What The KB Toys Bankruptcy Means for Toys R Us

KB Toys filed for Chapter 11 yesterday, or really, Chapter 22, since it’s the toy retailer’s second go-around in bankruptcy court. Both filings have private equity fingerprints all over them. In 2005, it was on Bain Capital’s watch. This time the failed owner is Prentice Capital (more of a hedge fund). Unlike in 2005, however, KB Toys isn’t going to reemerge.

So it’s actually more a Chapter 7 than Chapter 11. For its part, Prentice has had a rough go of it with distressed retailers. Goody’s Whitehall Jewelers, and Levitz Furniture have all gone under on the firm’s watch. Here’s a good Dealscape post on it.

But trouble in toy-land raises questions about the health of KB Toys’ main competitor, Toys R Us, which was taken private for $8.2 billion in 2005 by KKR, Vornado Real Estate, and, despite getting burned by toys once, Bain Capital. That was an 11x EBITDA multiple, which looks both impossible and extravagant nowadays.

This deal could be problematic for a few obvious reasons.

(1) I’m sure you’re aware, but there’s a recession on. Holiday sales will be disastrous.

(2) Few retailers rely more on Q4 than a toy store. A company like Toys “R” Us are more heavily weighted to holiday sales than other retailers.

(3) Add leverage to the disappointing sales equation and things look tight. Revolvers get drawn. PIKs get toggled.

(5) Wal-mart and Target have been creeping in on Toys “R” Us’ dominance in the space for years. KB Toys said in its filing that the three of them had pushed its market share to 2%.

All that said, I don’t think the Toys “R” Us buyout is in as great of danger as some of the other weak retail buyouts from the LBO heyday. With a stable non-investment grade B S&P rating, I doubt KKR and Bain are sweating Toys “R” Us as much as, say, Guitar Center of Dollar General. In fact, Toys’ PE backers have worked to improve its appeal to upper middle class shopper. According to the company’s latest quarterly report, sales have grown modestly, which is a pretty big deal considering the maturity of the toy industry. Vendors like Mattel or Hasbro generally have to acquire their growth.

Toys “R” Us was operating at an earning loss as of August 2008, and even if holiday sales are horrifically low this year, it could turn that into a positive. Despite the fact that Toys is surely losing market share to Wal-Mart in the same way KB Toys did, it is probably at a much slower pace. KB Toys’ small, shopping mall locations were always challenged compared to the big box retailers, and that includes Toys “R” Us.