Mod Note (Andy): This was originaly posted 10/22/13 on his blog
In a week during which both Google and Netflix hit all-time highs, you would think I would pick one of these high fliers for special valuation attention. While I still plan to look at these companies, I am going to spend this week on a quirky valuation challenge: valuing tracking stock on a star athlete’s future income. Last week, a company called Fantex filed an S-1 (prospectus for a forthcoming security issue) with the Securities Exchange Commission, making public its intention to issue tracking stock on Arian Foster, a star running back for the Houston Texans in the National Football League (NFL).
In the filing, Fantex reported that it had paid $10 million in early October to Mr. Foster in return for 20% of all contract and endorsement income that he will earn after February 28, 2013. The S-1 also specifies that Fantex plans to raise approximately $10 million (thus covering its outlay) from the issuance of 1.055 million Arian Foster tracking shares to the public, and use its share of Mr. Foster’s income to pay dividends to these shareholders. The picture below captures the initial set up:
Fantex intends to use its platform to attract more athletes and celebrities into the mix, thus creating a portfolio of tracking shares that can be traded by investors.
Arian Foster: Background
Arian Foster was born on August 24, 1986, and is a running back for the Houston Texans. He played college football at the University of Tennessee and was signed as an undrafted free agent by the Texans in 2009. In 2010, he had a monster year, leading the NFL in rushing, yards from scrimmage and touchdowns. He continued with impressive performances in 2011 and 2012, as can be seen in his career statistics page.
Arian is also clearly a self-promoter (in the best sense of the word) and has aspirations beyond the gridiron. He has his own website, where he characterizes himself as an all-pro running back, entrepreneur, philosopher and father.
On March 5, 2012, Arian signed a five-year contract with the Texans worth $43.5 million. The contract had a guaranteed payment of $20.75 million, including a signing bonus of $12.5 million, his first year salary (2013) and $3.25 million of his second year salary (2014). He is also entitled to bonus payments, based on performance in games, of up to $5.25 million in 2013, $5.75 million in 2014, $6 million in 2015 and $6.5 million in 2016. He is a free agent in 2017.
Claim and Contract details
To value the claim on Arian Foster’s income, you need to break down the cash flow claims that you have on the income. Note that while Fantex has a contractual claim on 20% of Foster’s future income, investors in the tracking stock don’t have that direct claim. Instead, they are dependent on the dividends that Fantex chooses to pay out from that income.
As noted in the figure, there are at least two expenses that Fantex will incur that will make the dividends paid less than the income that they get from Foster. The first is that a portion will be set aside to cover the expenses associated with managing and maintaining the Fantex platform. The second is that Fantex views its role as not just a contractual intermediary but also as a brand building organization. Effectively, that implies that Fantex can and will use some of the Foster income to market him better (and hopefully increase endorsement income).
To value the Foster tracking stock, we will go through three steps. In the first, we will lay out broadly the risks faced by investors in the tracking stock. In the second, we will value the cash flow claim that Fantex has on Foster’s contract and endorsement income. In the third, we will evaluate the claim that investors in the Foster tracking stock have on the dividends they receive from Fantex.
The Risks
The S-1 goes to great lengths to emphasize the point that this is a speculative investment, but since that should have been obvious to anyone thinking about the investment, it is important that we break down the risks at each stage of the process:
Working the risks through the pipeline, here at the layers of risks that we see, starting with risks to the earning stream and then moving on to risks in the intermediary and ending with risks at the investment level.
Earnings Risks
1. Player Risks
The most immediate impact on player earnings comes from the athlete with two big risks to earnings: injuries that are career ending or a drop off in performance skills, either as a result of age or earlier injuries.
1.1. Player Skills/Longevity
A. Player Injuries: If you are laying claim on a professional athlete’s future earnings, you are exposed to any injury/event risk that impedes his or her capacity to perform on the field. Part of this risk can be mitigated at the contract level, if you have guaranteed income (that will be paid even if the athlete is injured) but it will still affect the athlete's earnings power in terms of getting contract renewals & bonus income.
