Toys 'R' Us Gets Wound Up Again

When a trio of private equity buyers snapped up Toys "R" Us in 2005, many predicted the retailer wouldn't survive. With cutthroat competition in the toy world, some even suspected Kohlberg Kravis Roberts, Bain Capital Partners, and Vornado Realty Trust (VNO) would convert a number of store locations into condominiums. Instead, Toys "R" Us has expanded its revenues by billions of dollars and is likely to file for an initial public offering in early 2010, people close to the company say.

The turnaround underscores the success of CEO Gerald L. Storch's strategy of integrating baby products with toys while ramping up promotions and exclusive products. Now the world's largest specialty toy retailer is out to build market share. "We have the largest assortment of every product at every price point," says Storch. He is rolling out almost 350 temporary Holiday Express stores across the country in the coming weeks, which will add 1 million square feet of retail space.

While Toys "R" Us is entering the holiday season with more financial strength, having doubled year-over-year earnings, to $27 million in the second quarter, the battle for consumer dollars will be fierce. Wal-Mart Stores (WMT)is offering more than 100 toys at $10—up from just 10 last year. (Storch counters that his store has 6,000 toys under $10.) Target (TGT) and Kmart (SHLD) are also beefing up holiday specials. "It's going to be competitive," says Sean McGowan, a toy analyst at Needham. But he predicts that Toys "R" Us will finish the year with $750 million in operating earnings, up from $621 million in 2008.

MORE SELECTION, WIDER REACHOne source of optimism is Storch's choice to compete more on selection and reach than on price. Those efforts to differentiate itself from mass-market retailers, along with a series of recent acquisitions, have helped Toys "R" Us to increase its share of U.S. toy sales. Storch bought,, and over the past year, while also snapping up toy stalwarts FAO Schwarz and KB Toys.

He is extending the retailer's Internet presence and trying to position the traditionally high-end FAO Schwarz as a place to create trends. Storch has also increased the shelf space devoted to exclusive, higher-margin products, such as a $119.99 private-label remote-control toy all-terrain vehicle. When he took over in 2006, Storch reversed plans to spin off Babies "R" Us in favor of integrating its operations with the toy stores.

While Storch won't comment on any plans to go public, industry analysts say the move makes sense. "It's logical to assume the investors in Toys "R" Us want to see a return after investing for five years in the business," says Needham's McGowan. The investment community is enthusiastic about the company, with its strong balance sheet and surprisingly resilient earnings amid the recession.

The key factor in the timing of a public offer will be how Toys "R" Us performs in coming weeks. The fourth quarter typically makes up almost 40% of U.S. sales, and analysts are divided on the outlook for consumer spending. Storch's binge on temporary stores gives him more reach but also risks cutting into profits. Storch is optimistic. "Christmas will come," he says, arguing that few will skimp on gifts for the kids. "We sell toy cars, not real cars, and they don't need financing."

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