Toys R Us Case Study Question And Answer

1. Financial analysis using Exhibits 5-9:

(1) Discuss two key observations of Toys R Us’ income statement 

(2) Discuss two key observations of Toys R Us’ balance sheet

(3) Discuss two key observations of Toys R Us’ cash flow statement

Start your answer here: 

2. What caused Toys R Us to fail? Your discussions should cover aspects of macro-economic factors, changing consumer preferences, business models, and financials.

Start your answer here: 

3. What could Bain Capital, KKR, and Vornado have done differently to possibly create a different outcome? 

Start your answer here: 

4. Who are the constituencies of private equity firms? Who bears the risks in a private equity transaction? Should or will the government take a more active role in overseeing private equity activity as a result of bankruptcies like Toys R Us? 

Start your answer here: 

9-220-023

R E V : J U N E 1 7 , 2 0 2 0

Senior Lecturer Nori Gerardo Lietz, Erica Segall (MBA 2019), Alejandro Botto (MBA 2019), and Research Associate Terrence Shu prepared this case with the assistance of Research Associates Arthur Sobral and Sean Bracken. This case was developed from published sources. Funding for the development of this case was provided by Harvard Business School and not by the company. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2019, 2020 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545- 7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

N O R I G E R A R D O L I E T Z

E R I C A S E G A L L

A L E J A N D R O B O T T O

T E R R E N C E S H U

Toys “R” Us: Come Buy My Toys

Introduction By late June 2018, the shelves of the Woodbridge, New Jersey Toys “R” Us (TRU) stood mostly bare,

save for a small assortment of tween jewelry and leftover Pokémon Christmas ornaments. Like the other 734 U.S. locations of the iconic toy retailer, the Woodbridge store was in its final days of operation. Nevertheless, the Woodbridge employees, whether out of pride or denial, continued to work into the final weeks, opening the store at 6am and keeping price signs up to date as liquidation discounts grew higher and higher. Many worried about their ability to pay their upcoming bills.1

Across the country similar scenes were unfolding, and the media pounced at the opportunity to portray the epic casualty of one of America’s most recognized retailers. At its peak, TRU owned 1,450 locations worldwide and controlled 25% of the world’s toy market.2 But as store doors continued to close one by one, one critical question remained unanswered: who was to blame?

Big Box Retailers and Private Equity

The Rise of Big-Box Specialty Retailers

“Big-box” retailers get their name from their windowless, box-like stores that are typically over 50,000 square feet in size. The rise of big-box stores in the U.S. started in the 1960s when general merchandise retailers like Walmart and Target opened their first stores. The format’s success could be partly attributed to the rise of automobile ownership and to the decentralization of cities. Most of these stores’ customers owned cars, so stores could be located outside city centers where there was better access to land at lower costs. Retailers also made sure they had ample parking to accommodate their customers. Growth of the store format proved explosive in the 1980’s and 1990’s as top retailers rapidly increased their store footprints. Walmart, for example, grew from 276 store locations and 21,000 associates (Walmart’s term for employees) in 1980 to 1,928 stores and 371,000 associates by 1992, a ~7x and ~18x increase, respectively.3

For the exclusive use of K. Patel, 2020.

This document is authorized for use only by Krishna Patel in MBA 542 Fall 2020 Canada taught by CHEN LIU, Trinity Western University from Aug 2020 to Feb 2021.

220-023 Toys “R” Us: Come Buy My Toys

2

The success of the big-box format did not stop at general merchandise retailers. The business model soon expanded to specialty or “category-based” retailers—stores that carried a deep, but narrow, assortment of products.4 This led to the rise of specialty retailers like Staples (office supplies), Best Buy (electronics), Home Depot (home improvement), Barnes and Nobles (books), and Toys “R” Us (toys). These companies earned the nickname “Category Killers” for their negative impact on small, independent stores in new locations where they expanded.5 They used their scale to offer impressive, wider product ranges and lower prices using strategies similar to the ones employed by Walmart and Target, and they fundamentally shifted the way Americans shopped.

