WOLF STREET–Brick & Mortar Meltdown: Toys “R” Us can’t solve what’s killing it.
Bankruptcy indicators first started swirling publicly around Toys “R” Us on September 6. Unlike other retailers that have been dogged by bankruptcy rumors for years, such as Sears Holdings, Toys “R” Us threw in the towel only 12 days later, when its suppliers, fearing steep losses, reacted just as the company was trying to build its inventory before the crucial holiday sales period.
It wasn’t bondholders or banks that pulled the ripcord, but trade creditors. The US and Canadian entities filed for bankruptcy protection in order to be able to restructure their debts and stock up for the holidays with a proposed $3.1 billion in debtor-in-possession (DIP) financing.
Yet the toy industry has seen growing sales for five years in a row, hitting $20.4 billion in 2016, up from $16 billion in 2012. It’s respectable growth of around 5% a year. But TRU is getting clobbered by its competitors, including Walmart and Target, and particularly by the relentless shift to online shopping.
About 31% of all toy sales are now online, according to the Toy Association. In some key categories, the percentage is higher: video games (39%), apps (38%), and electronics (33%).
TRU is buckling under $5.2 billion in debt that its private-equity owners – Bain Capital, Kohlberg Kravis Roberts, and Vornado Realty Trust – piled on it after the leveraged buyout in 2005, and it did not invest sufficiently in creating a powerful online presence able to beat Amazon off its territory.
“But the immediate cause of the Chapter 11 filing was a crisis of confidence on the part of the company’s trade vendors, which historically has been a risk for retailers, particularly as they build inventory levels for the holiday season,” explained Stephen Selbst, chair of the law firm, Herrick’s Restructuring & Bankruptcy Group.
And when bankruptcy indicators became public, it happened fast. Selbst:
According to the company, the reaction among the vendor community was swift and brutal: within a week nearly 40% of its trade vendors put the company on COD status and many factors and credit insurers withdrew support. Prior to this crisis, Toys “R” Us had experienced an historic average of 60 days of trade credit support; the new terms would have required an immediate infusion of up to $1 billion in new cash, money that Toys “R” Us neither had nor could obtain.
Trade financing will likely be resolved with the proposed $3.1 billion in DIP financing. The longer-term problems are not so easily solved:
In papers filed with the Bankruptcy Court, Toys “R” Us chief executive David Brandon admitted that the debt service obligations have harmed company’s ability to compete: “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 failed to capitalize on the iconic Toys “R” Us brand and its unique position as a one-stop shop for toys every day year round.”
The Chapter 11 filing did not mention any additional store closings, shrinking its footprint, withdrawing from unprofitable markets, or selling or liquidating its business. Instead, it wants to use the DIP financing to improve its stores and operations. But Selbst explains:
[N]early all retailers that file for bankruptcy end up closing stores, in part because Chapter 11 gives management the opportunity to reject leases for unprofitable stores. Given the large number of stores Toys “R” Us operates, it is likely that there are some weak performers in the mix, so it is probable that Toys “R” Us will shrink its U.S. and Canadian footprint while in bankruptcy.Debtors are often unrealistically optimistic at the start of their bankruptcy cases about what they can achieve in Chapter 11 and the level of goodwill they have banked with their creditors. The long experience of retailers in Chapter 11 suggests that very few of them are able to reorganize; most liquidate or are sold in bankruptcy.
Numerous retailers that filed for Chapter 11 bankruptcy to restructure their debts and operations ended up liquidating. And a number of retailers that successfully emerged from bankruptcy ended up filing for bankruptcy a second time, which usually ends in liquidation. Here’s a recent sampling:
American Apparel, a manufacturer with 110 retail stores, filed for the second time in January 2017, after it had emerged from its first bankruptcy in October 2015. The second time, the only thing that survived was the name, whose rights Canadian apparel maker Gildan Activewear acquired for $88 million.
Hancock Fabrics filed for bankruptcy for the second time in February 2016, after having emerged from bankruptcy in 2008. It ended up closing all its 255 stores and liquidating. Arts and crafts retailer Michaels Cos. acquired its name for $1.3 million.
Wet Seal filed for the second time in February 2017, and closed all its remaining 137 stores. The teen fashion retailer had filed for the first time in January 2015, shortly after it closed 338 of its stores and laid off 3,700 employees.
Eastern Outfitters, the parent of discount chain Bob’s Stores and outdoor retailer Eastern Mountain Sports, filed for bankruptcy in February 2017. Its owner, private equity firm Versa Capital Management, had acquired Bob’s and Eastern Mountain Sports during the bankruptcy in 2016 of its previous owner, Vestis Retail Group.
RadioShack, which long ago had 7,200 stores, filed for bankruptcy for the second time in March 2017, and announced that it would close 1,000 stores, leaving only about 70 stores on the active list, after having filed for the first time in February 2015. The current bankruptcy is still tangled up in court over a lawsuit against its former partner Sprint. But preliminarily, the court approved a plan where the surviving entity has an online presence, warehouses, a few company-owned stores, and a gaggle of independent Radio Shack dealers. If the lawsuit against Sprint does not produce a large enough a settlement with which to re-pay creditors, that deal too could be off.
So Toys “R” Us faces daunting odds to survive over the next few years. Given the financial backing it has via the proposed $3.1 billion in DIP financing, it is likely that it will successfully emerge from bankruptcy. But it has not solved the issues that are killing it: Declining sales and loss of market share in a growing market.
It’s well over a decade late trying to create a powerful internet presence to fight off Amazon, Walmart, and Target. Its brick-and-mortar business is doomed, even if it fixes up its run-down stores: 31% of toy sales in the US are already online. That percentage is growing rapidly, as toys are shifting to electronics, apps, and video games. And it would take a major miracle for Toys “R” Us to build a powerful online presence a decade after it should have.
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