TIVP001: Madison Square Garden Sports (MSGS): Buying the Knicks & Rangers w/ Shawn O’Malley

26:05I was surprised to learn, though, that the teams do hedge some of this risk with insurance contracts that pay out if key players are injured. It makes perfect business sense why they would do that. It's not something as a lifelong sports fan I would have ever thought about, really, without digging into the business of sports franchises, though, from an owner's perspective. There's always the risk, too, that players go on strike if they're not satisfied with their collective bargaining arrangements. In 2012, the NHL season was shortened by 34 games due to lockouts, And that, of course, ripples across ticket sales and media rights.

26:39The point of mentioning this all, though, is to show that franchises do not have unlimited discretion. They are ultimately at the whim of randomness and freak injuries, while also being bound by a strict set of rules, which set the tone for how their teams are structured and the media and entertainment businesses built around those teams. The rules governing what MSGS can do competitively are far more explicitly defined and enforced than those that govern most other types of companies. Amazon has to adhere to the US legal system, but it's not like it and all its e-retailer competitors are organized in a league structure that very specifically outlines how they can and can't compete with each other.

27:18The leagues really have a considerable amount of power over individual franchises like the Knicks and Rangers. And while the league should be acting in everyone's best interest, they can hold teams accountable for violations with sizable fines or even by removing their draft picks, hurting their ability to build their rosters. So from an investor's perspective, there's always a risk that the Knicks or Rangers could be adversely affected by decisions made by the league commissioners of either the NBA or the NHL. In terms of competitors, MSGS ultimately competes in the attention economy. And while its most direct competitors are the other franchises and the NBA and NHL, it's vying for attention and fan interest in one of the busiest cities in the world.

28:00New York is also home to the Yankees, Mets, Giants, Jets, Islanders, and the Brooklyn Nets. So there are a number of pro teams across the NHL, NBA, MLB, and NFL anchored in the area, meaning there's strong competition for the dollars and eyeballs of New York's fan base. And of course, people in New York have plenty of entertainment alternatives besides sporting events too. From just a simple numbers perspective, there's competition for media rights dollars as well, which can always be diluted by new expansion teams since media rights agreements for the NHL and NBA are equally divided across the number of teams.

28:38This isn't something that happens super often, but it does happen and could materially reduce the Knicks and Rangers' share of revenue from licensing league media rights. The NHL's last expansion team was the Seattle Kraken in 2021, and the NBA's most recent new team was in 2004 with the Charlotte Hornets, formerly known as the Charlotte Bobcats. but there's a decent bit of speculation that Seattle and Las Vegas could soon get new NBA teams too. It's also worth mentioning that sports entertainment is a cyclical business. The media rights component of it may be more durable because I think cable packages or certain streaming subscriptions are stickier, but in an economic downturn, when there's less discretionary money floating around, people are certainly less inclined to buy tickets for Knicks games, pay$90 for a branded hoodie, or drop$20 on nachos at the garden.

29:28Ticket prices in particular are the biggest and also most volatile component of MSGS's different revenue streams. They can fluctuate pretty dramatically on a nightly basis depending on how good the Rangers and Knicks are, but also who they're playing against, whether key players are injured, and on what day of the week the game is. But for season ticket packages, at least, the Knicks have an impressive 97 % renewal rate, which definitely helps smooth out ticket sales from year to year. And the Nixon Rangers also receive about 50 % of the net profits from food and beverage sales during their games at the Garden.

30:01So about half of MSGS's revenues come from event-related sources, which include ticket, food, and beverage sales. And about a third comes from media rights, and the rest comes from sponsorships and distributions from the NBA and NHL. In terms of costs, player and personnel salaries are naturally the biggest expense for MSGS as a sports franchise holding company. On top of travel costs, player insurance costs, and a 6 % fee to the NBA for regular season ticket sales for the Knicks, across all major US sports, more than 50 % of revenues go to player compensation, which is just a huge and actually growing cost.

30:39We've already talked about the luxury tax in the NBA, but there's also an escrow system for the NBA and NHL too. In aggregate, players are supposed to be earning roughly half of league-wide revenues, and thus the leagues hold a portion of players' salaries in escrow throughout the year that's deducted from their paychecks, which can be distributed in case players' salaries fall short of their target percentages by the end of the season. In effect, players are guaranteed to receive roughly half of the league's revenues each year, and if players receive more than 50%, money is instead paid to team owners out of escrow to balance things out.