Private Equity Investments in Big-Box Specialty Retailers

Private equity (PE) firms, like many other investors, saw an opportunity to capitalize on the specialty big-box retail trend. Initially, investment theses on specialty retail acquisitions were based largely on growth potential. One of the first PE firms to start investing in big-box specialty retailers was Bain Capital. In 1986, the firm famously invested $2.5 million in Staples generating an eventual return of $13 million (5.2x multiple on invested capital or “MOIC”).6 In 1987, the firm also invested in Sports Authority and helped them open nine stores in six states. Bain Capital sold Sports Authority three years later to Kmart for $75 million.7 Another successful PE investment in the segment was KKR’s acquisition of Stop & Shop in 1988. KKR invested $100 million to buy the supermarket chain in a $1.45 billion leveraged buyout (LBO) transaction, eventually selling it to Royal Ahold for $1.8 billion in 1996.8

In the late 1990’s and early 2000’s, the macroeconomic conditions that had made specialty retailers very successful in prior decades began to fundamentally change. Specialized retailers started losing ground to e-commerce, particularly Amazon, and to general merchandise retailers, like Walmart, expanding their product categories. With these changing market dynamics, PE firms saw another way to capitalize on the sector. These retailers provided investors with an opportunity to invest in companies with modestly increasing but predictable cash flows at low multiples.9 These stable cash flows allowed PE firms to apply significant amounts of leverage, which could potentially produce very attractive returns. And, as many of their companies’ stores were poorly managed, investors also saw an opportunity to rapidly increase in-store efficiency using a standard retail “playbook” the PE firms had developed over time. In addition, the large and perceived valuable real estate assets of these retailers were viewed as an effective “backstop” to minimize downside risk.

Toys “R” Us: The Demise of an Iconic Retailer “The amount paid by the winning bidder for the business shows they believe it to be a strong ongoing business.

Toys ‘R’ Us is going to be around for a long time.”

— CEO John Eyler10

Company Early History

In June 1948, Charles Lazarus opened a baby furniture store in Washington D.C. during the post- war baby boom, which he called Children’s Bargain Town.11 Soon after, in response to growing customer requests, the retailer started offering toys alongside its core furniture products. Given the success of the toy products, in 1957 Lazarus decided to launch the first Toys “R” Us dedicated exclusively to selling toys in the Maryland suburbs.12 Lazarus decided to reverse the “R” in the name so that it would look like a child had written it. In 1965, Geoffrey the Giraffe became the store’s official mascot and would quickly become one of America’s most recognized retail icons.13 Lazarus also approved the ear worm jingle “I’m a Toys ‘R’ Us Kid.” Soon after, in 1966, the chain was acquired by

For the exclusive use of K. Patel, 2020.

This document is authorized for use only by Krishna Patel in MBA 542 Fall 2020 Canada taught by CHEN LIU, Trinity Western University from Aug 2020 to Feb 2021.

Toys “R” Us: Come Buy My Toys 220-023

3

Interstate Department Stores, and Lazarus was named the head of its toy division. Five years later, Interstate declared bankruptcy, and Lazarus was put in charge of restructuring the company and selling unprofitable divisions.

In 1978, TRU became a publicly traded company under Lazarus’ leadership. In the following years, the retailer would go on to open its first Kids “R” Us children’s apparel store (1983) and expand internationally into Canada and Singapore (1984). By 1988, the company had more than 400 stores globally and revenues of $4 billion. In 1994, Lazarus stepped down and Michael Goldstein was appointed the new CEO. At that time, TRU had annual revenues of $8.7 billion. In the following years, the company would invest in a new segment with the launch of Babies “R” Us and the acquisition of Baby Superstore for $376 million.14

The Sale Process

In the late 1990s and early 2000s, TRU began to suffer from the pressures of increased competition that many other specialty retailers then faced. First, general merchandise retailers like Wal-Mart and Target began including more toys in their product portfolios. By 1998, Wal-Mart had replaced TRU as America’s largest toy retailer by aggressively cutting prices.15 In addition, around that same time, new options of online toy retailers also started to appear, putting further pressure on TRU.

In 2000, TRU announced a 10-year partnership with Amazon for online sales. As part of the deal, TRU would be the exclusive supplier of toys and baby products for Amazon, and all TRU’s online sales would be sold and distributed by Amazon. In exchange, TRU agreed to give up its online presence, have ToysRUs.com redirect to Amazon, and pay an annual fee of $50 million to Amazon. Despite the partnership’s initial success, competition from other retailers soon pushed Amazon to look for ways to expand its toy and baby merchandise beyond what TRU was able to supply. In 2003, TRU noticed Amazon was selling toys and baby products from other merchants and, in 2004, filed a lawsuit against Amazon claiming the e-commerce website had breached their agreement.16

These combined pressures resulted in TRU’s revenues declining in the U.S. from $6.9 billion in 2001 to $6.5 billion in 2003 (see Exhibit 1).17 In August 2004, TRU announced that it was looking to sell part of its business and potentially spin off the better-performing brand, Babies “R” Us. In 2005, the hedge fund Cerberus offered to pay $5.5 billion for the entire company.18 This offer convinced TRU’s board to broadly market the company by creating an auction to include other bidders in the process, primarily PE firms.

