ITEM 1.
BUSINESS
As used herein, the “Company,” “we,” “us,” or “our” means Toys “R” Us Property Company II, LLC (“TRU Propco II”), except as expressly indicated or unless the context otherwise requires. Our fiscal year ends on the Saturday nearest to January 31 of each calendar year. This Annual Report on Form 10-K focuses on our last three fiscal years ended as follows: fiscal 2014 ended January 31, 2015; fiscal 2013 ended February 1, 2014; and fiscal 2012 ended February 2, 2013. With the exception of fiscal 2012, which includes 53 weeks, all other fiscal years presented are based on 52 week periods. References to fiscals 2014, 2013 and 2012 are to our fiscal years unless otherwise specified.
Our Business
We are a special purpose entity owned indirectly by Toys “R” Us, Inc. (“TRU”), through Toys-Delaware, and formed in July 2005. We own fee and ground leasehold interests in 124 properties in various retail markets throughout the United States (collectively, the “Properties” and each, a “Property”). We lease these Properties on a triple-net basis under a master lease to Toys-Delaware, the operating entity for all of TRU’s North American businesses, which operates the Properties as Toys “R” Us stores, Babies “R” Us stores or side-by-side stores, or subleases them to alternative retailers. Substantially all of our revenues and cash flows are derived from payments from Toys-Delaware under the Amended and Restated Master Lease Agreement (the “TRU Propco II Master Lease”). For the financial statements for fiscal year ended January 31, 2015 and other information about our master tenant, Toys-Delaware (“Master Tenant”), see Exhibit 99.1 to this report.
TRU, through its subsidiary Toys-Delaware, also operates other properties in which the fee and leasehold interests in such properties are owned by the following affiliated entities: MAP 2005 Real Estate, LLC, Toys “R” Us Property Company I, LLC (“Propco I”) and Toys-Delaware. In 2005, TRU allocated certain properties to various subsidiaries, including entities that would eventually become Propco I and the Company. In 2009, TRU reorganized certain of these entities, including MPO Properties, LLC (“MPO Properties”), a wholly-owned indirect subsidiary of TRU that was merged into TRU on November 20, 2009, for the business purpose of facilitating the 2009 financings obtained at that time. As a result of the reorganization on November 20, 2009, we received from Toys-Delaware and other affiliates, including MPO Properties, certain properties which we now lease to Toys-Delaware. As the reorganization was between entities under common control, the net assets transferred were recorded at their historical costs.
As of January 31, 2015, we owned fee and ground leasehold interests in 124 properties domestically, which include the following:
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69 traditional toy stores, which typically range in size from 30,000 to 50,000 square feet and devote 5,000 square feet to boutique areas for baby products (Babies “R” Us Express and Juvenile Expansion formats devote an additional 4,000 square feet and 1,000 square feet, respectively, for baby products);
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32 baby stores, which typically range in size from 30,000 to 45,000 square feet and devote 3,000 square feet to traditional toy products; and
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23 side-by-side stores, which typically range in size from 30,000 to 50,000 square feet and devote 20,000 to 30,000 square feet to traditional toy products and 10,000 to 20,000 square feet to baby products.
The Properties are important to the operations of Toys-Delaware, generating $978 million of U.S. store revenues, which represented approximately 13% of Toys-Delaware’s total U.S. store revenues for the fiscal year ended January 31, 2015. In the opinion of management, the Properties are adequately covered by insurance. Certain of the Properties are subject to customary encumbrances, such as ground leases, rights of first offer or refusal, third-party purchase rights, continuous-operations covenants and use restrictions.
The TRU Propco II Master Lease covers all of the Properties and is a triple-net lease requiring Toys-Delaware to pay all costs and expenses arising in connection with the ownership, operating, leasing, use, maintenance and repair of the Properties, including real estate taxes and assessments, utility charges, license and permit fees and insurance premiums, among other things. The TRU Propco II Master Lease requires the payment of a fixed rent which will increase by 10% every five years during its 20-year term. The TRU Propco II Master Lease provides that it is a single and indivisible lease of all the Properties.
Geographic Distribution of Properties
The following table sets forth the locations of the Properties as of January 31, 2015:
The TRU Propco II Master Lease
The net base cash rents to be paid by the Master Tenant to us under the TRU Propco II Master Lease, effective November 20, 2009, increased to approximately $91 million per annum, net of rents due to third parties. The base rents to be paid by Toys-Delaware in fiscal 2015 are expected to be $97 million, reduced for lease terminations and properties sold, and inclusive of the 10% rent increase effective on February 1, 2015 as required by the TRU Propco II Master Lease. Future rental payments are subject to additional 10% increases on February 1, 2020 and February 1, 2025. For a more detailed description of the TRU Propco II Master Lease, see Note 4 to the Financial Statements entitled “LEASES” and Item 13 entitled “CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE” of this Annual Report on Form 10-K.
Leases with Third Parties - Company as Lessee
All of our leases with third parties where we are the lessee include options that allow us to renew or extend the lease term beyond the initial lease period, subject to terms and conditions agreed upon at the inception of the lease. Such terms and conditions include the rental rates agreed upon at the inception of the lease that could represent below or above market rental rates later in the life of the lease, depending upon market conditions at the time of such renewal or extension. In addition, some of our leases include early termination options, which can be exercised by us under specified conditions, including, upon damage, destruction or condemnation of a specified percentage of the value or land area of the property.
Formation Documents
We are a Delaware limited liability company with no subsidiaries. We own no material assets other than the Properties and related assets. Our sole equity member is Giraffe Junior Holdings, LLC.
We were organized solely to acquire, own, hold, sell, assign, transfer, operate, lease and otherwise deal with real estate properties, and to exercise all powers enumerated in the Delaware Limited Liability Company Act relating thereto. We are not permitted to own any asset or property other than our interest in the Properties or other real property and incidental personal property. Further, subject to certain exceptions, we must maintain an arm’s length relationship with any affiliate, and not enter into or be a party to any transaction other than arm’s length transactions. In addition, our organizational documents place certain restrictions on our ability to institute bankruptcy proceedings, liquidate, dissolve, consolidate or merge. No assurance can be given that we will not file for bankruptcy protection or that our creditors will not initiate a bankruptcy or similar proceeding against us. See Item 1A
ITEM 1A.
RISK FACTORS
Investors should carefully consider the risks described below together with all of the other information in this Annual Report on Form 10-K. The risks and uncertainties described below are not the only ones that we face. Additional risks and uncertainties not presently known to us or that we currently believe to be less significant than the following risk factors, may also adversely affect our business and operations. If any of the following risks actually occur, our business, financial condition, cash flows or results of operations could be materially adversely affected.
Risks Relating to the Company
Our only assets, and sole source of revenue, are our Properties and the TRU Propco II Master Lease. Additionally, the Properties and the TRU Propco II Master Lease provide the sole source of cash to make payments on the Secured Notes.
Our only assets are our Properties. We have no operations and generate all of our revenues from payments made by Toys-Delaware pursuant to the terms of the TRU Propco II Master Lease. As discussed in more detail below under “- Risks Related to the Master Tenant’s and TRU’s Substantial Indebtedness,” Toys-Delaware is highly leveraged and will be required to devote a substantial portion of its cash flow to service its own debt. Absent continued payments from Toys-Delaware under the TRU Propco II Master Lease, we will rely solely on cash on hand and additional borrowings to make payments on the Secured Notes.
Although this Form 10-K contains certain financial and operating information with respect to Toys-Delaware and TRU, neither of these entities nor any of their respective subsidiaries (other than us) is an obligor on, or a guarantor of, the Secured Notes. As a result, holders of the Secured Notes do not have a direct claim against any of these entities or their assets.
All of our revenues are generated under the TRU Propco II Master Lease. Unexpected expenses, termination of the TRU Propco II Master Lease, sales of Properties under the TRU Propco II Master Lease or a bankruptcy of the Master Tenant could have a material impact on our financial condition.
The TRU Propco II Master Lease provides the only source of our revenue. The TRU Propco II Master Lease is a triple-net lease whereby Toys-Delaware, as tenant, is obligated to pay most operating costs with respect to the Properties. However, if we have unexpected expenses not covered by the TRU Propco II Master Lease, our net cash flow could be adversely affected. Toys-Delaware’s failure to make payments under the TRU Propco II Master Lease would have a material adverse effect on our financial condition.
In addition to the risk that Toys-Delaware might fail to make payments under the TRU Propco II Master Lease, Toys-Delaware may fail to perform other obligations under the TRU Propco II Master Lease, including the obligations to pay real estate taxes on the Properties and the rent owed under any underlying ground leases, insure the Properties, maintain the Properties in good repair and condition and in compliance with laws, remediate any environmental problems at the Properties and restore any Property following a casualty or condemnation. The failure of Toys-Delaware to perform these obligations may have a material adverse effect on the value of the Properties and our financial condition.
Pursuant to the TRU Propco II Master Lease, Toys-Delaware has the option to declare properties “uneconomic” and request the removal of such properties from the TRU Propco II Master Lease. Upon such a request from Toys-Delaware, we must use reasonable good faith efforts to sell such properties, free and clear of the liens in favor of the collateral agent. The sale of a substantial number of properties under the TRU Propco II Master Lease could have a material adverse effect on our cash flows. For a more detailed description of the TRU Propco II Master Lease, see Note 4 to the Financial Statements entitled “LEASES” and Item 13 entitled “CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE” of this Annual Report on Form 10-K.
Real estate investments are subject to various risks and fluctuations and cycles in value and demand, many of which are beyond our control.
Certain events may decrease cash available for payments on the Secured Notes, as well as the value of the Properties. These events include, but are not limited to:
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adverse changes in national or local economic and demographic conditions;
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adverse changes in the financial condition of the Master Tenant;
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inability to collect rent from the Master Tenant;
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reductions in the level of demand for commercial space and changes in the relative popularity of properties;
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increases in the supply of or demand for commercial space in a particular area;
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fluctuations in interest rates, which could adversely affect our ability, or the ability of buyers and tenants of properties, to obtain financing on favorable terms or at all;
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changes in, and changes in enforcement of, laws, regulations and governmental policies, including, without limitation, health, safety, environmental, zoning and tax laws, governmental fiscal policies and the Americans with Disabilities Act of 1990;
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property and casualty losses, some of which may be uninsured;
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liens, encumbrances, zoning matters or other matters affecting title to or use of real estate;
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asbestos/lead related liabilities and costs of containment or removal and other environmental hazards at the Properties for which we may be liable, including those created by prior owners or occupants, existing tenants, adjacent land or other parties; and
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terrorist attacks which, among other things, could lead to damage to one or more of the Properties, result in higher costs for insurance premiums or diminished availability of insurance coverage for losses related to terrorist attacks.
In addition, periods of economic slowdown or recession, rising interest rates or declining demand for real estate, or the public perception that any of these events may occur, could result in a general decline in market rents or property values. If we cannot operate the Properties to meet our financial expectations, our financial condition, results of operations, cash flow and ability to satisfy our debt service obligations could be materially adversely affected.
We lease, rather than own, a portion of the Properties and the leasing of such Properties exposes us to possible liabilities and losses.
Of our 124 Properties, 11 are leased from third parties where we have a leasehold interest via a ground lease. All of these leases include options that allow us to renew or extend the lease term beyond the initial lease period at rental rates agreed upon at the inception of the lease that could represent below or above market rental rates later in the life of the lease. As a result, we may be committed to pay rents at above market rental rates for certain of the Properties now and in the future.
In addition, because we lease these Properties, we will have no economic interest in the land or building at the expiration of the ground lease if not renewed or if such ground lease is terminated due to a breach by us. As a result, although we will share in the income stream derived from the lease, we will not share in any increase in the residual value of the land associated with the underlying property. Further, because we do not completely control the underlying land, the third party owners that lease this land to us could take certain actions to disrupt our rights in the Properties or Toys-Delaware’s operation of such Properties.
Several of the Properties are subject to rights of first refusal or other third party purchase rights, which may adversely affect the ability of the collateral agent to foreclose on such Properties.
Several of the Properties are subject to agreements that provide third parties with rights of first refusal, purchase options or other rights to purchase such Properties. These rights are most commonly triggered upon the occurrence of a store closing or the sale or lease of the Property to a non-affiliate. The rights of first refusal that apply to several of the Properties may be triggered by a sale resulting from a foreclosure, deed in lieu of foreclosure or other similar remedy of the collateral agent relating to the Property. In the event that any such right of first refusal or other repurchase right is interpreted as being exercisable upon a foreclosure, deed in lieu of foreclosure or other similar remedy of the collateral agent, or a sale following a foreclosure on the Property, the ability of the collateral agent to realize or foreclose on such Property may be adversely affected.
The Properties are concentrated in certain states and a downturn in such states could have a material adverse effect on us.
Toys-Delaware’s ability to make payments under the TRU Propco II Master Lease and the market value of the Properties could be materially adversely affected by economic conditions generally or in states where the Properties are located, conditions in the real estate markets where the Properties are located, changes in governmental rules and fiscal policies, acts of nature, including earthquakes, floods and hurricanes (which may result in uninsured losses), and other factors which are beyond our control. The Properties are located in 29 states. The economy of any state in which a Property is located may be adversely affected to a greater degree than that of other areas of the country by certain developments affecting industries concentrated in such state or region. Moreover, in recent periods, several regions have experienced significant downturns in the market value of real estate. Significant percentages of the Properties are located in Ohio (19 Properties, or 15% of the Properties); Pennsylvania (18 Properties, or 15% of the Properties); California (10 Properties, or 8% of the Properties); and Illinois, Massachusetts and Michigan (7 Properties in each of these states, or 6% of the Properties).
Insurance for the Properties may be inadequate to cover future losses.
The Properties are covered by insurance policies that also cover other TRU real estate, subject to self insurance retentions. These policies include property insurance with a per occurrence coverage limit of $600 million (which is less than the aggregate principal amount of the outstanding Secured Notes). In the event that such policies are drawn on to cover losses on real estate other than the Properties, the amount of insurance coverage available under such policies would thereby be reduced and could be insufficient to cover the Properties’ insurable risks.
Additionally, there is a possibility of catastrophic loss with respect to each Property for which insurance proceeds may not be adequate (such as floods) or which may result from risks not covered by insurance. Also, certain of the Properties are located in states that have been historically at greater risk to acts of nature (such as earthquakes, hurricanes and floods). As with all real estate, if reconstruction (for example, following fire or other casualty) or any major repair or improvement is required to a Property, changes in laws and governmental regulations may be applicable and may materially affect the cost to us or our ability to effect such reconstruction, major repair or improvement.
There can be no assurance that the amount of earthquake or flood or property insurance currently required or provided would be sufficient to cover damages caused by an earthquake or flood or other hazard, or that such insurance will be commercially available in the future.
Pursuant to the TRU Propco II Master Lease, we are entirely reliant on Toys-Delaware for providing and maintaining insurance. In addition to the risk that Toys-Delaware may fail to perform these obligations, the risks outlined above are also applicable to the insurance provided and maintained by Toys-Delaware.
We may be exposed to material environmental liabilities.
While we have established procedures to reduce the likelihood of incurring liabilities under applicable federal, state and local environmental laws, there may be material environmental liabilities of which we are unaware.
In addition, no assurances can be given that future laws, ordinances or regulations will not impose any material environmental liability on us or that the current environmental condition of our owned or leased Properties will not be adversely affected by conditions at locations in the vicinity of the Properties (such as the presence of leaking underground storage tanks) or by third parties unrelated to us.
We are entirely reliant on Toys-Delaware pursuant to the TRU Propco II Master Lease for our compliance with environmental laws. In addition to the risk that Toys-Delaware may fail to effect such compliance, the risks outlined above in this section are also applicable to such compliance by Toys-Delaware.
We, Toys-Delaware or TRU may become subject to bankruptcy proceedings and in that event our respective rights and obligations may be subject to material modification.
We were formed with the intent that we are a bankruptcy remote entity so as to reduce the likelihood of a bankruptcy of us. Although such measures reduce the likelihood that we would incur obligations that would result in a bankruptcy, no assurance can be given that we will not file for bankruptcy protection (including in connection with the commencement of any bankruptcy proceedings of another TRU entity, or otherwise) or that our creditors will not initiate a bankruptcy or similar proceeding against us. Because we are the owner or ground lessee of the Properties, the possibility that we could become such a debtor is likely greater, from a theoretical standpoint, than with respect to an entity that merely owns financial assets, because, among other reasons, claims may arise against us from our ownership or operation of the Properties.
Delay in Payments. In the event that we were to become a debtor in a case (a “Bankruptcy Case”) seeking reorganization or other relief under Title 11 of the United States Code (the “Bankruptcy Code”), a delay and/or substantial reduction in payments under the Secured Notes may occur.
