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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
For the fiscal year ended January 29, 2005
TOYS "R" US, INC.
(IRS Employer
One Geoffrey Way
Wayne, New Jersey
Common Stock, $0.10 par value
Equity Security Units
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
The aggregate market value of common stock held by non-affiliates was $3,527,173,089 based on the closing sales price of the common stock on the New York Stock Exchange on July 30, 2004, the last business day of the registrant's most recently completed second fiscal quarter.
The number of shares of common stock, $0.10 par value per share, outstanding as of March 31, 2005 was 219,225,970.
Market for the Registrant's Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities
PART III.
Principal Accounting Fees and Services
PART IV.
INDEX TO EXHIBITS
Except as expressly indicated or unless the context otherwise requires, as used herein, the "Company," "we," "us," or "our" means Toys "R" Us, Inc. and its subsidiaries. We are a worldwide specialty retailer of toys, baby products and children's apparel. As of January 29, 2005, we operated 1,499 retail stores worldwide. These consisted of 898 locations in the United States, comprised of 681 toy stores and 217 specialty baby-juvenile stores under the name "Babies "R" Us." Internationally, as of January 29, 2005, we operated, licensed or franchised an aggregate of 601 stores. We also sell merchandise through our Internet sites at www.toysrus.com, www.babiesrus.com, www.imaginarium.com, www.sportsrus.com, and www.personalizedbyrus.com. Toys "R" Us, Inc. is incorporated in the state of Delaware.
Our retail business began in 1948 when founder Charles Lazarus opened a baby furniture store, Children's Bargain Town, in Washington, D.C. The Toys "R" Us name made its debut in 1957. Since inception, Toys "R" Us has built its reputation as a leading consumer destination for toys and children's products, including apparel. We opened our first Babies "R" Us stores in 1996, expanding our presence in the specialty baby-juvenile market. We are among the market share leaders in most of the largest markets in which "R" Us retail stores operate, including the United States, the United Kingdom, and Japan.
On March 17, 2005, we announced that we had entered into an Agreement and Plan of Merger, dated as of March 17, 2005 (the "Merger Agreement"), with Global Toys Acquisition, LLC and Global Toys Acquisition Merger Sub, Inc. to sell our entire worldwide operations, including both our global Toys "R" Us and Babies "R" Us businesses. For further details on the completion of our strategic review refer to the section entitled "CONCLUSION OF STRATEGIC REVIEW – AGREEMENT FOR SALE" below.
This Annual Report on Form 10-K reports on our last three fiscal years, ended as follows: for the year ended January 29, 2005 (our 2004 fiscal year end), for the year ended January 31, 2004 (our 2003 fiscal year end), and for the year ended February 1, 2003 (our 2002 fiscal year end). References to 2004, 2003 and 2002 are to our fiscal years unless otherwise specified or the context otherwise requires.
Toys "R" Us – U.S.
We operated toy stores in 49 states and Puerto Rico as of January 29, 2005. We sell toys, plush, games, bicycles, sporting goods, VHS and DVD movies, electronic and video games, small pools, books, educational and development products, clothing, infant and juvenile furniture, and electronics, as well as educational and entertainment computer software for children. Our toy stores offer approximately 8,000 to 10,000 distinct items year-round, which we believe is more than twice the number of items found in other discount or specialty stores selling toys.
As of January 29, 2005, we operated 681 toy stores in the United States including 424 combo stores, which combine our toy offering with approximately 5,500 square feet of children's apparel. All of our U.S. toy stores conform to the prototypical designs consisting of approximately 30,000 to 45,000 square feet of space and are typically free-standing units or located in shopping centers. We opened one new toy store in 2004, relocated three stores to nearby locations, and closed five toy stores.
We seek to differentiate ourselves from competitors in several key areas, including product selection, product presentation, service, in-store experience, and marketing. In the last several years, we have taken a number of actions in our attempt to strengthen our franchise. These actions included:
• Enhancing our product offering and adding more exclusive products to our mix;
• Adding apparel to a number of our toy stores in the United States;
• Renovating our toy store base in the United States to freshen our stores and enhance the shopping experience;
• Adding an Imaginarium learning and educational toy boutique to all domestic toy stores;
• Reorganizing our store management teams into merchandise "Worlds" and improving customer service; and
• Opening a flagship store in New York City.
Some of these actions are discussed in more detail below.
U.S. Toy Store Product Offering
We offer a wide selection of popular national toy brands including many products that are unique to, or launched at, Toys "R" Us. Over the past few years, we have worked with key resources to obtain exclusive products and expand our private label brands enabling us to offer products that our guests will not find elsewhere. We offer a broad assortment of private label merchandise under names such as Animal Alley®, Fast Lane®, Fun Years®, and Dream Dazzlers® in our toy stores.
Currently 424 of our domestic toy stores carry apparel. We added apparel to 37 Toys "R" Us stores in 2004 following the closing of the free-standing Kids "R" Us stores during the later part of 2003 and throughout 2004. Apparel is also a key product line in Babies "R" Us stores.
Merchandise "Worlds" and Customer Service
To further enhance the shopping experience of our guests, we use a merchandise "World" concept in our toy stores in the United States. In 2004, the Worlds consisted of the following:
• Core Toy, which includes boys and girls toys (dolls and doll accessories, action figures, role play, and vehicles); pre-school toys (pre-school learning, activities and toys); and Imaginarium (educational and developmental products, accessories, games, Animal Alley® plush and puzzles);
• Seasonal (Christmas, Halloween, summer, bikes, sports, play sets, and other seasonal products);
• Juvenile (baby products and newborn to age four apparel);
• R Zone (video game hardware and software, electronics, computer software, and other related products);
• Geoffrey's Box Office (VHS and DVD movies and other content designed to appeal to parents and children); and
• Apparel (clothing within 424 combo stores with sizes ranging from newborn to age ten).
In the past three years, we have provided our store associates with additional training to deepen their product knowledge and enhance their targeted selling skills in order to improve customer service in our stores.
Flagship Store in Times Square
We operate a flagship store in New York City's Times Square. This 110,000 square foot, multi-level store offers guests a vast array of toys and dramatic retail attractions, including a 60-foot tall, indoor ferris wheel. We believe that our flagship store provides us with an effective platform for new product launches and increased visibility for the "R" Us brands, and serves to further strengthen our standing with the vendor community.
Although we believe the steps we have taken have strengthened our domestic toy store franchise in several respects, the financial impact of these actions has not been as favorable as we had hoped. Operating income from our toy stores in the United States has declined for a number of years. The financial performance of the U.S. toy stores was a catalyst for the strategic review that the Company completed in March 2005. This strategic review is discussed in further detail below under "CONCLUSION OF STRATEGIC REVIEW – AGREEMENT FOR SALE."
Toys "R" Us – International
Toys "R" Us – International ("International") operates, licenses and franchises toy stores in 30 foreign countries. These stores generally conform to traditional prototypical designs similar to those used by Toys "R" Us – U.S., typically consisting of approximately 37,000 square feet of space. Some international stores utilize proprietary brands and shopping Worlds that have been successful in the United States. The Worlds include Imaginarium boutiques, which are known in some countries as "World of Imagination," and Babies "R" Us boutiques.
As of January 29, 2005, we operated 299 international stores, two of which are Babies "R" Us stores, and licensed or franchised 302 international stores, seven of which are Babies "R" Us stores. We added 33 new International toy stores in 2004, including 26 licensed or franchised stores, and closed ten stores, including five licensed or franchised stores. We intend to add approximately 41 new toy stores in 2005, which include approximately 31 licensed or franchised stores.
At January 29, 2005, Toys "R" Us – Japan, Ltd. ("Toys "R" Us – Japan"), a licensee of ours, operated 153 stores, which are included in the 302 licensed or franchised international stores. Of these 153 stores, seven stores were Babies "R" Us stores and the remainder were toy stores. During 2005, Toys "R" Us – Japan intends to open an additional eight Babies "R" Us stores as well as three Toys "R" Us stores. We have a 48% ownership in the common stock of Toys "R" Us – Japan and have accounted for this investment under the equity method of accounting. For a further discussion of our investment in Toys "R" Us – Japan, refer to Note 8 to the Consolidated Financial Statements entitled "INVESTMENT IN TOYS "R" US – JAPAN."
Our international division has wholly-owned operations in Australia, Austria, Canada, France, Germany, Portugal, Spain, Switzerland, and the United Kingdom. We intend to pursue opportunities that may arise in these and other countries. Net sales in foreign countries (excluding sales by licensees and franchisees) represented approximately 25% of consolidated net sales in 2004. We are subject to the risks inherent in conducting our business across national boundaries, many of which are outside of our control. These risks include the following:
• Economic downturns;
• Currency exchange rate and interest rate fluctuations;
• Changes in governmental policy, including, among others, those relating to taxation;
• International military, political, diplomatic and terrorist incidents;
• Government instability;
• Nationalization of foreign assets; and
• Tariffs and governmental trade policies.
We cannot ensure that one or more of these factors will not negatively affect International and, as a result, our business and financial performance.
Babies "R" Us
In 1996, we opened our first Babies "R" Us stores. The acquisition of Baby Superstore, Inc. in 1997 added 76 locations, and the continued expansion of this brand helped Babies "R" Us become the leader in the specialty baby-juvenile market. These stores operate in a prototypical design consisting of approximately 24,000 to 37,000 square feet of space. Babies "R" Us stores target the pre-natal to infant market by offering room settings of juvenile furniture, such as cribs, dressers, changing tables, bedding, and accessories. We offer a broad assortment of private label merchandise under names such as Especially for Baby® and Koala Baby®. In addition, we provide baby gear, such as play yards, booster seats, high chairs, strollers, car seats, toddler and infant plush toys, and gifts. As of January 29, 2005, Babies "R" Us operated 217 specialty baby-juvenile retail locations, all of which are in the United States. The Babies "R" Us stores are designed with low profile merchandise displays in
the center of the stores, providing a sweeping view of the entire merchandise selection. Most Babies "R" Us stores devote between 3,000 to 5,000 square feet to specialty name brand and private label clothing. They also offer a wide range of feeding supplies, health and beauty aids, and infant care products.
In addition, we offer a computerized baby registry service, and we believe that Babies "R" Us registers more expectant parents than any other retailer in the domestic market. Our computerized baby registry offers a user-friendly printout as well as other features to guide registrants in making their selections.
Based on demographic data used to determine which markets to enter, we opened 19 Babies "R" Us stores in 2004. As part of our long-range growth plan, we plan to continue the expansion of our Babies "R" Us store base in 2005, some of which will be converted from former Kids "R" Us and Toys "R" Us stores.
Toysrus.com
Toysrus.com sells merchandise to the public via the Internet at www.toysrus.com, www.babiesrus.com, www.imaginarium.com, www.sportsrus.com, and www.personalizedbyrus.com. We launched our e-commerce website in 1998. In order to provide better customer service and order fulfillment, we have entered into a strategic alliance with Amazon.com, Inc. ("Amazon.com") and launched a co-branded toy store in 2000. Under the strategic alliance, this co-branded store offers toys and video games (Toysrus.com), baby products (Babiesrus.com), and learning and educational products (Imaginarium.com). The strategic alliance agreement, which expires in 2010, combines Toysrus.com's merchandising expertise and trusted brand name with Amazon.com's strengths in website operations, on-line customer service and reliable fulfillment. Toysrus.com is responsible for merchandising and content for the co-branded stores and identifies, purchases, owns, and manages the inventory. Amazon.com handles site development, order fulfillment for most items, customer service, and the housing of Toysrus.com's inventory in Amazon.com's fulfillment centers in the United States.
On October 26, 2004, Toys "R" Us, Inc., acquired all of the issued and outstanding shares of capital stock of SB Toys, Inc., for $42 million in cash. We originally recorded $39 million of goodwill related to this acquisition. In the fourth quarter of 2004, the purchase price allocation to goodwill was reduced by $34 million to reflect a reversal of a deferred tax liability. SB Toys, Inc. was previously owned by SOFTBANK Venture Capital and affiliates ("SOFTBANK") and other investors. Prior to this acquisition, SB Toys, Inc. owned a 20% interest, as a minority shareholder, of Toysrus.com, LLC, our Internet subsidiary. As a result we recorded a 20% minority interest in consolidation to account for the ownership stake of SB Toys, Inc. Beginning in the fourth quarter of 2004, we recognized 100% of the results of Toysrus.com, LLC in our consolidated financial statements.
On May 21, 2004, we, Toysrus.com, LLC, and two other affiliated companies, filed a lawsuit against Amazon.com and its affiliated companies related to our strategic alliance with Amazon.com to, among other things, enforce our exclusivity rights under the agreement. On June 25, 2004, Amazon.com filed a counterclaim against us and our affiliated companies alleging breach of contract relating to inventory and selection requirements. We believe the counterclaim is without merit. For further details refer to Item 3 entitled "LEGAL PROCEEDINGS" and to Note 25 to the Consolidated Financial Statements entitled "COMMITMENTS AND CONTINGENCIES."
Closing of Kids "R" Us and Imaginarium Free-standing Stores
On November 17, 2003, we announced plans to close all 146 of the remaining free-standing Kids "R" Us stores and all 36 of the free-standing Imaginarium stores, as well as three distribution centers that supported these stores. These free-standing stores had incurred significant performance declines in the few years preceding that announcement. This accelerated deterioration in financial performance led to our decision to cease operations in these free-standing stores. We continue, however, to expand our apparel business and the Imaginarium boutiques within our Toys "R" Us and Babies "R" Us stores. However, we believe that ceasing operations in the free-standing Kids "R" Us and Imaginarium stores will continue to benefit future cash flows and net earnings. All of the Kids "R" Us facilities as well as all of the Imaginarium stores were closed by January 29, 2005.
On March 2, 2004, we entered into an agreement under which Office Depot, Inc. ("Office Depot") agreed to acquire 124 of the former Kids "R" Us stores for $197 million in cash, before commissions and fees, plus the assumption of lease payments and other obligations. Twenty-four properties have subsequently been excluded from the agreement with Office Depot and are being separately marketed for disposition or have been disposed of to date. All closings were completed by January 29, 2005 and net cash proceeds of approximately $150 million were received. A $55 million gain associated with the closing of our Kids "R" Us stores was recorded during 2004, of which $53 million was related to our transaction with Office Depot.
Details of restructuring and other charges, as well as other strategic initiatives, are described in Item 7 entitled "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" and within Note 4 to the Consolidated Financial Statements entitled "RESTRUCTURING AND OTHER CHARGES."
Conclusion of Strategic Review – Agreement for Sale
Over the past few years, our performance and prospects have been adversely impacted by significant developments in the retail toy industry. Discount and mass merchandisers who have greater financial resources and lower operating expenses have driven down pricing and reduced profit margins for other players in the retail toy industry. Additionally, our toy sales have been negatively impacted by changing consumer habits, including "age compression," which is the acceleration of children abandoning traditional toy categories at increasingly younger ages for cell phones, DVD players, CD players, MP3 and other electronic devices.
As a result of these trends and the performance of the U.S. toy stores in the 2003 holiday season, the Company decided to conduct a thorough strategic evaluation of all of our worldwide assets and operations to determine the optimal configuration and uses of our resources. We announced this decision publicly in January of 2004. Following the announcement, the Company selected Credit Suisse First Boston as its financial advisor. After the Company retained Credit Suisse First Boston, the Company's management and Credit Suisse First Boston commenced a review of the Company and its businesses.
On August 11, 2004, we announced to the public that we had decided to pursue the separation of the global Toys "R" Us business and the Babies "R" Us business. We also announced that we were exploring, among other actions, the possible sale of the global Toys "R" Us business and the possible spin-off of the Babies "R" Us business.
On March 17, 2005, we concluded our strategic review and announced that we had entered into an Agreement and Plan of Merger, dated as of March 17, 2005, with Global Toys Acquisition, LLC ("Parent") and Global Toys Acquisition Merger Sub, Inc. ("Acquisition Sub") to sell our entire worldwide operations, including both our global Toys "R" Us and Babies "R" Us businesses. Parent and Acquisition Sub are entities directly and indirectly owned by an investment group consisting of entities advised by or affiliated with Bain Capital Partners LLC, Kohlberg Kravis Roberts & Co., L.P., and Vornado Realty Trust, collectively the "Sponsors."
Under the terms of the agreement, the Sponsors will acquire all of the outstanding shares of Toys "R" Us, Inc. for $26.75 per share, representing a transaction value of approximately $6.6 billion in addition to the assumption of debt. The Merger Agreement contemplates that Acquisition Sub will be merged with and into the Company and that each outstanding share of our common stock will be converted into the right to receive $26.75 per share without interest.
Consummation of the proposed merger is subject to various customary conditions, including adoption of the Merger Agreement by our Company's stockholders, receipt of debt financing by Parent, the absence of certain legal impediments to the consummation of the proposed merger and the receipt of certain regulatory approvals. We currently expect that the proposed merger will occur by the end of July 2005; however, there can be no assurance that the proposed merger will be consummated.
The Merger Agreement was filed on a Form 8-K dated March 22, 2005. The forgoing description of the Merger Agreement is qualified in its entirety by reference to the full text of the Merger Agreement.
On April 6, 2005, the Company and Parent each filed a pre-merger notification and report form under the Hart-Scott-Rodino Antitrust Improvement Act of 1976, as amended, and the rules and regulations promulgated thereunder, with the Federal Trade Commission and the Department of Justice. On April 15, 2005, we were notified by the Federal Trade Commission that we were granted early termination of the waiting period.
After the closing of the proposed merger, the Sponsors may direct us to make significant changes in our 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 cost and expenses.
Financing of the Merger
In connection with the proposed merger, if consummated, Parent will cause approximately $6.6 billion to be paid out to our Company's stockholders and holders of other equity interests in our Company. These payments are expected to be funded by a combination of equity contributions by affiliates of the Sponsors to Parent and debt financing. Affiliates of the Sponsors have collectively agreed to contribute, subject to the satisfaction of certain conditions, $1.2 billion of equity to Parent and the remaining funds necessary to finance the proposed merger are expected to be obtained through Parent's and its subsidiaries' debt financing.
Parent has obtained equity and debt financing commitments for the transactions contemplated by the Merger Agreement, which are subject to customary conditions. After giving effect to contemplated draws by the subsidiaries of our Company or Parent and its affiliates under the new debt commitments, Parent has advised us that it currently expects total existing and new debt outstanding at closing of the proposed merger transaction will be approximately $6 billion.
In connection with the execution and delivery of the Merger Agreement, Parent obtained commitments to provide approximately $6.2 billion in debt financing (not all of which is expected to be drawn at closing) consisting of (a) a $2.85 billion U.S. asset-based debt facility (the "Asset-Based Facility"), (b) a $2.0 billion bridge facility (the "U.S. Bridge Facility"), (c) a $1.0 billion European bridge facility (the "European Bridge Facility") and (d) a $350 million European working capital facility (the "European Working Capital Facility" and, together with the European Bridge Facility, the "European Facilities"). Parent expects to use these facilities and existing debt and may use alternative financing to finance the proposed merger.
