Description
Toys ‘R’ Us (TOY), the world’s largest retailer focusing primarily on toys, currently trades at eight times depressed earnings and owns a collection of assets worth more than $20 a share. The company operates about 1,600 stores under the names Toys ‘R’ Us, Kids ‘R’ Us, Babies ‘R’ Us, and Imaginarium. In addition to toys, Toys ‘R’ Us sells sporting goods, books, furniture, computer software, and children’s apparel. Problems with the Kids ‘R’ Us apparel business and increased competition from mass merchandisers such as Wal-Mart have combined with more recent concern about the U.S. consumer to make the stock price tumble from 40 to 10 over the last ten years. To counteract this slide, Toys ‘R’ Us brought in new management in 2000 that has made a major effort to revamp the Toys ‘R’ Us format.
The current stock price ignores both the significant progress made in restructuring the domestic toy franchise as well as other valuable assets, which TOY owns. At $10 a share TOY is a bargain.
Turning around the domestic toy business:
The domestic business consists of (1) Toys ‘R’ Us, (2) Kids ‘R’ Us, (3) Imaginarium, and (4) Babies ‘R’ Us. The first three are in various stages of being revamped.
Toys ‘R’ Us has approximately 700 domestic stores producing an estimated $6.950 million in revenue for 2002, with an operating margin of over 5%, producing $360 million in operating margin earnings. A dramatic repositioning and remodeling effort—“Mission Possible”--was introduced in June 2000. This has entailed a more focused product selection, a more visually appealing store layout including wider aisles and better lighting, improved customer service, and more competitive pricing on key items. At the end of fiscal 2001, the company had remodeled 433 domestic toy stores (out of approximately 700) and the company is on track to complete this program by Christmas season this year.
Kids’R’ Us has 147 stores producing $500 million in revenue for 2002, with an operating margin of negative 4.0%. This concept has been a drag on TOY earnings for a number of years but new management has been testing a new format and, according to the company, recent results are encouraging. They have closed or merged 37 of these stores into existing Toys ‘R’ Us, creating combo stores, and they are remodeling an additional 30 stores. These remodeled stores are registering double-digit same store comparison increases this year. Even though the comp growth is encouraging, this concept will lose about $20 million on an operating basis. Management does believe through their revamping efforts this concept can break-even in 2003.
Imaginarium consists of 36 stores selling educational and developmental products, accessories, games, and puzzles. The company does not breakout the revenue or earnings for this concept.
New Management
A new CEO hired in 1998 focused heavily on the online division, losing focus on the bricks-and-mortar business, according to critics. In 1999 TOY was overtaken by Wal-Mart in domestic toy sales. The company then clocked in seven straight quarters of sales declines. In early 2000 Toys ‘R’ Us lured John Eyler from F.A.O. Schwarz. In 2000 gross margins halted a two-year slide and started to recover, and the Mission Possible remodeling concept was launched.
Focus on Improving Domestic Margins
Toys ‘R’ Us has determined that one of the keys to its success will be offering more
differentiated products, in the form of private label and exclusives. Management believes that offering differentiated products will help on two Fronts: the company will be able to earn significantly higher margins on its private label offerings, and this will enable it to offer more competitive prices on a small number of key nationally advertised toys found at Wal-Mart and other mass merchants.
Private label and exclusive merchandise accounted for around 5% of TOY's domestic toy store sales in fiscal 1999, and management stated that it will account for approximately 20% of traditional toy sales in fiscal 2002. TOY believes it can increase the private label and exclusive product mix to 25% by fiscal 2005. Plush toys is one of the first areas the company earmarked for private label penetration, and as such, created the Animal Alley plush brand. Other private branding efforts include You & Me dolls for girls, Fast Lane play vehicles and Home Depot brand tool toys for boys, as well as Koala Baby and Especially Baby for baby goods.
Burnishing the brand--the Flagship New York Store
Toys ‘R’ Us did not have a lead store concept in New York until November 2001, when it opened a 110,000 square-foot dazzling flagship store on Times Square. The multi-level store offers families a vast array of toys and dramatic retail attractions including a 60-foot tall, indoor ferris wheel. During its first six weeks of operation, the Company estimates that more than two million shoppers visited Toys "R" Us Times Square to see what the company dubbed “The Center of the Toy Universe.” This flagship store provides increased visibility for the Toys "R" Us brand and an effective platform for new product launches and also serves to further strengthen its standing within the vendor community.
