By Thomas Graves Change has been good for Toys 'R' Us (TOY). The big retailer of products for children has reformatted its U.S. toy stores in an effort to improve their appeal to consumers, with merchandise organized around some relatively new concepts. And we at S&P expect Toys 'R' Us to bolster its U.S. market share by emphasizing exclusive products.
The upshot: As investors increasingly focus on expected profit and cash-flow improvement, we look for the stock's price-earnings multiple to expand, setting the stage for superior capital appreciation for investors. Toys 'R' Us carries S&P's highest investment ranking of 5 STARS (buy).
As of mid-November, 2002, its 1,584 stores worldwide included 689 U.S. toy stores, 178 Babies 'R' Us units, 526 international toy stores (including franchises), 148 Kids 'R' Us children's clothing stores, and 43 Imaginarium stores. Toys 'R' Us competes with a broad assortment of retailers, including general merchandisers such as Wal-Mart and Target, department stores, and numerous specialty outlets.
MODEST RISE. In recent years, market-share erosion in its core U.S. toy business has been a significant concern. But we expect Toys 'R' Us to counter this trend through its efforts to improve the look of its stores and provide products that can't readily be found elsewhere. By offering exclusives, Toys 'R' Us can protect itself against price competition and achieve a higher profit margin than it would realize on nonexclusive items.
In fiscal 2004 (ending January), we expect overall net sales to total $12 billion, up moderately from the $11.4 billion projected for fiscal 2003. In both years, we estimate that close to 60% of total sales will come from U.S. toy stores. However, we expect that the Babies 'R' Us, international toy stores, and Toysrus.com units will provide faster sales growth than the U.S. toy stores this year and next.
In fiscal 2003, we look for net sales at domestic toy stores to total $6.9 billion, little changed from 2002. Consolidated sales from international toy stores are expected to hit $2.1 billion, up 10% from 2002. This excludes sales from some operations in which Toys 'R' Us has less than a 50% ownership interest.
ONLINE INCREASES. Babies 'R' Us is projected to have fiscal 2003 sales of $1.6 billion, an increase of 12%. From the Kids 'R' Us business, net sales are estimated at about $460 million, down around 17%. Comparable-store sales have been weak, but future results could get a boost from renovations to a new prototype. Also, apparel sales include many combination stores, where U.S. toy stores have been converted to place more of an emphasis on Kids 'R' Us-related products.
Toys 'R' Us conducts its Internet business largely through an alliance with Amazon.com (AMZN). In fiscal 2003, we expect Toysrus.com sales to reach $365 million, up 32% from the prior year. In addition to a co-branded toy and video-game online store that launched in 2000, Toysrus.com includes two additional stores -- Babiesrus.com and Imaginarium.com -- which began operations in 2001. In fiscal 2002, the Internet unit had an operating loss, net of minority interest, of $76 million. We expect a smaller loss in fiscal 2003.
We at S&P have been generally pleased with the leadership of CEO John Eyler. Prior to joining Toys 'R' Us in January, 2000, Eyler was CEO of high-end toy retailer FAO Schwarz in New York. He has overseen a restructuring plan, announced in January, 2002, under which Toys 'R' Us planned to close 64 stores, eliminate about 1,900 positions, and consolidate some of its support-center facilities for an expected move into a new headquarters. In fiscal 2004, we look for Toys 'R' Us to get increased cash-flow and profit benefits from its restructuring.
READY FOR THE HOLIDAYS. The balance sheet looks good. In early November, 2002, it included total borrowings of $2.87 billion, compared to shareholders equity of $3.7 billion. We don't anticipate any significant liquidity problems. As of November 2, 2002, cash equivalents totaled $429 million.
The recent inventory situation is encouraging, and we think Toys 'R' Us is well-positioned for the important 2002 holiday selling season. As of early November, merchandise inventory, measured in dollars, was essentially flat with where it had been one year earlier. The in-stock position looked good in mid-November, and we don't expect a significant adverse impact from the dockworker lockout on the West Coast several months ago.
In fiscal 2004, we look for profit margins to be helped by the emphasis on exclusive toys, effective inventory management, and by an increased benefit from restructuring. Earnings per share should reach $1.40 in fiscal 2004, up from the $1.15 estimated for fiscal 2003. Also in fiscal 2004 we look for free cash flow (after both interest expense and capital expenditures) to approach at least $1 per share.
EXPANDING P-E. Our discounted free cash-flow analysis indicates an intrinsic value of close to $18 per share, including a sharp improvement in free cash flow in the current fiscal year, when capital spending is projected to decline more than $200 million from fiscal 2002. In fiscal 2004, we look for free cash flow to rise sharply, helped by both a sizable earnings increase and another decline in capital spending.
The stock is trading at 10 times estimated calendar 2003 EPS, which is sharply below the multiple of the S&P 500-stock index. As investors increasingly focus on expected profit and cash-flow improvement, we expect that the stock's p-e multiple will expand, enabling the shares to significantly outperform the S&P 500 in the next 6 to 12 months. Applying a relatively modest multiple of 12 on our fiscal 2004 EPS estimate, we have a target of $17 per share, or about 25% above the recent price. Analyst Graves follows electronics and toy retailers for Standard & Poor's