On March 17, 2005, a consortium of PE firms consisting of Bain Capital, KKR, and Vornado Realty Trust came together to outbid Cerberus and acquired TRU for $6.6 billion. The purchase price represented an 8% premium over the $24.77 stock price on the day prior to the acquisition announcement and a 63% premium over the $16.42 price per share on August 10, 2004, the day before the Company announced its intention to sell.19, 20 The acquisition was highly leveraged with debt, accounting for $5.3 billion of the total $6.6 billion purchase price or a loan to value ratio of 80%.21 The equity commitment of $1.3 billion was equally divided among the three firms.

TRU’s new owners believed the company had a number of attractive features that supported their investment thesis. In particular, Bain and KKR believed they could use their operational expertise to implement value-add improvements that would reduce costs and stimulate growth. For example, TRU was notorious for its cluttered, chaotic stores, and the retailer had virtually no online presence at the time due to its relationship with Amazon. Both Bain and KKR’s experience investing in big-box retailers like Staples, Sports Authority, and Stop & Shop had enabled them to develop their “retail playbook.” They saw an opportunity to implement their similar playbook with TRU.22

For the exclusive use of K. Patel, 2020.

This document is authorized for use only by Krishna Patel in MBA 542 Fall 2020 Canada taught by CHEN LIU, Trinity Western University from Aug 2020 to Feb 2021.

220-023 Toys “R” Us: Come Buy My Toys

4

In addition, the buyers—particularly Vornado, a publicly traded real estate investment trust (REIT)—were attracted to TRU’s vast and valuable real estate portfolio and felt those assets could serve as protection in a downside scenario. There was also the possibility of an “op co/prop co” real estate spinoff, meaning that the real estate could be sold to a REIT and TRU would lease back the space, that could create additional value. Many hotel companies had similarly followed this model.23

Toys “R” Us Under Private Ownership

With the ownership secured, TRU’s PE owners began to implement many of their planned short- term operational improvements. In particular, their plan focused on increasing the efficiency of TRU’s cluttered and outdated stores, eliminating many store-level positions, and rationalizing a number of corporate expenses that had grown seemingly out of hand (for instance, TRU had acquired a number of lavish corporate jets in recent years, and in 2001 had moved to a new 190-acre corporate campus that some viewed as excessive).24

By 2009, the company had realized many of the micro gains its owners had hoped for: efficiency measures like inventory turns rose over the period, EBITDA margins expanded from 6% in 2005 to 8% in 2010, and revenues grew through 2008 while staying remarkably consistent through the 2008–2009 Great Recession (see Exhibit 2 for select performance metrics from 2004 to 2009). Given their success in achieving their ownership objectives, the PE consortium considered an exit but ultimately held back given the unfavorable market conditions during the recession.

Following the Great Recession, however, retail expenditures increasingly shifted toward e- commerce and store footfall subsequently declined. Many large chains began rapidly closing their physical locations: over 6,000 retail stores were closed in the U.S. in 2008, followed by more than 8,000 across the 2009–2010 period (see Exhibit 3). It was becoming clear that the specialty retailer—which had so recently been the darling of PE investment—was in decline. The toys and games industry proved no exception. Amazon made an aggressive expansion in its toy business, bolstering its offering of traditional toy brands like Mattel, Hasbro, and Lego, coupled with its relentless focus on low price and the convenience of at-home delivery. Brick-and-mortar retailers felt the pinch. Walmart, for example, quickly recognized the Amazon challenge and dropped its own prices in response.25

TRU management and its PE owners recognized the need to adapt to the rapidly changing market environment. In 2009, the company went on a buying spree, acquiring eToys.com, Toys.com (one of the most commonly used URLs for online toy searches), KB Toys and KBToys.com (interestingly, a defunct Bain Capital investment), and iconic toy retailer FAO Schwarz to supplement its own lackluster e-commerce presence (see Exhibit 4 for TRU timeline).26 Ironically, TRU had only relaunched its own independent website in 2006, following TRU’s 2004 lawsuit against Amazon that resulted in the early termination of the online partnership between the two companies—a partnership that left TRU “10 years behind” on digital innovation.27

Still, the toy retailer’s sales struggled. Management identified several opportunities to address the foundational issues affecting its future growth, as exemplified in the 2014 “TRU Transformation Strategy” championed by then-CEO Antonio Urcelay (the third of four individuals who held the CEO position during TRU’s ownership under PE management; leadership changes are included in Exhibit 4). Potential efforts identified included: de-cluttering and upgrading stores, improving the in-store customer experience, developing clearer pricing strategies and promotions, and more tightly integrating the in-store and online businesses.28

But despite TRU’s cost savings and growth initiatives, the macro transformations affecting the U.S. toy industry proved insurmountable. By 2017, store-based retailing represented just 56% of U.S. toy

For the exclusive use of K. Patel, 2020.

