The Toys “R” Us Lbo Case free essay sample

They want to determine the risks and merits of an investment in Toys R Us, evaluate the spectrum of returns using multiple operating model scenarios, and identify strategic actions that might be undertaken to improve the risk/return profile of the investment. Leverage Buyout (LBO) A leveraged buyout is the purchase of a company by an outside individual, another firm, or the incumbent management using large amounts of debt to finance the purchase. Most often, LBOs are undertaken by private equity firms that specialize in these transactions. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital. An LBO analysis determines the maximum purchase price for a business that can be paid based on certain leverage (debt) and equity return parameter, develops a view of the leverage and equity characteristics of a leveraged transaction at a given price, and calculates the minimum valuation for a company. The returns in an LBO are driven by three factors, which we demonstrate in our topic on creating value in LBOs, including the deleveraging (paying down debt), operational improvement (e. . , margin expansion, revenue growth), and multiple expansion (buying low and selling high). Both equity holder and debt holder bear a high risk. For equity holders, in addition to the operational risk assumed risk arises due to significant financial leverage. Interest costs resulting from substantial amounts of debt are fixed costs that can be defaulted if not paid. Furthermore, small changes in the enterprise value of a company can have a magnified effect on the equity value when the company is highly levered and the value of the debt remains constant. Other than these risks, the equity holder hopes to exit an investment within a five year time frame by either issuing IPO to sell to a strategic buyer or another PE fund, or recapitalization. If the equity holder is unable to exit or is delayed in exiting the investment, it has a negative effect on investor returns. The debt holders bear the risk of default equated with higher leverage as well. Since they have the most senior claims on the assets of the company, they are likely to realize a partial, if not full, return on their investment, even in bankruptcy. Industry dynamics The U. S. Retail Toy Industry is in the mature stage of its life cycle. The growth will likely remain stagnant. Sales were suffering from painful revenue losses during the recession. The Industry demand is heavily dependent on economic factors, dwindling consumer sentiment and disposable income pushed consumers to cut back on discretionary spending. The industry has come under increasing pressure from discount department stores and mass Merchandisers. Retailers have also experienced change due to the influx of imported goods into the market, which has stimulated competition within the industry. In addition, as children are getting older younger, age compression is changing the dynamics of toys and games. There is a clear shift from traditional toys and games to video games. Consumers are willing to pay more for toys that they view as being beneficial to children’s play or learning experiences. Toy industry categories with the largest revenue gains were building sets, arts amp; crafts, infant/preschool and Learning and Exploration. Plush, games/puzzles, vehicles and outdoor amp; sports toys experienced the most significant declines. There are several potential options for the company to improve performance. Having exclusive rights to sell certain toys can be an advantage, as large discount department stores generally carry the most popular products at low prices. Retailing the right product at the right season, like outdoor games in the spring, is important to maximize sales. The continual display and presentation of new toys, games and crafts will attract customers and generate higher sales. Looking into expanding operations and product lines towards video games and other growth segments (e. g. Building sets and action figures). Building up a well-designed online marketing channel can promote efficiency and cost savings. Expanding the international market to avoid the intense competition in the U. S. Retail Toy Industry. Closing underperforming stores to improve liquidity through the expertise of Vornado Realty Trust and reinvest the money back into the operation. Approach In the base case, we assumed 11. 0% compounded annual growth rate. This is based on modest growth in domestic sales, and optimistic expectations for the international, Babies R Us, and online sales. Online sales can save relevant costs of physical display of products and associated costs of running a store. EBITDA margin is assumed higher and will be higher in the near future as the sales grow. Capital expenditure and depreciation amortization expenses are assumed fairly constant over the years . Overall operation will generate enough cash to support debt and interest payments. If Toys R Us would be able to specialize some of baby products, video games and pertain exclusive right to offer popular products, it will help boost sales. International, and online sales will turn out good as well. We assumed 16. 5% of compounded annual growth for the upside case. For the downside case, with a compounded annual growth rate of -4. %, the company will not be able to make interest payments later years. This case suggests that the company will highly likely default on its debt obligation. Conclusion Referring to the adjusted balance sheet close after acquisition for the fiscal year ended as of January, 2005, the total debt of the company was 6,712 million dollars. The total debt-to-EBITDA multiples reached 8. 61x high. We dont think the high total debt-to-EBITDA multiple will be a big problem since the multiples will decrease year by year based on our assumptions. In the base case, if exit multiple is 8. 00, the sponsor return including initial fees will be 4,820. million dollars. The return on investment will be 37. 7%. (Exhibit B) In the upside case, the sponsor return including initial fees will be 7,320. 4 million dollars with a higher ROI of 47. 6%, assume that exit multiple remains the same. (Exhibit C) In the downside case, the LBO sponsors probably wont exit after a 5-year period ending 2010 because they cannot pay all debt and add more value to the firm. Even if they sell the company at 10. 00 x, they will still lose money. (Exhibit D) Even though the base case and the upside case could provide nice returns, we don’t want to join the consortium. The risks are too high in the downside scenario. Exhibit A Prioritized Due Diligence List Items Requested| Reasons| Financial auditAnnual income statements, balance sheets, and cash flow statement (last five years)Year to date income statement amp;Current balance sheetCompany’s Properties List ProjectionsDetailed revenue/expenses amp; cash flow/use of funds (12 months)Future capital expendituresFive year summary projections| Access current and historical info to determine overall financial â€Å"health†. Confirmation that the business is what it appears to be. Determine candidates for favorable real estate transaction to boost cash flow. See future sales growth, cost management, and cash flow issues with Toys R Us business. Access future cash needs for growth. | Marketing auditCustomer lists –brief description of target customers in key markets. Interviews with store managers about sales processes and roadmaps. | Ensure future profitability. | Production auditMonthly Toys’ Inventory audit (last three years)Store Visits| To understand the overall stability of toys and how seasonality impact profitability. Verify existing operation and look for inefficiencies. Macro-environment auditIndustry growth trendsInterview with industry expertsOther successful LBOs in the industry| Impact of outside threats and competitions from rivals. Possible exit multiple projection. | Legal/environmental auditBylawsArticles of IncorporationMinutes of all Board of Directors, committee and shareholders meetings and all consents to actions without mee ting. All employment agreements and consultant agreementsAny pending legal actions on Toys R Us and/or felony convictions of its employeesList necessary regulatory approvals and requirements/timeline to achieve. Interview with state / federal government officials| Gain information that will be useful for valuing assets, defining representations and warranties, and/or negotiating price concessionsIdentify potential deal killer defects in the target and avoid a bad business transaction. Understand industry trends and potential governmental involvement down the road. | Management auditFull resumes for key personnelInterviews with Management Team amp; Board MembersInterviews with Company advisors| To understand strengths and backgrounds of each manager. Decide who to keep / who to fire. Dig into company culture. Seek outsiders’ point of view on the company. | Information systems auditList of Legacy systems used| | Compatibility auditIntegration PlanList existing investors and their contact information | Details on execution and different phases of the LBO. Verification that the transaction complies with investment or acquisition criteria. | Reconciliation auditFinal Plan Evaluation| A formal valuation to test whether LP values will be added and where synergies could be generated. | Exhibit B Return Summary (Base Case) Exhibit C Return Summary (Upside Case) Exhibit D Return Summary (Downside Case)