It would generally be considered strange for a victim to return to the scene of a crime, but after getting battered byan earlier investment in now bankrupt KB Toys, Bain Capital has ambled right back into the toy sector. The firm, as part of a consortium, has made another, larger investment in the toy retail space, acquiring industry leader Toys R’ Us. It’s this kind of persistence that brings to mind Christopher Morley’s adage, “Big shots are only little shots who keep shooting.”
The Boston firm, along with Kohlberg Kravis Roberts & Co. and Vornado Realty Trust, has agreed to acquire the toy giant, split evenly three ways, for $8.8 billion, a sum that includes $6.6 billion of equity, $1.8 billion of debt, and transaction costs. To win the deal, the consortium was seemingly pieced together to match up player for player with a rival bidding group containing Cerberus Capital Management, Goldman Sachs and Kimco Realty. Market pros say the buying group adds value in a number of different areas: KKR brings the financial structuring expertise, Vornado will make sense of the company’s vast real estate holdings, and Bain is well versed in the turnaround.
Perhaps the most important piece to the deal is Bain’s experience in the toy sector, although its recent experience has been negative. The firm’s KB Toys investment goes down as one of the bigger turkeys in its portfolio. After engaging in a pricing war with the likes of Wal-Mart, Target and even Toys R’ Us, KB quickly fell off pace and filed for bankruptcy protection shortly after the 2003 holiday season.
According to reports, Bain and KB blamed the toy makers for selling their goods to Wal-Mart at discounted prices, a development that has hurt other retailers as well, including Toys R’ Us. The manufacturers, meanwhile, pinned the blame on a stock redemption plan that allowed Bain to recoup a large chunk of its initial investment. While the battle has yet to find its way into the courts, the unsecured creditors in early March won a ruling that will allow them to pursue a lawsuit if they so choose.
That said, Bain clearly knows now how the inner workings of the toy industry operate, and most feel the firm is too smart to repeat the same mistakes twice. “You can’t argue the fact that Bain understands the toy industry,” Sage Principal Daniel Gardenswartz said. “They have a track record and they’ve done their homework. They will understand the threats and the weaknesses. From a strategy perspective, [Bain’s inclusion] makes a lot of sense.”
More importantly, the Toys R’ Us deal involves more than toys. Bain and the co-investors went after all of Toys R’ Us, including the Babies R’ Us franchise. Toys R’ Us management had originally intended to hold the Babies R’ Us division and operate the business as a separate company, but as the bidding for the toys business developed, new offers started coming in for the whole company. The motive is clear: While the toys business has been floundering, the infant-product retail outlets have been growing steadily. In 2003, for example, the Toys R’ Us toys division reported a 130% decline in its operating earnings, while Babies R’ Us grew at a 16% clip.
Even without Babies R’ Us, there are enough differences between Toys R’ Us and KB that the firm probably isn’t walking into the same trap. For one, Toys R Us is the leading retailer that operates exclusively in the space. It has a global brand and presence, and with its higher stature, the company has more leverage in the toy industry. Bain may have a bad history with the toymakers (some of whom are listed among the unsecured creditors of KB Toys), but the toy manufacturers ultimately need Toys R’ Us, as no business wants to be completely beholden to Wal-Mart or Target. Also, with its large global reach, Toys R’ Us can compete in areas where Wal-Mart and Target are not as foreboding.
Real Estate Vs. Mall Rent
The Toys R’ Us deal also includes a strong real estate component absent in KB, which is a mall-based store. Toys R’ Us typically operates out of free-standing, big-box type locations that range in size from 30,000 to 45,000 square feet. In a research note, Bear Stearns estimated the value of the Toys R’ Us real estate portfolio to be roughly $3.5 billion, and one buyout pro familiar with the deal credited this aspect as providing “great downside protection” that “creates a floor” in terms of value.
Wal-Mart and Target have clearly altered the toy retailing landscape, but few people can envision a marketplace without toy stores. And while the market is exceptionally competitive, Toys R’ Us has already started to adjust. The company, knowing it can’t compete on price alone, has redesigned many of its stores and has been trying to increase its quantity of exclusive and private label products. Wal-Mart has surpassed Toys R’ Us in marketshare, but that does not mean toy stores are the next buggy whip. “The toy retail channel is certainly viable,” Gardenswartz said. “Buying toys is an experience in and of itself. You just don’t get the same experience or the breadth products in a Target or other retailer.”