Fitch Downgrades Toys' IDR to 'CCC' and Revises Recovery Ratings

Fitch Ratings has downgraded the Issuer Default Ratings (IDRs) on Toys 'R' Us, Inc. and its various domestic subsidiaries to 'CCC' from 'B-'. A full list of rating actions follows at the end of this press release.

KEY RATING DRIVERS

Toys 'R' Us' (Toys)'s holiday comparable store sales (comps) for the nine weeks ended Jan. 4, 2014 at negative 4.7% for domestic operations and negative 3% for the international segment mirror the weak trends over the past few quarters. Fitch does not expect a turnaround in the business given sustained weakness in the juvenile (approximately 30% of Toys' total sales) and entertainment categories (11% of total sales) and increasing competitive pressure on the traditional toy categories (including core toy and learning products, together representing 45% of total sales).

As a result, Fitch expects mid-single comps declines and EBITDA in the $600 million range in 2013, assuming gross margin declines in the fourth quarter remains in the 100 basis point range (as posted through the first three quarters) as the company clears out excess inventory. FCF is expected to be in the negative $200 million-$250 million range in 2013 reflecting the debt refinancing related costs (approximately $50 million) and modest cash taxes but exclude significant working capital swings that could be a further drain on cash.

Fitch estimates that Toys would need to stabilize sales and modestly improve its gross margin to generate breakeven EBITDA at the $650 million level and be FCF neutral, assuming annual cash interest expense of $360 million, capital expenditures of $250 million and modest cash taxes. However, achieving this level is likely to be challenging in the face of a declining top line unless Toys is able to manage inventory levels more effectively to generate better gross margin or reduce SG&A expenses (that have been flat since 2010). Every 1% reduction in SG&A dollars could contribute approximately $40 million in cost savings. However, Fitch currently assumes SG&A will remain relatively flat as management to date has not outlined any strategy to restructure its cost base in spite of top line decelerating around 10% relative to the 2010-2011 levels.

As a result, Fitch currently projects EBITDA to be in the range $450-$500 million in 2014 and potentially lower in 2015, assuming a decline in annual comps of 2%-3% and gross margin decline of 25 basis points to 50 basis points.

Under this scenario, leverage (adjusted debt/EBITDAR) is expected to increase to the low-9x range and FCF is expected to be negative $150 million-$250 million before any working capital swings. The cash shortfall should cause increased revolver borrowings over the next 24 months. Availability under the ABL revolver during peak working capital season was $1.1 billion in 3Q13, and Fitch expects no borrowings at the end of January 2014. However, Fitch expects that this cushion will narrow in 2014 with year-end (January 2015) revolver borrowings expected to be in the $300 million range.

Availability at peak inventory season is expected to be in the $800-$900 million range in 2014 and $500-$600 million range in 2015. This indicates adequately liquidity for the next 24 months but raises concerns for 2016, particularly given that over $1 billion in debt comes due ($652 million of second lien term loan B-1 facility and $350 million of 7.375% second lien senior secured notes both issued at Toys-Delaware and due September 2016).

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 the holding company (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.

OpCo Debt

Fitch has assigned a 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-Canada

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.

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 and the equity residual from Canada estimated at $200 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 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'.

PropCo Debt

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 126 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. This translates into average recovery prospects of 31%-50% and the bonds are therefore rated 'CCC/RR4'.

RATING SENSITIVITIES

A negative rating action could result if comps trends in the U.S. and international businesses continue to be in the negative 4%-5% range beyond 2013 and/or gross margins decline by similar rates to 2013, without any offset from cost reductions. This could indicate more severe market share losses and lead to tighter liquidity than Fitch's current expectation over the next two years.

A positive rating action could result if there is a sustainable improvement in Toys' store and online traffic (indicating improved market share positioning) and the company restructures its cost base. Toys would need to drive EBITDA improvement to a level where it can meet fixed obligations and fund any working capital swings, as well as manage refinancing of upcoming debt maturities on a timely basis.

Fitch has downgraded or revised Recovery Ratings for the following ratings as indicated:

Toys 'R' Us, Inc. (HoldCo)

--IDR to 'CCC' from 'B-';

--Senior unsecured notes to 'CCC/RR4' from 'B-/RR4'.

Toys 'R' Us - Delaware, Inc. is a subsidiary of HoldCo

--IDR to 'CCC' from 'B-';

--Secured revolver to 'B/RR1' from 'BB-/RR1';

--Secured term loans revised to 'CCC+/RR3' from 'CCC+/RR5';

--Senior secured notes revised to 'CCC+/RR3' from 'CCC+/RR5';

--Senior unsecured notes to 'CC/RR6' from 'CCC/RR6'.

Toys 'R' Us Property Co. II, LLC is subsidiary of Toys 'R' Us -Delaware, Inc.

--IDR to 'CCC' from 'B-';

--Senior secured notes to 'B/RR1' from 'BB-/RR1'.

Toys 'R' Us Property Co. I, LLC is a subsidiary of HoldCo

--IDR to 'CCC' from 'B-';

--Senior unsecured term Loan facility to 'B/RR1' from 'BB-/RR1'.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (Aug. 5, 2013);

--'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

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715139

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=721836

Recovery Ratings and Notching Criteria for Equity REITs

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=722363

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=814830

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