Arian Foster shares: Foster's guaranteed income on his contract has dwindled down to $3.25 million and almost all of his remaining income will be at risk if he is injured. While Foster has been durable through his early years, there are two reasons to worry. The first is that he just hurt his hamstring this season, an injury that may keep him out for a portion of the season and may be a harbinger of things to come. The second is that injuries tend to climb as athletes age, and especially so for running backs whose bodies take significant punishment on the field.
1.2. Player performance
While a player’s current contract may be unaffected by declining performance, there are two reasons why it will feed through into the earnings claims. First, if there are bonus payments, as is the case with Arian Foster, they will clearly be put at risk, if performance deteriorates. Second, to the extent that you are counting on a continuation of earnings from a contract renewal (from the current team or another team), future earnings will be lower, if the player’s performance deteriorates.
Arian Foster shares: Age has to be factored into the equation since he is 27 in a sport where running backs seem to age faster than everyone else in the field. One assessment of running back output based on age yielded the following graph on production for running backs (and quarterbacks):
Note that output for running backs peaks early (24-25), levels off until about 27 and starts deteriorating after that age. Foster may very well be the exception to this rule, but it is dangerous to bet against history.
2. Macro Factors
There are two macro level risk factors that can affect a player’s earnings.
2.1. Collective Bargaining Constraints
In most sports, there is a players’ union that negotiates with team owners on both contract rules and constraints. While individual players may negotiate on their own behalf with teams, the constraints imposed by collective bargaining agreements may affect earnings potential for individual players. For instance, the hard caps on team payrolls imposed in the NBA and NHL and even the soft caps in the MLB (soft, because they can go over the cap as long as they pay the penalty tax) have affected player negotiations and contracts.
Arian Foster Tracking stock: The NFL’s current salary cap is $123 million per team and each team is required to spent more than 95% of that cap. Both teams and players, though, have become adept at evading the cap constraints by loading more of the payment into future years. With Arian Foster, I am going to assume that this will be a minor factor.
2.2. Economic factors
The magnitude of a player’s earnings may be affected by the overall economy, especially if a large proportion comes from endorsement income and that income is expected to grow over time. The growth in the aggregate economy can also affect revenues to a sport in the aggregate and thus indirectly affect how much can be paid out in contracts to players.
Arian Foster Tracking stock: Since only a small portion of Foster’s current earnings (less than one million) came from endorsements in 2013, the impact of the overall economy on his earnings is likely to be small.
3. Player Default
Even if the athlete in question generates high earnings, the earnings stream to investors is dependent upon that athlete carrying through his side of the contractual agreement and delivering the promised portion of earnings to investors. If the athlete defaults on that obligation, your earnings down stream are at risk. You could, of course, seek legal recourse but given that an athlete who defaults is also likely to have other financial problems, it is unlikely that you will get much of your promised payback.
Arian Foster shares: We have little evidence on Arian Foster’s default history. The strongest case that can be made for him is that he is ambitious and hopes to parlay his pro career into entrepreneurial ventures. Presumably, that will mean that he will not be cavalier in defaulting on contract obligations. That does not mean that there is no default risk but we will assume low default risk.
4. Intermediation Risks
Investors don’t have a direct claim on Arian Foster’s earnings, since those earnings will be first collected by Fantex, which will then decide how to much of these earnings will be returned to investors as dividends. Consequently, there are three additional risks to factor into the assessment:
4.1. Poor brand building investments
Fantex views itself as a brand builder for the athletes who decide to use it. That would imply that some of the earnings collected from the athlete will be spent in trying to increase earnings in the future, primarily from endorsements. There are no guarantees, though, that this trade off will be a positive one. Thus, it is possible that Fantex will expend 20%, 30% or even 50% of Foster’s earnings, trying to increase his marketability, with no discernible effect on endorsement earnings.
