coleco

UVA-F-0775

COLECO INDUSTRIES, INC.

Coleco’s chief financial officer, Paul Meyer, had to devise a capital-restructuring plan to put the company back on its feet. Just a couple of years earlier, Coleco could not make its smash-hit Cabbage Patch Kids fast enough to keep up with demand. Now, in March 1988, the Cabbage Patch craze was spent, and Coleco had not come up with any new blockbuster products. The company’s annual sales were two-thirds of what they had been only two years earlier, which resulted in losses that contributed to its negative equity position of $84 million.

Coleco’s capital position was precarious and impatient creditors were wary of lending any more to the firm, which was going into default on its loans.1 In its present condition, new equity from outsiders was virtually out of the question. As shown in Exhibit 1, the company’s stock price had ranged between $22.25 and $8.125 from 1984 through 1986 (when the company had a loss of $111 million). As losses continued to mount, the stock price fell to its year-end 1987 price of $3.625. By March 1988, following announcement of an annual loss of $105 million, the stock reached a low of $2.50 per share. The issue with which Meyer and the rest of Coleco’s board had to wrestle was how to restructure the company’s capital in a way that would satisfy its creditors without diluting the stock any further than was necessary.

The Toy Industry

Toy companies depended on several factors for success: the economy, demographic changes, seasonality, and successful product introductions on a regular basis. In the mid-1980s, the first two factors tended to favor toy manufacturers. In 1988, the economy was entering its sixth year of overall strength, and unemployment and interest rates were at their lowest in years. Demographics were also favorable; birth rates were increasing, and over 40% were of firstborn children. The expanding population of grandparents and two-income families led to more potential buyers. The Christmas season tended to be the most important for toy manufacturers. To reduce seasonality, the

1 Coleco announced that it might miss interest payments of $10 million due on debentures on April 1, 1988, and another $4 million due on May 1. The company was also not in compliance with most of the covenants for its $30 million revolving-credit facility.

This case was prepared by Casey S. Opitz, under the supervision of Professor Robert F. Bruner. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright © 1988 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Rev. 11/97. ◊

Can Coleco come up with a winner to revive it a third time? The outlook isn’t promising. Coleco had high hopes for Rambo, the boys’ action figure based on the Sylvester Stallone movie character, but it flopped. So did Wrinkles, a plush animal made by a company that Coleco bought. And Starcom, a space-age action figure, appears to be burning out.3

Exhibit 4 details Coleco’s sales by product and an analyst’s estimates for 1988.

Financial Performance

Coleco’s financial statements are provided in Exhibits 5 and 6. As late as December 1987, industry analysts were projecting minimal losses for the company, but as shown in Exhibit 7, fourthquarter 1987 losses totaled $99 million, as the negative effects of the October 19 stock market crash dampened Christmas sales and the ensuing corporate retrenchment program created write-offs.4

The company’s problems were compounded by the financial constraints it operated under, which disrupted production. Coleco estimated that fourth-quarter shipments were at least $15 million less than they would have been had adequate working-capital financing been available.

At year-end 1987, Coleco had $460 million of debt outstanding on an equity base of −$84 million. The company had lines of credit totaling $189.9 million, including a $150-million line with a group of foreign banks that allowed the company to borrow against receivables and a $30-million revolving-credit line with Connecticut National Bank and National Bank of Canada. These allowed Coleco to borrow against receivables and inventory. The revolver’s credit agreement contained various covenants regarding maintenance of working capital, net worth, and pretax income, ratio of debt to net worth, restrictions on unsecured indebtedness, and a prohibition of payment of cash dividends. Coleco was not in compliance with most of these restrictions, but 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 at the end of the first quarter of 1988,” according to the company’s annual report.

3Joseph Pereira, “Coleco Is Looking for Lettuce as Cabbage Patch Wilts,” Wall Street Journal (March 18, 1988): 4.

4The company reported that “more than 40% of the fourth-quarter loss was attributable to reserves established and charges taken related to cost-reduction efforts, modifying the company’s distribution channels and contracting certain product lines to assure greater operating efficiency.” Staff was reduced by 300 people, or by almost 25%, between November 1987 and March 1988. These reductions were expected to eliminate $70 million from operating costs in 1988.

