The Seeds of War . . . and the Prospects of Peace

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A popular historical precept holds that the seeds of a war are sown in the peace that ends the last conflict.  The onerous terms of the Treaty of Versailles signed at the end of World War I contributed in large part to the emergence of World War II, and the partitions of territory in the aftermath of World War II led directly to the Cold War and contributed to the present-day strife in the Middle East.  Over the last century,  society has repeatedly been reminded of how illusory the concept of “peace” can be, and how frequently it serves merely as a prelude to the next conflagration.  Yet, despite these reminders, society finds new ways to make the same mistakes.

In comparison to these world-changing events, the trials and tribulations of a professional hockey league appear trivial — and indeed they are.  However, the foibles of human behavior are such that the sins of the nations are echoed in the behavior of the citizenry, and perhaps no place is that more evident than in the NHL.  While other professional sports have their share of labor strife, the NHL and  NHLPA have elevated discord to an entirely new level.   Between the 1994-95 work stoppage and the 2004-2005 lockout, almost 1,700 regular season games have been lost — not including any games jeopardized by the current unpleasantness.  That’s more than twice the games lost to the NBA — which fields an identical 82-game season, and almost twice that of Major League Baseball, with its 162 game season.  The NFL over that time frame?  Zero regular season games missed.  Of course, the NFL has an $11 billion Golden Goose to preserve, while the NHL take is less than a third of that amount.  Now, one could argue that the NFL, having more at stake, is accordingly more interested in seeing that the goose is not cooked.  However, an equally compelling argument can be made that the NHL, being the veritable ugly duckling of the major sports quartet, should be more judicious in nurturing its product — and should certainly not do anything that would jeopardize the game or its prospects for growth.

This all seems like common sense, but once again the NHL finds itself at the brink, with today’s 11th hour offer from the NHL providing a glimmer of hope in an otherwise gloomy landscape.   How has this happened — again?  Why is the NHL on such an apparent self-destructive trajectory?   Will the NHL and players seize opportunity and achieve a lasting peace?  Or will they instead squander hope and sow further discord, disguised as an uneasy truce?  Let’s examine the trends:

The Spectre of Cost Certainty

The battle cry of the 2004-2005 lockout — for the owners and Gary Bettman — was “Cost Certainty.”   In their view, the NHL was facing unbridled salary escalation, while the prospects for revenue growth were not similarly rosy.  (As a reminder of where things were — Colorado’s Joe Sakic earned $17.0 million in salary for the 1997-98 season, then earned $9.8 million per year for the three years leading up to the 04-05 stoppage)  Of course, “cost certainty”  was simply a euphemism for “salary cap” – and those dreaded two words were worth fighting over, from the players’ perspective.  Depending upon whose numbers you choose to believe, player salaries accounted for somewhere between 66% and 76% of revenue, and you do not need any particular level of business acumen to understand that a profitable operation is not sustainable over the long term with those labor costs.   So, the salary cap was worth the loss of a season to the owners, most of whom had marginal or negative operating income at that time.  They got their wish, and in so doing, virtually assured that the labor strife would recur.

Why?  Several reasons.  First, in order to obtain that concession, the owners were required to agree to some things that mathematically did not make sense.  First and foremost was the commitment to pay the players more than 50% of the dreaded Hockey Related Revenue (HRR).  (While the 57% number is the one used universally at present, it was actually a scaled escalation from 54% to 57%, depending upon league revenue).    The entire concept of allocating a fixed percentage of top line revenue (independent of expenses) is a recipe for disaster — in any business.  This is particularly true where –as here — the owners have committed to increase the rate of sharing as revenue increases, thereby magnifying the actual dollars going out the door.    In most situations (think of commissioned sales), the rate decreases as the principal amount increases, thereby keeping overall cost reasonable.  Here, however, the collective wisdom (?) dictated otherwise, apparently believing that the merits of the cap would outweigh the risks of the mathematics.

So How Did It Work?

