Why the bankruptcy of Toys “R” Us is a one-off personal event?

The fallout of Toys “R” Us caused some stir in the toy industry. Some investors are asking:

“Is the toy industry in permanent decline?”

“Has the iPad and mobile gaming took away the entertainment from toys”

Or,

“Is this about distribution and price?”

At the moment, I’m lending towards the latter, but it isn’t the main cause for why the bankruptcy of Toys “R” Us. Their bankruptcy is created by a sequence of events, which led to this moment of doom.

As a UK-Based analyst, I will briefly cover some UK toy-related businesses to spot symptoms found in Toys “R” Us.

 

Let’s begin with what caused the bankruptcy of Toys “R” Us.

 

 

What caused the bankruptcy of Toys “R” Us?

Toys “R” Us filed for bankruptcy in 18th September and was one of the biggest toys distributors in the world. Sales peaked at $13.9bn in 2012.

The events unfolded when their bonds (trading as high as 97 cents on 4th September) suddenly took a 78% plunge to below 21 cents, a signal that shareholders are screwed.

But, Toys “R” Us problems go back a long time ago, before it went into administration.

If one looks at their balance sheet, one could spot that it has long-term debt of $5.2bn, along with negative equity of $1.3bn. Meanwhile, it made a quarterly net loss of $164 million.

So, a mix of negative earnings, negative equity and high debt means a toxic mixture that is becoming unhealthy.

 

The listed problems

Below are the listed problems investors should have spotted, before making an investment in the toy store:

1). Sales were declining steadily; – While the sector grew 5% per annum for the past five years. Toys “R” Us saw a 15% drop in sales in the same period. This tells us the company is losing market share while the sector grew.

2). Can’t pay off interest; – when a business is making losses it had to pay off interest in other ways such as borrowing more money, which increases interest costs. A self-defeating vicious cycle!

3). Debt maturity; – the biggest factor and a major cause of bankruptcy. Any business wants to rollover debt is reviewed by the bank investment managers. If they see no improvement in operations or if the business declines, then borrowing rates rises, which will depress the value of market equity.

Below details Toys “R” Us debt maturity and amounts due:

“In 2018, $400m is due. In 2019, $2.6bn is due. In 2020, $1.36bn is due.” Without improvement in operational performance, the debt mountain sealed the fate of the toy company and their shareholders. 

4). Once owned by Private Equity firms; – Toys “R” Us was owned by three PE firms that stripped them out of their cash and loaded the company with debt. This is clearly shown below:  

As the cash got taken out of their balance sheet and went into Private Equity firms’ back pockets. The extra $3bn of debt tab appears in Toys “R” Us balance sheet.   

 

P.S. The above is courtesy from the research and analysis done by Wolf Street. The original article is HERE.

Now, let’s us assess the UK toy industry.

 

Are UK toy companies in trouble like Toys “R” Us?

Every business is different. But, in the UK, the toy industry is worth £3.5bn, and it’s the largest in Europe.

But we start, here is a quick reminder of the factors you should watch to avoid Toys “R” Us financial problems:

1). Huge amount of debt;

2). Making net losses;

3). Sales have been declining;

4). Can’t afford to pay off debts that are due;

 

Below is s three toy-related businesses listed in the UK, they are Hornby, Character Group and Games Workshop.

Let’s start with

HORNBY

Hornby is a company that makes model railways dating back 1901.

The share price is down by 70%.

Starting with their P & L, it saw sales fell to £47m from £64m in five years. Meanwhile, losses piled up and latest net loss is £9.6m, an improvement from a net loss of £13.7m last year.

Some of these losses happened due “in part” to impairment charges of £3.3m in 2017 and £7.85m in 2016. However, the business saw no improvement on an adjusted net loss basis. It’s just that Hornby made their biggest write-off in 2016!

 

Onto their balance sheet, the company’s shareholders’ equity fell to £30m in 2017 from £40m in 2012, but five years ago, equity was bolstered by £17.4m which relates to goodwill and intangibles. Now, it’s £10m smaller meaning shareholders’ equity saw no improvements in that period.

