Description

Company: Toys “R” Us, Inc. (“TOYS”)

Security / Entity: 12% Senior Secured Notes due August 2021 / TRU TAJ LLC

Recommendation: Long

Current Price / Yield: 95c / 12.7% CY / 13.8% YTW

Issue size of 12% notes: $583 million

Total Opco debt at TAJ entities: $1.1 billion ($2.3 billion including Propco debt)

Executive Summary

In all likelihood the combination of ‘retail + bankruptcy’ elicits the ‘ick’ response…..but therein lies the opportunity!

TOYS filed its US and Canadian (North American) subsidiaries for bankruptcy on September 18, 2017 in the Eastern District of Virginia. This is an old-school “freefall’ chapter 11 filing with no restructuring support agreement (RSA) in place with the key creditor groups. In parsing through the company’s corporate and capital structure, I believe the 12% Senior Secured Notes ’21 located at the TRU Taj LLC (Taj) entity presents an attractive investment in the mid-90s context with high current pay (12.7%) and nearly 14% YTW. Here is why I think the risk/reward is attractive:

1. High cash-on-cash return – Taj noteholders continue to receive cash interest during bankruptcy at the contract rate: the company has received DIP financing at the Taj entity to pay cash interest to the 12% secured notes (adequate protection) for a period of 17 months (based on the DIP budget) and fund working capital.

2. Secured position and collateral protection – 12% Taj notes have a 1st and 2nd lien stock pledge on the Asian and European assets: the priming DIP has been largely provided by the secured noteholders in order to protect their position in the notes.

3. Attractive asset base and valuation – Taj notes have more than adequate asset coverage even using conservative multiples: the collateral securing the Taj notes include the high comp growth and attractive margin businesses in the Asian Joint Venture (Asia JV); with Chinese and Japanese retail trading for 12-13x EBITDA, the company’s advisors believe there is “deep” market and strategic interest at 10-12x; the company also has cash on hand and equity in the international propcos.

4. Upside optionality in post-reorg equity – Taj noteholders could get a meaningful stake in the plan of reorganization: given the assumed permanency of the DIP (rolling into a post-emergence term loan), there is limited capacity for take-back paper. As the Asia JVs contribute ~75% of the Taj EV, I expect a portion of the recovery for the 12% notes to be in the form of post-reorg equity which could be quite attractive under certain scenarios.

There are a few risks to consider:

1. Demise of traditional retail – this is currently more of a US phenomenon, and most of the value that accrues to the Taj bondholders is from the Asian business.

2. Bankruptcy process risk – a few: (i) royalty rate – will the US IPCo increase in the rate that the Taj entities pay for the use of the TOYS brand? (ii) crafting the plan of reorganization – which entities will play “nice” with the parent? (iii) month 18, then what? – what happens after the 17 months of earmarked cash interest payments from the DIP proceeds?  

Brief Description

TOYS is a global retailer of toys and baby products under the brands Toys “R” Us and Babies “R” Us. The company sells a variety of products in the baby, core toy, entertainment and children’s learning categories through omni-channel (brick-and-mortar and online) offerings. As of FY2016 (January 28, 2017), TOYS operated 1,691 stores and licensed an additional 257 stores, which are located in 38 countries and jurisdictions. In addition TOYS has significant real estate holdings in the US, UK, France and Spain.  For FY2016, the company generated net sales of $11.5 billion and Adj. EBITDA of $792 million (6.9% margin). This compares to $13.5bn in net sales and $1 billion in Adj. EBITDA in FY2012.

On July 21, 2005 the company was acquired in by PE firms Bain Capital, KKR and Vornado for ~$7.5 billion in Enterprise Value (of which ~$1.3 billion was equity) or 7.5x Adj. EBITDA.

