In news that will sadden children and sentimental parents alike, Toys R Us filed for Chapter 11 bankruptcy protection late Monday night in Virginia as the carnage in the retail sector claimed another victim. This comes seven years after the PE-backed company filed for an ultimately failed IPO and one year after a significant debt restructuring.

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Toys 'R' Us
By Photo: Andreas Praefcke (Own work own photograph) [GFDL or CC BY 3.0], via Wikimedia Commons
The company, which has some 1,600 stores in 38 countries, is carrying $5 billion in long-term debt and posted an operating loss of $54 million in 1Q, compared to a loss of $7 million in the same period last year amid an accelerating decline in same-store sales. Adding in the interest expense of $107 million, the net loss was more than $160 million—compared to $126 million in 2016.

The news took the credit markets by surprise, with the company's October 2018 bonds trading at 97.25 cents on September 5 before falling to as little as 18.6 cents Monday. In the petition to the court, CEO Dave Brandon used nostalgia to tug at the heartstrings:

"I don't want to grow up, I'm a Toys R Us kid.

There's a million toys at Toys R Us that I can play with.

From bikes to trains to video games, it's the biggest toy store there is.

I don't wanna grow up, 'cause if I did,

I couldn't be a Toys R Us kid."

The filing caps a multiyear struggle for the company as it battled management churn, online competition from Amazon, and an intense debt burden resulting from the $6.6 billion take-private buyout in 2005 led by Bain Capital, KKR and Vornado Realty Trust.

This marks the second time the company has been forced into bankruptcy, following a 1974 petition by a predecessor company (Interstate Stores, which bought the original Toys R Us in 1966). So, will the company behind Geoffrey the Giraffe live to fight another day, ridding itself of excess debt to free cash necessary for capital expenditures and growth? Or will it succumb to the same fate as FAO Schwarz and KB Toys?

The key to success will be leadership. And how much debt it can dump.

Rise and fall

Toys R Us founder Charles Lazarus—perhaps true to his surname's namesake—had a strong second act engineering a post-petition turnaround that ended with an IPO in 1978 and cleared the way for rapid growth in the 1980s and 1990s. He led an overseas expansion and the launching of the Babies R Us format before stepping down in 1994.

Yet the decades that followed Lazarus' exit slowly eroded the wide selection/low price mantra that fueled his success. Big box competitors like Costco and Walmart could offer lower prices in exchange for less selection. Online outlets like Amazon could offer both low prices and limitless selection, in exchange for a shipping wait and a lack of a showroom. Many accepted the tradeoffs.

The crucible of competition was made hotter by the debt burden Toys R Us was forced to bear, taking away the financial flexibility necessary to react.

For Bain Capital, there are dark parallels to the collapse of KB Toys in 2008 in the grips of the financial crisis and recession. The company line was the macroeconomic headwinds sank their ship; but muckraker Matt Taibbi blamed the firm and then-presidential candidate Mitt Romney in a 2012 Rolling Stones article alleging mismanagement, over-reliance on debt after a 2000 buyout, and the extinguishment of the passionate, entrepreneurial fire that earned KB Toys success in the first place.

Similar headwinds are blowing now. Retail sales growth is tepid despite a strong job market. UBS analyst Arpine Kocharyan in a recent note to clients highlighted the heavy promotional environment in the first half of the year, with some cautious signs of a turnaround heading into the holiday season. And established players like Lego are struggling as the rise of movie-branded toys—which went from 15% of the market in 2004 to 38% now, per UBS—seems to have peaked. Meanwhile, private equity investments in the US retail sector has dropped dramatically, with just 49 deals so far this year compared to 111 in 2016.

The keys to a turnaround

Toys R Us has more than a fighting chance, however, with Brandon previously leading a successful, tech- and product-focused turnaround at Domino's Pizza for Bain Capital after the firm acquired control in 1999. He wants to leverage the company's retail footprint by turning the stores into hangouts, where spur-of-the-moment purchases can flow from community and store-in-store events—like one tied to American Girl dolls that's already been rolled out.

Some $3 billion in debtor-in-procession financing has already been arranged from a JPMorgan-led syndicate that will help keep the company's doors open and toys on the shelves heading into the holiday season. In a statement, Mattel's management said they were "committed to supporting Toys R Us and its management team as they work through this process." So far, store operations appear to be unaffected.

That should be enough to put a smile back on the faces of any kids worried about where their Christmas presents are coming from. As well as the millions of fans of Geoffrey the Giraffe, and the 64,000 Toys R Us employees. Not so much for Bain Capital and KKR, which look set for a complete wipeout as equity holders.

And while "Chapter 22" double-dipping by struggling retailers is becoming a regular thing—where bankruptcy filings give way to incomplete debt extinguishment followed quickly by a second bankruptcy filing—Toys R Us appears to have some pieces in place to avoid such a fate.
We've compiled dozens of private and public companies affected by Amazon's growing influence and reach: read more.

Article by Anthony Mirhaydari, PitchBook

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