This document is authorized for use only by Krishna Patel in MBA 542 Fall 2020 Canada taught by CHEN LIU, Trinity Western University from Aug 2020 to Feb 2021.

Toys “R” Us: Come Buy My Toys 220-023

5

sales, down from 91% in 2004, and traditional toy stores represented just 8%, down from 18% over the same time period. By contrast, internet retailing exploded to 44% of toy sales by 2017, up from just 8% in 2004 (see Exhibit 6 for U.S. retail toy sales by channel). TRU experienced six consecutive years of negative sales growth from 2012−2017, and EBITDA margins shrank from a high of 8.0% in 2009 to 4.7% in 2017 (Exhibit 1). Moreover, the substantial debt placed on TRU’s balance sheet as part of its transition to PE ownership represented a significant burden to the company (see Exhibit 7 for TRU’s historical capital structure). Long-term debt remained essentially unchanged by 2017, and TRU spent much of its cash flows paying principal and interest (see Exhibit 8 for TRU’s balance sheet and Exhibit 9 for TRU’s statement of cash flows). The total Debt/EBIDTA ratio was consistently over 5x, even surpassing 10x in 2013.

In the end, with growing numbers of parents shopping on their laptops and phones, TRU’s PE owners had to wonder: was it really clear that, even if the cash were available, overhauling stores with additional capex would help? What good were beautiful stores, if no one was shopping in them?

Bankruptcy

TRU’s management knew they had a sword of Damocles hanging over their heads. They had $400 million of debt coming due in 2018 and speculation that they might file for Chapter 11 protection had spooked their vendors. It was reported that nearly 40% of its vendors were either refusing to ship product or requiring payments in advance or upon delivery.29

On September 18, 2017, TRU filed for Chapter 11 bankruptcy protection in a last-ditch effort to free itself from the handcuffs of debt, representing the third-largest retail bankruptcy in U.S. history.30 At the time of the announcement, TRU had a debt load of approximately $5.5 billion.31

Management, as well as many observers, appeared optimistic about TRU’s ability to emerge from Chapter 11, believing that the move would give the company flexibility to deal with its long-term debt, borrow to pay suppliers like Hasbro and Mattel, and continue to invest in operational improvements. In the release announcing the filing, then-CEO David Brandon remarked:

Today marks the dawn of a new era at Toys “R” Us where we expect that the financial constraints that have held us back will be addressed in a lasting an effective way…We are confident that these are the right steps to ensure that the iconic Toys “R” Us and Babies “R” Us brands live on for many generations.32

In particular, management was hopeful that a successful holiday season could ignite the Company’s momentum. Historically, TRU had fared well against competitors in the period between Thanksgiving and Christmas given its significant inventory offerings and a strategy of last-minute, high-margin sales after competitors had been depleted of the hottest items, or when last-minute shoppers feared online deliveries would not arrive in time.33 Confident in TRU’s ability to succeed over this key season, suppliers kept TRU shelves stocked with toys for the holidays.34

Sadly, those hopes failed to materialize. After a lackluster holiday performance—half the earnings expected in a typical Christmas season—TRU found itself losing $50−$100 million per month and tripping its new financing covenants.35 Management, projecting that the Company would run out of cash by May, hustled to develop a new plan for reorganizing which included closing 182 stores (approximately 20% of its U.S. base).36, 37

But five critical debt holders ran out of patience. Solus Alternative Asset Management, Angelo, Gordon & Co., Franklin Mutual Advisers, Highland Capital Management, and Oaktree Capital jointly

For the exclusive use of K. Patel, 2020.

This document is authorized for use only by Krishna Patel in MBA 542 Fall 2020 Canada taught by CHEN LIU, Trinity Western University from Aug 2020 to Feb 2021.

220-023 Toys “R” Us: Come Buy My Toys

6

held a crucial piece of TRU secured debt, essentially giving them all the negotiating leverage in any restructuring. These bondholders could force TRU into liquidation (Chapter 7) as opposed to a reorganization (Chapter 11).38

After the initial Chapter 11 filing, Bain, KKR, and Vornado continued to negotiate with the lenders and press for TRU’s reorganization. A liquidation would wipe out their collective investment in TRU and they would be forced to report nearly a complete loss to their limited partners. While this would be a devastating outcome, the PE consortium ultimately decided not to invest any additional capital into TRU to save the company. Citing their own needs for liquidity and returns to their investors, the hedge fund and PE creditors decided that a liquidation of TRU’s U.S operations and distribution of the proceeds would be more valuable than a functioning business.a,39,40,41,42,43 By March 15, 2018, they had successfully pressured TRU to convert its Chapter 11 filing into a Chapter 7 case.44 Exhibit 10 shows a timeline of the TRU bankruptcy.

