September 6, 2017 / 7:25 PM / 2 years ago

Fitch Affirms Toys 'R' Us' IDR at 'CCC'

(The following statement was released by the rating agency) NEW YORK, September 06 (Fitch) Fitch Ratings has affirmed the Issuer Default Ratings (IDRs) for Toys 'R' Us, Inc. (Toys, or the Holdco), Toys 'R' Us - Delaware, Inc., Toys 'R' Us Property Co. I, LLC and TRU Taj LLC at 'CCC'. Fitch has also upgraded the Toys-Delaware B-4 term loan to 'B-/RR2' from 'CCC+/RR3' and withdrawn the IDR of Toys 'R' Us Property Co. II, LLC. A full list of rating actions follows at the end of this release. KEY RATING DRIVERS Long-Term Headwinds: EBITDA (Fitch calculated) at $734 million in 2016 was essentially flat to 2015 levels versus $597 million in 2014. The improvement from 2014 levels was supported by approximately $325 million in SG&A savings. However, Fitch expects EBITDA to decline to $600 million-$650 million in 2017 given same-store sales declines of 3.5%-4.0% (on a consolidated basis) and gross margin pressure as the company clears excess inventory from the 2016 holiday season. Toys ended 2016 with domestic inventory up 10% year over year, which will put significant gross margin pressure at least through first-half 2017. Long term, we believe Toys faces both competitive and secular headwinds, and the company will continue to be a share donor. Toys has faced a multi-decade onslaught of competition from discounters such as Wal-Mart Stores, Inc. and Target Corporation, and more recently, online-only players such as, Inc., leading to market share losses. Fundamental characteristics of the toy industry, including its seasonality, hit-driven nature, and low importance of sales assistance and inviting in-store experience, continue to make it attractive for the discount and online channels to take share. Fitch believes Toys needs to invest further to improve its price perception and build out its omnichannel infrastructure. Its current online penetration, at approximately 16.8% and 13.0% of domestic and total revenue in 2016, respectively, lags the overall industry, especially in its core categories. Fitch estimates online penetration is in the low- to mid-20% range domestically in Baby and Core Toys. However, even with these investments Fitch is not confident the company will be able to stabilize share over the medium term given the level of investments needed relative to a constrained balance sheet. Fitch consequently expects same store declines to persist in the negative low single digit range and for EBITDA to be range bound in the $550 million to $650 million range. At these EBITDA levels, Toys will not be able to grow out of its capital structure and will largely remain dependent on favorable credit markets to refinance debt on an ongoing basis. Significant and Ongoing Refinancing Ahead: Toys has approximately $3.5 billion of debt due through 2020: $450 million of debt due in 2018, $1.7 billion in 2019 (excluding the $1.85 billion revolver) and $1.3 billion due in 2020 at various entities. Toys will primarily have to refinance with existing collateral that already supports the debt tranches as well as some excess liquidity, given the absence of material unencumbered assets. The $450 million of debt maturities coming due in 2018 consists of a EUR 48 million French PropCo facility due February 2018, $208 million of Holdco notes due October 2018 and $186 million of B-2/B-3 term loans due May 2018. We expect the French PropCo facility to largely remain intact and be secured by the same nine properties; this facility was already downsized from EUR 65 million when it was last refinanced in February 2013 against the same assets. Fitch expects the $208 million of 7.375% Senior Unsecured Holdco notes to be paid down through future exchanges into other debt or by transferring cash from various operating entities through restricted payment and investments baskets. A successful take-out of the 2018 Holdco Notes has the potential to make available assets (103 properties valued at approx. $570 million by Cushman & Wakefield in September 2016) on which there is a limitation on liens under the bond indenture. (Fitch has not allocated the value of these assets to any debt in its recovery analysis. Please see the Recovery Analysis and Considerations section for more details.) The B-4 term loan lenders have a springing first lien on these assets post the repayment of the Holdco notes and Fitch believes Toys could use these assets to negotiate with B-4 term lenders for an add-on or a more comprehensive refinancing plan to address the B-2/B-3 term loan maturities. The B-2, B-3 and B-4 term loan holders are equally secured by Toys intellectual property (IP) and trademarks (and have a second lien on the ABL collateral) but the B-4 term loan also benefits from an unsecured guaranty by the indirect parent of PropCo I and is secured by a first-priority pledge on two-thirds of the Canadian subsidiary stock. To the extent that B-4 lenders are over-collateralized with the addition of a first lien against the 103 Delaware properties, Toys may be able to effect a $200 million to $400 million add on to address the B-2/B-3 term loans as well as Holdco maturities. The inability to successfully negotiate with the B-4 term loan lenders could potentially lead to the B-2/B-3 term loans being refinanced with debt secured by a pro rata share of IP assets, which is the existing collateral for these loans. The remainder of the $3.5 billion debt due through 2020 is primarily secured by real estate. Refinancing prospects will depend on credit market conditions as well as updated real estate market valuation although we note that underlying properties were appraised and a significant portion of upcoming debt was put in place over 2012-2016. Real estate valuations since that time period largely remain the same or have modestly improved, although valuations could be impacted by recent weakness in the retail sector and the related square foot rationalization. DERIVATION SUMMARY Toys' CCC rating reflects the long-term competitive and secular headwinds faced by the company that have led to meaningful top-line and EBITDA declines and questions regarding long term competitive viability. As a result of these trends and a high debt load post its 2005 LBO, the company faces ongoing refinancing risk. Other single category retailers such as Best Buy (BBB-/Stable), The Gap (BB+/Stable) and Kroger (BBB/Stable) have also faced secular pressures but have been able to largely stem declines as a result of their ability to invest in their businesses due to lower leverage profiles and strong cash flow generation. Difference in category fundamentals has also prevented these retailers from experiencing the level of market share erosion to discount/online channels as seen with the toy category. Sears Holding Corporation (CC), like Toys, faces market share erosion but its significant cash burn yields heightened liquidity and refinancing risk versus Toys. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: --Fitch assumes comps remain in the negative low to mid-single digits in 2017 and be in the negative low single digits range thereafter. --EBITDA is expected to decline to around $600 million to $650 million in 2017, from 2016's level of $734 million, and remain rangebound thereafter. --Annual FCF is expected to be in the negative $80 million to $100 million range, absent any swings in working capital. FCF was negative $265 million in 2016 given a negative working capital swing of approximately $315 million. Barring refinancing needs, Fitch views liquidity available under its credit facilities as adequate to fund the upcoming 2017 and 2018 holiday seasons. --Leverage is expected to increase to the low to mid 8x over the next 24-36 months versus the 7x range in 2015/2016. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action A positive rating action could result from sustainable improvement in Toys' same-store sales trends, which would indicate stable and/or improved market share, while continuing to generate EBITDA at a level where the company is generating FCF. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action A negative rating action could result if same-store sales in the U.S. and international businesses revert to midsingle-digit declines and/or gross margins decline meaningfully without any offset from cost reductions. This would indicate more severe market share losses and lead to tighter liquidity than Fitch's current expectation over the next 24 months. The inability to refinance ongoing debt maturities starting 2018 would also be a rating concern. LIQUIDITY Adequate Liquidity: Toys held $301 million of cash ($35 million at Toys 'R' Us - Delaware, Inc.) and $252 million of availability under its various revolvers as of April 29, 2018, including $176 million available under its domestic $1.85 billion facility. Fitch views liquidity as adequate to fund the upcoming 2017 and 2018 holiday seasons. Recovery Analysis and Considerations For issuers with IDRs at 'B+' and below, Fitch performs a recovery analysis for each class of obligations. Issue ratings are derived from the IDR and the relevant Recovery Rating (RR) and notching based on expected recoveries in a distressed scenario for each of the company's debt issues and loans. Toys' debt is at three types of entities: operating companies (OpCo); property companies (PropCos); and HoldCos, with a structure summary as follows: 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. (II) TRU Taj LLC, an indirectly owned subsidiary of Holdco. (a) Toys 'R' Us Property Co. I, LLC (PropCo I) is a subsidiary of TRU Taj. OpCo Debt Fitch takes the higher of liquidation value or enterprise value (EV, based on 5.0x multiple applied to the stressed EBITDA) at the OpCo levels: Toys-Delaware and Toys-Canada and the international entities that provide a stock pledge to the debt at TRU Taj. The 5.0x is consistent with the 5.4x median multiple for retail going concern reorganizations but at the low end of the 12-year retail market multiples of 5x-11x, and below 7x-12x for retail transaction multiples. The stressed EV is reduced by 10% for administrative claims. Toys-Canada Toys has a $1.85 billion ABL revolver with Toys-Delaware as the lead borrower, and this contains a $200 million subfacility in favor of Canadian borrowers. Assets of the Canadian borrower and its subsidiaries secure only the Canadian liabilities (including the Canadian portion of the first in, last out term loan). The $200 million subfacility is more than adequately covered by the EV calculated based on stressed EBITDA at the Canadian subsidiary. The stressed EBITDA of $80 million assumes ongoing revenues of $800 million and a 10% EBITDA margin, which is in line with the average over the last five years. Therefore, the fully recovered subfacility is reflected in the recovery of the consolidated $1.85 billion revolver discussed below. The residual value of approximately $220 million is applied toward the FILO term loan and B-4 term loan. Toys-Delaware At the Toys-Delaware level, recovery on the various debt tranches is based on liquidation value of domestic assets rather than a going concern enterprise value. To derive a going concern enterprise value of $1.5 billion, Fitch assumes a going concern EBITDA of $310 million valued at a 5x multiple. This assumes (i) ongoing domestic EBITDA of $230 million based on revenue of $5 billion (an approximately 35% discount to current Toys-Delaware revenues (ex. Canada) of $7.1 billion) operating at a 5% EBITDA margin and (ii) $80 million of IP royalty fees that Toys charges its international businesses and third parties. In deriving a liquidation value of domestic assets of $1.9 billion at Toys Delaware, Fitch considered the liquidation value of domestic inventory and receivables assumed at seasonal peak, at the end of the third quarter, and applied typical advance rates of 70% and 80%, respectively, and estimated value for Toys' IP assets, which are held at Geoffrey, LLC as a wholly owned subsidiary of Toys-Delaware. In addition, the B-4 term loan benefits from the equity residual from Toys-Canada and from an unsecured guarantee from the indirect parent of PropCo I. Fitch's liquidation analysis did not include any valuation for plant, property and equipment (excluding Propco I and Propco II) because of the lack of transparency regarding the value of these properties. At the end of 2016, Toys operated 879 domestic stores of which 318 units are held at Propco I and 123 units are held at Propco II leaving 438 units at Toys Delaware. The mix of leased versus owned (included ground leases) is unclear although on Oct. 24, 2016, Toys filed an 8K disclosing that 103 Toys-Delaware properties (88 ground leased locations where Toys owns the building and 15 owned locations) were appraised by Cushman and Wakefield at $568 million. As mentioned previously, the B-4 term loan lenders have a springing first lien on these assets post the repayment of the Holdco notes, and Fitch believes Toys could use these assets to negotiate with B-4 term lenders for an add-on or a more comprehensive refinancing plan to address the B2/B3 term loan maturities. The $1.85 billion revolver is secured by a first lien on inventory and receivables of Toys-Delaware. Fitch assumes $1.3 billion, or approximately 70%, of the facility commitment is drawn under the revolver. The facility is fully recovered and is therefore rated 'B/RR1'. The FILO term loan is secured by the same collateral as the $1.85 billion ABL facility and ranks second in repayment priority relative to the ABL. The FILO tranche is governed by the residual borrowing base within the ABL facility and benefits from a lien against 15% of the estimated value of real estate at Toys-Canada. The facility is rated 'B/RR1' based on outstanding recovery prospects (91%-100%), as it benefits from the excess liquidation value of domestic inventory and A/R. The $1 billion B-4 term loan and the $186 million of B-2 and B-3 term loans have a first lien on all present and future IP, trademarks, copyrights, patents, websites and other intangible assets, and a second lien on the ABL collateral. The B-4 term loan also benefits from an unsecured guaranty by the indirect parent of PropCo I and is secured by a first-priority pledge on two-thirds of the Canadian subsidiary stock. After prorating the value of the IP assets (estimated at $350 million), the residual equity in Toys-Canada and applying the benefit from the guaranty by the indirect parent of PropCo I, the B-4 term loan is expected to have superior recovery prospects (71%-90%), and is therefore upgraded to 'B-/RR2' from 'CCC+/RR3'. The $186 million in remaining B-2 and B-3 term loans are rated 'CCC/RR4', as they are expected to have average recovery prospects (31%-50%), mainly from their prorated claim against the IP assets. The $22 million 8.75% debentures due Sept. 1, 2021 have poor recovery prospects (0%-10%) and are therefore rated 'CC/RR6'. Valuation of IP Toys' IP assets held at Geoffrey, LLC are the first lien collateral backing the senior secured term loans issued at Toys-Delaware. The annual license fees paid by HoldCo's international subsidiaries were $64 million as of Jan. 28, 2017, a decline from $102 million in 2012. In addition, Toys generated $16 million in license fees from third parties for a total of $80 million in licensing fees in 2016. In terms of valuing the IP, Fitch applied a 4.0x-5.0x multiple to these royalty streams from Toys' international subsidiaries (excluding Canada) and third parties to arrive at a value of $350 million. While the multiple paid could potentially be better, resulting in a higher IP valuation, there could also be further downward pressure on the royalty stream itself given weakness in its international businesses. PropCo Debt At the PropCo levels (PropCo I and other international PropCos) LTM net operating income (NOI) is stressed at 20%. PropCo I is set up as bankruptcy-remote entity with a 20-year master lease through 2029 covering all the properties within the entities, which requires Toys-Delaware to pay all costs and expenses related to leasing these properties from these two entities. The ratings on the PropCo debt reflect a distressed capitalization rate of 12% applied to the stressed 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. The 12% capitalization rate reflects the exposure to a single tenant versus a more diversified portfolio. As a reference the Fitch CMBS Large Loan Rating Criteria typically uses default cap rates of 8.5% to 11.25%. Applying these assumptions to the $866 million senior unsecured term loan facility at PropCo I results in outstanding recovery prospects (91%-100%) and the facility is therefore rated 'B/RR1'. The PropCo I unsecured term loan facility benefits from a negative pledge on all PropCo I real estate assets, which includes around 320 properties (318 stores, three distribution centers and headquarters). As described above, the residual value of approximately $334 million after fully recovering the $866 million term loan at PropCo I is applied toward the Toys-Delaware B-4 term loan via an unsecured guaranty by the indirect parent of PropCo I. TRU Taj LLC Debt The $583 million notes due 2021 are secured by a stock pledge in certain international subsidiaries, including guarantors of the European ABL, and the EBITDA attributed to TRU Taj was $173 million in 2016, calculated on a covenant basis. Fitch applied a 5.0x multiple to each entity's EBITDA (stressed at 20% from current levels to reflect the secular headwinds in the category), subtracted out any entity-level debt, and then applied the remaining value against the $583 million notes. This resulted in average recovery (31%-50%), and the notes are therefore rated 'CCC/RR4'. Toys 'R' Us, Inc. - HoldCo Debt The $208.3 million 7.375% unsecured notes due Oct. 15, 2018 (and the $741 million senior notes due to Toys-Delaware that are considered pari passu with the publicly traded HoldCo notes) have poor recovery prospects (0%-10%) because there is no residual value flowing in from the wholly owned subsidiaries. Therefore, they are rated 'CC/RR6'. FULL LIST OF RATING ACTIONS Fitch has affirmed the followings ratings: Toys 'R' Us, Inc. --IDR at 'CCC'; --Senior unsecured notes at 'CC/RR6'. Toys 'R' Us - Delaware, Inc. --IDR at 'CCC'; --Secured revolver at 'B/RR1'; --Secured FILO term loan at 'B/RR1' --Secured B-2 and B-3 term loans at CCC/RR4'; --Senior unsecured notes at 'CC/RR6'. Toys 'R' Us Property Co. I, LLC --IDR at 'CCC'; --Senior unsecured term Loan facility at 'B/RR1'. TRU Taj LLC --IDR at 'CCC'; --Senior secured notes at 'CCC/RR4'. Fitch has upgraded the following rating: Toys 'R' Us - Delaware, Inc. --Secured B-4 term loan to 'B-/RR2' from 'CCC+/RR3'. Fitch has withdrawn the following rating: Toys 'R' Us Property Co. II, LLC --IDR at 'CCC'. Contact: Primary Analyst Monica Aggarwal, CFA Managing Director +1-212-908-0282 Fitch Ratings, Inc. 33 Whitehall Street New York, NY 10004 Secondary Analyst JJ Boparai Associate Director +1-212-908-0543 Committee Chairperson Michael Weaver Managing Director +1-312-368-3156 Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below: --Historical and projected EBITDA is adjusted to exclude restructuring and related charges. For example, in fiscal 2016, Fitch adjusted EBITDA for $43 million in charges related to asset impairment and gains on sale of assets --Fitch has adjusted the historical and projected debt by adding 8x yearly operating lease expense. 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