“I don’t want to grow up!” sang Toys “R” Us’ famous jingle from our TVs, year after year.
Unfortunately, that’s not how the world works, and neither kids nor retailers get to skip out on that reality.
Retailers don’t necessarily have to die, but plenty of them have been digging their own graves. The bankruptcy of Toys “R” Us wasn’t an accident or a surprise.
In a move one can justifiably call a suicide, the company choked itself to death with debt.
The demise of Toys “R” Us is a lesson for all retailers, and it’s a lesson for investors.
The Original Toy Story
On September 18th, Toys “R” Us announced it had filed for Chapter 11 bankruptcy protection in U.S. Bankruptcy Court for the Eastern District of Virginia.
The stock market wasn’t rocked in the least; Toys “R” Us is a private company.
Founded in 1948 as a baby furniture retailer, the company’s first name was Children’s Bargain Town. It later merged into Interstate Stores and had its first brush with death when Interstate Stores declared bankruptcy. What emerged from that near-death experience in 1978 was a public company with a new name.
The NYSE stock symbol for Toys “R” Us was TOY. Now, let’s jump to 2005 when a leveraged buyout (LBO) worth $6.6 billion made TOY private.
It was a group effort by buyout specialists Kohlberg Kravis Roberts & Co., Bain Capital Inc., and Vornado Realty Trust, a commercial real estate investment trust (REIT). These big kahunas and other investors put up $1.3 billion in equity and borrowed (hence the leverage) $5.3 billion to close the deal.
There’s no denying that Toys is a commanding presence in its market. According to the company’s website, it currently has 885 Toys “R” Us and Babies “R” Us stores in 49 states, 810 international stores, and 65,000 employees.
But it also has extraordinary debt-service obligations. On top of huge retail space lease payments, many of them above market long-term leases, the company has been burdened with approximately $400 million a year in debt service. Another $444 million is due at the end of January, and, if not renegotiated, another $2.2 billion is due in 2018.
While in the process of gearing up for the holiday season (when the company generates a whopping 40% of its annual net retail sales), CNBC reported on September 6th that Toys “R” Us had “hired attorneys to consider its strategic options.”
Vendors took immediate notice and began demanding cash for inventory the company hoped to stockpile.
That was the last straw for the heavily burdened and cash-flow-poor private retailer. It filed for bankruptcy protection less than two weeks later.
But before you cry for the principal equity investors in the LBO, who will be wiped out of their remaining equity stake, take another look.
The investors extracted more than $470 million in fees and interest since the buyout, and several entities they control own senior and preferred company debt, which makes them first in line after suppliers and vendors if the company fails to emerge from bankruptcy and liquidates itself in the future.
You don’t need to worry about them. What you need to worry about are the steps Toys “R” Us didn’t take years ago that could have prevented this disaster.
Exactly Where Toys “R” Us Went Wrong
According to Charlie O’Shea, Moody’s lead retail analyst, Toys was in “constant refinancing mode.” (O’Shea has been following the company since it was public and continues to as it still has filing obligations with the SEC because of its publicly traded debt securities.) Management had its hands full with the company’s extraordinary debt load as realities in the retail space were shifting.
Amazon.Com Inc. (NASDAQ:AMZN) didn’t kill Toys “R” Us. Back in 2000, Toys tried to make a deal with Amazon, but it fell apart. There was more the company could have done in the wake of the failed deal.
Management could see the coming online onslaught, but couldn’t focus on much more than staying alive by making debt payments. The company not only failed to be proactive about its online and multichannel sales efforts, it also failed to cut its extraordinary overhead, namely huge retail stores around the world.
It also failed to embrace the growing popularity of online gaming as if the kids it catered to wouldn’t ever grow up and glue themselves to their computers, tablets, and smartphones.
And the company never recognized the absolute value of subscription services, which it could have easily started and commanded since parents are in constant need of baby supplies and services.
All Toys “R” Us has left is the tried and failed deep-discounting model that cratered its revenues when shoppers ran to its stores to scoop up merchandise that was advertised at, on average, 54% less than what one could find on Amazon. Those customers would then leave without buying other merchandise and return to Amazon et al. looking for other bargains.
Buying leveraged retailers who aren’t moving at lightning speed to create omnichannel sales pathways just because they’re big names is not the right move for investors and traders. Even if those once-darling stocks have bounced on account of the market making new highs, those bounces won’t last forever.
My tried-and-true method is to short these companies or buy puts on them like we do in Zenith Trading Circle. You can follow along with us there to get specific trades and guidance.
Toys “R” Us isn’t the first brick-and-mortar retailer to succumb to the pressures of the new world of retail, and it won’t be the last. I plan to keep a very close eye on any profit opportunities these debt-laden relics offer me.