OREANDA-NEWS. Fitch Ratings has assigned a rating of 'CCC/RR4' to the recently issued $583 million of 12% senior secured notes due Aug. 15, 2021 at the recently formed entity TRU Taj LLC, an indirectly owned subsidiary of Toys 'R' Us, Inc. (Toys, or the Holdco). The notes were issued through exchange offers and private placements, which, along with cash, are being used to fully address Holdco's $450 million 10.375% senior unsecured notes due 2017 and $192 million of its $400 million 7.375% senior unsecured notes due 2018. The 2017 notes were exchanged at par while the 2018 notes were exchanged at 90% of par. Post this transaction, $208.3 million of 2018 notes remains outstanding which we expect to be addressed through future exchanges or paid down with cash. The new notes offer improved terms relative to the existing notes, with a higher coupon rate and secured status in the capital structure. The notes are secured by a stock pledge in certain international subsidiaries, including guarantors of the European asset-backed loan (ABL).

Toys is also working on refinancing the $725 million of 8.5% senior secured notes due December 2017 that were issued by its subsidiary Toys 'R' Us Property Company II, LLC (Propco II). Toys is working with Bank of America, Goldman Sachs and Lazard to refinance this debt and explore various structures, including accessing the CMBS and mezzanine financing markets. In its 8-K filed Aug. 16, 2016, Toys disclosed that its advisors retained Cushman & Wakefield to perform an appraisal of Propco II properties. The aggregate of the individual values under the Leased at Market Rent and Dark Value scenarios as of the end of April was estimated at $878.8 million and $617.9 million, respectively. Additionally, Propco II had $115 million of cash and cash equivalents as of April 30, 2016. This suggests that the cash at the entity and $600 million to $625 million in new financing should address this maturity.

Fitch has also affirmed the Issuer Default Rating (IDRs) for Toys 'R' Us, Inc. (Toys, or the Holdco), Toys 'R' Us - Delaware, Inc., Toys 'R' Us Property Co. II, LLC, and Toys 'R' Us Property Co. I, LLC. A full list of rating actions follows at the end of this release.

KEY RATING DRIVERS

EBITDA Expected to Cross $800MM Given Recent Improvements

EBITDA (Fitch calculated) improved to $753 million in 2015 from $597 million in 2014 and $517 million in 2013. This reflects the benefit from cost reduction initiatives launched in 2014 which are expected to yield $325 million in savings by the end of 2016 and comp store sales that have stabilized over the past three quarters on the back of strong industry growth. Fitch expects Toys could cross $800 million in EBITDA this year, assuming flat-to-modestly positive comparable store sales (comps), gross margin decline of 50 bps and some further reduction in SG&A expense, which should enable Toys to generate modest free cash flow (FCF).

Long-Term Headwinds Remain

Long term, we believe Toys faces both competitive and secular headwinds and the company will continue to be a share donor. Within the toy industry, Toys has faced a multi-decade onslaught of competition from discounters like Wal-Mart and more recently online-only players such as Amazon leading to market share losses in recent years. Toy industry characteristics have left Toys vulnerable to market share losses. Fitch views Toys as disadvantaged for the following reasons:

--The toy industry is extremely seasonal, with discounters using toys to drive traffic (at low margin or even as loss leaders) into their stores during the holiday period. This challenge is made more acute by the fact that Toys essentially drives 75% of its EBITDA and virtually all its cash flow in the fourth quarter and is limited in its ability to drive sales productivity to cover fixed costs during non-holiday periods.

--The industry is hit-driven, with a small number of SKUs or popular toys driving a high percentage of sales. As a result, Toys generates only a marginal benefit from having the breadth of product it offers relative to other categories such as auto parts, crafts and vitamins.

