UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 31, 2004

Commission file number 1-11609

TOYS “R” US, INC.

(Exact name of registrant as specified in its charter)

 

(973) 617-3500

(Registrant’s telephone number, including area code)

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 checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes x      No ¨

The number of shares of common stock, $0.10 par value per share, outstanding as of August 26, 2004 was 214,139,744.

 

 

INDEX

 

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements                                                                                                                            

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TOYS “R” US, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In millions)

 

See accompanying notes to the condensed consolidated financial statements.

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TOYS “R” US, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In millions, except per share data)

 

See accompanying notes to the condensed consolidated financial statements.

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TOYS “R” US, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In millions)

See accompanying notes to the condensed consolidated financial statements.

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TOYS “R” US, INC. AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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1.  Basis of presentation
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 interim condensed consolidated financial statements are unaudited and are subject to year-end adjustments.  However, in our opinion, all known adjustments (which consist primarily of normal, recurring accruals, and estimates that impact the carrying values of assets and liabilities) have been made and the interim financial statements present fairly the consolidated financial condition and operating results for the unaudited periods.  Ultimate outcomes could materially differ from our estimates.  Because of the seasonal nature of our business, results for interim periods are not indicative of results to be expected for a full fiscal year.  The financial statements included herein should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended January 31, 2004. Unless otherwise stated, all per share figures refer to diluted per share amounts. Certain prior period amounts have been reclassified to conform to the current period presentation.

2.  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 in cost of sales the related reimbursement as an offset to coupon expense 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” (EITF 02-16), which we applied at the beginning of 2003. Our 2003 condensed 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 / (loss) before income taxes:

 

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 / (loss) before taxes would have been reduced by $14 million for the second quarter, $27 million for the first six months of 2003, and $74 million for the full year.  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 condensed consolidated statements of cash flows.

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Refer to the section “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further details regarding the restatement made to our condensed consolidated statement of operations for the second quarter and the six months ended August 2, 2003.

3.  Restructuring and other charges
Our condensed consolidated financial statements for the six-month period ended July 31, 2004 included the following pre-tax charges related to restructuring initiatives from current and prior years, and are as follows:

Restructuring and other charges totaled $38 million and $53 million for the second quarter and the six months ended July 31, 2004, respectively.

At July 31, 2004, we have total remaining reserves of $131 million to complete all of these restructuring initiatives.  We believe that remaining reserves at July 31, 2004 are adequate to complete these initiatives and commitments.  See below for a further discussion of individual restructuring initiatives and related charges and reserves.

2004 Initiatives
On August 11, 2004, we announced that our Board of Directors has decided to pursue a separation of the Toys “R” Us and Babies “R” Us businesses.  In addition, we announced our intention to restructure the company’s corporate headquarter operations in Wayne, New Jersey.  We recorded termination benefits of $14 million associated with this action in the second quarter of 2004.  Of these charges, $3 million were recorded in selling, general and administrative expenses, and were related to compensation benefits for associates terminated in the second quarter.  As of July 31, 2004, the entire $14 million of reserves for termination benefits remain for this initiative. We anticipate that additional termination benefits will be incurred in subsequent quarters relating to the restructuring of the company’s corporate headquarters.

2003 Initiatives
On November 17, 2003, we announced our decision to close all 146 of our free-standing Kids “R” Us stores and all 36 of our free-standing Imaginarium stores, as well as three distribution centers that support these stores.  A majority of these facilities were closed on or before January 31, 2004, and all but 6 have been closed at July 31, 2004.  We expect the remaining stores will close later this year.

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.  Certain properties have subsequently been excluded from this agreement and are being separately marketed for disposition. We currently expect to receive approximately $180 million in cash, before commissions and fees, from Office Depot, Inc. (or its designee) plus the assumption of lease payments and other obligations.  Those stores that will not be acquired by Office Depot, Inc. (or its designee) either had leases that ended, will be converted to Babies “R” Us stores, or are being marketed for disposition.  More than half of the closings were completed at July 31, 2004 and cash proceeds of more than $100 million have been received.  We anticipate that the remaining closings will be completed in phases and the resulting gain recorded over the next several months as the transaction is concluded.

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We recorded charges of $147 million in the fourth quarter of 2003 related to the closing of these 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 $74 million of charges were included in restructuring and other charges.

As outlined in the summary table above, we recorded charges of $20 million and $35 million during the second quarter and the first six months of 2004, respectively, for the closing of the free-standing Kids “R” Us stores.  Included in the $20 million and $35 million of charges, are inventory markdowns related to this initiative of $7 million, for the second quarter of 2004, and $10 million for the six month ended July 31, 2004, that were recorded in cost of sales. Also included in these charges are $13 million, for the second quarter of 2004, and $22 million, for the first six months of 2004, of asset impairment, lease obligations, and vacancy-related costs for the closed facilities recorded as restructuring and other charges. In addition, these charges include $3 million of accelerated depreciation recorded in the first six months of 2004. We expect to record additional charges for the remaining stores that will close later this year, as well as for vacancy related costs for closed facilities until their disposition.

