Interest payments of $6 billion limited firms' ability to
improve stores, compete online
By Miriam Gottfried and Lillian Rizzo
This article is being republished as part of our daily
reproduction of WSJ.com articles that also appeared in the U.S.
print edition of The Wall Street Journal (September 20, 2017).
Competition may have brought down Toys "R" Us Inc. But the debt
that three Wall Street firms heaped on the company when they took
it private -- and the way the ownership group was constructed --
left the retailer without a fighting chance.
When a consortium comprised of Vornado Realty Trust and
private-equity firms KKR & Co. and Bain Capital bought the toy
retailer for $6.6 billion in 2005, it was already struggling
against competition from discounters including Wal-Mart Stores Inc.
and Target Corp., and the threat of online competition from the
rapidly growing Amazon.com Inc. loomed. Still, Toys "R" Us had
valuable real estate and the investors planned to boost the
company's sales and financial performance, banking in part on the
strength of its name.
A dozen years later, Toys "R" Us has filed for bankruptcy
protection, seeking relief from creditors in a Virginia court late
Monday in a move that will all but wipe out the owners' $1.4
billion of equity. The company has $5.3 billion in debt, unchanged
from when it went private.
Vornado has marked down the value of its stake in Toys "R" Us to
zero, according to the real estate firm's annual securities filing.
KKR and Bain have similarly marked down their investments,
according to people familiar with the matter. The owners didn't pay
themselves any dividends and though they have been drawing advisory
fees, the amounts represent a small fraction of their overall
losses.
As in virtually all private-equity deals, the original purchase
was funded with significant debt.
Paying back that debt has cost Toys "R" Us dearly, with nearly
$6 billion in total interest payments, including some $910 million
in 2016 and 2017. And the company hasn't made progress reining in
its heavy debt load during its 12 years under private ownership, as
virtually all excess cash was earmarked for reinvestment. At the
end of the quarter after the deal's close, the retailer's net debt
was 7.2 times its earnings before interest, taxes, depreciation and
amortization. As of the end of this year's first quarter, the
leverage ratio stood at 7.8 times.
"The $400 million a year in debt service was really constrictive
as they were trying to compete," said Katherine Waldock, a finance
professor at Georgetown University's McDonough School of
Business.
Chief Executive David Brandon said in court papers Tuesday that
Toys "R" Us has been hampered by its "significant leverage," and
the result is "the company has fallen behind some of its primary
competitors on various fronts, including with regard to general
upkeep and the condition of our stores, our inability to provide
expedited shipping options, and our lack of a subscription-based
delivery service."
The deal recalls a time when doing buyouts with multiple
partners was popular because it opened up a wider array of big
targets. These so-called club deals have fallen out of favor in
recent years as limited partners who were often invested in more
than one buyer's funds pushed back. That has helped shrink the size
of private-equity deals.
Club deals also created a challenge when it came to managing
companies.
At Toys "R" Us, differences emerged among the three
private-equity owners over whether to manage the company for
growth. As a real-estate investment trust, Vornado was more focused
on the retailer's asset value and on profiting from its real
estate.
"At Toys, we invested in a club with two renowned private-equity
firms who are focused on improving operations and growing
earnings," Vornado Chief Executive Steven Roth wrote in an April
2015 letter to investors. "Our suggestions of realizing value
through real estate played second fiddle."
While some unprofitable stores were sold, Gerald Storch, who was
CEO in the early stages of the buyout, led a push to combine the
Toys "R" Us and Babies "R" Us brands under the same roofs and
remodel the stores. The company beefed up its marketing and began
selling online through its own websites.
The new superstores got high marks from consumers and helped
Toys "R" Us post stronger sales, but the retailer's heavy debt load
meant it was only able to convert 146 of its more than 1,500 stores
to the new format by the time it filed for an initial public
offering in 2010. E-commerce accounted for only $602 million of its
$13.57 billion in sales in fiscal 2009.
But five years had passed since the takeover and private-equity
firms typically get itchy for an exit around then. The idea was to
time the IPO for after the holiday selling season when Toys "R" Us
gets the bulk of its profits, according to a person familiar with
the matter. But results in the quarter suffered as discounters
stepped up their promotional efforts and the company put off the
IPO, later pulling the planned offering altogether.
Mr. Storch stepped down as chief executive in 2013 after Toys
"R" Us reported more disappointing holiday results, ceding the role
to longtime company executive Antonio Urcelay. Mr. Urcelay, who
began as an interim CEO and was later appointed to the role on a
permanent basis, put in place a plan that emphasized retailing
basics like keeping the right goods in stock and discounting
less.
Meanwhile, competition in the baby business had intensified as
rivals such as Bed Bath and Beyond Inc.'s Buy Buy Baby added
locations and as Amazon pushed deeper into the category following
its acquisition of Diapers.com. Margins for Babies "R" Us, which
had looked like the stronger part of Toys "R" Us at the time of the
leveraged buyout, began to get squeezed.
By the time Mr. Brandon, a veteran of Domino's Pizza and
Valassis Communications Inc., took over the top spot after Mr.
Urcelay retired in 2015, the company was primarily focused on
maximizing cash flow, according to a person familiar with the
matter.
One strategy Toys "R" Us could have pursued after it pulled the
IPO was to carve off and sell its businesses in Canada, Japan,
Europe and China -- markets where the competitive dynamics were
better than in the U.S. But the owners believed the process of
separating these businesses would be too complicated and decided
against such a move, according to people familiar with the
matter.
Toys "R" Us has lined up a $3.1 billion bankruptcy loan, and
received court approval Tuesday to begin using roughly $1 billion
toward retiring its bank debt, paying vendors to keep shipments
coming, and paying employees.
The company's attorneys said Tuesday this bankruptcy loan is
vital to allowing Toys "R" Us to buy inventory for the crucial
holiday season.
"I don't view this necessarily as a doomsday," said Louis Cisz,
a bankruptcy and restructuring attorney at Nixon Peabody LLP, which
isn't involved with the restructuring. "There's no immediate plan
to close stores. They're going to pay vendors in order to build up
inventory. Those are positive signs under the circumstances."
--Suzanne Kapner contributed to this article.
Write to Miriam Gottfried at Miriam.Gottfried@wsj.com and
Lillian Rizzo at Lillian.Rizzo@wsj.com
(END) Dow Jones Newswires
September 20, 2017 02:47 ET (06:47 GMT)
Copyright (c) 2017 Dow Jones & Company, Inc.
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