) to 'BB' from 'BB+'. The ratings remain on CreditWatch with negative implications, where they were placed on January 8, 2004.
The rating action follows Standard & Poor's completion of an interim review of management's operating strategies and expectations for the business as it is currently configured. Toys "R" Us is undertaking a major strategic review to determine the optimal configuration and uses of resources for its assets and operations. After the company has announced its findings and its future plans, Standard & Poor's will reassess the appropriateness of the 'BB' rating.
The downgrade is based on the significant drop in profitability at the company's U.S. toy division in 2003 and its inability to improve cash flow protection measures. In addition, Standard & Poor's believes that management faces significant challenges in turning around the performance of its U.S. toy business given the sizable market share Wal-Mart (WMT
) and Target (TGT
) have amassed and their strategies of using low prices on toys to generate traffic.
The ratings on Toys reflect the company's participation in the intensely competitive retail toy industry and its inability to find a differentiated niche within the industry. These risks are partially mitigated by the strength of its Babies "R" Us business, its geographically diverse U.S. and international store base, and its position as the leading specialty toy retailer in the U.S.
Since the mid-1990s, Toys has faced intense competition from discount department stores and other retailers of toys and electronic games. In addition, traditional toys have decreased in importance, as children are turning to video games, computer software, sporting goods, and music for entertainment at younger ages. As a result, Toys' performance has been inconsistent despite its important position in the toy industry and management's repositioning efforts.
During the 2003 holiday season, discounters were highly promotional in the toy category. At the same time, toy retailers encountered severe price deflation in the video segment (which accounts for more than one-third of industry sales). As a result, same-store sales at Toys' U.S. toy division fell 5.1% for the fourth quarter of 2003, and consolidated operating margins declined to 9.1% in 2003 from 9.6% in 2002. Other toy retailer chains faired worse. FAO Schwartz and KB Toys filed for bankruptcy due to their inability to compete on price, as well as heavy debt burdens.
Toys' earnings before interest, taxes, depreciation, and amortization, or EBITDA, coverage of interest remains at about 3 times as a result of the low level of profitability in its U.S. toy division. The company generated $565 million of free cash flow in 2003 due to a $160 million reduction in working capital (which is unlikely to be repeatable) and a low level of capital spending. Total debt to EBITDA is high at 4.7 times (pro forma for the February 2004 repayment of the $506 million Eurobond).
Liquidity: Financial flexibility is good due to a diverse source of liquidity. Liquidity is provided by a $200 million 364-day unsecured credit facility that matures in May 2004 and a $685 million unsecured credit facility that matures in September, 2006. The company had $1.5 billion of cash at January 31, 2004 (excluding cash needed to repay the $506 million Eurobond). In addition, Toys had no bank borrowings at Nov. 1, 2003, and owns half of its real estate. Net property, plant, and equipment on the balance sheet totaled $4.7 billion at January 31, 2004. The company's maturity schedule is light over the next few years.
Standard & Poor's expects Toys to fund capital expenditures with internally generated funds over the next few years. The company has no pension funding issues, as it does not have a defined benefit plan. From Standard & Poor's RatingsDirect