In order to facilitate discussion, I’ve distilled some data from 2003  and 2011 , courtesy of Forbes magazine. 2011 represents the last year of data available before the current situation arose, while 2003 occupies the same relative spot to the 2004-2005 lockout.    While some dispute the validity of the Forbes numbers, their methodology is consistent year over year.  Thus, while some details might vary from the calculations of others, the overall changes in the landscape remain consistent and valid.   Here are the numbers:

[table id=10 /]

A few explanatory notes are in order before we proceed.  First, the Value – Debt columns are simply what you would refer to as equity were we talking about your house.  Take its value, subtract the amount of the mortgage, and you have your equity.  Same principal here, except that the concept of fair market value for an NHL team is much fuzzier.  Unless you are in New York City and environs, there is generally only one franchise in the  local market, and only a very limited number of potential buyers.  Further, the concept of “value” is ethereal, unless you are selling (or borrowing against the equity).   It can change — rapidly — and I’ll discuss the ramifications of that fluidity in a bit.

Secondly, keep in mind that the entire CBA debate is rife with numbers, any of which can be manipulated or phrased in a way to suit a particular position.  As an example, consider that one of the major objections to a salary cap back in 2004-2005 was that it would prevent growth of player salaries.  Even today, Donald Fehr speaks about the sums (always in dollars, not percentages), that the players have “lost” or “given up” to the cap world.  Similarly, Gary Bettman decries the inflation of player salaries, moaning about how the average salary has doubled.   Going forward, it’s a lot of fun to listen carefully to those types of statements and note what reference points and measures they are using.  Then contrast them with a few numbers that are fairly undeniable.  First, everyone concedes that between the time immediately before the 2004-2005 lockout and today, the applicable revenue measure (league-wide) has increased from approximately $2.2 billion to $3.3 billion.  That’s a 50% increase.  Yet, over the same period of time the salary cap has increased from $39 million to $70.2 million (before any agreements to the contrary in these CBA talks)  That’s an 80% increase.  Certainly, owners are not compelled to spend to the cap, but that is a club by club determination — not a league wide function.  To confuse the situation even more, total player costs (including benefits and bonuses) equalled $1.389 billion in 2003, according to Forbes, while those same expenses in 2011 equalled $1.757 billion — an increase of 26.5%.  So, there appears to be a number that satisfies every position, depending upon who you listen to and the purpose you are trying to serve.  Where is the truth?

The Disappearing Middle Class

This being an election year in the U.S., the “disappearing middle class” is an appropriate metaphor for what has truly transpired in the salary cap environment.  In the uncapped world of 2003, player costs ranged from a low of $28 million (Minnesota) to a high of $79 million (N.Y. Rangers) –  a gap of $51 million.   Ten teams at that time were over $50 million, another 8 over $40 million, with the other 12 scattered below that figure.   In 2011, thanks to the advent of the salary cap, the numbers have compressed substantially.  The peak player cost burden was $74 million (again by the Rangers), but the low was only  $43 million (St. Louis, Winnipeg). So, while the top of the class actually declined, the bottom increased some $15 million.  Moreover, 24 of the 30 franchises were over the $50 million mark, and 14 of these were over $60 million.

Don Fehr

(Brad Penner-US PRESSWIRE)

This impact helps explain the divergence of views adopted by Messrs. Fehr and Bettman when it comes to the compensation statistics.  Fehr focuses more on the top end, where growth has been more limited. However, that top end number also impacts a relatively small, elite group of players.  Bettman, on the other hand, is focusing more on the “rank and file” in the league, who have benefited tremendously from the cap world — not because of the ceiling, but instead due to the floor.  Where clubs had previously been free to spend — or not– and take the risks associated with each course of action, the new CBA compelled teams to spend money where they otherwise might not.  While the desirability of a floor is understandable from the perspective of the richest clubs who help fund profit-sharing, it is undeniable that the result is an inflationary effect on overall salaries.  That is the point upon which Bettman focuses, and Fehr conveniently avoids.

However, if nothing else, the chart above demonstrates how illusory statistics can be, and that the salary cap world — as presently structured –  really has worked to the benefit of a chosen few.  Cynics might suggest that this was what was intended all along, but let’s try to look solely at the facts, with our initial focus on Operating Income.   In 2003, league wide Operating Income showed a loss of $123.7 million, with 20 of the 30 teams in the red operationally.  The fledgling Minnesota Wild led the way with a $20.1 million profit.  However, this is largely an illusory number, due to the abnormally low amount devoted to player costs ($28 million) and the fact that the franchise was new.  However, six teams had losses of over $10 million, while only Minnesota and Toronto posted gains of $10 million or more.  These were the danger signs that prompted the massive restructuring sought during the 2004-2005 stoppage.

