Coleco Industries, Inc.

Case 2

Coleco Industries, Inc.

Fifth largest toy manufacturer in the United States.

Head quarter is located in West HartFord, Connecticut

production line includes

• Cabbage Patch Kids

• plush Alf dolls and puppets

• Couch Potato Pals

• play sets

The Flintstones

Sesame Street

Sylvanian Families

INTRODUCTION

Annual sales were two third of what they had been only two years earlier

Its negative equity position of $84 million

INTRODUCTION (Contd.)

ECONOMY ANALYSIS

In the mid 1980s the economy tended to favor toy industry. In 1988, the economy was entering its sixth year of overall strength, and unemployment and interest rates at their lowest in years. As interest rate is decreasing, debt is becoming cheaper.

INDUSTRY ANALYSIS

Toy companies depended on several factors for success:

• The economy

• Demographic factors

• Seasonality

• Successful product introduction on a

regular basis

• In 1988, the economy was entering its sixth year of overall

strength

• Unemployment and interest rates at their lowest in years.

• Demographic factors also were favorable

• Attempt To reduce seasonality

• Importance successful product introductions

• Approximately 800 toy companies in the United States

• Only the largest were able to minimize sales and profit

volatility through diversification

• Attempt to reduce volatility through diversification

INDUSTRY ANALYSIS (Contd.)

Sales growth of selected toy companies

1983 1984 1985 1986 1987

Coleco 16.87 % 29.91 % 0.14 % (35.48 %) 0.76 %

Hasbro 63.45 218.99 71.54 9.02 0.03

Kenner Parker NA 20.17 (1.51) (21.23) NA

Mattel (52.80) 39.07 19.30 0.74 (3.65)

Tonka 8.26 58.31 75.83 20.05 30.40

INDUSTRY ANALYSIS (Contd.)

COMPANY ANALYSIS

known as the “high-wire act of the toy industry”

It had two notable success of recovery in the past.

the situation was skeptical of Coleco’s ability to recover for the third time.

Coleco's sales growth

1983 1984 1985 1986 1987

Coleco 16.87% 29.91% 0.14% -35.48% 0.76%

Coleco's Sales Growth

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

1983 1984 1985 1986 1987

Year

Gro

wth

(%

)

sales has been decreasing since 1984. Although the sales began to rise after 1986, it is not a fascinating sign for the company because they could not realize profit out of that increased sales.

COMPANY ANALYSIS (contd.)

1981 1982 1983 1984 1985 1986 1987

Current ratio 2.2124 2.0684 1.3601 1.3331 2.5835 1.3676 1.0752

Debt ratio 0.5224 0.6759 0.8127 0.9730 0.7425 1.0130 1.1574

Long term debt to totalCapitalization 0.7049 0.8256 0.8373 0.8933 0.9007 0.9489 0.9464

Time interest earned ratio 4.0121 9.8026 (0.2681) (1.2756) 4.5110 (1.7516) (0.7689)

Net profit margin 0.0433 0.0880 (0.0125) (0.1030) 0.1068 (0.2222) (0.2088)

Return on equity 0.1780 0.6408 (0.0816) (1.5976) 1.4694 (2.3498) 2.2919

Return on asset 0.0863 0.2331 (0.0195) (0.1842) 0.2108 (0.2250) (0.1870)


Current ratio

0.0000

0.5000

1.0000

1.5000

2.0000

2.5000

3.0000

1981 1982 1983 1984 1985 1986 1987

Year

Va

lue

s

Although Coleco’s current ratio is satisfactory it is fluctuating and another important observation is that the major portion of current asset is accounts receivable.


Debt ratio

0.0000

0.2000

0.4000

0.6000

0.8000

1.0000

1.2000

1.4000

1981 1982 1983 1984 1985 1986 1987

Year

Val

ues

The debt ratio shows a high degree of dependency of the company on borrowing.


Longterm debt to total capitalization

0.0000

0.1000

0.2000

0.3000

0.4000

0.5000

0.6000

0.7000

0.8000

0.9000

1.0000

1981 1982 1983 1984 1985 1986 1987

Year

Val

ues

On the firm’s capital, relative importance of long-term debt is increasing.