31:14Additionally, both the NHL and NBA have a revenue sharing plan that tries to even out what franchises across their leagues can earn. So the top earning teams may have to make contributions to the teams that generate the least revenue. Last year, the Knicks actually paid about$23 million to essentially subsidize the NBA's least profitable teams. So we've got an idea of the business model generally and the biggest costs for the Knicks and Rangers. Let's just quickly touch on MSGS's financials. Revenues rose 16 % last year to just over$1 billion, while operating income almost doubled to$146 million.

31:52After stripping out interest on debt and taxes, the net income available to shareholders was about$58 million, which is not a huge profit margin on a billion dollars in revenue. The rise in revenue was primarily attributed to more playoff games for the Knicks and Rangers, higher ticket prices during the regular season, and distributions from the NBA and NHL as league-wide revenues rose. And then the biggest cost increases came from paying players, incentive bonuses for helping both the Knicks and Rangers make playoff runs, as well as higher escrow costs. Because the Knicks didn't pay any luxury tax in the last two seasons, they were actually rewarded and paid a share of luxury tax receipts from the teams that did exceed the salary cap.

32:34Looking at the financials in the past few years for MSGS is a bit misleading because everything gets thrown out of whack from 2020 and 2021 with the pandemic, but also because financials before 2020 reflect how the company did when it was a combined entity before it spun off MSG Entertainment and MSG Networks. Over the past three years, both the Rangers and Knicks have done pretty well, but any downturn in their performance on the court and on the ice would probably be a severe blow to the recent upward trend in revenues. An interesting wrinkle of the business model for professional sports teams is a tax strategy known as roster depreciation allowance.

33:12Basically, because teams put so much time, effort, and money into developing their athletes, they effectively treat their rosters as intangible assets. When the Knicks or Rangers acquire or assign players, the costs are capitalized on MSGS's balance sheet, creating a player roster asset. And then these player assets can be amortized over time, which shows up as an expense on the income statement. This reduces taxable income. And the goal is to reflect that as players age, their value fades away and depreciates much like any other type of physical asset. There's essentially a double tax benefit here though, where not only can MSGS deduct the actual salary costs from its income, but it can also depreciate its intangible roster assets, further reducing the income that's reported to the IRS and saving the company on further taxes.

34:02The double benefit arises because under the roster depreciation allowance, owners amortize the purchase price of the team, player contracts, and other intangible assets like TV contracts and franchise rights over a 15-year span on top of actual payroll expenses. This partially explains why sports franchises are so attractive to billionaires. They can effectively be used as a tax shelter where teams may be profitable in terms of cash flows, but can report considerable paper losses that reduce tax liabilities. For example, when David Tepper paid$2.3 billion for the Carolina Panthers, that produced amortization expenses of around$140 million per year, more than wiping out any Panthers' profits reported for tax purposes.

34:48Depreciating the purchase price of a team is the main benefit of the RDA, which isn't applicable to MSGS since the Dolan family has owned the team for 30 years now, but it does help on the margins with capitalizing player contracts, and it's definitely a compelling factor that could support higher sales prices for the teams if the Dolans are ever forced to sell them. Crazy enough, there's actually an incentive and a way to pay a bunch of money up front to buy sports franchises so that you can amortize more of that cost over time to reduce taxes. Let's take a quick break and hear from today's sponsors.

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38:44All right, back to the show. When evaluating any company, it's of course important to consider the bear case too and try to see what could go wrong. I think this boils down to a few straightforward points. Firstly, the company's assets are obviously highly liquid. Sports teams are not sold often, and it's not easy to sell them. For years, MSGS has sold at a large discount to the sum of its parts valuation, and it's not obvious why that would change anytime soon. As sports franchises get more and more expensive, there are also fewer and fewer buyers who can easily participate in those deals. How many billionaires besides maybe Elon Musk and Jeff Bezos could comfortably write an$8 billion check for the Knicks?

39:26On that point, you have to wonder whether there's something of a bubble in prices for sports franchises that's not sustainable, especially since the underlying economics for these teams really isn't that compelling. The valuations for these assets are inflated relative to how much cash the Knicks and Rangers can actually produce and the consistency with which they can produce that cash. So the business models are just not nearly as good as you'd think, or at least as I would have thought when I first started researching this company. Players have a lot of leverage over teams, and as such, they command huge salaries that are a considerable chunk of total revenues, and that's definitely not changing anytime soon.

