Dec 20 - Fitch Ratings has downgraded the Issuer Default Ratings (IDR) for Toys 'R' Us, Inc. (Toys) and its various subsidiary entities to 'B-'. The Rating Outlook is Stable. A full list of rating actions follows at the end of this release.
The 'B-' IDR reflects Toys' weaker than expected comparable store sales (comps) performance year-to-date and the overhang of refinancing 2013 maturities, which Fitch had initially expected would be completed done by November. Fitch has concerns that the weak third quarter comps trend could continue in the critical holiday selling season and into 2013 and place pressure on margins. More than 40% of Toys' sales and over 70% of its EBITDA are typically generated in the fourth quarter.
TOP LINE DECELERATION
Toys' top-line sales are under increasing pressure with comps for the domestic and international segments at negative 2.8% and 4.7% in the first nine months of 2012, respectively, versus negative 1.7% and 2.7% for the full year 2011. The rate of decline has accelerated in each of the last three quarters, with comps declining 4.1% in its domestic business (60% of sales) and 4.6% in its international business in the third quarter.
Top line weakness is being primarily caused by continued weakness in the entertainment (approximately 13% of domestic and 12% of international sales) and juvenile categories (approximately 37% of domestic and 22% of international sales). Fitch expects the entertainment category which is going through structural changes will continue to face headwinds, while the juvenile category is being hurt by a decline in birth rates over the past few years. In addition, the overall toys category faces intensified pricing competition from discount and online retailers.
While Toys is the only remaining national brick-and-mortar specialty toy retailer in the U.S., it has muddled along against increasing competition from discounters and online retailers for the more commodity-type toy products. Toys' multi-channel strategy, coupled with recently implemented product and service initiatives including price match guarantee for the holidays, could potentially alleviate some top-line pressure. However, Fitch believes that it will be expensive and difficult for Toys to compete on pricing and retain its market share without sacrificing margins given its heavy cost structure. As a result, Fitch expects limited benefit from these initiatives on the company's top line and profitability in the near term.
Besides the sluggish domestic business, Fitch recognizes the challenging economic and capital market conditions in the major European markets (revenues generated between U.K. and Central Europe accounted for almost 17% of the consolidated revenue in 2011). This creates uncertainties in the refinancing process and could add pressure to operations going forward.
LEVERAGE EXPECTED TO CREEP UP
Fitch expects Toys' leverage (adjusted debt/EBITDAR) will remain in the low-6.0x in 2012 if EBITDA is essentially flat to last year. This assumes that top line is in the negative 3 - 4% range for the fourth quarter as well as some modest gross margin improvement.
However, with a weakening sales outlook and lack of 53rd week benefit, Fitch' expects that Toys' EBITDA could dip to the low to mid $800 million range over the next 24 months. As a result,
leverage could potentially creep up to the high-6.0x to the low-7.0x assuming some debt repayment as Toys completes the European refinancings. Coverage (operating EBITDAR/gross interest expense plus rents) is expected to be in the range of 1.3x - 1.4x. This assumes comps decline at 2%-3% at both the domestic and international segments and modest gross margin improvement. Assuming selling, general, and administrative (SG&A) expenses grow modestly in the flat to 1% range, Fitch expects a negative impact on the operating margin.
LIQUIDITY ADEQUATE ALTHOUGH FCF DEPENDENT ON WORKING CAPITAL IMPROVEMENT
Toys' weak top-line performance has pressured EBITDA and free cash flow (FCF) generation. FCF over the last two years has also been adversely affected by the continued challenge of managing working capital efficiently. Besides some timing related issues, the company has gotten stuck with excess inventory in the last two holiday seasons. As a result working capital was a use of cash of $485 million in 2010 and $273 million in 2011.
Toys has been addressing some of these issues more aggressively this year and inventory at the end of the third quarter was down 2.1% year over year (versus +5.9% in 3Q'11). Therefore, if working capital is flat overall this year - a significant improvement from the last two years - Fitch expects Toys to generate $200 million - $250 million in FCF in 2012. There could be some downside to these projections if comps are in the negative mid-single digit range.