--Due to the brand-focused nature of toy purchases, Toys has had difficulty developing a private label program. The company has also been unable to drive differentiation via product exclusives from vendors. As a result, Toys has not benefitted from unique merchandise content. While Toys' recent deal to sell Mattel's American Girl products is a step in the right decision, there may not be enough opportunities to drive a more meaningful scale.

--Sales assistance has not emerged as a competitive advantage for Toys, given relatively easy purchase decisions and online information availability.

--As toys are typically a gift purchase, an inviting in-store experience - compared to a discount or online shopping experience - has not benefitted Toys. Moreover, the company's limited FCF generation would preclude significant store-level investment even if an improved experience could drive positive comps.

In Fitch's view, Toys needs to invest further to improve its price perception and build out its omnichannel infrastructure. Its current online penetration, at approximately 14% and 7% of domestic (including Canada) and rest-of-world revenue in 2015, respectively, lags the overall industry, especially in its core categories, such as Baby and Core Toys, where Fitch estimates online penetration is in the low - to mid-20% range domestically. Even if online sales resume low - to mid-teens growth (after growing 8.3% in 2015), thereby adding 100 bps-150 bps to overall same-store sales, it may not be adequate to offset if domestic same-store sales trends at the store level worsen from recent levels (estimated at negative 2% in 2014/2015).

In recent years, the traditional toy industry has also been negatively impacted by low birth rates in developed markets (more than 80% of sales are in the U. S., Europe and Japan) and the increased penetration of 'screen-based' play. Purchases of board games and dolls have evolved into purchases of software and apps, which can occur online and not in a physical store. Fitch expects play habits to continue this evolution, with traditional toy category growth challenged.

As a result, Fitch expects same store sales to remain modestly negative over the longer term and EBITDA to peak at around $800 million to $850 million. At these levels, Toys will not be able to grow out of its capital structure and will largely remain dependent on favorable credit markets to refinance debt on an ongoing basis.

KEY ASSUMPTIONS

--Fitch assumes slightly flat to modestly positive comps over the next 24 months, based on flattish domestic comps and modestly positive international comps.

--EBITDA is expected to grow modestly over the next two years, potentially reaching $800 million in 2016, on gross margin decline of 50 bps and SG&A reduction of 3%. EBITDA is expected to be in the $800 million to $850 million range in 2017/2018.

--FCF, which was breakeven in 2015, could improve to $100 million annually beginning 2016, absent any swings in working capital.

--Leverage could improve from 7x in 2015 toward the low-6x range by 2018.

RATING SENSITIVITIES

Positive:

A positive rating action could result if there is sustainable improvement in Toys' domestic same-store sales and online traffic - which would indicate stable and/or improved market share - without material erosion in the EBITDA margin.

Negative:

A negative rating action could result if comps in the U. S. and international businesses revert to mid-single-digit declines and/or gross margins decline meaningfully 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.

LIQUIDITY

The company had liquidity of $1.6 billion comprising $458 million in cash and $1.1 billion in availability under the $1.85 billion ABL as of April 30, 2016. FCF, which was breakeven in 2015, could improve to $100 million in 2016, absent any swings in working capital. Excess availability under its domestic ABL revolver during the peak working capital season in 2016 is expected to be comparable to the $780 million in 2015.

FULL LIST OF RATING ACTIONS

ISSUE RATINGS BASED ON RECOVERY ANALYSIS

For issuers with IDRs at 'B+' and below, Fitch performs a recovery analysis for each class of obligations. Issue ratings are derived from the IDR and the relevant Recovery Rating (RR) and notching based on expected recoveries in a distressed scenario for each of the company's debt issues and loans. Toys' debt is at three types of entities: operating companies (OpCo); property companies (PropCos); and HoldCos, with a structure summary as follows:

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.

