Coleco Industries, Inc.

COLECO INDUSTRIES, INC.

        Teaching Note

Synopsis and Objectives

Suggested complementary cases dealing with financial distress: “Caledonian News- papers Ltd. (Abridged)” (UVA-F-1013); “Massive Power Design Corporation” (UVA-F-1086)

In March 1988, this large toy manufacturer is facing the consequences of bearing too much debt in a volatile competitive environment.  The student’s task is to recommend a response to the worsening situation by which the firm can be returned to financial health.  At the date of the case, the company is not under judicial protection, although bankruptcy looms as a distinct possibility if negotiations with lenders produce no mutually agreeable solution.

The case was developed to stimulate a discussion of the determinants of corporate-debt policy as part of a pair of cases set in the toy industry (the other being “Tonka Corporation,” UVA-F-0774).  In sharp contrast to the Tonka case, this case raises the costs of financial distress as a constraint on the use of debt.  The case discussion can also sharpen students’ thinking on the exact nature of financial distress and how it differs from the special case of bankruptcy.  Moreover, the case can be used to illustrate the allocative issues that arise in working out a satisfactory financial plan for recovery.  Finally, the case provides an opportunity to compare the equity in a distressed firm with an out-of-the-money option on the firm’s assets.

Suggested Questions for Advance Assignment to Students

1.        Assess the product-market strategy and financial strategy Coleco pursued through 1987.  Compare Coleco’s strategy with that of Tonka in early 1987.

2.        What went wrong?  How did Coleco respond?

3.        Assess various alternatives at this stage of Coleco’s difficulties.  What sort of refinancing plan would alleviate Coleco’s financial difficulties?

4.        What should Paul Meyer do now?  Consider this question from the perspective of (a) Coleco’s management, (b) its lenders, and (c) its shareholders.

Hypothetical Teaching Plan

1.        What is Coleco’s financial condition, and how did it come about?

This segment of the discussion might review many of the same industry and strategic considerations brought up in the “Tonka” discussion.  A comparison with Tonka can be an important teaching avenue of this case.  Identifying the origins of Coleco’s financial distress will also be useful to the analysis.

2.        At this point, who are the significant players in any potential outcome?  What are their motivations?  

A review of the goals and comparative strengths of management, creditors, and shareholders develops the allocational theme of the case and can motivate a discussion of the agency conflicts that arise in financial distress.

3.        What are management’s alternative courses of action?  How does each one work? 

The chief alternatives worthy of discussion are issuing equity, selling the company, recapitalizing the firm outside of bankruptcy, recapitalizing the firm in bankruptcy, and liquidating the firm.  At the end of this discussion, the instructor can observe that all the alternatives are variations on the theme of restructuring.

4.        What should Meyer do?  How should he persuade his colleagues and board of directors of the effectiveness of this course of action? 

The case discussion can be closed with a vote by the class on the most popular alternatives, followed by a presentation of the epilogue.

Case Analysis

Coleco’s financial condition

Discussion Question 1

This case is one of dramatic adversity.  As recently as 1985, Coleco reported sizable net earnings and offered promising prospects for the future.  Understanding the turn for the worse is one of the important learning vehicles for the students.  The record suggests that Coleco’s decline resulted from its strategy of financing its way out of adversity instead of making operational changes to “bootstrap” its way out.  

Exhibit TN1 gives a summary of the sources and uses of funds for the company for two time periods: 1980–85, the period of the firm’s explosive growth, and 1986–87, the period of the firm’s aggressive acquisition strategy and large losses.  The exhibit shows that, in the first period, uses were primarily in the form of additions to current assets, which were financed by subordinated debentures, additions to current liabilities, and profits.  In contrast, the large use of funds in the 1986–87 period was to cover operating losses, which were financed by additional subordinated debentures and current liabilities.  Coleco displayed an ability to stretch its current creditors, adding $289 million in current liabilities versus $278 million in current assets over the entire 1980–87 period.

The sources of Coleco’s adversity were the very shocks against which Tonka’s conservative debt policy was designed to guard:

!        External shocks such as the contraction in consumer spending on toys following the stock-market crash of October 1987

!        The foreshortened life cycle of a key product (i.e., Cabbage Patch)^[1]

!        The failure to develop new high-demand products to replace waning old products

!        The constriction of financial flexibility (evident in the wariness of lenders to finance ongoing operations)

!        Adverse settlement of lawsuits against the company related to alleged infringement of trademarks and designs (i.e., MCA and “Donkey Kong” and the Adam computer)

The combination of these shocks produced various danger signals about the company’s financial health: (1) Coleco’s debt (rated CCC+ by Standard & Poor’s), (2) steep losses for the fourth quarter and year of 1987 ($99 million and $105 million, respectively), (3) negative net worth ($84 million), (4) high debt level ($460 million), and (5) falling stock price to a quarter of what it had been a year earlier.  Another index of the firm’s health at the date of the case is provided by the yields of the firm’s subordinated bonds: they were yielding about 40 percent to maturity.^[2]  This high yield compares with yields of 12–19 percent on other CCC-rated issues listed in case Exhibit 11.  Plainly, investors are demanding a huge default-risk premium.