40:02If anything, players are getting paid dramatically more each year, and depending on how the teams are performing, there will be good years and bad years for the business, and any legal changes to how teams can implement the roster depreciation allowance I covered a moment ago could also seriously impact the estimated valuation of the Knicks and Rangers too by removing an incentive for paying a larger upfront price to buy the teams. MSGS is also not the epitome of a fortress balance sheet either. Its financial position doesn't inspire a ton of confidence because there's just not that much cash on hand to cushion shareholders from financial ruin.

40:39MSGS has a bit less than$90 million of cash on hand against over$300 million of debt, which alone isn't bad. But there's also a considerable amount of fixed obligations that MSGS has that aren't technically debt, yet pretty closely resemble it, like 30 years of payments on long-term leases for the garden and off-balance sheet contracts with players with guaranteed money for them that must be paid even if they're released or injured. This isn't my biggest point of concern, but you know, it does matter. I'm not saying MSGS is on the verge of bankruptcy by any means, but they do have pretty large liabilities that aren't captured by basic measures of debt.

41:15With an indefinite waiting period for MSGS's market value to reflect the true value of the Knicks and Rangers, plus a volatile business and potentially vulnerable financial position. It's not surprising to me at all that the company trades at such a discounted price. And then on top of all this, you have family risk too. If you've seen the show Succession, you'll know how messy things can get when families vie for control over publicly traded companies. Sibling rivalries, inheritance feuds, and nepotism can all derail returns for shareholders. I'm certain that the company could be more efficiently run if it weren't controlled by the Dolans.

41:49All you have to do is look at the board of directors to see this in action. With 18 members, the board that's supposed to be holding the CEO accountable and representing shareholders is massive with 18 members, of which many are family. Worse is that they're sitting around collecting$250 ,000 per year simply for being board members. If that isn't concerning enough, just consider that this sort of misuse of shareholder wealth is what they're willing to disclose publicly. I wouldn't be surprised if no penny of shareholder money is spared on lavish amenities for the Dolan family and their friends.

42:22So the company's management and governance is not ideal to understate things, but it is fair to say that the quality of MSGS's assets are so good that it might more than make up for this. People were attending events at Madison Square Garden almost 100 years ago, and they probably will still be doing so 100 years from now. The bear case, in short is that MSGS reeks of a value trap. There is a discount to intrinsic value that will surely lure investors in, but that discount may persist for years, burning investors who don't have the patience to potentially wait decades, if ever, for the Knicks and or Rangers to be sold.

42:57Fans have demanded for the teams to be sold for years, and James Dolan's response has been just to slowly withdraw from the operations of the company to take the spotlight off of him. But there doesn't seem like there's enough pressure to force him to sell, at least not in this moment. There's also a question of opportunity costs. If you're going to treat an investment in MSGS stock as a private investment that you hold for the long term, since you might be confident in the value you're getting, even if it's not reflected in the stock price, there are certainly companies with better business models who will be superior compounders to own over time, especially if you don't see any specific catalysts on the horizon that would drive a sale of the two teams.

43:34That is, in a nutshell, the bear case. Still, I'm here to estimate the intrinsic value of MSGS. Price is what you pay, value is what you get, and there's clearly a favorable difference between price and value in this case, even if there are good reasons for that to be true. For what it's worth, MSGS has made moves to try to enclose the discount that its stock trades at and compensate shareholders, but they've been limited. There was a special discount in October 2022 of$7 per share, and over the last decade, management has repurchased around$400 million worth of the company's outstanding stock, with over$100 million of authorized buybacks still remaining that they can choose to implement.

44:15I would prefer to see them ramp up buybacks more aggressively and expand the buyback program, which effectively reduces the number of shares outstanding and bids the stock price higher. And I think that special dividend would have gone much further as a buyback and signaling to markets that management is serious about closing the valuation gap, or even if the Dolans don't sell their controlling stakes in the Knicks and Rangers, selling minority stakes in the company to, say, private equity firms could be enough to at least meaningfully close the gap between what Forbes estimates the two teams to be worth and the market cap of MSGS.

