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Why Toys R Us is no fun to own
Some of the smartest deep-value investors see an end to the troubles in Toyland. I don't buy it. Big, bad discounters and an income statement from the Land of Make Believe are just the start.
By Jon D. Markman
Somewhere in the circle of hell reserved for companies that have abused the trust of children and retirees sits a giraffe with a goofy grin on its face.
Toys R Us (TOY, news, msgs), whose dun-colored mascot Geoffrey should be pink with embarrassment, has been one of the worst-performing large specialty-chain stores in the history of the U.S. stock market -- returning exactly nothing to shareholders over the past 13 years. Even during a 12-month stretch when both retailers and value stocks outperformed the rest of the market, Toys R Us has fallen 34%. Going back five years, shares have sunk 48%; over the past decade, -47%. One of the stocks that many parents put in their childrens college accounts in a mistaken attempt to interest kids in the market, Toys R US has offered a real education only in failure.
As a new fiscal year for the firm dawns, however, Toys R Us finds itself in the warm embrace of some of countrys smartest deep-value investors. Harris Associates, managers of the perennially successful Oakmark Funds, began to slowly acquire its 12% stake in January 2000. Brandes Investment Partners, managers of $70 billion for institutions and individuals in the value style, has amassed an 11% stake. Legg Mason Fund Advisors, manager of the popular Legg Mason Value (LMVFX), owns 7%.
On the surface, it might look as if Spider-Man, Yoda and Harry Potter will be responsible for the rescue of this battered corporate citizen, as blockbuster films provoke a superhero bonanza of toy and video buying in 2002. But, in fact, it must be value fund managers who believe that Toys R Us is over-hated and its management capable of accomplishing a few elusive but mundane chores: renovating stores, upgrading customer service, adding successful proprietary toys, cutting expenses and becoming price-competitive with discount chains like Wal-Mart Stores (WMT, news, msgs) and Target (TGT, news, msgs).
"If they get it right, this could become a feel-good stock, said Kevin Rendino, a Merrill Lynch mutual fund manager who likes its prospects, in an interview with Barrons magazine this week.
Im not so sure. Toys R Us is certainly cheap, with all the price-to ratios in the lower end of the range of both the market and its peer groups. Yet a close look at the companys recent financial reports makes me wonder whether the stock sports a high price-to-hope multiple, as its recovery story seems as uncertain as an escape from the Jedi.
The key to boosting its share price, after all, is pushing revenue growth in the right direction; expectations are so subdued that a low single-digit advance would bring celebration. But so far, managements two-pronged strategy of revamping tired stores and adding exclusive, high-margin merchandise like the new Animal Alley plush toys seems to be faltering. And last months sale of new stock near one-year-lows combined with scant insider buying suggests that executives arent terribly confident that a near-term turnaround will dramatically boost the stock soon.
Research by independent and brokerage analysts, indeed, reveals these additional problems: negative to flat sales growth combined with weak profitability in the past five years; a pattern of restructuring charges that impair earnings quality; poor free cash flow; deteriorating credit ratings; deteriorating quality of inventory; a board of directors with uncertain independence; and several class-action lawsuits.
William Nygren, world-class manager of the Oakmark Fund (OAKMX), says that this is exactly the sort of seemingly ugly situation he savors -- and hes willing to wait three to five years to be proved right. But everyone else could be anxiously clutching their teddy bears before this retailer truly turns itself around.
The delusional income statement
Lets start with self-delusion and the income statement. Although Toys R Us sales and profits have been steadily declining for the past three years, Chairman and Chief executive John Eyler placed the blame for poor fiscal 2001 performance squarely on the Sept. 11 terror attacks in his latest Letter to Shareholders. In eight direct references to Sept. 11, Eyler complained that tragic and unprecedented events had negatively affected performance.
