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Debt, Competition and Business Models
Apr. 5th, 2018 08:32 amThe Toys R Us bankruptcy has a lot of people talking about capital structure, restructuring and debilitating debt load. And a lot of what they have to say is really interesting, and worth thinking and talking about. However, there are some odd gaps in the discussion.
The biggest problem is that there is often very little discussion of _where_ did the debt come from and _why_ did the lender think they would be repaid. Lenders generally speaking do not loan money without being really quite certain they will be repaid (there are exceptions when the interest rate charged is so high that the lender really doesn’t give a flying anything about the principal, but that does not appear to be the case with the Toys R Us bankruptcy, and there is another rule about how if you owe the bank a certain amount of money, they own you, but if you owe the bank a much larger amount of money, you own the bank, but again, I’m unconvinced that applies here). For example, if a farmer borrows money to buy seed and other crop inputs, the lender expects that the money will be repaid when the harvest is sold. Problems arise when the harvest fails, or when the price at market is substantially less than expected. This is why demand shocks are so painful. People loan expecting to be repaid when something is sold; if it can’t be sold, or can’t be sold for a high enough price, there’s trouble.
_Why_ did people think that loaning money to Toys R Us was a sure thing? And _what changed_ to make that expectation invalid? I think that the idea of Toys R Us was an idea that made a great deal of sense when people had lots of kids when they were pretty young themselves and living in comparatively spacious homes. Younger parents often don’t have a ton of money, but they are often quite willing to spend what they have on toys. Older parents may have more money than younger parents, but are often less willing to spend what they have on toys, but, more relevantly, older parents rarely have living parents themselves, or at least, not ones hanging out with the kids and buying them toys. Young parents = more likely to spend, more likely to have living parents to buy things for the grandkids. So aging parents — especially a couple generations of older parents — can disrupt a toy buying business model. The comparatively spacious homes can also disrupt a toy buying business model, if people are living in more cramped spaces. For several years now, we have been expecting young families to move out of apartments and multi family and into suburban homes. They have been persistently NOT doing that, and there’s a lot of debate about why, but it is also disrupting space for toys.
In addition to what was expected not materializing, new unexpected things can materialize that also disrupt a business model. While it is common to talk about how online sales of toys have made it tough for retailers everywhere, it is much less common to talk about the competition between _physical_ goods and _virtual_ goods. Sure, we talk about how music went from p to e. We talk about how books went from p to e. We talk about how movies went from p to e. But toys have _also_ gone from p to e. Every time you see a kid playing a game on a tablet or a phone or something roughly that size and shape, you are looking at dollars that went to virtual (electronic) toys vs. physical toys.
Were these anticipatable events? Did the lenders totally cock it up? I think they did. The demographic shift has been slow moving, and while people keep expecting some kind of mean reversion, there is _zero_ evidence that the demographic shift is ever going to “revert” to some sort of “mean”. Smaller families are here to stay. Older parents are here to stay. Much older grandparents are here to stay. They’ve always been around (just like larger families will always be around, and younger parents and younger grandparents will always be around), but the composition of the population has shifted. And it wasn’t exactly a slow change.
The move to virtual toys from physical toys was signalled decades in advance, by video games (I was wee when the first Atari showed up in households), but more importantly by other cultural products shifting to a dominant e-model vs. a dominant p-model. Music could maybe excuse being caught with their shorts down. Books had less of an excuse. Toys have pretty much no excuse at all. To reach back into the past, the change in audio characteristics from vinyl to CDs didn’t stop that transition. The degradation to mpegs didn’t stop people from hoarding on drives and then switching to streaming. All the book huffing the the world hasn’t stopped people from switching to audiobooks and ebooks. Why on earth anyone thought that emphasizing the characteristics of physical toys would stop the transition to virtual toys is completely outside my capacity to explain. Deploying hoards of pedagogical, medical and other professionals to lament the damage done by screen time didn’t do much to stop the spread of TV; it wasn’t too likely to impact the spread of devices, especially since devices could argue interactivity vs. the passivity of TV, which the previous round of experts had relied on a little too heavily.
