Toys R US Case Study

Introduction: ​Toys R US (TRU) was founded in 1957, and was one of the largest toy retailers in the
world. The company operated three separate business units: US Toys, International Toys and US Babies,
and once dominated the toy industry. However, in the early 2000’s Toys R US didn’t successfully adapt
to the changing trends in the retail industry, and the emergence of mass merchants such as Walmart and
Target. Their US Toys segment struggled, while the International and Babies R US units continued to
grow. The company reevaluated their business operations in 2003 and 2004, and decided to enter into a
leveraged buyout in March 2005 to Bain, KKR and Vornado group at $26.75/share. Despite some
improved margins in the years that followed, Toys R US ultimately pulled their IPO offering in 2013.
This case study will analyze the factors that led Toys R US to enter into the LBO, evaluate potential
alternative strategies and the price paid of $26.75, and lastly the strategic issues of TRU and the degree of
success of the LBO will be discussed.
Questions:
1.Main factors supporting the LBO:
There were some factors that supported Toys R US to enter in to the LBO agreement. In the years prior to
2004, Toys R US’s financial and competitive performance was negatively impacted by developments and
changing trends in the retail toy industry. As seen in the Toys R US Statement of Operations, from 2002-
2004, the sales for their US toy operations were steadily declining, in comparison to Babies R US sales
that were increasing each year at approximately 2%, and international increased 5.9% in 2002, and slowly
increased to 2.1% in 2003. Despite low performance of sales, the board and upper management strongly
believed that their stock was undervalued, and that there was value in their real estate, and the growth
potential of International and Babies R US business units. According to UBS, in an Aug 30th, 2004
analyst report, it was determined that there was value left in the core US toy stores, and the business was
worth “more alive than dead to a buyer with a stronger retail background who can properly manage it”.
The company’s large cash flows, and potential for continued profit for Babies R’US attracted investors to
the prospect of an LBO.
Another factor that led to the buyout was TRU knew that they needed to make strategic business
changes in order to remain profitable in the increasingly competitive retail environment. As discussed in
the 2004 Annual Report, the firms involved in the buyout expressed that they were enthusiastic that the
company’s strong global brand recognition, collection of product offerings, and were motivated to help
Toys R US strengthen their long term financial and operating potential. Even more attractive, one of the
investors of the buyout, Vornado Group, was a real estate holding company that analysts say is famous for

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turning struggling retailers' real estate into gold mines. According to a Citigroup analyst report on Aug
23rd, 2004, prior to the buyout, their balance sheet was fairly solid, and reported that they believed that
the US toy business could provide enough free cash flow for a specialty toy retailer to operate in the
industry with the growing competition of discount retailers if TRU addresses their operational issues. It is
clear that there was profit potential left in the core businesses of Toys R US, if the business was able to
resize and restructure their operations according to the changing retail environment. Toys R US saw the
opportunity to bring in outside investors to help them achieve this goal.
a. Alternative Strategies to the LBO:
A potential alternative strategy that TRU could have considered instead of an LBO was to use
their cash on hand, in addition to a potential loan, in order to invest in systems and programs that would
allow them to be more competitive in the retail industry. One reason against an LBO according to a 2004
UBS analyst report, is that the extreme seasonality of their business “an unlikely LBO Candidate” We
believe that if managed correctly, Toys R US can drive more year round traffic, reducing some of the
seasonality to generate consistent cash flow and produce good returns for the buyers.” pg 14 UBS. One of
the main reasons that the LBO and TRU ultimately failed in the end is that the restructuring plan failed to
invest in innovations that would allow them to be competitive. The restructuring plan also did not address
the company’s lack of inventory systems, and marketing programs that were failing to bring customers in
store. As the result of the LBO, the large debt repayments​ limited managerial flexibility and forced
management to implement cost cutting measures to survive. This structure was a tool to discipline
management toward efficiency, but it limited spending on innovation, that the company needed to
survive. By closing underperforming stores, TRU could have reinvested their available cash towards more
effective and updated inventory and marketing solutions, coupled with more exclusive products and
services that were designed to eliminate some seasonality of their business. Such solution potentially
could have brought in more foot traffic, and sustained their business for longer as it directly addresses the
company’s strategic issues that ultimately led to the company liquidating in 2018.
2. Acquisition Valuation:
In March of 2005, Toys R. Us was taken private by a group of investors. The business was bought for
$26.75 a share or a $6.6 Billion valuation. At the time this share price was a premium of 8%. There are
key multiples below that show how expensive the purchase was. To highlight, the cost of the acquisition
was over 10x prior years EBITDA and 11.87x FCF. This means that Toys R. Us would have to generate
the same amount of FCF in 2004 for the next 12 years for the investor group to breakeven from a FCF
standpoint. ​ ​The deal was quite rich in that regard, and much of the deal was completed in debt. For these
reasons the deal is overpriced. Toys R. Us a booming business with great sales and a large market, the

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investing group looked past the price of the deal and only saw the potential, for this reason the valuation
at $26.75 a share was too high and it led to the ultimate failure of the business years later.

3. TRU’S Strategic Issues & affect on financing:

According to TRU’s Pro Forma Capitalization, Toys R US had a very high debt to asset ratio of
82.8%. They have too much debt on account which represents a high financial risk. TRU faced some
difficulty keeping up with both short term and long term debt obligations. Also, the high debt ratio makes
business less attractive to prospective lenders or creditors. This condition ultimately lead TRU to
bankruptcy. To calculate the ability of TRU to pay back debt, interest coverage ratio was calculated as a
measure. According to the chart below, based on data from Toys R Us statements of Operations, interest
coverage ratio decreased to less than 2 throughout the future nine years, which are relatively low numbers
of interest coverage ratio. If a company has a low interest coverage ratio, then it is highly likely that the
company is not going to service its debt, putting it at risk of bankruptcy.

