Is Toys 'R' Us Taking Baby Steps?

The retailer may sell its flailing toy business and focus on Babies 'R' Us. Its trump card: Real estate worth millions

Toys are everywhere. But real estate -- especially the prime locations that retailers seek -- isn't as plentiful. Those two facts, say analysts, underpin an announcement from Toys 'R' Us (TOY ) on Aug. 11 that it may sell its flagship Toys 'R' Us business while hanging on to its 200 Babies 'R' Us stores. By selling the money-losing Toys 'R' Us stores, the retailer could focus on its profitable Babies 'R' Us segment and also reap billions of dollars from valuable Toys 'R' Us real estate.

For years, Wayne (N.J.)-based Toys 'R' Us, which has 683 toy stores in the U.S. and 579 abroad, has been battered by competition, especially from discounter Wal-Mart (WMT ). Wal-Mart's enormous purchasing power has allowed it to consistently undersell virtually every other big toy retailer. Indeed, the power of Wal-Mart has contributed to the demise of several toy oufits, including FAO Schwarz on the high end, and KB Toys, which is largely a mall-based toy retailer. Both have recently filed for Chapter 11.


  The retailer's revenues of $11.6 billion have been flat from fiscal 2000 through fiscal 2004, but net income has fallen sharply over the same period, from $279 million four years ago to $88 million in the latest fiscal year, which ended Jan. 31. The growing Babies 'R' Us division, however, which caters to the needs of new parents and their children, has done well. In the first quarter of this fiscal year, Babies 'R' Us was the only segment that posted an operating profit. It earned $63 million, up from $54 million a year earlier. Online sales, as well as the international and domestic Toys 'R' Us business, all lost money. As a result, Toys 'R' Us ended up $28 million in the red for the quarter.

While it's possible that a retail buyer might emerge -- someone who wants to capitalize on the Toys 'R' Us brand name, radically shrink the business, and make it consistently profitable -- the biggest reason to scoop up the distressed toymaker could be its real estate. "The underlying real estate is worth billions," says Howard Davidowitz, chairman of the retail investment-banking firm Davidowitz & Associates. "That underlying value also reduces the buyer's [retailing] risk." Davidowitz estimates that the big-box stores, along with some below-market leases, could ultimately be worth as much $8 billion. The company valued its real estate, as of Jan. 31, 2004, at $2.3 billion, but it's almost certain the stores could fetch more if they were put up for sale.

That's why some analysts believe that the ultimate buyer of the toy chain won't be another retailer, but an investment or financial group eager for the real estate. "It could be somebody like a [Edward S.] Lampert before he bought Kmart [Holdings] (KMRT )," says James Ragan, senior equity analyst at Crowell Weeden. Lampert's ESL Investments controls the beleaguered Kmart and plans to continue selling off hundreds of K-Mart properties, which has pumped up Kmart's stock mightily over the past year.


  However, most analysts say a Toys 'R' Us deal won't happen until next year. First, it's likely to try to do the best it can in the upcoming holiday season. Along the way, Toys 'R' Us will restructure into two operating parts, Toys 'R' Us and Babies 'R' Us. Toys 'R' Us has already forecast additional charges for the rest of 2004. In early 2005, after the company cleans up its balance sheet and shutters select stores, buyers will have a clearer idea of how much they might be willing to pay. "The strategy will be to go through Christmas and then close the stores and sell the portfolio of cleaned-up stores," says Davidowitz. It will likely be well into next year before any deal closes.

These days, many retailers seem to be valued as much as for their real estate as for their merchandising expertise. In addition to ESL Investments and Kmart, many believe that Sun Capital Partners and the investors allied with them agreed to pay Target (TGT ) $1.65 billion for its ailing Mervyn's department stores largely as a real-estate play. And Toys 'R' Us has used this strategy before, too. Earlier this year, it closed down all 146 stores in its Kids 'R' Us segment, selling most of them to Office Depot (ODP ) for $180 million.

If all goes well -- and little has lately for Toys 'R' Us -- it could end up smaller, but with a fast-growing business focused on babies. This time next year, Toys 'R' Us could be in a strong position, with a pile of cash and a nice bump in its stock price. It will release quarterly earnings before the markets open on Aug. 23, a week later than originally scheduled. On the day it announced a possible spinoff, the stock closed down 1.6%, at $16.15.

McNattis an associate editor for BusinessWeek in New York Edited by Beth Belton

by Robert McNatt

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