The list of suspects behind the demise of Toys ‘R’ Us is hardly of Murder on the Orient Express or Death on the Nile proportions and yet the case is not as cut-and-dried as some financial commentators would have you believe.
Still, given this is hardly Hercule Poirot’s territory anyway, we thought we would exercise our own leetle grey cells, here on The Value Perspective, and put forward an alternative view on the real culprit.
The $6.9bn (£5bn) toy-store chain became one of US retail’s biggest-ever bankruptcies when it filed for so-called ‘Chapter 11 protection’ last September.
Market watchers were quick to point the finger of suspicion at Amazon but while this was perhaps understandable – after all, the online titan is something of a repeat offender when it comes to distress on the high street – it was also, in this instance, a case of mistaken identity.
But, if not Amazon, then who killed Toys ‘R’ Us? Well, in a good old Agatha Christie twist, it is not so much a ‘who’ as a ‘what’.
In 2005, one potential suspect entered the drama as Toys ‘R’ Us hired Credit Suisse to find a potential buyer and private equity answered the call. As this Financial Times article sets out, three firms put in $1.4bn in cash, split equally, and borrowed more than $5bn to finance the transaction.
Over the next decade, the historically low interest rate environment enabled the consortium to return to the debt market several more times to refinance the deal as the three firms sought to engineer some kind of exit.
That never materialised, however – in 2010, for example, a planned floatation never got off the ground – and, faced with the need to raise $1bn before Christmas, Toys ‘R’ Us filed for Chapter 11.
Clearly the group was facing structural pressures as consumers changed the way they shopped – annual sales shrank from $13.7bn in 2008 to $11.5bn in 2016, for examples, while profits have halved since 2009.
So that did not help but the obvious culprit was … Poirot pauses for effect, the camera pans round the room and comes to a halt on private equity as Poirot finally says: “Eet was you … debt.”
Ah – classic Christie misdirection.
Unnoticed back in 2005, debt had entered proceedings almost hand in hand with private equity. And of course debt never travels alone – interest rates are always at its side.
Even with interest rates at all-time lows, Toys ‘R’ Us was spending more than $250m a year servicing some $5bn of long-term debt and that is just not sustainable.
This is why value investors spend so much time analysing the financial position of potential investments – including how much debt has been taken on.
What we are looking for is a ‘margin of safety’ – or ‘wiggle room’, if you prefer – should things turn sour for a company. Businesses that have a margin of safety have the luxury of time or breathing space to reinvent themselves – and many do precisely that.
On an individual basis, if Toys ‘R’ Us had not been so laden with debt then maybe it could have avoided filing for bankruptcy and reinvented itself – or maybe not. But without that margin of safety, it never had the chance to find out. Debt was the killer. The case – eet is solved.