Monday, September 18, 2017

Toys ‘R’ Us On the Brink

Attention Toys ‘R’ Us gift card holders: now would be a good time to spend those gift cards.

Toys ‘R’ Us is one of the most popular gift cards in the United States, so there must be a good fraction of a billion dollars of them in consumers’ hands. Usually consumers hold on to the gift cards until they have a reason to buy a specific toy. But Toys ‘R’ Us has been living on the edge since the 2007 recession with more debt than it could realistically repay, and now Wall Street Journal says it is preparing for a possible bankruptcy before Christmas.

It is a complicated situation. Toys ‘R’ Us owes so much it needs an above-average shopping season every single Christmas just to carry on into the next year. This is a game that will almost certainly end as soon as the next recession hits. On the other hand, the current complaint at Toys ‘R’ Us is just a repeat of last year. Its limited credit meant it was unable to fill its shelves the way it wanted to. Yet the limited stock might have saved the retailer from a post-Christmas bankruptcy. The 2016 holiday shopping season was muted by a post-election hangover, but Toys ‘R’ Us did not face a crisis of unsold inventory because it had held back on purchases. That’s a strategy it is being forced into again now, and again, it is probably what the retailer should be doing anyway. What is different this year is that Toys ‘R’ Us has a $400 million debt payment due in May 2018 (with more to follow). My guess is that executives are betting big on shoppers being more exuberant than they realistically will be during the upcoming Christmas shopping season, because how else will they meet that payment? Yet the big gamble increases the chances of a sudden collapse. Though it might not sound very businesslike, the best chance for the troubled retailer to survive financially is for it to continue to limp along as efficiently as it can and hope for a miracle. Sometimes the prospect of bankruptcy gives a troubled business more leverage to negotiate, and with luck, in this case that might allow a debt restructuring just large enough to get by.

However, the potential for a bankruptcy is hanging in the air, and for a shopper holding a gift card, the simple thing is to spend the gift card and take delivery of the merchandise before the bankruptcy filing occurs. That is, make those Christmas, Halloween, or party decoration purchases in advance. Usually a bankruptcy court will allow gift cards up to a specific cutoff date, after which they are worth nothing, but the point is, if you’re still holding a gift card on the bankruptcy date, the fate of the gift card is something for the court to decide. That’s a complexity you avoid by spending the gift card sooner. No one knows whether a bankruptcy filing is on the way or what the date might be until the papers are signed and taken to the courthouse, but the people Wall Street Journal talked to were guessing this would happen within the next few weeks.

Most retail bankruptcies happen in January after a lackluster Christmas season, and that is another possibility here. For a retailer to be planning a bankruptcy before Christmas shows how desperate the situation is. That Toys ‘R’ Us’ financial predicament gets tighter every year is a measure of how thin its operating margins are, usually a sign of a business that is trying to do too much. A bankruptcy restructuring plan can correct for that, for example, by closing most locations and shutting down Babies ‘R’ Us.

One reason for doubt about a toy retailer is that more shoppers are doing their Christmas shopping in August and September, either to avoid the seasonal rush or just to get a chore off their to-do lists. The trend toward earlier shopping provides an efficiency gain for retailers but does not help a retailer counting on throngs of shoppers in December to keep the doors open. Another trend is that more toy purchases are being made online. With that trend, it is likely that the web store will remain after it is all over, whether operated by the current company, a successor, or an unrelated company that purchases the brand and domain in liquidation.

If Toys ‘R’ Us goes into bankruptcy in October, it will likely enter with a restructuring plan that does not represent a large enough change for the court to approve. The plan will be scaled up or otherwise refined during the bankruptcy proceedings, a process that could take weeks or months. In the meantime, specific stores might be approved to close. If the court is not convinced of the prospects of the restructured business, it could order a liquidation at any point. There is a possibility, either way, of Toys ‘R’ Us store-closing sales during the Christmas shopping season. That’s a prospect that should give all other U.S. toy retailers pause. Buyers for all U.S. toy retailers might be spending this week dialing back their inventory purchases for the holiday season.

Update, 24 hours later: Toys ‘R’ Us filed its bankruptcy papers Monday night. A public statement indicated that a bankruptcy filing for its Canadian subsidiary only would follow. Based on public statements, Toys ‘R’ Us is expected to remain in bankruptcy beyond the end of 2017. It was not immediately known whether stores would be able to fully stock toys for the holiday season or how many stores would be expected to close before and after Christmas. Statements are consistent with an incomplete restructuring plan that would carry a significant risk of bankruptcy liquidation, though any such move would more likely be decided in 2018. A court decision covering operational issues such as gift cards, payroll, and emergency funding is expected Tuesday.