10-K 1 d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K

 

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended February 2, 2008

Commission file number 1-11609

 

 

LOGO

TOYS “R” US, INC.

(Exact name of registrant as specified in its charter)

 

 

Delaware   22-3260693

(State or other jurisdiction of

incorporation or organization)

 

(IRS Employer

Identification Number)

 

One Geoffrey Way

Wayne, New Jersey

  07470
(Address of principal executive offices)   (Zip code)

(973) 617-3500

(Registrant’s telephone number, including area code)

 

 

Securities registered pursuant to Section 12(b) or 12(g) of the Act:

None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes  ¨     No  x

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 a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer ¨

  Accelerated filer ¨

Non-accelerated filer x (Do not check if a smaller reporting company)

  Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x

As of February 2, 2008, there were outstanding 1,000 shares of common stock, $0.01 par value per share, of Toys “R” Us, Inc. (all of which are owned by Toys “R” Us Holdings, Inc., our parent holding company, and are not publicly traded).

DOCUMENTS INCORPORATED BY REFERENCE

None

 

 

 


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Forward-Looking Statements

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, 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, product safety issues including product recalls, general economic conditions in the United States and other countries in which we conduct our business, our ability to implement our strategy, our substantial level of indebtedness and related debt-service obligations, restrictions imposed by covenants in our debt agreements, 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 other risks, uncertainties and factors set forth under Item 1A entitled “RISK FACTORS” of this Annual Report on Form 10-K and in our reports and documents filed with the Securities and 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.

 


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INDEX

 

     PAGE

PART I.

     

Item 1.

   Business    1

Item 1A.

   Risk Factors    13

Item 1B.

   Unresolved Staff Comments    18

Item 2.

   Properties    18

Item 3.

   Legal Proceedings    19

Item 4.

   Submission of Matters to a Vote of Security Holders    19

PART II.

     

Item 5.

   Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    20

Item 6.

   Selected Financial Data    20

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    21

Item 7A.

   Quantitative and Qualitative Disclosures About Market Risk    43

Item 8.

   Financial Statements and Supplementary Data    45

Item 9.

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    98

Item 9A.

   Controls and Procedures    98

Item 9B.

   Other Information    101

PART III.

     

Item 10.

   Directors, Executive Officers and Corporate Governance    101

Item 11.

   Executive Compensation    104

Item 12.

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    120

Item 13.

   Certain Relationships and Related Transactions and Director Independence    122

Item 14.

   Principal Accounting Fees and Services    123

PART IV.

     

Item 15.

   Exhibits and Financial Statement Schedules    125
SIGNATURES    126
SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(d) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT    127
INDEX TO EXHIBITS    128


Table of Contents

PART I

 

ITEM 1. BUSINESS

As used herein, the “Company,” “we,” “us,” or “our” means Toys “R” Us, Inc., and its consolidated subsidiaries, except as expressly indicated or unless the context otherwise requires. Our fiscal year ends on the Saturday nearest to January 31 of each calendar year. This Annual Report on Form 10-K focuses on our last three fiscal years ended as follows: fiscal 2007 ended February 2, 2008, fiscal 2006 ended February 3, 2007, and fiscal 2005 ended January 28, 2006. References to 2007, 2006 and 2005 are to our fiscal years unless otherwise specified. Fiscals 2007 and 2005 had 52 weeks, whereas fiscal 2006 had 53 weeks.

Merger Transaction

We were acquired on July 21, 2005, by an investment group consisting of entities advised by or affiliated with Bain Capital Partners LLC (“Bain”), Kohlberg Kravis Roberts & Co., L.P. (“KKR”), and Vornado Realty Trust (“Vornado”) (collectively, the “Sponsors”), along with a fourth investor, GB Holdings I, LLC (the “Fourth Investor”), an affiliate of Gordon Brothers, a consulting firm that is independent from and unaffiliated with the Sponsors and management. The acquisition was consummated through a $6.6 billion merger of the Company into Global Toys Acquisition Merger Sub, Inc. (“Acquisition Sub”) with the Company being the surviving corporation in the merger (the “Merger”) pursuant to an Agreement and Plan of Merger, dated as of March 17, 2005 (the “Merger Agreement”), among the Company, Global Toys Acquisition, LLC (“Parent”) and Acquisition Sub. The Sponsors and the Fourth Investor are collectively referred to herein as the “Investors.”