Rejection of TRU Propco II Master Lease. If Toys-Delaware were to become a debtor in a Bankruptcy Case, a trustee in bankruptcy for Toys-Delaware (or Toys-Delaware as debtor-in-possession) would have the right, under the Bankruptcy Code, to reject or assume the TRU Propco II Master Lease. If the TRU Propco II Master Lease were so rejected, Toys-Delaware would be required to surrender the Properties to us and we would have a general unsecured claim against Toys-Delaware limited to the lesser of (a) our actual damages (if any) as determined under applicable state law and (b) the rent required by the TRU Propco II Master Lease, without acceleration, for the greater of one year, or 15%, not to exceed three years, of the remaining term of the TRU Propco II Master Lease. It is impossible to predict how such a claim would be treated in any Toys-Delaware Bankruptcy Case or when any distributions would be made thereon.
Recharacterization of TRU Propco II Master Lease as financing. The foregoing assumes that the TRU Propco II Master Lease would be treated in bankruptcy as a lease, and not as a financing. While the matter is not free from doubt, we believe that if the issue was properly presented to a court and the court interpreted the relevant law on a basis consistent with the existing legal precedents, the court would hold that the TRU Propco II Master Lease constitutes a true lease. If the TRU Propco II Master Lease were treated as a financing by a bankruptcy court, however, we and Toys-Delaware would have the rights and obligations of, respectively, a creditor and debtor, rather than a landlord and tenant. It is difficult to predict fully the consequences that would result from this recharacterization, but they would include the potential of a non-consensual restructuring of Toys-Delaware’s obligations to us (a “cram-down”); the potential disallowance of the mortgage liens as having been granted by a party other than the equitable owners of the Properties; the absence of any requirement on the part of Toys-Delaware to accept or reject the TRU Propco II Master Lease and therefore to surrender the Properties in the event of a rejection; the elimination of Toys-Delaware’s obligation to either (i) pay, during the bankruptcy proceeding and prior to a TRU Propco II Master Lease rejection, as an administrative expense, the rents payable under the TRU Propco II Master Lease; or (ii) cure any outstanding monetary defaults prior to any assumption of the TRU Propco II Master Lease and the obligation to repay to Toys-Delaware for the benefit of its estate in bankruptcy payments made to us by Toys-Delaware under the TRU Propco II Master Lease during the one-year preference period prior to the commencement of the Bankruptcy Case.
Pari Passu treatment of claims. Regardless whether the TRU Propco II Master Lease were characterized as a true lease or as a financing by a bankruptcy court, any claim for damages against Toys-Delaware under the TRU Propco II Master Lease by us (to the extent allowed as discussed above) would be payable only out of the assets of Toys-Delaware available for such payment. Any such claim would rank pari passu with all unsecured general obligations of Toys-Delaware.
Severability of TRU Propco II Master Lease. Although the TRU Propco II Master Lease expresses the intention of the parties thereto that the TRU Propco II Master Lease constitutes a single, integrated lease for all of the Properties, there can be no assurance that a bankruptcy court would not permit a trustee in bankruptcy for Toys-Delaware (or Toys-Delaware as debtor-in-possession) to assume the TRU Propco II Master Lease only with respect to certain Properties and reject the TRU Propco II Master Lease with respect to other Properties. In that case, we would be entitled to lease rejection damages (limited as described above) but not rent and other rights to payment under the TRU Propco II Master Lease with respect to those Properties for which the TRU Propco II Master Lease was rejected and the surrender of only such Properties. Toys-Delaware would be entitled to remain in possession of those Properties for which the TRU Propco II Master Lease was assumed, or might be authorized to assign the TRU Propco II Master Lease with respect to some or all of those Properties to one or more other parties who will assume the TRU Propco II Master Lease with respect to those Properties, provided that all existing defaults under the TRU Propco II Master Lease with respect to such Properties are cured and we are provided with “adequate assurance” (as determined by the bankruptcy court) of future performance by the tenant of its obligations under the TRU Propco II Master Lease with respect to such Properties. In addition, we may determine that agreeing to a modification of the TRU Propco II Master Lease in a Toys-Delaware bankruptcy proceeding would be better for us than a rejection of the TRU Propco II Master Lease in its entirety by Toys-Delaware followed by a liquidation of Toys-Delaware.
No covenant to operate. Toys-Delaware is not required under the TRU Propco II Master Lease to operate any of the Properties as Toys “R” Us or Babies “R” Us stores and is permitted to sublease Properties. As a consequence, Properties in which Toys-Delaware is not operating may be maintained to a lesser standard than those in which it is operating, and, in the event of a Bankruptcy Case involving Toys-Delaware, Toys-Delaware may be more inclined to reject the TRU Propco II Master Lease with respect to such Properties, assuming the TRU Propco II Master Lease is not held to be indivisible, or reject the TRU Propco II Master Lease in its entirety assuming the TRU Propco II Master Lease is held to be indivisible, if the number of such Properties is substantial.
Ineffectiveness of bankruptcy-remoteness; consolidation with TRU or Toys-Delaware; fraudulent conveyance. We have taken steps that are intended to ensure that the voluntary or involuntary application for relief by TRU or Toys-Delaware under the Bankruptcy Code will not result in the consolidation of our assets and liabilities with those of TRU or Toys-Delaware or their subsidiaries (other than us). These steps include the maintenance of our own books and records and the requirement that all transactions between us, on the one hand, and TRU or Toys-Delaware, on the other hand, and our respective affiliates will be on an arm’s-length basis. In the event, however, that we, Toys-Delaware or TRU were to become a debtor in a Bankruptcy Case, a creditor, receiver, conservator or the trustee in a bankruptcy of the debtor might request a court to order our assets and liabilities be consolidated with our, Toys-Delaware’s or TRU’s assets (including its properties), as the case may be, for the satisfaction of claims of creditors of the debtor. If our assets and liabilities were consolidated with Toys-Delaware, the TRU Propco II Master Lease would be eliminated. Alternatively, any such party may seek to void any part of the 2005 financing transactions as a fraudulent transfer. In addition, any claim described herein against the bankruptcy estate of us, Toys-Delaware or TRU would be an unsecured claim against such bankruptcy estate and, as such, full recovery may be unlikely and the extent to which such claim would be paid, and the form and timing of such payment, is uncertain. As a result, under such circumstances, the amount and timing of distributions on the Secured Notes would be adversely affected.
We have two independent members whose approval is required as a condition to our commencement of a Bankruptcy Case with respect to ourselves. That requirement will not prevent the commencement of such a Bankruptcy Case (including, in connection with the commencement of any Bankruptcy Case of another TRU entity, or otherwise).
Risks Relating to the Master Tenant’s Business
Toys-Delaware’s business is highly seasonal, and its financial performance depends on the results of the fourth quarter of each fiscal year and, as a result, its operating results could be materially adversely affected if it achieves less than satisfactory sales prior to or during the holiday season.
Toys-Delaware’s business is highly seasonal. During fiscals 2014, 2013 and 2012, 41%, 42% and 43%, respectively, of Toys-Delaware’s Total revenues were generated in the fourth quarter. Toys-Delaware typically incurs net losses in each of the first three quarters of the year, with a substantial portion of its operating earnings generated in the fourth quarter, with the exception of the fourth quarter of fiscal 2013, which resulted in a net loss primarily due to certain non-cash charges. As a result, Toys-Delaware depends significantly upon the fourth quarter holiday selling season. If Toys-Delaware achieves less than satisfactory sales, operating earnings or cash flows from operating activities during the fourth quarter, it may not be able to compensate sufficiently for the lower sales, operating earnings or cash flows from operating activities during the first three
quarters of the fiscal year. Its results in any given period may be affected by dates on which important holidays fall and the shopping patterns relating to those holidays. Additionally, the concentrated nature of Toys-Delaware’s seasonal sales means that its operating results could be materially adversely affected if it achieves less than satisfactory sales prior to or during the holiday season, including as a result of natural disasters and labor strikes, work stoppages, terrorist acts or disruptive global political events prior to or during the holiday season, as described below.
Toys-Delaware’s industry is highly competitive and competitive conditions may materially adversely affect its revenues and overall profitability.
The retail industry is highly and increasingly competitive and Toys-Delaware’s results of operations are sensitive to, and may be materially adversely affected by, competitive pricing, promotional pressures, competitor credit programs, additional competitor store openings, growth of e-commerce competitors and other factors. As a specialty retailer that primarily focuses on toys and baby products, Toys-Delaware competes with discount and mass merchandisers, such as Walmart and Target, national and regional chains and department stores, as well as local retailers in the markets Toys-Delaware serves. Toys-Delaware also competes with national and local discount stores, consumer electronics retailers, supermarkets and warehouse clubs, as well as Internet and catalog businesses, such as Amazon. Competition is principally based on product variety, price, quality, availability, advertising and promotion, convenience or store location, safety and customer support and service. Toys-Delaware believes that some of its competitors in the toy and baby products market, as well as in the other markets in which it competes, have a larger market share than its market share. In addition, some of its competitors have greater financial resources, lower merchandise acquisition costs and lower operating expenses than Toys-Delaware does.
Much of the merchandise Toys-Delaware sells is also available from various retailers at competitive prices. Discount and mass merchandisers use aggressive pricing policies and enlarged toy-selling areas during the holiday season to increase sales and build traffic for other store departments. Toys-Delaware’s business is vulnerable to shifts in demand and pricing, as well as consumer preferences.
Toys-Delaware is vulnerable to competitive pressures from e-commerce activity in the market, both as they impact its own e-commerce business and its stores. The Internet provides greater price transparency of its merchandise that is widely available to customers. Toys-Delaware’s “Price Match Guarantee” may lead to reduced margins as a result of intense price competition, especially during the holiday selling season. In addition, sales of video games have been impacted by a shift to sales in channels other than traditional retail stores, including direct online distribution to customers through download or cloud play, which eliminates the need for a retailer. Furthermore, competitors’ recent launches of subscription models for diapers, formula, and other commodities eliminate the need for customers to visit Toys-Delaware’s stores or e-commerce websites. Toys-Delaware believes that this e-commerce activity has adversely affected its sales and profitability, and any increase in the proportion of its customers’ purchases via the Internet could materially adversely affect its sales and profitability from physical stores.
The baby registry market is highly competitive, based on convenience, quality and selection of merchandise offerings and functionality. Toys-Delaware’s baby registry primarily competes with the baby registries of mass merchandisers, Internet retailers and other specialty format and regional retailers. Some of Toys-Delaware’s competitors have been aggressively advertising and marketing their baby registries through national television, magazine and Internet campaigns. These trends present consumers with more choices for their baby registry needs, and as a result, increase competition for Toys-Delaware’s baby registry.
If Toys-Delaware fails to compete successfully, Toys-Delaware could face lower sales and may decide or be compelled to offer greater discounts to its customers, which could result in decreased profitability.
Toys-Delaware’s sales may be adversely affected by changes in economic factors and changes in consumer spending patterns.
Many economic and other factors outside Toys-Delaware’s control, including consumer confidence, consumer spending levels, employment levels, consumer debt levels, individual income tax and sales tax rates, inflation and deflation, as well as the availability of consumer credit, affect consumer spending habits. A significant deterioration in the global financial markets and economic environment, recessions or an uncertain economic outlook adversely affects consumer spending habits and results in lower levels of economic activity. The domestic and international political situation, including the economic health of various political jurisdictions, also affects economic conditions and consumer confidence. In addition, changing economic and regulatory conditions and increasing consumer credit delinquencies may cause banks to re-evaluate their lending practices and terms which could have an adverse effect on Toys-Delaware’s credit card program and consequently, an adverse effect on its sales. Any of these events and factors could cause consumers to curtail spending and could have a negative impact on Toys-Delaware’s financial performance and position in future fiscal periods.
Toys-Delaware’s operations have significant liquidity and capital requirements and depend on the availability of adequate financing on reasonable terms. If its lenders are unable to fund borrowings under their credit commitments or Toys-Delaware is unable to borrow, it could have a significant negative effect on its business.
Toys-Delaware has significant liquidity and capital requirements. Among other things, the seasonality of Toys-Delaware’s businesses requires it to purchase merchandise well in advance of the fourth quarter holiday selling season. Toys-Delaware depends on its ability to generate cash flow from operating activities, as well as on borrowings under its revolving credit facility, to finance the carrying costs of this inventory and to pay for capital expenditures and operating expenses. As of January 31, 2015, Toys-Delaware had no outstanding borrowings under its $1.85 billion secured revolving credit facility (“ABL Facility”). For fiscal 2014, peak borrowings under its ABL Facility amounted to $852 million, with remaining availability under the ABL Facility of $707 million in excess of a minimum excess availability covenant. As of January 31, 2015 and February 1, 2014, Toys-Delaware also had outstanding balances of $376 million and $316 million, respectively, in short-term intercompany loans with TRU. If its lenders are unable to fund borrowings under its credit commitments or Toys-Delaware is unable to borrow, it could have a significant negative effect on its business. In addition, any adverse change to its credit ratings or business could negatively impact its ability to refinance its debt on satisfactory terms and could have the effect of increasing its financing costs. While Toys-Delaware believes it currently has adequate sources of funds to provide for its ongoing operations and capital requirements for at least the next 12 months, any inability on Toys-Delaware’s part to have future access to financing, when needed, would have a negative effect on its business.
A loss of, or reduction in, trade credit from Toys-Delaware’s vendors could reduce its liquidity, increase its working capital needs and/or limit its ability to purchase products.
Trade credit from Toys-Delaware’s vendors is an important source of financing for the purchase of the inventory Toys-Delaware sells in its stores. Accordingly, the loss of, or reduction in, trade credit could have a significant adverse impact on Toys-Delaware’s inventory levels and operating cash flow and negatively impact its liquidity. Toys-Delaware’s vendors may seek credit insurance to protect against non-payment of amounts due to them. If credit insurance is not available to vendors at reasonable terms or at all, vendors may demand accelerated payment of amounts due to them or require advance payments or letters of credit before goods are shipped to Toys-Delaware. Any adverse changes in Toys-Delaware’s trade credit for these or other reasons could increase the costs to Toys-Delaware of financing its inventory or negatively impact its ability to deliver products to its customers, which could in turn negatively affect Toys-Delaware’s financial performance.
Toys-Delaware may not retain or attract customers if it fails to successfully implement its strategic initiatives, which could result in lower sales and a failure to realize the benefit of the expenditures incurred for these initiatives.
Toys-Delaware continues to implement a series of customer-oriented strategic programs designed to differentiate and strengthen its core merchandise content and service levels and to expand and enhance its merchandise offerings. As part of Toys-Delaware’s omnichannel strategy to integrate its e-commerce and brick-and-mortar businesses, it aims to satisfy its customers’ evolving shopping preferences by utilizing fulfillment channels such as “In-Store Pick Up,” “Ship from Store” and “Ship to Store.” Toys-Delaware seeks to improve the effectiveness of its marketing and advertising programs for its “R” Us stores and e-commerce business. The success of these and other initiatives will depend on various factors, including the implementation of its strategy, the appeal of its store and website formats, its ability to offer new products to customers, its financial condition, its ability to respond to changing consumer preferences and competitive and economic conditions. Toys-Delaware continuously endeavors to minimize its operating expenses, without adversely affecting the profitability of the business. If it fails to implement successfully some or all of its strategic initiatives, it may be unable to retain or attract customers, which could result in lower sales and a failure to realize the benefit of the expenditures incurred for these initiatives.
If Toys-Delaware cannot increase profitability within existing stores or open new stores, its performance may be materially adversely affected.
Toys-Delaware’s performance is dependent on maintaining and increasing sales in existing stores and the ability to successfully open profitable new stores. Increases in sales in existing stores are dependent on factors such as competition, merchandise selection, store operations (including maintaining and remodeling these stores) and other factors discussed in these Risk Factors. Toys-Delaware’s ability to successfully open new stores and expand into additional market areas depends in part on the following factors, which are in part beyond Toys-Delaware’s control:
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the availability of sufficient funds for the expansion;
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the availability of attractive store locations and the ability to accurately assess the demographic or retail environment and customer demand at a given location;
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the ability to negotiate favorable lease terms and obtain the necessary permits and zoning approvals;
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the absence of occupancy delays;
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the ability to construct, furnish and supply a store in a timely and cost effective manner;
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the ability to hire and train new personnel, especially store managers, in a cost effective manner; and
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general economic conditions.
Delays or failures in successfully opening new stores, or achieving lower than expected sales in existing or new stores, could materially adversely affect Toys-Delaware’s profitability. In addition, Toys-Delaware may not be able to anticipate all of the challenges imposed by the expansion of its operations and, as a result, may not meet its targets for opening new stores or relocating stores or expanding profitably.
