Updated: Dec 22, 2019
Toys R Us filed for chapter 11 bankruptcy last year. At the time this was not the belly-up variety of bankruptcy, rather it was the variety where your equity goes to zero and you have the opportunity, through the courts, to renegotiate your debt and then subsequently emerge with a viable long-term capital structure. After many months of trying to find a way to reconfigure its capital structure, Toys R Us now appears to be going the way of Korvettes, Circuit City, Montgomery Ward, Crazy Eddie, and countless others that litter the roadside of retail for the past fifty years. This is the belly-up variety of bankruptcy. Bankruptcy is the downside of leverage in a market that is competitively challenged. Most of the discussion around retail bankruptcies (see the top ones for last year here) has pointed the finger at Amazon as the culprit. However, in almost all cases, the real culprit is debt.
Let’s do some quick math. Toys R Us was competitively challenged to be sure – not just by Amazon, but by Walmart, Target, and others. Having said that, they were generating about $460M in earnings before interest and taxes (EBIT), which for a company of their size, was not bad. Normally, this amount of operating earnings would provide the opportunity to reinvest in the business.
But wait, you have to pay the mortgage first. In this case, it’s the interest on the $4.6B in debt that you have as a result of the leveraged buyout ten years ago. And, because the ratio of your debt to your EBIT is large, the ratings agencies call it junk debt and the lenders give you a high interest rate, something like 10% (the Toys R Us debt tables show a list of debt with interest rates up to 12%). The simple math is this: 10% times $4.6B is $460M, which is your annual interest payment (the actual interest payment for Toys R Us was $457M). This is the amount of your operating earnings that you need to shelve out before you can invest in anything important, like revamped stores and ecommerce. The ratio of debt to EBIT is known as your leverage position and it’s very important to your debt rating and thus, the interest rate you pay. In this case, the ratio is about ten, which is stratospheric. The only way to reduce it is to grow, which brings us to a catch-22.
When the finance guys and management put these deals together, they intend to increase EBIT through a combination of cost cutting and revenue growth. The original spreadsheet models probably showed revenue and EBIT being about 50% higher by now. Thus, management and boards get caught in a catch 22 – you need to grow revenue in order to invest, but you need to invest in order to grow revenue, but you don’t have money to invest and you can’t borrow money to invest because your leverage position is already too high. You might consider divesting some operating assets to reduce debt, but the assets need to be priced at a level such that it improves your leverage position and no one wants to buy assets at 10X EBIT. Management essentially gets painted into a corner and, while no one wants to admit it, the entire business is driven by the debt position. Debt becomes the absolute master.
Of course, it was management that signed up for the original plan to increase revenue while at the same time levering up. Much of the spreadsheet math associated with these deals is fine. But spreadsheet math is often based on benign competitive conditions. In retail, these benign conditions no longer exist; in fact, they may have never existed. Management is paid to look around corners and even 10 years ago you didn’t have to look too far around the corner to see Amazon – by that time, Amazon was already a $15B company (they have grown ten-fold in the ten years since then). Furthermore, Amazon listed, it its 2007 annual report, toys as one of the categories in which it competed.
In retail today, and increasingly in other industries, when the crap hits the fan, the common refrain is to blame it on Amazon. This sounds almost as if Amazon is some exogenous event that is out of the control of management. But, as Jeff Bezos said when asked about what happened to bookstores, “Amazon didn’t happen to bookstores; the future happened to bookstores.” It is the role of leadership to map the future and execute to it, maneuvering along the way. If you define the future incorrectly and cannot maneuver fast enough, you may be toast. If you are running a risky business model burdened with debt, and your future map is incorrect, or you are hindered in executing to it, you will be toast.