Toys R is the leading global retailer of toys in terms of net sales, operating more than 1,500 stores in 36 countries worldwide. In addition to these, it runs hundreds of smaller format shops on a seasonal basis to take advantage of the increasing demand in the winter season. The contribution of the international segment has steadily increased over the past years, reaching 40 per cent in the latest quarter (ended April 2015).
The company was founded in 1948 and since 2005 has been controlled by an investment group led by Bain Capital Partners, Kohlberg Kravis Roberts & Co and Vornado Realty Trust; following this change in shareholding, Toys R was taken private.
Given the subdued consumption seen over the last few years and the ongoing rise in online sales, the American toys retailer experienced a decline in turnover and a sharp fall in margins. Indeed, EBITDA halved during 2009-13. This led to high inventories, cash burn and, consequently an increase in leverage, with the net interest bearing debt reaching as much as 10 times EBITDA in 2013 from 3.5x in 2009.
However, the company took stock of the market changes and moved to implement cost cutting measures to improve margins, downsize inventories, increase online presence, improve customer experience etc. Although these are still early days, the 2014 financial figures confirmed that some progress is being made with EBITDA improving despite the persistent decline in sales. Against this backdrop, the company managed to deleverage during financial year 2014 (ending in January 2015). Noteworthy, given the intense competition higher income is due to come via higher volumes and lower costs as price increases are hard to envisage.
The latest results refer to the three months ending April 2015, However, Q1 is traditionally a weak quarter, characterized by much lower sales volumes and, consequently margins. The cash burn is also high during the early months of the year and hence leverage tends to increase. This is to say that quarter-on-quarter (QoQ) comparisons are not really relevant. Indeed, over 40% of the revenues are generated in the final quarter of the fiscal year (ending January); as a result, the company routinely reports net losses over the first three quarters and higher debt as it makes recourse to credit facilities.
Having said this, Q1 sales were six per cent weaker year-on-year (YoY), reflecting to a large degree the fall in international sales which is turn was due to FX translation effects; the company estimates that excluding the FX impact, turnover was 1% lower YoY. As such, comparable store sales declined by a more manageable 1% despite quite adverse base effects (Q1 FY14 was a strong quarter with sales 2.7% higher) and they were marginally higher YoY for the international segment. YoY, EBITDA improved significantly, mainly due to cost cutting progress and the FX translation impact. Indeed, EBITDA beat estimates.
Overall, the financial results confirm that Toys R Us has managed to bring its decline to a halt. However, the longer term challenges are still present, most notably due to the shift in consumers’ behaviour. For this reason, I find that the most attractive risk-return trade-off for bond investors is found in the secured note 8.5 per cent TOYS 2017 issued by Toys R Property CO II.
The issuer, set up as a bankruptcy-remote entity, owns and rents out properties in various US retail market; these properties are leased to Toys-Delaware (a subsidiary operating part of Toys R US and Canadian stores), resulting in the company’s revenues being exclusively given by its parent’s lease payments. Noteworthy, the agreement between the two parties puts the maintenance, administrative and tax costs on Toys-Delaware’s back. Furthermore, the partnership is governed by a 20-year agreement (expiring in 2030) which stipulates that the rent will see a 10% increase every five years. Additionally, the tenant has the right to terminate the contract for the stores which become uneconomical but, in this case, the landlord will sell that property and look to recover the difference between the foregone rent and the sale price from Toys-Delaware.
The company will likely attempt to refinance the bond prior to its maturity but the management suggested that it is not a pressing issue at this moment. The comfortable asset coverage should facilitate this process, with Fitch estimating that the recovery rate stands at more than 90 per cent, even under distressed conditions. Indeed, it is for this reason that this bond is rated higher than other bonds in the Toy Group.
Disclaimer: This article was issued by Raluca Filip, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.