Reviewing first day motions from a company's chapter 11 docket, and more specifically the CEO's declaration, can be a great way to learn exactly what happened in the days/weeks leading up to a bankruptcy filing. The company spends millions of dollars every month on expensive lawyers (Kirkland & Ellis in the case of Toys "R" Us), investment bankers (Lazard), turnaround advisors (Alvarez & Marsal), claims administrators, etc., who all spend many sleepless nights in the days leading up to a filing trying to make sure the first day motions are as informative as possible.
With those high expectations, you can imagine our surprise when we opened the Toys "R" Us CEO's declaration to find this "preliminary statement":
Yes, Kirkland & Ellis was paid $800 an hour (ish) to type up the Toys "R" Us jingle in a court filing. Bravo!
In any event, once you get beyond the amateur-hour antics, CEO David Brandon explains why Toys "R" Us was forced to file for bankruptcy in such a hurry. While debt service on a excessively levered capital structure was a big part of it, Brandon explains that media speculation over a potential bankruptcy filing led to a rapid tightening of trade terms just as the company was trying to build inventory ahead of the holiday season. Here are the details:
1. Debt - Apparently spending the majority of your FCF on debt service while ignoring capital improvements and store remodels is a bad long-term business strategy for a bricks-and-mortar retailer.
Toys “R” Us, however, has been operating for more than a decade with significant leverage, necessitating the use of substantial amounts of cash each year (approximately $400 million) to service the more than $5.0 billion of funded indebtedness. But these substantial debt service obligations impair the Company’s ability to invest in its business and future. As a result, the Company has fallen behind some of its primary competitors on various fronts, including with regard to general upkeep and the condition of our stores, our inability to provide expedited shipping options, and our lack of a subscription-based delivery service.
2. Vendors - Media speculation of an imminent bankruptcy filing starting on September 6th caused 40% of vendors to restrict shipments and demand "cash on delivery" for new inventory purchases which would have required $1 billion incremental liquidity.
More recently, the Company’s need for a comprehensive solution to its capital structure issues caused widespread “bankruptcy” speculation in the media, leading to a severe constriction in the Company’s trade terms. More specifically, in late July the Company hired Kirkland & Ellis LLP and Alvarez & Marsal North America, LLC, complementing its retention of Lazard, to consider restructuring and capital structure solutions.
A news story published on September 6, 2017, reporting that the Debtors were considering a chapter 11 filing, started a dangerous game of dominos: within a week of its publication, nearly 40 percent of the Company’s domestic and international product vendors refused to ship product without cash on delivery, cash in advance, or, in some cases, payment of all outstanding obligations. Further, many of the credit insurers and factoring parties that support critical Toys “R” Us vendors withdrew support. Given the Company’s historic average of 60-day trade terms, payment of cash on delivery would require the Debtors to immediately obtain a significant amount—over $1.0 billion—of new liquidity.
3. Holiday Inventory Build - Finally, this all came at the exact moment that the company was trying to build inventory for the holiday selling season.
The timing of all of this could not have been worse, as the Company is in the process of building holiday inventory. While birthdays, new game releases, and other special events drive year-round sales, the holiday season is the most important for annual results. In the fourth quarter (the weeks prior to Christmas), the Company generates approximately 40% of its annual revenue.
To prepare for the holiday season, Toys “R” Us significantly increases inventory in September to fill store shelves with the selection and variety of products our customers expect. Accordingly, I believe it is critical that the Company reopen its supply chain immediately to ensure a successful holiday season.
Given that, it's somewhat ironic that Bloomberg notes this morning how important Toys "R" Us is to vendors and how Mattel and Hasbro couldn't possibly allow the company to liquidate.
Rest easy, kids. Toys “R” Us Inc. isn’t going anywhere, at least not if the makers of Barbie and Transformers have their way.
Yet, the company, which operates about 1,600 stores globally, will likely survive because manufacturers such as Mattel Inc., Hasbro Inc. and closely held MGA Entertainment Inc. need the last remaining toy chain. These vendors are eager for whatever remaining leverage they have against the might of Amazon and Wal-Mart, the bane of all companies focused on a single category of shopping.
“Oh my God, they are very important, and people don’t understand,” Isaac Larian, founder and chief executive officer of MGA, said of the toy chain. “That’s the only place where kids can go and just buy toys. There is no toy business without Toys ‘R’ Us.”
In many respects, suppliers have been propping up Toys “R” Us for years, according to Moody’s Corp. analyst Charlie O’Shea; they give the chain exclusive products during the holidays and funds for promotions to help it compete with the general merchandisers. The manufacturers offer this support because they want a place to sell toys at full price, year round. Major brands have also been funding an overhaul of Toys “R” Us stores by adding more featured areas for top brands such as Mattel’s American Girl dolls.
In the toy business, the incentive is particularly powerful. Last year, Toys “R” Us accounted for 11 percent of sales at Mattel and 9 percent at Hasbro -- the second most at both companies after Wal-Mart.
Meanwhile, many have speculated this week over how/why TOY bonds traded off 75 points on the company's filing? How could they be so wrong? While the timing of the filing was probably somewhat of a surprise, we can't help but wonder whether this simplistic org structure might have contributed in some small way?