Beyond 2012, Toys would need to be working capital neutral to enable the company to generate modest FCF of $40 million-$50 million. Fitch estimates that breakeven EBITDA is around $750 million assuming interest expense of $440 million - $450 million (based on the new capital structure with higher interest rates offset by some debt paydown), capital expenditures of $300 million - $325 million and neutral working capital.
While successfully refinancing the HoldCo notes due April 2013, Toys still has $896 million of European real estate facilities due between February and April 2013. This constitutes: $79 million French; $163 million Spanish and $654 million UK real estate credit facilities. Given the tough CMBS markets, Fitch expects Toys to be able to issue significantly less debt against the same collateral.
However, Toys has $557 million of liquidity at HoldCo, comprised of upstreamed dividend from Toys 'R' Us -Delaware (including the proceeds from the borrowings of a $225 million incremental term loan) that can be applied towards any unrefinanced balance of the European real estate facilities. Fitch expects Toys to address all its refinancing needs by the maturity dates, although it remains an overhang.
Assuming the successful refinancing of the remaining 2013 maturities, Toys has adequate liquidity with $399 million of cash and cash equivalents and $1.8 billion of availability under its various revolvers as of Oct. 27, 2012.
RECOVERY ANALYSIS AND CONSIDERATIONS
The ratings on the specific securities reflect Fitch's recovery analysis using a going concern approach. This analysis is used to determine expected recoveries in a distressed scenario to each of the company's debt issues and loans.
Below is a summary organizational structure (details are provided at the end of the press release) for the purpose of the recovery analysis:
Toys 'R' Us, Inc. (HoldCo)
(I) Toys 'R' Us-Delaware, Inc. (Toys-Delaware) is a subsidiary of HoldCo.
(a) Toys 'R' Us Canada (Toys-Canada) is a subsidiary of Toys-Delaware.
(b) Toys 'R' Us Property Co. II, LLC is a subsidiary of Toys-Delaware.
(II) Toys 'R' Us Property Co. I, LLC is a subsidiary of HoldCo.
Consolidated Stressed EBITDA
In estimating Toys' EV for recovery purposes, Fitch has used a going-concern approach. Toys' debt is at three types of entities: operating companies (OpCo); property companies (PropCo); and the holding company (HoldCo), as described below.
At the OpCo levels -- Toys-Delaware, Toys-Canada, and other international operating companies -- LTM EBITDA (as of Oct. 27, 2012) is stressed at 15%. Fitch has assigned a 5.5x multiple to the stressed EBITDA, which is consistent with the low end of the 10-year valuation for the public space and Fitch's average distressed multiple across the retail portfolio. The stressed EV is adjusted for 10% administrative claims.
Toys-Canada: Toys has a $1.85 billion secured revolving credit facility with Toys-Delaware as the lead borrower, and this contains a $200 million sub-facility in favor of Canadian borrowers. Any assets of the Canadian borrower and its subsidiaries secure only the Canadian liabilities. The $200 million sub-facility is more than adequately covered by the $472 million in calculated EV based on a stressed EBITDA of $86 million. Therefore, the fully recovered sub-facility is reflected in the recovery of the consolidated $1.85 billion credit facility discussed below.
The residual value is applied toward debt at Toys-Delaware.
Toys-Delaware: In allocating $2.1 billion of calculated stressed EV (which includes the recovery on the Canadian sub-facility, approximately $238 million in residual value from Canada, and no residual value from PropCo II) at Toys-Delaware across the various tranches of debt, Fitch ascribes a higher priority to the senior secured credit facility, due to its first lien tangible security package over the term loans and 7.375% senior secured notes.
The $1.85 billion credit facility is secured by a first lien on inventory and receivables of Toys-Delaware and its domestic subsidiaries. In allocating an appropriate recovery, Fitch has considered the liquidation value of domestic inventory and receivables assumed at seasonal peak (at end of the third quarter), corresponding to peak borrowings of $1.725 billion ($1.85 billion minus the $125 million in minimum excess availability).
Fitch assumes peak domestic inventory levels of $2.25 billion and receivables of $85 million, for recovery purposes and has applied liquidation values of 70% and 80%, respectively. This liquidation value of $1.5 billion is applied toward the secured revolver, in addition to the approximately $200 million recovered on the Canadian sub-facility. As a result, the facility is fully recovered and is therefore rated 'BB-/RR1'.