Toys R Us also suffered from a store location problem (and various tiers of the companies involved seem to have an enormous amount of indebtedness associated with the real estate and leases — it is entirely possible that one reason people kept loaning Toys R Us money is simply because no one really knew how much Toys R Us already owed). For decades, people kept moving further out from cities. But that changed in 2007-8, and while, again, there has been an expectation of reversion and a great deal of words written online predicting when that would happen, it is not happening, outside of a few pockets that when probed more deeply often do not support the thesis after all (a lot of “new” “suburban” development is actually infilling leapfrogged areas and/or brown fields development — hardly expanding the overall radius further into the exurbs). Many commentators treat existing debt as an overhang, a thing which prevents reinvestment. It is as if it fell from the sky. But debt exists because there was a belief in the past that by investing in this thing, there would be a payoff. When that payoff doesn’t happen (see above), one shouldn’t pretend the effort at investment didn’t happen. We got student loans because we thought education would help us repay those loans and make more money than we would make without the loans. We got a car loan, because we thought having reliable transportation would make it possible for us to get and keep a better job. We got a house loan, because we thought that controlling housing costs would help us better control our future spending. But unfortunately, when we forget _why_ we invested (borrowed) and don’t notice that things have changed, we sometimes double down foolishly. We take out more loans for another degree, when the first one doesn’t pay enough. And I have to wonder in Toys R Us’ case, if they kept building more stores because their underlying business model actually hasn’t worked in decades, and the whole thing was debt funded expansion in the hopes of some future pay day.
It’s one thing to make fun of Tesla for doing that (we won’t know for a while how that is going to turn out). But when the perpetrator is a company like Toys R Us? Makes me wonder how many more bankruptcies we’ll be watching go by in the next few years. [ETA: for the record, I am noting that _other people_ make fun of Tesla — and Amazon, and others — for profitless expansion. I don’t.]
The good news is, the employment market is well able at this point in time to absorb many if not all of the workers who will be laid off as a result of this large chain going out of business — that wasn’t the case 10 years ago. And one can hope that future large bankruptcies will similarly be timed in an optimal way to ensure minimal disruption to the employment of hardworking employees, who never had any say at all in these larger decisions.
The biggest problem is that there is often very little discussion of _where_ did the debt come from and _why_ did the lender think they would be repaid. Lenders generally speaking do not loan money without being really quite certain they will be repaid (there are exceptions when the interest rate charged is so high that the lender really doesn’t give a flying anything about the principal, but that does not appear to be the case with the Toys R Us bankruptcy, and there is another rule about how if you owe the bank a certain amount of money, they own you, but if you owe the bank a much larger amount of money, you own the bank, but again, I’m unconvinced that applies here). For example, if a farmer borrows money to buy seed and other crop inputs, the lender expects that the money will be repaid when the harvest is sold. Problems arise when the harvest fails, or when the price at market is substantially less than expected. This is why demand shocks are so painful. People loan expecting to be repaid when something is sold; if it can’t be sold, or can’t be sold for a high enough price, there’s trouble.
_Why_ did people think that loaning money to Toys R Us was a sure thing? And _what changed_ to make that expectation invalid? I think that the idea of Toys R Us was an idea that made a great deal of sense when people had lots of kids when they were pretty young themselves and living in comparatively spacious homes. Younger parents often don’t have a ton of money, but they are often quite willing to spend what they have on toys. Older parents may have more money than younger parents, but are often less willing to spend what they have on toys, but, more relevantly, older parents rarely have living parents themselves, or at least, not ones hanging out with the kids and buying them toys. Young parents = more likely to spend, more likely to have living parents to buy things for the grandkids. So aging parents — especially a couple generations of older parents — can disrupt a toy buying business model. The comparatively spacious homes can also disrupt a toy buying business model, if people are living in more cramped spaces. For several years now, we have been expecting young families to move out of apartments and multi family and into suburban homes. They have been persistently NOT doing that, and there’s a lot of debate about why, but it is also disrupting space for toys.