Fast forward to 2011, and superficially things look just great.  That $123.7 million deficit has become a $126.5 million gain.  Terrific, right?   Not so fast.  Look more closely.  Six franchises (Toronto, the Rangers, Vancouver, Montreal, Detroit and Edmonton) accounted for $228 million in positive operating performance.  That means that the  remaining 24 clubs posted a cumulative $101.5 million operating loss.  In fact, despite the salvation that is the salary cap, 18 of the 30 NHL franchises again posted negative operating figures in 2011.    Thus, the cap enabled the rich to get richer, while the remained largely continued to struggle.  Toronto increased operating income almost six-fold from 2003, to $81.8 million, and saw its equity increase by almost $200 million.   That’s good, but the Rangers turned a $7 million deficit into a $41.4 million operational gain, while eliminating its debt and increasing its equity by some $480 million.  The Rangers, of course, are one of the clubs who saw their annual player cost decrease in the cap environment (as did Toronto, Detroit, Colorado, Dallas and St. Louis).

Most clubs, however, were not so fortunate. Despite having its player cost decline by $19 million, the franchise went from the black to the red operationally, but more significantly converted $121.5 million in equity from 2003 into a $59.8 million deficit in 2011.  The New Jersey Devils saw a similar equity swing, from a $78.3 million surplus to a debt of $79.64 million. Despite the fact that only three franchises (Dallas, the Islanders and Colorado) actually declined in value during this time frame, fully half of the league members saw their equity numbers decline between 2003 and 2011.   This evidences increasing reliance on debt to meet the economic burdens of the salary cap floor, which is a slippery slope to navigate for any economic enterprise.

The Illusions of the Market

Much of the current rhetoric, and indeed many of the underpinnings of the 2005 CBA, involve assumptions and assertions that simply do not correspond with the reality of the NHL — or indeed any other business model.  Despite their best efforts to negotiate and operate the NHL as if it were a true free market economy, nothing could be further from the truth, and the consequences reflected in the numbers serve merely to confirm that fact.

First, as should be readily apparent, there are a select few franchises — mostly in Canada — who are relatively immune to economic turmoil  They are in environments where hockey is

Gary Bettman

(Kellen/Icon SMI)

THE game in town, have virtually unlimited opportunities for derivative income and media outlets, and are in markets that will support extraordinarily high prices.  Other franchises find economic solace through their ownership of arenas  — either individually or jointly with an NBA franchise –  or other similar economies of structure that not all clubs enjoy.  Those types of clubs typically require little debt service, and can recycle surplus capital into new income-generating ventures, which in turn increase the value of the franchise, and the equity available to ownership.  That equity, in turn, can fuel such things as improved arenas, and the cycle continues.  The numbers demonstrate that the majority of clubs, who faced significant increases in their player expenses due to the cap floor, have struggled to keep up, often eroding the equity to meet obligations.  Despite the prevalence of the Dallas and Phoenix discussions in the media, this is an issue that significantly impacts the majority of franchises today.

Despite what many would have you believe, the NHL is nothing like an open market economy.  The players correctly note that they are the best players in the world, and that the supply of players at that level is very finite.  Basic principles of economics dictate that limited supply equals increased value, thereby giving credence to the NHLPA position that the players are leaving hundreds of millions of dollars on the table.  However,  things are not that simple, as the owners have constraints of their own.

The NHL is, without question, the premier hockey league in the world at the moment.  It serves the prime cities in Canada and the United States, and utilizes the finest venues in those areas.  However, unlike a “normal” business, a hockey franchise is closely circumscribed in how it can adjust to economic conditions and pursue opportunities for growth.  A hockey club has 23 active spots — no more.  There are limits on the number of contracts the club can hold, and strict rules on how and when teams can acquire new players.  A club is told how many games it can play, both home and away, and can’t add new products (i.e. games) or hire more players when times are good.  Similarly, when times are bad, the owner can’t reduce the number of playing personnel, trim product offerings or take other moves that executives in other endeavors routinely take to adjust to conditions. Arenas can only hold so many people, and the ability to raise prices differs dramatically from city to city.  The owners assume the risks of injuries, economic downturns and currency fluctuations, among many others, to which the players are largely immune.  Of course, the owners are also subject to the risks that they create and perpetuate — such as unworkable economic structures and an apparently insatiable desire to find ways to circumvent the processes they advocate, all for the “privilege” of paying outlandish sums of money over ridiculous contract lengths.

