A Whole New Game for Toys 'R' Us

By Nanette Byrnes

On Mar. 17, as the drums and bagpipes of the St. Patrick's Day Parade boomed only blocks from its showcase store in New York's Time Square, Toys 'R' Us (TOY ) gave its shareholders a bit of green. After a seven-month "strategic review," the board voted to accept an offer from a trio of high-powered financiers: buyout firm Kohlberg Kravis Roberts (KKR), Bain Capital Partners, and real estate high flyers Vornado Realty Trust. Stock in the toy- and baby-goods retailer immediately jumped $1.23, to end the day at $26, near the $26.75 the trio will give shareholders to take the concern private.

Shareholders will get $6.6 billion in cash, and the group will also assume some debt. The deal, which will see the partners each own one-third of the outfit, came together late the night before, with KKR -- which originally bid alone and only on the toy business, not the baby-products stores -- joining with Bain and Vornado to buy the whole operation. The sale is expected to close this summer.

SPACE FOR RENT?

  The agreement is the latest in a string of high-dollar retail deals, including Kmart's (KMRT ) purchase of Sears (S ) last November for $13.85 billion and Federated Department Stores' (FD ) $17.48 billion bid for May Department Stores (MAY ), announced Feb. 28.

As in those other deals, the target company's large real estate portfolio constitutes a big part of the attraction. Toys 'R' Us operates 1,500 stores around the world, with 681 in the U.S. Of those, around 150 could be closed and the locations rented for high prices to fast-growing chains like Lowes (LOW ), Bed Bath & Beyond (BBBY ), even Target (TGT ) -- or sold altogether.

Faith Hope Consolo, chairman of Douglas Elliman's retail real estate business notes that, in the past 12 months, retail rents have climbed 20%, and that Vornado has been one of the best at playing the rising market. "Have they done anything wrong yet?" she laughs, adding that the toy outfit "couldn't have found a better buyer."

Toys 'R' Us, which has lost significant market share to Wal-Mart (WMT ) and Target over the past 10 years, will have a much easier time unlocking the value of its real estate as a private company than if it had remained public, notes Sean McGowan, an industry analyst with Harris Nesbitt Gerard. "With shareholders clamoring to regain market share, it was hard to get excited about downsizing," McGowan says.

ACCOUNTING REVIEW.

  On the other hand, as a private company, Toys 'R' Us can easily close stores, sell land, and start paying rent at the stores it does choose to continue operating. The hit to earnings that any new rent bills might add would well merit the cash to be gained by selling some of the real estate at today's lofty prices. The company valued its real estate, as of Jan. 31, 2004, at $2.3 billion, but that likely understates its current market value.

Being private will limit other costs as well, including compliance with the requirements of Sarbanes-Oxley, the law put into effect after the Enron and Worldcom scandals that requires more extensive reporting on compliance and costs. Two days before the sale, Toys 'R' Us announced a delay in filing its fourth-quarter earnings because of a review of accounting for leases and store improvements.

Whether the deal will help address its long-term competitive decline is a lot less certain. Shareholders seem to have faith. Toys 'R' Us stock has gone up 64% over the past 12 months, vs. an 8% rise for the benchmark Standard & Poor's 500. And under John Barbour, who has been running the toy stores, and CEO John Eyler, Toys 'R' Us has been pushing to improve prices and customer service, and to continue its push into private-label toys and merchandise sold exclusively through its own outlets.

FEROCIOUS COMPETITION.

  But despite investing hundreds of millions of dollars in staff training and store remodeling, Toys 'R' Us sales have remained stagnant. It has struggled, too, to find a good Internet strategy. Its relationship with Amazon (AMZN ), which hosts its Web site, has been rocky. While it posted $11.6 billion in sales last year, the much smaller Babies 'R' Us superstore division contributed most of its earnings, and the entire operation posted companywide net income of only $88 million.

It's unclear how much better the chain will do with the new owners. "Will they regain 20% market share? I don't think so," says McGowan. "Five years from now, we may be looking at another round of store closings. Wal-Mart and Target are not going away. DVDs, videos, and all the other thing kids go to instead of toys will not change. These challenges will still be there."

Still, McGowan thinks that Toys 'R' Us will be better-positioned to respond to those challenges than under current management. Suppliers seem optimistic as well. "I'm feeling better," says Alfred Kahn, CEO of 4Kids Entertainment, which licenses toys and other products and produces television shows and movies based on Yu-Gi-Oh, Pokemon, and other juvenile favorites.

One reason: The Bain-KKR-Vornado group purchased all of the company rather than hiving off the toy business, as many observers anticipated. Kahn and others read that as an indication the group really does intend to try running the toy business as an ongoing concern, even if it is a somewhat smaller operation.

MISSED CONNECTION?

  Kahn sees room for an independent toy seller, despite the pressures from deep-discount chains. The challenge, as he sees it, will be to improve the connection to kids and attract shoppers at what are now relatively quiet times of the year. With the chain continuing to rely on the holiday season for its profits, Kahn argues that Toys 'R' Us could balance that with a broader product line and improved focus on customers. Selling products for the whole family in hotter -- and higher-margin -- categories like video games and electronics is one possible strategy, he notes.

"They have to get creative in managing that connection to customers," Kahn says. Another option would be to combine the Babies 'R' Us stores, which has a better year-round business, with the toy stores, and launch incentives like frequent shopper programs. Adds Kahn: "It's really being a retailer...it's doing some of the things other traditional retailers have done to turn themselves around."

For a retailer that has long been searching for an answer to its problems, new ownership may be the fresh start it needs.

Byrnes is a writer for BusinessWeek in New York

Edited by Beth Belton