Parent has advised us that all of the new indebtedness to be incurred in connection with the proposed merger will be incurred by our subsidiaries and that some or all of the new financing to be incurred in connection with the proposed merger will be secured by our assets or assets of our subsidiaries. As a result, substantially all of our existing debt is likely to be contractually or effectively subordinated to this new indebtedness. In addition, this new indebtedness may contain restrictive covenants, which may adversely affect our ability to service our existing indebtedness or operate our business.
Asset-Based Facility. Borrowings under the Asset-Based Facility will be limited by a borrowing base which is calculated periodically based on specified percentages of the value of eligible inventory, eligible credit card accounts receivable and eligible real estate (with a limit of $725 million on borrowing based on eligible real estate at closing), subject to certain reserves and other adjustments. The Asset-Based Facility will be guaranteed by certain U.S. subsidiaries of the Company and secured by a perfected first priority lien on substantially all assets of such subsidiaries, subject to various limitations and exceptions. Acquisition Sub is not required to complete mortgage documentation by closing in order to borrow up to $725 million against the value of the real estate. At or prior to closing, up to $725 million of the Asset-Based Facility may be transferred to the U.S. Bridge Facility, subject to certain conditions. The Asset-Based Facility commitments are conditioned on the proposed merger being consummated by October 31, 2005, as well as other customary conditions including the absence of a material adverse change at the company, the creation of security interests, the execution of satisfactory definitive documentation, receipt of at least $1.2 billion (in the aggregate) in equity or junior capital from equity investors, including affiliates of the Sponsors, receipt of certain proceeds from the U.S. Bridge Facility and the
European Bridge Facility or alternate financing sources, receipt of all required consents and approvals, the absence of any material amendments or waivers to the Merger Agreement to the extent materially adverse to the lenders which have not been approved by the lenders and the absence of any event of default.
U.S. Bridge Facility. The U.S. Bridge Facility will be reduced by the amount of Yen denominated debt outstanding at closing. The U.S. Bridge Facility will become obligations of certain U.S. subsidiaries of the Company and is conditioned on the proposed merger being consummated by October 31, 2005, as well as other customary conditions, including the absence of a material adverse change at the Company, the execution of satisfactory definitive documentation, receipt of at least $1.2 billion (in the aggregate) in equity or junior capital from equity investors, including affiliates of the Sponsors, receipt of certain proceeds from the Asset-Based Facility and the European Bridge Facility, receipt of all required consents and approvals, the absence of any material amendments or waivers to the Merger Agreement to the extent materially adverse to the lenders which have not been approved by the lenders and the absence of any event of default.
European Facilities. The European Facilities will initially be secured by a pledge of the assets (including stock) of the entities borrowing under the European Bridge Facility and, following closing, will be secured, to the extent legally possible and practicable, by a lien over substantially all of the assets of the borrowers and guarantors under the European Facilities. The European Facilities will be conditioned upon the execution of the definitive documentation by October 17, 2005. Initial borrowings under the European Bridge Facility will be subject only to limited conditions including the creation of security interests, the absence of payment default under the facility, the absence of a bankruptcy at Parent, the absence of a breach by Parent under certain material negative covenants and representations, the absence of any amendments or waivers to the Merger Agreement which are materially adverse to the interests of, and have not been approved by, the lenders, and the absence of a breach by the Company with respect to certain undertakings in respect of the merger. Borrowings under the European Working Capital Facility will also be subject to customary conditions such as the absence of a material adverse change at the Company.
Financial Information About Industry Segments
Information about industry segments is set forth within Note 24 to the Consolidated Financial Statements entitled "SEGMENTS."
In the United States, our stores are supported by 12 distribution centers, which average approximately 700,000 square feet in size, and are strategically located throughout the United States to efficiently support our stores. We also operate eight international distribution centers that support our International toy stores.
These distribution centers employ warehouse management systems and material handling equipment that help to minimize overall inventory levels and distribution costs. We believe the flexibility afforded by our warehouse/distribution system and by operating the fleet of trucks used to distribute merchandise, provides us with operating efficiencies and the ability to maintain a superior in-stock inventory position at our stores. We are currently implementing initiatives to improve our supply chain management and to optimize our inventory assortment. We are also expanding our automated replenishment system to improve inventory turnover.
"TOYS "R" US"®, "BABIES "R" US" ®, "IMAGINARIUM" ®, "GEOFFREY" ®, "TOYSRUS.COM"® as well as variations of our family of "R" Us marks, either have been registered, or have trademark applications pending, with the United States Patent and Trademark Office and with the trademark registries of many foreign countries. We believe that our rights to these properties are adequately protected.
Risks Associated with Our Business
Our worldwide toy business is highly seasonal with net sales and earnings highest in the fourth quarter. During the last three fiscal years, more than 40% of the net sales from our worldwide toy business and a substantial portion of our operating earnings and cash flows from operations were generated in the fourth quarter. Our results of operations depend significantly upon the holiday selling season in the fourth quarter. If less than satisfactory net sales, operating earnings or cash flows from operations are achieved during the key fourth quarter, we may not be able to compensate sufficiently for the lower net sales, operating earnings, or cash flows from operations during the first three quarters of the fiscal year. Our Babies "R" Us business is not significantly impacted by seasonality.
For further details regarding the seasonal nature of our business, refer to the tabular presentation in the "QUARTERLY RESULTS OF OPERATIONS" section at the end of Item 8.
Liquidity and Capital Requirements
We have significant liquidity and capital requirements. Among other things, the seasonality of our toy business requires us to purchase merchandise well in advance of the holiday selling season. We depend on our ability to generate cash flow from operations as well as borrowings from our unsecured revolving credit facility to finance the carrying costs of this inventory, to pay for capital expenditures, and to maintain operations. Standard & Poor's and Moody's rate our debt as non-investment grade. There is a risk that these ratings may be lowered in the future, particularly as a result of the proposed merger. See Item 7 entitled "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – LIQUIDITY AND CAPITAL RESOURCES – CREDIT RATINGS." Our credit ratings could (1) negatively impact our ability to finance our operations on satisfactory terms; (2) have the effect of increasing our financing costs; and (3) have the effect of slightly increasing our insurance premiums and collateral requirements necessary for our self-insured programs. We currently have adequate sources of funds to provide for our ongoing operations and capital requirements; however, any inability to have future access to financing, when needed, could have a negative effect on our financial condition and results of our operations.
For a discussion of our liquidity and capital resource requirements, refer to Item 7 entitled "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
The retailing industry is highly competitive and our results of operations are sensitive to, and may be adversely affected by, competitive pricing, promotional pressures, additional competitor store openings, and other factors. We compete with discount and mass merchandisers such as Wal-Mart, Target, and Kmart; electronic retailers, such as Best Buy and Circuit City; national and regional chains; as well as local retailers in the market areas we serve. Competition is principally based on price, store location, advertising and promotion, product selection, quality, and service. Some of our competitors may have greater financial resources, lower merchandise acquisition costs, and lower operating expenses than our Company. If we fail to compete successfully, we could face lower net sales and may decide to offer greater discounts to our guests, which could result in decreased profitability.
Most of the merchandise we sell 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 build traffic for other store departments. We seek to address these competitive tactics and attract more guests by continually building brand image and by offering exclusive products, high value items, and the best available selection of toys and toy-related products relative to the discount and mass merchandisers.
In addition, competition in the retail apparel business consists of national and local department stores, specialty and discount store chains, as well as Internet and catalog businesses. Our apparel business is vulnerable to demand and pricing shifts and to less than optimal selection as a result of these factors. We review our merchandise assortments in order to identify slow-moving items and use markdowns to clear such inventory.
We continue to implement a series of guest-oriented strategic programs designed to differentiate and strengthen our core merchandise content and service levels. The success of these plans will depend on various factors including the appeal of our store formats, our ability to offer new products to guests, and competitive and economic conditions. We are also continuing with plans to reduce and optimize our operating expense structure. If we are unsuccessful at implementing some or all of our strategic initiatives, we may be unable to retain or attract guests, which could result in lower net sales and a failure to realize the benefit of the sizeable expenditures incurred for these initiatives.
Consumer Preferences
Our financial performance depends on our ability to identify, originate, and define product trends, as well as to anticipate, gauge, and react to changing consumer demands in a timely manner. Our toy and other products must appeal to a broad range of consumers whose preferences cannot be predicted with certainty and are subject to change. We cannot guarantee our ability to continue to meet changing consumer demands in the future. If we misjudge the market for our products, we may be faced with significant excess inventories for some products and missed opportunities for other products. In addition, because we place orders for products well in advance of purchases by guests, we could experience excess inventory if our guests purchase fewer products than anticipated. The retail apparel business fluctuates according to changes in consumer preferences dictated in part by fashion, perceived value, and season. These fluctuations affect the merchandise in stock since purchase orders are made well in advance of the season and, at times, before fashion trends and high-demand brands are evidenced by consumer purchases.
Sales of toys and other products may depend upon discretionary consumer spending, which may be affected by general economic conditions, consumer confidence, and other factors beyond our control. A decline in consumer spending could, among other things, negatively affect our net sales and could also result in excess inventories, which could in turn lead to increased inventory financing expenses. As a result, changes in consumer spending patterns could adversely affect our profitability.
Age Compression Trend
Toy sales may be negatively impacted by "age compression," which is the acceleration of children leaving traditional play categories at increasingly younger ages for more sophisticated products such as cell phones, DVD players, CD players, MP3 devices, and other electronic products. The age compression pattern tends to decrease consumer demand for traditional toys. To the extent that we are unable to offer consumers more sophisticated products or that these more sophisticated items are also available at a wider range of retailers than our traditional competitors, our sales and profitability could be detrimentally affected and we could experience excess inventories.
Vendor Relationships
We have more than 2,000 vendor relationships through which we procure the merchandise that we offer to guests. For 2004, our top 20 vendors worldwide, based on our purchase volume, represented approximately 42% of the total products we purchased. The concentration of goods coming from a limited number of vendors could negatively affect our business if our relationship deteriorated with this group of vendors. If we were unable to negotiate reasonable terms to acquire merchandise from this group of vendors and then failed to obtain similar products from alternative sources, our net sales and profitability would be negatively affected.
A significant portion of the toys and other products sold by us are manufactured outside of the United States, primarily in Asia. As a result, any event causing a disruption of imports, including the imposition of import restrictions or trade restrictions in the form of tariffs or otherwise, acts of war, or terrorism could increase the cost and reduce the supply of products available to us, which could, in turn, negatively affect our net sales and profitability. In addition, over the past few years, port-labor issues, rail congestion, and trucking shortages have had an impact on all direct importers. Although we attempt to anticipate and manage such situations, both our sales and profitability could be adversely impacted by such developments in the future.
Internet Operations
The success of our on-line business depends on our ability to provide quality service to our Internet guests and on our strategic alliance with Amazon.com. On May 21, 2004, we, Toysrus.com, LLC, our Internet subsidiary, and two other affiliated companies, filed a lawsuit against Amazon.com and its affiliated companies related to our strategic alliance with Amazon.com. On June 25, 2004, Amazon.com filed a counterclaim against us and our affiliated companies alleging breach of contract relating to inventory and selection requirements. For further details refer to Item 3 entitled "LEGAL PROCEEDINGS" and to Note 25 to the Consolidated Financial Statements entitled "COMMITMENTS AND CONTINGENCIES."
If our strategic alliance were terminated and we were unable to provide the same level of website and fulfillment services ourselves or through other third parties, the net sales and profitability of our on-line business could be negatively affected.
Information Technology Systems
We depend upon our information technology systems in the conduct of our operations. We are in the process of upgrading the inventory management, distribution and supply chain management systems, our point of sale systems, as well as other essential information technology. Implementation of new systems and enhancements to existing systems could cause disruptions in our operations. If our major information systems fail to perform as anticipated, we could experience difficulties in replenishing inventories or in delivering toys and other products to store locations in response to consumer demands. Any of these or other systems related problems could, in turn, adversely affect our net sales and profitability.
Risks Related to the Proposed Merger
Failure to Complete Merger
The proposed merger is subject to the satisfaction of closing conditions, including the approval by our stockholders and other conditions described in the Merger Agreement. We cannot assure you that these conditions will be satisfied or that the proposed merger will be successfully completed. In the event that the proposed merger is not completed:
• Management's attention from our day-to-day business may be diverted;
• We may lose key employees;
• Our relationships with vendors may be disrupted as a result of uncertainties with regard to our business and prospects;
• We may be required to pay significant transaction costs related to the proposed merger, such as a transaction termination (break-up) fee of $247.5 million as well as legal, accounting and other fees; and
• The market price of shares of our common stock may decline to the extent that the current market price of those shares reflects a market assumption that the proposed merger will be completed.
Any such events could adversely affect our stock price and harm our business and operating results.
Sales of Assets
After the closing of the proposed merger, the Sponsors may direct us to make significant changes to our 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 cost and expenses. We cannot assure you that the future business operations of our Company will remain broadly in line with our existing operations or that significant real estate and other assets will not be sold. It is possible that a significant portion of our assets may be encumbered to support financings arranged by the Sponsors to fund their acquisition of our Company or future operations.
Potential Effects of the Merger on our Business
The announcement and consummation of the proposed merger may have a negative impact on our ability to attract and retain key management and maintain and attract new vendor relationships. Any such events could harm our operating results and financial condition.
Uncertain Capital Structure
In connection with the execution and delivery of the Merger Agreement, Parent obtained commitments to provide approximately $6.2 billion in debt financing, and Parent expects to use these facilities and existing debt and may use alternative financing to finance the proposed merger. After giving effect to the contemplated draws by our or Parent's subsidiaries under the new debt commitments, Parent has advised us that it currently expects total existing and new debt outstanding at closing of the proposed merger transaction will be approximately $6 billion. However, Parent has advised us that it has not made any definitive decisions regarding this debt financing or our anticipated capital structure following consummation of the proposed merger. Accordingly, we cannot predict what our capital structure will look like following the merger, if consummated.
Substantial Indebtedness
Parent has advised us that we will have substantial indebtedness if the proposed merger is consummated. There can be no assurance that our business will be able to generate sufficient cash flows from operations to meet our debt service obligations, as they are subject to general economic, business, financial, competitive and other factors beyond our control. Our level of indebtedness has important consequences, including limiting our ability to invest operating cash flow to expand our business or execute our strategy, to capitalize on business opportunities and to react to competitive pressures, because we must dedicate a substantial portion of these cash flows to service our debt. In addition, we could be unable to refinance or obtain additional financing because of market conditions, our high levels of debt and the debt restrictions expected to be included in the debt instruments contemplated by Parent. Any of this new indebtedness may contain restrictive covenants, which may adversely affect our ability to service our existing indebtedness or operate our business.
Subordination of Existing Indebtedness
Parent has advised us that all of the new indebtedness to be incurred in connection with the proposed merger will be incurred by our subsidiaries. We are a holding company and conduct all of our operations through subsidiaries, and thus our or Parent's ability to meet our obligations under our existing indebtedness will be dependent on the earnings and cash flows of those subsidiaries and the ability of those subsidiaries to pay dividends or to advance or repay funds to us. Our right to participate as an equity holder in any distribution of assets of any subsidiary (and thus the ability of our debt holders to benefit as creditors of our Company from such distribution) is junior to creditors of that subsidiary, including trade creditors, debt holders, secured creditors, taxing authorities and any guarantee holders. As a result, claims of holders of substantially all of our existing indebtedness are likely to be effectively subordinated to the existing and future creditors of our subsidiaries. In the event of our liquidation or reorganization, holders of our existing indebtedness will generally have a junior position to claims of creditors of our subsidiaries. In addition, any payment of dividends, distributions, loans or advances by our subsidiaries to us could be subject to contractual restrictions, including restrictive covenants that may be included in the new indebtedness.
Parent has advised us that some or all of the new financing to be incurred in connection with the proposed merger will be secured by our assets or assets of our subsidiaries. Thus, our existing unsecured indebtedness will be effectively subordinated to our existing and future secured indebtedness to the extent of the value of the assets securing that indebtedness.
As of January 29, 2005, we employed approximately 60,000 full-time and part-time individuals. Due to the seasonality of our business, we employed approximately 97,000 full-time and part-time employees during the 2004 holiday season.
Our investor relations website is www.toysrusinc.com. On this website under "INVESTOR RELATIONS, SEC Filings," we make available, free of charge, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, as well as amendments to those reports as soon as reasonably practicable after we electronically file with or furnish such material to the Securities Exchange Commission.
Our Amended and Restated Corporate Governance Guidelines ("Corporate Governance Guidelines") and the charters for our Audit Committee, Corporate Governance and Nominating Committee, Compensation and Organizational Development Committee and Executive Committee may also be found on our investor relations website at www.toysrusinc.com. In addition, our website contains the Toys "R" Us, Inc. and Subsidiaries Code of Ethical Standards and Business Practices and Conduct ("Code of Ethics"), which is our code of ethics and conduct for our directors, officers and employees, and the Toys "R" Us, Inc. Chief Executive Officer and Senior Financial Officers Code of Ethics ("CEO and Senior Financial Officers Code"), which is an additional code of ethics for our Chief Executive Officer and our senior financial officers. Any waivers from our Code of Ethics for our directors and executive officers and any amendments to or waivers from the CEO and Senior Financial Officers Code that apply to our Chief Executive Officer, Chief Financial Officer, principal accounting officer or controller, or persons performing similar functions will be promptly disclosed to the Company's stockholders on the Company's website. These materials are also available in print, free of charge, to any stockholder who requests them by writing to: Toys "R" Us, Inc., One Geoffrey Way, Wayne, New Jersey 07470, Attention: Investor Relations.
We are not incorporating by reference in this Annual Report on Form 10-K any material from our websites.
This Annual Report on Form 10-K contains "forward looking" statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are intended to be covered by the safe harbors created thereby. All statements herein that are not historical facts, including statements about our beliefs or expectations, are forward-looking statements. We generally identify these statements by words or phrases, such as "anticipate," "estimate," "plan," "expect," "believe," "intend," "foresee," "will," "may," and similar words or phrases. These statements discuss, among other things, our strategy, store openings and renovations, future financial or operational performance, anticipated cost savings, results of store closings and restructurings, anticipated domestic or international development, our proposed merger, future financings, and other goals and targets. These statements are subject to risks, uncertainties, and other factors, including, among others, competition in the retail industry, seasonality of our business, changes in consumer preferences and consumer spending patterns, general economic conditions in the United States and other countries in which we conduct our business, the timing and receipt of approvals for the proposed merger, our ability to implement our strategy, availability of adequate financing, our dependence on key vendors for our merchandise, domestic and international events affecting the delivery of toys and other products to our stores, economic, political and other developments associated with our international operations, existence of adverse litigation and risks, uncertainties and factors set forth in our reports and documents filed
with the Securities Exchange Commission. We believe that all forward-looking statements are based on reasonable assumptions when made; however, we caution that it is impossible to predict actual results or outcomes or the effects of risks, uncertainties or other factors on anticipated results or outcomes and that, accordingly, one should not place undue reliance on these statements. Forward-looking statements speak only as of the date they were made, and we undertake no obligation to update these statements in light of subsequent events or developments. Actual results may differ materially from anticipated results or outcomes discussed in any forward-looking statement.