44:49But let's look at this supposed valuation gap more closely. There are two general approaches to valuation that investors can rely on. We can take a discounted cash flow perspective and map out the cash available to shareholders we think a company will produce over the next decade or so, and then reduce that back to a present value. Or we can take a pricing approach where we value assets based on what similar assets have sold for. For MSGS, I think the latter makes more sense, at least in my opinion, because we can't map out the company's profits without implicitly anticipating how the Knicks and Rangers will perform, which is not something you can predict with any real confidence.

45:26And as we've talked about a bit, sports teams aren't solely economic transactions. There are non-economic factors baked into the prices of sports teams from billionaires' egos to tax sheltering. So taking a pricing approach, I found a list from Morgan Stanley with details on all sales of major US sports franchises from 2021 to 2023. This includes sales of minority and majority stakes in teams like the Dallas Mavericks, Charlotte Hornets, Washington Commanders, Los Angeles Lakers, Golden State Warriors, Tampa Bay Lightning, and nine others. These teams in America's four major sports leagues sold at an average 17 % premium to their valuation, as estimated by Forbes, at an average 10 times multiple of revenue.

46:07If we were to assume no premium to the Forbes estimate of the Rangers and Knicks value, the combined value of those two teams is about$10 billion. If we tack on the average 17 % premium to what Forbes estimates, then the combined value is closer to$12 billion. Meanwhile, the company's enterprise valuation is roughly half that, which reflects the actual costs to acquire MSGS, including not just the market value of its equity, but also its outstanding debt. In other words, MSGS is currently valued at around 50 % of the current value of its two main assets, the Knicks and Rangers, even after you subtract out the company's debt and long-term lease commitments.

46:46As we look forward from there, the Knicks have compounded their Forbes valuation at 17 % per year for the last 15 years, while the Rangers have compounded their Forbes valuation at about 9 % per year over that same period. I don't think it's crazy then to say that over the next decade or so, the combined estimated value of the teams will probably continue to grow by at least 10 % per year. But this is speculative because while I think it's plausible, the number isn't necessarily in line with how the business will perform going forward. To help me grasp the thesis and valuation for MSGS, I spoke with Vince Pagano, who specializes in value investing and special situations.

47:23His basic approach to the valuation is to add up the Forbes estimates for the Nixon Rangers, subtract MSGS's net debt, and then divide that number by the number of outstanding shares. And that gives you a rough proxy of value per share. The numbers fluctuate depending on what you count as debt and whether you add a premium to the Forbes valuation. But for the sake of conservatism, I added no premium and used the largest calculation of debt, including long-term lease contracts for the garden. On top of that, Pagano recommended to me that I add in another 15 % discount to that value to reflect the fact that the valuation gap may never fully close.

47:59So at 85 % of the estimated net asset value of MSGS, I get around$350 per share. Over a three-year period, this implies a compound annual return of as much as 16 % per year from current prices. For the valuation gap to narrow like that, MSGS would have to get more aggressive about share buybacks or sell a sizable and minority stake in the company, or even better, if the Dolan family is forced out completely, the returns could be much higher. This also doesn't account for the fact that over the next few years, if the past 15 have been any guide, the combined estimated values for the Knicks and Rangers will probably continue to compound at double digit rates, adding to possible returns.

48:42I do have some mild concerns though about the Knicks and their valuation and whether it can persist because there've been a ton of reports lately about how viewership for the NBA has fallen off and it's not nearly what it was a decade ago and how ratings may be down even as much as 20 % year over year. I'm not sure what really to make of that though. And overall, I do feel pretty good that the NBA is in safe hands and any short-term headwinds can probably be rectified down the road. And I also know that I'd be buying in at a hefty discount to current estimates of the team's valuations. That said, I could easily imagine that a bad season for the Knicks could derail MSGS's operating results and further expand the discount between the stock's implied valuation for the two teams and what Forbes estimates.

49:24So I am conflicted. I feel like I'm biased by the fact that I think it would be objectively cool to call myself an owner of the Knicks and Rangers, but I can buy into the story here too, though. In all honesty, it is a pretty straightforward thesis. Forbes has a very good track record of estimating team values relative to what they end up selling for. And if anything, they usually end up being too conservative. And as we've covered at length, MSGS trades at a large discount to what Forbes estimates. If I want to put my Ben Graham hat on, then I can really convince myself that I shouldn't care about market pricing.

