Toys "R" Us, Inc. is the world’s leading dedicated toy and juvenile products retailer. As of January 29, 2005, it operated 1,499 retail stores worldwide and generated 11.1 billion in revenue. However, that’s a decrease of 1.9 percent from a year ago. Toys "R" Us has suffered from both downstream demand and increased competition from mass/discount channel such as Wal-Mart and Target. A group of private equity investors intends to do a leverage buyout of Toys "R" Us. They want to determine the risks and merits of an investment in Toys "R" Us, evaluate the spectrum of returns using multiple operating model scenarios, and identify strategic actions that might be undertaken to improve the risk/return profile of the investment. Leverage Buyout (LBO)
A leveraged buyout is the purchase of a company by an outside individual, another firm, or the incumbent management using large amounts of debt to finance the purchase. Most often, LBOs are undertaken by private equity firms that specialize in these transactions. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital. An LBO analysis determines the maximum purchase price for a business that can be paid based on certain leverage (debt) and equity return parameter, develops a view of the leverage and equity characteristics of a leveraged transaction at a given price, and calculates the minimum valuation for a company. The returns in an LBO are driven by three factors, which we demonstrate in our topic on creating value in LBOs, including the deleveraging (paying down debt), operational improvement (e.g., margin expansion, revenue growth), and multiple expansion (buying low and selling high). Both equity holder and debt holder bear a high risk. For equity holders, in addition to the operational risk assumed risk arises due to significant financial leverage. Interest costs resulting from substantial amounts of debt are fixed costs that can be defaulted if not paid. Furthermore, small changes in the enterprise value of a company can have a magnified effect on the equity value when the company is highly levered and the value of the debt remains constant. Other than these risks, the equity holder hopes to exit an investment within a five year time frame by either issuing IPO to sell to a strategic buyer or another PE fund, or recapitalization. If the equity holder is unable to exit or is delayed in exiting the investment, it has a negative effect on investor returns. The debt holders bear the risk of default equated with higher leverage as well. Since they have the most senior claims on the assets of the company, they are likely to realize a partial, if not full, return on their investment, even in bankruptcy. Industry dynamics
The U.S. Retail Toy Industry is in the mature stage of its life cycle. The growth will likely remain stagnant. Sales were suffering from painful revenue losses during the recession. The Industry demand is heavily dependent on economic factors, dwindling consumer sentiment and disposable income pushed consumers to cut back on discretionary spending. The industry has come under increasing pressure from discount department stores and mass Merchandisers. Retailers have also experienced change due to the influx of imported goods into the market, which has stimulated competition within the industry. In addition, as children are getting older younger, age compression is changing the dynamics of toys and games. There is a clear shift from traditional toys and games to video games. Consumers are willing to pay more for toys that they view as being beneficial to children’s play or learning experiences. Toy industry categories with the largest revenue gains were building sets, arts & crafts, infant/preschool and Learning and Exploration. Plush, games/puzzles, vehicles and outdoor & sports toys experienced the most significant declines. There are several potential...