Coleco generally borrowed as much as it could under these lines throughout 1987 at interest rates averaging 9.5%, as shown in Exhibit 8. The $150-million credit agreement was set to expire on April 15, 1988, but the company was negotiating with a group of foreign banks to extend the agreement for one year for $135 million. The $30-million credit was to expire on May 1, 1988, and renewal negotiations were also underway with a group of domestic banks.5 As shown in Exhibit 8, the company also had $10.8 million of mortgage and equipment term loans at rates up to 2.5% over prime.

As shown in Exhibit 1, in March 1988, the 11.125% and 14.375% debentures traded around prices of $27 and $34.25, respectively.6 Coleco also had $80 million in convertible subordinated debentures outstanding. The 11% convertibles were issued at a maturity value of $55 million and had a conversion price of $13.75 per common share. If remaining debentures outstanding were to be converted, the company would have to issue 3.54 million shares of stock. Coleco could terminate the convertibility of the debentures if the value of the company’s stock exceeded 150% of the conversion price for 20 straight days. These debentures traded around a price of $38 in March 1988.

The 6.5% convertibles were issued at a maturity value of $44.48 million and had a yield to maturity at the date of issue of 10.4%; interest was payable in Swiss francs. The conversion price was $17.125 per common share. If remaining debentures were to be converted, Coleco would have to issue 1.72 million shares. The company could redeem the debentures if the stock price were over $20.55 for 25 days. These debentures were not widely traded in the first quarter of 1988.

In February 1987, MCA, Inc., a motion-picture company, bought $20 million of the company’s preferred stock (22,223 shares) that would convert to 2.2 million shares of common stock on January 1, 1995. MCA had sued Coleco over its use of the name “Donkey Kong” for one of its games, because MCA held the rights to the King Kong movies; Coleco had then countersued in an attempt to recoup royalties it had already paid MCA. The stock acquisition resolved the dispute, and MCA agreed not to purchase any more stock in the company for eight years without Coleco’s approval.

The investment made MCA one of the largest equity investors (23% of total common and preferred and capital in excess of par) in the company; Coleco Chairman Arnold Greenberg owned 16%. Insiders owned a total of 25.3%, and holders of 5% or more owned a total of 41.2%. Greenberg’s brother, Leonard, a private investor not directly associated with the company, owned 9.7%. Institutions owned 11.4%.

5“Coleco’s 4th-Period Loss Is $98.8 Million; Toy Maker May Miss Interest Payment,” Wall Street Journal (March 15, 1988): 10.

6According to a company analyst, based on monthly data for the previous two years, the annual volatility of the 11.125% debenture was 41.1%; the annual volatility of the 14.375% debt was 43.1%. Weekly data for the past seven months suggested that the annual volatility of Coleco’s common stock was 64.7%.

In August 1987, Coleco issued 644,295 shares of common stock worth $6 million as final payment of a 1985 settlement related to the Adam computer lawsuit against the company and several officers. In October 1987, the company’s shareholders increased the number of authorized preferred shares from 300,000 to 12 million.

Alternatives

Meyer sifted through this financial information in an effort to find some means of satisfying management, creditors, and shareholders. Should the company continue with business as usual, in the hopes that one or more of its products would do well? He wondered whether liquidation was an alternative, especially given the numbers and classes of creditors, as shown in Exhibit 9; it would certainly be a very messy process. Also, it had been suggested that the company might be able to merge with another firm; Meyer wondered whether there might be some latent value in the company’s assets. Alternatively, Coleco could issue more equity, but the market price would have to be right. Finally, the company could financially restructure. This would involve the renegotiation of debts, either through a debt/equity swap or the issuance of common stock or warrants. This would also mean that the old shareholders’ shares would be badly diluted. Bankruptcy could be a part of either the liquidation or restructuring option. Relevant interest-rate data are provided in Exhibits 10 and 11. Standard & Poor’s rated Coleco’s debt CCC+.

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Sources: Datext, Moody’s Bond Record, Standard & Poor’s Bond Guide, and Standard & Poor’s Statistical Service.

Exhibit 2

COLECO INDUSTRIES, INC.

Comparative Financial Data, 1987 ($ Millions, except per-share data)

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1 Value Line estimates.

Note: NMF means “not a meaningful figure.”

Sources: Value Line Investment Survey, annual reports.

Exhibit 4

COLECO INDUSTRIES, INC.

Actual Sales and Estimates by Product

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Source: Oppenheimer & Co., Inc., Toy Industry Report, November 27, 1987.

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Source: Annual Reports.