Some of Toys-Delaware’s new stores may be located in areas where it has little or no meaningful experience. Those markets may have different market conditions, consumer preferences and discretionary spending patterns than Toys-Delaware’s existing markets, which may cause its new stores to be less successful than stores in its existing markets. Other new stores may be located in areas where Toys-Delaware has existing stores. Although Toys-Delaware has experience in these markets, increasing the number of locations may result in unanticipated over-saturation of markets and temporarily or permanently divert customers and sales from its existing stores, thereby adversely affecting Toys-Delaware’s overall financial performance.
The success and expansion of Toys-Delaware’s e-commerce business depends on its ability to provide quality service to its customers and if it is not able to provide such services, Toys-Delaware’s operating results may be materially adversely affected.
Toys-Delaware’s Internet operations are subject to a number of risks and uncertainties which are in part beyond its control, including the following:
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failure of Toys-Delaware’s Internet service providers to perform their services properly and in a timely and efficient manner;
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changes in consumer willingness to purchase goods via the Internet;
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increases in software filters that may inhibit Toys-Delaware’s ability to market its products through e-mail messages to its customers and increases in consumer privacy concerns relating to the Internet;
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changes in applicable federal and state regulation, such as the Federal Trade Commission Act, the Children’s Online Privacy Act, the Fair Credit Reporting Act and the Gramm-Leach-Bliley Act and similar types of international laws;
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breaches of Internet security;
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failures in Toys-Delaware’s Internet infrastructure or the failure of systems or third parties, such as telephone or electric power service, resulting in website downtime or other problems;
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failure by Toys-Delaware to process online customer orders properly and on time, which may negatively impact future online and in-store purchases by such customers;
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failure by Toys-Delaware’s service provider to provide warehousing and fulfillment services, which may negatively impact future online and in-store purchases by customers; and
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failure to keep up with changes in technology.
As technology continues to advance, customers are increasingly using a variety of devices, such as computers, tablets and smartphones to shop online with Toys-Delaware and its competitors. Toys-Delaware continues to enhance its customers’ shopping experience on each of these devices as well as incorporate social media as another means of communicating with its customers. If Toys-Delaware fails to provide attractive, user-friendly online shopping platforms or fails to continually meet the evolving expectations of customers with developments in online merchandising technology and competitor offerings, Toys-Delaware could be at a competitive disadvantage and its business and results of operations may be materially adversely affected.
Moreover, if Toys-Delaware is not able to provide satisfactory service to its Internet customers, its future operating results may be materially adversely affected. Toys-Delaware is also vulnerable to the special competitive pressures from the growing e-commerce activity in its market, as they impact its own e-commerce business.
Toys-Delaware’s sales may be adversely affected if it fails to respond to changes in consumer preferences in a timely manner.
Toys-Delaware’s financial performance depends on its ability to identify, originate and define product trends, as well as to anticipate, gauge and react to changing consumer preferences in a timely manner. Its products must appeal to a broad range of consumers whose preferences cannot be predicted with certainty and are subject to change. Its business fluctuates according to changes in consumer preferences dictated in part by fashion trends, perceived value and season. These fluctuations affect the merchandise in stock since purchase orders are written well in advance of the holiday season and, at times, before fashion trends and high-demand brands are evidenced by consumer purchases. If it overestimates the market for its products, it may be faced with significant excess inventories, which could result in increased expenses and reduced margins associated with having to liquidate obsolete inventory at lower prices or write it off. For example, in fiscal 2013, Toys-Delaware recorded an incremental write-down of $51 million of excess and obsolete inventory. Conversely, if it underestimates the market for its products, Toys-Delaware will miss opportunities for increased sales and profits, which would place it at a competitive disadvantage.
Sales of video games and video game systems may be adversely affected by changing trends in the interactive entertainment industry including the rise in popularity of browser, mobile, tablet and social games distributed through alternative channels.
Sales of video games and video game systems, which have accounted for 6%, 7% and 7% of Toys-Delaware’s annual Total revenues for fiscals 2014, 2013 and 2012, respectively, have been impacted by trends in the interactive entertainment industry. Video games are now played on a wide variety of products, including mobile phones, tablets, social networking websites and other devices. The popularity of such non-traditional gaming has increased greatly and this popularity is expected to continue to grow. Browser, mobile, tablet and social gaming is accessed through hardware other than the consoles and traditional hand-held video game devices Toys-Delaware sells and its games are available through websites or proprietary app stores via direct online distribution at a fraction of the cost of console games. While Toys-Delaware continues to develop and implement various strategies to incorporate these new trends into its offerings, including selling third party tablets and other devices, there can be no assurance that these strategies will be successful or contribute to profitability. Similarly, a continued rise in the popularity of mobile and tablet gaming could negatively impact sales and profitability of traditional toys.
The decrease of birth rates in countries where Toys-Delaware operates could negatively affect its business.
Most of Toys-Delaware’s end-customers are newborns and children and, as a result, its revenues are dependent on the birth rates in countries where it operates. In recent years, many countries have experienced a drop in birth rates as their population ages and education and income levels increase. A continued and significant decline in the number of newborns and children in these countries could have a material adverse effect on Toys-Delaware’s operating results.
Toys-Delaware depends on key vendors to supply the merchandise that it sells to its customers and its vendors’ failure to supply quality merchandise in a timely manner may damage its reputation and brands and harm its business.
Toys-Delaware’s performance depends, in part, on its ability to purchase merchandise in sufficient quantities at competitive prices. Toys-Delaware purchases its merchandise from numerous international and domestic manufacturers and importers. Toys-Delaware has no contractual assurances of continued supply, pricing or access to new products, and any vendor could change the terms under which they sell to it or discontinue selling to it at any time. Toys-Delaware may not be able to purchase desired merchandise in sufficient quantities on terms acceptable to it in the future. Better than expected sales demand may also lead to customer backorders and lower in-stock positions of its merchandise.
In fiscal 2014, Toys-Delaware had 1,800 active vendor relationships through which it procures the merchandise that it offers to its customers. For fiscal 2014, Toys-Delaware’s top 20 vendors worldwide, based on its purchase volume in USD, represented 43% of the total products it purchased. Toys-Delaware’s inability to purchase suitable merchandise on acceptable terms or the loss of one or more key vendors could have a negative effect on its business and operating results and could cause it to miss products that it felt were important to its assortment. Toys-Delaware may not be able to develop relationships with new vendors, and products from alternative sources, if any, may be of a lesser quality and/or more expensive than those from existing vendors.
In addition, Toys-Delaware’s vendors are subject to various risks, including raw material costs, inflation, labor disputes, union organizing activities, financial liquidity, product merchantability, inclement weather, natural disasters and general economic and political conditions that could limit its vendors’ ability to provide Toys-Delaware with quality merchandise on a timely basis and at prices and payment terms that are commercially acceptable. For these or other reasons, one or more of Toys-Delaware’s vendors might not adhere to its quality control standards, and Toys-Delaware might not identify the deficiency before merchandise ships to its stores or customers. In addition, Toys-Delaware’s vendors may have difficulty adjusting to Toys-Delaware’s changing demands and growing business. Toys-Delaware’s vendors’ failure to manufacture or import quality merchandise in a timely and effective manner could damage its reputation and brands, and could lead to an increase in customer litigation against Toys-Delaware and an increase in its routine and non-routine litigation costs. Further, any merchandise that does not meet Toys-Delaware’s quality standards could become subject to a recall, which could damage Toys-Delaware’s brand reputation and harm its business.
If Toys-Delaware’s vendors fail to provide promotional support consistent with past levels, Toys-Delaware’s sales, earnings and cash flow could be materially adversely affected.
Toys-Delaware’s vendors typically provide it with promotional support for the sale of their products in Toys-Delaware’s stores and on Toys-Delaware’s websites. Toys-Delaware also receives allowances for volume-related purchases. As part of this support, Toys-Delaware receives allowances, payments and credits from the vendors which reduce its cost of goods sold, supports the promotion and merchandising of the products Toys-Delaware sells and drives sales at its stores and on its websites. There can be no assurance that vendors will continue to provide it with this support consistent with past levels. If Toys-Delaware’s vendors fail to do so, its sales, earnings and cash flow could be materially adversely affected.
If current store locations become unattractive, and attractive new locations are not available for a reasonable price, Toys-Delaware may be adversely affected.
The success of any store depends in substantial part on its location. There can be no assurance that current locations will continue to be attractive as demographic patterns change. Neighborhood or economic conditions where stores are located could decline in the future, potentially resulting in reduced sales in these locations. If Toys-Delaware cannot obtain desirable locations at reasonable prices, its ability to implement its strategy will be adversely affected.
Toys-Delaware has substantial obligations under long-term leases that could materially adversely affect its financial condition and prevent it from fulfilling its obligations.
As of January 31, 2015, Toys-Delaware leased 850 of its properties pursuant to long-term space and ground leases with third parties (other than subsidiaries of Toys-Delaware, including us), of which 323 (including three distribution centers and its headquarters) and 32 are leased from Propco I and MAP 2005 Real Estate, LLC, respectively. Total unrelated third party rent expense, net of sublease income, was $219 million, $219 million and $209 million in fiscals 2014, 2013 and 2012, respectively. Total related party rent expense under leases with affiliates other than subsidiaries of Toys-Delaware was $243 million, $249 million and $257 million for fiscals 2014, 2013 and 2012, respectively. In addition, as of January 31, 2015, Toys-Delaware leased 124 properties from us with total rent expense of $103 million, $104 million and $107 million for fiscals 2014, 2013 and 2012, respectively. Many of Toys-Delaware’s leases provide for scheduled increases in rent. The substantial obligations under its leases could further exacerbate the risks described below under “Toys-Delaware’s substantial indebtedness could adversely affect its ability to raise additional capital to fund its operations or refinance its maturing debt, limit its ability to react to changes in the economy or its industries, expose it to interest rate risk to the extent of its variable rate debt and prevent it from meeting its obligations under its various debt instruments and the TRU Propco II Master Lease.”
If Toys-Delaware is unable to renew or replace its current store leases or if it is unable to enter into leases for additional stores on favorable terms, or if one or more of its current leases are terminated prior to expiration of their stated term and it cannot find suitable alternate locations, Toys-Delaware’s growth and profitability could be negatively impacted.
Toys-Delaware currently leases the majority of its stores, including those leased to it by us. Most of its current leases provide for its unilateral option to renew for several additional periods at specific rental rates. Toys-Delaware’s ability to re-negotiate favorable terms on an expiring lease or to negotiate favorable terms for a suitable alternate location or for additional store locations could depend on conditions in the real estate market, competition for desirable properties and Toys-Delaware’s relationships with current and prospective landlords or may depend on other factors that are not within Toys-Delaware’s control. Any or all of these factors and conditions could negatively impact Toys-Delaware’s growth and profitability.
Toys-Delaware’s business, financial condition and results of operations are subject to risks arising from its international suppliers which could negatively impact its financial condition and results of operations.
The products Toys-Delaware sells are sourced from a variety of international suppliers, with China being a significant source. Political or financial instability, trade restrictions, labor unrest, transport capacity and costs, port security or other events that could slow port activities and affect foreign trade are beyond Toys-Delaware’s control and could disrupt its supply of merchandise and/or materiality adversely affect its results of operations. In addition, changes in the costs of procuring raw materials used in its merchandise or the costs related to its supply chain, including labor, fuel, tariffs, and currency exchange rates could have a material adverse effect on gross margin, expenses and results of operations.
In addition, any significant or prolonged deterioration in U.S. - China relations could adversely affect Toys-Delaware’s business. Certain risks and uncertainties of doing business in China are solely within the control of the Chinese government, and Chinese law regulates the scope of foreign investments and business conducted within China. There are also uncertainties regarding the interpretation and application of laws and regulations and the enforceability of intellectual property and contract rights in China.
Toys-Delaware’s business is subject to fluctuations in foreign currency exchange rates and such fluctuations may have a material adverse effect on its business, financial condition and results of operations.
Exchange rate fluctuations may affect the translated value of Toys-Delaware’s earnings and cash flow associated with its international operations, as well as the translation of net asset or liability positions that are denominated in foreign currencies. In Canada, Toys-Delaware generates revenues and incurs operating expenses and selling, general and administrative expenses denominated in the local currency. In countries where Toys-Delaware does not operate stores, Toys-Delaware’s licensees pay royalties in USD. However, as the royalties are calculated based on local currency sales, Toys-Delaware’s revenues are still impacted by fluctuations in exchange rates. In fiscal years 2014, 2013 and 2012, 10%, 10% and 10% of Toys-Delaware’s Total revenues, respectively, were completed in a currency other than the USD. In fiscal 2014, Toys-Delaware’s reported operating earnings would have decreased or increased $4 million if the related foreign currencies uniformly weakened or strengthened by an incremental 10% relative to the USD.
Toys-Delaware enters into foreign exchange agreements from time to time with financial institutions to reduce its exposure to fluctuations in currency exchange rates referred to as hedging activities. However, these hedging activities may not eliminate foreign currency risk entirely and involve costs and risks of their own. Although Toys-Delaware hedges some exposures to changes in foreign currency exchange rates arising in the ordinary course of business, foreign currency fluctuations may have a material adverse effect on Toys-Delaware’s business, financial condition and results of operations.
Because of Toys-Delaware’s extensive international activities, it could be adversely affected by violations of the United States Foreign Corrupt Practices Act and similar worldwide anti-bribery laws.
The United States Foreign Corrupt Practices Act and similar worldwide anti-bribery laws generally prohibit companies and their intermediaries from making improper payments to non-U.S. officials for the purpose of obtaining or retaining business. Toys-Delaware’s policies mandate compliance with these anti-bribery laws. There can be no assurance that its internal control policies and procedures always will protect Toys-Delaware from reckless or criminal acts committed by the employees or agents of Toys-Delaware. Violations of these laws, or allegations of such violations, could disrupt Toys-Delaware’s business, damage its reputation and result in a material adverse effect on its financial condition, results of operations and cash flows.
International events could delay or prevent the delivery of products to Toys-Delaware’s stores, which could negatively affect its sales and profitability.
A significant portion of products sold by Toys-Delaware are manufactured outside of the United States, primarily in Asia. As a result, any event causing a disruption of imports, including labor strikes, work stoppages, boycotts, safety issues on materials, the imposition of trade restrictions in the form of tariffs, embargoes or export controls, “anti-dumping” duties, port security or other events that could slow port activities, could increase the cost and reduce the supply of products available to Toys-Delaware. In addition, port-labor issues, rail congestion and trucking shortages can have an impact on all direct importers. Although Toys-Delaware attempts to anticipate and manage such situations, both Toys-Delaware’s sales and profitability could be materially adversely impacted by any such developments in the future.
Toys-Delaware’s results may be materially adversely affected by fluctuations in raw material and energy costs.
Toys-Delaware’s results may be affected by the prices of the components and raw materials used in the manufacture of its toys and baby products. These prices may fluctuate based on a number of factors beyond Toys-Delaware’s control, including: oil prices, changes in supply and demand, general economic conditions, labor costs, competition, import duties, tariffs, currency exchange rates and government regulation. In addition, energy costs have fluctuated dramatically in the past. These fluctuations may result in an increase in Toys-Delaware’s transportation costs for distribution, utility costs for its retail stores and overall costs to purchase products from its vendors.
Toys-Delaware may not be able to adjust the prices of its products, especially in the short-term, to recover these cost increases in raw materials and energy. A continual rise in raw material and energy costs could adversely affect consumer spending and demand for Toys-Delaware’s products and increase its operating costs, both of which could have a material adverse effect on its financial condition and results of operations.
A significant disruption to Toys-Delaware’s distribution network or to the timely receipt of inventory could adversely impact sales or increase its transportation costs, which would decrease its profits.
Toys-Delaware relies on its ability to replenish depleted inventory in its stores through deliveries to its distribution centers from vendors and then from its distribution centers or direct ship vendors to its stores by various means of transportation, including shipments by sea, rail, air and truck. Toys-Delaware relies on various third-party vendors to manage services related to the delivery of inventory from distribution centers to its stores. Unexpected delays in those deliveries or increases in transportation costs (including from increased fuel costs) could significantly decrease its ability to generate sales and earn profits. In addition, labor shortages or labor disagreements in the transportation industry or long-term disruptions to the national and international transportation infrastructure that lead to delays or interruptions of deliveries could negatively affect its business.
Product safety issues, including product recalls, could harm Toys-Delaware’s reputation, divert resources, reduce sales and increase costs.
The products Toys-Delaware sells in its stores are subject to regulation by the Federal Consumer Product Safety Commission and similar U.S. state, Canadian and other international regulatory authorities. As a result, such products have been and could be in the future subject to recalls and other remedial actions. Product safety concerns may require Toys-Delaware to voluntarily remove selected products from its stores. Such recalls and voluntary removal of products can result in, among other things, lost sales, diverted resources, potential harm to Toys-Delaware’s reputation and increased customer service costs, which could have a material adverse effect on Toys-Delaware’s business, financial condition and results of operations.
