Toys ‘R’ Us Grade? Incomplete

I was on CNBC this morning (video here) to discuss last year’s $6.6 billion buyout of the original category killer: Toys ‘R’ Us.

It was part of an ongoing “Buyout Scorecard” series, but the reality is that it’s too early to be rending judgment on equity sponsors Bain Capital, KKR and Vornado Realty. Not far too early, but just about three weeks too early. Why? Because toy retailers generate around 40% of their revenue during Q4, with the vast majority coming between Thanksgiving and Christmas.

Now I know what you’re thinking: “Didn’t the company get bought in the summer of 2005? Why not judge it on Q4 of last year?”

You could, but that would then fall into that “far too early” category. Toys ‘R’ Us was an absolute mess when it got bought last year, with dingy stores that only a diehard giraffe lover would want to spend time in. The popular perception was that the new owners would immediately sell off real estate to sell off a massive leverage load, shut hundreds of stores and then redouble their efforts to beat Wal-Mart in the raced to lowest prices. Or maybe even sell the toy operation with some other retailer, and just hold on to the more profitable Babies ‘R’ Us franchise.

But the private equity firms instead have viewed Toys ‘R’ Us as a turnaround opportunity – not as a buy-and-strip operation. They’ve also viewed the real estate as an insurance policy, not as a cash cow.

So back to the scorecard issue. The new owners simply did not have enough time to turn things around by the 2005 holiday season. They installed an interim CEO following the LBO and made a few other changes (including a small handful of store closures and balance sheet maneuvers), but the real action didn’t come until earlier this past February, when they brought former Target exec Jerry Storch aboard as CEO.

Storch immediately went to work on (literally) burnishing the chain’s image, by insisting the floored be waxed twice as often and bettering the paper and photo quality of its circular advertisements. He also reduced the overall inventory, but has redesigned the display strategy so that it doesn’t look any less robust (just less cluttered). I went to my local Toys ‘R’ Us last night and only saw a few cardboard boxes on the ground, and no giant stacks. Plus, each section had a visible sign. Still not Shangri la, but a noticeable improvement.

Storch also has played around with some new ideas, including combined Toys/Babies ‘R’ Us mega-stores, toy-testing/play areas and an order-at-home/pick-up at store system that has worked so well for Best Buy.

The goal is to increase overall revenue 15% this year to around $13 billion. It’s well on its way with 14% growth through the end of Q2, but – as I said originally – the real key is this quarter. The average consumer is expected to spend around 12% more on toys during this holiday season than they did last year, which means that Toys ‘R’ Us needs to beat the market (or its overseas and Babies stores need to over-overcompensate).

If successful, Toys ‘R’ Us could be well on its way to being one of the decades best turnaround stories – and a reminder that today’s LBO firms are more interested in growing companies than stripping them for parts. If not, some already-nervous bondholders might begin demanding changes. After all, the company’s first-half cashflow was unable to even cover the interest on its debt (let alone on interest & CapEx).

We should know in a few weeks…