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Dealing with debt isn't child's play

Stores in Asia must learn from the mistakes of Toys 'R' Us, which filed for Chapter 11 bankruptcy protection last month

Children grow into adults when grim responsibilities hit them.

Toys 'R' Us, the world's largest toy retailer, filed for Chapter 11 bankruptcy protection last month. The potential collapse of this icon, which has 11 stores in Singapore, is a source of anguish for the millions of children who relish its wares.

It is also a parable on the dangers of excessive leverage fuelled by childish exuberance.

Toys 'R' Us was founded by Charles Lazarus in 1948.

He predicted that the post-war baby boom would lead to a craving for toys. Also, toys break easily, so demand would be easily sustained.

Mr Lazarus' success was built on tactics that were novel then but common today. He was a pioneer in running a speciality toy store. Toys had traditionally been sold in department stores, which sold especially large volumes during the holiday period.

Toys 'R' Us would need to sell toys throughout the year to be successful. Mr Lazarus had timed his launch to perfection. Heavy advertising on TV led to year-round toy sales. Children wanted toys regardless of the time of the year.

Mr Lazarus ensured that parents could easily find the hot toys. He projected a limitless selection of toys in his stores. Each outlet had endless rows of shelves stacked with toys.

He was also a path-breaker in discount retailing. He sold rare items at a deep discount. In 1977, an electronic game called Simon was the prized toy of the day. He priced it at US$20, compared with US$30 elsewhere. The public assumed the entire inventory of Toys 'R' Us was available at a discount.

The demise of Toys 'R' Us has been blamed on the rise of online shopping, particularly at Amazon. This is a fallacy.

Toy stores are relatively immune from online encroachment, as the very act of entering a toy shop is entertaining to children. Moreover, Toys 'R' Us had been proactive in partnering Amazon for online sales as early as 2000.

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The real root of its travails is a vile combination of financial leverage and operational leverage. Its dalliance with debt began with a leveraged buyout in 2005.

A group of private equity investors led by Bain Capital paid US$6.6 billion for Toys 'R' Us. The deal was financed by Toys 'R' Us' debt.

The new owners spun off the real assets to improve its attractiveness to lenders. This helped the company sustain higher debt levels.

The train wreck took over a decade to play out. Toys 'R' Us delayed the inevitable by skimping on its store development and online sales.

But eventually, the debt load was unbearable. Today, Toys 'R' Us has US$5 billion in debt, and the annual debt service costs of US$400 million. The Ebit (earnings before interest and tax) is a small fraction of the interest burden.

The company was also at the mercy of operational leverage.

The ratio of fixed costs to its total costs is high. In the last seven years, revenue has fallen 15 per cent but Ebitda (earnings before interest, tax, depreciation and amortisation) has fallen 29 per cent.

The Chapter 11 filing was ignited by jittery suppliers. With the holiday season looming, toy manufacturers were wary of supplying the behemoth. Chapter 11 provides breathing space with temporary financing. But the company is under a cloud.

There are lessons from Toys 'R' Us for retailers in South-east Asia. Leverage could claim victims in this region, where retailers have been on a debt binge.

Over the last decade, the total leverage at listed Asian retailers has risen three-fold.

As Toys 'R' Us found, playing with lenders' money is not as simple as selling toys.

The writer is an analyst who covers Asean and the commodities sector. This article appeared in The Business Times yesterday.

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