How Did Toys "R" Us Implode So Fast? The CEO Explains

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.

Toy

 

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?

Comments

venturen Wed, 09/20/2017 - 12:36 Permalink

quicker story....private equity owners want to screw people out of pension, medical and wages....and other creditors...and this is the quickest way!

Herp and Derp MrSteve Wed, 09/20/2017 - 15:43 Permalink

It would be great if the movies were worth seeing.  The local to Seattle theater chains (not owned by the film festivals/coops) have taken Chinese money and upgraded to electronic reclining chairs and serve beer.  They are cold as heck though because you and maybe one or two couples at most will be the only people in the theater.

In reply to by MrSteve

Common_Cents22 MrSteve Thu, 09/21/2017 - 08:19 Permalink

People still go to movie theaters????If you haven't looked into home theater projectors, you should.   They are incredible "value" compared to large flat screen TV or movie theaters.   HD 1080P for a few hundred bucks and you can get a huge screen projection, 90-150in diag.    All in the comfort of your own home.4K (interpolated, not native yet) projectors are now getting to $2,000 price point.Couple that with the various streaming services, and even Free KODI add-ons that have moves in HD that are still in the theaters.

In reply to by MrSteve

Dammit Walter the late idi armin Wed, 09/20/2017 - 17:39 Permalink

Exactly!  Any company that took on debt at relatively high interest rates of 80s, 90s, 2000s, must pay a larger portion of their profit to service the debt, than folks that get lower interest rate loans at todays near zero financing rates.   That puts you at a disadvantage, because that money could go to improving the store or hiring more employees, giving raises (Ha!) and retaining good employees, expanding into other areas, marketing, etc, etc.  Especially when competing against Amazon which avoids the cost of a brick store, and has access to the same suppliers that you do.  Lower cost tends to supercede most other differentiators.  Online retailers are eating into B&M to the point where business forecast is flurries of Closures and Bankruptcies for the foreseable future.  (Not that this is a good thing... just the current reality)

In reply to by the late idi armin

twh99 tmosley Wed, 09/20/2017 - 13:04 Permalink

Not necessarily true.  If you have the proper cash flow, then credit can be a help.  In their case they didn't have the proper cash flow.What really screwed them was their excessive debt and loss of confidence by their vendors.Given the same conditions many many public companies could find themselves in the same boat.

In reply to by tmosley

MrSteve twh99 Wed, 09/20/2017 - 13:43 Permalink

And what listed firm hasn't borrowed bigly for stock buybacks and C-suite options jackpots? Shrinking the share count just like shrinking the product packaging is the opposite of how firms grow. As the economy loses purchasing power, debt will only become more of a crush on cash flow, same as in any recession. The credit contraction impulse from the FED via bond rollover shutdown may be enough to trigger a panic, like rumors TOY was going Chapter 11 shut off vendor credit. Full faith has been broken in the USA credit structure.

In reply to by twh99

tmosley Rockatanski Wed, 09/20/2017 - 17:16 Permalink

ToysRUs went private via a leveraged buyout. They have been a dead store walking since 2005. ObummerCare probably put the last nail in the coffin, as some handsome poster above mentioned.Well, that plus the outdated business model. They were the "expensive" toy store. Everyone else gets their toys from Walmart and Amazon. If they buy toys at all. Kids these days have their eyes glued to portable devices (which is TERRIBLE for their developing eyes, by the way).

In reply to by Rockatanski

BlindMonkey Wed, 09/20/2017 - 12:40 Permalink

One wonders when the State of Illinois is going to be put on a COD program since they aren't paying vendors either.  The outstanding tab is around $13-15 Billion or so.

NoWayJose Wed, 09/20/2017 - 12:40 Permalink

I am baffled why these retailers load up on debt - store ownership is a horrible model (ask Sears). Much cheaper to license your name to someone else who will lease storefront space. Then supply the licensee with your products. Any retailer in the 'we own our own stores' space is going to go under.

mkkby NoWayJose Wed, 09/20/2017 - 15:35 Permalink

Overpriced crap nobody wants might have something to do with it. In case you haven't noticed, kids play video games at an early age. Even as a kid I didn't like the junk in those stores.

A robot that turns into a building. I don't get it. What's fun about that?

Buy your kid a bat, softball, basketball, soccer ball. Last forever and promote good health. No electronic shit that makes them fat and stupid, and doesn't last as long as the credit car bill.

In reply to by NoWayJose

lucyvp mkkby Wed, 09/20/2017 - 21:02 Permalink

Problem is you can't buy the bat, ball, truck, etc at toys-r-us.I have kids and tried.  Some accountant took over merchandising in the 2000's and the store was heavily tilted toward high margin crappy toys that are fascinating for a few hours then abandoned, then I throw them away the following year.  Simple toys last a life time.  Simple toy trucks, cars, balls, bats.  Inexpensive and due to their simple nature it is the mind that can decide how they are to be used.  Electronic do-dads are so sophisticated/dedicated it can only be used one way.  I stopped going to toys-r-us 12 years ago.

In reply to by mkkby

migra NoWayJose Wed, 09/20/2017 - 16:00 Permalink

If you have a great product store ownership is a good way to protect the brand. Starbucks comes to mind. Selling an addictive product with them owning the vast majority of stores is a great way to control quality. At the same time their error has been pissing off millions of current and potenial customers with their out spoken left wing political postions. 

In reply to by NoWayJose

rockstone Wed, 09/20/2017 - 12:44 Permalink

It appears to be yet another case of running out of other people's money.

I do like this guy's attitude though;

“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."

Nice way to hustle for that bail out. "It's for the children! My God, have you no compassion?"

Nope....

CRM114 rockstone Wed, 09/20/2017 - 19:28 Permalink

Exactly.Effectively mortgaged the company up to the hilt. Put suppliers on 60 day credit.Put themselves on a pedestal. It fell over.Sympathy? You will find it in the dictionary between sh!t and syphillis.Dear Stock/Bondholders, the senior management doesn't just not give a f#ck about customers and employees, they don't give a f#ck about you either.

In reply to by rockstone