In its announcement declaring liquidation, TRU management pointed to unrelenting competition from Amazon, Walmart, and Target as the cause of its demise. These competitors, TRU reasoned, priced toys at low margins or as loss leaders during the holiday shopping season and offered more attractive online shipping options; TRU could not match such aggressive pricing due to its exclusive dependence on toys for profit.45 The filing entailed closure of the company’s roughly 800 U.S. store locations, liquidation of all remaining inventory, and the loss of approximately 33,000 jobs.46

Public Scrutiny Following Chapter 7

On July 5, 2018, 19 members of Congress sent a letter to Bain Capital, KKR, and Vornado questioning their role in TRU’s bankruptcy, criticizing the LBO model as a propagator of job loss and business failure, and encouraging the firms to contribute to the compensation of the 33,000 TRU employees who had lost their jobs in the bankruptcy. The members of Congress wrote:

Leveraged buyouts—such as those facilitated by your companies—often result in mass job loss, closure of profitable businesses and unnecessary financial burdens for local government. Such buyouts harm communities, while investment managers walk away with significant gains. In fact, due to the closure of Toys ’R’ Us, 33,000 workers lost their jobs, while your firms have extracted over $500 million from Toys ‘R’ Us during the period you have owned the company.47

The PE firms maintained that (i) market forces, not PE ownership, were the cause of TRU’s troubles; (ii) the debtholders were the ones who pushed for liquidation; and (iii) they themselves had lost considerably. In its response to the Congressional letter, KKR stated that it had reinvested $3.5 billion in TRU throughout the holding period without taking any investment profits, and that it had written down its entire equity investment of $418 million.48 The firm wrote, “Even accounting for fees received from Toys ‘R’ Us, we have lost many millions of dollars. To find anyone who profited, one would need to look at the institutions that pushed for Toys to liquidate its US business.”49

However, the reality was that the PE firms had, in fact, received $464 million over the holding period in fees, reimbursed expenses, transaction fees and interest (see Exhibit 11 for PE fees and interest collected from TRU). This amount was in addition to any asset management fees, typically 2% on a TRU’s U.S. business was first to file for bankruptcy, followed by administrations of the company’s U.K. and Australia operations (notes 34 and 35). Other regions were affected by the bankruptcy (e.g., Canadian operations were sold to Fairfax Financial (note 36), and Toys ‘R’ Us Asia was sold to Fung Retailing and a consortium of lenders (note 37)). Globally, TRU still reported over $3 billion in revenues in 2018, despite discontinuation of its U.S. business (note 38).

For the exclusive use of K. Patel, 2020.

This document is authorized for use only by Krishna Patel in MBA 542 Fall 2020 Canada taught by CHEN LIU, Trinity Western University from Aug 2020 to Feb 2021.

Toys “R” Us: Come Buy My Toys 220-023

7

invested capital, the PE firms would have received from their limited partners of their respective funds. This would equate to an additional ~$100 million per firm over a 12-year holding period, unless they were waived. Some transaction fees were waived in 2013 and 2014.50 It should be noted that the PE firms did not at any point perform a “dividend recap,” meaning that they did not refinance the original acquisition loan at a higher amount and dividend out amounts to their partnerships, which would have reduced their clients’ basis in the investment. In the end, most of any investment losses were incurred by the limited partners, not the PE firms.

At the same time, TRU employees, who were collectively contractually entitled to $75 million in severance, did not take the bankruptcy proceedings quietly. However, this claim was unsecured and therefore wiped out in the liquidation. Led by the worker advocacy group Rise Up Retail, ex-employees took part in protests across the country and demanded new laws that would limit leverage on PE transactions as well as guarantees of employee severance.51 Fifty thousand terminated workers and their supporters signed a petition to the firms demanding some severance payments given the fees the PE firms had received, which they claimed equated to $15,000 per worker.52

In the following months, workers visited investment meetings of 14 pension funds who had invested with Bain Capital and KKR to air their grievances and call for the funds to take a stand against Bain Capital and KKR as limited partners. These efforts did not fall on deaf ears; for instance, Minnesota’s state pension plan temporarily halted investments in KKR funds upon hearing of KKR’s initial refusal to contribute to employee severance.53 As Sarah Bloom Raskin, former Deputy Treasury Secretary in the Obama administration stated, “Workers don’t want their pension money invested in ways that hurts other workers. No one wants to be invested in their own decline.”54

Pension funds as limited partners, in particular, have historically been critical of investments that were unpopular with their constituencies. For instance, some investors limit or prohibit investments in categories like guns or fossil fuels, and PE firms have often been willing to concede on these issues to avoid alienating important sources of capital.55 Given that many public pension board members represented labor unions, pension funds had a vested interest in avoiding investments that may actively hurt workers. As exemplified by the Minnesota pension plan’s freeze on investments with KKR until it contributed to employee severance, the TRU case highlights the ability of limited partners to hold general partners accountable on social issues—and of workers to indirectly exert their own influence through pension boards. However, the cash flows into the PE asset class indicate that some sources of capital may be willing to look the other way in their continued search for superior returns (see Exhibit 12 for global PE fundraising activity in 2017).