Recent Events

Needless to say the retail landscape has experienced seismic change in consumer buying behavior over the last several years. As such, TOYS, which is essentially a third party ‘warehouse’ retailer and real estate owner, has suffered meaningful market share loss to the online discount channel. With an unwieldy balance sheet of $5.3 billion, significant cash interest burden of ~$450 million annually and challenged operating performance – approximately 15% and 22% cumulative decline in net sales and Adj. EBITDA, respectively, over the last five years - it finally came as little surprise that TOYS filed its North American debtors for bankruptcy. Commentary from the first day motions suggest that this was a classic “vendor-driven” squeeze where nearly all the company’s vendors to its North American entities required cash on delivery to ship product which would have necessitated an additional $1 billion in liquidity that the company didn’t have. The company’s main vendors are some of the largest toy brand manufacturers globally, including Mattel, Hasbro, Graco, Lego, MGA Entertainment and Just Play Ltd., that were particularly focused on ensuring product placement (through TOYS or elsewhere) in the run up to the holiday season. While the toy chain’s suppliers tightened trade terms considerably in the few weeks leading to bankruptcy, it is important to appreciate that TOYS represents a meaningful piece of overall revenue for some of these toy manufacturers – 9% for total sales Hasbro, which is tied for the 2nd largest customer with Target. In addition to the absolute revenue exposure, the manufacturers are acutely aware of the potential margin squeeze if they had to make up the revenue displacement from TOYS via the online/mass market discount channel such as Amazon and Wal-Mart, and therefore are further incentivized to keep TOYS “alive” as a viable competitor.

While the bankruptcy filing is certainly necessary to highlight, it doesn’t bare much day-to-day operational relevance to the Taj (international) subsidiary businesses which are operating outside the remit of the bankruptcy court.  From a process perspective, the 12% notes are certainly impacted particularly as it relates to the post-petition Debtor-in-Possession (DIP) financing which TOYS negotiated/received for liquidity purposes (especially to give the company’s vendors that TOYS had the funds to pay them at this time in the year). The company secured two DIPs which amount to $3.125 billion:

• Toys “R” Us Delaware Inc. (Delaware) – parent of the North American (US and Canada) assets; received $2.75 billion in DIP financing in the form of an ABL ($1.85 billion), a Term Loan ($450 million) and a FILO Facility ($450 million) largely for working capital purposes.

• TRU Taj LLC (Taj) – parent of the international (Asia, Europe and Australia) subsidiaries; $375 million 9.5% ABL facility largely provided by the existing 12% noteholders to fund working capital and pay cash interest on the notes; importantly, the noteholders have agreed to a forbearance agreement against cross-default actions.

As aforementioned this a freefall bankruptcy with no RSA in place. The filing was a necessity for the company to ensure that its stores were adequately stocked for the holiday season. From a process standpoint, I think we are in a ‘quiet’ period until TOYS gets through Q4. The company has the court protections, DIP financing and exclusivity to wait until Q1-2018 before thinking about operational restructuring drivers, pockets of value and negotiating a plan with the different creditor constituencies.

Corporate Structure

There is a tangled web of intercompany transactions but the two main ones to focus on are the royalties and lease payments which, if modified, could impact the flow value around the debtor entities:

• Toys “R” Us Europe, LLC (parent of Taj) -> pays $75 million (2.1% of Taj revenue) in annual royalty fees to Geoffrey Holdings, LLC (IPCo, subsidiary of Delaware); there is a risk to Taj (discussed further in ‘Risks’ section) if Delaware looks to increase to royalty rate (to 3%?) and extract more value (which they presumably will) from Taj for the benefit of the Delaware creditors.

• Delaware -> pays Wayne/Propco I (subsidiary of Taj) $240 million in annual lease payments; in the 1st days motions the company suggested it was “generally” paying above market rents so Delaware could use the threat of lease rejection to negotiate lower fees which would indirectly impact Taj ; however, the Wayne entity has provided a guarantee to the B-4 Term Loan in the Delaware complex, and based on my estimates, the B-4s are impaired so there is no residual value to Taj after the guarantee. This therefore looks like an internal fight at Delaware - between the B-4s, the other Term Loans that don’t have the Wayne guarantee and Propco I at Wayne.

Given the complexity and clear conflicts of interest between the different creditors at the Delaware complex, the various Delaware groups have hired separate financial advisors (FA) and legal counsel. The Taj group is relatively straightforward to understand in terms of game theory and value maximization for the 12% notes – they are unified and represented by one FA and one legal.