The recovery value of the debt structure below the first lien revolver comprises two components: (1) excess EV at the Toys-Delaware level (EV at Toys-Delaware minus liquidation value of assets) and (2) equity residual value from Canada. The component (1) is fully applied toward the $1.325 billion loans and $350 million 7.375% senior secured notes, while the component (2) is applied across the capital structure (excluding the fully recovered revolver).
This results in recovery prospects of 11% - 30% for the term loans and the secured notes, which are therefore rated 'CCC+/RR5'. The term loans due 2016 and 2018, and the senior secured notes due 2016, are secured by a first lien on intellectual property rights and a second lien on accounts receivable and inventory of Toys-Delaware and its domestic subsidiaries.
The 8.75% debentures due Sept. 1, 2021, have poor recovery prospects and are therefore rated 'CCC/RR6'.
At the PropCo levels - Toys 'R' Us Property Co. I, LLC; Toys 'R' Us Property Co. II, LLC; and other international PropCos - LTM NOI is stressed at 15%. The ratings on the PropCo notes reflect a distressed capitalization rate of 12% applied to the NOI of the properties to determine a going-concern valuation. The stressed rates reflect downtime and capital costs that would need to be incurred to re-tenant the space.
Applying these assumptions to the $725 million 8.50% senior secured notes at PropCo II and $950 million 10.75% senior unsecured notes at PropCo I results in recovery well in excess of 90%. Therefore, these facilities are rated 'BB-/RR1'.
The PropCo I unsecured notes benefit from a negative pledge on 351 properties while the PropCo II notes are secured by 129 properties. PropCo I and PropCo II are set up as bankruptcy-remote entities with a 20-year master lease covering all the properties, which requires Toys-Delaware to pay all costs and expenses related to the ownership.
Toys 'R' Us, Inc. - HoldCo Debt
The $450 million 10.375% unsecured notes due Aug. 15, 2017, and the $400 million 7.375% unsecured notes due Oct. 15, 2018, benefit from the residual value at PropCo I. There is no residual value ascribed from Toys-Delaware or other operating subsidiaries. This results in average recovery prospects of 31%-50% and the bonds are therefore rated 'B-/RR4'.
WHAT COULD TRIGGER A RATING ACTION
A negative rating action could result if:
--If comps trends in the U.S. and international businesses continue to be in the negative 4% - 5% range, and indicate market share losses that would cause leverage to increase meaningfully and/or lead to tightened liquidity over the next two years, particularly during its peak working capital season;
--FCF is significantly weaker than Fitch's expectation, either due to weakening EBITDA trend or continued lack of efficiency in managing working capital;
A positive rating action could result if:
--There is sustainable improvement in the business as a result of the company's new product and service initiatives which help drive improved store and online traffic, and curb share losses. The company would need to improve EBITDA to the $1.1 billion range and leverage to the high 5.0x range.
--In addition, management will need to prove their ability to manage working capital effectively over the next two years to ensure FCF generation.
Fitch has downgraded Toys as follows:
Toys 'R' Us, Inc. (HoldCo)
--IDR to 'B-' from 'B';
--Senior Unsecured Notes to 'B-/RR4' from 'B/RR4'.
Toys 'R' Us - Delaware, Inc. is a subsidiary of HoldCo
--IDR to 'B-' from 'B';
--Secured Revolver to 'BB-/RR1' from 'BB/RR1';
--Secured Term Loans to 'CCC+/RR5' from 'B-/RR5';
--Senior Secured Notes to 'CCC+/RR5' from 'B-/RR5';
--Senior Unsecured Notes to 'CCC/RR6' from 'CCC+/RR6'.
Toys 'R' Us Property Co. II, LLC is subsidiary of Toys 'R' Us -Delaware, Inc.
--IDR to 'B-' from 'B';
--Senior Secured Notes to 'BB-/RR1' from 'BB/RR1'.
Toys 'R' Us Property Co. I, LLC is a subsidiary of HoldCo
--IDR to 'B-' from 'B';
--Senior Unsecured Notes to 'BB-/RR1' from 'BB/RR1'.
The Rating Outlook is Stable.