Markets & Finance

S&P Lowers Rating on Toys "R" Us


On May 28, Standard & Poor's cut the long-term corporate credit rating on Toys "R" Us Inc. by one notch to BBB from BBB+ and was removed from CreditWatch. The A-2 short-term corporate rating on the company was affirmed at that time; this rating was not on CreditWatch. A BBB rating was also assigned to Toys' $402.5 million equity security units due in 2007.

The downgrade was based on a lack of improvement in credit protection measures in 2001 and Standard & Poor's expectation that these measures will not improve significantly during 2002 due to the company's continuing store remodeling programs, the weak retail environment, and intense competition in the toy retailing industry, says analyst Diane Shand. Standard & Poor's had indicated in its Mar. 14 CreditWatch update that the above rating actions would take place on the completion of the company's refinancing plans.

The ratings on Toys "R" Us reflect the company's important position in the toy industry, its geographically diverse store base, a solid financial profile, and management's recognition that it must reformat its toy store concept to remain competitive. The company had $1.8 billion of funded debt outstanding as of Feb. 2, 2002.

Toys has more than 700 toy stores in the U.S., which hold a market share in the domestic toy market in the high-teens percent area, and more than 500 international stores, affording the company strong buying power. The company's 163 Babies "R" Us superstores and 184 Kid "R" Us stores provide diversification beyond the toy category, but comprise a small portion of earnings.

Although Toys is the largest specialty toy retailer in the U.S., intense competition from discount department stores has taken market share. In addition, Toys' traditional stores have lost some of their former appeal, as customers have found the stores difficult to shop despite the broader product assortment available.

The company's difficulties are demonstrated in an inconsistent record of performance beginning in 1995. In 2001, the operating margin was only up slightly from depressed 2000 levels--8.8% versus 8.7%. Operating profits were negatively impacted by the store remodeling program, stiff competition, and the weak U.S. economy.

From 1990 to 1995, Toys generated margins between 13% and 14%. Return on permanent capital declined to 8.1% in 2001 from 10.0% in 2000 and compares negatively with the high-teens levels it generated from 1990 to 1995.

Still, Toys is benefiting from management's strategies to position the company as a true specialty driven, value-added retailer. Early results from the company's new "Mission Possible" stores are encouraging, and its U.S. toy operation's same-store sales increased 2% in the 2001 holiday season. In addition, margins began to stabilize in the fourth quarter of 2001 and are expected to show improvement in the first quarter of 2002. However, it may take until 2003 to assess the success of management's initiatives, as 2002 will continue to be impacted by costs associated with the store remodeling program and the weak economy.

Lower profitability has been accompanied by a moderate increase in financial risk during the past few years, as lease-adjusted debt to capitalization trended up to the 50% area. The recent issuance of $264 million of equity and $402.5 million of equity-linked notes modestly delevers the company's balance sheet. Pro forma for these offerings, total debt to total capital is 46%. Funds from operations to total debt receded to 16.4% in 2001, well below the 20.0% to 25.0% recorded throughout most of the 1990s.

EBITDA coverage of interest improved slightly in 2001 to 3.6 times from 3.2 times in 2000, but is below the mid-4.0 to 5.0 times level generated from 1990 to 1995. Still, maturities are modest, and the company's $1 billion multicurrency revolving credit facility and commercial paper program provide solid liquidity.

Outlook

Although Toys is being impacted by its costly remodeling program and a poor retail environment, Standard & Poor's believes management's strategies position the company for favorable long-term performance. The outlook incorporates Standard & Poor's belief that operating performance and credit measures will gradually improve and that no share repurchase activity will occur until the company stabilizes operations. From Standard & Poor's RatingsDirect


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