The following summarizes our worldwide operating store and distribution center facilities as of January 29, 2005 (excluding International licensed and franchised stores):
Leased (a)
9 — 3 12
14 — 6 20
Total Operating Stores and Distribution Centers
(a) Owned buildings on leased land.
In 2003, we consolidated five New Jersey store support center facilities into our Global Store Support Center facility in Wayne, New Jersey, which is financed under a lease arrangement commonly referred to as a "synthetic lease." Further details of the recent consolidation of these store support facilities into the Global Store Support Center facility and the "synthetic lease" are described within Note 4 to the Consolidated Financial Statements entitled "RESTRUCTURING AND OTHER CHARGES," Note 18 to the Consolidated Financial Statements entitled "LEASES" and Item 7 entitled "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." We also utilize other facilities worldwide for administrative and store support purposes.
On March 31, 2005, we submitted a purchase election option to Wachovia Development Corporation for the purpose of purchasing our Global Store Support Center facility, details of which are included in Note 18 to the Consolidated Financial Statements entitled "LEASES."
We have former stores and distribution centers that are no longer part of our operations. Approximately 45% of these locations are owned and the remaining locations are leased. We have tenants in more than two- thirds of these locations, and for those without tenants, we continue to market the facilities for disposition. The net costs associated with these locations are reflected in our Consolidated Financial Statements, but the number of surplus locations are not listed above.
For further information regarding properties, refer to Exhibit No. 13.
On May 21, 2004, we, Toysrus.com, LLC, our Internet subsidiary, and two other affiliated companies, filed a lawsuit against Amazon.com and its affiliated companies related to our strategic alliance with Amazon.com. The lawsuit was filed to protect our exclusivity rights in the toy, game, and baby products categories for the
online e-commerce site on the Amazon.com platform. The complaint seeks injunctive and declaratory relief, monetary damages and contract rescission against Amazon.com. The suit was filed in the Superior Court of New Jersey, Chancery Division, Passaic County. On June 25, 2004, Amazon.com filed a counterclaim against us and our affiliated companies alleging breach of contract relating to inventory and selection requirements. This counterclaim seeks monetary damages and invokes contract termination rights. We believe the counterclaim is without merit, and at this time, we do not anticipate that this lawsuit, or the subject matter thereof, will disrupt our ability to continue to offer products and services on our e-commerce sites, affect our guests and suppliers, or have any material adverse effect on our financial condition or results of operations.
In March 2005, two purported class action complaints were filed by putative stockholders of our Company in the Court of Chancery in the State of Delaware in and for New Castle County against the Company and certain of its officers and directors challenging the proposed merger. The first complaint, styled Iron Workers of Western Pennsylvania Pension & Profit Plans v. Toys "R" Us, Inc. (CA No. 1212-N), was filed on March 25, 2005 and the second complaint, styled Jolly Roger Fund LP v. Toys "R" Us, Inc. (CA No. 1218-N), was filed on March 31, 2005 (collectively, the "Complaints").
The Complaints raise substantially similar allegations on behalf of a purported class of the Company's stockholders against the defendants for alleged breaches of fiduciary duty in connection with the approval of the merger. The Complaints allege that in determining to enter into the Merger Agreement, the defendants failed to take appropriate steps to obtain maximum value for stockholders and did not engage in an adequate, conflict-free, fair process to obtain maximum value for stockholders, that certain directors and officers engaged in self-dealing and suffered from conflicts of interests, and that the defendants have failed to disclose all material information concerning the value of the Company and the process leading to the Merger Agreement. The Complaints seek to enjoin the consummation of the proposed merger or, alternatively, to rescind it. Plaintiffs also seek an award of damages for the alleged wrongs asserted in the Complaints.
The lawsuits are in their preliminary stages. On April 20, 2005, the cases were consolidated in the Court of Chancery in the State of Delaware in and for New Castle County. The defendants have moved to dismiss the lawsuits. We believe that the lawsuits are without merit and intend to defend vigorously against them.
From time to time, in the ordinary course of business, we are involved in various legal proceedings, including commercial disputes, personal injury claims and employment issues. We do not believe that any of these proceedings will have a material adverse effect on our financial condition, results of operations, or cash flows.
No matters were submitted for a vote of stockholders during the fourth quarter of the fiscal year ending January 29, 2005.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is listed on the New York Stock Exchange under the symbol "TOY." The following table sets forth, for the periods indicated, the high and low sales prices (rounded to the nearest hundredth) as reported on the New York Stock Exchange composite tape since February 1, 2003.
Sale Price of Common Stock
17.44 13.88 10.52 7.70
We have not paid any cash dividends on our common stock. Our Board of Directors periodically reviews whether to pay dividends and any decision to pay dividends will depend upon our earnings, financial condition, and other factors. The Merger Agreement provides, among other things, that we may not pay any dividends on our common stock without the consent of the Parent.
We had approximately 31,341 stockholders of record as of March 31, 2005.
Purchases of Equity Securities by the Issuer and Affiliate Purchases
The following table presents information with respect to repurchases of common stock made by us during the three months ended January 29, 2005.
Purchased as Part
of Publicly
Plans or Programs
Approximate Dollar
Value of Shares That
May Yet Be
Purchased Under the
10/31/2004 – 11/27/2004(1)
9,275 $ 18.89 — $ —
5,682 19.41 — —
266 20.77 — —
15,223 $ 19.12 — $ —
(1) Represents shares of common stock purchased and held in a rabbi trust established under our Non-Employee Directors' Deferred Compensation Plan to mirror deferred restricted stock units that were granted during this period pursuant to our Non-Employee Directors' Stock Unit Plan.
(2) Represents shares of common stock delivered to us as payment of taxes on the vesting of restricted units under our Amended and Restated 1994 Stock Option and Performance Incentive Plan.
Selected financial data is hereby incorporated by reference from Exhibit No. 13.
The following Management's Discussion and Analysis is intended to provide the readers of our financial statements with a narrative discussion about our business. This discussion and analysis is presented in six sections: Overview, Results of Operations, Restructuring and Other Charges, Liquidity and Capital Resources, Off-Balance Sheet Arrangements, and Critical Accounting Policies. This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our Consolidated Financial Statements and the related notes, and contains forward-looking statements that involve risks and uncertainties. See Item 1 entitled "BUSINESS – RISKS ASSOCIATED WITH OUR BUSINESS, RISKS RELATED TO THE PROPOSED MERGER and FORWARD-LOOKING STATEMENTS."
Our Company generates sales, earnings and cash flows by retailing specialty children's products worldwide. We operate all of our retail stores in the United States, as well as approximately 50% of our branded retail stores internationally. As of January 29, 2005, there were 1,499 "R" Us branded retail stores operating worldwide in the following formats:
• 681 Toys "R" Us specialty toy stores throughout the United States which offer toy, baby-juvenile, and children's clothing products;
• 601 international Toys "R" Us specialty toy stores, nine of which are Babies "R" Us stores. Included in the 601 stores are 302 licensed or franchised stores; and
• 217 Babies "R" Us specialty baby-juvenile stores in the United States.
In addition to the above, we sell merchandise through our Internet sites at www.toysrus.com, www.babiesrus.com, www.imaginarium.com, www.sportsrus.com, and www.personalizedbyrus.com.
We conducted a strategic review of all of our worldwide assets and operations, which we announced publicly in January 2004. See Item 1 entitled "BUSINESS – CONCLUSION OF STRATEGIC REVIEW – AGREEMENT FOR SALE."
We concluded this strategic review in March 2005, having reached a definitive agreement to sell our entire worldwide operations, including both our global Toys "R" Us and Babies "R" Us businesses, to the Sponsors. On March 17, 2005, we entered into a Merger Agreement with Parent and Acquisition Sub. Under the terms of the Merger Agreement, Parent will acquire all of the outstanding shares of Toys "R" Us, Inc. for $26.75 per share, representing a transaction value of approximately $6.6 billion in addition to the assumption of debt. Consummation of the proposed merger is subject to various customary conditions, including adoption of the Merger Agreement by our Company's stockholders, receipt of debt financing by Parent, the absence of certain legal impediments to the consummation of the proposed merger and the receipt of certain regulatory approvals. There can be no assurance that the proposed merger will be consummated.
In connection with the proposed merger, if consummated, Parent will cause approximately $6.6 billion to be paid out to the Company's stockholders and holders of other equity interests in our Company. These payments are expected to be funded by a combination of equity contributions by affiliates of the Sponsors to Parent and debt financing. Affiliates of the Sponsors have collectively agreed to contribute, subject to the satisfaction of certain conditions, $1.2 billion of equity to Parent and the remaining funds necessary to finance the proposed merger are expected to be obtained through Parent's and its subsidiaries' debt financing. Parent has obtained equity and debt financing commitments for the transactions contemplated by the Merger Agreement, which are subject to customary conditions. After giving effect to contemplated draws by the subsidiaries of our Company or Parent and its affiliates under the new debt commitments, Parent has advised us that it currently expects total existing and new debt outstanding at closing of the proposed merger transaction will be approximately $6 billion.
In connection with the execution and delivery of the Merger Agreement, Parent obtained commitments to provide approximately $6.2 billion in debt financing (not all of which is expected to be drawn at closing) consisting of (a) a $2.85 billion U.S. asset-based debt facility (the "Asset-Based Facility"), (b) a $2.0 billion high-yield bridge facility (the "U.S. Bridge Facility"), (c) a $1.0 billion European bridge facility (the "European Bridge Facility") and (d) a $350 million European working capital facility (the "European Working Capital Facility" and, together with the European Bridge Facility, the "European Facilities"). The Asset-Based Facility will be guaranteed by certain U.S. subsidiaries of the Company and secured by a perfected first priority lien on substantially all assets of such subsidiaries; the U.S. Bridge Facility will become obligations of certain U.S. subsidiaries of the Company; and the European Facilities will initially be secured by a pledge of assets (including stock) of the entities borrowing under the European Bridge Facility and, following closing, will be secured, to the extent legally possible and practicable, by a lien over substantially all of the assets of the borrowers and guarantors under the European Facilities.
Opportunities, Challenges, and Risks
As a worldwide retailer of specialty goods, we are faced with significant opportunities, as well as challenges and risks.
We believe our major opportunities are as follows:
• Babies "R" Us growth – We believe that continued growth opportunities exist in the United States for Babies "R" Us. We opened 19 Babies "R" Us stores in the United States in 2004 and operated 217 stores as of January 29, 2005. We plan to continue the expansion of our Babies "R" Us store base in 2005.
• International growth – We believe that growth opportunities exist outside of the United States for the Toys "R" Us store and Babies "R" Us store formats. During 2004, 33 Toys "R" Us stores were opened internationally, of which seven are operated by us. We plan to open approximately 41 additional stores internationally in 2005, and we estimate ten will be operated by us. Included in the 41 projected openings are 11 stores for Toys "R" Us – Japan, of which eight are Babies "R" Us stores and three are Toys "R" Us stores.
We believe the following are our principal challenges and risks, predominantly for our Toys "R" Us – U.S. division:
• Increased competition – Our businesses operate in a highly and increasingly competitive retail market. We face strong competition from discount and mass merchandisers, national and regional chains and department stores, local retailers in the market areas we serve, and Internet and catalog businesses. We compete on the basis of selection, variety and availability of product, guest service, and price. Price competition in the United States toy retailing business continued to be intense during the 2004 holiday season. Currently, the leading discounters are estimated to account for approximately 45% of total sales in the United States toy market, and as their share continues to increase, we are likely to experience ongoing pricing pressures. We believe that success in this competitive environment can be achieved through enhancing the shopping experience for our guests, superior inventory management, strengthening brand loyalty, and competitive pricing. We also continue to focus on strengthening our relationships with our vendors.
• Spending patterns and age compression – In recent years, toy sales have been negatively impacted by "age compression," which is the acceleration of children leaving traditional play categories at increasingly younger ages for more sophisticated products such as cell phones, DVD players, CD players, MP3 devices, and other electronic products. The age compression pattern tends to decrease consumer demand for traditional toys. To the extent that we are unable to offer consumers more sophisticated products or that these more sophisticated items are also available at a wider range of retailers than our traditional competitors, our sales and profitability could be detrimentally affected and we could experience excess inventories.
Video game business – The video game category is a significant piece of our worldwide toy store business. Over the course of a video cycle, from release of a video platform until the release of the next generation
of video platforms, video games have tended to account for 10-20% of our domestic toy store sales. The peak of the current cycle occurred in 2001 when video represented more than 19% of domestic toy sales for the year. We have seen significant declines in sales in this category during the last several years, primarily as a result of price deflation on video game platforms released in 2001, as well as the impact of the maturation of this category. In addition, competition in the video game market has increased as the discounters have expanded and specialty players, such as Best Buy, Electronics Boutique and Gamestop, have all experienced significant growth. Video sales for 2004 represented 13.6% of domestic toy sales versus 14.3% in 2003.
• Seasonality – Our worldwide toy store business is highly seasonal with net sales and earnings highest in the fourth quarter. During the last three fiscal years, more than 40% of the net sales from our worldwide toy store business and a substantial portion of the operating earnings and cash flows from operations were generated in the fourth quarter. Our results of operations depend significantly upon the holiday selling season in the fourth quarter. If less than satisfactory net sales, operating earnings or cash flows from operations are achieved during the key fourth quarter, we may not be able to compensate sufficiently for the lower net sales, operating earnings, or cash flows from operations during the first three quarters of the fiscal year. Our Babies "R" Us business is not significantly impacted by seasonality.
Restatement of Financial Statements
On February 7, 2005, the Office of the Chief Accountant of the Securities and Exchange Commission ("SEC") issued a letter to the American Institute of Certified Public Accountants expressing its views regarding certain lease accounting issues and their application under generally accepted accounting principles in the United States of America ("GAAP"). In light of this letter, our management conducted a review of our accounting for leases and leasehold improvements and determined that our then-current practices of accounting for leases and leasehold improvements were incorrect.
On February 17, 2005, we decided to restate our previously issued financial statements for the fiscal years ended January 31, 2004 and February 1, 2003 and for the first three fiscal quarters of the fiscal years ended January 29, 2005 and January 31, 2004 to reflect a correction in our accounting practices for leases and leasehold improvements. As a result, we have restated the consolidated balance sheet as of January 31, 2004, and the consolidated statements of earnings, stockholders' equity and cash flows for the years ended January 31, 2004 and February 1, 2003 in this Annual Report on Form 10-K (see Note 2 to the Consolidated Financial Statements entitled "RESTATEMENT OF FINANCIAL STATEMENTS FOR ACCOUNTING FOR LEASES AND LEASEHOLD IMPROVEMENTS") and "QUARTERLY RESULTS OF OPERATIONS" in Item 8 of this Annual Report on Form 10-K. The impact of the restatement on periods prior to the fiscal year ended February 1, 2003 has been reflected as an adjustment to retained earnings as of February 2, 2002 in the accompanying consolidated statements of stockholders' equity. We have also restated the applicable financial information for the fiscal years ended February 3, 2001, February 2, 2002, February 1, 2003, and January 31, 2004 in Item 6 of this report. The restatement corrects our historical accounting for leases and depreciation for leasehold improvements and had no impact on net sales or net cash flows. We have not amended our previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for the restatement, and the financial statements and related financial information contained in those reports should no longer be relied upon. Throughout this Annual Report on Form 10-K, including this management's discussion and analysis, all referenced amounts for prior periods and prior period comparisons reflect the balances and amounts on a restated basis.
In order to calculate the cumulative impact and complete the restatement, we commenced a detailed review of our lease portfolio. In certain instances we adjusted initial lease terms to include rent holiday periods and option renewals that are reasonably assured of being exercised and included the straight-line effect over the lengthened term to include option periods with escalating rents, which generally has the effect of increasing rent
expense. We have also reviewed our leasehold improvements to ensure amortization over the shorter of their economic lives or the adjusted lease term and in certain instances shortened the depreciation or amortization periods for leasehold improvements, which generally has the effect of increasing annual depreciation and amortization expense. The changes in the accounting treatment for leases and leasehold improvements have impacted our earnings as a result of a change in rental expenses, impacting selling, general and administrative expenses, and a change in depreciation and amortization, and a related impact on restructuring and other charges. We also evaluated leases which we had exited, including those disposed of in connection with the shut down of our stand-alone Imaginarium and Kids "R" Us operations. Additionally, we reviewed the depreciable lives of assets related to the leases that have been terminated and modified those lives where appropriate.
Consolidated net earnings for 2004 and 2003 were not materially affected by the restatement. The effect of the restatement for 2002 was to decrease 2002 net earnings by $16 million and resulted in a decrease in opening retained earnings of $196 million at the beginning of fiscal year 2002. Refer to Note 2 to the Consolidated Financial Statements entitled "RESTATEMENT OF FINANCIAL STATEMENTS FOR ACCOUNTING FOR LEASES AND LEASEHOLD IMPROVEMENTS" for a summary of the effects of these changes on our consolidated balance sheet as of January 31, 2004, as well as on the consolidated statements of earnings, for fiscal years 2003 and 2002.
We have provided below a discussion of our results of operations, which are presented on the basis required by accounting principles generally accepted in the United States ("GAAP"). In addition, we have provided certain information on an adjusted basis to reflect accounting changes and unusual items (non-GAAP measures). Management uses these non-GAAP measures to evaluate operating performance. We have incorporated this information into the discussion below because we believe it is a meaningful measure of our normalized operating performance and will assist you in understanding our results of operations on a comparative basis and in recognizing underlying trends. This adjusted information supplements, and is not intended to represent a measure of performance in accordance with, disclosures required by GAAP.
Consolidated Earnings
Consolidated net earnings were $252 million, or $1.16 per diluted share, for the year ended January 29, 2005, $63 million, or $0.29 per diluted share, for the year ended January 31, 2004, and $213 million, or $1.02 per diluted share, for the year ended February 1, 2003.
Our 2004 consolidated financial statements were impacted by the adoption of the provisions of Emerging Issues Task Force ("EITF") Issue No. 03-10, "Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor, by Resellers to Sales Incentives Offered to Consumers by Manufacturers" ("EITF 03-10"). Beginning in the first quarter of 2004, sales have been recorded net of coupons that were redeemed. Under the provisions of EITF 03-10, when we receive credits and allowances from vendors for coupons related to events that meet the direct offset requirements of EITF 03-10, we recognize as a reduction of cost of sales the related reimbursement during the period of redemption. Our 2003 consolidated financial statements have been restated to the current year's presentation, as permitted by the provisions of EITF 03-10.
We receive credits and allowances that are related to formal agreements negotiated with our vendors. These credits and allowances are predominantly for cooperative advertising, promotions, and volume related purchases. Credits and allowances received from vendors that do not meet the direct offset requirements of EITF 03-10 have been recorded as a reduction of product costs in accordance with EITF Issue No. 02-16, "Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor" ("EITF 02-16"). Our 2004 and 2003 consolidated financial statements were impacted by the implementation of EITF 02-16. We adopted the provisions of EITF 02-16 at the beginning of 2003. Under this guidance, amounts received from vendors are considered a reduction of product cost, unless certain restrictive provisions are met. EITF 02-16 was effective for all new arrangements, and modifications to existing arrangements, entered into after December 31, 2002. Beginning in 2003, we began to treat cooperative advertising arrangements as a reduction of product cost. Our
2002 consolidated financial statements have not been restated as part of the adoption of EITF 02-16 since the provisions of EITF 02-16 did not permit restatement. For further details on the impact of adoption of EITF 02-16 and EITF 03-10 refer to Note 3 to the Consolidated Financial Statements entitled "CHANGES IN ACCOUNTING." The adoption of EITF 02-16 and EITF 03-10 had no impact on our consolidated statements of cash flows.
Our consolidated financial statements for 2004 and 2003 also include restructuring and other charges, some of which are recorded in cost of sales. In addition, our consolidated financial statements for 2003 include depreciation that was accelerated during the closing periods of the Kids "R" Us stores. Refer to Note 4 to the Consolidated Financial Statements entitled "RESTRUCTURING AND OTHER CHARGES" for further details.
Comparable Store Sales Performance
Increase/(decrease)
(In local currencies)
(3.7 )% (3.6 )% (1.3 )%
0.6 % 2.1 % 5.9 %
Consolidated net sales decreased 1.9% to $11.1 billion in 2004 from $11.3 billion in 2003 and 2002. Excluding the impact of foreign currency translation that increased net sales for 2004 by $227 million, and a $387 million decline in net sales associated with the previously announced Kids "R" Us store closings, total net sales decreased by $60 million, or 0.6%, compared with 2003. For 2003, currency translation had a $324 million favorable impact, while the Kids "R" Us closings resulted in a $39 million decline in net sales. Excluding these amounts, net sales for 2003 decreased by $270 million, or 2.5% compared to 2002. The 2003 sales have been restated to reflect the unfavorable impact of implementation of the provisions of EITF 03-10 of $246 million. Sales at our International division reflect favorable foreign currency translation impacts of 9.2% in 2004, 15.0% in 2003, and 2.0% in 2002.
The decrease in net sales for 2004 and 2003 was primarily the result of declines in comparable store sales at the Toys "R" Us – U.S. division, which posted comparable store sales declines of 3.7% for 2004 following comparable store sales decreases of 3.6% and 1.3% in 2003 and 2002, respectively. These decreases in net sales were partially offset by net sales increases in our Babies "R" Us division of 7.2% to $1.9 billion in 2004, and net sales increases in our International division of 1.7% (excluding the effect of currency translation) to $2.5 billion in 2004, primarily due to the addition of 19 Babies "R" Us stores in the United States and seven wholly owned International stores in 2004. In addition, comparable store sales at our Babies "R" Us and International divisions, showed favorable increases, as indicated in the table above.
Overall net sales decreases in 2004 and 2003 were primarily attributable to soft sales in the Toys "R" Us – U.S. division, resulting from decreases in net sales of video game products of 8.9% in 2004 and 15.4% in 2003. These declines reflected price deflation of video game products associated with the continued maturation of the last significant video game platform releases in 2001, as well as increased competition.
Video game sales trends improved modestly during the latter part of 2004. This improvement reflected the resurgence in video gaming software and accessories due in part to new title releases and a complete line up of Plug and Play TV games. In addition, the launch of the Game Boy Advance video product, that offers full color video and audio, and the release of Nintendo's Dual Screen player were also significant contributors to the improvement in trends during the latter part of the year. We are cautiously optimistic of continued improvement in video game sales trends in 2005, contingent on favorable sales of Sony PlayStation 2, the recently launched Sony Handheld PSP and Nintendo's Dual Screen player.
Below are selected items from our consolidated statements of earnings, as a percentage of net sales:
Percentage of Net Sales
as restated
67.6 % 67.5 % 69.0 %
Operating earnings
Earnings before income taxes
Income tax (benefit)/expense
(0.5 )% 0.3 % 1.1 %
Net earnings
Cost of Sales and Gross Margin
Consolidated gross margin, as a percentage of net sales, decreased by 0.1 percentage points to 32.4% during 2004 following a 1.5 percentage point increase to 32.5% in 2003. Consolidated gross margin for 2004 included the unfavorable impact of $157 million in inventory markdowns recorded in 2004 primarily to liquidate selected older toy store inventory and therefore enhance store productivity and supply chain efficiency. The markdowns were also intended to accelerate inventory turnover and generate additional cash flow. These markdowns affected our Toys "R" Us – U.S., International and Kids "R" Us divisions. Excluding the unfavorable impact of these inventory markdowns, consolidated gross margin was 33.8% for 2004.
Consolidated gross margin for 2003 included the unfavorable non-recurring impact of the initial implementation of the provisions of EITF 03-10 and EITF 02-16 of $74 million. In addition, consolidated gross margin for 2003 included store closing inventory markdowns of $49 million related to the closing of the Kids "R" Us and Imaginarium free-standing stores.
Excluding the impact of inventory markdowns in 2004 and 2003, as well as the initial implementation impact of EITF 03-10 and EITF 02-16 in 2003, consolidated gross margin, as a percentage of net sales, increased by 0.3 percentage points to 33.8% for 2004. For 2003, consolidated gross margin excluding the inventory markdowns and the initial implementation impact of EITF 03-10 and EITF 02-16 increased 2.5 percentage points to 33.5%. The increases in gross margin of 0.3 percentage points in 2004 and of 2.5 percentage points in 2003 reflect the impact of a favorable shift in the sales mix, driven in part by sales increases in higher margin exclusive and license product lines.
Gross margin as a percentage of net sales for the Toys "R" Us – U.S. division was 29.0% for 2004 compared to 30.3% for 2003. Gross margin for 2004 included a special $132 million unfavorable charge related to a 2004 initiative to liquidate selected older store inventory. The decline in gross margin for 2004 was attributable to the impact of this initiative. This represents an unfavorable impact of 2.2 percentage points for 2004. Excluding the unfavorable impact of this initiative, gross margin increased from 30.3% in 2003 to 31.2% in 2004.
The 2003 gross margin of 30.3% for the Toys "R" Us – U.S. division included an unfavorable non-recurring impact of $53 million due to the initial implementation of the provisions of EITF 03-10 and EITF 02-16. The implementation of these provisions adversely affected gross margin for 2003 by 0.9 percentage points. Excluding the effect of inventory markdowns in 2004 and the effect of the implementation of EITF 03-10 and EITF 02-16 in 2003, gross margin for the Toys "R" Us division for 2004 remained in line with 2003 at 31.2%.
Babies "R" Us reported a 0.3 percentage point increase in gross margin to 37.9% of net sales for 2004. Gross margin for 2003 for the Babies "R" Us division included the unfavorable non-recurring impact of the initial implementation of the provisions of EITF 03-10 and EITF 02-16 of $6 million. The implementation of these provisions adversely affected gross margin for 2003 by 0.4 percentage points.
The International division reported an increase in gross margin of 1.5 percentage points to 36.7% for 2004 up from 35.2% for 2003. Gross margin for 2004 included inventory markdowns of $15 million, which adversely affected gross margin by 0.6 percentage points. Excluding the effect of inventory markdowns, gross margin was 37.3% for 2004.
Gross margin for 2003 for the International division included the implementation effects of EITF 03-10 and EITF 02-16. Implementation of these provisions adversely affected gross margin for 2003 by 0.6 percentage points. Excluding the effect of inventory markdowns in 2004 and the effect of implementation of EITF 03-10 and EITF 02-16 in 2003, gross margin for the International division increased by 1.5 percentage points in 2004 and 3.6 percentage points in 2003. These increases for 2004 and 2003 reflected the effects of favorable shifts in sales mix offset by a highly promotional and competitive environment in most of our foreign markets.
Toysrus.com reported an increase of 2.0 percentage points in gross margin to 29.5% for 2004 and of 2.8 percentage points in 2003 to 27.5%. The inventory markdowns and the implementation of EITF 03-10 and EITF 02-16 did not affect gross margin at Toysrus.com. The increase in gross margin for Toysrus.com in 2004 and 2003 reflected a favorable shift of business from lower margin video game products to higher margin baby and toy products, as well as lower markdowns due to improved inventory management.
We record the costs associated with operating our distribution network as a part of consolidated selling, general, and administrative expenses ("SG&A"), including those costs that primarily relate to transporting merchandise from distribution centers to stores. Therefore, our consolidated gross margin may not be comparable to the gross margin of other retailers that include similar costs in their cost of sales. Credits and allowances received from vendors are recognized in consolidated cost of sales and also have a positive impact on our consolidated gross margin.
Consolidated SG&A expense as a percentage of net sales for 2004 decreased 0.3 percentage points compared to an increase of 2.6 percentage points in 2003. The decrease for 2004 reflected a $68 million reduction in payroll and related benefits as a result of our decision to close the Kids "R" Us division. In addition, the decrease reflected net proceeds from a settlement with MasterCard and Visa of $20 million in 2004 as further detailed in Note 27 to the Consolidated Financial Statements entitled "OTHER MATTERS." In addition, we recorded a $14 million gain for the sale of real estate of our former toy store in Santa Monica, California. These savings were offset by additional expenditures that we incurred during 2004 related to our strategic review initiative and Sarbanes-Oxley compliance totaling $29 million. SG&A expense as a percentage of net sales for 2003 was impacted by the implementation of EITF 02-16, which represented 2.0 percentage points of the increase. Consolidated SG&A for 2003, excluding the impact of EITF 02-16, increased by 0.6 percentage points to 24.7%. The remaining increase was primarily attributable to higher payroll and benefit costs, mainly driven by higher medical and workers' compensation costs. Consolidated SG&A for 2004 and 2003 included adjustments related to straight-line rent expense of $2 million and $4 million, respectively.
Depreciation and amortization was $354 million in 2004 versus $368 million in 2003 and $339 million in 2002. Depreciation for 2004, 2003 and 2002 included the effect of shorter depreciation or amortization periods for leasehold improvements which increased expenses by $21 million, $20 million, and $22 million, respectively. Depreciation for 2004 also included the effect of the sale of the Kids "R" Us real estate during 2004 which decreased depreciation by approximately $15 million.
Depreciation and amortization for 2003 also included $24 million of depreciation recorded during the fourth quarter of 2003 that was accelerated through the closing periods for the free-standing Kids "R" Us stores. Depreciation and amortization for 2002 also included an increase of $22 million, which was primarily due to our Mission Possible store remodeling program, new store openings, and strategic investments to improve our information technology systems. These increases were partially offset by the impact of closed stores.
Interest expense decreased by $12 million versus 2003 to $130 million in 2004 and increased by $23 million versus 2002 to $142 million in 2003. The $12 million decrease in 2004 was comprised of a $42 million reduction in interest expense as a result of long-term debt principal repayments offset by an $18 million increase in interest expense related to the annualizing of long-term debt issued during 2003, and a $12 million increase due to rising short-term interest rates. The $23 million increase in 2003 was mainly attributable to an increase in long-term borrowings as a result of our initiative to refinance shorter-term debt. Refer to the section entitled "LIQUIDITY AND CAPITAL RESOURCES" for further details.
Our effective tax rate was (30.4)% for 2004, 32.0% for 2003, and 36.0% for 2002. Our effective tax rate in 2004 reflects the tax benefit of a reversal of previously accrued income taxes of $200 million based on the settlement of an IRS audit, and a $54 million tax charge on the repatriation of indefinitely reinvested foreign earnings. Refer to "CRITICAL ACCOUNTING POLICIES – INCOME TAXES" below and to Note 19 to the Consolidated Financial Statements entitled "INCOME TAXES" for further details.
Foreign currency translation had a favorable impact on our consolidated and international operating earnings for 2004, 2003 and 2002 of $17 million, $20 million and $16 million, respectively. This represents an operating earnings benefit to the international division, for 2004, 2003, and 2002 of 10%, 13% and 10% respectively. The favorable impact on consolidated operations earnings for 2004, 2003 and 2002 was 8%, 5% and 3%, respectively.
Inflation did not have a significant impact on our consolidated net earnings in 2004, 2003 or 2002.
RESTRUCTURING AND OTHER CHARGES
On August 11, 2004, we announced our intention to restructure the Company's Global Store Support Center operations in Wayne, New Jersey. As a result, we recorded termination costs of $14 million associated with this action in the second quarter of 2004 and additional net costs of $7 million in the second half of 2004. Of these total charges, $13 million were recorded in restructuring and other charges, and charges of $8 million were recorded in selling, general and administrative expenses, comprised of $2 million for payroll-related costs and $6 million for stock option compensation charges resulting from modifications to stock option agreements for the severed executives. As of January 29, 2005, $10 million of reserves for termination costs remain to complete this initiative. We anticipate that additional termination costs will be incurred in subsequent quarters relating to the restructuring of the Company's Global Store Support Center operations.
On November 17, 2003, we announced our decision to close all 146 of the remaining free-standing Kids "R" Us stores and all 36 of the free-standing Imaginarium stores, as well as three distribution centers that support these stores. These free-standing stores incurred significant performance declines in the past few years. This accelerated deterioration in financial performance led to our decision to cease operations in these free-standing stores. While we continue to expand our apparel business and Imaginarium boutiques within our Toys "R" Us and Babies "R" Us stores, we believe that ceasing operations in the free-standing Kids "R" Us and Imaginarium stores will have a favorable impact on future cash flows and net earnings. As of January 29, 2005, all of the free-standing Kids "R" Us and Imaginarium stores were closed. Most of the leases have been terminated, with the remaining terminations under negotiation. We are in the process of converting some of the former Kids "R" Us locations to Babies "R" Us stores and anticipate completing this process over the next year.
On March 2, 2004, we entered into an agreement with Office Depot, Inc. ("Office Depot") under which Office Depot agreed to acquire 124 of the former Kids "R" Us stores for $197 million in cash, before commissions and fees, plus the assumption of lease payments and other obligations. Twenty-four properties have subsequently been excluded from the agreement with Office Depot and these properties are being marketed for disposition or have been disposed of to date.
We recorded charges of $132 million in the fourth quarter of 2003 related to the closing of these Kids "R" Us facilities. These charges included $49 million of inventory markdowns recorded in cost of sales and $24 million of depreciation that was accelerated through the closing periods of the Kids "R" Us stores. The remaining $59 million of charges were included in restructuring and other charges.
We recorded net gains of $16 million during the fiscal year ended January 29, 2005, for the closing of the free-standing Kids "R" Us stores. Included in the $16 million of gains is $10 million in inventory markdowns related to this initiative, which were recorded in cost of sales; $3 million recorded as accelerated depreciation; $26 million recorded as restructuring and other charges, for asset impairment, lease obligations, termination costs, and vacancy-related costs for the closed facilities; and net gains of $55 million on the sale of Kids "R" Us real estate. All closings were completed by January 29, 2005 and net cash proceeds of approximately $150 million were received.
In 2001, we recorded charges to close 27 Toys "R" Us stores and 37 Kids "R" Us stores, all of which have closed. In conjunction with most of the Kids "R" Us store closings, we converted the nearest Toys "R" Us store into a Toys "R" Us combo store, which combines our toy offering with approximately 5,500 square feet of apparel offering. Also, as part of this plan, we eliminated approximately 1,700 staff positions in our stores and headquarters and consolidated five of our store support center facilities into our current Global Store Support Center facility in Wayne, New Jersey. We have sold our former store support center facility in Montvale, New Jersey and received net proceeds of $15 million, which equaled our net book value. We continue to pursue a sub-tenant for our former store support center facilities in Paramus and Fort Lee, New Jersey. We recorded net charges of $208 million in the fourth quarter of 2001 for these initiatives and have recorded additional net charges of $14 million in 2004 and $6 million in 2003, primarily related to the disposition of the real estate properties discussed above.
Refer to Note 4 to the Consolidated Financial Statements entitled "RESTRUCTURING AND OTHER CHARGES" for further details.
Our primary sources of liquidity are cash flow provided from operations, our existing cash balances, and our revolving credit facility. The seasonal nature of our business typically causes cash balances to decline from the beginning of the fiscal year through October as inventory increases for the holiday selling season and funds are used for construction of new stores, as well as remodeling and other initiatives that normally occur in this period. Our revolving credit facility is available for seasonal borrowings and general corporate purposes. Additionally, we have lines of credit with various banks to meet certain of the short-term financing needs of our foreign subsidiaries. We had no short-term borrowings outstanding at either January 29, 2005 or January 31, 2004. We had cash and cash equivalents of $1,250 million at January 29, 2005 and $1,432 million at January 31, 2004, of which $506 million was used to repay a euro-denominated bond plus accrued interest on February 13, 2004. In addition, we had highly liquid short-term investments of $953 million and $571 million at January 29, 2005 and January 31, 2004, respectively. We generated positive cash flow from operations of $746 million in 2004, $801 million in 2003, and $575 million in 2002.
We believe that cash flow from our operations in 2005, along with our existing cash and our revolving credit facility, will be adequate to meet our expected 2005 cash flow requirements (without regard to potential cash flow requirements related to the financing of the proposed merger). In addition, our next significant debt maturity will be our 6.875% Notes due in 2006 and we believe that we will be able to either repay or refinance this maturing debt. However, if the proposed merger is consummated, we expect to have significant new debt. For further details, refer to the section entitled "CONCLUSION OF STRATEGIC REVIEW – AGREEMENT FOR SALE – FINANCING OF THE MERGER" in Item 1 – entitled "BUSINESS".
Selected Statements of Cash Flows Highlights:
(In millions)
February 1,
$ 746 $ 801 $ 575
Capital expenditures, net
(269 ) (262 ) (395 )
Free cash flow(1)
$ — $ 792 $ 548
Long-term debt repayments
Net cash (used in) / provided by financing activities
$ (476 ) $ 482 $ 613
(1) We define "free cash flow" as cash flows from operations, net of capital expenditures.
For further details on our cash flow data, refer to the Consolidated Statements of Cash Flows.
Net cash flows from operating activities for 2004 was $746 million and included the favorable impact of an increase in year on year earnings, reduced inventory levels resulting from continued inventory management improvement, and the reduction in cash invested in prepaid and other operating assets driven primarily by a reduction in the over-funding of the Company's supplemental executive retirement program assets of $35 million. These benefits were offset by non-cash income related to the reversal of approximately $200 million in income tax reserves related to settlement of certain IRS audits.
Net cash flow from operating activities for 2003 reflects an increase of $226 million resulting from favorable variances for inventory, accounts receivable and accounts payable balances brought about by improved inventory and cash flow management and the effect of inventory liquidation at our Kids "R" Us stores. Inventories at Kids "R" Us decreased by $83 million to $4 million during 2003, and were liquidated as the remaining free-standing stores closed during the first half of 2004. In addition, cash flow from operating activities for 2003 reflected the effect of the non-cash portion of restructuring and other charges of $63 million for the year.
Net cash flow from operating activities for 2002 reflects an increase of $70 million due to the effect of higher net earnings of $145 million, and favorable variances in accounts payable, accrued expenses and other liabilities resulting from improved cash management, offset by the unfavorable impact of increased inventory levels compared to the prior year.
Cash flows used in investing activities for 2004 decreased by $357 million. The decrease was driven by the receipt of net proceeds from the sale of Kids "R" Us assets of $157 million, the net proceeds from the sale of our store in Santa Monica, California of $24 million, $15 million related to the sale of one of our former Store Support Center locations and an additional $20 million related to the sale of other fixed assets. In addition, our investment in short term and other securities decreased by $190 million versus 2003. These decreases were partially offset by $42 million related to the acquisition of SB Toys, Inc., previously a minority shareholder in Toysrus.com. Capital expenditures of $269 million for the opening of 19 new Babies "R" Us stores and one new toy store in the United States, seven new wholly-owned International toy stores, as well as on-going maintenance and improvement capital expenditures, were in line with 2003.
Cash flows used in investing activities for 2003 increased by $439 million. This increase was due to higher investments in short term and other securities of $572 million. Capital expenditures of $262 million for the opening of 16 new Babies "R" Us stores, six new wholly-owned international toy stores, information technology projects, and on-going maintenance and improvement capital expenditures were $133 million lower as compared to 2002. This decrease was due to the completion of the Mission Possible formatting during 2002.
Cash flows used in investing activities for 2002 were $395 million, and related to costs to complete the reformatting of existing toy stores in the United States into the Mission Possible format and to convert certain existing toy stores in the United States into the combo format. This represented a $310 million reduction from 2001 where the significant amount of the Mission Possible reformattings occurred.
In addition, our capital expenditures in each of the preceding three years included costs to improve and enhance our information technology systems.
During 2005, we plan to continue to expand our Babies "R" Us store base in the United States and our Toys "R" Us store base abroad. However, we can provide no assurance that this expansion will occur.
Net cash flow used in financing activities in 2004 included the payment of $466 million to retire our 500 million euro-denominated bond. Net cash flow from financing activities in 2003 included the net proceeds of $792 million from notes issued under a "shelf" registration statement filed with the Securities and Exchange Commission. Long-term debt repayments in 2003 included $342 million to retire our 475 million Swiss Franc note that matured on January 28, 2004. Net cash flow from financing activities in 2002 of $613 million was driven by the net proceeds from the issuance of common stock and equity security units, which were used to refinance short-term borrowings and for other general corporate purposes. Refer to Note 12 to the Consolidated Financial Statements entitled "ISSUANCE OF COMMON STOCK AND EQUITY SECURITY UNITS" for further details.
Refer to Note 10 to the Consolidated Financial Statements entitled "SEASONAL FINANCING AND LONG-TERM DEBT" and to Note 28 to the Consolidated Financial Statements entitled "SUBSEQUENT EVENTS" for further details regarding debt issuances and outstanding obligations, including the tender offer we commenced for our 6.25% senior notes due in 2007.
Contractual Obligations and Commitments
Our contractual obligations consist mainly of operating leases related to real estate used in the operation of our business, and long-term debt. Below are the operating leases and principal amounts due under long-term debt issuances, as well as other obligations:
Contractual Obligations at January 29, 2005
Payments Due By Period
2010 and
Operating leases(a)
$ 337 $ 635 $ 557 $ 1,412 $ 2,941
Less: sub-leases to third parties
Net operating lease obligations
311 592 528 1,351 2,782
Capital lease obligations
2 3 — — 5
47 708 (b) 17 1,500 2,272
Purchase obligations(c)
1,111 — — — 1,111
Guarantees(d)
7 13 14 101 135
Other(e)
Total contractual obligations
$ 1,586 $ 1,457 $ 674 $ 3,009 $ 6,726
(a) Includes a synthetic lease obligation for our Global Store Support Center facility in Wayne, New Jersey, as described in Note 18 and Note 28 to the Consolidated Financial Statements entitled "LEASES" and "SUBSEQUENT EVENTS," respectively.
(b) Includes $403 million of senior notes due 2007, which are a component of our equity security units and which we are contractually obligated to remarket in 2005. On April 6, 2005, we commenced a cash tender offer to purchase up to $403 million of the senior notes due in 2007. Refer to the section entitled "FINANCING ACTIVITIES" as well as Notes 12 and 28 to the Consolidated Financial Statements entitled "ISSUANCE OF COMMON STOCK AND EQUITY SECURITY UNITS" and "SUBSEQUENT EVENTS," respectively.
(c) Purchase obligations consist primarily of open purchase orders for merchandise that are not included in our consolidated balance sheet at January 29, 2005. Certain of these open purchase orders allow us to cancel the order without recourse.
(d) We are the guarantor of various loans to Toys "R" Us – Japan from third parties in Japan. For further details see Note 8 to the Consolidated Financial Statements entitled "INVESTMENT IN TOYS "R" US – JAPAN."
(e) Includes minimum royalty obligations, pension obligations, risk management liabilities, and other general obligations.
We are in compliance with all covenants associated with the above contractual obligations. The covenants include, among other things, requirements to provide financial information and public filings and to comply with specified financial ratios. We also are in compliance with covenants associated with our unsecured revolving credit facility. One covenant requires our total debt to capital ratio to be less than 58%. This ratio was 34.8% as of January 29, 2005. The other covenant requires our fixed charge ratio to be greater than 1.8. This ratio is calculated by dividing earnings before interest, income tax, depreciation, amortization, and rent expense, by the total of interest and rent expense, and was 2.33 at January 29, 2005. Non-compliance with associated covenants could give rise to accelerated payments, requirements to provide collateral, or changes in terms contained in the respective agreements.
We currently have a $685 million unsecured committed revolving credit facility from a syndicate of financial institutions. The credit facility is available for seasonal borrowings and other general corporate purposes. We had $885 million in unsecured committed revolving credit facilities from a syndicate of financial institutions on January 31, 2004. There were no outstanding balances under these credit facilities at the end of 2004, 2003 or 2002. Additionally, we have lines of credit with various banks to meet certain of the short-term financing needs of our foreign subsidiaries. The following table shows our commercial commitments with their related expirations and availability:
Commercial Commitments at January 29, 2005
Amount of Commitment Expiration By Fiscal Period
Unsecured revolving credit facility:
Facility expiring in September 2006(a)
$ 685 $ — $ 685 $ — $ — $ 685
(a) At January 29, 2005, we had $18 million of stand-by letters of credit issued under the revolving credit facility.
In addition to the above, we had $43 million of outstanding letters of credit related to import merchandise at January 29, 2005.
On March 10, 2004, Standard & Poor's revised our long-term debt rating to BB, a one level downgrade from BB+. On March 17, 2005, Moody's placed our long-term debt rating on review for a possible downgrade. These current ratings are considered non-investment grade. Our current ratings are as follows:
Standard and Poor's
Ba2 BB
Under review Negative
Other credit ratings for our debt are available; however, we have disclosed only the ratings of the two largest nationally recognized statistical rating organizations.
Our current credit ratings, as well as future rating agency actions, could (1) negatively impact our ability to finance our operations on satisfactory terms; (2) have the effect of increasing our financing costs; and (3) have the effect of slightly increasing our insurance premiums and collateral requirements necessary for our self-insured programs. Our debt instruments do not contain provisions requiring acceleration of payment upon a debt rating downgrade.
In connection with the related financing transactions to be undertaken as a result of the proposed merger, it is possible that the rating agencies will revise the ratings in respect of our outstanding debt securities. See Item 1 entitled "BUSINESS – CONCLUSION OF STRATEGIC REVIEW – AGREEMENT FOR SALE – FINANCING OF THE MERGER," for further details. At this time, we are unable to predict the ratings to be so assigned to our outstanding debt by the rating agencies.
Our Global Store Support Center facility in Wayne, New Jersey is financed under a lease arrangement commonly referred to as a "synthetic lease." Under this lease, unrelated third parties arranged by Wachovia Development Corporation, a multi-purpose real estate investment company, funded the acquisition and construction of the facility. On March 31, 2005, we submitted a purchase election option to Wachovia Development Corporation for the purpose of purchasing our Global Store Support Center facility for $126.6 million, details of which are in Note 18 to the Consolidated Financial Statements entitled "LEASES." The purchase is scheduled to occur on June 1, 2005.
We are the guarantor of 80% of a 10 billion yen ($97 million) loan to Toys "R" Us – Japan from a third party in Japan. We also guarantee 80% of three installment loans totaling 7.4 billion yen ($71 million) to Toys "R" Us – Japan from a third party in Japan. See Note 8 to the Consolidated Financial Statements entitled "INVESTMENT IN TOYS "R" US – JAPAN" for a further discussion on these guarantees.
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. 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 consolidated financial statements.
We believe the following are our most critical accounting policies that include significant judgments and estimates used in the preparation of our consolidated financial statements. We consider an accounting estimate to be critical if it requires assumptions to be made that were uncertain at the time they were made, and if changes in these estimates could have a material impact on our consolidated financial condition or results of operations:
Merchandise Inventories:
Merchandise inventories for the Toys "R" Us – U.S. division, other than apparel, are stated at the lower of LIFO (last-in, first-out) cost or market value, as determined by the retail inventory method and represent approximately 58% of total merchandise inventories. All other merchandise inventories are stated at the lower of FIFO (first-in, first-out) cost or market value as determined by the retail inventory method.
We receive various types of merchandise and other types of allowances from our vendors based on negotiated terms. We use estimates at interim periods to record our provisions for inventory shortage, to adjust certain inventories to a LIFO basis, and to record merchandise allowances from our vendors. These estimates are based on the development of the cost-to-retail ratios (estimated average markup percentages for product categories), consumer price index data, estimated inventory turnover, and the accounting for retail price adjustments. These estimates are based on available data and are adjusted to actual amounts at the completion of our physical inventories, finalization of all vendor allowance agreements, and the closing of our books at the end of our fiscal year. In addition, we perform an inventory-aging analysis for the establishment of markdown reserves. Our policy for the establishment of inventory markdowns reserves is established based on various management's assumptions. Among them the establishment of criteria to identify and reserve for obsolete inventory based on the type and the inventory's receipt date. Inventory is reviewed on an interim basis and adjusted as appropriate to reflect write-downs determined to be necessary following the evaluation of the adequacy of existing reserves.
We also establish markdown reserves for items that will soon be obsolete due to anticipated developments in technology or products that are updated each year. Specific reserves are established based on the above and anticipated turnover of specific items based on planned marketing events and negotiated vendor support for reduced pricing of the identified items.
Factors such as slower inventory turnover due to changes in competitors' tactics, consumer preferences, consumer spending and unseasonable weather patterns, among other factors, could cause excess inventory requiring greater than estimated markdowns to entice consumer purchases, resulting in an unfavorable impact on our Consolidated Financial Statements. Sales shortfalls due to the above factors could cause reduced purchases from vendors and associated vendor allowances that would also result in an unfavorable impact on our Consolidated Financial Statements.
Insurance Risks:
We insure a substantial portion of our general liability and workers' compensation risks through a wholly-owned insurance subsidiary, in addition to third party insurance coverage. Provisions for losses related to self-insured risks are based upon independent actuarially determined estimates. We maintain stop-loss coverage to limit the exposure related to certain risks. The assumptions underlying the ultimate costs of existing claim losses are subject to a high degree of unpredictability, which can affect the liability recorded for such claims. For example, variability in inflation rates of health care costs inherent in these claims can affect the amounts realized. Similarly, changes in legal trends and interpretations, as well as a change in the nature and method of how claims are settled can impact ultimate costs.
Although our estimates of liabilities incurred do not anticipate significant changes in historical trends for these variables, any changes could have a considerable effect upon future claim costs and currently recorded liabilities and could have a material impact on our Consolidated Financial Statements.
Deferred Rent
The Company recognizes fixed minimum rent expense on non-cancelable leases on a straight-line basis over the term of each individual lease including the build-out period. The difference between recognized rental expense and amounts payable under the lease is recorded as a deferred lease liability.
Impairment of Assets:
We periodically review the carrying value of long-lived assets, other than goodwill, for indicators of impairment, and we test goodwill for impairment annually. Indicators of impairment for long-lived assets, other than goodwill, include current period losses combined with a history of losses or a projection of continuing
losses, and a significant decrease in the fair market value of an asset. In addition, plans and intentions of management, such as a decision to close stores, which could impact the future cash flows associated with long-lived assets could indicate impairment. Goodwill is evaluated for impairment annually under the provisions of SFAS No. 142, which requires us to estimate future cash flows to measure the recoverability of goodwill.
Future indicators of impairment for long-lived assets, other than goodwill, could result in asset impairment charges. In addition, while we have concluded that our net goodwill of $353 million as of January 29, 2005 will be fully recoverable in future periods, changes in estimated future cash flows could require us to record impairment charges on this asset.
Income Taxes:
The calculation of the Company's provision for income taxes is based on a number of factors, including the Company's income, legal entity structure, permanent differences, temporary differences, statutory tax rates, tax credits, tax reserves, and valuation allowances, by jurisdiction. A schedule of the current and deferred provision for federal, foreign, and state taxes is included in Note 19 to the Consolidated Financial Statements entitled "INCOME TAXES."
The Company's effective tax rate is determined by dividing the Company's worldwide income before taxes by the provision for income taxes. Our effective tax rate is based on our income, statutory tax rates, and various tax planning opportunities available to us, by jurisdiction. Significant judgment is required in determining our effective tax rate and in evaluating our tax positions. A reconciliation of the effective tax rate to the statutory 35% U.S. federal income tax rate is included in Note 19 to the Consolidated Financial Statements entitled "INCOME TAXES."
The Company establishes tax reserves when, despite our belief that our tax return positions are fully supportable, we believe it likely that certain of these positions will be challenged, and that we may not succeed in defending our positions. We adjust these reserves, as well as the related interest, in light of changing facts and circumstances, including progress made during the course of a tax audit. U.S. federal, foreign, and state tax authorities regularly examine the Company's tax returns. While it is often difficult to predict the final outcome of, the timing of, or the tax treatment of, any particular tax position or deduction, we believe that our reserves reflect the probable outcome of known tax contingencies. The Company maintains its tax reserves in the Income taxes payable account.
Tax law and accounting rules often differ as to the timing and treatment of certain items of income and expense. As a result, the tax rate reflected in our tax return (our current or cash tax rate) is different than the tax rate reflected in our Consolidated Financial Statements. Some of the differences are permanent, while other differences are temporary as they reverse over time. Temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in a future tax return for which we have already recorded a tax benefit in our current financial statement. An example would be a loss carry forward for federal, foreign or state tax purposes. We establish valuation allowances for our deferred tax assets when we believe that the expected future taxable income or tax thereon is not likely to support the use of a deduction or credit. An example would be a valuation allowance for the tax benefit associated with a loss carryover. Deferred tax liabilities generally represent items that can be deducted currently on the tax return and will be deducted in our Consolidated Financial Statements in a future year. An example would be accelerated depreciation on fixed assets. The Company maintains the current and non-current portion of its deferred tax assets in the Prepaid expenses and other current assets, and the Other assets accounts, respectively, and maintains the current and non-current portion of its deferred tax liabilities in the Accrued expenses and other current liabilities, and Deferred income tax accounts, respectively. Schedules showing the major temporary differences that give rise to the deferred tax assets and deferred tax liabilities are included in Note 19 to the Consolidated Financial Statements entitled "INCOME TAXES."
A portion of the Company's foreign earnings is invested indefinitely outside the United States. The U.S. federal income tax that would be imposed on the repatriation of these earnings has not been accrued in the financial statements. The American Jobs Creation Act of 2004 created an opportunity for companies like ours to repatriate these foreign earnings at an advantageous effective tax rate. We took advantage of this provision and repatriated most of our unremitted foreign earnings this year. In doing so, the Company accrued U.S. federal income tax at an effective tax rate of 8.9% on these repatriated earnings. Technical corrections legislation is pending, and if passed, would reduce the effective tax rate on these repatriated earnings to approximately 3.5%. If and when this happens, the tax benefit of this legislation will be reflected in the period the legislation is enacted.
Derivatives and Hedging Activities:
We enter into derivative financial arrangements to hedge a variety of risk exposures, including interest rate and currency risks associated with our long-term debt, as well as foreign currency risk relating to import merchandise purchases. We account for these hedges in accordance with SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," and we record the fair value of these instruments within our consolidated balance sheet.
Gains and losses from derivative financial instruments are largely offset by gains and losses on the underlying transactions. The ineffective portion of an instrument's change in fair value will be immediately recognized in earnings. Generally, the contract terms of hedge instruments closely mirror those of the item being hedged, providing a high degree of risk reduction and correlation. At January 29, 2005, we increased the carrying amount of our long-term debt by $48 million, representing the fair value of debt in excess of the carrying amount on that date. Also at January 29, 2005, we recorded derivative assets of $44 million and derivative liabilities of $22 million.
We intend to continue to meet the conditions for hedge accounting. However, if hedges were not to be highly effective in offsetting cash flows attributable to the hedged risk, the changes in the fair value of the derivatives used as hedges could have an impact on our consolidated financial statements. Assuming that all derivatives at January 29, 2005 were deemed ineffective, our consolidated pre-tax earnings would be favorably impacted by $22 million.
Refer to Note 26 to the Consolidated Financial Statements entitled "RECENT ACCOUNTING PRONOUNCEMENTS" for a discussion of recent accounting pronouncements and their impact on our Consolidated Financial Statements.
We are exposed to market risk from potential changes in interest rates and foreign exchange rates. The countries in which we own assets and operate stores are politically stable, and we regularly evaluate these risks and have taken the following measures to mitigate these risks: our foreign exchange risk management objectives are to stabilize cash flow from the effects of foreign currency fluctuations; we do not participate in speculative hedges; and we will, whenever practical, offset local investments in foreign currencies with liabilities denominated in the same currencies. We also enter into derivative financial instruments to hedge a variety of risk exposures including interest rate and currency risks.
Our foreign currency exposure is primarily concentrated in the United Kingdom and Continental Europe, Canada, Australia and Japan. We face currency exposures that arise from translating the results of our worldwide operations into U.S. dollars from exchange rates that have fluctuated from the beginning of the period. We also face transactional currency exposures relating to merchandise that we purchase in foreign currencies. We enter into forward exchange contracts to minimize and manage the currency risks associated with these transactions. The counter-parties to these contracts are highly rated financial institutions and we do not have significant exposure to any single counter-party. Gains or losses on these derivative instruments are largely offset by the gains or losses on the underlying hedged transactions. For foreign currency derivative instruments, market risk is determined by calculating the impact on fair value of an assumed one-time change in foreign exchange rates relative to the U.S. dollar. Fair values were estimated based on market prices, where available, or dealer quotes. With respect to derivative instruments outstanding at January 29, 2005, a 10% appreciation of the U.S. dollar would have increased pre-tax earnings in 2004 by $1 million and increased comprehensive income in 2004 by $19 million, while a 10% depreciation of the U.S. dollar would have decreased pre-tax earnings in 2004 by $1 million and decreased comprehensive income in 2004 by $21 million. Comparatively, considering our derivative instruments outstanding at January 31, 2004, a 10% appreciation of the U.S. dollar would have increased comprehensive income in 2003 by $19 million, while a 10% depreciation of the U.S. dollar would have decreased comprehensive income in 2003 by $19 million. Considering our derivative instruments outstanding at February 1, 2003, a 10% appreciation of the U.S. dollar would have increased comprehensive income in 2002 by $39 million, while a 10% depreciation of the U.S. dollar would have decreased comprehensive income in 2002 by $42 million.
We are faced with interest rate risks resulting from interest rate fluctuations. We have a variety of fixed and variable rate debt instruments. In an effort to manage interest rate exposures, we strive to achieve an acceptable balance between fixed and variable rate debt and have entered into interest rate swaps to maintain that balance. For interest rate derivative instruments, market risk is determined by calculating the impact to fair value of an assumed one-time change in interest rates across all maturities. Fair values were estimated based on market prices where available or dealer quotes. A change in interest rates on variable rate debt impacts earnings, cash flow and the fair value of debt. A change in interest rates on fixed rate debt does not impact the fair value of debt, earnings or cash flow. Based on our overall interest rate exposure related to floating rate debt outstanding at January 29, 2005, January 31, 2004, and February 1, 2003, a 1% increase in interest rates would have had an unfavorable annualized impact on pre-tax earnings of $20 million in 2004, $20 million in 2003, and $15 million in 2002. A 1% decrease in interest rates would have had a favorable annualized impact on pre-tax earnings of $20 million in 2004, $20 million in 2003, and $15 million in 2002. A 1% increase in interest rates would decrease the fair value of our long-term debt at January 29, 2005 and January 31, 2004 by approximately $98 million and $101 million, respectively. A 1% decrease in interest rates would increase the fair value of our long-term debt at January 29, 2005 and January 31, 2004 by approximately $107 million and $93 million, respectively.
The Merger Agreement generally requires us to terminate our existing interest rate swaps prior to closing of the proposed merger.
Refer to Note 11 to the Consolidated Financial Statements entitled "DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES" for a discussion of recent accounting pronouncements and their impact on our consolidated financial statements.
Consolidated Statements of Earnings
Consolidated Statements of Stockholders' Equity
Quarterly Results of Operations (Unaudited)
The Board of Directors and Stockholders of
We have audited the accompanying consolidated balance sheets of Toys "R" Us, Inc. and subsidiaries as of January 29, 2005 and January 31, 2004, and the related consolidated statements of earnings, stockholders' equity and cash flows for each of the three years in the period ended January 29, 2005. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes 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, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Toys "R" Us, Inc. and subsidiaries at January 29, 2005 and January 31, 2004, and the consolidated results of their operations and their cash flows for each of the three years in the period ended January 29, 2005, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, the Company has restated its financial statements for each of the three years in the period ended January 29, 2005 to correct its accounting for leases and leasehold improvements.
As discussed in Note 3 to the consolidated financial statements, in the year ended January 29, 2005, the Company adopted EITF 03-10, "Application of Issue No. 02-16 by Resellers to Sales Incentives Offered to Consumers by Manufacturers," retroactive to February 2, 2003. In the year ended January 31, 2004, the Company adopted the provisions of EITF 02-16, "Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor," effective February 2, 2003.
We also have audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Toys "R" Us, Inc.'s internal control over financial reporting as of January 29, 2005, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated April 28, 2005, expressed an unqualified opinion on management's assessment and an adverse opinion on the effectiveness of internal control over financial reporting.
/s/ Ernst & Young LLP
Toys "R" Us, Inc. and Subsidiaries
(In millions, except per share data)
(as restated) (as restated)
$ 11,100 $ 11,320 $ 11,305
7,506 7,646 7,799
4 63 —
Other (expense) income:
Interest and other income
Income tax (benefit) / expense
(59 ) 30 120
$ 252 $ 63 $ 213
Basic earnings per share
$ 1.17 $ 0.30 $ 1.03
See Notes to Consolidated Financial Statements.
(as restated)
Accounts and other receivables
Merchandise inventories
Net property assets held for sale
Current portion of derivative assets
Property and Equipment:
Real estate, net
Other, net
Total property and equipment
Goodwill, net
Derivative assets
Deferred tax asset
$ 9,768 $ 10,265
Short-term borrowings
Minority interest in Toysrus.com
Additional paid-in-capital
(7 ) (64 )
Restricted stock
(5 ) —
Treasury shares, at cost
Adjustments to reconcile net earnings to net cash from operating activities:
Amortization of restricted stock
(40 ) 27 99
(6 ) (8 ) (14 )
Other non-cash items
2 1 (9 )
Non-cash portion of restructuring and other charges
(5 ) 62 8
221 133 (100 )
Prepaid expenses and other operating assets
76 28 (118 )
Accounts payable, accrued expenses and other liabilities
(45 ) 117 109
(74 ) (53 ) 48
Proceeds from sale of fixed assets
216 — —
Purchase of SB Toys, Inc.
(42 ) — —
Purchase of short – term investments and other
(382 ) (572 ) —
Short-term borrowings, net
Long-term borrowings
— 792 548
Long-term debt repayment
Decrease / (increase) in restricted cash
— 60 (60 )
Proceeds from issuance of stock and contracts to purchase stock
— — 266
Net cash (used in) provided by financing activities
(476 ) 482 613
25 (40 ) (53 )
(Decrease) increase during year
Beginning of year
1,432 1,023 283
$ 1,250 $ 1,432 $ 1,023
Supplemental Disclosures of Cash Flow Information
Net income tax payments
$ 27 $ 33 $ 32
$ 143 $ 117 $ 93
paid-in-
of restricted
(loss) / income
In Treasury
Balance, February 2, 2002 (as previously reported)
300.4 $ 30 (103.7 ) $ (2,021 ) $ 444 $ — $ (267 ) $ 5,228 $ 3,414
Prior year adjustment (see Note 2)
— — — — — — — (196 ) (196 )
Balance, February 2, 2002 (as restated, see Note 2)
Net earnings (as restated, see Note 2)
— — — — — — — 213 213
Foreign currency translation adjustments (as restated, see Note 2)
— — — — — — 124 — 124
Unrealized loss on hedged transactions
— — — — — — (9 ) — (9 )
Common stock equity offering
— — 14.9 301 (35 ) — — — 266
Issuance of restricted stock, net and other
— — 0.9 (2 ) 5 — — — 3
300.4 $ 30 (87.9 ) $ (1,722 ) $ 414 $ — $ (152 ) $ 5,245 $ 3,815
Net earnings (as restated, see Notes 2, 3)
— — — — — — 63 63
— — — — — 105 — 105
— — — — — (5 ) — (5 )
Minimum pension liability adjustment
— — — — — (12 ) — (12 )
— — 1.1 15 (7 ) — — — 8
Balance, January 31, 2004 (as restated see Notes 2, 3)
300.4 $ 30 (86.8 ) $ (1,707 ) $ 407 $ — $ (64 ) $ 5,308 $ 3,974
Net earnings for the year
— — — — — — 58 — 58
— — — — — — 2 — 2
Exercise of stock options, net
1.9 37 (6 ) — 31
Stock compensation expense
— — — — 6 — — — 6
— — 0.4 12 (2 ) (12 ) — — (2 )
— — — — — 7 — — 7
Balance, January 29, 2005
300.4 $ 30 (84.5 ) $ (1,658 ) $ 405 $ (5 ) $ (7 ) $ 5,560 $ 4,325
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Except as expressly indicated or unless the context otherwise requires, as used herein, the "Company," "we," "us," or "our" means Toys "R" Us, Inc. and its subsidiaries. We are a worldwide specialty retailer of toys, baby products and children's apparel.
Our fiscal year ends on the Saturday nearest to January 31. Unless otherwise stated, references to years in this report relate to the 52-week fiscal years below:
We have made certain reclassifications to prior period information to conform to current presentations.
In 2004, we reclassified our auction rate securities and variable rate demand notes from cash and cash equivalents to short-term investments for the current and prior years. We have also made corresponding adjustments to our consolidated statements of cash flows to reflect the gross purchases and sales of these securities as investing activities rather than as a component of cash and cash equivalents. The fair value of these investments was $953 million and $571 million at January 29, 2005 and January 31, 2004, respectively. As of April 21, 2005, we no longer own auction rate securities or variable rate demand notes.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its subsidiaries. We eliminated all material intercompany balances and transactions. We translated all assets and liabilities of foreign operations at current rates of exchange at the balance sheet date and translated the results of foreign operations at average rates in effect for the period. We show any unrealized translation gains or losses as a component of the line item accumulated other comprehensive (loss) income within the consolidated statements of stockholders' equity.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results may differ from those estimated.
We recognize sales at the time the guest takes possession of merchandise, either at the point of sale in our stores or at the time of shipment for products purchased from our websites. We recognize the sale from layaway transactions when our guests satisfy all payment obligations and take possession of the merchandise. We recognize the sale from gift cards and the issuance of store credits as they are redeemed.
Notes to Consolidated Financial Statements—(Continued)
Reserve for Sales Returns
We reserve amounts for sales returns for estimated product returns by our guests. We estimate our reserve for sales returns based on historical return experience and changes in customer demand.
Advertising Costs
Gross advertising costs are recognized in selling, general and administrative expenses ("SG&A") at the point of first broadcast or distribution and were $336 million in 2004, $364 million in 2003, and $358 million in 2002.
We consider our highly liquid investments with original maturities of less than three months to be cash equivalents.
Credits and Allowances Received from Vendors
We receive credits and allowances that are related to formal agreements negotiated with our vendors. These credits and allowances are predominantly for cooperative advertising, promotions, and volume related purchases. Beginning in 2003, we began to treat credits and allowances, including cooperative advertising allowances, as a reduction of product cost in accordance with the provisions of Emerging Issues Task Force Issue No. 02-16, "Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor" ("EITF 02-16"). Therefore, beginning in 2003, we recognized as a reduction to cost of sales those credits and allowances that related directly to inventory purchases as that inventory is sold. All cooperative advertising allowances that are related to arrangements entered into prior to 2003 offset the costs of cooperative advertising expense and were included in SG&A in the period that the expense was recognized.
We have also applied the provision of EITF Issue 03-10, "Application of EITF Issue No. 02-16, 'Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor,' by Resellers to Sales Incentives Offered to Consumers by Manufacturers" ("EITF 03-10"). EITF 03-10 applies to coupon arrangements entered into or modified after November 25, 2003. We adopted the provisions of EITF 03-10 beginning in 2004. Our 2004 sales were recorded net of coupons that we redeemed. The transition provisions for EITF 03-10 provided for restatement of our comparable fiscal 2003 consolidated financial statements only. Refer to Note 2 entitled "RESTATEMENT OF FINANCIAL STATEMENT FOR ACCOUNTING FOR LEASE AND LEASEHOLD IMPROVEMENTS" and to Note 3 entitled "CHANGES IN ACCOUNTING" for further details on the impact on our results due to the adoption of EITF 03-10.
Cost of Sales and Selling, General, and Administrative Expenses
The following table illustrates costs associated with each expense category:
"SG&A"
• The cost of acquired merchandise from vendors; • Store payroll and related payroll benefits;
• Freight in; • Rent and other store operating expenses;
• Markdowns; • Advertising expenses;
• Provision for inventory shortages; and • Cooperative advertising allowances prior to 2003;
• Credits and allowances from our merchandise vendors. • Costs associated with operating our distribution network that primarily relate to moving merchandise from distribution centers to stores; and
• Other corporate related expenses.
We record property and equipment at cost. Leasehold improvements represent capital improvements made to our leased properties. We record depreciation and amortization 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. We utilize accelerated depreciation methods for income tax reporting purposes with recognition of deferred income taxes for the resulting temporary differences. We periodically evaluate the need to recognize impairment losses relating to long-lived assets. If indications of impairment exist and if the values of the assets are determined to be impaired, an impairment charge would be recognized and the related assets would be written-down to fair value. See Note 2 entitled "RESTATEMENT OF FINANCIAL STATEMENTS FOR ACCOUNTING FOR LEASES AND LEASEHOLD IMPROVEMENTS."
Costs of Computer Software
We capitalize certain costs associated with computer software developed or obtained for internal use in accordance with the provisions of Statement of Position No. 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"), issued by the American Institute of Certified Public Accountants ("AICPA"). We capitalize those costs from the acquisition of external materials and services associated with developing or obtaining internal use computer software. We capitalize certain payroll costs for employees that are directly associated with internal use computer software projects once specific criteria of SOP 98-1 are met. We expense those costs that are associated with preliminary stage activities, training, maintenance, and all other post-implementation stage activities as they are incurred. We amortize all costs capitalized in connection with internal use computer software projects on a straight-line basis over a useful life of five years, beginning when the software is ready for its intended use.
We adopted the provisions of Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133") beginning in 2002. This statement requires that we record all derivatives on the Consolidated Balance Sheets at fair value and that we recognize changes in fair value currently in earnings unless specific hedge accounting criteria are met.
We enter into forward foreign exchange contracts to minimize the risk associated with currency movement relating to our foreign subsidiaries. We recognize the gains and losses, which offset the movement in the
underlying transactions, as part of such transactions. Pre-tax gross deferred unrealized losses on the forward contracts were $1.6 million and $5.6 million at January 29, 2005 and January 31, 2004, respectively. We include the related receivable, payable and deferred gain or loss on a net basis in the Consolidated Balance Sheets.
At January 29, 2005, we had $335 million of short-term outstanding forward contracts maturing in 2005. At January 31, 2004, we had $452 million of short-term outstanding forward contracts maturing in 2004. We entered into these contracts with counter-parties that have high credit ratings and with which we have the contractual right to net forward currency settlements.
We account for stock options in accordance with the provisions of Accounting Principles Board Opinion No. 25 "Accounting for Stock Options Issued to Employees" ("APB 25"). We have adopted the disclosure only provisions of SFAS No. 123, "Accounting for Stock Based Compensation" ("SFAS No. 123"), issued in 1995.
In accordance with the provisions of SFAS No. 123, we apply APB 25 and related interpretations in accounting for our stock option plans and, accordingly, do not recognize compensation expense. If we had elected to recognize compensation expense based on the fair value of the options granted at grant date as prescribed by SFAS No. 123, net earnings and earnings per share would have been reduced to the pro forma amounts indicated in the following table:
Net earnings – as reported
Add stock option compensation expense
Less total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects
Net earnings – pro forma
Basic earnings per share – as reported
Diluted earnings per share – as reported
Basic earnings per share – pro forma
Diluted earnings per share – pro forma
The weighted-average fair value at the date of grant for options granted in 2004, 2003, and 2002 were $4.96 per option, $2.86 per option, and $6.42 per option, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. As there were a number of options granted during the years of 2002 through 2004, a range of assumptions follows:
Expected stock price volatility
0.302 – 0.458 0.473 – 0.548 0.407 – 0.507
2.7% – 3.9% 2.3% – 3.4% 2.6% – 5.0%
Weighted average expected life of options
5 years 5 years 5 years
The effects of applying SFAS No. 123 and the results obtained through the use of the Black-Scholes option-pricing model are not necessarily indicative of future values.
In December 2004, the Financial Accounting Standards Board ("FASB") issued FASB Statement No. 123 (Revised 2004), "Share-Based Payment" ("SFAS No. 123(R)"). SFAS No. 123(R) replaces SFAS No. 123 "Accounting for Stock-Based Compensation", which supersedes Accounting Principles Board ("APB") Opinion No. 25 "Accounting for Stock Issued to Employees", ("APB 25"), and amends FASB Statement No. 95, "Statement of Cash Flows". SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. SFAS No. 123(R) is effective for the first annual reporting period beginning after June 15, 2005. The Company is evaluating the transition applications and the impact the adoption of SFAS No. 123(R) will have on its consolidated financial position, results of operations and cash flows.
Insurance Risks
We insure a substantial portion of our general liability and workers' compensation risks through a wholly owned insurance subsidiary, in addition to third party insurance coverage. Provisions for losses related to self-insured risks are based upon independent actuarially determined estimates. We maintain stop-loss coverage to limit the exposure related to certain risks. The assumptions underlying the ultimate costs of existing claim losses are subject to a high degree of unpredictability, which can affect the liability recorded for such claims. For example, variability in inflation rates of health care costs inherent in these claims can affect the amounts realized. Similarly, changes in legal trends and interpretations, as well as a change in the nature and method of how claims are settled can impact ultimate costs.
Consolidation of Variable Interest Entities
In December 2003, the FASB issued Interpretation No. 46 (revised December 2003) ("FIN 46(R)"), "Consolidation of Variable Interest Entities." FIN 46(R) replaces FIN 46 that was issued in January 2003 and implementation is required in our consolidated financial statements for our interests in Variable Interest Entities ("VIEs"). Implementation of the provisions of FIN 46(R) was effective for the first reporting period after March 15, 2004. FIN 46(R) requires the consolidation of entities that are controlled by a company through interests other than voting interests. Under the requirements of this interpretation, an entity that maintains a majority of the risks or rewards associated with VIEs, also known as Special Purpose Entities, is viewed to be effectively in the same position as the parent in a parent-subsidiary relationship. Our Global Store Support Center headquarters facility located in Wayne, New Jersey is leased through a synthetic lease arrangement from unrelated third parties arranged by a multi-purpose real estate investment company that we do not control. In addition, we do not have the majority of the associated risks or rewards. Accordingly, we believe that FIN 46(R) has no impact on the accounting for the synthetic lease for this facility. The synthetic lease is detailed in Note 18 entitled "LEASES."
