Toys ‘R’ Us’ aggressive capital structure

Toys “R” Us filed for Chapter 11 bankruptcy protection in the US and the similar in Canada. A lot of people have been speculating about the position TRU is in. Many speculate that e-commerce is the culprit of TRUs pain. I don’t necessarily agree. Toys ‘R’ Us was doomed in large part due to its aggressive capital structure. A structure that didn’t provide wiggle room. My historical information on TRU can be accessed at https://en.wikipedia.org/wiki/Toys_”R”_Us.

Steering into the aggressive capital structure

TRU started, as a toy store in 1957 by Charles P. Lazarus (earlier than that as a furniture store). It was bought out in 1966 by Interstate Department Stores. Then it went public (offered on the stock exchanges so that the general public can become shareholders) in 1978. Finally, it was taken private (bought back from the public) by a consortium of private equity players in 2005.

When TRU was taken private by Bain Capital, KKR, and Vornado Realty Trust, the group paid $6.6 billion using only $1.3 billion in equity. The rest of the deal was in debt. The company reported net earnings of $252 million for the fiscal year ending January 29, 2005 (accessible most recently on Form 10, at https://www.sec.gov/Archives/edgar/data/1005414/000119312508100880/d10k.htm). To the net earnings we should subtract off a $59 million income tax benefit and add back $130 million in interest expense.

This gets us something closer to what the company had to service debt with. Servicing debt means to be able to pay that debt. This means that TRU, based on the January 29, 2005 earnings would have $323 million available for debt servicing. The trouble is, from 2006 to 2008, TRU would pay anywhere between $401 million to $530 million in interest alone. Thus, meaning that based on the 2005 earnings before taxes and interest, TRU was not able to service its new debt.

Private equity comes to play

When TRU was taken private, the private equity would have known without significant changes the company would be in danger (because of the inability to service the debt). So why would the group take this amount of risk?

TRU was bought at $26.74 a share when it’s all time high had once been $45. If the group was able to restore some level of profitability and lustre to the TRU brand and take the new TRU public at the equivalent of $45 a share, there is a significant windfall. It would mean that a go public at $45 a share would see a little over $11 billion to the group. The group pays back the debt of $5.3 billion and receive $5.7 billion for their equity (which was originally $1.3 billion). Thus, making a 438% return – ideally occuring in under 5 years. This is a prime example of a leveraged buyout – something Bain and KKR do regularly.

Challenges of such a structure

Toys ‘R’ Us is a prime example of why capital structure (the mix of debt and equity) is something to look at very carefully. On one hand, with more leverage (more debt) there comes the opportunity for more gain. On the other hand, with more leverage there comes more risk of untimely demise. Such a demise leads to nothing for the equity holders.

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