4.2. Spillover risks
One of the stranger features of the Arian Foster stock is that investors in the stock may be called upon to bear losses incurred by Fantex on other athletes that it may have in its portfolio. Thus, if Fantex makes a big up front investment in a potential superstar (Andrew Luck) and that star suffers a career ending injury, investors in the Foster stock may take a hit.
4.3. Corporate governance risk
The nature of tracking stock is that holders of the stock are onlookers when it comes to corporate governance, since they have no power to change or even influence managers. This is going to be a factor on two levels. The first is that Fantex will take a portion of the collective revenues it gets from player earnings to cover management expenses & fees; if it keeps “too large a portion” of the earnings for these expenses, there is little recourse for you as an investor. The second is that Fantex is not required to pay the residual earnings (after brand building expenses, management expenses and other portfolio charges) to investors) as dividends. While this is always a problem with publicly traded company stock, investors in conventional shares get a claim on the cash balance which may compensate (at least partially) for the unpaid dividends. There is no such compensating claim with tracking stock.
5. Investment Risk
If you are an investor who decides to buy Arian Foster tracking stock, there is one final risk that has to come into the picture. Since there is no ready market (yet) for these shares, it may be difficult and expensive to liquidate these investments. In valuation, that is generally a reason for either charging a “illiquidity premium” in your discount rate (increasing the discount rate) or attaching an “illiquidity discount” to the value. The extent of the effect will depend upon how much you value liquidity as an investor and how easy/difficult it is to trade these shares.
Arian Foster tracking stock: Since this is the first set of tracking stock, I will assume that there is substantial illiquidity risk. That risk may decline over time as more athletes get listed and the Fantex trading market becomes more liquid, but neither is a reality yet.
Valuing the Fantex Claim
To value the claim on Arian Foster's earnings, I began by forecasting aggregate earnings to Arian Foster. In making these forecasts, I assumed that:
- Expected playing time: I will assume that Foster will play for nine more years, until the age of 36, at which point both his contract income and his endorsement income will end.
- Current contract: The current contract would deliver on the remaining $23.5 million due between 2013 and 2016. On average, that works out to $5.875 million a year. During the current contract period, I will also assume that he will earn approximately $2 million in bonuses each year, approximately a third of his overall potential bonus payments.
- Contract renewal: At the end of the current contract period, I am assuming that Arian Foster will get resigned to a new contract for the rest of his, worth $4 million a year, assuming that his age (31) and the production decline that comes with age with affect his earning power. I will also assume a step down in bonus income to $1 million a year for the rest of his career.
- Player fines/penalties: Given Foster's clean history and the position he plays, I will assume no dollar penalties will be imposed on his during his lifetime.
- Endorsement Income: Arian Foster's endorsement income in 2013 was $687,750 (though some of it is contingent on performance). I will assume that there is substantial growth potential (10% annual growth rate) in this income.
To value the cash flows, I have to make assumptions about player and default risk. For player risk, I will assume that there is a 5% probability of a career ending injury each year, resulting in cumulative probabilities that will increase over time (to 37% by the last year). For default risk, I will assume that Arian Foster's history & desire for commercial success will keep default risk low (a default spread of 1.50% and a discount rate of 4.1%). will be added to the risk free rate. For endorsement earnings, I will assume that there is low exposure to macroeconomic risk, resulting in an equity risk premium of 3% (and a discount rate of 5.60%). The table below captures the cash flows, discounted value and the value today (with the link to the spreadsheet).
The value of the claim on Foster's earnings to Fantex, based on these assumptions, is $10.06 million (before accounting for expenses and injury probabilities). Fantex paid $10 million to get these claims, this looks like a break even deal for both sides of the transaction, with Arian Foster having the slight edge.
