Case Analysis: Toys R Us Loses The Leverage Game

Toys “R” Us Loses the Leverage Game

The recent painful demise of the iconic Toys “R” Us empire was no surprise to many in the world of corporate finance. The toy wonderland that nurtured baby boomers had become stale and obsolete in the eyes of millennial buyers more interested in technological playthings than Geoffrey the Giraffe. Mega toy manufacturers like Mattel and Hasbro realized that Toys “R” Us could no longer serve as their paradigm for new product testing and marketing data. Wal-Mart dethroned Toys “R” Us in 1998, usurping their status as the biggest toy seller, and Amazon – who reneged on an exclusivity contract with Toys “R” Us – now took their place as the darling for market testing and research. We could view Toys “R” Us as

They became a household name after their ground-breaking 1989 leveraged buyout of conglomerate RJR Nabisco. It was the largest leveraged buyout in corporate America at the time. KKR’s aggressive purchase made big news because it was primarily funded by borrowed funds. It so galvanized the industry that the story of the RJR Nabisco transaction was published in a popular book, "Barbarians at the Gate" by journalists Bryan Burrough and John Helyar, and was eventually made into a television movie.

The sale of RJR Nabisco involved a long and dirty battle but, in the end, KKR won the right to take control of the food and tobacco giant in the greatest leveraged buyout ever. The expectation was that KKR would hold Nabisco for a few years, improve its operations and then re-sell. The new charm called “leverage” would painlessly allow the value of their newly purchased business to grow and rapidly translate into enormous profits for the equity holders without making a dent in KKR’s capital.

Leveraged

If ABC would assume unsupportable interest payments, their operating cash flow may prove insufficient to pay the debt. Assume that the company enjoys sales of $1,000,000,000 and has costs of goods sold of $800,000,000 for a gross profit of $200,000,000 and requires $150,000,000 in operating expenses. If the company borrows money at 8% to fund its inventory – which turns over four times a year – for annual interest of $16,000,000 (Cost of Goods Sold × 8% ÷ 4), then ABC’s earnings before tax equals $34,000,000, and $22,100,000 of net income after a 35% corporate tax (see