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Vornado Realty Trust : Heavy Debt Crushed Owners of Toys "R" Us

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09/19/2017 | 11:32pm CET
By Miriam Gottfried and Lillian Rizzo 

Competition may have brought down Toys "R" Us Inc. But the debt that three Wall Street firms heaped on the company when they took it private -- and the way the ownership group was constructed -- left the retailer without a fighting chance.

When a consortium comprised of Vornado Realty Trust and private-equity firms KKR & Co. and Bain Capital bought the toy retailer for $6.6 billion in 2005, it was already struggling against competition from discounters including Wal-Mart Stores Inc. and Target Corp., and the threat of online competition from the rapidly growing Amazon.com Inc. loomed. Still, Toys "R" Us had valuable real estate and the investors planned to boost the company's sales and financial performance, banking in part on the strength of its name.

A dozen years later, Toys "R" Us has filed for bankruptcy protection, seeking relief from creditors in a Virginia court late Monday in a move that will all but wipe out the owners' $1.4 billion of equity. The company has $5.3 billion in debt, unchanged from when it went private.

Vornado has marked down the value of its stake in Toys "R" Us to zero, according to the real estate firm's annual securities filing. KKR and Bain have similarly marked down their investments, according to people familiar with the matter. The owners didn't pay themselves any dividends and though they have been drawing advisory fees, the amounts represent a small fraction of their overall losses.

As in virtually all private-equity deals, the original purchase was funded with significant debt.

Paying back that debt has cost Toys "R" Us dearly, with nearly $6 billion in total interest payments, including some $910 million in 2016 and 2017. And the company hasn't made progress reining in its heavy debt load during its 12 years under private ownership, as virtually all excess cash was earmarked for reinvestment. At the end of the quarter after the deal's close, the retailer's net debt was 7.2 times its earnings before interest, taxes, depreciation and amortization. As of the end of this year's first quarter, the leverage ratio stood at 7.8 times.

"The $400 million a year in debt service was really constrictive as they were trying to compete," said Katherine Waldock, a finance professor at Georgetown University's McDonough School of Business.

Chief Executive David Brandon said in court papers Tuesday that Toys "R" Us has been hampered by its "significant leverage," and the result is "the company has fallen behind some of its primary competitors on various fronts, including with regard to general upkeep and the condition of our stores, our inability to provide expedited shipping options, and our lack of a subscription-based delivery service."

The deal recalls a time when doing buyouts with multiple partners was popular because it opened up a wider array of big targets. These so-called club deals have fallen out of favor in recent years as limited partners who were often invested in more than one buyer's funds pushed back. That has helped shrink the size of private-equity deals.

Club deals also created a challenge when it came to managing companies.

At Toys "R" Us, differences emerged among the three owners over whether to manage the company for growth. As a real-estate investment trust, Vornado was more focused on the retailer's asset value and on profiting from its real estate.

"At Toys, we invested in a club with two renowned private-equity firms who are focused on improving operations and growing earnings," Vornado Chief Executive Steven Roth wrote in an April 2015 letter to investors. "Our suggestions of realizing value through real estate played second fiddle."

While some unprofitable stores were sold, Gerald Storch, who was CEO in the early stages of the buyout, led a push to combine the Toys "R" Us and Babies "R" Us brands under the same roofs and remodel the stores. The company beefed up its marketing and began selling online through its own websites.

The new superstores got high marks from consumers and helped Toys "R" Us post stronger sales, but the retailer's heavy debt load meant it was only able to convert 146 of its more than 1,500 stores to the new format by the time it filed for an initial public offering in 2010. E-commerce accounted for only $602 million of its $13.57 billion in sales in fiscal 2009.

But five years had passed since the takeover and private-equity firms typically get itchy for an exit around then. The idea was to time the IPO for after the holiday selling season when Toys "R" Us gets the bulk of its profits, according to a person familiar with the matter. But results in the quarter suffered as discounters stepped up their promotional efforts and the company put off the IPO, later pulling the planned offering altogether.

Mr. Storch stepped down as chief executive in 2013 after Toys "R" Us reported more disappointing holiday results, ceding the role to longtime company executive Antonio Urcelay. Mr. Urcelay, who began as an interim CEO and was later appointed to the role on a permanent basis, put in place a plan that emphasized retailing basics like keeping the right goods in stock and discounting less.

Meanwhile, competition in the baby business had intensified as rivals such as Bed Bath and Beyond Inc.'s Buy Buy Baby added locations and as Amazon pushed deeper into the category following its acquisition of Diapers.com. Margins for Babies "R" Us, which had looked like the stronger part of Toys "R" Us at the time of the leveraged buyout, began to get squeezed.

By the time Mr. Brandon, a veteran of Domino's Pizza and Valassis Communications Inc., took over the top spot after Mr. Urcelay retired in 2015, the company was primarily focused on maximizing cash flow, according to a person familiar with the matter.

One strategy Toys "R" Us could have pursued after it pulled the IPO was to carve off and sell its businesses in Canada, Japan, Europe and China -- markets where the competitive dynamics were better than in the U.S. But the owners believed the process of separating these businesses would be too complicated and decided against such a move, according to people familiar with the matter.

Toys "R" Us has lined up a $3.1 billion bankruptcy loan, and received court approval Tuesday to begin using roughly $1 billion toward retiring its bank debt, paying vendors to keep shipments coming, and paying employees.

The company's attorneys said Tuesday this bankruptcy loan is vital to allowing Toys "R" Us to buy inventory for the crucial holiday season.

"I don't view this necessarily as a doomsday," said Louis Cisz, a bankruptcy and restructuring attorney at Nixon Peabody LLP, which isn't involved with the restructuring. "There's no immediate plan to close stores. They're going to pay vendors in order to build up inventory. Those are positive signs under the circumstances."

--Suzanne Kapner contributed to this article.

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Financials ($)
Sales 2017 2 316 M
EBIT 2017 656 M
Net income 2017 224 M
Debt 2017 9 007 M
Yield 2017 3,51%
P/E ratio 2017 64,10
P/E ratio 2018 51,83
EV / Sales 2017 9,77x
EV / Sales 2018 10,6x
Capitalization 13 631 M
Duration : Period :
Vornado Realty Trust Technical Analysis Chart | VNO | US9290421091 | 4-Traders
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Mean consensus OUTPERFORM
Number of Analysts 12
Average target price 83,6 $
Spread / Average Target 16%
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Joseph Macnow Chief Financial Officer
Robert Entin Chief Information Officer & Executive VP
Robert P. Kogod Independent Trustee
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