The Thesis

1. High cash-on-cash return of ~13% – Taj noteholders continue to receive cash interest at the contract rate (12%) during bankruptcy

The Taj entities have secured a $375 million DIP to partially pay the 12% coupon on the notes. The DIP budget (below) shows an amount of $215 million placed in escrow at the beginning of the bankruptcy process to pay, among other expenses, $105 million in “Interest on Pre-Petition Taj Notes” between September 2017 and February 2019:

The inevitable question of “month 18, then what?” is addressed in the ‘Risks’ section. For the 17 month forecast in the DIP budget, the noteholders will continue to receive current pay at the 12% contract rate.

2. Secured position and collateral protection – 12% Taj notes have a 1st and 2nd lien ‘stock pledge’ on the Asian and European assets

Secured position: The Taj notes have security in the form of a 1st and 2nd lien on 65% of the stock in the company’s international subsidiaries. Under the US “deemed dividend” tax rule, lenders can only receive a pledge of less than 2/3rds of a controlled foreign subsidiary’s stock. If the pledge is greater than 662/3%, then the ‘deemed distribution’ is triggered and all of the foreign subsidiary’s earnings are immediately subject to US income tax up to the amount of the US loan (or note in this case) obligation. The reality is there isn’t any unsecured debt at the TRU Taj LLC entity, where the 12% notes are issued, that would have a claim on the ‘unencumbered’ residual 35% stock in the foreign subsidiaries so the 100% interest would flow to 12% notes, BUT fall behind the $120 million Japan and European opco debt, and the $375 million priming DIP.

Collateral protection: While the risk of being primed has already occurred with the priming DIP, which has a post-petition administrative claim, the notes continue to receive ‘adequate protection’. The reason for this is due to the strength of the underlying collateral, particularly the Asia JV, which I believe provides a par recovery to the notes even when using conservative EBITDA multiples relative to the peer group (see below).  

3. Attractive asset base and valuation:

Approximately 75% of the value that accrues to the Taj claimholders ‘flows up’ from the 85% interest in the Asia JV. The Asia JV can be segmented into two geographies can contribute essentially equal value: (i) Japan (~$70 million Adj. EBITDA) – growing topline at LSD and generating 5-6% EBITDA margins; and (ii) China (~$48 million Adj. EBITDA) – growing topline at LDD and generating 13-14% EBITDA margins.

Comp Analysis: Asian Retail

Estimated Value of Opco Earnings Contributions Rolling up to TAJ

Waterfall Recovery: Taj Claims

Note: These recovery figures are based on the overriding assumption that the company does not significantly damage international earnings through the bankruptcy

process. Thus far, it doesn’t appear like that is the case and the pre-petition operational framework seems intact – vendor relationships have been restored and the

supply chain has been successfully re-established.

In using a conservative blended EBITDA multiple of 8.6x for the Asia JV, the bankruptcy recovery analysis should provide a healthy safety margin. The valuation also doesn’t include the international propcos which could contribute additional value if there was residual equity (I have been informed it could be ~$220 million but haven’t included it because I haven’t been able to verify the value on property-by-property basis as yet). Using the average multiple for the Asian comps (10.4x for Japan and 12.6x for Asia ex-Japan), the blended multiple would be 11.4x and the estimated EV would be $1.54 billion, approximately 50% higher than the total claims pool at Taj.

4. Upside Optionality in the post-reorg equity:  

There is a plausible scenario that given the amount and assumed permanency of the priming DIP, the debt capacity post-emergence won’t be sufficient to refinance or reinstate the 12% notes. I have assumed in my base case that up to 50% will be in take-back paper and 50% in post-reorg equity.

The upside ‘bull’ case (beyond par recovery) is if the Taj entities pursue a standalone plan or if the Taj creditors get a meaningful stake in a consolidated plan. If the Taj group can argue (post-exclusivity of 18 months) for the parent debtor to run a parallel process where they explore an IPO/sale of the Asian/European/Australian assets as a stand-alone. If the 12% Taj noteholders can argue that given the ‘impairment’ of their class due to the stock component of their recovery, then they could, at worst, use the outcome of that process to receive more consideration in the consolidated company, and, at best, get the thing separated and listed in Asia.

