Streaming subscriptions are something you must sell constantly because they can be cancelled easily. You also are now at least in part competing with Netflix, Disney+, Hulu, HBO, etc. Most of us are already subscribing to multiple streaming services, and picking what to prioritize can be difficult. This will make the dollars from an online only delivery model a lot less stable, and the demographics for baseball skew older. Older people are less likely to want to use a streaming service, and in some cases will not be set up to do so.

For the Royals, to replace a reported $48 to $52 million from their recent regional broadcasting contract with subscriptions to a streaming service, it would take half a million people paying $100 per season. Could ad revenue offset some of that, sure, but some people are going to be monthly subscribers rather than full season. Some might only subscribe when the team is competitive or for only certain parts of the season. Also, there are only 883,621 households in the KC metro area. That is where the vast majority of the subscribers would come from, and you are not getting half a million from that because you can’t get 56.6% of households to do almost anything.

It is definitely possible that this bankruptcy takes money away from a lot of teams, or at least makes it harder for them to generate the same revenue. That does not make this clearly a bad thing. On one hand, the idea of the Royals going to another city or just ceasing to exist because they can’t make enough money in Kansas City is scary. I love baseball, and have devoted a large amount of time in my life to watching them play. Still, the fact that small market teams can basically do nothing and make tons of money from television and competitive balance taxes on the big market teams without ever putting a reasonably competitive team on the field is less than ideal as well.

Maybe this is the change that would spur smaller teams to work a bit harder, spend a bit more to make sure their product isn’t garbage for long stretches of time so that people will keep subscribing to watch the games. The only reason I’m not sure that can entirely be the case is the chart above. If the revenue variance makes it harder to take on more fixed costs, then when the revenue variance increases the idea that the teams will become more willing to extend their stars or sign big free agents makes no sense. Higher baseline risk does not generally lead to even higher levels of risk taking except in bad executive incentive structures or situations like gambling addiction.

I think the most dire ways to take this or any other doom saying writing surrounding this bankruptcy is probably not something we should be concerned about in the short term. There are still plenty of people subscribing to cable, and that means that broadcasting games is still valuable, so someone will likely be broadcasting them. Since Diamond is going through Chapter 11 bankruptcy, that usually means at least some of the company is going to make it out the other side intact, and that they can to some extent operate throughout the process. If they can get the debt restructured so that it is not such a burden, then things might go right back to where they were before, but that depends on how the bankruptcy court treats the contracts with the teams. Part of the restructuring could include those contracts.

For now, there is really nothing any of us can do but wait and see how this all plays out. There are many more things I could speculate about, but I have no real information about what direction the company is pushing, nor the debt holders. All I know is that companies hate risk, and this is both a short-term disruption that creates risk, and a possible long-term risk to one of their biggest revenue streams. That can change the way companies think and act, so it is something to worry about.