Timeinterest earned ratio

(4.0000)

(2.0000)

0.0000

2.0000

4.0000

6.0000

8.0000

10.0000

12.0000

1981 1982 1983 1984 1985 1986 1987

Year

Val

ue

s

The time interest earned ratio is frustrating in the last years.


Net profit margin

(0.2500)

(0.2000)

(0.1500)

(0.1000)

(0.0500)

0.0000

0.0500

0.1000

0.1500

1981 1982 1983 1984 1985 1986 1987

Year

Val

ues

The ratio infers the company’s overall net loss in last years.


Return on equity

(3.0000)

(2.0000)

(1.0000)

0.0000

1.0000

2.0000

3.0000

1981 1982 1983 1984 1985 1986 1987

Year

Val

ues

ROE is decreasing except 1985.


Return on asset

(0.3000)

(0.2000)

(0.1000)

0.0000

0.1000

0.2000

0.3000

1981

1982

1983

1984

1985

1986

1987

Year

Val

ues

ROA is showing volatility over the years.


SWOT ANALYSIS

Strength (S):

1. Two notable success of recovery in the past.

2. Current ratio is satisfactory.

Weakness (W):

1. Sales reduction has resulted in losses that contributed to its negative equity position.

2. Negative or near zero sales growth in recent years.

3. Escalating dependency on debt.

4. Coleco’s capital position was precarious.

5. Huge reduction in stock price.

SWOT ANALYSIS (Contd.)

Opportunities (O):

1. The economy was entering its sixth year of overall strength.

2. Unemployment and interest rates at their lowest in years.

3. Demographic factors also were favorable; birth rates were increasing.

4. The toy industry had begun to consolidate.

5. Basic and technology-enhanced toys did well.


Threats (T):

1. Of the approximately 800 toy companies in the United States, only the largest were able to minimize sales and profit volatility through diversification.

2. Each companies fortune rose and fell with the strength of its new products

3. Lack of exciting new toy introductions


STATEMENTMENT OF THE PROBLEM

Capital position was precarious,

Creditors were wary of lending any more to

the firm and

New equity from outsiders was virtually out of

the question.

The problem is to determine whether the company’s capital could be restructured in a way that would satisfy its creditors without diluting the stock any further than was necessary.

STATEMENTMENT OF THE PROBLEM

ALTERNATIVE COURSES OF ACTION

1. To go on with the business in the hope that one or more of its product would do well.

2. To merge with another firm with the hope that there might be some latent value in the company’s assets

3. To issue more equity at right market price.

4. To restructure or renegotiate debts, either through a debt/equity swap or the issuance of common stock or warrants.

5. To go for liquidation.

Analysis of the Alternatives

Alternative 1: To go on with the business

• The company’s sales became weak from 1986.

• Recovery is skeptical (no exciting new toy

introduction)

• prospects for increasing the company’s sales

based on its current product line were limited.

• Net income for Coleco is negative ($105.4m in

1987)

• Net worth is also negative.

• Creditors became impatient and were wary of

ending any more to the firm.

• The company was going into default on its loans.

• New equity from outsiders was virtually out of

question.

Alternative 1: To go on with the business (Contd.)

But to achieve the expected sales the firm needs additional fund of $205.15 million (Appendix 9):

AFN = (A / S) S – (L / S) S – MS1 (1 – d)

Here,

A / S = 475180000 / 504483000 = 0.942

S1 = 625m

S = 625m – 504.5m = 120.5m

(L / S) = 162798000 / 504483000 = 0.3227

M = (105351000) / 504483000 = (0.2088)

d = 0

Hence, AFN = 205.15 million


So we can conclude that going on with the business will be an inappropriate decision for Coleco.


Alternative 2: To merge with another firm

Merger is beneficial only when a synergy will take place.

But the value of total assets is less than the total value of liabilities. Moreover the firm’s sales are not adequate to cover the relevant costs.

So no firm will be interested to acquire it.