Valuing the Tracking Stock
To value the tracking stock, I have to factor in the drains on the cash flows from management expenses and branding investment, as well as the additional risks from not getting a direct claim on the earnings. For the first, I will assume that management expenses will consume 5% of the flow through earnings (as specified in the S-1) and branding investments will account for 15%, leaving 80% of the earnings as residual earnings. While I will assume that all of the residual earnings will be paid out as dividends, Fantex has no history (good or bad) in this respect and I will add an extra 3% to my discount rates to capture my absence of any corporate governance power (over either expenses or dividends). Finally, I will incorporate an additional premium of 3% in my discount rate for illiquidity, since it is unclear to me how I would exit this investment, without bearing significant costs. The value of my claim is illustrated below (with the link to the spreadsheet):
Specifically, I will be willing to pay $6.11/share for the Adrian Foster tracking shares, with my assumptions. There is a conversion feature on these shares, but it can be exercised only by the company to convert these tracking shares into Fantex platform shares; that option will make my claim less valuable, not more so. Consequently, I would not be a buyer at the $10 share price that Fantex has tentatively tagged the shares as worth in the S-1 filing.
Update: In both the Fantex and tracking stock claim valuations above, I did not incorporate the injury probabilities. Since I have an estimated probability that Foster will be playing in future years, I decided to incorporate that probability into the value and not surprisingly, it brings both numbers down:
Note that there is only a 63% chance that Foster will be playing in year 9 and the value of the Fantex claim drops to $8.2 million, giving Foster the clear edge on the deal, and the value per claim drops to $5.07.
http://aswathdamodaran.blogspot.fr/2013/10/game-on-tracking-stock-on-ar…
What incentive does Fantex have to pay out dividends to the tracking stock? It would make me feel better if Fantex had some skin in the game but it appears they get back the $10m from they paid to Foster from the tracking stock investors.
Fantex needs to entice investors with something; obviously from their angle, they'd rather give out dividends than give its investors access to the 20% claim as well. In effect, it's a brilliant way for Fantex to cover its initial investment while still owning its 20% claim.
Thank you for posting this valuation. I have been very interested in this firm since it announced its S-1 and was looking to create my own valuation as some point for the fun of it. My major concern with this tracking stock and investment idea in general is the definition of “brand income”. It stated anything related to brand would be part of the 20% deal but how far does that go to? I know Arian just invested to be a partner and ambassador of Health Warrior, purveyor of premium Chia Seeds and Chia Bars, does the income from his share of the business count toward 20% brand income? Considering the fact that his NFL reputation and brand is definitive an added bonus for this company. If so there may be additional income to consider in the valuation if this company or any similar were to do well e.g. George Forman Grill haha
No desire to take the Fantex risk - selling tracking stock in pro athletes isn't an very viable business. And while greater fool works to a point, it also tends to attract regulatory scrutiny.
f Foster gets lucky with an endorsement a la 50 Cent and Vitamin Water or Beat by Dre someone will find a way to structure the deal to avoid the claim.
Also, not clear the NFL salary cap continues to grow (likely flatish when Foster's contract is up). So $4mm on his next deal could be very optimistic.
The idea that you would risk capital on a completely uncontrollable and unpredictable asset such as another human being with no direct upside unless they can produce above the market expectation is just a loosing idea. If he goes out and gets a DWI, tears an ACL, gets tagged as a diva and loses 60% of future earning potential you can kiss your money good bye. As opposed to investing in Apple where you can always dump your stake and recoup at least some of it.
Too high risk. To fathom this one out versus singer's royalty (a la Michael Jackson or Bowie) bonds, it's just too high risk.
Hey Aswath, so i am working on revising your model for Vernon Davis, since he is the next player for Fantex, however I noticed you included the injury risk in valuation.
This makes logical sense since these players are prone to career ending injuries, but when you look into S1 they have a clause stating the converison of Arian Foster stock into Fantex Platform stock at equal fair value. This makes me think the valuation should be adjusted to show a stock converison for platform stock. Working on that part now, but if you have any suggestions how to do it, let me know.
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