On November 20, 2018, both Bain Capital and KKR announced that each had committed $10 million to a fund for former TRU employees—a rare move in the industry, though still significantly shy of the $75 million outstanding severance. Notably, the $20 million in total contributions to the TRU Financial Assistance Fund did not come from either PE firm’s limited partners.56 As of July 2019, Vornado had not yet announced a commitment.57 Similar requests to the other PE firms, especially Solus Alternative Asset Management, were rebuffed. Solus told their investors the requests were tantamount to extortion.58

Assigning Blame: PE Firms, Creditors, and Changing Markets? In the midst of the tremendous public scrutiny over TRU’s downfall, politicians, employees, public

pension funds, the creditors and the PE firms were each quick to point fingers and assign blame. Some, particularly Bain Capital and KKR, blamed TRU’s creditors, claiming that they were too quick to force liquidation; with a little more patience and time a Chapter 11 restructuring might have allowed TRU to rebound.59

For the exclusive use of K. Patel, 2020.

This document is authorized for use only by Krishna Patel in MBA 542 Fall 2020 Canada taught by CHEN LIU, Trinity Western University from Aug 2020 to Feb 2021.

220-023 Toys “R” Us: Come Buy My Toys

8

Others, pointing to the poor performance of established toy brands like Mattel, cite TRU as indicative of a broader decline in the U.S. toy industry as electronic devices like iPads and Kindles came to replace more traditional, “old-school” toys like the Barbies and remote-controlled helicopters that dominated TRU’s offerings.60 Exhibit 13 shows the decline in U.S. toy demand and shipments over the 2006−2016 period. Did market shifts doom Toys “R” Us?

Still, the bulk of the media and public scrutiny pointed in one direction: Bain Capital, KKR, and Vornado. TRU’s significant debt burden rendered the company financially incapable of making the strategic investments or business model adaptations required to respond to the shifting retail landscape. This was not a downfall caused by disruption, critics claimed, but by the PE firms’ avarice and the debt they piled on TRU.

The data on whether this criticism is warranted is mixed. Multiple studies and media publications have cited that a significant percentage of retail related bankruptcies over the past decade were PE−backed LBOs.61,62 Whether these bankruptcies were caused by a debt overload or market forces remained unclear. Further, the overarching criticism that PE firms are “job destroyers” is similarly unclear. There is academic evidence to suggest that PE buyouts, in the long run, may have a modest net impact on employment levels. One study found that high debt levels in LBOs caused initial layoffs as companies reallocated resources, but these losses were later recouped with corporate expansion and job creation over a longer term.63 See Appendix A for certain public data on retail-related bankruptcies and the impact LBOs have had on job losses and job creation. But, while the case for PE buyouts might satisfy academics, examples such as Toys “R” Us and others are severe reminders of the human costs when the LBO playbook doesn’t work.

Leverage undoubtedly exacerbated TRU’s problems, but perhaps the underlying big-box, specialty retail business model was fundamentally flawed. With little differentiation in terms of product or experience, TRU’s business model faced increasing competition from all sides. Once Amazon began offering the same assortment of branded products with guaranteed same- or next-day delivery, justifying a 30,000 square-foot store to sell Barbies grew increasingly difficult. Similarly, general retailers like Walmart and Target relied on other product categories to manage both seasonality and pricing pressure in toys. Outside the holiday season, they could keep toy floor space and inventory low rather than stockpile excess product year-round, and in the most competitive months, they could lower prices and absorb the margin impact across other categories.

Across the retail industry, a number of categories, particularly those best-suited for e-commerce (books, electronics, office supplies, sporting goods, and toys), saw the consolidation or elimination of longstanding specialty, big-box retailers. Categories that fared better—like home improvement—had products more resilient to the threat of online competition. Exhibit 14 shows recent U.S. store closings indicating the disproportionate impact on consumer products retailers (as opposed to grocers or general merchandisers), while Exhibit 15 shows relative digital versus in-store shopping preferences of U.S. shoppers across retail categories, including toys.

Such evidence points towards a critical question: even if TRU had been able to invest significantly in operational changes, would that have been money well spent? Or, were the macro forces at play simply too powerful to overcome; did the leverage simply accelerate TRU’s inevitable demise?

