With the $1.05 billion "Transformation" of Madison Square Garden (MSG) Arena finally complete, the company released its Fiscal 2014 Second Quarter earnings report and the results appear to be very impressive at face value. However, a deep dive into MSG's performance pre-Transformation reveals that the massive renovation project and arena upgrade may not have yielded its desired financial impact.
For the first time since 2010, MSG was operating near full-capacity with both the New York Knicks and Rangers playing complete home schedules, no longer affected by union-related lockouts. As a result, MSG second quarter revenues grew by 31 percent to $509.4 million and operating income grew 19 percent to $96.5 million.
In essence, the growth in revenue and operating income was only so strong because the prior year second quarter was negatively affected by the NHL work stoppage. MSG's Sports segment lost substantial revenue as the Rangers played 17 fewer home games, while MSG Media broadcasted 34 fewer hockey games. Because of the NBA work stoppage during the 2011-12 season, the only true gauge of MSG's earnings is a comparative analysis to the quarter ending in December 2010.
Qtr end 12/2010
Qtr end 12/2013
Growth % (Annualized)
It is clear that Q2 2014 results are not nearly as impressive when comparing to the quarter ending December 2010. The Entertainment segment lost revenue, and total annualized growth of 5.69 percent is substantially lower than the 31 percent being reported by the company in Fiscal 2014 Q2.
The net loss for the Sports segment is of particular concern considering the additional games played at the Garden. Why is the Sports segment losing money, in spite of added seating capacity from the "Transformation?" The answer lies partially in something I have written extensively about while covering MSG; the freshly negotiated NBA and NHL Collective Bargaining Agreements and its provisions for revenue sharing and luxury taxes. To promote competitive balance among small and large market teams, both the NBA and NHL have implemented more aggressive luxury taxes for teams with the highest payrolls and increased revenue sharing to stand up less profitable franchises.
MSG's Chief Financial Officer, Robert Pollichino, spoke at length on this subject during the earnings conference call. According to Pollichino, operating expenses for the Sports segment increased by $16 million from the prior second quarter due to the NBA luxury tax and NBA/NHL revenue sharing system. The luxury tax for the Knicks is projected to be even more punitive next season. The team's 2014-15 payroll will grow at least $1 million for a total of $90.7 million, which is a staggering $19 million over the 2014 luxury tax threshold of $71.7 million. This is based solely on players signed for next season and does not include draft picks and any other additions to the team. As it stands currently, the Knicks are paying $3.25 for every $1 over the luxury tax threshold. By adding just $1 million in payroll, the Knicks operating expenses would grow by $3.25 million.
The news on the luxury tax front only gets worse for the long term. If a team pays into the luxury tax pool for 4 out of 5 seasons, a repeat offender penalty kicks in that increases the tax formula to $4.25 for every $1 over the threshold. Based on the current payroll, this would add an additional ~$20 million to the team's operating expenses.
What makes matters worse is that despite MSG management's excessive spending on player salaries, the Knicks are not winning and on the outside looking in for making the playoffs. Home playoff games generate approximately $3.6 million in revenue and up to $2 million in adjusted operating cash flow per game. Considering the Knicks played six home playoff games last year, the team's failure to make the playoffs would cost the Sports segment nearly $22 million.
One other concern that was raised during the earnings conference call was a small subscriber decline for MSG networks over recent months, which may have a negative impact on Media revenues for the upcoming quarter. It's unknown whether the subscriber decline is directly related to the Knicks disappointing season, but it certainly will not help subscriber demand and advertising fees if the team is playing meaningless games in February and March.
In spite of the aforementioned concerns and issues, there are still several positives that make MSG an appealing long term investment. First, and most importantly, capital expenditures will drop dramatically in upcoming financial statements. The "Transformation" is complete and MSG has already paid 92 percent of the $1.05 billion tab in cash. In addition, the renovation of the Forum in Inglewood, CA is also complete and the company has paid off 76 percent of the $103 million project in cash. The Forum's completion and grand re-opening in January 2014 will certainly help grow the revenue base for the Entertainment segment, with income growing simultaneously as capital expenditures decrease.
On the Media side, MSG networks are successfully diversifying viewer content, offering more than just Knicks and Rangers coverage. Its networks are also showing New Jersey Devils, New York Islanders, and Buffalo Sabres hockey games, in addition to hundreds of high-profile college basketball and football games. This is a wise move for the company as it offers more quality content and demand becomes less dependent on the win-loss percentage of the Knicks and Rangers.
MSG has still grown its profit base considerably over the past few years. The real question is whether $59 a share is still a good value for investors based on the company's performance and where it is heading. The week of 30 December 2011, MSG was trading for $29 a share. Based on operating income growing nearly 92 percent during the 3-year span, $55 a share or less would be a fair price for investors to jump in. For current shareholders, my recommendation is to hold and see the complete effect of the "Transformation" and the opening of the Forum on MSG's earnings. Investors will also get a good look at just how dependent MSG's earnings are on the success of its sports teams, since the Knicks may miss the playoffs for the first time since the 2009-10 season.