People think Hornby reduced their net loss drastically in 2017 by reporting £117k in net cash outflow, but that’s due to a £8.6m contribution in the decline of inventories and receivables as the business shrunk in size. This improvement is a one-off event.

If we see no improvement in operations, Hornby will struggle and revert to borrowing or be raising equity to survive.

 

There is a takeover offer for Hornby by Phoenix Group. But, the group values Hornby at 32 pence per share.

Character Group

It’s an independent toy company that manufacture toys in the UK. Under licence, it designs and manufacture toys based on television, film and digital characters and distribute these products in the UK and overseas.

That is a risk-free company because whatever toys are in favour, it will manufacture. As long as the toy designers choose The Character Group to do their manufacturing.

The share price is trading near their all-time highs for two years, after leaping by 200% during 2014/15.

There is a substantial revenue increase from £75m in 2012 to £121m in 2016, causing net profit to double to £10.8m.

This proves the business works as it wins more contracts.  

Despite being a toy manufacturer, it is a very asset-light business, as the proportion of non-current assets totalled less than 20% of their total current assets.  

It has a decent cash backing of £28.56m, which is up from £5.9m in 2012, while short-term borrowings rose to £21.6m from £13.8m. The borrowings requirement is largely short-term to help with working capital. Notice the increase in cash balance vs. the increase in short-term borrowing. Cash rose by 350%, while debt rose by 70%. That is a sign of de-risking their operations. Also, it won’t be long when the business could fund itself with reduced short-term borrowings.

The Character Group borrowing facilities

The UK Facilities include a bank overdraft of £6m and £13.5m in trade finance facility.

The interest charged on these facilities is between 1.65% to 1.70% per annum over LIBOR or bank base rate.

Certain Far East subsidiaries have bank overdraft and trade finance facilities equivalent to approximately £12.3 million. The interest charged is between 0.25% per annum and 3.55% per annum over Prime or HIBOR.

Cumulatively, the company has £32m in borrowing facilities, which they are £11m within the limit.

One Concern for Character Group

The one concern I might have is the accounting of revenue for 2017. Trade receivables rose by 40% to £23m from £12.6m, a much larger % increase than sales. Also, their prepayment fell by £840,000. That big increase in receivables caused the fall in net cash flow to £8.235m from £17.3m last year and contributed to a smaller share buyback for that year to £1.2m from £6m, but dividends payout of £2.785m was an increased from £1.864m.

Tip alert: Keep an eye on trade receivables, in case this pattern continues. 

Games Workshop

This British miniature war gaming manufacturing company is best known as a developer and publisher of the tabletop wargames:  Warhammer Age of Sigmar (previously Warhammer Fantasy Battle), Warhammer 40,000 and The Lord of the Rings Strategy Battle Game.

But shareholders enjoyed their share price jumping by 200% in one year!

Onto the financials, sales amounted to £158m, an increase of £27m in five years. It manages to doubled net income to £30m in this period.

Cash balance is stable at £18m. Shareholders’ equity at £63m. It has no debt.

More intriguingly, is net cash earnings rose to £43.9m, a near doubling from last year of £24.2m.

Games Workshop share price is at an all-time high, but is this stable?

Only time and opportunity will tell.

 

My Thoughts

The UK toy companies mentioned are not in distressed like Toys “R” Us. But, the weakest link is Hornby with no improvement in their operations. The rise in Games Workshop could go further, but, unless you know the reasoning behind their optimism, then it’s wise to hold off on the investment.

Out of the three businesses, The Character Group is my pick for investment because of the following:

-The shares stood still for two-and-a-half years waiting for fundamentals to catch up with valuation;

-It has doubled profits in five years.

-The idea behind manufacturing toys for others would “de-risked” their business model.

-Also, market cap. is under £100m with EV close to £90m, giving a low PE ratio of under 10X.

 

Hope this dispels the myth of the toy industry going bust.

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Disclosure

The opinions expressed by the writer is for entertainment and research purposes. It does not constitute professional investment advice. Data is correct on available information at the time.

Finally, the writer does not own the company’s stock, unless stated otherwise.