The link between Sept. 11 and the companys operational difficulties is tenuous at best, as the years results were in line with the past three years. Fiscal 2001 revenues were $11 billion, down 2.8% from 2000, and down 7.1% from 1999. Profits were just 0.6% of sales in 2001, at $67 million. Results for the first quarter of fiscal 2002, ended May 2, were just marginally better as the firm narrowed its net loss to $4 million (up from -$18 million a year earlier) due to a 1.6% improvement in sales and a 0.5% cut in operating expenses.
Donn Vickrey, vice president at Camelback Research Alliance, supplier of MSN Moneys StockScouter rating system, points out that results were actually worse than the companys official report suggests if you remove the effects of non-recurring items. The company realized a temporary boost in profits in 2000, for instance, through the $315 million gain realized in its initial public offering of Toys R Us-Japan (JP:7645, news, msgs). And ongoing restructuring charges in 1998 and 2001 of $294 million and $213 million, which have the effect of boosting earnings, should be adjusted as well to help investors understand the companys sustainable earnings. Plus, Toys R Us reported that earnings would have been reduced by $39 million and $19 million if it had recorded compensation expenses for executive stock options in 2001 and 2000, respectively.
All told, Vickreys analysis suggests that core, sustainable earnings fell 41.3% in fiscal 2001. And while reported earnings improved from a loss of $18 million in the first quarter of 2001, to a loss of $4 million in the first quarter of 2002, Vickreys figures show that after adjusting for the effects of restructuring charges and goodwill amortization, the apparent improvement disappears and sustainable earnings actually fell 1.2% on a year-over-year basis.
Meanwhile, cash flow from operations was fairly strong and exceeded net income in fiscal 2001, suggesting the company is genuinely, if marginally, profitable. But free cash flow -- which backs out cash paid for plant and equipment -- has steadily declined to -$201 million in fiscal 2001, from $591 million in fiscal 1999, as the company has thrown a lot of money into its new sales objectives. Yet it has little to show for the expense. Toys R Us spent $705 million, or 6.4% of sales, for property and equipment in 2001 as part of its store renovation exercise but got virtually no boost in sales for the trouble. In contrast, Wal-Mart spends about 4% of sales for property and equipment, and its sales are increasing at 15% or more per year. This leaves Toys R Us vulnerable to cash-flow shortages in the future if sales continue to flat-line.
Goldman Sachs, in a generally positive first-quarter report, noted that even though Toys R Us is generating incremental sales from its remodeling effort, the base off which it is building continues to sink. Specifically, sales at stores remodeled in 2001 rose 3.5% in the first quarter, outpacing unrenovated stores by 7 percentage points. But stores remodeled in 2000 posted net same-store declines and were disproportionately depressed by apparel sales at a time when many of its peers gained ground in the category.
The balance sheet looks stable, debt levels are consistent with its industry and solvency is not an issue. But its fair to worry that the companys debt-to-equity ratio has risen every year since 1997, to 0.22 from 0.11, reflecting investment costs that have not provided any advance in shareholder equity. At the same time, inventory turnover appears to be decreasing -- a bad sign for any retailer. In 1999, its inventory turned over every 86 days on average; in 2001, every 104 days. In the most recent four quarters, inventory stayed on shelves an average of 114 days, according to Vickreys calculations. For a company that has spent billions of dollars over the last few years to increase sales, this does not bode well, Vickrey says. In contrast, inventory averages 50 days for Wal-Mart, 77 days for Kmart, and 58 days for Target. Decreasing inventory turnover could be indicative of outdated inventory that might have to be charged off against earnings in the near future, the analyst warned.
Wheres the insider buying?
Despite the reasonable borrowing levels, bond-rating agencies Moodys and Standard & Poors have both recently revised the companys long-term debt and commercial paper ratings downward. S&P on May 28 said it cut Toys R Us senior rating to BBB, its second-lowest investment grade, because it believes the companys balance sheet will not improve significantly during 2002 due to the company's continuing store remodeling programs, the weak retail environment and intense competition in the toy retailing industry." This has the effect of increasing the companys future interest expenses, an impediment to growing earnings at the pace investors would prefer.