Details on the activity of charges and reserves for the six-month period ended July 31, 2004 are as follows:

 

2001 Initiatives
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 $237 million, which were partially offset by the reversal of $24 million of previously accrued charges ($11 million from the 1998 charge and $13 million from the 1995 charge) that we determined to be no longer needed.  Therefore, we recorded net charges of $213 million in the fourth quarter of 2001, of which $27 million of charges were recorded in cost of sales.  During the second quarter and the first six months of 2004, we recorded an additional $12 million and $13 million of charges related to lease commitments on idle facilities, respectively.

Details on the activity of charges and reserves for the six-month period ended July 31, 2004 are as follows:

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Other Prior Year Initiatives
We had $32 million of reserves remaining at July 31, 2004 from charges previously recorded in 1998 and 1995, primarily for long-term lease commitments, that will be utilized in 2004 and thereafter.  In addition, we have recorded additional charges of $7 million during the first six months of 2004 related to properties included in these restructuring initiatives, of which $2 million were recorded in the second quarter of 2004.

Property Assets Held for Sale
We have included certain real estate assets as current assets in our condensed consolidated balance sheets as they are being held for sale.  Property assets held for sale at July 31, 2004 included former Kids “R” Us real estate assets as discussed above, as well as our former store support center facility in Montvale, New Jersey.

4.  Stock-based compensation
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 the date of grant 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:

 

The weighted-average fair value at the date of grant for options granted in the second quarter of 2004 and 2003 was $5.65 and $4.16 per option, respectively. The weighted-average fair value at the date of grant for options granted in the first six months of 2004 and 2003 was $4.95 per option and $2.75 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 six months periods ended July 31, 2004 and August 2, 2003, a range of assumptions are provided below:

 

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.

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5.  Credits and allowances received from vendors
We receive credits and allowances from vendors that are related to formal agreements negotiated with such vendors.  These credits and allowances, predominantly for cooperative advertising, promotions, and volume-related purchases, are recognized in cost of sales and have a positive impact on our consolidated gross margin.

Credits and allowances from vendors for coupons related to events that meet the direct offset requirements of EITF 03-10 are recognized as an offset to coupon expense, in cost of sales, during the period of redemption (see Note 2 to the condensed consolidated financial statements for further discussion related to EITF 03-10).

Credits and allowances from vendors not meeting the direct offset requirements of EITF 03-10, along with other credits and allowances from vendors, are recorded as a reduction of product costs in accordance with EITF 02-16 that are recognized when the related merchandise inventories are sold.

6.  Cost of sales and selling, general and administrative expenses
The following table illustrates types of costs included in each category:

 

 

7.  Comprehensive income / (loss)
Comprehensive income / (loss) 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 liability adjustments, which are reported separately on the consolidated statements of stockholders’ equity in our Annual Report on Form 10-K for the fiscal year ended January 31, 2004.  The components of comprehensive income / (loss) are as follows:

 

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8.  Segments
A summary of operations by reportable segment is as follows:

 

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9.  Merchandise inventories
Merchandise inventory for our domestic stores, excluding 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 July 31, 2004, August 2, 2003, 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:

10.  Long-term debt and issuance of common stock
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% per annum.  In 2001, this obligation was swapped into a $466 million fixed rate obligation with an effective interest rate of 7.43% per annum, interest payments due annually, and principal due on February 13, 2004.

In March 2003, we filed a “shelf” registration statement with the Securities and Exchange Commission giving us the capability to sell up to $800 million of debt securities.  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, and 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 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.  The notes were sold at a price of 99.6% of the principal amount, resulting in an effective yield of 7.424% per annum, and we received net proceeds of $395 million.  Simultaneously with the sale of the notes, we entered into interest rate swap agreements.  As a result of these swap agreements, interest 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.  These swaps are designated as highly effective fair value hedges, as defined by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (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 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.

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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 from the settlement date of that remarketing until their maturity in August 2007. If the remarketing were to be unsuccessful, 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.

11.  Derivative instruments 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 sheets.

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 July 31, 2004, we increased the carrying amount of our long-term debt by $23 million, representing the fair value of debt in excess of the carrying amount on that date. Also at July 31, 2004, we recorded derivative assets of $48 million and derivative liabilities of $42 million.

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 condensed consolidated statements of cash flows presented.

12.  Commitments and contingencies
Our condensed consolidated balance sheets contain carrying amounts for certain assets and liabilities that are based on estimates and assumptions.  Certain of these estimates are related to loss contingencies, recoverability of assets, and to other potential obligations for which we are contingently liable. Such estimates include reserves for self-insured risks, litigation reserves, reserves for disputed amounts with vendors, and tax reserves.  We believe that these reserves are adequate to cover all probable and estimable loss exposures at July 31, 2004.

