Toys 'R' Us Bondholders Form Group to Seek Covenant Relief

NEW YORK (The Deal) -- Certain bondholders of Toys 'R' Us Inc. have formed a group to seek covenant modifications with a goal of making refinancing for the retailer easier, according to a bondholder.

One path toward refinancing -- and a hoped-for turnaround -- would be to pursue a sale-leaseback deal for its domestically owned properties, that person said.

"There's a strong market for sale-leaseback transactions," the investor said, citing American Realty Capital Properties Inc.'s $1.5 billion sale-leaseback deal for 500 Red Lobster restaurants as one recent, sizable example of such a single-tenant deal. That deal closed July 28 as part of Golden Gate Capital's acquisition of Red Lobster from Darden Restaurants Inc.

Other retailers that have used the value of their real estate to secure debt revamps recently include J.C. Penney (JCP) , Sears Holdings (SHLD)  and SuperValu (SVU) .

"It's a pretty well-worn path," the investor said.

The real estate could also be used as security for a loan, likewise gaining the company a "substantial" interest rate savings over an unsecured deal, the investor said. A combination of a new loan and a sale-leaseback deal would also be a good option, the bondholder said.

However, at the moment, a pesky debt covenant stands in the way for Toys 'R' Us. The limitations on liens covenant on the 7.375% holding company bonds due 2018 restricts the company's ability to grant liens on its assets.

The investor understands that the bondholder group, which has been formed in recent months, is seeking relief on that covenant.

The person said that though the company's earliest debt maturities aren't until 2016, given the favorable state of credit markets and the uncertainty surrounding the company's operations and the retail industry in general, Toys 'R' Us should kick a refinancing effort into gear in the next month or so.

That initiative may be crucial to the financial health of Toys 'R' Us going forward. Observers are watching the company's performance in 2014, as it has about one to two years to execute a turnaround, industry sources said.

A source who specializes in the restructuring of private equity portfolio companies said that if Toys 'R' Us has stable revenue and operating income, but is losing money, then it is a balance sheet problem partially due to the debt servicing and can be fixed.

However, if operating income is drastically falling, the problems could be deeper and indicate that the business may not have long-term viability.

The company went private in 2005 when a private equity consortium including Bain Capital LLC and Kohlberg Kravis Roberts & Co. LP, as well as Vornado Realty Trust, bought it for $6.6 billion.


For the year ended Feb. 1, Toys 'R' Us generated about $12.5 billion in net sales, compared to about $13.5 billion for the same period a year prior, while the company had a net loss of about $1 billion from net earnings of nearly $40 million for the same period a year earlier, the company said in its earnings statement released Monday.

Ebitda dropped for the fiscal year to $35 million from about $960 million the year prior, while adjusted Ebitda was nearly $600 million, down from about $1 billion. Operating income fell from about $550 million the year prior to nearly $30 million for the fiscal year ended Feb. 1.

While the company stabilized sales in the first quarter ended May 3, profitability remains a concern.

Sales increased slightly to $2.45 billion from $2.4 billion, but Ebitda fell to $13 million from $27 million for the same period a year prior. Net loss for the first quarter was almost $200 million compared to about $110 million net loss for the same period a year ago.

The toy retailer has roughly $370 million in cash and cash equivalents and was able to renew and lower the pricing on its $1.85 billion asset-backed lending facility in March.

The difficulty with retailing toys, the industry source said, is that once a child determines that it wants a particular toy, usually through online advertising, it doesn't need to actually inspect the toy in a physical store before deciding whether to buy. Therefore, the brick-and-mortar retailers of toys are only going to face more pressure from e-commerce going forward.

Toys 'R' Us has the added problem of competing against retail giant Wal-Mart Stores (WMT) , which has built its toy business into a powerhouse over the years, the source said.

In order to improve the company's performance, Toys 'R' Us brought two new finance executives on board this summer, which the bondholder views as evidence of a commitment to addressing its debt structure in the near future. The company replaced CFO F. Clay Creasey Jr. with Michael Short, the former CFO of automotive retailer AutoNation Inc. and Universal Orlando, in June. Then on Aug. 6, the retailer hired Chetan Bhandari as its treasurer and senior vice president of finance. Bhandari was formerly a managing director at GLC Advisors & Co. LLC, a financial advisory firm notable for its restructuring acumen.

The bondholder cited these hires as "very positive steps," explaining, "they brought in seasoned people with a corporate finance background, particularly involving highly leveraged capital structures."

Credit-default swaps imply a fairly modest 17% chance that the toy retailer defaults on its debt within the next year but the likelihood of a qualifying credit event by September 2019 is high, at about 76%, according to data compiled by Bloomberg. The models assume a standard 40% recovery rate.

The up-front cost to insure $10 million of Toys 'R' Us debt for five years is around $3.075 million, according to Bloomberg. That's up roughly 9% from $2.825 million at the start of 2014 but off 23% from an early-May high. Comparatively, the up-front cost to insure $10 million's worth of RadioShack's debt for five years was recently quoted at $6.2 million.

As of August 15, the Depository Trust & Clearing Corp.'s Trade Information Warehouse reported 2,814 open CDS contracts referencing Toys R Us debt. That's up nearly 24%, from 2,272 open contracts a year ago -- an indication of the trade's popularity.

The latest number of open CDS contracts have a gross notional value of $8.35 billion. The GNV includes offsetting trades but still gives an indication of how much CDS traders are wagering on Toys 'R' Us.

The company's total long-term debt is about $5.1 billion. Its debt structure includes a secured term loan facility due in 2016 of $645 million, an incremental secured term loan due in 2018 of $371 million, and a second incremental secured term loan due in 2018 of $209 million.

It includes $125 million drawn on a secured revolving credit facility that expires in 2019, a senior unsecured term loan due in 2019 of $971 million, a U.K. real estate credit facility due in 2020 of $444 million, Toys-Japan unsecured credit lines that expire in fiscal years 2014 to 2015 of $87 million, a Spanish real estate credit facility due in 2015 of $70 million, a European and Australian asset-based revolving credit facility due in 2016 of $21 million and a French real estate credit facility due in 2018 of $66 million.

Toys 'R' Us also has Toys-Japan 1.85% to 2.85% loans due in the fiscal years 2014 to 2021 of $86 million, 8.75% debentures due in 2021 of $22 million, 7.375% senior secured notes due in 2016 of $355 million, 10.375% senior notes due in 2017 of $447 million, 8.5% senior secured notes due in 2017 of $720 million and 7.375% senior notes due in 2018 of $403 million.

The company did not immediately respond to a request for comment. 

--Also by Richard Collings

Nils Van Liew also contributed to this report

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