49:56I want to treat stock investments like any private business I could own and recognize that the stock market can have other reasons for discounting the value of a company like MSGS, but aren't all that relevant to long-term investors who truly like to think like owners of an underlying business. But buying into a stock long-term with such poor corporate governance and a system that's just really ripe for abuse from management is definitely a big red flag for me. Plus, there's the fact that the underlying business behind the Nixon Rangers is not super high quality, meaning that to some extent, the Forbes estimates are premised on billionaires continuing to pay more and more for sports teams at the same pace they have in the past, which is by no means guaranteed.

50:35I wouldn't want to bet on that not happening, but acting on an intrinsic value estimate for MSGS that isn't primarily based on real cash flows and profitability makes me a bit uneasy too. This is what makes a market, as I say, and this is what makes investing hard. I can see why it will likely work out with some protection working in my favor via the discount to Forbes valuation and the potential to quickly double the investment if the Dolan family unexpectedly sells the team. But I can just as easily imagine the stock stagnating for years and the discount widening further if either team doesn't perform well.

51:09Buying a stock at a discount to its sum of the parts valuation without a clear catalyst on the horizon is an infamous mistake investors have made in the past. And that's what is really giving me second thoughts here. My decision for the intrinsic value portfolio is not to add MSGS because I just don't feel good enough about the underlying business. If the profit margins on the Knicks and Rangers were higher and the teams kicked off more meaningful free cash flows, I'd have much stronger conviction in the private market value of the teams. But I can't help but think that the purchase price for sports franchises are pretty far separated from their operating profits and that there may very well be a bubble forming in acquiring sports franchises more generally.

51:48At some point, we have to hit a ceiling on who can even afford to buy these teams. There are only so many billionaires who could even pony up$8 billion in cash for the Knicks. And even with a consortium of billionaires making a purchase or investment funds getting involved with minority stakes, the momentum and prices paid for sports franchises has to wear out eventually. Your guess is as good as mine, but after 15 years or so of pretty rapid appreciation, We definitely aren't in the early stages. Like I said, if I felt there was a good economic reason that the Knicks were worth, say,$8 billion, I'd be all over this opportunity.

52:23It's another thing entirely to speculate that they could or should be sold for that much, though. It's like buying a house in a nice neighborhood just to flip it. That might work out for you, or it might not, and there's a component of random luck involved. The Knicks or Rangers valuations based strictly off of cash flows would be a fraction of what Forbes estimates, which is something Aswalt Demodaran covered generally in a 2023 video I'll link to in the show notes. And of course, there isn't a clear catalyst for a sale either. And while MSGS has the opportunity to close the valuation gap with aggressive buybacks, they have yet to really do that.

52:58While I do think MSGS is probably trading at a discount to its intrinsic value, I think there are likely better opportunities for companies to invest in long term, but if you did want to invest in MSGS, it's not something I'd recommend making a core portfolio holding. It's more of a special situation than a true long-term compounder, and as such, you'd want to manage your position size accordingly and very cautiously. All it would take is a bad season or two for the Knicks or Rangers to derail MSGS's financial results and hit the stock hard, but that actually probably wouldn't weigh on the estimated prices that the teams could sell for, so that would make for a pretty interesting buying opportunity, potentially.

53:37Right now, the Knicks and Rangers are both expected to continue doing well, and as such, the financial outlook for MSGS is better than it otherwise would be. But as we've covered today, MSGS's financial results could be a short-term headwind to the stock, while the value of its assets are not closely tied to their underlying economics. Meaning MSGS will very much continue to be on my watch list, and if for some reason the gap widens further between its stock market valuation and Forbes' estimated value of the Knicks and Rangers, I'd be increasingly interested in it. So that's it for today, folks.

54:10And I hope you enjoyed the first ever episode of the Intrinsic Value Podcast. For more on MSGS and some of the numbers I used and assumptions I made, make sure you're signed up for the Intrinsic Value newsletter, which I'll send out each week to complement the podcast. You can find the link to sign up in the show notes below. Next week, I'll be breaking down another interesting business and investment opportunity for you, and once again, decide whether it should be added to the show's portfolio. Obviously, I'm still looking for the first stock to add to it, but I know that patience will pay off over time.

54:43To wrap things up here, let me leave you with a timely message from the Oracle of Omaha, Warren Buffett. He tells us, quote, I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years. That's all for today, folks. I'll see you again next time. Thank you for listening to TIP. Make sure to follow the Intrinsic Value Podcast on your favorite podcast app and never miss out on our episodes. To access our show notes and courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. before making any decisions, consult a professional.

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