Toys-Delaware’s business exposes it to personal injury and product liability claims which could result in adverse publicity and harm to its brands and its results of operations.
Toys-Delaware is from time to time subject to claims due to the injury of an individual in its stores or on its property. In addition, Toys-Delaware has in the past been subject to product liability claims for the products that it sells. Subject to certain exceptions, Toys-Delaware’s purchase orders generally require the manufacturer to indemnify it against any product liability claims; however, if the manufacturer does not have insurance or becomes insolvent, there is a risk that Toys-Delaware would not be indemnified. Any personal injury or product liability claim made against Toys-Delaware, whether or not it has merit, could be time consuming and costly to defend, result in adverse publicity or damage to Toys-Delaware’s reputation and have an adverse effect on Toys-Delaware’s results of operations.
Adverse litigation judgments or settlements resulting from legal proceedings in which Toys-Delaware may be involved could expose it to monetary damages or limit its ability to operate its business.
Toys-Delaware is involved in private actions, investigations and various other legal proceedings by employees, suppliers, competitors, government agencies or others. The results of such litigation, investigations and other legal proceedings are inherently unpredictable. Any claims against Toys-Delaware, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and divert significant resources. If any of these legal proceedings were to be determined adversely to Toys-Delaware, Toys-Delaware could be exposed to monetary damages or limits on its ability to operate its business, which could have a material adverse effect on its business, financial condition and results of operations.
Healthcare reform legislation could have an adverse impact on Toys-Delaware’s business, financial condition and results of operations.
The enacted healthcare reform legislation under the Patient Protection and Affordable Care Act and Health Care and Education Reconciliation Act of 2010 will potentially impact Toys-Delaware’s healthcare cost structure and may, over time, increase its employee healthcare related expenses. Provisions of this law have become and will become effective in 2015 and at various dates over the next several years and many of the regulations and guidance for the law still have not been implemented. Toys-Delaware continues to evaluate the potential additional impact the healthcare reform legislation will have on its business as regulations and guidance are communicated. Due to the breadth and complexity of this law, the lack of regulations and guidance for implementation and the phased-in nature of new requirements, Toys-Delaware cannot predict with certainty the future effect of this law on its results. Because it may increase the costs of providing medical insurance to its employees, the new healthcare legislation may adversely affect Toys-Delaware’s results of operations, financial condition and cash flow.
Toys-Delaware is subject to certain regulatory and legal requirements. If it fails to comply with regulatory or legal requirements, its business and results of operations may be materially adversely affected.
Toys-Delaware is subject to numerous regulatory and legal requirements. Its policies and procedures are, to the extent applicable, required to comply with all applicable laws and regulations, including those imposed by the Federal Trade Commission and the Securities and Exchange Commission. In addition, its business activities require it to comply with complex regulatory and legal issues on a local, national and worldwide basis (including, in some cases, more stringent local labor law or regulations). Future legislative and regulatory actions relating to credit cards could also have an adverse impact on Toys-Delaware’s credit card program and its sales. Additionally, Toys-Delaware may be subject to new disclosure and reporting requirements, established under existing or new state or federal laws. Failure to comply with such laws and regulations could adversely affect its operations, involve significant expense and divert management’s attention and resources from other matters, which in turn could materially harm its business and results of operations.
Toys-Delaware’s business operations could be disrupted if its information technology systems fail to perform adequately or Toys-Delaware is unable to protect the integrity and security of its customers’ information.
Toys-Delaware depends largely upon its information technology systems in the conduct of all aspects of its operations. If Toys-Delaware’s information technology systems fail to perform as anticipated, Toys-Delaware could experience difficulties in virtually any area of its operations, including but not limited to replenishing inventories or in delivering its products to store locations in response to consumer demands. Any of these or other systems-related problems could, in turn, materially adversely affect Toys-Delaware’s sales and profitability.
Other sophisticated retailers have recently suffered serious security breaches. A compromise of Toys-Delaware’s security systems (or a design flaw in its system environment) could result in unauthorized access to certain personal information about Toys-Delaware’s employees or customers (including credit card and gift registry information) which could adversely affect its reputation with its customers and others, as well as its operations, and could result in litigation against it or the imposition of
penalties. In addition, a security breach could require that it expend significant additional resources related to its information security systems. Such risks may be difficult to insure against or insurance may be costly.
Natural disasters, inclement weather, pandemic outbreaks, terrorist acts or disruptive global political events could cause permanent or temporary distribution center or store closures, impair Toys-Delaware’s ability to purchase, receive or replenish inventory or decrease customer traffic, all of which could result in lost sales and otherwise materially adversely affect Toys-Delaware’s financial performance.
The occurrence of one or more natural disasters, such as hurricanes, fires, floods, earthquakes, tornadoes and volcano eruptions, or inclement weather such as frequent or unusually heavy snow, ice or rain storms, or extended periods of unseasonable temperatures, or the occurrence of pandemic outbreaks, labor strikes, work stoppages, terrorist acts or disruptive global political events, such as civil unrest in countries in which Toys-Delaware operates stores or its suppliers are located, or similar disruptions could materially adversely affect Toys-Delaware’s operations and financial performance. To the extent these events impact one or more of Toys-Delaware’s key vendors or result in the closure of one or more of its distribution centers or a significant number of stores, Toys-Delaware’s operations and financial performance could be materially adversely affected through an inability to make deliveries to its stores and through lost sales. In addition, these events could result in increases in fuel (or other energy) prices or a fuel shortage, delays in opening new stores, the temporary lack of an adequate work force in a market, the temporary or long-term disruption in the supply of products from some local and overseas vendors, the temporary disruption in the transport of goods from overseas, delay in the delivery of goods to Toys-Delaware’s distribution centers or stores, the temporary reduction in the availability of products in its stores and disruption to its information systems. These events also can have indirect consequences such as increases in the costs of insurance if they result in significant loss of property or other insurable damage.
Toys-Delaware’s results of operations could suffer if it loses key management or is unable to attract and retain experienced senior management for its business.
Toys-Delaware’s future success depends to a significant degree on the skills, experience and efforts of its senior management team. The loss of services of any of these individuals, or the inability to attract and retain qualified individuals for key management positions, could harm Toys-Delaware’s business and financial performance.
Toys-Delaware may experience fluctuations in its tax obligations and effective tax rate, which could materially adversely affect its results of operations.
Toys-Delaware is subject to income taxes in the United States, Puerto Rico and Canada. Toys-Delaware records tax expense based on current tax payments and its estimates of future tax payments, which include reserves for estimates of probable settlements of international and domestic tax audits. At any one time, many tax years are subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these issues. As a result, Toys-Delaware expects that throughout the year there could be ongoing variability in its quarterly tax rates as taxable events occur and exposures are re-evaluated. Further, Toys-Delaware’s effective tax rate in a given financial statement period may be materially impacted by changes in tax laws, changes in the mix and level of earnings by taxing jurisdiction, changes to existing accounting rules or regulations, or by changes to its ownership or capital structures. Fluctuations in Toys-Delaware’s tax obligations and effective tax rate could materially adversely affect its results of operations.
Changes to accounting rules or regulations may materially adversely affect Toys-Delaware’s results of operations.
Changes to existing accounting rules or regulations may impact Toys-Delaware’s future results of operations. New accounting rules or regulations and varying interpretations of existing accounting rules or regulations have occurred and may occur in the future. Future changes to accounting rules or regulations may materially adversely affect Toys-Delaware’s reported results of operations and financial position.
Toys-Delaware’s total assets include a substantial amount of property and equipment. Changes to estimates or projections related to such assets, or operating results that are lower than its current estimates at certain store locations, may cause Toys-Delaware to incur impairment charges that could materially adversely affect its results of operations.
Toys-Delaware’s total assets include a substantial amount of property and equipment and have historically included a substantial goodwill balance prior to impairments recorded in fiscal 2013. Toys-Delaware makes certain estimates and projections in connection with impairment analyses for these assets, in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 360, “Property, Plant and Equipment” (“ASC 360”), and ASC Topic 350, “Intangibles - Goodwill and Other” (“ASC 350”). Toys-Delaware reviews the carrying value of these assets for impairment whenever events or changes in circumstances indicate that the carrying value of the asset may not be recoverable in accordance with ASC 360 or ASC 350. Toys-Delaware will record an impairment loss when the carrying value of the underlying asset, asset group or reporting unit exceeds its fair value. These calculations require Toys-Delaware to make a
number of estimates and projections of future results. During fiscal 2013, Toys-Delaware recorded impairment losses of $20 million on property and equipment and $361 million on goodwill. If these estimates or projections change, Toys-Delaware may be required to record additional impairment charges on certain of these assets. If these impairment charges are significant, Toys-Delaware’s results of operations could be materially adversely affected.
Toys-Delaware may from time to time pursue acquisitions, which could have an adverse impact on its business, as could the integration of the businesses following acquisition.
Toys-Delaware may from time to time acquire complementary companies or businesses. Acquisitions may result in unanticipated costs, delays or other operational or financial problems related to integrating the acquired company and business with Toys-Delaware, which may result in the diversion of its capital and its management’s attention from other business issues and opportunities. Toys-Delaware may not be able to successfully integrate operations that it acquires, including their personnel, technology, financial systems, distribution and general business operations and procedures. There can be no assurance that any acquisition it makes will be successful and its operating results may be adversely impacted by the integration of a new business and its financial results.
An investment group led by Bain Capital Partners, LLC, Kohlberg Kravis Roberts & Co. L.P., and Vornado Realty Trust (collectively, the “Sponsors”) controls Toys-Delaware and may have conflicts of interest with it in the future.
Investment funds or groups advised by or affiliated with the Sponsors currently indirectly control Toys-Delaware through their ownership of 98% of TRU’s voting common stock. As a result, the Sponsors have control over Toys-Delaware’s decisions to enter into any corporate transaction and have the ability to prevent any transaction that requires the approval of stockholders. In addition, the Sponsors may have an interest in pursuing dispositions, acquisitions, financings or other transactions that, in their judgment, could enhance their equity investments, even though such transactions might involve risks to Toys-Delaware as a company.
The Sponsors may direct Toys-Delaware to make significant changes to its business operations and strategy, including with respect to, among other things, store openings and closings, new product and service offerings, sales of real estate and other assets, employee headcount levels and initiatives to reduce costs and expenses. There can be no assurance that Toys-Delaware’s future business operations will remain broadly in line with its existing operations or that significant real estate and other assets will not be sold.
The Sponsors are also in the business of making investments for their own accounts in companies, and may from time to time acquire and hold interests in businesses that compete directly or indirectly with Toys-Delaware. One or more of the Sponsors may also pursue acquisition opportunities that may be complementary to Toys-Delaware’s business and, as a result, those acquisition opportunities may not be available to Toys-Delaware. So long as investment funds associated with or designated by the Sponsors continue to indirectly own a significant amount of the outstanding shares of TRU’s common stock, the Sponsors will continue to be able to strongly influence or effectively control TRU’s and, accordingly, Toys-Delaware’s decisions.
Risks Related to the Master Tenant’s and TRU’s Substantial Indebtedness
Toys-Delaware’s substantial indebtedness could adversely affect its ability to raise additional capital to fund its operations or refinance its maturing debt, limit its ability to react to changes in the economy or its industry, expose it to interest rate risk to the extent of its variable rate debt and prevent it from meeting its obligations under its various debt instruments and the TRU Propco II Master Lease.
Toys-Delaware is highly leveraged. As of January 31, 2015, Toys-Delaware’s total long-term indebtedness was $2.4 billion, of which $2.2 billion was secured indebtedness. Toys-Delaware’s substantial indebtedness could have significant consequences, including, among others, the following:
•
increasing its vulnerability to general economic and industry conditions;
•
requiring a substantial portion of its cash flows from operating activities to be dedicated to the payment of principal and interest on its indebtedness, and as a result, reducing its ability to use its cash flows to fund its operations and capital expenditures, capitalize on future business opportunities and expand its business and execute its strategy;
•
increasing the difficulty for it to make scheduled payments on its outstanding debt and other obligations, including the TRU Propco II Master Lease, as its business may not be able to generate sufficient cash flows from operating activities to meet its obligations;
•
exposing it to the risk of increased interest expense due to changes in borrowing spreads and short-term interest rates;
•
causing it to make non-strategic divestitures;
•
limiting its ability to obtain additional financing for working capital, capital expenditures, debt service requirements and general, corporate or other purposes; and
•
limiting its ability to adjust to changing market conditions and reacting to competitive pressure, placing it at a competitive disadvantage compared to its competitors who are less leveraged.
Despite Toys-Delaware’s current level of indebtedness, it may still be able to incur substantially more debt. This could further exacerbate the risks to its financial condition described above.
Toys-Delaware may be able to incur additional indebtedness in the future, including under its current secured revolving credit agreement, subject to the restrictions contained in its debt instruments. Although its indentures, credit agreements and documents governing its other indebtedness contain restrictions on the incurrence of additional indebtedness, these restrictions are subject to a number of qualifications and exceptions, and the additional indebtedness incurred in compliance with these restrictions could be substantial. These restrictions also will not prevent Toys-Delaware from incurring obligations that do not constitute indebtedness. If new indebtedness is added to its current debt levels, the related risks that it now faces could intensify.
If Toys-Delaware’s cash flows and capital resources are insufficient to fund its debt service obligations or it is unable to refinance its indebtedness, it may be forced to take other actions to satisfy its obligations under its indebtedness, its obligations under the TRU Propco II Master Lease and/or other obligations, which may not be successful.
Toys-Delaware’s ability to make scheduled payments on or to refinance its debt obligations depends on its financial condition and operating performance, which are subject to prevailing global economic and market conditions and to certain financial, business and other factors beyond its control. Even if it were able to refinance or obtain additional financing, the costs of new indebtedness could be substantially higher than the costs of its existing indebtedness.
If Toys-Delaware’s cash flows and capital resources are insufficient to fund its debt service obligations or it is unable to refinance its indebtedness, it could face substantial liquidity problems, and it may be forced to reduce or delay investments and capital expenditures, or to sell assets, seek additional capital or restructure its indebtedness. These alternative measures may not be successful and may not permit it to meet its debt obligations. Additionally, in the event of such liquidity problems, Toys-Delaware may become unable to meet its obligations under the TRU Propco II Master Lease which may impact our cash flow and consequently, our ability to meet our obligations under the Secured Notes. If Toys-Delaware was unable to repay amounts when due, the lenders could proceed against the collateral granted to them to secure that indebtedness.
Toys-Delaware’s debt agreements contain covenants that limit its flexibility in operating its business.
The agreements governing Toys-Delaware’s indebtedness contain various covenants that limit its ability to engage in specified types of transactions, and may materially adversely affect its ability to operate its business. Among other things, these covenants limit Toys-Delaware’s and its subsidiaries’ ability to:
•
incur certain additional indebtedness;
•
transfer money between Toys-Delaware, its various subsidiaries and TRU;
•
pay dividends on, repurchase or make distributions with respect to its or its subsidiaries’ capital stock or make other restricted payments;
•
issue stock of subsidiaries;
•
make certain investments, loans or advances;
•
transfer and sell certain assets;
•
create or permit liens on assets;
•
consolidate, merge, sell or otherwise dispose of all or substantially all of its assets;
•
enter into certain transactions with its affiliates; and
•
amend certain documents.
A breach of any of these covenants could result in default under one or more of Toys-Delaware’s debt agreements, which could prompt the lenders to declare all amounts outstanding under one or more of the debt agreements to be immediately due and payable and terminate all commitments to extend further credit. If Toys-Delaware were unable to repay those amounts, the lenders could proceed against the collateral granted to them to secure that indebtedness. If the lenders under the debt agreements accelerate the repayment of borrowings, Toys-Delaware may not have sufficient assets and funds to repay the borrowings under its debt agreements or meets its obligations under the TRU Propco II Master Lease.
TRU and its subsidiaries are highly leveraged and may need to refinance debt in the future, which refinancing may not be available.
TRU’s ability to make scheduled payments on or to refinance its debt obligations depends on its financial condition and operating performance, which are subject to prevailing global economic and market conditions and to certain financial,
business and other factors beyond its control. Even if it were able to refinance or obtain additional financing, the costs of new indebtedness could be substantially higher than the costs of its existing indebtedness.
If TRU’s cash flows and capital resources are insufficient to fund its debt service obligations or it is unable to refinance its indebtedness, it could face substantial liquidity problems, and it may be forced to reduce or delay investments and capital expenditures, or to sell assets, seek additional capital or restructure its indebtedness. These alternative measures may not be successful and may not permit it to meet its debt obligations. If TRU were unable to repay amounts when due, the lenders could proceed against the collateral granted to them to secure that indebtedness.