Denouement

On March 15, 2018, the foreclosed company announced that it would begin the liquidation process. Geoffrey the Giraffe walked out of a Toys “R” Us (see Exhibit 16). On March 22, 2018, TRU began liquidating assets. Sadly, Toys “R” Us founder, Charles Lazarus, died that same day.64

For the exclusive use of K. Patel, 2020.

This document is authorized for use only by Krishna Patel in MBA 542 Fall 2020 Canada taught by CHEN LIU, Trinity Western University from Aug 2020 to Feb 2021.

Toys “R” Us: Come Buy My Toys 220-023

9

Exhibit 1 TRU Net Sales Breakdown, FY2001−2004 (USD Millions)

Net Sales 2001 2002 2003

Toys “R” Us – U.S. 6,877 6,755 6,476 Toys “R” Us – International

1,889 2,161 2,528

Babies “R” Us 1,421 1,595 1,763

Toysrus.com 277 340 376

Kids “R” Us 555 454 423

Total 11,019 11,305 11,566

Source: Casewriters’ compilation based on “Form 10-K.” Toys “R” Us, Inc. April 04, 2004. Accessed September 20, 2019.

Exhibit 2 Select TRU Performance Metrics, FY2004−2009

2004 2005 2006 2007 2008 2009

Growth Over Prior Year Same Store Sales Growth (3.7%) (1.4%) 0.2% 2.7% (0.1%) (3.0%) Total Revenue Growth (1.5%) 1.6% 15.2% 5.7% (0.5%) (1.1%)

Asset Turnover Inventory Turnover 3.8x 4.5x 5.4x 4.9x 4.8x 4.9x

Profitability EBITDA Margin 6.0% 7.0% 7.6% 7.5% 7.1% 8.0% Gross Margin 32.8% 32.8% 33.8% 34.8% 34.6% 35.2%

Source: Casewriters’ compilation based on data from Capital IQ.

Exhibit 3 Annual U.S. Retail Store Closings

Source: Compiled by casewriters based on Basenese, Louis. “Friday Charts: Tesla’s Absurd Valuation and Amazon’s Endless Warpath.” Wall Street Daily. April 13, 2017. Accessed October 28, 2019. https://www.countingpips.com/2017/04/friday-charts-teslas-absurd-valuation-and-amazons-endless-warpath/.

For the exclusive use of K. Patel, 2020.

This document is authorized for use only by Krishna Patel in MBA 542 Fall 2020 Canada taught by CHEN LIU, Trinity Western University from Aug 2020 to Feb 2021.

220-023 Toys “R” Us: Come Buy My Toys

10

Exhibit 4 TRU Timeline

2000 ● John Eyler joins Toys“R”Us, Inc. as President and CEO ● Toys“R”Us, signs partnership deal with Amazon.com®

2001 ● Toys“R”Us, Inc. establishes a flagship store with the highly-anticipated opening of Toys“R”Us Times Square, The Center of the Toy Universe®

2004 ● Toys“R”Us, Inc. announces strategic review of all business units

2005 ● Toys“R”Us, Inc. becomes a private company after being sold to Bain Capital, KKR, and Vornado for $6.6 billion

2006 ● Gerald Storch appointed Chairman and CEO of Toys“R”Us, Inc. ● Toys“R”Us, Inc. separates from Amazon; launches independent Toysrus.com

website

2009 ● Toys“R”Us, Inc. acquires eToys.com and Toys.com ● Toys“R”Us, Inc. acquires the KB Toys™ brand, including its URL, KBToys.com, its

trademarks and other intellectual property rights ● Toys“R”Us, Inc. acquires FAO Schwarz, including its Fifth Avenue flagship store in

New York City, and its e-commerce and catalog businesses

2013 ● Antonio Urcelay appointed Chairman and CEO

2015 ● David Brandon appointed Chairman and CEO

Source: Casewriters’ compilation based on “Form 10-K.” Toys “R” Us, Inc. April 04, 2004. Accessed September 20, 2019; “Form 10-K.” Toys “R” Us, Inc. May 15, 2007. Accessed September 20, 2019; “Form 10-K.” Toys “R” Us, Inc. March 24, 2010. Accessed September 20, 2019; and “Form 10-K.” Toys “R” Us, Inc. March 24, 2016. Accessed September 20, 2019;

For the exclusive use of K. Patel, 2020.

This document is authorized for use only by Krishna Patel in MBA 542 Fall 2020 Canada taught by CHEN LIU, Trinity Western University from Aug 2020 to Feb 2021.

