Amazon isn't killing Toys 'R' Us and other retailers — debt is
Reports of retail's death are greatly exaggerated: its debt problem, though, tends to be understated
After a slew of bankruptcies among iconic retailers in recent years, blame has been aimed at online sellers such as Amazon. But a peek at the numbers shows that isn't the only reason — much less the main one.
In Toys "R" Us's case, the first steps toward its own downfall seem to have been taken in 2007, when it was taken private in a leveraged buyout from three firms who specialize in such things: Bain Capital, KKR & Co. and the ominously named Vornado Realty Trust.
Leveraged buyouts are a procedure whereby firms like the ones above take over operating companies, but lack the financial muscle to do it in cash.
They do it by borrowing the money they need, using the purchased company as collateral. The debt itself then gets dropped onto the books of the acquired company.
Most LBO firms don't plan to own the asset forever. They usually hope to sell it in an initial public offering of stock at a higher price down the line, or make money chopping it into pieces and selling those off.
It's a bit like taking out a monster mortgage on a home you don't have enough money to buy outright, so a lender fronts you the cash assuming the value of the house will keep going up. The main breadwinner who's going to live there is on track to see salary increases over time, and they plan to rent out the basement anyway. Everybody wins.
The plan works great on paper. But when something goes wrong at the underlying asset, it can be as if the apocryphal homeowner loses their job and the housing bubble bursts. Everybody loses.
To be sure, Toys "R" Us had problems even before $5 billion US of debt landed on its books after their LBO. But the company was the dominant toy retailer and a valuable asset, David Silverman, senior director of corporates at ratings agency Fitch, said in a CBC interview.
"At the time, the company had a growth trajectory," Silverman said, one that if it worked out would have netted a tidy profit for the new owners.
But earnings growth slowed while the debt repayments remained the same. "Management time and attention was placed on looking at resolving its capital structure, versus developing an operating strategy."
While Toys "R" Us has certainly fallen from where it once was, the notion that it's been waylaid by shifting consumer tastes just isn't the whole story.
Financial disclosures from that time show Toys "R" Us had just over $11 billion US in sales the year they were taken over. Amazon, meanwhile, had about $14 billion in revenue that same year.
Amazon's revenue has shot up 12-fold in the past decade. But it's not as if people stopped shopping at Toys "R" Us. Bloomberg data suggests the chain still sold $11 billion worth of toys this year, and its online sales are actually growing.
Normally, $11 billion in toy sales might have bought the company enough time to fix its problems, spruce up dated stores, and invest in its archaic online shopping portal. With high interest payments to service above all else, however, the chain ran out of breathing space.
"A good chunk of the cash went to servicing that debt," said Bruce Winder, a co-founder and partner of the Retail Advisers Network.
As specialty toy sellers like Mastermind up their game on the bricks-and-mortar side, and Amazon outflanks it on the other, Toys "R" Us has been hit by the crossfire, Winder said. "They have no money left to put into refurbishing stores," he said. "They are caught in the middle."
They aren't the only ones.
Toys "R" Us isn't the only iconic retail name to find itself teetering on the edge this month. Tween jewelry seller Claire's announced this week that it, too, is seeking bankruptcy protection.
Claire's was taken over the same year Toys was, when Apollo Global Management borrowed $2.1 billion to take the company private. More than a decade later, $1.9 billion of that debt has yet to be repaid, a millstone that's eating up almost $200 million in interest costs every year.
One of Claire's big businesses is ear piercings — the chain likes to claim it has pierced more than 100 million ears over its six-decade history. While the chain faces other problems, a slowdown in that business isn't something that can be blamed on online competition.
As any consumer who has ever struggled to pay the bills can attest, debt load can be a killer when things turn south. Which is reason its presence on the balance sheet of another iconic retail name is worth paying attention to, for every Canadian worker.
High-end luxury chain Neiman Marcus was taken private in a $5.1-billion leveraged buyout in 2005. Then the new owners flipped the chain again in 2013 for $1 billion more to a consortium that includes a name most Canadians would recognize.
The Canada Pension Plan Investment Board teamed up with Ares Management LLC to buy the chain, justifying the deal on the notion that high end retail was faring much better than everything else at the time.
But a lot has happened since then. Amid retail's well documented problems, the chain scuttled IPO plans a few years ago, and then two months ago, the CEO abruptly retired. Now her replacement must fix — among other things — a $4.7-billion debt load acquired in those two leveraged buyouts.
Neiman Marcus is a mainstay in dozens of luxury retail strips, with 42 stores across the U.S., but it clusters in tourism-heavy cities like New York, Los Angeles and Miami, where wealthy tourists tend to flock and open their wallets.
The name still has cachet, but that doesn't make it immune from retail's problems beyond debt. "We actually believe it's a best-in-class retailer," Silverman said. "But given some weakness in tourism over the past few years, the company's [earnings] have shrunk, and we see some problems."
The biggest chunk of the company's debt is currently charging interest north of eight per cent, Bloomberg data shows, and roughly $2.8 billion of it is coming due as soon as 2020.
"Unless earnings improve dramatically," Silverman said, "we don't see them being able to refinance."
Silverman, it should be noted, was among the first to sound the alarm on Toys 'R' Us's debt, and Claire's after that. So his flashing a yellow light on Neiman Marcus warrants attention.
A lot can happen between now and then, of course, but given that the chain is backed by the retirement funds of every Canadian worker, the chain's problems are a sobering reminder that debt tends to bite deepest at the time when you are least able to withstand it.
And that's true whether you're selling toys to kids, piercing ears for preteen girls, or selling $10,000 purses to the world's elite.
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