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Toys R Us: New Management Brings Results and Hope for IPO Story

Posted On: April 21, 2011

The new management at Toys R Us has helped improve the company through better inventory selection, more disciplined inventory management and tighter controls on expenses, several industry sources said. This appears to be an opportune time for an initial public offering, given the resilient state of the equity markets, they added.

However, the initial public offering was recently delayed until July, according to report by Reuters. Given the success of recent private equity-backed IPOs such as HCA (NYSE: HCA), it is questionable why Toys R Us was delaying the offering, said an independent research analyst focused on IPOs.

The PE owners may feel the price the company would fetch right now is too low, speculated Kim Noland, director of high yield research at Gimme Credit.

The new management team at Toys R Us is doing well, said Bill Emerson, president of Emerson Advisors, an independent research firm that focuses on the retail industry.

Toys R Us has always had “a great concept,” said David Iannini, investment banker and president of William & Henry Associates. “Toys are forever, and kids love toys,” Iannini said.

Ana Lai, a credit analyst at S&P, said she believes the company has performed well. Toys R Us has a good merchandising strategy and did well during the key holiday period, Lai noted.

Holiday sales were not as robust as hoped, Noland said. But, fourth quarter results and year end results were decent, she said.

Net sales increased 2%, to USD 6bn, with same store sales rising 1.8%. Broken down, domestic sales rose 4.6%, attributable primarily to new store openings, while international sales fell 2%, due to decreasing sales of video games and hardware, Noland said.

Gross margins were flat, but SG&A increased slightly, Nolan added. According to Lai, this was a result of new store openings.

Iannini said that Toys R Us can do well even in a difficult economic environment. Many parents will continue to spend money on their children, viewing it as somewhat non-discretionary, he added. Operating margins were maintained during the recession, Noland said.

Emerson, however, said there are questions about the company’s business model. The company makes its money six weeks out of the year during the Christmas holiday season. Pop-up stores (smaller stores opened temporarily during the holiday season) and the internet will be key components going forward, he added.

The firm is the last major toy retailer with physical stores remaining in the U., said the analyst focused on IPOs. According to the analyst, the company has high debt levels and plans to use the IPO funds to lower leverage. It is likely to repay longer-term debt that has higher yields, he added.

In a post IPO scenario, leverage will fall to the mid-5x range, from the current 6.5x, Lai noted. According to Noland, debt at year-end was USD 5.3bn, an improvement from the prior year. She said she believes that the company has ample liquidity at USD 1.9bn.

Competition

According to Lai, Toys R Us operates in a highly competitive sector. In the past, the company lost market share, but regained its footing recently. It has helped that competitors such as KB Toys have gone out of business, Lai said. Current executives have improved operations through differentiated merchandise, higher service levels, and cost controls, she added.

When Toys R Us went private in 2005, retailers such as Target (NYSE: TGT) and Wal-mart (NYSE: WMT) were discounting toys during the holiday season. Since then the two competitors have seen their business deteriorate, the independent analyst noted.

However, Toys R Us spent heavily to remain competitive with the two retail behemoths. Last year, the company spent USD 325m on capital expenditures, Noland said. It will continue to spend at a robust rate this year now that the downturn appears to have eased as it remodels existing stores and integrates its business in line with its long-term strategy, she added.

The company appears to have found a “winning strategy with side-by-side Toys R Us and Babies R Us stores” Noland said. Over 10% of the company’s locations have the combined format, and this has improved sales and provides labor and working capital savings, Noland said.

Drawing a parallel from the threat Netflix (NASDAQ: NFLX) posed to Blockbuster, Iannini said the digital gaming realm could impact Toys R Us, which would move towards interactive gaming space with time.

The internet will be a very important consideration for the company, but it has a long way to go, the independent research analyst said. Currently, 10% of sales come from the company’s on-line portal. He predicted that this figure could rise to 20-30% in three to five years.

Emerson said, however, that currently Wal-mart and Target are major threats. Though Toys R Us took market share this holiday season, competing on brands and price against those two is daunting, Emerson said.

Talking of the pop up store strategy, Iannini said that he does not expect the real estate market to “go back up” for some time. If rents increase, it may affect Toys’ margin, but this should not impact the company’s strategy of taking advantage of seasonal demand, Iannini added.

Comps for valuation

Specialty retailers that focus on a particular category would make appropriate comparable companies, Iannini said. He cited non-discretionary, specialty retailers like Big 5 Sporting Goods (NASDAQ: BGFV) in the sporting goods, or apparel retailers that focus on specific categories as examples. Best Buy (NYSE: BBY) and Barnes & Noble (NYSE: BKS) would not fit this category, he explained.

Lai agreed with Iannini’s logic but said Best Buy, although it has a comparable business model, has a very different leverage profile.

by Larry Rothman, CFA and Malathi Nayak

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