What can we learn from Toys "R" Us bankruptcy?

In September, 2017 Toys ‘R’ Us, a toy, clothing and baby product retailer filed for bankruptcy. Founded by Charles Lazarus in its modern iteration in June 1957, Toys "R" Us traced its origins to Lazarus's children's furniture store, which he started in 1948 to capture the post war baby boom market. The focus of the store changed in June 1957, when the first Toys "R" Us store dedicated exclusively to toys was opened by Lazarus in Rockville, Maryland.

While the veteran brick and mortar retail industry has faced a lot of disruption since the emergence of online retailing, Toys ‘R’ Us is an interesting case of an old and healthy company can run out of business due to the mismanagement of company resources and assets.

In early 1990's, Toys "R" Us was also known as a the king of the toy castle. It was ranked as one of the biggest toy seller in the world, killing smaller owned chains as it expanded rapidly across the US and outside. At its peak, Toys "R" Us was a classic example of a "category killer" retailer. However, the market landscape changed in the next decade with retail giants like Walmart and Target selling more toys than the erstwhile king.

The company, at the time, launched an ambitious program to relaunch the chain store by separating their baby and their toy business. The company was seeking a turnaround by raising capital that would allow it to align itself closely with its closest competitors like Walmart and Target.

Finally, in 2005 KKR and Bain Capital bought Toys R Us for about $6.6billion. The company was valued at $7.5 billion, with the assumption that there was just under $1B of debt. However, the company was not bought using Equity. Instead the investors only put in $1.3billion, and used the company's assets to raise $5.3billion in additional debt. This saddled Toys R Us with an astronomical amount of debt of roughly $6.2B, which was 82.7% of total capital at the time. Additionally, the interest rates at the time were unusually high, hovering around 7.5%, creating a cash outflow of $450million/year only to pay the interest on all the debt. At the time Toys R Us was barely making a profit of 2% - so the debt was double company net profits.

There are a couple of assumptions that underlie a leverage buyout deal. Mainly, in order to be able to raise leverage, an organization needs to make sure the it has the financial stability to pay off its short and long term debt. This means that there should be a substantial reduction in operational costs to improve cash flow and generate the ability to pay interest. The new investors thought that they could reduce the by selling off assets that were not strategic enough. The financiers also did not predict the rapid shift of consumers to e-commerce platforms that were offering products at lower prices. The increased pressure on cost reduction prevented the retailer from making any renovations to their stores

Moreover, the new owners did not expect that online retail would have an impact on their hard assets, such as their retail real estate portfolio. Up until the crash of 2018, everyone found it safe to assume that real estate was a commodity that would continue to go up in value. KKR and Bain capital could then use their real estate as a collateral to raise cash for debt repayment. However, as online e-commerce kept growing America had an oversupply of retails space shattering prices and delivering a big blow for Toys ‘R’ Us.

References:

https://www.bloomberg.com/research/stocks/private/snapshot.asp?privcapId=190358

https://www.nytimes.com/2018/03/22/obituaries/charles-p-lazarus-toys-r-us-founder-dies-at-94.html

https://www.businessinsider.com/why-toys-r-us-is-closing-stores-2018-3

https://www.forbes.com/sites/adamhartung/2017/09/20/toys-r-us-is-a-lesson-in-how-bad-assumptions-feed-bad-financial-planning-creating-failure/#4f29808358ea