While TRU and its subsidiaries (other than Toys-Delaware or us) are not obligated to make payments under the TRU Propco II Master Lease or the Secured Notes, respectively, in the event that TRU or its subsidiaries were to become a debtor in a Bankruptcy Case, a creditor, receiver, conservator or the trustee in such bankruptcy might request a court to order TRU and its subsidiaries’ assets and liabilities be consolidated with ours or Toys-Delaware’s (including its properties) for the satisfaction of claims of creditors of TRU or its subsidiaries. We, Toys-Delaware or TRU or its subsidiaries may become subject to bankruptcy proceedings and in that event our respective rights and obligations may be subject to material modification.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2.
PROPERTIES
The following summarizes our properties as of January 31, 2015:
(1)
Owned buildings on leased land.
See also section of Item 1 entitled “Geographic Distribution of Properties” of this Annual Report on Form 10-K for more information on our Properties.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
Although we do not currently have material legal proceedings pending against us, in the future, we may be involved in various lawsuits, claims and proceedings incident to the ordinary course of business. The results of litigation are inherently unpredictable. Any claims against us, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in diversion of significant resources. The results of these lawsuits, claims and proceedings cannot be predicted with certainty.
ITEM 4.
ITEM 4.
MINE SAFETY DISCLOSURE
None.
PART II
ITEM 5.
ITEM 5.
MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
As of April 24, 2015, all of our outstanding membership interests were privately held by our sole member, Giraffe Junior Holdings, LLC.
See Note 6 to the Financial Statements entitled “LONG-TERM DEBT” for a description of restrictions on our ability to pay dividends.
We evaluate our cash balances on an ongoing basis and periodically distribute cash to our parent companies. During fiscals 2014 and 2013, we made cash distributions of $13 million and $14 million in dividends, respectively.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
Item 6 is omitted as we meet the conditions set forth in General Instructions (I)(1)(a) and (b) of Form 10-K.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help facilitate an understanding of our historical results of operations during the periods presented and our financial condition. This MD&A should be read in conjunction with our Financial Statements and the accompanying notes, and contains forward-looking statements that involve risks and uncertainties. See “Forward-Looking Statements” and Item 1A entitled “RISK FACTORS” of this Annual Report on Form 10-K. Our MD&A includes the following sections:
EXECUTIVE OVERVIEW provides an overview of our business.
RESULTS OF OPERATIONS provides an analysis of our results of operations for fiscal 2014 compared to fiscal 2013 and fiscal 2013 compared to fiscal 2012. With the exception of fiscal 2012, which included 53 weeks, all other fiscal years presented include 52 weeks.
LIQUIDITY AND CAPITAL RESOURCES provides an overview of our cash flows, financing and contractual obligations.
CRITICAL ACCOUNTING POLICIES provides a discussion of our accounting policies that require critical judgment, assumptions and estimates.
RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS provides a brief description of significant accounting standards which were adopted during fiscal 2014. This section also refers to Note 10 to our Financial Statements entitled “RECENT ACCOUNTING PRONOUNCEMENTS” for accounting standards which we have not yet been required to implement and may be applicable to our future operations.
All information in this MD&A is presented on a historical basis and reflects results of continuing operations for all periods presented.
EXECUTIVE OVERVIEW
Our Business
We are a special purpose entity, owned indirectly by TRU, through Toys-Delaware, and formed in July 2005. We own fee and ground leasehold interests in 124 properties in various retail markets throughout the United States. Under the operating company/property company structure, we lease these properties on a triple-net basis to Toys-Delaware, the operating entity for all of TRU’s North American businesses. Substantially all of our revenues and cash flows are derived from payments from Toys-Delaware under the TRU Propco II Master Lease. For the financial statements for fiscal year ended January 31, 2015 and other information about our Master Tenant, Toys-Delaware, see Exhibit number 99.1 to this report.
Our primary business operations consist of leasing properties to our affiliate Toys-Delaware, servicing our debt via payments on our debt instruments and, subject to compliance with our debt agreements, distributing cash to our parent companies. Our management does not currently have plans to purchase additional properties. As a result, we do not believe we are subject to risks associated with obtaining financing for individual properties when availability of capital in the marketplace may be limited or may be subject to the overall economic environment. Substantially all of our cash revenues are subject to fixed increases under the TRU Propco II Master Lease which will expire in 2030. Also, interest payments under the senior secured 8.500% notes due fiscal 2017 (the “Secured Notes”) are fixed at 8.500%.
Although a majority of our properties are owned, we lease several of our properties from third parties and as these leases expire, we may need to renew these leases on terms that may not be as favorable as under the expiring lease. However, none of our leases expire prior to the maturity of the Secured Notes. Also, the terms of the TRU Propco II Master Lease allow us to charge real estate taxes, common area maintenance expenses and certain other operating expenses to Toys-Delaware.
Material Trends and Uncertainties
Our primary source of rental revenue and cash flows is derived from the leasing arrangements we have entered into with Toys-Delaware under the TRU Propco II Master Lease which expires in fiscal 2030. We record rental revenue using the straight-line method, which results in recording a consistent rate of revenue over the terms of our lease agreements even when cash rents received increase or decrease over the lease term. Rental payments under the TRU Propco II Master Lease increased by 10% for each property on February 1, 2015 and are scheduled to further increase by 10% on February 1, 2020 and February 1, 2025. Future annual related party base rents may be reduced by payments we receive from Toys-Delaware as a result of an early termination of a lease, as set forth under the terms of the TRU Propco II Master Lease, or the successful execution of the sale of such properties by us to a third party. Our largest expense is interest expense; the payment and recording of which is fixed over the term of the Secured Notes.
RESULTS OF OPERATIONS
Fiscal 2014 Compared to Fiscal 2013
Earnings from continuing operations includes the results of properties disposed of in the current year, whereas the results of properties disposed of in the prior year are presented in Earnings from discontinued operations. Refer to “RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS” below for further details.
Total Revenues
Total revenues increased by $2.5 million in fiscal 2014 compared to fiscal 2013. The increase was primarily due to a termination payment of $3.1 million recognized from Toys-Delaware as required under the TRU Propco II Master Lease for one property sold.
Depreciation
Depreciation decreased by $0.4 million in fiscal 2014 compared to fiscal 2013. The decrease was primarily due to assets that were fully depreciated in the current year and accelerated depreciation taken in the prior year for properties which we committed to exit prior to the end of the useful lives of the assets.
Rental Expense
Rental expense remained relatively consistent in fiscal 2014 compared to fiscal 2013.
Common Area Maintenance Expenses
Common area maintenance expenses increased by $0.4 million in fiscal 2014 compared to fiscal 2013. The increase was primarily due to an increase in Real estate taxes. These expenses are fully reimbursed by our tenant under the TRU Propco II Master Lease, and are reflected in Tenant reimbursements, which is a component of Total revenues.
Other Operating Expenses, Net
Other operating expenses, net increased by $3.3 million in fiscal 2014 compared to fiscal 2013. The increase was primarily due to the sale of an owned property and a non-operating parcel to unrelated third parties, which resulted in a net loss of $3.2 million.
Interest Expense, Net
Interest expense, net increased by $0.1 million in fiscal 2014 compared to fiscal 2013.
Earnings from Continuing Operations
Earnings from continuing operations decreased by $0.9 million in fiscal 2014, compared to fiscal 2013. The decrease was primarily due to an increase in Other operating expenses, net, partially offset by an increase in Total revenues.
Earnings from Discontinued Operations
We did not have Earnings from discontinued operations in fiscal 2014. Earnings from discontinued operations in fiscal 2013 consisted primarily of termination payments of $11.8 million recognized from Toys-Delaware as required under the TRU Propco II Master Lease for an early lease termination, a lease expiration for which we opted not to exercise the renewal option and two properties sold.
Fiscal 2013 Compared to Fiscal 2012
Total Revenues
Total revenues decreased by $1.7 million in fiscal 2013 compared to fiscal 2012. The decrease was primarily due to a decline in Base rents predominantly as a result of 52 weeks of revenue included in fiscal 2013 compared to 53 weeks in fiscal 2012.
Depreciation
Depreciation decreased by $0.1 million in fiscal 2013 compared to fiscal 2012.
Rental Expense
Rental expense remained relatively consistent in fiscal 2013 compared to fiscal 2012.
Common Area Maintenance Expenses
Common area maintenance expenses decreased by $0.1 million in fiscal 2013 compared to fiscal 2012. These expenses are fully reimbursed by our tenant under the TRU Propco II Master Lease, and are reflected in Tenant Reimbursements, which is a component of Total revenues.
Other Operating Expenses, Net
Other operating expenses, net decreased by $0.1 million in fiscal 2013 compared to fiscal 2012.
Interest Expense, Net
Interest expense, net decreased by $1.1 million in fiscal 2013 compared to fiscal 2012. The reporting period for fiscal 2013 included 52 weeks compared to 53 weeks for fiscal 2012, resulting in one less week of interest expense.
Earnings from Continuing Operations
Earnings from continuing operations decreased by $0.2 million in fiscal 2013 compared to fiscal 2012.
Earnings from Discontinued Operations
Earnings from discontinued operations increased by $11.7 million in fiscal 2013 compared to fiscal 2012. The increase was primarily due to termination payments of $11.8 million recognized from Toys-Delaware as required under the TRU Propco II Master Lease for two lease terminations and two properties sold.
Liquidity and Capital Resources
Overview
As of January 31, 2015, we were in compliance with all of the covenants related to the Secured Notes.
Our largest source of operating cash flows is cash collections from our lessee, Toys-Delaware. In general, we utilize our cash to service debt, pay normal operating costs and at the discretion of our sole member, based on the recommendation of our management, and as permitted by the indenture governing the Secured Notes, declare and pay dividends or make distributions.
Additionally, the indenture governing the Secured Notes allows us to re-invest the net cash proceeds from the sale of properties (“Asset Sales” as defined in the indenture) within 720 days subsequent to the receipt of the proceeds. If net cash proceeds are not reinvested within 720 days of receipt, the net cash proceeds are deemed to be excess proceeds (“Excess Proceeds”). When the aggregate amount of Excess Proceeds exceeds $10.0 million, we are required to make an offer to all holders of the Secured Notes within 30 days to purchase Secured Notes with the Excess Proceeds. We have not recognized cumulative Asset Sales, as defined in the indenture, in excess of $10.0 million as of January 31, 2015.
We have been able to meet our operating cash needs principally by using cash on hand and cash flows from operations and we believe that cash generated from operations along with existing cash will be sufficient to fund our expected cash flow requirements for at least the next twelve months.
Cash Flows
Cash Flows Provided by Operating Activities
Net cash provided by operating activities for fiscal 2014 was $28.5 million compared to $31.2 million for fiscal 2013. The decrease in Net cash provided by operating activities was primarily due to a decrease in termination payments received from Toys-Delaware in fiscal 2014 as required under the TRU Propco II Master Lease, partially offset by an increase in collections of base rents in the current year due to the timing of rental payments received.
Net cash provided by operating activities for fiscal 2013 was $31.2 million compared to $34.9 million for fiscal 2012. The decrease in Net cash provided by operating activities was primarily due to a decrease in collections of base rent due to the timing of rental payments received, partially offset by termination payments received from Toys-Delaware in fiscal 2013 as required under the TRU Propco II Master Lease.
Cash Flows Provided by Investing Activities
Net cash provided by investing activities for fiscal 2014 was $1.4 million compared to $3.9 million for fiscal 2013. The decrease in net cash provided by investing activities was due to a decrease in proceeds received from the sale of real estate.
Net cash provided by investing activities for fiscal 2013 was $3.9 million due to proceeds received from the sale of real estate.
Cash Flows Used in Financing Activities
Net cash used in financing activities for fiscals 2014, 2013 and 2012 was $12.6 million, $13.6 million and $16.8 million, respectively. The decrease in Net cash used in financing activities was due to a decline in Distributions in each of the respective fiscal years.
Debt
Refer to Note 6 to the Financial Statements entitled “LONG-TERM DEBT” for further details regarding our Secured Notes.
From time to time, we, TRU, its subsidiaries, the Sponsors or their affiliates, may acquire debt or debt securities issued by us in open market transactions, tender offers, privately negotiated transactions or otherwise. Any such transactions, and the amounts involved, will depend on prevailing market conditions, liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. Refer to Note 9 to the Financial Statements entitled “RELATED PARTY TRANSACTIONS.”
Contractual Obligations and Commitments
Our contractual obligations consist mainly of payments related to Long-term debt and related interest, and operating leases related to real estate used in the operation of our business. The following table summarizes our contractual obligations associated with our Long-term debt and other obligations as of January 31, 2015:
(1)
Excluded from Operating leases displayed above are $71 million related to options to extend ground lease terms that are reasonably assured of being exercised, the balance of which predominantly relates to fiscals 2020 and thereafter.
Obligations under our operating leases in the above table do not include payments for real estate taxes or maintenance and other expenses. The following table presents these expenses for fiscals 2014, 2013 and 2012:
Off-Balance Sheet Arrangements
None.
CRITICAL ACCOUNTING POLICIES
Our Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The preparation of these financial statements requires us to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosures of contingent assets and liabilities as of the date of the financial statements and during the applicable periods. We base these estimates on historical experience and on other factors that we believe are reasonable under the circumstances. Actual results may differ materially from these estimates under different assumptions or conditions and could have a material impact on our Financial Statements.
We believe the following are our most critical accounting policies that include significant judgments and estimates used in the preparation of our Financial Statements. We consider an accounting policy to be critical if it requires assumptions to be made that were uncertain at the time they were made, and if changes in these assumptions could have a material impact on our financial condition or results of operations.
Long-lived Asset Impairment
We evaluate the carrying value of all long-lived assets, which include land and buildings, for impairment whenever events or changes in circumstances, including the tenant’s intent to exit a property in advance of the TRU Propco II Master Lease term, indicate that the carrying value of an asset may not be recoverable, in accordance with ASC 360. This evaluation requires management to make judgments relating to an estimate of undiscounted future cash flows to determine whether an asset group is recoverable. Our calculation of undiscounted cash flows takes into consideration any termination payments to be received from Toys-Delaware as set forth under the terms of the TRU Propco II Master Lease where Toys-Delaware is required to make a termination payment equal to the excess (if any) of the net present value of the base rent for such Property over the remaining term for such Property, discounted at 10% per annum less any third party sale proceeds. If as a result of this evaluation, a long-lived asset group is found to be non-recoverable, we record an impairment charge equal to the amount by which the asset group’s carrying value exceeds its fair value. We estimate the fair value of an asset group using a valuation method such as discounted cash flows or a relative, market-based approach.
Revenue Recognition
Base rental revenue is reported on a straight-line basis over the non-cancelable terms of our respective leases. Straight-line rent receivable from affiliate as reported on the Balance Sheets represents rental income recognized in excess of rent payments
actually received pursuant to the terms of the TRU Propco II Master Lease. The leases also typically provide for tenant reimbursements of common area maintenance and other operating expenses and real estate taxes. Accordingly, revenues associated with tenant reimbursements are recognized in the period in which the expenses are incurred based upon the tenant lease provision. Ancillary and other property-related income, which includes the leasing of vacant space to temporary tenants, is recognized in the period earned. Lease termination fees are included in Base rents and recognized upon termination of a tenant’s lease and relinquishment of space after which we have no further obligation to the tenant.
Deferred Rent
The difference between recognized rental expense and amounts payable under the leases is recorded as Deferred third party rent liabilities. We recognize operating leases on a straight-line basis over the lease term, which includes renewal options only if those options are specified in the lease agreement and if failure to exercise the renewal option imposes a significant economic penalty to us. For Ground Lease Locations, we include renewal options in the lease term through the estimated useful life of the owned building located on the property as failure to renew a ground lease during the estimated useful life of the building would result in forgoing an economic benefit given our significant capital investment at the inception of the lease to construct a new building.
RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS
In November 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-17, “Business Combinations (Topic 805): Pushdown Accounting” (“ASU 2014-17”). ASU 2014-17 provides an acquired entity with an option to apply pushdown accounting in its separate financial statements upon occurrence of an event in which an acquirer obtains control of the acquired entity. The acquired entity may elect the option to apply pushdown accounting in the reporting period in which the change-in-control event occurs. If pushdown accounting is not applied in the reporting period in which the change-in-control event occurs, an acquired entity will have the option to elect to apply pushdown accounting in a subsequent reporting period as a change in accounting principle in accordance with ASC Topic 250, “Accounting Changes and Error Corrections”. If pushdown accounting is applied to an individual change-in-control event, that election is irrevocable. ASU 2014-17 also requires an acquired entity that elects the option to apply pushdown accounting in its separate financial statements to disclose information in the current reporting period that enables users of financial statements to evaluate the effect of pushdown accounting. The Company has adopted the amendments in ASU 2014-17, effective November 18, 2014, as the amendments in the update are effective upon issuance. The adoption did not have an impact on our Financial Statements.
