Toys in the Attic: Talk of Dayton Hudson Deal Sparks Toys R Us Rally

It doesn't take much to get an aging, slowing toy retailer to jump 7% in less than three hours of trading.

Talk that Dayton Hudson(DH Quote) was willing to pay $27 a share, or 69% above Tuesday's closing price, to play with Toys R Us (TOY Quote) did just that Wednesday, even as the rationale for the purported deal raised eyebrows all over Wall Street.

The chatter, accompanying a presentation Toys R Us executives made during a Gerard Klauer Mattison conference, sparked an early rally that eventually saw the stock rise 6.2% Wednesday to close at 16 1/8. Dayton Hudson shares dropped 1/2 to close at 63 3/16. Thursday, they were up nearly 6%, or 15/16, at 17 1/8.

Toys in the Options Pit

Beginning early in Wednesday's session, call-option buyers started "coming out of the woodwork," says one Chicago options trader. That typically signals some type of speculation that a company is in play.

In this case, the trader says, it was difficult to determine why the call-buying ramped up, jacking the price of the November 17 1/2 calls to 1/2 ($50) from a slim 3/16 ($18.75). That essentially means that some investors saw a good chance for Toys to trade higher than 18 a share by Nov. 19, when November options expire.

But the Internet and its often capricious dissemination of rumors make it tougher to read options. Smart money, a.k.a. insider trading, has been replaced by people who've picked up tips at any of the Net roadside outposts. So are the options feeding the rumor? Or are the rumors feeding the options?

Naturally, both Dayton Hudson and Toys R Us officials declined to comment on rumors.

Sure, Toys R Us isn't in the best shape, and yep, Dayton Hudson doesn't sell many toys. But before we go chasing a takeover tale into personal bankruptcy, let's consider some of the other themes out there, which don't give much credence to the promise of a deal.

Sense and Sensibility

Analysts and investors say they see little logic in such a marriage, save for the potential for Dayton Hudson to break Toys R Us into more shareholder-friendly pieces, or to convert Toys R Us stores into Target locations.

"On the surface, it doesn't make a lot of sense," says Margaret Whitfield, an analyst with Tucker Anthony who rates Toys R Us a hold. (She doesn't follow Dayton Hudson. Her firm hasn't performed underwriting for Toys R Us or Dayton Hudson.) "With the emergence of e-commerce and the competitive pressures from Wal-Mart (WMT Quote), Toys R Us would be a tough sell."

But, Whitfield continues, a buyer of Toys R Us could unlock value by breaking up the company. Problems at the flagship Toys R Us stores, she says, are masking growth in other areas.

Sales at Toys R Us domestic and international units grew by a scant 6% to $1.8 billion in the quarter ended July 31. Operating earnings for the period plunged 20% to $44 million. This summer, Chief Executive Robert Nakasone resigned amid mounting pressure to improve the company's weakening position in Toyland.

Meanwhile, Babies R Us, which focuses on supplying first-time parents with a one-stop shop, is seeing "tremendous growth," Whitfield says. "There's no competitor quite like it." Toys R Us considers the division, with 121 stores, too small to report its sales separately.

Yet unlocking the value in Babies R Us presents problems in that "Babies R Us is intrinsically tied to Toys R Us, if in name and nothing else," says Jeff Matthews of Ram Partners, a hedge fund that holds no position in Toys or Dayton Hudson.

A Different Spin

Toys R Us does plan to spin off its e-commerce unit, toysrus.com, which recently signed marketing deals with Yahoo! (YHOO Quote), America Online (AOL Quote) and Microsoft (MSFT Quote).

But investors may not see the pop in Toys R Us stock that they'd expect, Matthews warns. "Very rarely do e-commerce spinouts translate into value for mixed-breed retailers," notes Matthews, who points to Barnes & Noble(BKS Quote) and Petsmart(PETM Quote). Barnes & Noble shares, for instance, are down more than 20% since its May spinoff of barnesandnoble.com (BNBN Quote).

Ironically, investors have long wished that Dayton Hudson, Minneapolis, would sell its department stores and Mervyn's division to unlock value in the Target discount store chain. Despite comments made last year that Dayton Hudson would consider alternatives if Mervyn's sales failed to improve within 12 months, the company "remains committed to our three divisions," says Susan Eich, a spokeswoman. "We are satisfied with Mervyn's performance."

Toys Rn't Us

On a more fundamental level, toys have never been Dayton Hudson's bag, so to speak, accounting for less than 10% of Target's sales in the most recent fiscal year. Eich, the spokeswoman, says the company doesn't break out sales by category.

As at rival Wal-Mart, toys are seasonal items for Target. The chain tends to make a big push around the holidays and then scales back its toy offerings through the remainder of the year. One Dayton Hudson shareholder who declined to be named points out that if Target intended to become a big dealer in toys, it has the clout with vendors to purchase and merchandise the products on its own.

All of which leads Matthews, the hedge fund manager, to question: "Why would Dayton Hudson want a chain that's so troubled?"

That's just what we were thinking.

Hit of the Week: Proving the ol' broken clock theory, StockRumors.com reported that Air Express International (AEIC Quote) was on the block. This week, the company confirmed it's negotiating unspecified "transactions" with third parties.

Miss of the Week: The following dispatch came across JagNotes' rumor section: "Oct. 26 11:22 a.m. Citicorp Group (C Quote) Rumors circulating that at 12 noon today company will announce that they are looking to buy MER (MER Quote), price unknown." Uhhhh, no. But the company did announce something with some guy named Rubin. He used to be a trader or something.