The Other Valuable Assets
Toys ‘R’ Us International: Operations abroad are advanced in comparison to many U.S. retailers, with over 500 stores located in 28 countries. This includes 282 company-operated stores, 120 stores in Japan (where TOY holds a 48% ownership stake), and 105 joint venture or franchised stores. TOY reported fiscal 2001 international segment revenue of almost $2 billion (excluding $1.6 billion from licensees, joint ventures, and Toy-Japan) and international operating income of $131 million. While this segment is quite large, we note that TOY's international growth has been lackluster for the past three years.
Baby’s ‘R’ Us Franchise: The most compelling growth concept for TOY is Babies ‘R’ Us. This concept consists of 185 stores producing $1,580 in revenue for 2002 with operating income of $163mm. This division has operating margins of over 10.3%, which is a strong improvement from 8.4% in 2000. Since 1998, Babies ‘R’ Us has generated a CAGR of 28%. Management plans on opening 20 new Babies ‘R’ Us per year for the next few years.
Real Estate: Toys ‘R’ Us owns a large number of its stores (693 out of 1599) and distribution centers (14 out of 21). This real estate is on the books at a total value of 2.5 billion (approximately ½ of EV), which represents original cost. Most of the owned stores were purchased many years ago (new locations are typically leased now) and as such are certainly worth much more than cost now—potentially even a multiple of cost.
Sum-Of-the-Parts Analysis:
$ Value Per Share Value
Babies 'R' Us 1,630 7.69 10x operating income of 2002 estimated CAGR of 28% ('99-'02)
Kids 'R' Us - - 500m in sales loss of ($20m) for 2002
Toysrus.com - - Online retail giving $0 value will do $350m in revenue for 2002
Imaginarium - - 36 stores
Toys 'R' Us International 1,080 5.09 8x operating income of 2002
Real Estate 1,150 5.42 Valuing the R/E at half book value which is unencumbered and extremely undervalued
Toy 'R' Us 2,872 13.55 40% of '02 sales, 8x operating income of '02
Minus debt (2,400) End of '02
Plus cash 450 End of '02
Total "fair” value of TOY 4,782 22.56
** this value does not assign any value to Imaginarium, Kids 'R' Us, Toysrus.com
It also values the Real Estate at only half of book value which is currently valued at $2.3 Billion on the balance sheet
Caveats:
Debt and Free Cash flow– TOY does now have a lot of debt ($2.5 billion as of 8/3/02). This is up from $1.2 billion in 1998 and the result of the capital investment in the Toys ‘R’ Us U.S. division. That said, TOY’s current liquidity is ample. The Company has $985 million in unsecured committed revolving credit facilities from a syndicate of financial institutions and roughly $400 million in cash (largely proceeds from an equity offering done this past May at 17.65/shr). Further, capital needs are going down. For 2002, capital requirements for expansion plans mentioned above, as well as other capital requirements are estimated to be approximately $475 million. This is down from $700 million in 2001 and is expected to drop to $400 million in 2003 As a result of these reduced capital needs and because margins are expected to improve, management expects debt to go from 2.5 billion this year to 2 billion next. Free cash flow will improve from $76 million this year to an estimated $236 million in 2003.
New format is still somewhat untested – Though the initial prognosis is good (same store sales comps up 8%), it is still unclear how sustainable. When my wife (a long time Toys ‘R’ Us shopper) and I have toured the new Mission Possible store formats, we both feel that the improvements are significant but not revolutionary. The stores have better lighting. Service is improved. The selection of toys is better and higher end (a complaint from the past). The new format is significantly fresher and better organized than before. However, despite the improvements, my wife and I felt the changes could/should have gone further. The new format was still too cramped, though less so. I think they should have eliminated the Kids ‘R’ Us section in the combination stores freeing up space and focusing the customer. As my wife says, she will never buy clothes here. Given how wonderful the shopping experience is at the Babies ‘R’ Us stores, it is somewhat disappointing that the experience couldn’t be completely transferred.
Where is the insider buying?? – There has been no buying by top management. But, the top brass’s compensation is heavily stock based. Eyler has over 5 million shares of restricted stock, 3 million of which vest only if the average price of the stock is above $41 in 2005.
Catalyst
- Continued margin improvement in the US Toys ‘R’ Us franchise.
- Continued growth of the Babies ‘R’ Us chain
- Potential monetization of the real estate assets
- Trading at 9 times 2002 earnings and less than 8 times 2003 earnings.
- As capital spending declines, free cash-flow will be used to pay down debt and for continued share buy-backs.
- The 3rd quarter earnings report (which is tomorrow 11/18) will hopefully confirm the growth story.