Alternative 3: To issue more equity

Appendix-1: Stock and bond price data

Stock price

S&P 500

Closing Bond PricesS&P Long-Term Govt. Bond Index High Low Close 11.13% 14.38%

1984 $22.250 $9. 625 12.125 167.24 - $90.125 40.29

1985 21.500 10.125 16.000 211.28 - 101.875 48.93

1986 20.500 8.125 8.375 242.17 $81.875 100.875 58.04

1987 Apr 11.625 10.000 10.375 288.36 82.000 99.500 60.69

May 10.750 9.875 10.500 290.10 77.750 96.500 51.55

June 11.625 10.250 10.625 304.00 76.000 95.000 52.42

July 11.000 9.750 9.750 318.66 94.000 95.000 51.89

Aug 10.375 9.125 9.375 329.80 75.625 98.625 50.40

Sept 10.250 8.500 9.125 321.83 76.125 96.000 47.39

Oct 9.125 4.250 5.500 251.79 72.000 94.375 47.17

Nov 6.000 4.375 4.625 230.3 55.250 68.875 50.31

Dec 4.625 3.625 3.875 247.08 50.000 63.500 49.89

1988 Jan 4.250 3.125 3.500 257.07 41.500 50.000 51.28

Feb 3.500 2.625 3.000 267.82 41.750 54.125 53.67

14-Mar 2.500 266.37 27.000 34.250 52.50

• The company is facing loss in the last years

• The value of equity is ($84) million. In this

situation

New equity from outsiders was virtually out of question.

Alternative 3: To issue more equity (Contd.)

Alternative 4: Renegotiation of debt

• It has announced that it might miss interest payments of $10

million due on debentures on April1, 1987 and another $4

million due on May 1 1987.

• At the same time the company has failed to comply with

most of the covenants of revolver’s credit agreement

regarding

maintenance of working capital,

net worth and pre tax income,

ratio of debt to net worth,

restrictions on unsecured indebtedness and

a prohibition of payment of cash dividends.

• The creditor banks had amended the

agreement to eliminate the violations at that

date and to take into consideration the

projected financial condition of the company.

• The annual volatility of the 11.25% debenture was 41.1%

the annual volatility of the 14.375% was 43.1%.

So under this situation, renegotiation of debt will not be possible to Coleco.

Alternative 4: Renegotiation of debt (Contd.)

Alternative 5: To liquidate

Coleco is now in both stock based and flow based insolvency.

D

E

B

T

ASSETS

Negative Equity $84.3m

Stock based Insolvency

Contractual obligation

$

Flow based insolvency

Cash flow shortfall

Insolvency

Alternative 5: To liquidate (Contd.)

To justify whether the company should be liquidated or not we took the help of distress analysis. We have calculate the Zi scores of the company using the following revised multivariate model of Altman.Zi = 0.717X1i + 0.847X2i + 3.107X3i + 0.420X4i + 0.998X5i

Where

X1i = (Current assets – Current liabilities) / Total assets

X2i = Retained earnings / Total assets

X3i = Earning before interest and taxes / Total assets

X4i = Book value of preferred and common equity / Book value

of total liabilities

X5i = Sales / Total assets

Zi = Index of bankruptcy


The cutoff points Altman reported were

Assign to nonbankrupt group if Z > 2.90

Assign to bankrupt group if Z < 1.20

Gray area if 1.20 ≤ Z ≤ 2.90

According to this formula any firm with a Z-score below 1.20 is considered to be a prime candidate for bankruptcy, and the lower the score, the higher the failure probability.


Year 1980 1981 1982 1983 1984 1985 1986 1987

Zi score 4.04781862 3.25805175 3.5526636 1.58343312 1.7081271 3.497728 0.50546 0.410293

Zi = 0.717X1i + 0.847X2i + 3.107X3i + 0.420X4i + 0.998X5i

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

1980 1981 1982 1983 1984 1985 1986 1987

Year

Val

ue

s

Nonbankrupt

Gray area

Bankrupt


Since the Zi score is far below from 1.2, the firm can be considered as a prime candidate for bankruptcy and it has a higher probability of being bankrupt.

Recommendation

The firm should be liquidated.

Ways of Liquidation:

1. Informal liquidation.

• Reorganization.

• Assignment.

2. Formal liquidation.

So Coleco should go for formal liquidation.

Question answer session.

Coleco Industries, Inc.

Documents

flow based

negative equity

toy industry

profit volatility

net worth

current ratio

industry analysis

capital position