All of this is wrapped in the single grand illusion — namely that either side has a unified interest in the CBA proceedings. ( At least the players are free to talk about the situation, as they do not face the $1 million “gag order” fine that members of ownership allegedly confront if they stray from the company line and dare to discuss the CBA process at all.)  From the owners’ perspective, the “haves” and “have nots” are necessarily at war, even if not in public.  The panacea promised by the salary cap has not materialized, except for a select few.  While 29 clubs may be willing to put the All Star Game at risk in the CBA talks, Columbus (who hosts this year’s game) is not.  The 30 clubs simply cannot have an aligned position on revenue sharing, particularly since the cap environment has created greater need.  Yet the clubs who have reaped the benefit are apparently loathe to open their wallets sufficiently to insure the health of the game as a whole.  These are but examples of a wide spectrum of issues where any rational owner would realize that his/her interests diverge.

Make no mistake, the players are no more aligned.  Much of the 2004-2005 CBA, and the circumvention of its provisions, was focused on such things as cap hits, cap avoidance, and contract lengths.  That all sounds fine, but it really only impacts a very, very small group of elite players who earn enough to require cap avoidance and similar sleight of hand tricks.  The majority of players, who struggle to maintain their roster spots each year and are thrilled to receive any multi-year, one-way contract, are more concerned about the fundamentals — waiver rights, minimum salaries, medical issues, etc.  The advent of the cap floor came to the rescue of these players more than anything else, and this was (or should have been) the biggest divide among the players  during the last CBA negotiations.  Most players don’t care about the ceiling or the per contract limits — they will never get there.

Thus, if the truth were told, the players and owners are really in their own Cold War situation of Mutual Assured Destruction — all based on illusion.   The franchises of the Best League in the World are denying the Best Players in the World the opportunity to ply their trade.  For the majority of those franchises, the lockout means avoidance of losses.  For a select few, it means loss of major revenue.  Ditto on the players’ side of the fence.  Only the elite get the big money contracts in the KHL.

Is Peace at Hand?

As this goes to press, the NHL and the NHLPA are in their first negotiating session since the NHL came down with what is being widely referred to as the “50/50 offer.”  Is this an opportunity for resolution?  Without question.  Will the NHLPA accept the offer “as is”?  Of course not.  Nor should they.   While both sides have spoken about a “partnership”, the fact remains that neither the structure of the CBA nor the attitude of the parties comes anywhere close to a partnership.   A 50/50 revenue split is perhaps the first step in that process, but it will need to go beyond that.   For their part, the owners need to avoid the inherent, systemic flaws of the 2005 CBA, which virtually guaranteed that we would reach the point we occupy today.   The fact is that a professional sports franchise, without a significant national television deal, simply does not generate the operational cash necessary to support the unbridled growth in salaries Donald Fehr would love to see, and which some owners would like to exploit.

I do think that the parties are starting to understand that the risks of continuing the lockout are beginning to outweigh the advantages, and that the current proposal will forge the basis for ultimate agreement.  However, to achieve something that is truly lasting, both the NHLPA will have to find a way to appropriately share both risk and reward.  At present, the risk resides exclusively with the owners, notwithstanding the fact that they are their own worst enemies.  As the NHLPA has noted from the beginning, the key is the revenue sharing piece, which helps to even the playing field.  One idea would be to divide player compensation between salary, negotiated and paid by the team as it is today, and an equity bonus pool, jointly administered by the NHL and the NHLPA, and funded based upon equity increases and decreases of the member clubs.  This would share risk and reward, free operational capital, and go a long way to establishing the missing “partnership” elements in the dealings between the league and its players.

Whatever happens, the NHL and NHLPA need to be mindful of the fact that the next labor battle will be spawned — or not — by what is agreed to now.   This is not Versailles, and we don’t need another war.

 

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