September 21, 2000

The Imbalance Sheet

Crying Snake

by Keith Law

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Reaction to the Arizona Diamondbacks' recent decision to increase the team's debt load by $20 million has been loud and unanimous: the sky is, once again, falling. How could one of baseball's "most successful" teams--a defending divisional champion--find itself in need of cash? As you might expect, there's a lot more to this news than meets the eye or, in this case, a lot less than the commentators in question would have you believe.

Americans are funny when it comes to debt. When investing, they often decry it, see it as a bad sign, and worry about the interest the company must pay. Yet when conducting their own personal finances, Americans routinely pay interest rates on their credit cards that nearly violate United States usury laws and that would seem unreasonable to Tony Soprano.

In the corporate world, any CFO worth his salt will tell you that you should always carry some debt. Debt has the beneficial effect of boosting the return a company gives to its shareholders. It does this via two mechanisms:

• Debt provides a company with additional capital to invest. The capital comes at a fixed price; right now, between seven and eight percent for the most creditworthy companies. If the company can find a use for that capital that returns more than the interest rate--say, 10%--then borrowing the funds and making the investment is a no-brainer. The 2-3% earned above the cost of the interest is pure profit to the shareholders, who didn't have to pony up any extra capital but suddenly saw their profits rise.

• The U.S. government's labyrinthine tax code allows a U.S. company to deduct most of the interest it pays on corporate borrowings. For example, a company that pays taxes at a 35% rate and that pays $7 million a year in interest (7% per year on $100 million of debt) would reduce its tax payment to the government by $2.45 million each year.

Furthermore, $20 million in debt is infinitesimal when we're discussing a baseball team. If a high-revenue team like the Diamondbacks is worth $250 million (a conservative figure, in light of recent franchise sales and the fee Colangelo Inc. paid for the expansion franchise) then adding $20 million in debt barely budges the team's debt/equity ratio. Even if Arizona already had $100 million in debt--and I haven't seen any press estimates that placed their current load that high--their new debt/equity ratio would still be under 0.5, which is a very safe level for a firm with solid financial prospects. The annual interest payments on the debt in question will be under $2 million, or less than a third of what the Snakes pay Jay Bell for 162 games of mediocrity each season.

What's notable about the Diamondbacks' call for cash is that one of the great spenders among high-payroll teams has found out that laying out all that cash doesn't pay on the field or at the till. The D'backs were widely criticized for buying a pennant last year, but much of the team's heavy spending has now come back to bite Jerry Colangelo on his sunburned ass: Bell, Matt Williams, Travis Lee, Todd Stottlemyre, Armando Reynoso, Matt Mantei and Tony Womack all look like white elephants right now.

If the Diamondbacks are really in tight financial straits, it's good news for the game, because it should serve as a warning to other owners that there are limits to how much poor investing the fans will cover through luxury-box and merchandising revenues.

Keith Law can be reached at klaw@baseballprospectus.com.