Playing With Debt Killed Toys 'R' Us

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by: e21

By Jacob Reyes

With Toys 'R' Us's (NYSE:VNO) announcement this month that it will be closing all its U.S. stores, Geoffrey the Giraffe will join Radio Shack and Borders in the so-called retail apocalypse. Most observers would claim that Toys 'R' Us was made uncompetitive by e-commerce and online retailers such as Amazon (NASDAQ:AMZN). While new business models did play a factor, the primary cause of the company's collapse should be traced back to its billions of dollars in corporate debt.

In 2005, Toys 'R' Us was purchased by a consortium of private equity companies in a leveraged buyout (LBO). In a leveraged buyout, a financier - in this case private equity companies - purchases a company using borrowed funds, or leverage, rather than the financier's own assets. The LBO left Toys 'R' Us with $5.3 billion of debt, secured through the company's assets.

This brought the company's total debt up to $6.2 billion when accounting for the $1 billion Toys 'R' Us had previously accumulated. The interest rate of the LBO was around 7.25 percent, leaving Toys 'R' Us with annual interest payments of $450 million, nearly double its annual net profit.

That debt, as has been the case with so many other retailers, is what kept Toys 'R' Us from being able to compete with Amazon. While few predicted that online retailers would grow to dominate markets as they do today, any business could have forecast the shift towards e-commerce. Instead of investing in opportunities to diverge from the traditional brick-and-mortar business model, Toys 'R' Us had to pay millions of dollars each year to service its debt.

Although some leveraged buyouts have been successful, in a Chapter 11 bankruptcy filing to the SEC last year, Toys 'R' Us CEO David Brandon stated that debt service obligations kept the business from reinvesting in itself. Ideas that could have given the company a competitive edge over both big-box retailers and e-commerce companies fell by the wayside. Toys 'R' Us had plans to unveil a subscription-based delivery service and cheaper expedited shipping options; however, both were unfeasible because of the massive cash outflow to pay off debt.

Another significant factor in the company's collapse was the deterioration of the shoppers' overall experience in the store. Brandon admits the company was unable to fund improvements and general upkeep of the stores. This would have included hiring more employees, recruiting better management, perhaps launching a play zone, and creating party hosting capabilities within the stores. Toys 'R' Us's inability to create a unique retail experience for customers meant that Amazon's lower prices and fast delivery easily lured consumers away.

Unfortunately for American retailers, Toys 'R' Us may have only been the first domino to fall. Many of the large retail brands are over-leveraged, the victims of past LBOs as well, and much of that debt is just now beginning to mature. According to a 2017 Bloomberg report, within the retail industry alone, $1.9 billion will be due in 2018. That number will expand from 2019 through 2025, with an "annual average of almost $5 billion."

In the past, retailers saved themselves through refinancing their debt. This was made possible by the Federal Reserve's willingness to continue dumping cheap money into the economy, which kept interest rates artificially low. This incentivized risky lending and made it possible for retailers to continue refinancing throughout the last decade.

Within the last year, the Fed's efforts to normalize interest rates have started to restrict the easy credit that retailers counted on in the past. Toys 'R' Us serves as a perfect example of how increasing rates could spell disaster for the retail bubble. The company's Chapter 11 filing was the result of an inability to refinance just $400 million of its massive debt. However, that enormous debt is marginal compared to the debt shared between the eight publicly traded retailers, $24 billion. If the Fed continues to raise rates three more times this year, that debt could prove insurmountable to retailers such as Bon-Ton Stores (OTCPK:BONTQ) and Sears Holdings (SHLD).

Toys 'R' Us's closing is unfortunate. The company employed around 31,000 people and had solidified itself in the hearts of young and old customers alike. However, thousands more could find themselves out of a job if these mega-retailers are unable to pay off their debt and find ways to reinvest in themselves.

Companies with available cash are looking for ways to compete in the digital age. Some have altered their business models in fruitful ways, helping to retain their profits and customers. However, overleveraged retailers who cannot afford to innovate may soon find themselves drowning in their balance sheets.