Toy retailer Toys "R" Us filed an S-1 registration statement on May 27 with the SEC. The company's owners want to sell up to $800 million of its shares in what would be the biggest IPO in 15 years. Bain Capital, Kohlberg Kravis Roberts and Vornado Realty (NYSE:VNO) are hoping to catch lightning in a bottle, taking advantage of an extremely robust IPO market for retailers. Last October and November, Vitamin Shoppe (NYSE:VSI), Dollar General (NYSE:DG) and rue21 (NYSE:RUE) all went public. To date, their stocks are up 58%, 49% and 80% respectively. It would be irresponsible for Bain and the other owners not to strike while the iron is hot. That doesn't mean it's a good idea for investors to take the bait. I have five reasons to pass on the Toys 'R' Us deal.
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Passing the Buck
As is often the case with private equity deals, the acquired company is loaded with debt used by those firms to acquire the company in the first place. Toys "R" Us is no different. The current owners paid $6.6 billion in cash for the toy retailer in 2005, assuming $1.6 billion in debt. One quarter later under new ownership, Toys "R" Us debt had ballooned to $6.1 billion, meaning approximately $4.5 billion of the $6.6 billion purchase price was Toys "R" Us' own borrowing capacity. So for the purposes of discussion, we'll say that the three equal partners used $2.1 billion of their own capital. Now they're trying to get some of it back.
Have you been in a Toys "R" Us store lately? I have and to me there doesn't appear to be much different from a store circa 2005. I'm sure management feels otherwise. However, sales comparisons between the time the new owners took over in late 2005 and today would at least indicate there's been no metamorphosis at the New Jersey company. Let me explain. In the first quarter of 2006, the company consolidated the results of its 48%-owned interest in Toys "R" Us Japan. That year the Japanese stores had revenues of $1.65 billion and an operating loss of $12 million. Overall revenues were $13.1 billion with an operating profit of $649 million. Remove the Japanese stores from the 2006 numbers and you get the numbers for 2005. There was zero growth in 2006 and to make matters worse, 83% of the operating profit was eaten up by interest, mostly incurred to pay for the company. In the almost five years of owning Toys "R" Us, the owners have been able to increase revenues by just 5.9% and net earnings by 23.8%. Not much has changed here except the pile of debt.
In its S-1, Toys "R" Us lists the competition as one of the risk factors in investing in its business. Ya think? Walmart (NYSE:WMT) accounts for one quarter of the toy sales in the U.S., and some estimates put its toy sales worldwide at $18 billion, $4.5 billion higher. In the time the current owners have had their hands on the company, Walmart has grown its revenues 41.7%, or seven times more than Toys "R" Us. Add in Amazon.com (Nasdaq:AMZN), Target (NYSE:TGT) and all the other smaller players in toy sales and you are taking a big chance on a faded name. Especially when you consider how much it's going to ask for its shares come IPO time.
I'd be surprised if Toys 'R' Us isn't aiming for some sort of average of the three retailers that went public at the end of last year. In terms of price to sales, Vitamin Shoppe went public at $17 and a price-to-sales of 0.73, Dollar General at $21 and a P/S of 0.65, and rue21 at $19 and a P/S of 1.07. Averaging them together, you get 0.82. In my opinion, Toys "R" Us should sell for lower than that, closer to Dollar General's valuation. However, should it go public with a 0.82 valuation against revenues, its market value will be $11.1 billion. This would mean the three partners stand to make as much as $8.3 billion or 400% on their investment. All this for producing 6% growth.
I'm not a fan of IPOs. Too many times, it's a group of people simply trying to unload their problem on to the backs of new investors. In the case of Toys "R" Us, it's paying off $800 million of its existing $5 billion in debt. This does little to change the current business model but does get the wheels in motion for a quick exit by its three existing partners. Considering you could invest in Walmart at a lower valuation, it makes absolutely no sense to buy this IPO. (For more stock analysis articles, take a look at How Microsoft Lost Its Mojo.)
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