Fitch Downgrades Toys' HoldCo Notes; Affirms IDR at 'CCC'
NEW YORK--(BUSINESS WIRE)--Fitch Ratings has downgraded the issue ratings on Toys 'R' Us, Inc.'s (Toys, HoldCo) $450 million 10.375% senior unsecured notes due August 2017 and $400 million 7.375% senior unsecured notes due October 2018 to 'CCC-/RR5' from 'CCC/RR4'. Fitch has also affirmed the Issuer Default Ratings (IDRs) on Toys 'R' Us, Inc. and its various domestic subsidiaries at 'CCC'. A full list of rating actions follows at the end of this press release.
Toys has provided better clarity in its recent 8-K filing dated June 18, 2014 related to its intercompany loans between HoldCo and Toys 'R' Us-Delaware, Inc. (Toys-Delaware). These include $783 million in long-term notes payable to Toys-Delaware by HoldCo and $316 million in short-term loans due from Toys-Delaware to HoldCo as of Feb. 1, 2014. Previously, Toys-Delaware only disclosed $777 million of intercompany receivables due from HoldCo and affiliates as of Feb. 1, 2014, which included $265 million of long-term loans made to HoldCo in 2012. The nature of these long-term loans as well as the remaining payable from HoldCo to Delaware was not disclosed.
In its recent 8-K, Toys disclosed that HoldCo had issued $783 million of notes due to Delaware between 2005 and 2012 - and that all of the notes are documented, unsecured and include a market rate of interest. In addition, Toys stated that the $206 million notes issued in FY 2012 are expressly subordinated in right of payment to the senior obligations of Holdco, which implies that the remaining $577 million are pari passu with the $850 million HoldCo notes. Therefore, any recovery value allocated to these public bonds would now need to be prorated with the $577 million senior notes due to Toys-Delaware.
While Toys-Delaware has $316 million short-term loans due to HoldCo, Fitch does not assume HoldCo can effectuate a setoff against their long-term obligation to Toys-Delaware. The short-term unsecured loans at Toys-Delaware are used to fund seasonal working capital needs and therefore considered unsecured claims that rank below all the secured debt at Toys-Delaware. In addition, Fitch does not believe that HoldCo can net these current assets against their debt due to Toys-Delaware because any liquidation proceeds from the HoldCo assets would need to pay down both the $850 million HoldCo notes and the $577 million notes due to Toys-Delaware on a pro rata basis.
KEY RATING DRIVERS
Fitch's ratings on Toys reflects the company's deteriorating top-line and EBITDA trends, increasing risk of market share loss and weakening liquidity position.
While Toys reported comparable store sales (comps) growth at 4% and 1% in first quarter 2014 for its domestic and international segments, respectively, Fitch believes these were due to easy comparisons with the comps of negative 8.4% and negatively 5.8% in first quarter 2013. Fitch expects Toys' comps will remain under pressure declining by low single digits for its domestic and international segments in the next 12-18 months. The company has seen sales decline in its major categories such as juvenile (approximately 30% of Toys' total sales) and sustained weakness in the entertainment category (11% of total sales) due to low birth rates and secular pressure.
The company faces intensified pricing competition from both discount and online retailers. Despite Toys' multichannel strategy and series of product and service initiatives, Fitch believes it will be expensive and difficult for Toys to compete on pricing and retain its market share without sacrificing margins.
Fitch estimates that Toys would need to stabilize sales and modestly improve its gross margin to generate adequate EBITDA at the $650 million level to cover annual interest expense assumed at $360 million, capex of $250 million and modest cash taxes. However, achieving this level is likely challenging without significantly lowering its cost structure and controlling inventory levels. Fitch expects 2014 EBITDA to be in the $450 million-$500 million range, assuming a low/single digit comps decline and gross margin decline of 20 bps-50 bps. Fitch expects limited reduction of SG&A expense in the near term as the company is committed to allocating the modest cost savings toward further investments in its online strategy and improving store presentation and service.
Fitch expects leverage (adjusted debt/EBITDAR) to increase to the 9x level and FCF to be negative $250 million, excluding significant working capital swings in 2014 and 2015. Availability under the ABL revolver during peak working capital season is expected to be around $700 million in 2014 and $500 million in 2015. This indicates adequate liquidity for the next 18 months but liquidity concerns increase in 2016 given more than $1 billion of debt maturities.
RECOVERY ANALYSIS AND CONSIDERATIONS
Fitch has conducted a recovery analysis across Toys' organizational structure to determine expected recoveries in a distressed scenario to 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 is a subsidiary of Toys-Delaware.