In April 2014, FASB issued ASU No. 2014-08, “Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity” (“ASU 2014-08”). ASU 2014-08 limits the requirement to report discontinued operations to disposals of components of an entity that represent strategic shifts that have (or will have) a major effect on an entity’s operations and financial results. The amendments also require expanded disclosures concerning discontinued operations, disclosures of certain financial results attributable to a disposal of a significant component of an entity that does not qualify for discontinued operations reporting and expanded disclosures for long-lived assets classified as held for sale or disposed of. Early adoption is permitted, but only for disposals (or assets classified as held for sale) that have not been reported in financial statements previously issued or available for issuance. The Company early adopted the amendments in ASU 2014-08, effective February 2, 2014. As a result of the adoption of ASU 2014-08, results of operations for properties that are disposed of (or classified as held for sale) in the ordinary course of business on or subsequent to February 2, 2014 are included in continuing operations on the Statements of Operations, to the extent such disposals do not meet the criteria for classification as a discontinued operation described above. Any related gain or loss on sale of real estate that does not meet the criteria for classification as a discontinued operation is presented in Other operating expenses, net on the Statements of Operations. Additionally, termination payments are recorded in Base rents. These were previously included in Earnings from discontinued operations. For disposals prior to February 2, 2014, which were not subject to the early adoption of ASU 2014-08, the Company continued to report the gain on sale and results of operations prior to the sale as discontinued operations for the periods ended February 1, 2014 in our Statements of Operations.
In April 2013, the FASB issued ASU No. 2013-07, “Presentation of Financial Statements (Topic 205): Liquidation Basis of Accounting” (“ASU 2013-07”). ASU 2013-07 clarifies when an entity should apply the liquidation basis of accounting and provides principles for the measurement of associated assets and liabilities, as well as required disclosures. The Company adopted the amendments in ASU 2013-07, effective February 2, 2014. The adoption did not have an impact on our Financial Statements.
In February 2013, the FASB issued ASU No. 2013-04, “Liabilities (Topic 405): Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation Is Fixed at the Reporting Date” (“ASU 2013-04”). ASU 2013-04 provides guidance for the recognition, measurement and disclosure of obligations resulting from joint and several liability arrangements for which the total amount of the obligation within the scope of this ASU is fixed at the reporting date. The guidance requires an entity to measure those obligations as the sum of the amount the reporting entity agreed to pay on the
basis of its arrangement among its co-obligors as well as any additional amount the reporting entity expects to pay on behalf of its co-obligors. ASU 2013-04 also requires an entity to disclose the nature and amount of those obligations. The Company adopted the amendments in ASU 2013-04, effective February 2, 2014. The adoption did not have an impact on our Financial Statements.
Refer to Note 10 to the Financial Statements entitled “RECENT ACCOUNTING PRONOUNCEMENTS” for discussions of accounting standards which we have not yet been required to implement and may be applicable to our future operations and their expected impact on the Financial Statements.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We do not participate in speculative derivative trading.
Interest Rate Exposure
During fiscal 2014, we had only fixed rate debt and had not entered into any derivatives.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Member of
Toys “R” Us Property Company II, LLC:
We have audited the accompanying balance sheets of Toys “R” Us Property Company II, LLC (the "Company") as of January 31, 2015 and February 1, 2014, and the related statements of operations, changes in member’s deficit, and cash flows for each of the three fiscal years in the period ended January 31, 2015. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of Toys “R” Us Property Company II, LLC as of January 31, 2015 and February 1, 2014, and the results of its operations and its cash flows for each of the three fiscal years in the period ended January 31, 2015, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ Deloitte & Touche LLP
New York, New York
April 24, 2015
TOYS “R” US PROPERTY COMPANY II, LLC
STATEMENTS OF OPERATIONS
See Notes to the Financial Statements.
TOYS “R” US PROPERTY COMPANY II, LLC
BALANCE SHEETS
See Notes to the Financial Statements.
TOYS “R” US PROPERTY COMPANY II, LLC
STATEMENTS OF CASH FLOWS
See Notes to the Financial Statements.
TOYS “R” US PROPERTY COMPANY II, LLC
STATEMENTS OF CHANGES IN MEMBER’S DEFICIT
See Notes to the Financial Statements.
Toys “R” Us Property Company II, LLC
Notes to the Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Business and Organization
As used herein the “Company,” “we,” “us,” or “our” means Toys “R” Us Property Company II, LLC (“TRU Propco II”), a Delaware limited liability company, which was formed in July 2005 as part of a legal reorganization of the businesses of Toys “R” Us, Inc. (“TRU”). TRU, through various subsidiaries, operates or licenses Toys “R” Us and Babies “R” Us stores in the United States and foreign countries and jurisdictions. We are ultimately owned by TRU through our indirect parent, Toys “R” Us-Delaware, Inc. (“Toys-Delaware”), to whom we lease or sublease substantially all of our properties and from whom we derive substantially all of our revenues and cash flows. The Company is one reportable segment.
As a result of the reorganization, we received, as contributions from Toys-Delaware and other affiliates, certain properties which we now lease to Toys-Delaware. As the reorganization was between entities under common control, the net assets transferred were recorded at their carrying value.
Fiscal Year
Our fiscal year ends on the Saturday nearest to January 31. Unless otherwise stated, references to years in this report relate to the fiscal years ended below:
Use of Estimates
The preparation of our Financial Statements requires us to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, and the related disclosures of contingent assets and liabilities as of the date of the Financial Statements and during the applicable periods. We base these estimates on historical experience and other factors that we believe are reasonable under the circumstances. Actual results may differ materially from these estimates and such differences could have a material impact on our Financial Statements.
Cash and Cash Equivalents
We consider our highly liquid investments with original maturities of three months or less at acquisition to be cash equivalents.
Real Estate, Net
We record depreciation using the straight-line method over the shorter of the estimated useful lives of the assets or the terms of the respective leases, if applicable, which for buildings is generally 50 years and for buildings on ground leases is the lesser of the lease term or 50 years, and for leasehold improvements is generally the lesser of the lease term or 25 years.
Impairment of Long-Lived Assets
We evaluate the carrying value of all long-lived assets, which include land and buildings, for impairment whenever events or changes in circumstances, including the tenant’s intent to exit a property in advance of the Amended and Restated Master Lease Agreement (the “TRU Propco II Master Lease”) term, indicate that the carrying value of an asset may not be recoverable, in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 360, “Property, Plant and Equipment”. This evaluation requires management to make judgments relating to an estimate of undiscounted future cash flows to determine whether an asset group is recoverable. Our calculation of undiscounted cash flows takes into consideration any termination payments to be received from Toys-Delaware as set forth under the terms of the TRU Propco II Master Lease where Toys-Delaware is required to make a termination payment equal to the excess (if any) of the net present value of the base rent for the property over its remaining term, discounted at 10% per annum, less any proceeds from sale. If as a result of this evaluation, a long-lived asset group is found to be non-recoverable, we record an impairment charge equal to the amount by which the asset group’s carrying value exceeds its fair value. We estimate the fair value of an asset group using a valuation method such as discounted cash flows or a relative, market-based approach. There were no impairment charges in fiscals 2014, 2013 and 2012.
Discontinued Operations
In April 2014, the FASB issued Accounting Standards Update (“ASU”) No. 2014-08, “Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity” (“ASU 2014-08”), which limits the requirement to report discontinued operations to disposals of components of an entity that represent strategic shifts that have (or will have) a major effect on an entity’s operations and financial results. The amendments also require expanded disclosures concerning discontinued operations, disclosures of certain financial results attributable to a disposal of a significant component of an entity that does not qualify for discontinued operations reporting and expanded disclosures for long-lived assets classified as held for sale or disposed of. Early adoption is permitted, but only for disposals (or assets classified as held for sale) that have not been reported in financial statements previously issued or available for issuance. The Company early adopted the amendments, effective February 2, 2014. As a result of the adoption, results of operations for properties that are disposed of (or classified as held for sale) in the ordinary course of business on or subsequent to February 2, 2014 are included in continuing operations on the Statements of Operations, to the extent such disposals do not meet the criteria for classification as a discontinued operation described above. Any related gain or loss on sale of real estate that does not meet the criteria for classification as a discontinued operation is presented in Other operating expenses, net on the Statements of Operations. Additionally, termination payments are recorded in Base rents. These were previously included in Earnings from discontinued operations. For disposals prior to February 2, 2014, which were not subject to the early adoption of ASU 2014-08, the Company continues to report the gain on sale and results of operations prior to the disposal as discontinued operations for the fiscal years ended February 1, 2014 and February 2, 2013, respectively, in our Statements of Operations. During fiscal 2014, we sold one owned property and a non-operating parcel to unrelated third parties, which did not meet the criteria for classification as discontinued operations. Refer to Note 2 entitled “REAL ESTATE, NET” for further details on disposals in fiscal 2014 and Note 3 entitled “DISCONTINUED OPERATIONS” for further details on disposals in fiscals 2013 and 2012.
Rental Revenues
Base rental revenues are recognized on a straight-line basis over the non-cancelable terms of the related leases. Differences between rental revenues recognized and amounts due per the respective lease agreements are recorded on our Balance Sheets as Straight-line rent receivable from affiliate. Tenant reimbursements for taxes, maintenance, and other operating expenses are billed and recognized as revenues in the period the applicable costs are incurred.
The TRU Propco II Master Lease requires Toys-Delaware to make a payment to us upon early termination of a lease, as set forth under the terms of the TRU Propco II Master Lease, or the successful execution of the sale of a property by us to a third party if the proceeds from the sale are less than the net present value of the base rent for the property over its remaining term, discounted at 10% per annum. We recorded termination payments of $3 million and $12 million in fiscals 2014 and 2013, respectively, in Base rents and Earnings from discontinued operations, respectively, within our Statement of Operations. We did not record any termination payments in fiscal 2012.
Debt Issuance Costs
We defer debt issuance costs and amortize such costs into Interest expense, net over the term of the related debt facility. Debt issuance costs amortized to Interest expense, net were $4 million, $3 million and $4 million for fiscals 2014, 2013 and 2012, respectively. Unamortized amounts at January 31, 2015 and February 1, 2014 were $10 million and $14 million, respectively.
Deferred Rent
We recognize fixed minimum rent expense on non-cancelable leases on a straight-line basis over the term of each individual lease starting at the date of possession, including the build-out period, and record the difference between the recognized rental expense and amounts payable under the leases as Deferred third party rent liabilities. Deferred third party rent liabilities in our Balance Sheets totaled $14 million and $13 million at January 31, 2015 and February 1, 2014, respectively. Landlord incentives and abatements received are included in Deferred third party rent liabilities and amortized over the term of the lease.
Leases for Lessee only
We lease land used in our operations. We account for our leases under the provisions of ASC Topic 840, “Leases,” which require that leases be evaluated and classified as operating or capital leases for financial reporting purposes.
Operating leases are recorded on a straight-line basis over the lease term. At the inception of a lease, we determine the lease term by assuming the exercise of renewal options that are reasonably assured if a significant economic penalty exists for not exercising such options. Renewal options are exercised at our sole discretion. The expected lease term is used to determine whether a lease is capital or operating and is used to calculate straight-line rent expense. Additionally, the useful life of buildings and leasehold improvements are limited by the expected lease term. Refer to Note 4 entitled “LEASES” for further details.
All of our leases include options that allow us to renew or extend the lease term beyond the initial lease period, subject to terms and conditions agreed upon at the inception of the lease. Such terms and conditions include rental rates agreed upon at the inception of the lease that could represent below or above market rental rates later in the life of the lease, depending upon market conditions at the time of such renewal or extension. In addition, many leases include early termination options, which can be exercised under specified conditions, including upon damage, destruction or condemnation of a specified percentage of the value or land area of the property.
Income Taxes
No income tax expense or benefit is recognized in the accompanying Financial Statements. We are treated as a disregarded entity for income tax purposes and, accordingly, our taxable income or loss is included in the income tax returns of our owners.
We have calculated the net basis of our assets and liabilities for income tax purposes as if the Company was a stand-alone entity (i.e., on a “Separate Company” basis). The net basis of our assets and liabilities for income tax purposes is $36 million higher than the amount reported in our Financial Statements.
NOTE 2 - REAL ESTATE, NET
During fiscal 2014, we sold one owned property and a non-operating parcel to unrelated third parties for proceeds of $1 million, resulting in a net loss of $3 million, which is included in Other operating expenses, net. The TRU Propco II Master Lease requires Toys-Delaware to make a payment to us, as set forth under the terms of the TRU Propco II Master Lease, upon early termination of a lease or the successful execution of the sale of a property by us to a third party if the proceeds from the sale are less than the net present value of the base rent for the property over its remaining term, discounted at 10% per annum. We recorded a termination payment of $3 million during fiscal 2014 in Base rents in the Statement of Operations.
Subsequent Event
Subsequent to fiscal 2014, we sold an owned property to an unrelated third party for gross proceeds of $1 million, resulting in a gain of less than $1 million.
NOTE 3 - DISCONTINUED OPERATIONS
During fiscal 2013, we sold two owned properties and a non-operating parcel to unrelated third parties for proceeds of $4 million, resulting in a net gain of $1 million. Additionally, we had an early termination of a ground lease and had a ground lease expire with an unrelated third party landlord for which we opted not to exercise the renewal option. As per the terms of the TRU Propco II Master Lease, we recorded termination payments of $12 million in fiscal 2013.
During fiscal 2012, we sold no properties and had no leases expire with unrelated third party landlords.
The operating results of properties classified as discontinued operations have been segregated from continuing operations and reported separately as Earnings from discontinued operations on the Statements of Operations for fiscals 2013 and 2012. These amounts have been summarized below:
(1) Includes termination payments from Toys-Delaware.
NOTE 4 - LEASES
As lessor
Our operations consist of leasing or subleasing properties to our affiliate, Toys-Delaware under a master lease agreement.
In connection with the offering of the 8.500% senior secured notes due fiscal 2017 (the “Secured Notes”) on November 20, 2009 described in Note 6 entitled, “LONG-TERM DEBT,” we entered into the TRU Propco II Master Lease with Toys-Delaware under which Toys-Delaware continues to lease properties from us, including properties, which were formerly owned by MPO Holdings, LLC and are now held by TRU Propco II. The term of the TRU Propco II Master Lease was extended through January 31, 2030 except with respect to any property that is ground or space leased from a third party landlord to us with a term expiring prior to such date. Annual net base rents under the TRU Propco II Master Lease increased by 10% for each property on February 1, 2015 and are scheduled to further increase by 10% on February 1, 2020 and February 1, 2025. The TRU Propco II Master Lease continues to require Toys-Delaware to pay real estate taxes and certain other amounts. Future annual related party base rents may be reduced by payments we receive from Toys-Delaware, as set forth under the terms of the TRU Propco II Master Lease, as a result of an early termination of a lease or the successful execution of the sale of such properties by us to a third party.
Future base rents to be received under the TRU Propco II Master Lease as of January 31, 2015 are as follows:
(1)
Future Related Party Base Rents for straight lease locations are based on the initial or current contractual term of the respective third party lease and for owned locations are based on the TRU Propco II Master Lease term. Excluded from Future Related Party Base Rents are options to extend ground lease terms that are reasonably assured of being exercised.
Leased retail properties under the TRU Propco II Master Lease consist of locations which are owned outright by us (“Owned Locations”) and locations which have buildings that are owned by us and land which is controlled through ground leases with unrelated third parties (“Ground Lease Locations”). For Owned Locations, the TRU Propco II Master Lease contains predetermined fixed escalations of the minimum rentals on February 1, 2015, February 1, 2020 and February 1, 2025. For Ground Lease Locations, the base rents consist of a net lease payment plus the rent on the underlying ground lease. The predetermined fixed escalations are applied separately. The rent escalations for the underlying ground leases occur as provided in the respective lease agreements. For Ground Lease Locations, Toys-Delaware has a unilateral right to have us exercise the renewal option prior to the time the initial underlying lease term expires, so long as the renewed option is exercised prior to expiration of the TRU Propco II Master Lease. We did not have Deferred related party revenue at January 31, 2015 and February 1, 2014, respectively.
The TRU Propco II Master Lease includes early termination options, which can be exercised by Toys-Delaware under specified conditions, including upon damage, destruction or condemnation of a specified percentage of the value or land area of the property.
As lessee
Our minimum rental commitments under non-cancelable operating leases to unaffiliated third parties having a term of more than one year as of January 31, 2015 are as follows:
(1)
Excluded from Future Minimum Rentals displayed above are approximately $71 million related to options to extend ground lease terms that are reasonably assured of being exercised, the balance of which predominantly relates to fiscals 2020 and thereafter.
