Fitch Assigns Ratings to Toys' New Term Loans; Affirms IDR at 'CCC'

Fitch Ratings has assigned a 'B/RR1' rating to the new $350 million secured FILO term loan and a 'CCC+/RR3' to the $1,025 million secured B-4 term loan that is being launched at Toys 'R' Us - Delaware, Inc.(Toys-Delaware) this week. The new term loans will be used to repay the $646 million B-1 term loan and $350 million of the 7.375% senior secured term loans, both due Sept. 1, 2016. The company will also refinance up to $380 million of the $580 million of B-2 and B-3 term loans. Toys-Delaware will seek amendments to the term loan and asset-backed loan (ABL) credit agreements to complete these transactions.

Effective this refinancing, Fitch has downgraded the remaining $200 million B-2 and B-3 term loans to 'CCC/RR4' from 'CCC+/RR3'. Fitch has also downgraded the $450 million 10.375% senior unsecured notes due August 2017 and $400 million 7.375% senior unsecured notes due October 2018 at Toys 'R' Us, Inc. (Toys, HoldCo) to 'CC/RR6' from 'CCC-/RR5', given the structural enhancements provided to the new loans discussed under the 'Recovery Analysis and Considerations' section.

The transaction will address all of Toys-Delaware's 2016 maturities and a portion of 2018 maturities. This will push Toy's next maturities to 2017 when $1.175 billion of debt comes due.

Fitch has affirmed the Issuer Default Ratings (IDRs) on Toys and its various domestic subsidiaries at 'CCC'. A full list of rating actions follows at the end of this press release.

KEY RATING DRIVERS

Fitch's ratings on Toys reflects the company's weak top-line and EBITDA trends and weakening liquidity position given Fitch's expectation of negative free cash flow (FCF). Toys' adjusted EBITDA declined materially to $521 million in 2013 from the average $1 billion range posted in the last few years. Fitch expects EBITDA to remain depressed at $475 million to $550 million over the next three years, relative to approximately $800 million required annually to cover cash interest expense, capex and modest taxes.

While Toys reported positive comparable store sales (comps) growth in the first half of 2014, Fitch expects Toys' comps will remain flat to modestly negative over the intermediate term given the weakness 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 ongoing secular pressure on the category.

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 grow sales by 1.5% to 2% and have flat to modestly improved gross margin to generate annual EBITDA in the $725 million range to cover annual cash interest expense of $415 million to $420 million post-refinancing, 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 $475 million-$500 million range, assuming flat comps and flat-to-modest lower gross margin for the second half of the year. Assuming similar trends for 2015/2016, Fitch expects EBITDA to remain at these levels or modestly better with some modest SG&A reduction given that Toys will need to make further investments in sharpening its prices, growing its online business and improving store presentation and service.

Fitch expects leverage (adjusted debt/EBITDAR) to be mid-9x and FCF to be negative $300 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 $400 million to $450 million in 2015. This indicates adequate liquidity over the next 24 months but concerns remain around declining liquidity and significant debt maturities in 2017 ($1.175 billion) and 2018 ($600 million).

RECOVERY ANALYSIS AND CONSIDERATIONS

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 liquidation or 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 sub-facility in favor of Canadian borrowers. Any assets of the Canadian borrower and its subsidiaries secure only the Canadian liabilities under the ABL facility. 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 of approximately $200 million is applied toward certain debt at Toys-Delaware.

Toys-Delaware

At the Delaware level, the recovery on the various debt tranches is based on the: (1) liquidation value of the domestic assets at the Toys-Delaware level estimated at $1.75 billion; (2) estimated value for Toys' trademarks and IP assets (which are held at Geoffrey, LLC (IPCo) as a wholly owned subsidiary of Toys-Delaware; (3) equity residual from Toys-Canada; and (4) the benefit to the new 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 assumed at 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 new financing at Toys-Delaware will consist of a new $350 million FILO term loan and $1,025 million B-4 term loan. The new term loans will be used to repay the $646 million B-1 term loan and $350 million of the 7.375% senior secured term loans, both due Sept. 1, 2016. The company will also refinance up to $380 million of the $580 million of B-2 and B-3 term loans.

The FILO term loan will be secured by the same collateral as the existing $1.85 billion ABL facility and will rank second in repayment priority relative to the ABL. The proposed FILO Tranche will be governed by the residual borrowing base within the ABL facility and will benefit from a lien against 50% of the estimated value of real estate at Toys-Canada. Fitch has assigned a 'B/RR1' rating to the FILO term loan 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 new B-4 term loan will benefit 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 will also benefit from an unsecured guaranty by the indirect parent of PropCo I and will be secured by a first priority pledge on two-thirds of the Canadian subsidiary stock.

After pro-rating the ascribed value of the IP assets (estimated at $400 million), the residual equity in Toys-Canada (of which half was applied to the FILO term loan) and applying the benefit from the guaranty by the indirect parent of PropCo I, the new loans are expected to have good recovery prospects (51% to 70%), and are therefore assigned a rating of 'CCC+/RR3'.

The $200 million in remaining B-2 and B-3 term loans have been downgraded to 'CCC/RR4' as they are expected to have average recovery prospects (31% to 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% to 10%) 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 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, 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 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 (343 properties). 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.

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 will no longer benefit from the residual value at PropCo I, as 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% to 10%) and have been downgraded to 'CC/RR6' from 'CCC-/RR5'.

RATING SENSITIVITIES

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 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 18-24 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 its obligations of interest expense, capex and taxes and fund any working capital swings, and manage refinancing of upcoming debt maturities on a timely basis.

Fitch has taken the following rating action on Toys and its various subsidiaries:

Toys 'R' Us, Inc.

--IDR affirmed at 'CCC';

--Senior unsecured notes downgraded to 'CC/RR6' from 'CCC-/RR5'.

Toys 'R' Us - Delaware, Inc.

--IDR affirmed at 'CCC';

--Secured revolver affirmed at 'B/RR1';

--Secured FILO term loan assigned 'B/RR1';

--Secured B-4 term loan assigned 'CCC+/RR3';

--Secured B-2 and B-3 term loans downgraded to 'CCC/RR4' from 'CCC+/RR3';

--Senior unsecured notes affirmed at 'CC/RR6'.

Toys 'R' Us Property Co. II, LLC

--IDR affirmed at 'CCC';

--Senior secured notes affirmed at 'B/RR1'.

Toys 'R' Us Property Co. I, LLC

--IDR affirmed at 'CCC';

--Senior unsecured term Loan facility affirmed 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:

Recovery Rating and Notching Criteria for Equity REITs - Effective May 12, 2011 to May 3, 2012

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=628490

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers

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

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=885094

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