Fitch Affirms Toys 'R' Us, Inc.'s IDR at 'CCC'
KEY RATING DRIVERS
Secular/Competitive Pressures Dampen Revenue Growth:
Secular issues in the baby and entertainment product categories, which comprise roughly 40% of Toys' revenues, underpin Fitch's expectations for generally flat to modestly negative consolidated comparable store sales (comps) growth through the medium term. Domestic comps have been positive in only two of the last 12 quarters, hampered by the company's increased (41%) exposure to the secularly challenged baby (newborns and children up to four years old) and entertainment (video game software, systems and accessories) categories. Internationally these categories are less than 30% of revenues. On a constant currency basis, international comps have been positive in the 1% to 3% range in each of the past six quarters, benefitting from exposure to action figures and construction toys within the core toy and learning categories as well as net sales from new locations. These two categories comprise more than 50% of international revenues.
For the most part, Toys is a slow growth developed market story with less than 10% of revenues in markets with high birth rates and relatively rapid increases in per capita income. More than 80% of sales are in the U.S., Europe and Japan. The population is shrinking in continental Europe and Japan (21% of 2014 revenues) with fertility rates under the 2.1 times needed to maintain a stable population. The U.S. growth rate is also shrinking, helping to limit the market for categories dependent on this population such as Toys' baby category (baby clothes, joggers, diapers etc.).
Competitive intensity and channel shift adds to the secular issues. The ongoing encroachment by discount formats and the rise of ecommerce, particularly in the U.S., has contributed to a channel shift from traditional specialty brick and mortar toy retailers eating into this shrinking category. Additionally, there is a global secular decline in the video game market from physical purchases in the brick and mortar retailers to subscription and digital downloads. Per the NPD Group (NPD), dollar sales for U.S. computer and videogames purchased at physical retail stores have dwindled to 34% in 2014 from 44% in 2012. Toys has also been disadvantaged by having to maintain a large physical footprint year-round and bearing high levels of inventory risk compared to most competitors. With this, Fitch's expectation for sustained positive top line momentum is muted.
Comp Variability Modest So Far:
Fitch expects comps to be flat to down 2% in the near term. Despite the secular pressure on revenue growth (except for 2013 when discounting, inventory clearance and write-downs had an outsized negative impact on revenues), consolidated comps on a constant currency basis has been modest thus far. Comps have been between -2.1% and +2.1% over the past five years. While the first half is not representative of this highly seasonal company's performance, first half 2015 consolidated performance has been in line with historical levels with -1% or less.
Positively, annual comp store sales have improved sequentially from -5.2% in 2012 to flat at 2014. Domestic comps have been a trouble spot with negative results in each of the past four quarters. That is not expected to abate, though there could be a modest uptick in 4Q2015 as the NPD Group expects robust 6.2% growth for traditional toys this year after many years at essentially flat levels. This should be helpful even if the company does not grow as fast - signifying market share loss - but it should still enjoy some part of the category lift. If the company can keep comps essentially flat to modestly negative and with costs declining at a much faster pace, margins and FCF should improve.
Highly Seasonal Profits and FCF:
Almost all of Toys' profits and FCF are generated in the fourth quarter. As with all seasonal companies, including the traditional toymakers, poor performance in one or more holiday seasons can begin a cascade of negative impacts including discounting through vendors tightening trade terms. Toys' leveraged capital structure limits its financial flexibility.
Periodic Foreign Exchange Volatility:
A side effect of Toys' 40% geographic diversity will be periods of currency volatility with translation creating moderate short-term swings in revenues and margins. The U.S. Dollar's strength has negatively impacted revenue growth and reduced profits in each of the past three years and through the first half of 2015. Translation negatively impacted EBITDA margins by almost 100bps in 2014 and 150bps in the first half of this year. Translation increased leverage (Total Adjusted Debt/EBITDAR) by approximately a half of a turn up to the 8x seen in 2014. The spread is even wider at the LTM. Based on current Bloomberg forecasts, average exchange rates for the Euro, Yen and Sterling are expected to be flat in 2016, which should minimize the currency impact on Toys' next year. There is also potential for an upside to gross margins with the August 2015 3.5% devaluation of the Chinese Yuan, but it would be modest next year as Toys' private label brands sourced and manufactured in China account for only 14% of products sold.