In fact, the debt downgrades are symptomatic of Toys R Us main problem: Its numerous restructurings, remodelings and alliances with the likes of Amazon.com (AMZN, news, msgs) -- largely done under the corporate rubric of Mission: Possible -- have simply failed to attract enough customers from the powerful discount department store chains, which use aggressive pricing on toys as a lure to encourage higher-margin sales elsewhere on their floors.
Meanwhile, the companys board of directors might not offer the sort of critical thinking investors would prefer during difficult times. Eyler, the chairman, is also company president and chief executive, so hes not independent. Director Charles Lazarus, the founder and a former chief executive, is not independent. Director Michael Goldstein, another former chief executive, is not independent. Three of the remaining seven directors have been on the board for a year or less, so their ability to influence decision-making may be rather slim.
If these directors are sure that their efforts will turn the company around, they certainly have not been expressing it with open-market purchases. Over the past 12 months, insiders have sold nearly 400,000 shares and purchased just 5,000. The strong selling during a period when the stock is resting near decade lows certainly does not inspire confidence.
Sally H. Wallick, a Legg Mason analyst who has called the twists and turns at Toys R Us better than any of her peers in the past five years, believes that all of these concerns reflect the past, not the future. She said she is hopeful that the new store formats will make the company more productive, and that, in the absence of disruptive new factors in the marketplace, the price will rise to $26 over the next 12 to 18 months from its current perch around $18 -- a 44% move.
Likewise, Nygren said he believes Eyler is in only the third year of a five-year turnaround at Toys R Us that will bring four key improvements: better top and middle management; a better shopping experience in every store; a better public perception; and better operating margins. He thinks the stock will sell for a P/E multiple in the mid-20s over the next three to five years and make $2 to $3 a share, suggesting the potential for a $60 price by 2007.
Color me skeptical. I doubt Toys R Us can distinguish itself enough with exclusive plush toys or educational specialty boutiques to meaningfully vanquish the discount department stores. So I will warily take on the big-cap value establishment and short the stock in our SuperModels watch portfolio if it gets to $19.50, with targets of $14 and $10, and a stop loss at $23.20 in case Im wrong.
Fine Print
To shop at Toys R Us online, visit its well-organized site at Amazon here. ... Nygren likes the chains spin-off Babies R Us stores, too, and thinks theyre worth at least $10 a share by themselves (click here). And click here to find a store near you, and determine whether the retail experience really has improved. Nygrens fund is up almost 2% so far this year; it has risen 4% annualized over the past three years and 9% over the past five years. . In the That-Didnt-Take-Long Department: Stocks listed as potential shorts in my Goodwill Asteroid column two weeks ago have fallen 5.3% as a group, paced by 30%, 20% and 12% declines by Tyco International (TYC, news, msgs) Argosy Gaming (AGY, news, msgs) and Georgia-Pacific (GP, news, msgs). On May 15, I warned that the iShares tracking the S&P Smallcap 600 BARRA Value Index (IJS, news, msgs) was slipping out of favor as it approached its 50-day moving average at around 95. It has plunged through that level and now sits at 91.20. (I no longer own it personally). Responding to my last column about StarMine and its predicted surprise model, Bryan Plumley, a senior financial adviser at First Union, wrote: In an efficient market, any widely published and accepted information will impact the market so quickly that it renders the information useless to the investor. If StarMine's strategy is effective, the attention you have just called to it may signal its demise just in time for thousands of your readers to plunk down their subscription fees. In a way, this is no different than the scenario you mentioned in your article. Twists the mind doesn't it?
While Jon Markman cannot provide personalized investment advice or recommendations, he invites you to send comments on his column to 7jonmail@microsoft.com. At the time of publication, Jon Markman owned none of the equities mentioned in this column.
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