Our corporate income tax returns are routinely examined by the Internal Revenue Service ("IRS") and other taxing authorities.  In the past year, the IRS proposed, and we agreed to, several adjustments to certain deductions claimed in our 1997 to 1999 federal income tax returns.  Based on specific facts and circumstances, from time to time, management establishes reserves to cover certain tax related contingencies including contingencies resulting from questions raised by the taxing authorities during the course of an examination.  On June 29, 2004, the IRS notified us that its examination of our 1997 to 1999 U.S. federal tax returns was completed and its adjustments were final.  As a result, the Company reversed previously accrued income tax reserves that had been established to cover tax related contingencies in the years 1997 to 1999.  This reversal decreased income tax expense and increased net earnings for our second quarter ended July 31, 2004 by $200 million.

We file unclaimed property returns as required by law.  In certain jurisdictions, the rules concerning proper treatment of unclaimed properties are ambiguous.  In 2003, four states commenced an audit of our unclaimed property returns using contingent fee, third-party auditors.  As of July 31, 2004, we believe we have adequate reserves established for potential unclaimed property liabilities.

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On May 21, 2004, we, Toysrus.com, LLC, our Internet subsidiary, and two other affiliated companies, filed a lawsuit against Amazon.com, Inc. and its affiliated companies related to our strategic alliance with Amazon.com, Inc.  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, Inc.  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.  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 customers and suppliers, or have any material effect on our financial condition or results of operations.  We anticipate continuing to make payments in accordance with the agreement.

We are exposed to other claims and litigation arising out of the ordinary course of business.  We believe the currently identified claims and litigation will not have a material adverse effect on our condensed consolidated financial statements.

13.  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.  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.

At July 31, 2004, the quoted market value of our investment was $319 million, which exceeds our carrying value.  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 ($90 million) loan to Toys “R” Us – Japan from third parties in Japan.  The loan has an annual interest rate of 6.47% and is due in 2012.

14.  Earnings per share
The following table sets forth the computation of basic and diluted earnings per share:

 

 

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Options to purchase approximately 21.7 million shares of common stock were outstanding during the second quarter and six-month period ended July 31, 2004.  However, these options to purchase shares of common stock 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.

15.  Subsequent events
On August 11, 2004, we announced that our Board of Directors has decided to pursue a separation of the Toys “R” Us and Babies “R” Us businesses.

Our Board of Directors continues to evaluate the means of effecting the separation and intends to effect the separation in a manner designed to enhance shareholder value.  We are taking steps, among other actions, to explore the possible sale of the global toy business as well as to prepare for a possible spin-off of Babies “R” Us. We expect to complete the separation of the ownership of the two businesses during the first half of fiscal 2005.

On August 17, 2004 we sold our former global support center in Montvale, New Jersey.   We received net proceeds of $14.5 million, which equaled our net book value.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

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General
Toys “R” Us, Inc. and its subsidiaries generate sales, earnings, and cash flow by retailing specialty toys, baby products and children’s apparel worldwide.  We operate all of the “R” Us branded stores in the United States, as well as approximately 50% of the “R” Us branded stores internationally, the balance of which are either licensed or franchised.  Our operating segments include: Toys “R” Us – U.S., Toys “R” Us – International, our Babies “R” Us specialty baby-juvenile stores, Toysrus.com, our Internet subsidiary, and Kids “R” Us.

The Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide information to help you better understand and evaluate our financial condition and results of operations.  We recommend that you read this section in conjunction with our condensed consolidated financial statements in Item 1 and with our Annual Report on Form 10-K for the fiscal year ended January 31, 2004.

Results of Operations
Consolidated net income was $61 million, or $0.28 per share, for the second quarter ended July 31, 2004 versus a consolidated net loss of $11 million, or $0.05 per share for the second quarter ended August 2, 2003.  Consolidated net income was $33 million, or $0.15 per share, for the six months ended July 31, 2004 versus a consolidated net loss of $37 million, or $0.17 per share for the six months ended August 2, 2003. Net income for the second quarter and the first six months of 2004 reflects the reversal of $200 million of previously accrued income tax reserves that had been established to cover tax related contingencies in the years 1997 to 1999.  See Note 12 to the condensed consolidated financial statements for further details.

As discussed in Note 2 to the condensed consolidated financial statements, we applied the provisions of EITF 03-10 beginning in the first quarter of 2004.  Our 2003 condensed consolidated financial statements have been restated for comparability purposes, as permitted by the provisions of EITF 03-10.  Also, as discussed in Note 2 to the condensed consolidated financial statements, we applied the provisions of EITF 02-16 beginning in the first quarter of 2003.  The following tables present our second quarter 2003 condensed consolidated and segment results, as previously reported and as restated for comparability to the 2004 presentation, as permitted by the provisions of EITF 03-10:

 

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