EBITDA/Leverage to Improve:
Despite the pressure on revenues the firm has taken two key actions, which Fitch anticipates should result in improved profitability if holiday revenues increase to the 2% range in 4Q2015. The first is a more rational approach to promotional activity, although it has meant some decline in comp store sales growth domestically. The second is reducing costs by \\$196 million to date with a goal of \\$325 million with the Fit For Growth program. As a result, Fitch expects EBITDA margins to improve to the 6% range over the next two years from the 4.5% average of the past two years. EBITDA is also anticipated to be in the \\$700 million range over the next two years from an average of \\$560 million. EBITDA growth based on cost savings further buttressed by less F/X translation in 2016 and less demand for growth based CAPEX as major projects such as side by side and flat debt is expected to result in lower leverage of around half a turn to the 7.5x range.
KEY ASSUMPTIONS
--Flat to modestly negative comps to the -2% range;
--F/X will be in the -5% range in 2015, after tracking at -5.5% in the first half of this year, leading to overall revenue declines of nearly the same amount before moderating in 2016;
--EBITDA margin improvement to the 6% range over the next two years with FCF steady in the \\$70 million range over the comparable period.
RATING SENSITIVITIES
Positive Rating Action: A positive rating action could result if there is sustainable improvement in Toys' domestic comp and online traffic, which indicates stable and/or improved market share. The company's ability to maintain the benefits of cost savings is also required. Toys would need sustainable positive FCF in the \\$100 million range to enable it to fund moderate to meaningful levels of its financing requirements (including working capital) from internally generated cash flow. These steps are viewed as base requirements to comfortably refinance its debt maturity wall in 2017.
Negative Rating Action:
Toys' inability to extend or refinance its \\$450 million 10.375% million senior notes and the \\$725 million 8.25% senior secured notes before they become current in August and December 2015 would be of concern, potentially prompting a negative rating action.
Additionally, a negative rating action could result if comps trends in the U.S. and international businesses revert to mid-single 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 18-24 months.
LIQUIDITY
Adequate Near-Term FCF:
FCF has been uneven over the past four years but has averaged approximately \\$90 million but was as high as \\$269 million last year. Toys was able to wring out significant improvements in working capital over the past two years, but those benefits are not expected to remain high going forward. FFO from operations will improvement strongly from the -\\$28 in 2013 and \\$215 million in 2014 to \\$235 million. However, lower working capital benefits are likely to leave FCF steady in the \\$70 million range over the next two years.
The company's liquidity remains adequate under a scenario of flat to positive FCF which is expected in the next two years barring a marked under-performance from Fitch's forecasts during holiday 2015. At Aug. 1, 2015 Toys' liquidity was \\$914 million comprised of \\$417 million in cash, which Fitch views as unrestricted and available to pay down debt and \\$497 million in availability under the \\$1.85 billion ABL. However, in 2017 Toys has a \\$450 million 10.375% senior note and a \\$725 million, 8.5% senior secured notes maturing. Refinancing prospects may be heavily contingent upon holiday performance.
ISSUE RATINGS BASED ON RECOVERY ANALYSIS
For issuers with IDRs at 'B+' and below, Fitch performs a recovery analysis for each class of obligations of the issuer. Issue ratings are derived from the IDR and the relevant Recovery Rating and notching based on the expected recoveries in a distressed scenario of each of the company's debt issues and loans. Toys' debt is at three types of entities: operating companies (OpCo); property companies (PropCo); and HoldCo, with a summary structure highlighted below:
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 (PropCo II) is a subsidiary of Toys-Delaware.
(II) Toys 'R' Us Property Co. I, LLC (PropCo I) is a subsidiary of HoldCo.
