Toys ‘R’ Us Investors Show Doubt of Repayment: Corporate Finance

Toys “R” Us Inc. is paying the highest yields among 16 issuers of CCC+ rated bonds as investors grow dubious the retailer with three years of falling profit will repay or refinance $2.85 billion of debt due through 2016.

The company’s $450 million of 10.375 percent notes maturing in August 2017 yield 15.9 percent, 9.69 percentage points more than the average for the top tier of CCC bonds in the Bank of America Corp. U.S. High Yield Super Retail Index. A 15 percent yield indicates a 33 percent risk of default within one year, according to Martin Fridson, chief executive officer of FridsonVision LLC, a New York research firm specializing in high-yield debt.

Toys “R” Us stands at the brink almost nine years after KKR & Co., Bain Capital LLC and Vornado Realty Trust took it over in a $6.6 billion 2005 leveraged buyout as competition intensifies from more diversified retailers such as Wal-Mart Stores Inc. and online vendors including Inc. The yield on the 2017 notes rose from 7.44 percent in May as net income at the world’s largest toy-store chain turned negative on a trailing 12-month basis in each of the last two quarters, making it harder to service $5.6 billion of debt.

The company’s earnings declined each year since 2010, to $963 million in the period ended Feb. 2, according to data compiled by Bloomberg.

‘Legacy Debt’

“Our expectation is that sales growth will be difficult, based on earnings they reported in the first nine months and a tough holiday season for retailers in general in the U.S. in the fourth quarter,” Ana Lai, an analyst at S&P in New York, said in a telephone interview. “Its capital structure has always been onerous and highly leveraged because of the legacy debt from the leveraged buyout.”

Toys “R” Us saw sales fall to $7.28 billion in the 39 weeks ended Nov. 2 from $7.77 billion for the comparable 2012 period, according to a Dec. 17 regulatory filing. The company’s net loss expanded to $829 million from $201 million.

Its ratio of debt to earnings before interest, taxes, depreciation and amortization for the year that ends Jan. 31 is expected to increase to the low- to mid-6 times area, according to S&P, from 5.2 times 12 months earlier.

“The company has a successful track record of refinancing and, at this time, has no outstanding debt repayments due until 2016, providing a large window to grow and develop new strategic initiatives,” Kathleen Waugh, a spokeswoman for Wayne, New Jersey-based Toys “R” Us, wrote in an e-mailed statement.

2016 Maturities

The company has a $647 million term loan and $358 million of 7.375 percent notes that come due on Sept. 1, 2016, according to the filing.

A $1.85 billion asset-backed credit line, which had $497 million of borrowings outstanding at Nov. 2, expires August 2015, according to the filing.

Credit-default swaps protecting Toy “R” Us debt rose to 1,515 basis points yesterday from as low as 567 basis points in May, according to prices compiled by data provider CMA, which is owned by McGraw-Hill Financial Inc. and compiles prices quoted by dealers in the privately negotiated market. That means it now costs $1.51 million a year to protect $10 million of the toy seller’s debt for five years.

“Toy’s capital structure is not viable” given its earnings, Barclays Plc analysts led by Hale Holden wrote in a Dec. 20 report. Refinancing the debt due in 2016 may prove “difficult/contentious,” they wrote.

Standard & Poor’s lowered its grade on Toys “R” Us senior unsecured debt to CCC from CCC+ and the company to B- from B last month.

‘Promotional Environment’

“We lowered the rating mid-last month after earnings,” said S&P’s Lai. “We think sales will remain pressured as the company faces more competitive pressure due to the promotional environment.” Its main rivals are Wal-Mart and Amazon, according to Lai.

Moody’s Investors Service grades Toys “R” Us’s unsecured bonds Caa1, one step higher than S&P, after a June reduction, and has a B2 corporate grade on the borrower with a “stable” outlook.

“We take a longer-term view than a CDS price or a bond price. We’re looking out years, not days, not weeks,” Charlie O’Shea, a credit analyst at Moody’s in New York said in a telephone interview. “I can’t recall a period in time when the company has had less debt to refinance for an extended time period than it does now. Toys has executed debt refinancings in difficult environments in the past and there are two-plus years before the 2016s come due.”

Baby Furniture

Fitch Ratings gives Toys “R” Us a B- grade. The 2017 bonds hold a Bloomberg Composite rating of CCC+, equivalent to the Moody’s ranking.

“With three consecutive quarters of at least double-digit declines, and a bump up in revolver usage ahead of the holiday quarter, the weak year to date results are beginning to take a meaningful toll,” analyst James Goldstein at debt research firm CreditSights Inc., wrote in a Dec. 18 report.

The roots of Toys “R” Us date back to 1948, when 25-year-old Charles Lazarus opened a baby furniture store that started focusing on toys in 1957. The company adopted the name Toys “R” Us and went public in 1978. It established the Babies “R” Us brand in 1996.

The retailer sells merchandise in about 879 stores in the U.S. and more than 705 international locations in 35 other countries, according to its website.

Holiday Sales

U.S. retail sales rose 2.7 percent this holiday season, the smallest increase since 2009, according to researcher ShopperTrak. Customer traffic in November and December declined 15 percent from the similar period a year earlier, the Chicago-based firm said today.

Toys “R” Us’s $450 million of 10.375 percent notes due in August 2017 last traded at 86.5 cents on the dollar on Dec. 20, according to Trace, the bond price reporting system of the Financial Industry Regulatory Authority. The notes are the second-highest yielding obligations of all 86 constituents in the Bank of America index, behind RadioShack Corp.’s lower-rated $324.8 million of 6.75 percent notes due in May 2019 at 18.33 percent.

The toy retailer’s $400 million of 7.375 percent bonds that expire in October 2018 fell to 73.75 cents yesterday, to yield 15.3 percent.

Not ‘Cavalier’

“It’s not a fair presumption to make that we are cavalier about rating agencies or bond prices,” Clay Creasey, chief financial officer, said on a Dec. 20 teleconference with analysts and investors to discuss third-quarter earnings. “We consider those to be outcomes and not inputs to the business process. If we spend all day staring at the bond price, it would probably be worse.”

The company’s $975 million term loan that matures in August 2019 fell to 96.313 cents on the dollar today, from a high of 100.125 cents on the dollar on Aug. 7, according to prices compiled by Bloomberg.

Toys “R” Us made permanent the interim appointment of Antonio Urcelay as chief executive officer in November, and it hired Hank Mullany, who previously worked for ServiceMaster Co. and Wal-Mart, as president.

“This new leadership team along with the existing management group and the sponsors who own Toys ‘‘R’’ Us are totally dedicated to managing the business in such a manner as to optimize our performance in the quarters and years ahead,” Creasey said.

Price Competition

While Toys “R” Us, trying to preserve profitability, has resisted cutting prices, it risks losing market share. The company’s online toy prices were 7.8 percent above Wal-Mart’s and 11.1 percent above Amazon’s, excluding third-party sellers, according to a Nov. 14 online toy price study by Bloomberg Industries.

The world’s biggest toy retailer’s strategy to increase revenue at its toy stores has been to combine some of them with Babies “R” Us and invest in its web operations.

“These defensive strategies sound strategically correct but have had limited impact on alleviating the top-line pressure thus far,” according to Isabell Hu, an analyst at Fitch ratings. “It will be expensive and difficult for Toys to compete on pricing and improve market share without sacrificing margins given its heavy cost structure.”

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