Credit analyst: Toys 'R' Us fundamentals, lack of funding show no upside

By Ronda Fears

Nashville, Jan. 10 - Toys 'R' Us Inc. pulled off a coup in 2002 with a stock and convertible offering but its liquidity position seem precarious and Carol Levenson, director of research at Gimme Credit, sees little upside in the paper.

"It's kind of hard to put a positive spin on a weak holiday season if you're a toy store operator, such as Toys 'R' Us (Baa3/BBB)," Levenson said, noting the company posted a disappointing holiday season that failed to meet even the company's extremely modest comparable store sales expectations.

With earnings for the year seen somewhat lower than consensus estimates and the continuing difficulty in operating amid the competitive pressures from the likes of Wal-Mart Stores Inc., she said liquidity concerns outweigh credit quality for Toys 'R' Us.

"It's difficult to fault management's merchandising strategy (given the cards they've been dealt). Like so many other retailers Toys 'R' Us continues to struggle against the Wal-Mart behemoth," Levenson said.

Toys 'R' Us' U.S. toy store comparable store sales for the nine-week holiday season were down 1%, after being up 2% last year. Kids 'R' Us comparable store sales fell 7%, after dropping 3% last year. The money-losing internet operation slowed precipitously, with sales up a mere 12%.

Despite projections of higher inventory at the end of this year, management expects fourth quarter gross margins to be flat. And although full-year earnings will fall below consensus estimates, Toys 'R' Us still expects net income to increase 15%-20%.

"Although all these factors combine to produce yet another 'wait until next year' holiday season for Toys 'R' Us, we don't see disastrous consequences for its credit quality," Levenson said.

The overriding concern is liquidity, she said.

"We didn't see how the company could finance the inventory necessary to make it through the holiday season without having ready access to the commercial paper markets and with bank lines of less than $1 billion," the analyst said.

"But Toys 'R' Us showed surprising financial flexibility by issuing nearly $700 million in equity and [a mandatory convertible] in May. Thanks to this, the company sailed through its peak borrowing season using only half of its bank line capacity."

Thus, she believes Toys 'R' Us' modest increase in earnings should lead to stable to slightly improving debt protection measures. Lease-adjusted debt/EBITDAR will be just under 4x, she said, which is higher than historical levels but not getting any worse.

So, there's the funding issue looming again.

"Toys 'R' Us needs to figure out how to finance its next holiday season, and we doubt the equity markets can be counted on again to help out," Levenson said.

"It's difficult for a retailer to operate with ratings as low as Toys 'R' Us' (especially when the competition is much stronger), and unless its fundamentals take a distinct turn for the better, which clearly won't happen this fiscal year, we continue to see little upside in this paper."

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