We record operating leases on a straight-line basis over the lease term, which includes renewal options only if those options are specified in the lease agreement and if failure to exercise the renewal option imposes a significant economic penalty on us. For Ground Lease Locations, we include renewal options in the lease term through the estimated useful life of the owned building located on the property as failure to renew a ground lease during the estimated useful life of the building would result in forgoing an economic benefit given our significant capital investment at the inception of the lease to construct a new building. All of our leases include options that allow us to renew or extend the lease term beyond the initial lease period, subject to terms and conditions agreed upon at the inception of the lease. Such terms and conditions include rental rates agreed upon at the inception of the lease that could represent below or above market rental rates later in the life of the lease, depending upon market conditions at the time of such renewal or extension. In addition, some of our leases include early termination options, which can be exercised by us under specified conditions, including upon damage, destruction or condemnation of a specified percentage of the value or land area of the property.
The difference between recognized rental expense and amounts payable under the leases is recorded as Deferred third party rent liabilities. Deferred third party rent liabilities in our Balance Sheets totaled $14 million and $13 million at January 31, 2015 and February 1, 2014, respectively.
NOTE 5 - COMMITMENTS AND CONTINGENCIES
Although we do not currently have material legal proceedings pending against us, we may be subject to various claims and contingencies related to lawsuits and real estate taxes, as well as commitments under contractual and other commercial obligations. We recognize liabilities for contingencies and commitments when a loss is probable and estimable. Refer to Note 4 entitled “LEASES” for minimum rental commitments under non-cancelable operating leases having a term of more than one year as of January 31, 2015.
TRU self-insures a substantial portion of our property insurance risks, in addition to third party insurance coverage. Accordingly, TRU bills Toys-Delaware, which leases our retail properties and is responsible for insuring our properties. As such, any property losses incurred by us would be reimbursed by Toys-Delaware.
NOTE 6 - LONG-TERM DEBT
As of January 31, 2015 and February 1, 2014, the carrying value of our Long-term debt was $721 million and $719 million, respectively.
8.500% senior secured notes, due fiscal 2017 ($721 million at January 31, 2015)
On November 20, 2009, we completed the offering of $725 million aggregate principal amount of senior secured 8.500% notes, which will mature on December 1, 2017. The Secured Notes were issued at a discount of $10 million which resulted in proceeds of $715 million. The Secured Notes are solely our obligation and are not guaranteed by TRU or Toys-Delaware. The Secured Notes are secured by the first priority security interests in all of our existing and future real estate properties and our interest in the TRU Propco II Master Lease between us as landlord and Toys-Delaware as tenant. Fees paid in connection with the sale of the Secured Notes were deferred and expensed over the life of the Secured Notes. Investment funds or accounts advised by or affiliated with Kohlberg Kravis Roberts & Co. L.P. (collectively, “KKR”) owned an aggregate of $5 million of
the Secured Notes as of February 1, 2014. Deferred debt issuance costs for these notes were $10 million and $14 million as of January 31, 2015 and February 1, 2014, respectively.
The indenture governing the Secured Notes contains covenants that, among other things, restrict our ability to incur additional indebtedness, sell assets, enter into affiliate transactions, pay dividends or make other distributions, make other restricted payments and investments, or create liens. The indenture governing the Secured Notes also contains covenants that limit the ability of TRU to cause or permit Toys-Delaware to incur indebtedness, pay dividends, make distributions or make other restricted payments and investments. These covenants are subject to a number of important qualifications and limitations. The Secured Notes are redeemable, in whole or in part, at the specified redemption prices, plus accrued and unpaid interest, if any. Following specified kinds of changes of control with respect to TRU, Toys-Delaware or us, we will be required to offer to purchase the Secured Notes at a purchase price in cash equal to 101% of their principal amount, plus accrued and unpaid interest, if any to, but not including, the purchase date. Interest on the Secured Notes is payable in cash semi-annually in arrears through maturity on June 1 and December 1 of each year.
NOTE 7 - FAIR VALUE MEASUREMENTS
To determine the fair value of our assets and liabilities, we utilize the established fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).
Long-term Debt
As of January 31, 2015 and February 1, 2014, the fair value of our Long-term debt was $719 million and $739 million, respectively, which was estimated using Level 1 inputs, representing quoted market prices of our debt instrument.
Other Financial Instruments
Other financial instruments that are not measured at fair value on our Consolidated Balance Sheets include cash and cash equivalents, accounts receivable, accounts payable and accrued expenses. Due to the short-term nature of these assets and liabilities, their carrying amounts approximate fair value.
NOTE 8 - MEMBER’S DEFICIT
Giraffe Junior Holdings, LLC, an indirect wholly-owned subsidiary of TRU, is the direct owner of 100% of our limited liability company interests. We evaluate our cash balances on an ongoing basis and periodically distribute cash to our parent companies. During fiscals 2014, 2013 and 2012 we made cash distributions of $13 million, $14 million and $17 million in dividends, respectively.
NOTE 9 - RELATED PARTY TRANSACTIONS
Rental Revenues
Our rental revenues are derived from payments received under the TRU Propco II Master Lease we entered into with Toys-Delaware. The TRU Propco II Master Lease provides for Toys-Delaware to reimburse us for property related costs including, among others, real estate taxes and common area maintenance charges. These costs are directly paid by Toys-Delaware and are recorded as both an expense and a tenant reimbursement. During fiscals 2014, 2013 and 2012, we earned related party Base rent revenues of $103 million, $104 million and $107 million, respectively, excluding termination payments from Toys-Delaware. During each of fiscals 2014, 2013 and 2012, we recorded Tenant reimbursements of $13 million, respectively, under the TRU Propco II Master Lease. Refer to Note 4 entitled “LEASES” for further details regarding our rental arrangements.
Termination Payments
As discussed in Note 2 entitled “REAL ESTATE, NET” and Note 3 entitled “DISCONTINUED OPERATIONS”, the TRU Propco II Master Lease requires Toys-Delaware to make a payment to us upon early termination of a lease, as set forth under the terms of the TRU Propco II Master Lease, or the successful execution of the sale of a property by us to a third party if the proceeds from the sale are less than the net present value of the base rent for the property over its remaining term, discounted at 10% per annum. We recorded termination payments of $3 million and $12 million in fiscals 2014 and 2013, respectively, in Base rents and Earnings from discontinued operations, respectively, within our Statements of Operations. We did not record any termination payments in fiscal 2012.
Management Service Fees
Toys-Delaware provides a majority of the centralized corporate functions, including accounting, human resources, legal, tax and treasury services to TRU, other affiliates and us under the Domestic Services Agreement (“Agreement”). The costs are based on a formula for each affiliate, as defined in the Agreement and are recorded in Other operating expenses, net in the Statements of Operations. The amount charged to us for these services was $2 million, $1 million and $2 million during fiscals 2014, 2013 and 2012, respectively.
Transactions with the Sponsors
KKR did not own any of the Secured Notes as of January 31, 2015 and owned an aggregate of $5 million as of February 1, 2014. See Note 6 entitled “LONG-TERM DEBT” for further details.
Due from Affiliate, Net
As of January 31, 2015 and February 1, 2014, Due from affiliate, net of $3 million and $4 million, respectively, primarily represents real estate taxes, base rents and certain property reimbursements owed to us by Toys-Delaware.
NOTE 10 - RECENT ACCOUNTING PRONOUNCEMENTS
In April 2015, the FASB issued ASU No. 2015-03, “Interest - Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs” (“ASU 2015-03”). The FASB issued ASU 2015-03 as part of its initiative to reduce complexity in accounting standards. ASU 2015-03 simplifies the presentation of debt issuance costs by requiring that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. Under the previous practice, debt issuance costs were recognized as a deferred charge (that is, an asset). This ASU will create consistencies with the guidance in International Financial Reporting Standards as well as the guidance in FASB Concepts Statement No. 6, “Elements of Financial Statements”, which states that debt issuance costs are similar to debt discounts and in effect reduce the proceeds of borrowing, thereby increasing the effective interest rate. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this ASU. Upon transition, an entity is required to comply with the applicable disclosures for a change in an accounting principle. The amendments in this ASU are effective for reporting periods beginning after December 15, 2015, with early adoption permitted. A reporting entity should apply the amendments on a retrospective basis to all prior periods presented in the financial statements. Other than the revised balance sheet presentation of debt issuance costs from an asset to a deduction from the carrying amount of the debt liability and related disclosures, the adoption of ASU 2015-03 is not expected to have an impact on our Financial Statements.
In February 2015, the FASB issued ASU No. 2015-02, “Consolidation (Topic 810): Amendments to the Consolidation Analysis” (“ASU 2015-02”). ASU 2015-02 is intended to improve targeted areas of consolidation guidance for reporting organizations that are required to evaluate whether they should consolidate certain legal entities. This ASU simplifies consolidation accounting by reducing the number of consolidation models and improves current GAAP by (1) placing more emphasis on risk of loss when determining a controlling financial interest; (2) reducing the frequency of the application of related-party guidance when determining a controlling financial interest in a VIE; and (3) changing consolidation conclusions for public and private companies in several industries that typically make use of limited partnerships or VIEs. The amendments in this ASU are effective for reporting periods beginning after December 15, 2015, with early adoption permitted. Entities can transition to the standard either retrospectively or as a cumulative effect adjustment as of the date of adoption. The adoption of ASU 2015-02 is not expected to have an impact on our Financial Statements.
In January 2015, the FASB issued ASU No. 2015-01, “Income Statement - Extraordinary and Unusual Items (Subtopic 225-20): Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items” (“ASU 2015-01”). ASU 2015-01 eliminates from U.S. GAAP the concept of extraordinary items. Under the previous practice, an entity was required to separately classify, present, and disclose extraordinary events and transactions. The FASB issued this ASU as part of its initiative to reduce complexity in accounting standards. This ASU will also align more closely U.S. GAAP income statement presentation guidance with IAS 1, “Presentation of Financial Statements,” which prohibits the presentation and disclosure of extraordinary items. The amendments in this ASU are effective for reporting periods beginning after December 15, 2015, with early adoption permitted. A reporting entity may either apply the amendments prospectively or retrospectively to all prior periods presented in the financial statements. The adoption of ASU 2015-01 is not expected to have an impact on our Financial Statements.
In August 2014, the FASB issued ASU No. 2014-15, “Presentation of Financial Statements-Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern” (“ASU 2014-15”). ASU 2014-15 is intended to define management’s responsibility to evaluate whether there is substantial doubt about an organization’s ability to continue as a going concern and to provide related footnote disclosures. The amendments in this ASU are effective for reporting periods beginning after December 15, 2016, with early adoption permitted. Other than the additional disclosures
regarding the Company’s ability to continue as a going concern, the adoption of ASU 2014-15 is not expected to have an impact on our Financial Statements.
In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606)” (“ASU 2014-09”). ASU 2014-09 amends the guidance for revenue recognition to replace numerous, industry-specific requirements and converges areas under this topic with those of the International Financial Reporting Standards. The ASU implements a five-step process for customer contract revenue recognition that focuses on transfer of control, as opposed to transfer of risk and rewards. The amendment also requires enhanced disclosures regarding the nature, amount, timing and uncertainty of revenues and cash flows from contracts with customers. Other major provisions include the capitalization and amortization of certain contract costs, ensuring the time value of money is considered in the transaction price, and allowing estimates of variable consideration to be recognized before contingencies are resolved in certain circumstances. The amendments in this ASU are effective for reporting periods beginning after December 15, 2016, and early adoption is prohibited. Entities can transition to the standard either retrospectively or as a cumulative-effect adjustment as of the date of adoption. Management is currently assessing the impact the adoption of ASU 2014-09 will have on our Financial Statements.
TOYS “R” US PROPERTY COMPANY II, LLC
SCHEDULE III - REAL ESTATE AND ACCUMULATED DEPRECIATION (in thousands)
January 31, 2015
Reconciliations of gross amount at which assets are carried for the three fiscal years ended 2014, 2013 and 2012 are as follows:
Reconciliations of accumulated depreciation for the three fiscal years ended 2014, 2013 and 2012 are as follows:
(1) Assets disposed of in connection with sale of property and retirement of minor alterations.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
(a) Disclosure Controls and Procedures
Disclosure controls and procedures are the controls and other procedures that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer’s management, including the principal executive and principal financial officer, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure. Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.
We have evaluated, under the supervision and with the participation of our management, including our principal executive and principal financial officer, the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act as of the end of the fiscal year covered by this annual report.
Based on that evaluation, our principal executive and principal financial officer has concluded that our disclosure controls and procedures were effective as of the end of the fiscal year covered by this Annual Report on Form 10-K to accomplish their objectives at the reasonable assurance level.
(b) Management’s Annual Report on Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Securities Exchange Act Rule 15d-15(f). Internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and preparation of financial statements for external purposes in accordance with United States Generally Accepted Accounting Principles.
Under the supervision and with the participation of management, including our principal executive and principal financial officer, we conducted an assessment of the design and effectiveness of our internal control over financial reporting as of the end of the fiscal year covered by this report based on the framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework (2013).
Based on this assessment, management concluded that, as of January 31, 2015, our internal control over financial reporting was effective.
This Annual Report on Form 10-K does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to the rules of the Securities and Exchange Commission applicable to non-accelerated filers, which permit us to provide only management’s report in this Annual Report on Form 10-K.
(c) Change in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting during our fourth quarter of fiscal 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Item 10 is omitted as we meet the conditions set forth in General Instructions (I)(1)(a) and (b) of Form 10-K.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
Item 11 is omitted as we meet the conditions set forth in General Instructions (I)(1)(a) and (b) of Form 10-K.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Item 12 is omitted as we meet the conditions set forth in General Instructions (I)(1)(a) and (b) of Form 10-K.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
TRU Propco II Master Lease
We own fee and ground leasehold interests in 124 properties in the United States (collectively, the “Properties” and each, a “Property”), which we lease on a triple-net basis to Toys “R” Us-Delaware, Inc. (“Toys-Delaware”) pursuant to the Amended and Restated Master Lease Agreement (the “TRU Propco II Master Lease”). Set forth below are the principal terms of the TRU Propco II Master Lease.
Parties
TRU Propco II, as the “Landlord,” and Toys-Delaware, as the “Tenant.”
Leased properties
124 properties, comprising either fee interests or ground-leased land and the improvements thereon.
Term
The TRU Propco II Master Lease was amended and restated and commenced on November 20, 2009, and will expire on January 31, 2030.
Landlord’s termination right for unimproved portions of properties
The Landlord may terminate the TRU Propco II Master Lease with respect to any unimproved parcels located at a Property with no adjustment in rent; provided (i) the unimproved parcel shall be used for the purpose of erecting, maintaining and operating other structures and improvements not inconsistent with the use of the related Property, and (ii) such termination will not materially adversely affect either the value of the remaining portion of the related Property or the net operating income of the remaining portion of the related Property.
Tenant’s termination rights with respect to an uneconomic property
The Tenant may request a termination of the TRU Propco II Master Lease with respect to a Property if, in the good faith judgment of the Tenant, such Property becomes or imminently will become, and will remain for the foreseeable future, uneconomic or unsuitable for its then primary use. If and when the Landlord (using reasonable, good faith efforts to sell such Property) is able sell the Property at its fair market value (unencumbered by the TRU Propco II Master Lease), the TRU Propco II Master Lease with respect to such Property will terminate and, in addition to its sale proceeds, the Landlord will receive from the Tenant a termination payment equal to the excess (if any) of the net present value of the base rent for the Property over its remaining term, discounted at 10% per annum, over the sales proceeds for the Property received by the Landlord.
Base rent
The Tenant agreed to pay to the Landlord base rent for the term of the TRU Propco II Master Lease for each Property.
The net base cash rents to be paid by the Tenant to us under the TRU Propco II Master Lease, effective November 20, 2009, increased to approximately $91 million per annum, net of rents due to third parties. The base rents to be paid by Toys-Delaware in fiscal 2015 are expected to be $97 million, reduced for lease terminations and properties sold, and inclusive of the 10% rent increase effective on February 1, 2015 as required by the TRU Propco II Master Lease. Future rental payments are subject to additional 10% increases on February 1, 2020 and February 1, 2025. If Tenant requests Landlord to make (at Landlord’s cost), or pay the cost of, a capital improvement at a Leased Property, and Landlord agrees to such request, or if Landlord offers to Tenant that Landlord make (at Landlord’s cost), or pay the cost of, a capital improvement at a Leased
Property and Tenant accepts such offer, then the base rent for such Leased Property shall be increased by an amount agreed upon by the parties to reflect a rental increase that would be agreed upon by a landlord and tenant, who are unrelated to one another and dealing with each other on an arm’s length basis, in consideration for such capital improvement or payment by Landlord, taking into account then-market conditions and the terms and conditions of this TRU Propco II Master Lease. For clarity, any making of any request, agreement, offer or acceptance referred to above in this section shall be in the sole discretion of each of Landlord and Tenant.
