Credit analyst: Toys R Us stock, convertible deals vital

By Ronda Fears

Nashville, Tenn., March 15 - Toys R Us (Baa3/BBB+) has succumbed to the latest fad for balance sheet strengthening programs with a stock and convertible deal, which is crucial to boost liquidity and may have averted a downgrade to junk, said Gimme Credit director of research Carol Levenson. Even with it, however, she said there is more downside to this name.

"The equity deal is vital, but even if it gets done we see additional downside in this name," Levenson said in a report Friday.

Toys R Us reported 2001 earnings as dismal as expected, down more than 25% from the prior year, and announced plans to issue $550 million in equity and convertibles. Ironically, the analyst noted that Toys was actually buying back stock as recently as third quarter, and repurchased an "alarming" $630 million in stock in fiscal 2000.

"Although Moody's didn't mention the equity offering in its downgrade of the company Wednesday, we would be willing to bet management shared their plans with the rating agency before this week's rating action," Levenson said in the report.

"This leads us to believe Moody's might have downgraded Toys all the way to junk without the promise of the equity issuance. S&P was more direct yesterday, saying if the equity issuance goes off as planned it will only downgrade the company one notch to mid BBB with a stable outlook."

Toys is probably feeling pressure to issue equity from a variety of sources, the analyst said, although its shareholder base is unlikely to be one of them since the stock fell as much as 8% on Thursday.

The mystery men at this point are the bankers, Levenson said, without whose cooperation the company might have to scramble to fund its peak seasonal borrowing this fall.

"Toys is probably more holiday-dependent than any other retailer. This year, in fact, the company lost money through its first three quarters and only moved into the black in the fourth quarter," Levenson said in the report.

"And in order to make those holiday sales, Toys needs lots of short-term funding. The commercial paper market is now out of the question, just as we long feared."

In October, the company's peak seasonal borrowing included nearly $1 billion in commercial paper, none of which was outstanding at the end of the fiscal year, according to management. Toys has a $975 million bank facility, one-third of which matures in September.

Even with the best inventory discipline in the world, the analyst said, the company is unlikely to be able to fund its holiday inventory with only two-thirds of the facility. She noted, also, that when Toys originally negotiated this facility, it carried ratings of A3/BBB+ and could still access the commercial paper markets.

Levenson said all signs point to a need to renew and expand the facility later this year, probably at a higher cost and with more restrictions. Thus, she said, a benefit to issuing stock and convertibles would be to demonstrate to the banks that Toys still maintains some measure of financial flexibility.

"Interestingly, the prospectus for the equity securities says proceeds will be used to pay down short-term debt. Although Toys as usual included few balance sheet or cash flow details in its earnings release, management implied short-term debt was minimal at the end of January," Levenson said in the report.

"We can only assume continuing negative free cash flow has caused Toys to draw down its bank line since then."

Free cash flow was negative by $200 million last year, she said, but capital spending should be lower this year and earnings are projected to be slightly higher. So, working capital will likely be the wild card, determining whether Toys will turn free cash flow positive.

Thus, Levenson still sees considerable downside for Toys.

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