Long-Term Prospects Are Bleak for KB Toys, Analyst Says

What are the chances for long-term survival at KB Toys Inc. following its bankruptcy filing yesterday?

“Twenty percent, maximum,” said Howard Davidowitz, chairman of retail consulting and investment banking firm Davidowitz & Associates Inc., New York.

More than a month after FAO Inc. declared bankruptcy for the second time, KB Toys, Pittsfield, MA, filed for Chapter 11 bankruptcy reorganization in U.S. Bankruptcy Court for the District of Delaware.

“They will never win a pricing game,” Davidowitz said. “I think they can come out of it. The question is, 'What will come out of it?' It is not particularly difficult to come out. It is very difficult to find a niche in the marketplace and survive. Their stores, unlike Toys 'R' Us, are in malls and not strip centers. Mall traffic has been declining for years because department stores are the anchors of malls, and they are all down.”

KB historically has been a low-end retailer emphasizing price, he said.

“They will have to find something — educational toys — I don't know,” Davidowitz said. “They will have to find some way to … make themselves special.”

Wal-Mart and Target, he said, have much lower operating costs.

“Toys 'R' Us has bigger stores, and they will always have bigger assortments than KB,” he said. “Wal-Mart and Target will always have lower prices, so what's the reason to go to KB?”

KB Toys said that to fund its restructuring and continuing operations, it secured from a lending group led by Fleet Retail Group Inc. a $350 million senior secured debtor-in-possession financing facility. The facility is subject to court approval and has a four-year term, including the period during which the company is in Chapter 11 proceedings.

The company said initial aspects of the process would involve closing unprofitable or underperforming stores, staff reductions and “reengineering the organization” to cut expenses. The privately held retailer and online marketer also said that it would pay vendors, suppliers and other business partners under normal terms during the reorganization. It has asked the court to permit it to honor its return policies and gift cards.

The company noted that it experienced a rapid decline in its liquidity resulting from below-plan sales and earnings performance in the fourth quarter of 2003.

“Wal-Mart decided to use toys as a loss leader to drive traffic,” Davidowitz said. “Can you find a better loss leader than toys at Christmas? Impossible! And they started selling a lot of desirable toys at cost, or a little above cost, or a little below cost, as a driver for footsteps. That's a $250 billion company. You don't want to play games with them.

“KB announced 45 days ago the bills due in December couldn't be paid due to a shortfall in cash flow. End of story. At that point it had to be a Chapter 11. When that starts, it's the kiss of death since suppliers won't supply you with fresh merchandise.”

In its filings the company indicated that it has targeted emergence for prior to the 2004 holiday season.

“During the reorganization they will … [I believe] close hundreds of stores,” Davidowitz said. “They'll get a chance. They'll get their year, and we'll see if they can get exit financing, how they are performing in their best stores and how their new concept works.”

Suppliers may provide hope in the situation.

“The suppliers will want to keep them alive since there are fewer people to sell to,” he said. “Consolidation weakens the suppliers since they don't have a lot of customers to sell to. Suppliers used to have hundreds of people to sell to. Suppliers lose leverage with fewer customers.”

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