Struggling online retailer eToys Inc., deep in a make-or-break holiday season, is being abandoned by four institutional shareholders and appears to be readying itself to be acquired, according to several industry analysts.
In recent weeks, four shareholders HFTP Investment LLK, Leonard LP, Wingate Capital Ltd. and Fisher Capital Ltd. have been accelerating the conversion of $100 million in preferred stock to common stock, and then selling it.
An “escape clause” in the investment agreement, entered into in June, allows the preferred shareholders to accelerate their conversion/cash-out if eToys’ stock price drops below $2.30 a share. The stock, which has been battered by investor concerns and a glut of common shares as the preferred shares are converted and sold, has been nose-diving. Last week it sank to a 52-week low of $1.03 a share, down from a high of $86 more than a year ago.
The early exodus of the preferred shareholders and resultant stock price slide prompted analysts to downgrade their recommendations on eToys’ shares.
As of Dec. 5, the e-tailer was able to sell enough common stock to repay the preferred shareholders $72 million of their $100 million investment, according to Clem Teng, eToys’ vice president of investor relations.
Officials from the investment companies declined to comment for this story.
But other observers who have been following the company said eToys may be preparing itself to be sold.
“I would say they (eToys) are cleaning up their balance sheet for the year end,” said Alex Cappello, chairman and chief executive of the Cappello Group, a local stock underwriter who is familiar with eToys’ investment deals. “They will look better for a suitor trying to acquire them or for someone to invest in them.”
Among the potential buyers, the one considered most likely to emerge as the acquirer of eToys is K-B Toys, the nation’s second-largest toy retailer.
Analysts believe that an eToys acquisition would be a wise move. While K-B has its own online sales operation already, the value of eToys to any acquirer would be its well-known name and its loyal, large base of customers.
Other potential suitors mentioned by industry observers include educational toy retailers Zany Brainy Inc. and The Right Start Inc.
One unlikely candidate is archrival Toys R Us, which, like eToys, had delivery problems last holiday season. To resolve that, Toys R Us teamed up with powerhouse online retailer Amazon.com to take care of distribution.
Although K-B Toys is considered the most likely candidate to acquire eToys, officials at the Pittsfield, Mass.-based company would not comment on a possible eToys merger, adding that they have had their own online site for two years. They further said that they are concentrating on other things right now. In early December, K-B Toys split from its parent company, Consolidated Stores, in a $300-million deal that made the toy store retailer a privately held company.
“Right now we’re just concentrating on this transaction,” K-B Toys spokesman John Reilly said.
Teng of eToys said that finishing the stock conversion quickly will reduce uncertainty for investors by allowing them to know exactly how many common shares are outstanding.
“We would like to put this behind us as quickly as we can,” Teng said.
Toby Lenk, a former Walt Disney Co. executive who helped found eToys in 1996 with Idealab’s Bill Gross and who still heads the company, was unavailable for comment last week.
The accelerated repayment of the $100-million investment has prompted observers to note that the company’s last gasp may be soon.
Following the SEC filing in late November, analyst Sasha Kostadinov of McDonald Investments downgraded the stock from a “buy” in February to a “hold.”
Kostadinov, who finds the company’s financial structure troubling, was cautious when talking about eToys’ future or its possible sale. He believes the company is doing what it needs to be doing. “They are operating the business the best they can,” he said.
But the company itself may be in a death spiral because sales during the critical holiday period are softer than expected.
Analysts said that holiday sales won’t approach the $210-million mark needed to keep the company alive after it lost $190 million last year on sales of $151 million. In fact, researchers with BizRate.com, a shopping service that compares and rates online retailers, noted that total Internet toys sales for 133 Web sites between Nov. 20 and Dec. 12 this year was $279.7 million. Obviously, for eToys to single-handedly generate $210 million of that total would seem unlikely.
With soft holiday sales and a stock worth almost nothing, eToys might find it difficult to woo investors next year. And it will be hard to cut costs because of the tremendous infrastructure it has built, which includes five distribution facilities in the U.S. and a sixth in Belgium.
“Their cash burn is very significant,” noted Banc of America Securities analyst Tom Courtney “Without capital, you can’t advertise and without advertisements it’s hard to get sales growth.”
This year’s do-or-die holiday season follows a rough season last December. That’s when the online company was visited by millions of people who were trying out the Web site for the first time. Many were pleased with the relatively easy way of breezing through the site, clicking to buy a toy and then having it shipped.
But hundreds were disappointed when their toys showed up the day after Christmas due to distribution problems.
Lenk has been busy in recent months trying to reassure customers that operations have been improved.
In various television and newspaper interviews, Lenk has been spreading the word that the company is not outsourcing its distribution this year. Instead, it has its own in-house distribution operation and 700 customer service representatives to handle orders.
In early December, the company issued a press release noting that 99 percent of its deliveries were on time and that customer service had never been better.
The online toy purveyor also took out an ad in The Wall Street Journal in early December, noting that it had secured a $40 million revolving line of credit in November from Foothill Capital Corp., a subsidiary of Wells Fargo & Co., for working capital and general corporate purposes.
News of the credit line prompted Robertson Stephens analyst Lauren Cooks Levitan to announce that the capital could help alleviate investors’ concerns about eToys’ ability to fund its growth. But she still views the stock as a risky investment.