In addition to what was expected not materializing, new unexpected things can materialize that also disrupt a business model. While it is common to talk about how online sales of toys have made it tough for retailers everywhere, it is much less common to talk about the competition between _physical_ goods and _virtual_ goods. Sure, we talk about how music went from p to e. We talk about how books went from p to e. We talk about how movies went from p to e. But toys have _also_ gone from p to e. Every time you see a kid playing a game on a tablet or a phone or something roughly that size and shape, you are looking at dollars that went to virtual (electronic) toys vs. physical toys.
Were these anticipatable events? Did the lenders totally cock it up? I think they did. The demographic shift has been slow moving, and while people keep expecting some kind of mean reversion, there is _zero_ evidence that the demographic shift is ever going to “revert” to some sort of “mean”. Smaller families are here to stay. Older parents are here to stay. Much older grandparents are here to stay. They’ve always been around (just like larger families will always be around, and younger parents and younger grandparents will always be around), but the composition of the population has shifted. And it wasn’t exactly a slow change.
The move to virtual toys from physical toys was signalled decades in advance, by video games (I was wee when the first Atari showed up in households), but more importantly by other cultural products shifting to a dominant e-model vs. a dominant p-model. Music could maybe excuse being caught with their shorts down. Books had less of an excuse. Toys have pretty much no excuse at all. To reach back into the past, the change in audio characteristics from vinyl to CDs didn’t stop that transition. The degradation to mpegs didn’t stop people from hoarding on drives and then switching to streaming. All the book huffing the the world hasn’t stopped people from switching to audiobooks and ebooks. Why on earth anyone thought that emphasizing the characteristics of physical toys would stop the transition to virtual toys is completely outside my capacity to explain. Deploying hoards of pedagogical, medical and other professionals to lament the damage done by screen time didn’t do much to stop the spread of TV; it wasn’t too likely to impact the spread of devices, especially since devices could argue interactivity vs. the passivity of TV, which the previous round of experts had relied on a little too heavily.
Toys R Us also suffered from a store location problem (and various tiers of the companies involved seem to have an enormous amount of indebtedness associated with the real estate and leases — it is entirely possible that one reason people kept loaning Toys R Us money is simply because no one really knew how much Toys R Us already owed). For decades, people kept moving further out from cities. But that changed in 2007-8, and while, again, there has been an expectation of reversion and a great deal of words written online predicting when that would happen, it is not happening, outside of a few pockets that when probed more deeply often do not support the thesis after all (a lot of “new” “suburban” development is actually infilling leapfrogged areas and/or brown fields development — hardly expanding the overall radius further into the exurbs). Many commentators treat existing debt as an overhang, a thing which prevents reinvestment. It is as if it fell from the sky. But debt exists because there was a belief in the past that by investing in this thing, there would be a payoff. When that payoff doesn’t happen (see above), one shouldn’t pretend the effort at investment didn’t happen. We got student loans because we thought education would help us repay those loans and make more money than we would make without the loans. We got a car loan, because we thought having reliable transportation would make it possible for us to get and keep a better job. We got a house loan, because we thought that controlling housing costs would help us better control our future spending. But unfortunately, when we forget _why_ we invested (borrowed) and don’t notice that things have changed, we sometimes double down foolishly. We take out more loans for another degree, when the first one doesn’t pay enough. And I have to wonder in Toys R Us’ case, if they kept building more stores because their underlying business model actually hasn’t worked in decades, and the whole thing was debt funded expansion in the hopes of some future pay day.
It’s one thing to make fun of Tesla for doing that (we won’t know for a while how that is going to turn out). But when the perpetrator is a company like Toys R Us? Makes me wonder how many more bankruptcies we’ll be watching go by in the next few years. [ETA: for the record, I am noting that _other people_ make fun of Tesla — and Amazon, and others — for profitless expansion. I don’t.]
The good news is, the employment market is well able at this point in time to absorb many if not all of the workers who will be laid off as a result of this large chain going out of business — that wasn’t the case 10 years ago. And one can hope that future large bankruptcies will similarly be timed in an optimal way to ensure minimal disruption to the employment of hardworking employees, who never had any say at all in these larger decisions.