KKR & Toys "R" Us: Valuations

Dennis Berman recently wrote a piece in the Wall Street Journal on KKR's (and co-owners) imminent floating of an IPO for Toys "R" Us.

The failed toy chain had been sold to a group of private equity firms on the advice of management, which, five years ago, contended that the company's future performance had,

"been adversely impacted by significant developments in the retail toy industry."

The private equity shops hope to sell the retooled toy firm to public investors for something in the range of 1.5 times the $6.6B it cost the group to buy Toys R Us in 2005.

According to the IPO's prospectus, the toy firm's new management, under the private equity group, had performed major surgery on expenses. These are activities that tend to be one-off actions. You can't close the same store twice, multiplying the savings.

Berman frames the interesting question in the last paragraphs of his column,

"The question for future Toys "R" Us investors is whether there are still improvements and opportunities for left for the company which is in a notoriously competitive, low-margin business.

But the bigger challenge will be about setting the narrative. Do investors really want to play in the KKR sandbox? Toys "R" Us will be an important way to find out."

Precisely.

I've never found comfort in corporate performances which are the result of one-time, radical cost-cutting. Rather, my proprietary research provided me with evidence that consistent performance, over time, is worth far more to shareholders.

Given the earlier troubles of Toys "R" Us having been blamed on industry structure and practices, Berman is right on target to wonder why that would have changed. And why new, public investors would be any better off, over time.

In fact, this is the key point. A point with which I struggled for years, before my research confirmed my suspicions.

Buying an equity right after someone else has extracted huge value from restructuring is asking for trouble. If a management has managed for maximum shareholder gain, as the Toys "R" Us management surely has done for is private equity owners, why would you believe there is continuing value creation left?

If there were, why would KKR and its co-owners be selling all of Toys "R" Us?

It's rather like buying the Goldman Sachs IPO. Why would you buy equity when the smartest guys in the room are selling from their private supply of the stuff?

That's essentially what is occurring with Toys "R" Us. Everyone who has been associated with the failed toy firm from its purchase by the private equity group, until now, has likely been compensated on the IPO price.

Not an equity price of the firm five years from now.

Berman is correct to note the immense risk that any new Toys "R" Us shareholders run in buying the IPO. They won't have the leverage which KKR & Co. had when they owned the failed company. Worse, they'll be buying after the largest value extraction at Toys "R" Us in something like a decade.

About The Kodak-KKR Financing Deal

I read of the Kodak-KKR financing deal yesterday with mixed feelings. It wasn't until today, reading another, more analytical piece in the Wall Street Journal, that I settled on a final opinion of the matter.

It seems to me that Kodak's CEO and senior management are probably guilty of some poor corporate governance behavior.

In retrospect, the Journal's Thursday edition headline, "Kodak Gets Financial Lifesaver from KKR," should have immediately tipped me off. Yet another management team of a publicly-held company enriches lenders at the expense of its own shareholders.

The way the deal is structured, KKR comes out much like Warren Buffett in his GE financing deal. KKR gets a 10% rate on its loan of up to $700MM, warrants that are already in the money, and senior status to all other Kodak debt.

The article, and this morning's analysis, note that KKR has, predictably, feathered its nest on both the upside and downside. They get a hard 10% income stream and the best protection available on the balance sheet. If Kodak miraculously improves its condition, KKR then gets to convert warrants to own up to 20% of the company.

You have to ask, as I did this morning, reading that second piece, out of whose hide do these generous terms come?

Why, the Kodak shareholders', of course. And I didn't notice any changes in management compensation. You know, like tying bonuses or large parts of salaries to Kodak's total return.

No, the management is basically rolling the dice with their owners' money, after having pissed away so much of it over the past five years, as I noted in this recent post.

Schumpeterian dynamics, as I noted in that post, have gutted this company's ability to function in a manner that would deliver its shareholders consistently superior total returns.

What does management do? Does it explore avenues to reap gains on sale of assets to those who could more profitably use them? Or at least stem the losses? No.

Instead, they are doubling down with borrowed money. Expensively-borrowed money, at that. Paying 10% in an era of 0% Fed funds.

Am I the only person who wonders why those choosing to remain as shareholders in this hapless has-been aren't suing to block the KKR deal?

As for me, I simply don't own this pig.

KKR Demonstrates Why Public Banks Don't Need Capital

Thursday's Wall Street Journal carried a detailed piece on KKR's preparation for a larger, broader role in the financial services sector.

For now, according to the article, the firm is adding syndication of its own investment assets and infrastructure finance as new businesses.

Whether the private equity shop actually goes public seems less material to me than that they demonstrate what I contended in this recent post.

Why should we think KKR will stop with these few new businesses? Once they build a larger infrastructure to manage a broader range of financial units, can basic loans, various types of equity underwriting, and asset management be far behind?

Having moved to wean itself from the simple leverage buyouts for which KKR became famous in the 1980s, there wouldn't seem to be a natural stopping point.

Of course, with each new business will come some more watering-down of returns, competition for capital and expense dollars, more resources spent managing the internal efforts of the businesses, etc. Which will gradually mean lower returns on a larger income stream for partners.

But in the meantime, wouldn't it make more sense for KKR to just hire the necessary people, raise capital and do the businesses which make sense, than to buy into badly-managed banks, commerical or investment, which are publicly-held and in bad shape?