KKR sweeps in to save Toys 'R' Us-and U.S. toy business

DSN Retailing Today, March 28, 2005 by Doug Desjardins

WAYNE, N.J. -- Things are suddenly looking up for the toy business--or at least the juvenile products side of the industry.

Just when it looked as though Toys "R" Us was contemplating chopping up its toy empire--possibly even selling it off for its real estate value--a consortium of veteran retail investors, headed up by private equity firm Kohlberg Kravis Roberts (KKR) came along and bought the entire company for $6.6 billion. That figure, which equals $26.75 per share, is roughly $1 billion more than earlier-reported bids of $5.5 billion and $5.7 billion, and even higher than the $18 to $23 per-share valuation circulating back in August 2004.

The deal, which was announced after months of speculation as to whether anyone would even buy the struggling Toys "R" Us toy store division, came about as a result of the formation of a joint venture between KKR, Bain Capital Partners and Vornado Realty Trust, a group that outbid a rival consortium headed by Cerberus Capital Management.

Now the big question is to what extent the group led by KKR--which has pursued institutional-size investments in the past in such retailers as Fred Meyer, Safeway and Stop n Shop--will advance the current management strategy of converting the traditional toy business to a year-round baby goods business, including aggressive growth of the profitable Babies "R" Us division.

For the moment, the early speculation that prospective buyers were interested in the land value of its toy division--since the company owns 466 of its 685 U.S. toy stores--doesn't seem as if it will play a big part in the reshaping of Toys "R" Us.

"I'm not someone who thinks Toys "R" Us will be gone once the deal is complete," said George Whalin, president of Retail Management Consultants in San Marcus, Calif. "These guys have investments in retail and they know how to run a company."

The prospect of Toys "R" Us closing stores has been a given since the chain started a strategic review of its operations last August and put its stores on the sales block. Harris Nesbit analyst Scan McGowan said he expects more than 100 underperforming U.S. toy stores to be closed, a number echoed by several retail analysts. "I've been hearing anywhere from 60 to 140, but it's still anybody's guess," said toy industry analyst Chris Byrne. "But those closings were inevitable--sale or no sale."

Other analysts have suggested the chain would shut between 150 to 200 stores. From a retail perspective, putting companies like KKR and Bain Capital in control is seen as a positive given their experience in the retail world.

"It's good news for the toy industry because they have retail expertise and I think the chain is going to just keep on keeping on," said Byrne. "Personally, I'm pretty optimistic for Toys "R" Us." Bain Capital in particular is familiar with the toy retail business, since it's the majority shareholder of KB Toys, which filed for bankruptcy in January 2004 and is now under pressure to come up with a reorganization plan (see sidebar above).

KKR has extensive investments in supermarkets, drug stores and specialty retail in the United States and Europe. The companies will also have the luxury of operating as a private entity without pressure from shareholders, something that Byrne says will be a big plus as they begin to re-metchandise stores. "Getting away from Wall Street frees them to do what they want," said Byrne, who expects stores to offer a "more diverse product mix" that doesn't rely solely on toys.

One unexpected element of the sale was that the buyers purchased the entire chain rather than just the toy store division. Up until early March, four bidders were offering up to $3.5 billion for the toy division alone but that changed when the groups headed by KKR and Cerberus began bidding on Babies "R" Us as well. Even though Toys "R" Us wanted to hold on to Babies "R" Us, McGowan said the company made the right decision to sell. "They couldn't be sure they would be able to sell it for that much down the road if they held on to it so it was a good decision for the shareholders," said McGowan.

Bundling the chains also bodes well for the future of its toy store division, since Babies "R" Us will generate year-around business for the new owners. "It makes a lot of sense because Toys and Babies have two very different business paradigms," said Byrne. "The toy business isn't profitable outside of the holidays but the company has Babies "R" Us to generate cash flow for the other three quarters of the year."

Another question raised by the sale is the whether the investment group will retain some of the current Toys "R" Us management team or bring in their own people once the deal is approved. "John Barhour has been the key guy the past few months and they'd be crazy to let him go," said Byrne. "So I think you'll see people who have been making direct contributions to the day-to-day operations like John [Barbour] stay on after the deal is approved." McGowan agreed, noting that "keeping key managers like John Barbour in place is very important."