22 0-

02 3

-1

1-

Ex hi

bi t 5

TR U

In co

m e

St at

em en

t, FY

20 00

−2 01

7 (U

SD M

ill io

ns )

20

00

20 01

20

02

20 03

20

04

20 05

20

06

20 07

20

08

20 09

20

10

20 11

20

12

20 13

20

14

20 15

20

16

20 17

To ta

l R ev

en ue

11

,3 32

11

,0 19

11

,3 05

11

,3 20

11

,1 55

11

,3 33

13

,0 50

13

,7 94

13

,7 24

13

,5 68

13

,8 64

13

,9 09

13

,5 43

12

,5 43

12

,3 61

11

,8 02

11

,5 40

11

,1 46

G

ro w

th O

ve r P

ri or

Y ea

r (4

.5 %

) (2

.8 %

) 2.

6%

0. 1%

(1

.5 %

) 1.

6%

15 .2

%

5. 7%

(0

.5 %

) (1

.1 %

) 2.

2%

0. 3%

(2

.6 %

) (7

.4 %

) (1

.5 %

) (4

.5 %

) (2

.2 %

) (5

.0 %

)

C os

t o f G

oo ds

S ol

d 7,

80 5

7, 60

4 7,

75 0

7, 64

6 7,

49 6

7, 61

1 8,

63 5

8, 98

7 8,

97 6

8, 79

0 8,

93 9

8, 93

9 8,

59 2

8, 10

3 7,

92 2

7, 57

6 7,

43 2

7, 32

9 G

ro ss

P ro

fi t

3, 52

7 3,

41 5

3, 55

5 3,

67 4

3, 65

9 3,

72 2

4, 41

5 4,

80 7

4, 74

8 4,

77 8

4, 92

5 4,

97 0

4, 95

1 4,

44 0

4, 43

9 4,

22 6

4, 10

8 3,

81 7

G ro

ss p

ro fit

m ar

gi n

31 %

31

%

31 %

32

%

33 %

33

%

34 %

35

%

35 %

35

%

36 %

36

%

37 %

35

%

36 %

36

%

36 %

34

%

O pe

ra tin

g In

co m

e 54

4 38

6 51

6 28

0 31

5 39

4 58

0 67

8 61

8 73

9 67

3 59

3 56

8 13

6 21

5 38

8 41

3 26

0 O

pe ra

tin g

m ar

gi n

4. 8%

3.

5%

4. 6%

2.

5%

2. 8%

3.

5%

4. 4%

4.

9%

4. 5%

5.

4%

4. 9%

4.

3%

4. 2%

1.

1%

1. 7%

3.

3%

3. 6%

2.

3%

In te

re st

E xp

en se

(1

27 )

(1 17

) (1

19 )

(1 42

) (1

30 )

(3 94

) (5

37 )

(5 03

) (4

19 )

(4 47

) (5

21 )

(4 42

) (4

80 )

(5 24

) (4

51 )

(4 29

) (4

57 )

(4 27

) In

te re

st a

nd In

ve st

. I nc

om e

23 .0

8.

0 9.

0 18

.0

19 .0

31

.0

31 .0

27

.0

16 .0

7.

0 7.

0 10

.0

16 .0

7.

0 4.

0 3.

0 2.

0 2.

0 N

et In

te re

st E

xp .

(1 04

) (1

09 )

(1 10

) (1

24 )

(1 11

) (3

63 )

(5 06

) (4

76 )

(4 03

) (4

40 )

(5 14

) (4

32 )

(4 64

) (5

17 )

(4 47

) (4

26 )

(4 55

) (4

25 )

% o

f O p.

In co

m e

19 %

28

%

21 %

44

%

35 %

92

%

87 %

70

%

65 %

60

%

76 %

73

%

82 %

38

0%

20 8%

11

0%

11 0%

16

3%

N et

In co

m e

40 4

67

21 3

63

25 2

(3 84

) 10

9 15

3 21

8 31

2 16

8 14

9 38

(1

,0 39

) (2

92 )

(1 30

) (3

6)

(6 12

)

EB IT

D A

83

4 69

4 85

5 64

8 66

6 79

4 98

9 10

40

97 4

10 90

10

42

97 4

94 8

49 3

55 8

69 4

69 4

52 4

EB IT

D A

m ar

gi n

7.

4%

6. 3%

7.

6%

5. 7%

6.

0%

7. 0%

7.

6%

7. 5%

7.

1%

8. 0%

7.

5%

7. 0%

7.

0%

3. 9%

4.

5%

5. 9%

6.

0%

4. 7%

So ur

ce :

C as

ew ri

te rs

’ c om

pi la

tio n

ba se

d on

d at

a fr

om C

ap ita

l I Q

.

N ot

e:

Se le

ct li

ne it

em s

sh ow

n. 2

01 7

fig ur

es re

pr es

en t L

TM O

ct ob

er 2

8, 2

01 7.

For the exclusive use of K. Patel, 2020.