Is the Party Over for Highly Leveraged Seasonal Retailers?

Party City Holdco Inc., the parent company of the popular party goods retailer Party City, filed for Chapter 11 bankruptcy in January 2023. The company joined a slew of retailers that have been struggling in the past year, including Bed Bath & Beyond, Stitch Fix, Carvana, and GameStop. Moody’s EDF-X early warning system captured Party City’s increasing credit risk as early as summer 2019.

Challenge

Prior to the pandemic, Party City was facing challenges including poor Halloween sales and supply shortages that dampened profits. Once the pandemic hit, problems were exacerbated as lockdowns brought the demand for party supplies to a screeching halt. Were there early credit risk warnings all along? How exceptional is Party City in a space as volatile and troubled as US brick-and-mortar retail?

It is tempting to retrospectively pronounce a firm “exceptional” and identify early warning signs once it has failed. The challenge is to find ways to flag companies and provide actionable insights before they fail. Looking for credible and timely early warning signals is a complex exercise. A probability of default computed using firms’ financials or stock prices cannot determine on its own when and which exposures are at risk. The decision rules that we use to determine which exposures belong on our watchlist are arguably more important than the risk measures themselves. Such rules need to be carefully calibrated so they do not flag too many false positives— which are costly to monitor—while at the same time do not flag too few names generating false negatives.

Insights

When comparing a distressed firm with its peers, it is important to discern which specific factors disproportionately affected the firm and furnish meaningful signals of its trajectory. For example, certain metrics may indicate that a firm has a higher credit risk compared to others in its peer group, even if its profitability does not distinguish it from the group. We leverage insights and early warning signals from EDF-X to compare Party City’s credit risk metrics with those of its peers.

Analysis

Undoubtedly, many headwinds have plagued brick-and-mortar retail in recent years, including supply chain constraints, increased competition with e-commerce, inflation, and shifts in household discretionary spending, among others. Seasonal specialty businesses such as Party City have also endured some idiosyncratic challenges, aggravating their demand for cash to fund inventory in advance of peak seasons.

In 2019, Party City saw softened Halloween sales – a significant portion of Q4 revenues for the company—as well as helium shortages that ate into balloon sales. Like almost all retailers, the company struggled at the onset of the pandemic. Nonetheless, the company’s share price enjoyed a modest rebound in late 2020 and through 2021 on account of several drivers, including pent-up demand across retail, a more curated assortment of in-store and online goods, and favorable debt refinancing. In fact, even 2022 showed some promise: although Q3 same-store sales in 2022 fell 3.2% from 2021, they were up 11.2% from 2019. Brewing under the surface of the brief rebound, however, was a highly leveraged cash-guzzling business that was struggling to keep some 800 stores open across the US. Rising interest expenses and input costs (including costs associated with their supply chain, raw materials, sourced merchandise, and labor) presented further challenges that hastened the eventual decision to file for Chapter 11. Since filing, the company’s penny stock has been delisted from NYSE and over 30 stores have been set to close.

Contextualizing Party City’s default risk among peers ¹ shows severe early warnings years ago, which we can appreciate using the EDF-X early warning signal (EWS). The EWS combines two decision rules into an actionable early warning framework. The first decision rule is the distance between the firm’s point-in-time one-year probability of default (PD) and a trigger ² identifying the riskiest firms in its region/industry peer group. The second decision rule is the year-on-year change in the firm’s PD-implied rating, which measures the significance of a recent change in credit risk. The EWS synthesizes relative-to-peers and absolute credit risk information into a simple, actionable signal presented in the quadrant view. Based on these decision rules, the EWS flags a firm as “severe,” “high,” “medium,” or “low,” as seen in Figure 1 and Table 1.

The EDF-X early warning system classifies a firm into one of four warning categories: severe, high, medium, and low, based on the firm’s current relative credit risk (point-in-time PD vs. EDF-X trigger) and a recent credit risk movement (implied rating 12-month change). The trigger threshold is set according to an industry/region peer group. The implied rating is the alphanumeric rating (e.g., Aaa, Aa1, etc.) determined by the PD.

The EWS detected trouble almost four years before Party City filed for Chapter 11. By the second quarter of 2019, the company’s PD breached our trigger, and has remained above the threshold ever since (Figure 2). ³ Concurrently, the firm’s PD-implied rating has deteriorated since 2019 as well, notwithstanding an improvement in early 2021. This combination of factors kept it in “severe”. Despite a rebound in the PD-implied rating in 2021 (coincident with the increase in Party City’s stock price), the early warning was still marked as “high” as the PD stayed above the trigger. It is also important to highlight that since the trigger is peer-based, the signal is adaptive and thus avoids overstating or understating the number of risky names in a portfolio. We can see in Figure 2 that the trigger level spiked at the onset of the pandemic; this means retail firms that experienced a sudden rise in their PD at the time would not necessarily have been marked with a “severe” early warning. Therefore, a peer-based early warning indicator is an invaluable tool for forward-looking decision making.

Party City has shown mixed performance relative to peers in terms of business risk and financial risk. Its business risk has been relatively low compared to its peer counterparts, in spite of store closures and restructuring after Chapter 11. But in terms of financial risk, Party City’s market leverage has surpassed that of its increasingly leveraged peers. After being in the 75th percentile in 2019, its market leverage rose to the 97th percentile in 2023 with a value over 99% (Figure 3). Additionally, Party City’s debt-to-equity ratio has consistently been higher than that of its peers since going public in 2015, reaching the 97th percentile in 2021 with a value over 2,670%. This trend in the debt-to-equity ratio indicates a weakened solvency position for the company. Thus, Party City’s high financial risk, reflected by its leverage position, has been a key contributor to the increase in its PD relative to its peers.

Key Takeaways

• The EDF-X solution allows for industry-wide peer analysis that provides actionable insights on forward-looking credit risk signals and exceptional risk factors.
• The EDF-X Early Warning Signal placed Party City on a watchlist four years ago, identifying its substantial market leverage.
• US retail and wholesale consumer products firms have been experiencing an uptick in financial risk (market leverage), and seasonal specialty businesses are particularly under duress as they need cash to fund inventory in advance of peak seasons. With inflation and changes in consumer spending, highly leveraged and cash-intensive firms face an elevated risk of bankruptcy.