As a side note, according to a Bloomberg article on October 18 this year, TOYS and its Asian JV partner, the (billionaire) Fung brothers, have been speaking to investment banks about the feasibility of a listing in Hong Kong and apparently the valuation could be as high as $2 billion. As I have not been able to validate the authenticity of the story, I put little stock in the valuation as it implies a very aggressive 15.7x EBITDA multiple. I mention the article because it appears that there is interest, at least by the JV partner, to crystallize an independent valuation for the Asian assets, which would obviously bode well for the 12% Taj noteholders.

The Risks

1. Demise of traditional retail:

One can make a rhetorical argument that the Asian comps are trading at an ‘excess’ valuation and it’s only a matter of time before Amazon et al. compete aggressively in Asia. The reality is that brick-and-mortar retail is at an earlier stage in the product life cycle in Asia, especially in China which is still experiencing LDD comp growth. However, if investors believe that secular headwinds are a realistic concern in the near-term, particularly in Japan, then hedging exposure with a basket of retail companies of similar size and exposure is worth exploring. I generally think the discount I am using in the blended EBITDA multiple provides for a sufficient margin for safety.

2. Bankruptcy process risk:

For 18 months post the filing date, the debtor has exclusivity to draft, negotiate and file a plan of reorganization in the bankruptcy court. In the strictest sense, exclusivity is initially granted for 120 days (section 1121) but the debtor can apply for an extension up to a period of 18 months if it can show that it is making progress in the emergence process. Given the jurisdiction – the Eastern District of Virginia is generally considered a ‘debtor-friendly’ court – my base case assumption is that the debtor will have exclusivity for the full term. During the bankruptcy process, subject to certain timeline restrictions imposed by the DIP lenders, the company can take a variety of actions aimed at resuscitating its business including rejecting real estate leases, amending royalty contracts and generally restructuring its liabilities. There are three potential overhangs worth monitoring as it relates to the Taj entities:

• Royalty rate – according to the CFO declaration filed with the bankruptcy court, the Taj international subsidiaries are paying, on average, 2.1% in royalties to Delaware (via Geoffrey IPCo) for use of the brand. While I certainly don’t have expertise in determining the appropriate royalty rate for this business, the following comps are worth noting: (i) Black & Decker is paying Sears royalties in the 2.5-3.5% range for the use of Craftsman; (ii) J.Crew recently entered into an internal licensing agreement at a rate of 3%. If we substitute the 2.1% for the 3% of revenue, the incremental 90bps would equate to a $33.5 million hit to EBITDA or $242 million in value using a 7.2x blended multiple:

As you can see from the chart, the ‘break-even’ recovery point for the 12% notes is a 7.67x multiple for the Asian JV. This is below my 8.6x base case multiple and significantly lower than the average multiple for the peer group. It also doesn’t include any potential equity value from the international propcos. Nevertheless, the increase in royalty is a risk that requires monitoring.

• Crafting the plan – bankruptcy processes, especially those involving multiple entities and creditor class constituencies under a single parent, are known for their complicated and intense negotiations among claimholders and the debtor to split the value pie. While the relevant players have armed themselves with advisors, the debtor is currently focused on stocking its stores for the Q4 holiday season.  I expect the debtor to approach the different groups in Q1-2018 but ultimately look to work with the 12% noteholders at Taj and perhaps the Term Loan B-4s at Delaware – the largest ‘impaired’ creditors in their respective constituency – to craft a plan. As aforementioned, it would behoove the Taj noteholders to ‘convince’ the debtor to run a parallel sale/IPO process for the international subsidiaries to determine their value in the context of a Taj standalone or a consolidated plan.

• Month 18, then what? – given that the DIP budget is only for 18 months, my sense is the debtor will try to use this exclusivity period to craft a consensual plan and exit bankruptcy before February 2019. If the debtor fails to do so, losing current pay could actually benefit the 12% noteholders assuming value in the Asian JV is intact and growing: $1 in cash vs $1 in potentially undervalued stock argument. In lieu of cash interest, the 12% notes will begin to accrete at the contract rate on a post-petition basis which will give the Taj noteholders a higher claim to negotiate in the value split.

Catalyst

• Q4 performance of international subsidiaries
• Crafting the restructuring plan with the debtor
• Crystalization of value for the Asia JV, European and Australian assets