Base rent is payable monthly in advance. Future base rents increase upon escalation of ground lease rents and the exercise of renewal options based on the terms of the underlying ground leases. Decreases in future base rents will occur upon the reduction of ground lease rents or expiration of the underlying ground lease. Base rent will also be reduced if and when the TRU Propco II Master Lease shall terminate with respect to any individual Property as described above in the immediately preceding section or in - “Casualty and Condemnation” below. See Item 1A. “Risk Factors - Risks Relating to the Company - All of our revenues are generated under the TRU Propco II Master Lease. Unexpected expenses, termination of the TRU Propco II Master Lease, sales of Properties under the TRU Propco II Master Lease or a bankruptcy of the Master Tenant could have a material impact on our financial condition” in this Annual Report on Form 10-K.
Additional rent
In addition to the base rents described above, the Tenant will pay, directly to third party ground lessors, the rents owed under the ground leases affecting certain Properties. The Tenant will also pay when due, directly to the parties entitled to receive the same, all real estate taxes, insurance premiums, utility charges and common area or association charges or dues.
Late charge
If the Tenant fails to pay base rent within five business days after the same is due, the Tenant will owe the Landlord interest on such amount from the date due until paid at the rate of 10% per annum or, if less, the maximum rate permitted by law.
Net lease; no termination or abatement
Subject to any provision of the TRU Propco II Master Lease which expressly provides otherwise, the base rent and any additional rent payable to the Landlord will be paid net to the Landlord, so that the TRU Propco II Master Lease will, throughout the term, yield to the Landlord the full amount of the base and additional rent payable to the Landlord; the Tenant will not be entitled any abatement, deferment or set-off of rent; and the respective obligations of the Landlord and the Tenant will not be affected by reason of damage to or condemnation of a Property, the interruption or discontinuance of any service or utility servicing a Property, any claim which the Tenant has or might have against the Landlord or by reason of any default or breach of any warranty by the Landlord under the TRU Propco II Master Lease or any other agreement between the Landlord and the Tenant or any of its affiliates, any bankruptcy, insolvency, reorganization, composition, readjustment, liquidation, dissolution, winding up or other proceedings affecting the Landlord or any assignee or transferee of the Landlord, or for any other cause whether similar or dissimilar to any of the foregoing other than a discharge of the Tenant from any such obligations as a matter of law.
Tenant’s obligations
The Tenant is obligated (subject to the contest right described below) to:
•
obtain and maintain all rights, licenses and permits required by law in respect of the Properties and maintain, repair and improve the Properties in material compliance with all laws;
•
undertake such alterations to the Properties as may be required to cause the Property to comply with applicable law;
•
keep the Properties insured for the risks and amounts specified in the TRU Propco II Master Lease or (at the Tenant’s option) in a manner that conforms in all substantial respects to the insurance coverages generally maintained by the Tenant from time to time for other similarly situated properties owned by Tenant, naming the Landlord as an additional insured and loss payee, as applicable;
•
observe and perform all of the obligations of the Landlord, as tenant, under each ground lease, reciprocal easement or other operating agreement or easement affecting the Properties, including, to the extent required by any such lease, agreement or easement, remain in operation as a Toys “R” Us or Babies “R” Us store;
•
maintain and preserve the Properties in good working order and repair, reasonable wear and tear excepted, and from time to time make, or cause to be made, all reasonably necessary repairs, renewals, replacements, betterments and improvements thereto;
•
comply with all of the requirements pertaining to the Properties or other improvements of any insurance board, association, organization or company necessary for the maintenance of insurance covering the Properties; and
•
promptly pay and discharge any lien or charge against the Properties (except for certain permitted encumbrances), including claims and demands of contractors and suppliers that, if unpaid, would result in a lien on any Property, and cause the discharge of all such liens and encumbrances (other than certain permitted encumbrances) within 45 days after receiving written notice of the filing thereof.
Tenant’s contest rights
The Tenant, at its own expense, may contest by appropriate legal, administrative or other proceeding, promptly initiated and conducted in good faith and with due diligence, the amount or validity or application of any real estate taxes, contractor and supplier claim, lien or encumbrance, legal or insurance requirement and other claims asserted by governmental or third parties that are or would be the Tenant’s obligation under the TRU Propco II Master Lease, and, if permitted by law, the Tenant may withhold its performance and/or any payment otherwise required by the contested matter pending the completion of such contest; provided the following conditions (among others) are satisfied:
(a) no TRU Propco II Master Lease Event of Default (as defined below) has occurred and is continuing, except for a TRU Propco II Master Lease Event of Default caused by the matter being contested;
(b) such proceeding shall suspend any collection of the contested claim from the Property and from the Tenant and the Landlord, or adequate time shall at all times remain prior to such collection;
(c) the affected Property will not be in danger of being sold, forfeited, terminated, canceled or lost;
(d) in the case of a contested insurance requirement, the failure to comply therewith shall not impair the validity of any insurance required to be maintained by the Tenant or the right to full payment of any claims thereunder;
(e) in the case of any essential or significant service to a Property, the contest or failure to pay will not result in a discontinuance of any such service without replacement thereof;
(f) in the case of any instrument of record affecting any Property, the contest or failure to perform under any such instrument shall not result in the placing of any lien on any such Property (except if such lien would be removed upon completion of such proceedings and the compliance by the parties with the terms of the resulting order, decision or determination);
(g) the Tenant shall promptly, upon final determination thereof, pay the amount of any such taxes or liens, together with all costs, interest and penalties which may be payable in connection therewith; and
(h) the Tenant shall respond promptly to any inquiries by the Landlord regarding the status of such contest.
Alterations
The Tenant, at its own expense, may alter, demolish, improve, expand or reduce any Property (each, an “Alteration”) so long as the Alteration is performed in accordance with applicable legal and insurance requirements; no TRU Propco II Master Lease Event of Default (as defined below) shall have occurred and be continuing; if the Alteration, when completed, shall adversely affect the value of the Property, the Tenant must restore the Property no later than the expiration or earlier termination of the TRU Propco II Master Lease to its state prior to such Alteration; the Alteration shall be performed with due diligence in a good and workmanlike manner; and all materials used in connection with any Alteration shall be not less than the standard of quality of the materials generally used at the applicable Property as of the date of the TRU Propco II Master Lease.
Assignment and subletting
The Tenant shall not assign, mortgage or encumber its interest under the TRU Propco II Master Lease, without the Landlord’s consent, except that the Tenant may assign the TRU Propco II Master Lease to an affiliate. In addition, the Tenant may sublet one or more of the Properties and in consideration for a subtenant’s attornment, the Landlord shall provide to such subtenant a non-disturbance agreement on commercially reasonable terms. No assignment or subletting shall release the Tenant from its obligations under the TRU Propco II Master Lease.
Casualty and condemnation
The Tenant shall be obligated to restore any Property affected by a casualty or condemnation, regardless of the amount of insurance proceeds or condemnation award, which shall be paid to the Tenant for use in connection with such restoration, except as described below. Tenant’s base rent obligation shall not abate during such period of restoration. In the case of a
condemnation of all or substantially all of a Property, the TRU Propco II Master Lease will terminate with respect to the affected Property. In the case of a casualty affecting more than 50% (by value) of the Property that cannot be restored prior to the last five years of the term of the TRU Propco II Master Lease, or in the case of a condemnation of more than 20% (but less than 50%) of the square footage of a Property that cannot be restored prior to the last five years of the term, or in the case of a casualty or condemnation where Tenant does not have the right to restore the affected Property pursuant to the provisions of the applicable ground lease (if any), the Tenant shall have the right to terminate the TRU Propco II Master Lease in respect of the affected Property and not restore the same, and the Landlord will be entitled to the insurance proceeds and condemnation award (less any portion thereof previously used by Tenant to secure the Property).
TRU Propco II Master Lease Events of Default
The occurrence of any one or more of the following events shall constitute a “TRU Propco II Master Lease Event of Default”:
•
the Tenant fails to pay base rent within five days after the day the same is due and payable and such failure continues for two business days after notice thereof;
•
the Tenant fails to pay any other amount owed under the TRU Propco II Master Lease when due and payable and such default shall continue for 10 days after notice thereof;
•
the Tenant fails to observe or perform any other obligation under the TRU Propco II Master Lease and such failure is not cured within a period of 30 days after receipt of notice from the Landlord, unless such failure is susceptible of cure but cannot reasonably be cured within such 30-day period, in which case, provided the Tenant shall have commenced to cure such failure within such 30-day period and thereafter diligently proceeds to cure the same, such cure period shall be extended for such time as is reasonably necessary for the Tenant in the exercise of due diligence to cure such failure, such additional period not to exceed 90 days; and
•
a voluntary bankruptcy filing by the Tenant, or an involuntary bankruptcy filing in respect of the Tenant that is not dismissed within 90 days after commencement.
Upon the occurrence and continuation of a TRU Propco II Master Lease Event of Default, the Landlord shall be entitled to terminate the TRU Propco II Master Lease, enter the leased premises and re-let the same for the Tenant’s account and seek current and final lease damages.
Indemnification generally and for environmental matters
The Tenant will indemnify the Landlord against all liabilities, claims, damages, costs and reasonable expenses imposed upon or incurred by or asserted against the Landlord by reason of: any accident, injury to or death of persons or loss of or damage to property occurring on or about any Property, any contest of any legal or insurance requirement (regardless whether the same is permitted under the TRU Propco II Master Lease), the release or threat of release of any hazardous materials on, in, or under or affecting any Property or surrounding areas or the material violation of any environmental law relating to or affecting any Property, in each case first occurring prior to the Landlord acquiring possession and control over such Property, except in each case to the extent resulting from the Landlord’s gross negligence or willful misconduct. The Tenant’s indemnification obligations for environmental matters shall terminate with respect to any Property, except to the extent of any claims for such indemnity then pending, five years after the date on which the Landlord’s debt is satisfied in full, or the Landlord shall have first acquired control and possession over such Property, by termination of the TRU Propco II Master Lease or otherwise.
Governing law
The TRU Propco II Master Lease shall be construed with respect to each Property under the substantive laws of the State in which such Property is situated.
Landlord’s right to request a separate lease
If the Landlord conveys or transfers any individual Property, if so requested in writing by the Landlord, the Tenant shall execute a new lease with the new owner of the applicable Property, as landlord, which shall relate solely to the conveyed Property and be for the same term as would otherwise pertain under the TRU Propco II Master Lease, be for the same rent as would otherwise be payable under the TRU Propco II Master Lease with respect to such Property and otherwise generally be on all of the same terms and conditions as set forth in the TRU Propco II Master Lease.
True lease
It is the intent of the Landlord and the Tenant that the TRU Propco II Master Lease shall constitute a “true lease” of the Properties.
Single lease
It is the intent of the Landlord and the Tenant that (except as a separate lease, as described above, shall have been executed) the TRU Propco II Master Lease constitutes a single, integrated and indivisible agreement between the parties for the lease of all parcels constituting the Properties.
Rental Revenues
Our rental revenues are derived from payments received under the TRU Propco II Master Lease we entered into with Toys-Delaware. The TRU Propco II Master Lease provides for Toys-Delaware to reimburse us for property related costs including, among others, real estate taxes and common area maintenance charges. These costs are directly paid by Toys-Delaware and are recorded as both an expense and a tenant reimbursement. During fiscals 2014, 2013 and 2012, we earned related party Base rent revenues of $103 million, $104 million and $107 million respectively, excluding termination payments from Toys-Delaware. During each of fiscals 2014, 2013 and 2012, we recorded Tenant reimbursements of $13 million, respectively, under the TRU Propco II Master Lease. See Note 4 to the Financial Statements entitled “LEASES” regarding our rental arrangements.
Termination Payments
The TRU Propco II Master Lease requires Toys-Delaware to make a payment to us upon early termination of a lease, as set forth under the terms of the TRU Propco II Master Lease, or the successful execution of the sale of a property by us to a third party if the proceeds from the sale are less than the net present value of the base rent for the property over its remaining term, discounted at 10% per annum. We recorded termination payments of $3 million and $12 million in fiscals 2014 and 2013, respectively, in Base rents and Earnings from discontinued operations, respectively, within our Statement of Operations. We did not record any termination payments in fiscal 2012.
Subordination, Non-Disturbance and Attornment Agreement
Concurrently with the execution and delivery of the TRU Propco II Master Lease, the Tenant and the collateral agent executed and delivered a Subordination, Non-Disturbance and Attornment Agreement (the “SNDA”). The SNDA provides that, so long as no Event of Default (as defined in the TRU Propco II Master Lease) exists, the Tenant’s possession of the Properties and its rights under the TRU Propco II Master Lease shall not be disturbed by the collateral agent, and the collateral agent will not join the Tenant as a party defendant in any action or proceeding to foreclose on a mortgaged property, and if the collateral agent or another person acquires one or more of the Properties upon or following a foreclosure on a mortgaged property, then, the Tenant will attorn to and recognize the collateral agent or such other person (as applicable) as the Landlord under the TRU Propco II Master Lease with respect to such Properties.
Management Service Fees
Toys-Delaware provides a majority of the centralized corporate functions, including accounting, human resources, legal, tax and treasury services to TRU, other affiliates and us under the Domestic Services Agreement (“Agreement”). The costs are based on a formula for each affiliate, as defined in the Agreement and are recorded in Other operating expenses, net in the Statements of Operations. The amount charged to us for these services was $2 million, $1 million and $2 million during fiscals 2014, 2013 and 2012, respectively.
Transactions with the Sponsors
Investment funds or accounts advised by or affiliated with Kohlberg Kravis Roberts & Co. L.P., did not own any of the Secured Notes as of January 31, 2015 and owned an aggregate of $5 million as of February 1, 2014. See Note 6 to the Financial Statements entitled “LONG-TERM DEBT” for further details.
Due from Affiliate, Net
As of January 31, 2015 and February 1, 2014, Due from affiliate, net of $3 million and $4 million, respectively, primarily represents real estate taxes, base rents and certain property reimbursements owed to us by Toys-Delaware.
Policy with Respect to Transactions with Related Parties
Pursuant to the indentures of us and Toys-Delaware, we must maintain an arm’s length relationship with any affiliate and may not enter into or be a party to any transaction other than arm’s length transactions, subject to certain exceptions.
Director Independence
Information regarding director independence is omitted as we meet the conditions set forth in General Instructions (I)(1)(a) and (b) of Form 10-K.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTING FEES AND SERVICES
Appointment of Independent Registered Public Accounting Firm
The Audit Committee appointed Deloitte & Touche LLP as the Company’s independent registered public accounting firm to conduct the audit of our Financial Statements for fiscals 2014 and 2013.
Audit Fees
Deloitte & Touche LLP, and the member firms of Deloitte Touche Tohmatsu and their respective affiliates (collectively “D&T”) provided professional services to TRU and its consolidated subsidiaries for fiscals 2014 and 2013. A portion of these costs have been allocated to TRU Propco II.
The aggregate fees billed by D&T for professional services rendered on our behalf for the audits of the annual Financial Statements for fiscals 2014 and 2013 and for the reviews of our Quarterly Reports on Form 10-Q for those fiscal years were estimated as follows:
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)
Financial Statements and financial statement schedules
(1) and (2) The financial statements and financial statement schedules required to be filed as part of this report are set forth in Item 8 of Part II of this report.
(3) Exhibits. See Item 15(b) below.
(b)
Exhibits required by Item 601 of Regulation S-K
The information required by this item is incorporated herein by reference from the Index to Exhibits beginning on page 56 of this Annual Report on Form 10-K. We will furnish to any security holder, upon written request, any exhibit listed in the accompanying Index to Exhibits upon payment by such security holder of our reasonable expenses in furnishing any such exhibit. Written requests should be sent to Investor Relations, Toys “R” Us Inc., One Geoffrey Way, Wayne, New Jersey 07470.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
TOYS “R” US PROPERTY COMPANY II, LLC
(Registrant)
By:
/s/ Michael J. Short
Name:
Michael J. Short
Title:
President and Chief Financial Officer
Date: April 24, 2015
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated at Toys-Delaware, the Managing Member of Giraffe Holdings, LLC, the Managing Member of Giraffe Junior Holdings, LLC, the Managing Member of Toys “R” Us Property Company II, LLC, such person performing the similar functions of a board of directors of the registrant, on April 24, 2015.
Signature
Title
/s/ Antonio Urcelay
Chief Executive Officer of Toys-Delaware
Antonio Urcelay
/s/ Michael J. Short
Executive Vice President - Chief Financial Officer of Toys-Delaware and President and Chief Financial Officer of the registrant
(Principal Executive and Financial Officer of the registrant)
Michael J. Short
/s/ Charles D. Knight
Senior Vice President - Controller of Toys-Delaware
Charles D. Knight
(Principal Accounting Officer of the registrant)
/s/ Michael J. Short
Authorized officer of the Managing Member of the Company
Michael J. Short
SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(d) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT
We have not sent a copy of our annual report or proxy statement to our security holders.
INDEX TO EXHIBITS
The following is a list of all exhibits filed as part of this Report: