The last few years have not been all fun and games for investors in the debt issues of privately held Toys R Us. The need to refinance a looming 2017 debt maturity presented an immediate challenge. Debt investors as well as vendors were concerned. Fortunately, this story has a happy ending. Commitments were announced on 6/13/2016 to exchange 89% of the 2017 notes as well as a portion of the 2018 notes for a new debt issue maturing in 2021.
XKE is a par $10 bond trust that holds Toys R Us 2021 unsecured notes and passes the interest through to shareholders as dividends. The positive case for XKE was presented in my 4/7/2016 article "The Top 10 Reasons To Speculate On This 18.0% Yielder". My prior article concluded that the "...near term refinancing of the 2017 notes could be a catalyst for XKE to trade higher". That is precisely what happened. This follow up article looks at the revised outlook for XKE. Could improving operating results and a potential IPO be the catalyst for further gains?
What is XKE?
XKE is a NYSE listed par $10 trust preferred issue. The trust holds the Toys R Us 9/1/2021 notes (CUSIP 892335AC4) and passes the bond interest through to shareholders as semi-annual dividends. At a recent price of $8.18, XKE is trading at a 13.4% yield to maturity (calculated from my Excel model) and offers a cash yield of 9.6%. See prospectus for additional details. XKE dividends are not considered qualified dividends for tax purposes. They are taxed at your ordinary tax rate. XKE is a smaller issue with an average daily trading volume of approximately 10,000 shares. Use limit orders and patience when trading.
Comparing XKE to the 2017 and 2018 notes
Approximately 89% of the Toys R US 2017 (CUSIP 892335AN0) notes are being swapped for the new 2021 notes. This will leave only about $50 million of the 2017 notes outstanding. The par 2017 notes have a 10.375% coupon, mature on 8/15/2017 and are currently trading at $96.25 with a 14.1% yield to maturity. As of 4/30/2016, the company had a cash balance of $458 million. Given such robust liquidity, the credit risk for the remaining 2017 notes has become quite minimal. The 2017 notes may be a good choice for investors seeking an attractive short term yield.
Following the debt swap, approximately $350 million of 2018 notes (CUSIP 892335AL4) will remain outstanding. The 2018 notes have a 7.375% coupon and mature on 10/15/2018. At a recent price of $80.09, the 2018 notes are now trading at an 18.4% yield to maturity. I'm omitting a comparison to the 2021 notes since they are very thinly traded.
Improving operating results
Toys R Us reported solid results for Q1 2016. The 13% increase in adjusted EBIDTA (as compared to Q1 2015) was encouraging even though this is not the critical holiday season quarter. Over the last year, the critical net leverage number (see highlights on page #1 of the earnings report) has improved from 6.8X to 5.9X. Net leverage is defined as (net debt ) / (adjusted EBIDTA). Trailing adjusted EBIDTA is now $809 million as per the earnings highlights on page #1.
Is an IPO the next step?
An initial public offering would not be possible if equity investors were concerned about near term debt maturities. As noted in this 6/14/2016 Wall St. Journal article, the successful debt swap may facilitate an IPO. Toys R Us Chief Executive Officer David Brandon comments:
"...It puts us in a position where IPOs are a viable option to consider,"
An equity capital raise would further strengthen the company's balance sheet and improve access to capital. In this scenario, XKE would be likely to trade near par $10.
How much cash could an IPO raise?
Toys R Us has a different market niche than other large publicly traded retailers. There is no exact match to use for valuation purposes. While not perfect, Macy's Inc (NYSE:M) and JC Penney (NYSE:JCP) are reasonably good comps. For fiscal 2015, Macy's reported operating income of $2.04 billion. With an enterprise value of $16.8 billion, M is now trading at 8.2X trailing operating earnings. JCP is now trading at a 7X multiple based on a $7 billion enterprise value and 2016 adjusted EBIDTA guidance of $1 billion. Based on its thriving overseas franchise, I believe that Toys R Us may deserve a premium to JCP. Macy's is a higher quality retailer that has been consistently profitable. I believe a 7X multiple (using the lower JCP multiple) would be a conservative valuation estimate for Toys R Us.
How much equity value would Toys R Us have based on a 7X multiple with trailing adjusted EBIDTA of $809 million? Since net leverage is currently 5.9X, the implied equity value is therefore:
(7X - 5.9X ) * $809 million = $890 million.
If a 50% equity stake was sold in a Toys R Us IPO, the company would raise approximately $445 million. This would be more than sufficient to repay the approximately $400 million of remaining 2017 and 2018 notes (after completion of the swap) without dipping into any of the company's $458 million cash hoard.
My Panick Value Research Report is focused on high yield preferred stocks and exchange-traded debt issues. I provide members with continued coverage and real time alerts on all of the high yield issues I write about here. Refinancing news can be especially critical and time sensitive for a distressed debt issue such as XKE. XKE was trading at $7.05 on the morning of 6/14/2016 when an alert went out to Panick Report members about the refinancing. XKE closed that day at $7.85.
At a current price of $8.18, XKE has moved significantly higher since my April article. While the current valuation is certainly not as compelling as it was, an IPO could be the catalyst for further gains. Leverage has been reduced over the last year making an IPO feasible. An IPO would further deleverage the balance sheet and provide additional liquidity. Par $10 beckons for XKE. The Toys R Us 2017 and 2018 notes may also be of interest for those investors willing to trade bond market issues.
Disclosure: I am/we are long XKE.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.