We have determined that we have not created or entered into any VIEs that would require consolidation by us. The adoption of the provisions of FIN 46(R) in the first quarter of 2004 had no impact on our results of operations, cash flows or financial position.
NOTE 2 – RESTATEMENT OF FINANCIAL STATEMENTS FOR ACCOUNTING FOR LEASES AND LEASEHOLD IMPROVEMENTS
On February 7, 2005, the Office of the Chief Accountant of the United States Securities and Exchange Commission ("SEC") issued a letter to the American Institute of Certified Public Accountants expressing its views regarding certain operating lease accounting issues and their application under generally accepted accounting principles in the United States of America ("GAAP"). In light of this letter, our management conducted a review of our accounting for leases and leasehold improvements and determined that our then-current practices of accounting for leases and leasehold improvements were incorrect.
On February 17, 2005, we decided to restate our previously issued financial statements for the fiscal years ended January 31, 2004 and February 1, 2003 to reflect a correction in our accounting practices for leases and leasehold improvements. As a result, we have restated the consolidated balance sheet at January 31, 2004, and the consolidated statements of earnings, stockholders' equity and cash flows for the years ended January 31, 2004 and February 1, 2003 in this Annual Report on Form 10-K. The impact of the restatement on periods prior to 2002 has been reflected as an adjustment to retained earnings as of February 2, 2002 in the accompanying consolidated statements of stockholders' equity. The restatement corrects our historical accounting for leases and leasehold improvements and had no impact on net sales or net cash flows.
The restatement resulted in a decrease to retained earnings of $196 million as of February 2, 2002, a $16 million decrease in net earnings for the year ended February 1, 2003, and an increase in net earnings of $2 million for the year ended January 31, 2004.
Following is a summary of the effects of these changes on our consolidated statements of earnings for fiscal years 2003 and 2002 (in millions, except per share data) as well as the effect of these changes on our consolidated balance sheet as of January 31, 2004. In addition, our consolidated statement of earnings for the 2003 fiscal year and the related consolidated balance sheet as of January 31, 2004 also reflects the restatement adjustment for the implementation of EITF 03-10. Refer to Note 3 entitled "CHANGES IN ACCOUNTING" for further details.
Consolidated Statement of Earnings
Year ended January 31, 2004
EITF 03-10
As previously
$ 11,320 $ — $ (246 ) $ 11,566
7,646 — (203 ) 7,849
3,674 — (43 ) 3,717
3,026 4 — 3,022
63 (22 ) — 85
217 (2 ) (43 ) 262
(142 ) — — (142 )
18 — — 18
Earnings / (loss) before income taxes
93 (2 ) (43 ) 138
30 (4 )(a) (16 ) 50
Net earnings / (loss)
$ 63 $ 2 $ (27 ) $ 88
$ 0.30 $ 0.01 $ (0.12 ) $ 0.41
(a) Includes the benefit associated with the cumulative impact of the lease accounting restatement on the effective tax rate.
Year ended February 1, 2003
$ 11,305 $ — $ 11,305
2,724 6 2,718
3,063 28 3,035
443 (28 ) 471
(119 ) — (119 )
$ 213 $ (16 ) $ 229
$ 1.03 $ (0.07 ) $ 1.10
reported*
$ 1,432 $ — $ — $ 1,432
571 — — 571
161 74 — 87
4,729 74 (43 ) 4,698
4,439 (133 ) — 4,572
399 138 — 261
273 (3 ) — 276
$ 10,265 $ 76 $ (43 ) $ 10,232
$ — $ — $ — $ —
1,022 — — 1,022
866 (10 ) — 876
319 104 (16 ) 231
5,308 (210 ) (27 ) 5,545
(64 ) (11 ) — (53 )
(1,707 ) — — (1,707 )
* Adjusted for current year presentation
NOTE 3 – CHANGES IN ACCOUNTING
In the first quarter of 2004, we applied the provisions of Emerging Issues Task Force (EITF) Issue No. 03-10, "Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor, by Resellers to Sales Incentives Offered to Consumers by Manufacturers" (EITF 03-10). Beginning in the first quarter of 2004, sales have been recorded net of coupons that were redeemed. Under the provisions of EITF 03-10, when we receive credits and allowances from vendors for coupons related to events that meet the direct offset requirements of EITF 03-10, we will recognize as a reduction of cost of sales the related reimbursement during the period of redemption. Credits and allowances received from vendors that do not meet the direct offset requirements of EITF 03-10 will be recorded as a reduction of product costs in accordance with EITF Issue No. 02-16, "Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor", which we applied at the beginning of 2003. Our 2003 consolidated financial statements have been restated to the current year's presentation, as permitted by the provisions of EITF 03-10.
The following table outlines the unfavorable impact of the adoption of EITF 02-16 and restatement for EITF 03-10 on our 2003 earnings before income taxes:
EITF
Source of change
$ 50 $ 43 $ 93 $ 74 $ 19 $ 93
The provisions of EITF 02-16 and EITF 03-10 did not permit adoption through a cumulative effect adjustment at the beginning of 2003. As noted above, if we had been permitted to record a cumulative effect adjustment at the beginning of 2003, the unfavorable impact on 2003 earnings before taxes would have been reduced by $74 million for the year ended January 31, 2004. The recognition of credits and allowances received from vendors for the current period effect noted above, and for all periods subsequent to 2003, will be driven by changes in vendor agreements, the amount of credits and allowances received from vendors, and changes in sales and inventory levels. The adoption of EITF 02-16 and EITF 03-10 had no net impact on our consolidated statements of cash flows.
NOTE 4 – RESTRUCTURING AND OTHER CHARGES
Our consolidated financial statements for the fiscal year ended January 29, 2005 included the following pre-tax charges related to restructuring initiatives from current and prior years, and are as follows:
and other charges
and amortization
$ 13 $ — $ — $ 8 $ 21
(29 ) 3 10 — (16 )
14 — — — 14
1998 and 1995 Initiatives
$ 4 $ 3 $ 10 $ 8 $ 25
For the fiscal year ending January 29, 2005, we recorded net restructuring and other charges of $4 million. Net restructuring and other charges were $63 million for the year ended January 31, 2004, including a $22 million reduction related to our restatement of leases and leasehold improvements for 2003.
At January 29, 2005, we had total remaining reserves of $115 million to complete all of these restructuring initiatives. We believe that remaining reserves at January 29, 2005 are adequate to complete these initiatives and commitments. See below for a further discussion of individual restructuring initiatives and related charges and reserves.
On August 11, 2004, we announced our intention to restructure the Company's Global Store Support Center operations in Wayne, New Jersey. As a result, we recorded termination costs of $14 million associated with this action in the second quarter of 2004 and additional net costs of $7 million in the second half of 2004. Of these total charges, $13 million were recorded in restructuring and other charges, and charges of $8 million were recorded in selling, general and administrative expenses, comprised of $2 million for payroll-related costs and $6 million for stock option compensation charges resulting from modifications to stock option agreements for the severed executives. As of January 29, 2005, $10 million of reserves for termination costs remained to complete this initiative. We anticipate that additional termination costs will be incurred in subsequent quarters relating to the restructuring of the Company's Global Store Support Center operations.
On November 17, 2003, we announced our decision to close all 146 of the remaining free-standing Kids "R" Us stores and all 36 of the free-standing Imaginarium stores, as well as three distribution centers that support these stores. All of these facilities were closed by January 29, 2005.
On March 2, 2004, we entered into an agreement under which Office Depot, Inc. agreed to acquire 124 of the former Kids "R" Us stores for $197 million in cash, before commissions and fees, plus the assumption of lease payments and other obligations. Twenty-four properties have subsequently been excluded from the agreement with Office Depot, Inc., and are being separately marketed for disposition or have been disposed of to date. All closings were completed by January 29, 2005 and net cash proceeds of approximately $150 million were received. A $53 million gain associated with this transaction was recorded during 2004. An additional $2 million gain for the disposition of other Kids "R" Us properties was also recorded.
As outlined in the summary table above, we recorded net gains of $16 million during the fiscal year ended January 29, 2005, for the closing of the free-standing Kids "R" Us stores. Included in the $16 million of gains are inventory markdowns related to this initiative of $10 million, which were recorded in cost of sales; $3 million recorded as accelerated depreciation; $26 million recorded as restructuring and other charges for asset impairment, lease obligations, termination costs, and vacancy-related costs for the closed facilities; and $55 million of net gains on the sale of Kids "R" Us real estate recorded as restructuring and other charges. We expect to record additional charges for vacancy-related costs for closed facilities until their disposition.
Details on the activity of charges and reserves for the fiscal year ended January 29, 2005 are as follows:
Utilized
Reserve balance
at January 31,
Existing lease
reserves in
Inventory markdowns
$ 49 $ (28 ) $ 21 $ — $ 10 $ (31 ) $ —
Asset impairment(1)
29 (29 ) — — 9 (9 ) —
Lease commitments
15 (2 ) 13 7 2 (9 ) 13
Sale of Kids "R" Us real estate
— — — 16 (55 ) 39 —
Termination costs
11 — 11 — (2 ) (9 ) —
Accelerated depreciation
Vacancy costs and other
4 (4 ) — — 17 (17 ) —
$ 132 $ (87 ) $ 45 $ 23 $ (16 ) $ (39 ) $ 13
(1) Initial charge of $44 million originally recorded in fiscal 2003 was adjusted by $15 million due to our restatement of leasehold improvements as detailed in Note 2 entitled "RESTATEMENT OF FINANCIAL STATEMENTS FOR ACCOUNTING FOR LEASES AND LEASEHOLD IMPROVEMENTS."
In 2001, we recorded charges to close a number of stores, to eliminate a number of staff positions, and to consolidate five store support center facilities into our Global Store Support Center facility in Wayne, New Jersey. These actions resulted in total pre-tax charges of $208 million. These were partially offset by the reversal of $24 million of previously accrued charges ($11 million from the 1998 restructuring charges and $13 million from the 1995 restructuring charges) that we determined to be no longer needed. Therefore, we recorded net charges of $184 million in the fourth quarter of 2001, of which $27 million of charges were recorded in cost of sales. During the fiscal year ended January 29, 2005, we recorded additional net charges of $14 million primarily related to lease commitments on idle facilities.
to charges
through 2003
Store closings:
Lease commitments(1)
$ 43 $ 12 $ (3 ) $ (24 ) $ 28 $ (2 ) $ (12 ) $ 14
Write-down of property and equipment(1)
67 — (6 ) (61 ) — 2 (2 ) —
27 — — (27 ) — — — —
4 — — (4 ) — — — —
Store support center consolidation:
16 14 21 (5 ) 46 14 (11 ) 49
Write-down of property and equipment
29 — 6 (35 ) — — — —
15 — (2 ) (13 ) — — — —
Total restructuring and other charges
$ 208 $ 26 $ 16 $ (176 ) $ 74 $ 14 $ (25 ) $ 63
(1) Initial charges of $52 million and $28 million originally recorded in fiscal 2001 for lease commitments related to our store closings and store support center consolidation, respectively, were adjusted by $9 million and $12 million due to our restatement of leases. Write-downs of store property and equipment originally recorded as $75 million were adjusted by $8 million resulting from the restatement of prior years' leasehold improvements. For further details refer to Note 2 entitled "RESTATEMENT OF FINANCIAL STATEMENTS FOR ACCOUNTING FOR LEASES AND LEASEHOLD IMPROVEMENTS."
Other Prior Year Initiatives
We had $29 million of reserves remaining at January 29, 2005 from restructuring charges previously recorded in 1998 and 1995, primarily for long-term lease commitments, that will be utilized in 2005 and thereafter. During the fiscal year ended January 29, 2005, we recorded additional charges of $6 million, which were net of a $1 million reversal in the third quarter and a $3 million reversal in the fourth quarter of 2004, related to properties included in these restructuring initiatives.
Property Assets Held for Sale
We have included certain real estate assets as current assets in our consolidated balance sheets as they are being held for sale. Property assets held for sale at January 29, 2005 include the remaining former Kids "R" Us real estate assets. On August 17, 2004 we sold one of our former store support center locations in Montvale, New Jersey. We received net proceeds of $15 million, which equaled our net book value.
We believe that remaining reserves at January 29, 2005 are adequate to complete all remaining initiatives and commitments.
NOTE 5 – MERCHANDISE INVENTORIES
Merchandise inventory for our domestic toy stores, other than for apparel, is stated at the lower of LIFO (last-in, first-out) cost or market. If inventories had been valued at the lower of FIFO (first-in, first-out) cost or
market, inventories would show no change at January 29, 2005 or January 31, 2004. Apparel inventory and inventory for our international and Toysrus.com divisions are stated at the lower of FIFO cost or market.
Details on the components of our consolidated merchandise inventories are as follows:
Kids "R" Us
NOTE 6 – GOODWILL
In 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets" (SFAS No. 142), which we adopted at the beginning of 2002. SFAS No. 142 changed the accounting for goodwill from an amortization method to impairment only approach and accordingly, we ceased amortization of goodwill in 2002.
The carrying amount of goodwill at January 29, 2005 was $353 million and included goodwill relating to the acquisition of Baby Super Stores, Inc. in 1997 ($319 million), which is now part of the Babies "R" Us reporting unit, and goodwill relating to the acquisition of Imaginarium Toy Centers, Inc. in 1999 ($29 million), which is now part of the Toys "R" Us – U.S. reporting unit. In addition goodwill reflects the acquisition of SB Toys, Inc. ($5 million), previously a minority shareholder in Toysrus.com. On October 26, 2004 we originally recorded $39 million of goodwill related to this acquisition. In the fourth quarter of 2004, the purchase price allocation to goodwill was reduced by $34 million to reflect a reversal of a deferred tax liability. The offset to the goodwill adjustment was a reduction in deferred tax liabilities. Refer to Note 23 entitled "TOYSRUS.COM" for more details.
Based on the estimated fair market values (calculated using historical operating results of the reporting units to which the goodwill relates and relative industry multiples) of these reporting units compared with the related book values, we have determined that no impairment of this goodwill exists.
NOTE 7 – PROPERTY AND EQUIPMENT
Useful life
(in years) (as restated)
45-50 2,055 2,075
5-20 1,664 1,670
12 1/2-35 1,702 1,792
Leased property and equipment under capital lease
Less accumulated depreciation and amortization
Less net property assets held for sale
NOTE 8 – INVESTMENT IN TOYS "R" US – JAPAN
We have accounted for our 48% ownership investment in the common stock of Toys "R" Us – Japan, a licensee of ours, using the "equity method" of accounting since the initial public offering of Toys "R" Us – Japan in April 2000. As part of this initial public offering, Toys "R" Us – Japan issued 1.3 million shares of common stock to the public at a price of 12,000 yen, or $113.95 per share. In November 2001, the common stock of Toys "R" Us – Japan split 3-for-1. Our policy is to account for the sale of subsidiaries' stock by recognizing gains or losses for value received in excess of, or less than, our basis in such subsidiary.
Our equity in the earnings of Toys "R" Us – Japan is included in consolidated SG&A and was $23 million for 2004, $32 million for 2003, and $30 million for 2002. The carrying value of the investment is reflected on our consolidated balance sheets as part of the line item other assets and was $157 million in 2004 and $150 million in 2003. At January 29, 2005, the quoted market value of our investment was $262 million. The valuation is derived from a mathematical calculation based on the closing quotation published by the Tokyo over-the-counter market and is not necessarily indicative of the amount that could be realized upon sale. We are the guarantor of 80% of a 10 billion yen ($97 million) loan to Toys "R" Us – Japan from a third party in Japan. The loan has an annual interest rate of 6.47% and is due in 2012. We also guarantee 80% of three installment loans totaling 7.4 billion yen ($71 million) to Toys "R" Us – Japan from a third party in Japan. These loans have annual interest rates of 2.6% - 2.8%.
NOTE 9 – ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES
Gift card / gift certificate liability
Accrued bonus
Accrued interest
Sales and use tax / VAT payable
Current deferred tax liabilities
Other includes, among other items, accrued payroll and other benefits, profit sharing and other operating accruals.
NOTE 10 – SEASONAL FINANCING AND LONG-TERM DEBT
500 million euro-denominated bond, due and paid on February 13, 2004
$ — $ 624
6.875% notes, due fiscal 2006
Note at an effective cost of 2.23% due in semi-annual installments through fiscal 2008 (a)
8.750% debentures, due fiscal 2021, net of expenses (b)
Less current portion
(a) Amortizing note secured by the expected future yen cash flows from license fees due from Toys "R" Us – Japan.
(b) Fair value was $205 million in 2004 and $223 million in 2003. The fair value was estimated using quoted market rates for publicly traded debt and estimated interest rates for non-public debt.
Long-term debt balances as of January 29, 2005 and January 31, 2004 have been impacted by certain interest rate and currency swaps that have been designated as fair value and cash flow hedges, as discussed in Note 11 entitled "DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES."
On the maturity date of February 13, 2004, we paid a total of $506 million, including interest, to retire our 500 million euro-denominated bond bearing an original interest rate of 6.375%. In 2001, this obligation was swapped into a $466 million fixed-rate obligation with an effective interest rate of 7.43% per annum, with interest paid annually, and principal paid on February 13, 2004.
In March 2003, we filed a "shelf" registration statement with the Securities and Exchange Commission. This registration statement gave us the capability to sell up to $800 million of debt securities that would be used to repay outstanding debt and for general corporate purposes. In April 2003, we sold and issued $400 million in notes bearing interest at a coupon rate of 7.875% per annum, maturing on April 15, 2013. The notes were sold at a price of 98.3% of the principal amount, resulting in an effective yield of 8.125% per annum. We received net proceeds of $390 million. Simultaneously with the sale of the notes, we entered into interest rate swap agreements. As a result of these swap agreements; interest effectively accrues at the rate of LIBOR plus 3.6% per annum. Interest is payable semi-annually and commenced on October 15, 2003. In September 2003, we sold an additional $400 million in notes bearing interest at a coupon rate of 7.375% per annum, maturing on October 15, 2018, which fully utilized our capacity to issue debt under the "shelf" registration statement filed in March 2003. The notes were sold at a price of 99.6% of the principal amount, resulting in an effective yield of 7.424% per annum. We received net proceeds of $395 million. Simultaneously with the sale of the notes, we entered into an interest rate swap agreement. As a result of this swap agreement, interest effectively accrues at the rate of LIBOR plus 2.3% per annum. Interest is payable semi-annually and commenced on April 15, 2004. We used the net proceeds from these notes for the repayment of debt that matured in 2004 and for other general corporate purposes.
In 2002, we completed public offerings of Toys "R" Us common stock and equity security units, as described in Note 12 entitled "ISSUANCE OF COMMON STOCK AND EQUITY SECURITY UNITS." On April 6, 2005 we commenced a cash tender offer to purchase up to $402,500,000 of our outstanding senior notes due August 16, 2007 issued originally as part of our Equity Security Units. For further details refer to Note 28 entitled "SUBSEQUENT EVENTS."
In 2001, we issued and sold $750 million of notes comprised of $500 million of notes bearing interest at 7.625% per annum, maturing in August 2011, and $250 million of notes bearing interest at 6.875% per annum, maturing in August 2006. Simultaneously with the issuance of these notes, we entered into interest rate swap agreements. As a result of the interest rate swap agreements, interest effectively accrued on the $500 million notes at the rate of LIBOR plus 1.512% per annum and on the $250 million notes at the rate of LIBOR plus 1.1515% per annum. Interest is payable on both notes semi-annually on February 1 and August 1, and commenced on February 1, 2002. In October 2002, we terminated a portion of the interest rate swap agreements and received a payment of $27 million which is being amortized over the term of the related notes. Concurrently, we entered into new interest rate swap agreements. Of the $500 million notes, $200 million effectively accrues interest at the rate of LIBOR plus 3.06%, and $125 million of the $250 million notes accrues interest at the rate of LIBOR plus 3.54%.
At January 29, 2005 we had a $685 million unsecured committed revolving credit facility from a syndicate of financial institutions that expires in September 2006. The facility is primarily used for seasonal borrowings and for general corporate purposes. As of January 29, 2005, we had no borrowings under the credit facility and had $18 million in stand-by letters of credit.
The annual maturities of long-term debt at January 29, 2005 are as follows:
Annual maturities,
including fair value
hedging adjustment
$ 452 (a) $ — $ 452
2010 and subsequent
$ 2,264 $ 48 $ 2,312
(a) Includes $403 million of senior notes due 2007 which are a component of our equity security units and which we are contractually obligated to remarket in 2005. On April 6, 2005 we commenced a cash tender offer to purchase up to $403 million of the senior notes due in 2007. Refer to the section entitled "Management's Discussion and Analysis of Financial and Results of Operations – LIQUIDITY AND CAPITAL RESOURCES – FINANCING ACTIVITIES" as well as Notes 12 and 28 entitled "ISSUANCE OF COMMON STOCK AND EQUITY SECURITY UNITS" and "SUBSEQUENT EVENTS," respectively.
Long-term debt balances as of January 29, 2005 were impacted by certain interest rate and currency swaps that were designated as fair value and cash flow hedges, as discussed in Note 11 entitled, "DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES."
NOTE 11 – DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
We are exposed to market risk from potential changes in interest rates and foreign exchange rates. We regularly evaluate these risks and take measures to mitigate these risks, including, among other measures,
entering into derivative financial instruments to hedge these risks. We enter into foreign exchange forward contracts to minimize and manage the currency risks related to our merchandise import purchase program. We enter into interest rate swaps to manage interest rate risk and strive to achieve what we believe is an acceptable balance between fixed and variable rate debt.
The counter-parties to these foreign exchange forward contracts are highly rated financial institutions and we do not have significant exposure to any single counter-party. These contracts are designated as cash flow hedges, as defined by SFAS No. 133, and are effective as hedges. Accordingly, changes in the effective portion of the fair value of these forward exchange contracts are included in accumulated other comprehensive income. Once the hedged transactions are completed, or when merchandise is sold, the unrealized gains and losses on the forward contracts are reclassified from accumulated other comprehensive income and recognized in earnings. The unrealized gains or losses related to the import merchandise purchase program contracts that were recorded in accumulated other comprehensive income were not material at January 29, 2005 or January 31, 2004.
In September 2003, we entered into interest rate swap agreements, in connection with the issuance of $400 million in notes bearing interest at a coupon rate of 7.375% per annum, maturing on October 15, 2018, and as further described in Note 10 entitled "SEASONAL FINANCING AND LONG-TERM DEBT." As a result of the swap agreements, interest effectively accrues at the rate of LIBOR plus 2.3% per annum. Interest is payable semi-annually and commenced on April 15, 2004. This swap is designated as a perfectly effective fair value hedge, as defined by SFAS No. 133. Changes in the fair value of the interest rate swap offset changes in the fair value of the fixed rate debt due to changes in market interest rates.
In April 2003, we entered into interest rate swap agreements on our issuance of $400 million in notes bearing interest at a coupon rate of 7.875% per annum, maturing on April 15, 2013, and as further described in Note 10 entitled "SEASONAL FINANCING AND LONG-TERM DEBT." As a result of the swap agreements, interest effectively accrues at the rate of LIBOR plus 3.6% per annum. Interest is payable semi-annually and commenced on October 15, 2003. This swap is designated as a perfectly effective fair value hedge, as defined by SFAS No. 133. Changes in the fair value of the interest rate swap offset changes in the fair value of the fixed rate debt due to changes in market interest rates.
In May 2002, we entered into an interest rate swap agreement on our Equity Security Units. Under the agreement, we pay interest at a variable rate in exchange for fixed rate payments, effectively transforming these notes to floating rate obligations. This swap is designated as a highly effective fair value hedge, as defined by SFAS No. 133. Changes in the fair value of the interest rate swap offset changes in the fair value of the fixed rate debt due to changes in market interest rates with some ineffectiveness present. The amount of ineffectiveness did not have a material effect on earnings.
In March 2002, we refinanced a note payable originally due in 2005 and increased the amount outstanding to $160 million from $100 million. This borrowing is repayable in semi-annual installments of principal and interest, with the final installment due on February 20, 2008. The effective cost of this borrowing is 2.23% and is secured by expected future cash flows from license fees due from Toys "R" Us – Japan. We also entered into a contract to swap yen to U.S. dollars, within exact terms of the loan. This cross currency swap has been designated as a foreign currency cash flow hedge, as defined by SFAS No. 133, and is effective as a hedge.
In July 2001, we entered into interest rate swap agreements on our 7.625%, $500 million notes due on August 1, 2011, and our 6.875%, $250 million notes due on August 1, 2006. Under these agreements, we pay interest at a variable rate in exchange for fixed rate payments, effectively transforming the debentures to floating rate obligations. These swaps are designated as perfectly effective fair value hedges, as defined by SFAS No. 133. Changes in the fair value of the interest rate swaps perfectly offset changes in the fair value of the fixed rate debt due to changes in market interest rates.
At January 29, 2005, we increased the carrying amount of our long-term debt by $48 million, representing the fair value of the debt in excess of the carrying amount on that date. Also in 2004, we recorded derivative assets of $44 million and derivative liabilities of $22 million, representing the fair value of these derivatives at that date. The current portion of derivative liabilities is reflected on the Consolidated Balance Sheets as part of the line item accrued expenses and other current liabilities and the long-term portion is disclosed separately on the face of the Consolidated Balance Sheets. The derivative assets are reflected separately on the face of the Consolidated Balance Sheets.
We did not realize any material gains or losses related to these transactions for any of the periods presented. Accordingly, non-cash changes in assets, liabilities and equity have been excluded from the consolidated statements of cash flows presented.
NOTE 12 – ISSUANCE OF COMMON STOCK AND EQUITY SECURITY UNITS
In May 2002, we completed public offerings of Toys "R" Us common stock and equity security units. On that date, we issued approximately 15.0 million shares of our common stock at a price of $17.65 per share and received net proceeds of $253 million. Also on that date, we issued approximately 8.0 million equity security units with a stated amount of $50 per unit and received net proceeds of $390 million.
Each equity security unit consists of a contract to purchase, for $50, a specified number of shares of Toys "R" Us common stock in August 2005, and a senior note due in 2007 with a principal amount of $50. The senior notes are initially pledged to secure the holder's obligation to purchase our common stock under the related purchase contract. When the purchase contracts are settled in 2005, we will issue common stock. We will issue a minimum of approximately 18.7 million shares and up to a maximum of 22.8 million shares on the settlement date, depending on our average stock price.
In May 2005, we are obligated to remarket the senior notes at the then prevailing market interest rate for similar notes in order to provide the holders of the units with the cash to settle their purchase contracts. If the senior notes are successfully remarketed, they will pay interest at the reset rate (not to be less than the original rate of 6.25%) from the settlement date of that remarketing until their maturity in August 2007. If the remarketing (as well as subsequent remarketings specified by the purchase contract agreement) were to be unsuccessfully remarketed, the unit holders would be entitled to deliver the senior note or an equivalent treasury security for payment of the common stock. If the senior notes are not delivered for settlement of the purchase contracts, the senior notes will pay interest at the reset rate until their maturity in August 2007. If the senior notes are not successfully remarketed and remain outstanding after settlement of the purchase contracts, the senior notes would bear interest at a default rate (which will not be less than the original rate of 6.25%) to be determined by the remarketing agent based on the average of the interest rates quoted to it by three nationally recognized investment banks that in their judgment reflects an accurate market rate of interest applicable to the notes at that time as determined in accordance with the purchase contract agreement.
The fair value of the contract to purchase shares of Toys "R" Us common stock was estimated at $1.77 per equity security unit. The fair value of the senior note was estimated at $48.23 per equity security unit. Interest on the senior notes is payable quarterly at an initial rate of 6.25%, which commenced in August 2002. The proceeds allocated to the purchase contracts were recorded in stockholders' equity on the Consolidated Balance Sheets. The fair value of the senior notes is reflected as long-term debt on the Consolidated Balance Sheets. The net proceeds from the public offerings were used to refinance short-term borrowings and for other general corporate purposes. As a result of interest rate swap agreements, interest on the senior notes effectively accrues at the rate of LIBOR plus 3.43% per annum. Interest is payable quarterly each year, beginning in August 2002.
If the purchase contracts that are a part of the equity security units are settled after consummation of the proposed merger described in Note 28 entitled "SUBSEQUENT EVENTS", holders will receive cash of $26.75
per share in lieu of each share of common stock that otherwise would have been issuable under the purchase contract upon settlement thereof. In addition, after consummation of the proposed merger, the holders of the Company's equity security units will have the right to accelerate and settle their purchase contracts at the settlement rate in effect immediately before the proposed merger.
On April 6, 2005 we commenced a cash tender offer to purchase up to $403 million of the senior notes due in 2007. For further details refer to Note 28 entitled "SUBSEQUENT EVENTS."
NOTE 13 – DEFINED BENEFIT PENSION PLANS
We sponsor defined benefit pension plans covering certain international employees, mainly in the United Kingdom and Germany, with such benefits accounted for on an accrual basis using actuarial assumptions. We account for these defined benefit pension plans in accordance with SFAS No. 132 (revised 2003), "Employers' Disclosures about Pensions and Other Postretirement Benefits" (SFAS No. 132, as revised) which revises SFAS No. 87, "Employers' Accounting for Pensions" ("SFAS No. 87"). SFAS No. 132, as revised, requires additional disclosures about assets, obligations, cash flows and net periodic benefit cost of defined benefit pension plans. This statement did not change the measurement or recognition of these plans required by SFAS No. 87. We use a measurement date that approximates the end of our fiscal years for our pension plans described above.
Information regarding our pension plans at January 29, 2005, is as follows:
Obligation and funded status at end of fiscal year (in millions):
Change in benefit obligation:
Benefit obligation at beginning of year
Interest cost
Benefits, expenses paid
(1 ) (1 )
Actuarial loss
Foreign currency impact
Benefit obligation at end of year
Change in plan assets:
Fair value of plan assets at beginning of year
Actual return on plan assets
Foreign currency – Impact
Fair value of plan assets at end of year
(25 ) (21 )
Unrecognized actuarial loss
Related tax benefit
Net amount recognized at year-end
$ (11 ) $ (6 )
Amounts recognized in the statement of financial position consist of:
Accrued benefit liability
$ (24 ) $ (18 )
Prepaid pension cost
Net amount recognized
The accumulated benefit obligation for our defined benefit pension plans was $47 million and $37 million at January 29, 2005 and January 31, 2004, respectively.
Information for pension plans with an accumulated benefit obligations in excess of plan assets:
Projected benefit obligation
Accumulated benefit obligation, net
Fair value of plan assets
Components of net periodic benefit cost:
$ 3 $ 2 $ 2
Expected return on plan assets
(1 ) (1 ) (1 )
Recognized actuarial loss
Net periodic benefit cost
Weighted-average assumptions used to determine benefit obligations at fiscal year end:
Rate of compensation increase
Weighted-average assumptions used to determine net periodic benefit costs as of fiscal year end:
Long-term rate of return on plan assets
The expected return on assets is the rate of return expected to be achieved on pension fund assets in the long term, net of Plan expenses. The expected return on assets assumption for 2005 has been determined by considering the actual asset classes held by the Plan at February 1, 2005 and our expectations of future rates of return on each asset class. The Plan's assets are currently invested 68% equity securities, 31% in debt securities, and 1% in real estate.
For equities, we have assumed that the long-term rate of return will exceed that of foreign government bonds by a margin known as the "equity risk premium". Based on historic data and current expectations, we have adopted a risk premium of 2.0% per annum above the 20-year foreign government bond yield. For bonds (currently a mixture of both government and corporate bonds), we have assumed that the long-term rate of return will exceed the current return on 20-year government bonds by 0.5%. Again this is based on historic data and
current expectations. At February 1, 2005, the 20-year foreign government bond yield was just over 4.6%. Therefore, we have assumed an equity return of 6.6% and a bond return of 5.0%, which based on the current asset allocation, gives an overall expected return on assets for 2005 of 6%.
Our pension plan's weighted-average asset allocation at January 29, 2005 and January 31, 2004, by asset category are as follows:
Equity securities
1 % —
— 2 %
100 % 100 %
Our overall investment policy falls into two parts. The strategic management of the assets is the responsibility of the Trustees (acting based on advice as they deem appropriate) and is driven by investment objectives as set out below. The remaining elements of our investment policy are part of the day-to-day management of the assets, which is delegated to a professional investment manager. The trustees of our defined benefit pension plans are guided by an overall objective of achieving, over the long-term, a return on the investments, which is consistent with the long-term assumptions made by the Actuary in determining the funding of the Plan. The investment returns that the Trustees expect to achieve are those that are broadly in line with or above the returns of the respective market indices and performance targets against which the investment manager is benchmarked. Over the longer term, the Trustees expect to achieve an investment return in excess of Retail Price Inflation. The Trustees meet with the investment manager regularly to review the manager's actions together with the reasons for, and the background to, investment performance. We have retained investment consultants to assist the Trustees in fulfilling their responsibility for monitoring the investment manager and they provide investment reports to the Trustees as and when the Trustees so request. Our current strategic asset allocation for our pension plan is 68% in equities and 32% in debt securities and real estate. Approximately 70% of our equity investments are in European equities with the remainder invested in U.S. and Asian markets.
We expect to contribute $2.3 million to our pension plan in 2005. Pension benefit payments, which reflect future service, as appropriate, are expected to be less than $1 million for the years 2005 to 2009, and $1 million for the years 2010 to 2014.
NOTE 14 – COMPREHENSIVE INCOME
Comprehensive income is calculated in accordance with SFAS No. 130, "Reporting Comprehensive Income" ("SFAS No. 130"). SFAS No. 130 requires that comprehensive income include net income, foreign currency translation adjustments, unrealized gains / (losses) on hedged transactions, and minimum pension liabilities, which are reported separately on the Consolidated Statements of Stockholders' Equity.
The following table sets forth the detail of accumulated other comprehensive earnings (loss).
21 (37 ) (142 )
Unrealized loss on hedged transactions net of tax
(18 ) (15 ) (10 )
Minimum pension liability adjustment net of tax
(10 ) (12 ) —
$ (7 ) $ (64 ) $ (152 )
NOTE 15 – STOCKHOLDERS' EQUITY
The common stock of the company, par value $0.10 per share, were as follows:
Authorized shares
Issued shares
Issued and outstanding shares
NOTE 16 – EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per share:
Net earnings available to common shareholders
Denominator for basic earnings per share – weighted average shares
Impact of dilutive securities
Denominator for diluted earnings per share – weighted average shares
Options to purchase approximately 11.5 million, 27.8 million, and 32.5 million shares of common stock were outstanding during 2004, 2003 and 2002, respectively, but were not included in the computation of diluted earnings per share because the option exercise prices were greater than the average market price of the common shares.
NOTE 17 – STOCK PURCHASE WARRANTS
We issued 1.2 million stock purchase warrants for $8.33 per warrant in 2000. Each warrant gives the holder thereof the right to purchase one share of Toys "R" Us common stock at an exercise price of $13 per share, until their expiration in 2010. As of January 29, 2005 none of these warrants were exercised.
In addition, we granted a warrant in 2000 entitling Amazon.com, Inc. ("Amazon.com") to acquire up to 5% (subject to dilution under certain circumstances) of the capital of Toysrus.com, LLC at the then market value. The warrant expired on December 31, 2004. Amazon.com has delivered a purported notice of exercise with respect to a portion of the warrants, however, we believe that Amazon.com did not provide proper notice in a timely manner.
NOTE 18 – LEASES
We lease a portion of the real estate used in our operations. Most leases require us to pay real estate taxes and other expenses and some leases require additional payments based on percentages of sales.
Minimum rental commitments under non-cancelable operating leases having a term of more than one year as of January 29, 2005 are as follows:
$ 2,941 $ 159 $ 2,782
Total rent expense, net of sublease income, was $300 million, $307 million, and $288 million in 2004, 2003 and 2002, respectively. We remain contingently liable for lease payments related to the sub-lease of locations to third parties. To the extent that sub-lessees fail to perform, our total net rent expense would increase.
Our Global Store Support Center facility in Wayne, New Jersey is financed under a lease arrangement commonly referred to as a "synthetic lease." Under this lease, unrelated third parties arranged by Wachovia Development Corporation, a multi-purpose real estate investment company, funded the acquisition and construction of the facility. The lease expires in 2011 and the rent is based on a mix of fixed and variable interest rates that is applied against the final amount funded.
On March 31, 2005 we submitted a purchase election option to Wachovia Development Corporation for the purpose of purchasing our Global Store Support Center facility in accordance with the terms of the lease agreement. The purchase is scheduled to occur on June 1, 2005.
NOTE 19 – INCOME TAXES
Worldwide income before income taxes is as follows:
$ (10 ) $ (64 ) $ 180
Worldwide income before income taxes
The provision for income taxes is as follows:
$ (109 ) $ (16 ) $ 4
36 (28 ) (3 )
Total provision for current taxes
(21 ) 3 32
Deferred:
Total provision for deferred taxes
Total provision for income taxes
$ (59 ) $ 30 $ 120
The tax effects of temporary differences are included in deferred tax accounts as follows:
Federal loss carry-forwards
$ 63 $ —
Foreign loss carry-forwards
State loss carry-forwards
Tax credit and other carry-forwards