OpCo Debt
Fitch takes the higher of liquidation value or enterprise value (based on 5.0x-5.5x multiple applied to the stressed EBITDA) at the OpCo levels - Toys-Delaware and Toys-Canada. The 5.0x-5.5x is consistent with the low end of the 10-year valuation for the public retail space and Fitch's average distressed multiple across the retail portfolio. The stressed enterprise value (EV) is adjusted for 10% 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. Any assets of the Canadian borrower and its subsidiaries secure only the Canadian liabilities, besides 65% of Canadian real estate which secures the whole facility (with 50% toward the Canadian subfacility and 15% applied toward the domestic ABL and FILO term loan). The \\$200 million subfacility is more than adequately covered by the EV calculated based on stressed EBITDA at the Canadian subsidiary. Therefore, the fully recovered subfacility is reflected in the recovery of the consolidated \\$1.85 billion revolver discussed below.
The residual value of approximately \\$200 million is applied toward the ABL revolving facility and term loan.
Toys-Delaware
At the Toys-Delaware level, the recovery on the various debt tranches is based on the: liquidation value of the domestic assets at the Toys-Delaware level estimated at over \\$1.5 billion; estimated value for Toys' trademarks and IP assets, which are held at Geoffrey, LLC as a wholly owned subsidiary of Toys-Delaware; equity residual from Toys-Canada; and the benefit to the B-4 term loan from an unsecured guarantee from the indirect parent of PropCo I.
The \\$1.85 billion revolver is secured by a first lien on inventory and receivables of Toys-Delaware. In allocating an appropriate recovery, Fitch has considered the liquidation value of domestic inventory and receivables at the seasonal peak at the end of the third quarter, and has applied advance rates of 75% and 80%, respectively. 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 and the recovery on the Canadian real estate.
The \\$1,025 million B-4 term loan benefits from the same credit support as the existing B-2 and B-3 term loans, which includes 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. It 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 ascribed 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 good recovery prospects (51%-70%), and is therefore rated 'CCC+/RR3'.
The \\$200 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'.
PropCo Debt
At the PropCo levels - PropCo I, PropCo II and other international PropCos - LTM net operating income (NOI) is stressed at 20%.
PropCo I and PropCo II are set up as bankruptcy-remote entities 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.
Applying these assumptions to the \\$725 million 8.50% senior secured notes at PropCo II and the \\$985 million senior unsecured term loan facility at PropCo I results in recovery in excess of 90%. Therefore, these facilities are rated 'B/RR1'.
The PropCo II notes are secured by 125 properties. The PropCo I unsecured term loan facility benefits from a negative pledge on all PropCo I real estate assets, which includes around 340 properties. Fitch typically limits the recovery rating on unsecured debt at 'RR2' or two notches above the Issuer Default Rating (IDR) level (under its criteria Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers, dated June 12, 2015). However, in the few instances where the recovery waterfall suggests an 'RR1' rating and such a recovery rating is supported by the structural and legal characteristics of the debt, unsecured debt may qualify for an 'RR1' rating. In addition, the rating also benefits from the structural consideration that Toys 'R' Us has limited capacity to secure debt using real estate given that there is a limitation on principal property of domestic subsidiaries at 10% of consolidated net tangible assets under the
\\$400 million of 7.375% notes due 2018 issued by HoldCo.
As described above, the residual value of \\$300 million after fully recovering the \\$985 million term loan at PropCo I is applied towards the Delaware B-4 term loan via an unsecured guaranty by the indirect parent of PropCo I.
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, no longer benefit from the residual value at PropCo I and there is no residual value ascribed from Toys-Delaware or other operating subsidiaries. Therefore the HoldCo debt and the \\$577 million senior notes due to Toys-Delaware that are considered pari passu with the publicly traded HoldCo notes have poor recovery prospects (0%-10%) and are rated 'CC/RR6'.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following 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-4 term loan at 'CCC+/RR3'
--Secured B-2 and B-3 term loans at CCC/RR4';
--Senior unsecured notes at 'CC/RR6'.
Toys 'R' Us Property Co. II, LLC
--IDR at 'CCC';
--Senior secured notes at 'B/RR1'.
Toys 'R' Us Property Co. I, LLC
--IDR at 'CCC';
--Senior unsecured term Loan facility at 'B/RR1'.
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