(III) TRU Taj LLC, an indirectly owned 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 and the international entities that provide a stock pledge to the debt at TRU Taj LLC. 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 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 subfacility in favor of Canadian borrowers. Any assets of the Canadian borrower and its subsidiaries secure only the Canadian liabilities (including the Canadian portion of the FILO term loan). The $200 million subfacility is more than adequately covered by the EV calculated based on stressed EBITDA at the Canadian subsidiary. Therefore, the fully recovered subfacility is reflected in the recovery of the consolidated $1.85 billion revolver discussed below.

The residual value of approximately $200 million is applied toward the ABL revolving facility and term loan.

Toys-Delaware

At the Toys-Delaware level, recovery on the various debt tranches is based on: the liquidation value of the domestic assets at the Toys-Delaware level, estimated at over $1.5 billion; estimated value for Toys' trademarks and IP assets, which are held at Geoffrey, LLC as a wholly owned subsidiary of Toys-Delaware; equity residual from Toys-Canada; and the benefit to the 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 FILO term loan is secured by the same collateral as the $1.85 billion ABL facility and ranks second in repayment priority relative to the ABL. The FILO tranche is governed by the residual borrowing base within the ABL facility and benefits from a lien against 15% of the estimated value of real estate at Toys-Canada. The facility is rated 'B/RR1' 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 $1.025 billion B-4 term loan benefits 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 also benefits from an unsecured guaranty by the indirect parent of PropCo I and is secured by a first-priority pledge on two-thirds of the Canadian subsidiary stock.

After prorating the value of the IP assets (estimated at $350 million), the residual equity in Toys-Canada, and applying the benefit from the guaranty by the indirect parent of PropCo I, the B-4 term loan is expected to have good recovery prospects (51%-70%), and is therefore rated 'CCC+/RR3'.

The $200 million in remaining B-2 and B-3 term loans are rated 'CCC/RR4' as they are expected to have average recovery prospects (31%-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%-10%) and are therefore rated 'CC/RR6'.

PropCo Debt

At the PropCo levels - PropCo I, PropCo II 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 within the entities, 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 $923 million senior unsecured term loan facility at PropCo I results in recovery in excess of 90%. Therefore, these facilities are rated 'B/RR1'. The PropCo II notes are secured by 123 properties. The PropCo I unsecured term loan facility benefits from a negative pledge on all PropCo I real estate assets, which includes around 320 properties.

As described above, the residual value of approximately $260 million after fully recovering the $923 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.

TRU Taj LLC Debt

The notes are secured by a stock pledge in certain international subsidiaries, including guarantors of the European ABL and the EBITDA associated with these pledged entities was $152 million in 2015, calculated on a covenant basis. Fitch applied a 5x multiple to each entity's EBITDA (stressed at 15%-20% from current levels), subtracted out any entity level debt, and then applied the remaining value against the $583 million new notes. This resulted in average recovery (31%-50%) and the notes are therefore rated 'CCC/RR4'.

Toys 'R' Us, Inc. - HoldCo Debt

The $208 million 7.375% unsecured notes due Oct. 15, 2018 (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%-10%) because there is no residual value flowing in from the wholly owned subsidiaries. Therefore, they are rated 'CC/RR6'.

Fitch has affirmed the following ratings:

Toys 'R' Us, Inc.

--IDR at 'CCC';

--Senior unsecured notes at 'CC/RR6'

Fitch has removed the Rating Watch Negative on the senior unsecured notes.

Toys 'R' Us - Delaware, Inc.

--IDR at 'CCC';

--Secured revolver at 'B/RR1';

--Secured FILO term loan at 'B/RR1'

--Secured B-4 term loan at 'CCC+/RR3'

--Secured B-2 and B-3 term loans at CCC/RR4';

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

Toys 'R' Us Property Co. II, LLC

--IDR at 'CCC';

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

Toys 'R' Us Property Co. I, LLC

--IDR at 'CCC';

--Senior unsecured term Loan facility at 'B/RR1'.

Fitch has assigned the following ratings:

TRU Taj LLC

--IDR at 'CCC';

--Senior secured notes at 'CCC/RR4'.