(II) Toys 'R' Us Property Co. I, LLC is a subsidiary of HoldCo.
Fitch has assigned a 5.0x-5.5x multiple to the stressed EBITDA at the OpCo levels - Toys-Delaware and Toys-Canada - 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 has a $1.85 billion asset-based revolving credit facility (ABL revolver) 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 EV calculated based on stressed EBITDA at the Canadian subsidiary. Therefore, the fully recovered sub-facility is reflected in the recovery of the consolidated $1.85 billion revolver discussed below.
The residual value is applied toward debt at Toys-Delaware.
At the Delaware level, the recovery on the various debt tranches is based on the liquidation value of the assets estimated at $2.1 billion, approximately $115 million recovery against the $577 million of intercompany loans to HoldCo, and the equity residual from Canada estimated at $210 million.
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 assumed at seasonal peak (at the end of the third quarter), and has applied advance rates of 75% and 80%, respectively. Fitch currently assumes $1.3 billion (or approximately 70% of the facility commitment) drawn under the revolver at the peak season in 2015 based on Fitch's projections of EBITDA and liquidity needs. The facility is fully recovered and is therefore rated 'B/RR1'.
The recovery value of the debt structure below the first lien revolver is derived from three components: (1) excess liquidation value at the Toys-Delaware level (liquidation value after the full recovery of ABL revolver); (2) estimated value for Toys' trademarks and intellectual property assets (IP, which are held at Geoffrey, LLC (IPCo) as a wholly owned subsidiary of Toys-Delaware); and (3) equity residual value from Canada. Components (1) and (2) are fully applied toward the senior secured term loans and 7.375% secured notes, while 3) is applied across the capital structure.
The $1.24 billion term loans due 2016 and 2018 and the $350 million senior secured notes due 2016 are secured by a first lien on the IP and a second lien on the ABL revolver collateral. They are assumed to have recovery prospects of 51%-70%, which reflects excess value from the credit facility collateral as well as some modest valuation of the IP assets, and are therefore rated 'CCC+/RR3'.
The 8.75% debentures due Sept. 1, 2021, have poor recovery prospects and are therefore rated 'CC/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 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, 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 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 well 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 (343 properties as of May 4, 2013). Fitch typically limits the Recovery Rating on unsecured debt at 'RR2' or two notches above the IDR level (under its criteria 'Recovery Ratings and Notching Criteria for Non-financial Corporate Issuers' dated Nov. 20, 2013). 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.
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, currently estimated at approximately $300 million. There is no residual value ascribed from Toys-Delaware or other operating subsidiaries. Prorating the residual value against the $577 million senior notes due to Toys-Delaware that are considered pari passu with the publicly traded HoldCo notes translates into below-average recovery prospects of 11%-30% for the bonds which are therefore rated 'CCC-/RR5'.
A negative rating action could result if comps trends in the U.S. and international businesses continue to be in the negative 4%-negative 5% range and/or gross margins decline by similar rates to 2013 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 months.
A positive rating action could result if there is sustainable improvement in Toys' store and online traffic, indicating improved market share positioning, and meaningful cost restructuring. Toys would need to drive EBITDA improvement to a level where it can meet fixed obligations and fund any working capital swings, and manage refinancing of upcoming debt maturities on a timely basis.
Fitch has affirmed the following ratings except for downgrading the issue rating of the HoldCo notes as follows:
Toys 'R' Us, Inc. (HoldCo)
--IDR at 'CCC';
--Senior unsecured notes downgraded to 'CCC-/RR5' from 'CCC/RR4'.
Toys 'R' Us - Delaware, Inc. is a subsidiary of HoldCo
--IDR at 'CCC';
--Secured revolver at 'B/RR1';
--Secured term loans at 'CCC+/RR3';
--Senior secured notes at 'CCC+/RR3';
--Senior unsecured notes at 'CC/RR6'.
Toys 'R' Us Property Co. II, LLC is subsidiary of Toys 'R' Us -Delaware, Inc.
--IDR at 'CCC';
--Senior secured notes at 'B/RR1'.
Toys 'R' Us Property Co. I, LLC is a subsidiary of HoldCo
--IDR at 'CCC';
--Senior unsecured term Loan facility at 'B/RR1'.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (May 28, 2014);
--'Recovery Ratings and Notching Criteria for Nonfinancial Corporate Issuers' (Nov. 20, 2013);
--'Recovery Rating and Notching Criteria for Equity REITs' (Nov. 19, 2013).
Applicable Criteria and Related Research:
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage
Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers
Recovery Ratings and Notching Criteria for Equity REITs