In the past 10 years, TRU’s inventory markdowns increased. A large part of the inventory issues
were company-specific. TRU should have implemented a more advanced inventory system to better
understand the inventory levels at each store. In addition, according to the Toy Industry Outlook, “the
increased market share of diversified retailers (versus specialty toy players) has resulted in increased
seasonality of sales.” TRU was operating with high seasonality, and more than 80% of their annual
revenue came from sales in the last two months, specifically during the holiday season. Therefore, it was
important to prepare a large amounts of inventory waiting for the peak of sales in the whole year. In this

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way, holding a large volume of items means a large amount of space is needed, which leads to higher
costs. If the demand changes, then it is likely that a large amount of inventory cannot be sold due to shift
in market demands. The business strategy was unable to attract more people in to the stores during
months earlier in the year. According to UBS Investment Research, “Another example of inefficient
management and inept systems is EITF 03-10 implementation. TRU is the only major retailer that had to
reverse already reported revenue because they lacked the systems to match purchases, sales and coupons
down to the SKU level. This led to a $246 million reduction in 2003 revenue and a $43 million pre-tax
accounting charge”. TRU’s inventory system was not effective, and they did not evaluate their product
offerings in order to break the seasonality trend of their business, and generate more profits.
One of the business strategies of TRU focused on was growing their Babies unit aggressively. In
this way, they have to spend more on creating stores, and improving merchandising and marketing, which
increases expenses in the income statement. The increase in cash outflow will put Toys’s financial
position in a dangerous situation that they may not have enough cash to cover production costs or pay
back debt and face liquidity problems. On the other hand, Toys also pursue the strategy to be aggressive
on pricing. In 2004, Toys set the prices of products from 5% to 11% lower than those of Walmart. This
action will eventually decrease the profit margin of Toys and may potentially worsen the financial
condition of Toys.

4. Degree of success of the LBO for the respective stakeholders. Based on this analysis, would you
have recommended doing anything different to the path that they followed in 2005?
In March 2005, TRU announced an LBO sale to Bain/KKR/Vornado group at $26.75 per share.
Purchase of equity cost $6,599 million. In order to carry out the leverage buyout, the group had to raise
$4,381 million new in debt. With the additional debt, TRU’s long term debt increased from $1,860
million to $5,540 million and interest expense increased to $394 million from $130 million in 2004. As a
result, they ended 2005 with a negative $384 million in net income. However, even under the unfavorable
position of their balance sheet in 2005, TRU still had a positive free cash flow of $115 million that was
available for distribution to stakeholders.
TRU regained some pace immediately following 2005. Although there were still large increases
in interest expense, they managed to boost up their operating income by lowering cost through aggressive
cost reduction initiations, and ended 2006 with $109 million in net income. From then on, TRU managed
to slowly grow their net income each year up to 2009 and cut down their long term debt to $4,718 million
in 2010. During the process, TRU’s free cash flow always stayed positive and showed promising

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numbers. In addition, TRU opened up 97 additional stores from 2005 - 2010, 66 of which are new
international stores.
By looking at the promising numbers such as growing sales and decreasing long term liabilities,
we can determine that stakeholders value had increased after the LBO. TRU managed to reach some
degree of success after the LBO, mainly by three main strategies: Grow Babies R Us aggressively,
Revitalize Toys in US, and Company wide cost saving. Cost saving is their most successful strategy since
gross profit percentages, and operating income gradually increased. Cutting selling, general and
admission expenses was the deciding factor in 2006 for TRU to achieve a positive operating income of
$649 million, from a negative $142 million in 2005, while most other factors stayed almost constant. The
success of Baby R Us is hard to tell due to the fact that TRU combined some of their stores together;
however, looking back from a 2019 point of view, the act of restructuring their business, and entering into
the LBO may have seemed like a successful venture in the short term. However, TRU ultimately failed in
the long run, forcing them to finally close their doors in 2018. The LBO in the end restricted the company
by taking on large amounts of debt, it limited their ability to innovate, when in return hurt them the most
for the future as they couldn't compete with the convenience of discount retailers such as Walmart and
Target, and Amazon’s eventual domination in the market. At some point after the LBO, TRU should have
reevaluated their spending, and could have proposed an alternative capital structure that would have
allowed for spending for innovation. If TRU addressed their strategic business issues sooner, they likely
could have provided more value to their shareholders.

Sources

Ma, Steven, and Steven MaI. “What Toys 'R' Us Should Have Done to Stay in Business.” ​SparkFlow​, 9
July 2018, sparkflow.co/what-toys-r-us-should-have-done-to-stay-in-business/.

Renholding. “Toys 'R' Us and Bankruptcy: Death by Disruption, Not Debt.” ​CLS Blue Sky Blog,​ 23 Apr.
2018, clsbluesky.law.columbia.edu/2018/04/23/toys-r-us-and-bankruptcy-death-by-disruption-not-debt/.

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“Toys 'R' Us Agrees to $6.6 Billion Buyout by KKR Group.” ​CNNMoney​, Cable News Network,
money.cnn.com/2005/03/17/news/fortune500/toysrus/index.htm?cnn=yes.