Under the Merger Agreement, the former holders of the Company’s common stock (the “Company Common Stock”), par value $0.10 per share, received $26.75 per share, or approximately $5.9 billion. In addition, approximately $766 million was used, among other things, to settle our equity security units and our warrants and options to purchase the Company Common Stock, restricted stock and restricted stock units, and pay fees and expenses related to the Merger and severance, bonuses and related payroll taxes. The Merger consideration was funded by the Company’s available cash, cash equity contributions from the Investors and debt financings. We refer to the July 21, 2005 Merger and recapitalization as the “Merger Transaction.” Refer to Note 13 to our Consolidated Financial Statements entitled “MERGER TRANSACTION” for further details.

Our Business

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. We opened our first Babies “R” Us stores in 1996, expanding our presence into the specialty baby-juvenile market. Based on sales, we have a leading market share in most of the largest toy (and baby-juvenile) markets in which “R” Us branded retail stores operate, including the United States and United Kingdom. We attribute our market-leading positions in these markets to our broad product offerings, our highly recognized brand names, our substantial scale and geographic footprint, and our strong vendor relationships.

We generate sales, earnings and cash flows by retailing toys, baby-juvenile products, electronic products and children’s apparel worldwide. We operate all of the “R” Us branded retail stores in the United States and Puerto Rico, as well as approximately 70% of the “R” Us branded retail stores internationally. The balance of the “R” Us branded retail stores outside the United States are operated by franchisees and licensees, which do not have a material impact on our Net sales. We also sell merchandise through our Internet sites at www.toysrus.com and www.babiesrus.com in the United States, and through other Internet sites internationally.

As of February 2, 2008, we operated 1,560 “R” Us branded retail stores worldwide in the following formats:

 

   

Traditional toy store, which typically ranges in size from 30,000 to 46,000 square feet and devotes approximately 5,500 square feet to boutique areas for specialty baby-juvenile products, learning products or apparel;

 

   

Specialty baby-juvenile store, which typically ranges from 30,000 to 37,000 square feet and devotes approximately 2,000 to 5,000 square feet to specialty name brand and private label clothing;

 

   

Side-by-side store, which ranges in size from 30,000 to 46,000 square feet and devotes approximately 20,000 to 34,000 square feet to traditional toy products and 10,000 to 12,000 square feet to specialty baby-juvenile products; and

 

   

“R” superstore, which typically ranges from 60,000 to 64,000 square feet by combining a traditional toy store of approximately 32,000 square feet with a specialty baby-juvenile store of approximately 30,000 square feet.

Our extensive experience in retail site selection has resulted in a portfolio of stores that include attractive locations in many of our chosen markets. Markets for new stores and formats are selected on the basis of proximity to other “R” Us branded

 

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stores, demographic factors, population growth potential, competitive environment, availability of real estate and cost. Once a potential market area is identified, we select a suitable location based upon several criteria, including size of the property, access to major commercial thoroughfares, proximity of other strong anchor stores or other destination superstores, visibility and parking capacity.

We continually review our store portfolio for potential closures, relocations, format conversions and remodels. In fiscal 2005, our Board of Directors approved the closing of 87 Toys “R” Us stores in the United States. Twelve of these stores were converted into Babies “R” Us stores and 75 stores were permanently closed. For further details of our fiscal 2005 and prior years’ restructuring initiatives, refer to Note 2 to our Consolidated Financial Statements entitled “RESTRUCTURING AND OTHER CHARGES.”

As part of our worldwide growth strategy, we plan to open a number of new outlets for our toy and specialty baby-juvenile businesses by identifying attractive locations in new markets and converting existing stores into different formats. For fiscal 2008, we plan to invest in several remodels and will continue to test different store formats, such as side-by-side stores and “R” superstores, to maximize returns.

Our current reportable segments are Toys “R” Us – U.S. (“Toys – U.S.”), Toys “R” Us – International (“International”) and Babies “R” Us (“Babies”). See Note 14 to our Consolidated Financial Statements entitled “SEGMENTS” for our segments’ financial results for fiscals 2007, 2006 and 2005. The following is a brief description of our segments:

 

   

Toys – U.S. Our Toys – U.S. segment sells a variety of products in the learning, entertainment, core toys, seasonal and juvenile categories through 585 stores that operate in 49 states in the United States and Puerto Rico and through our Internet sites in the United States. Toys – U.S. Net sales are derived from its various store formats, which include 553 traditional toy stores, 28 side-by-side stores and 4 “R” superstores. Toys – U.S. includes all results of side-by-side and “R” superstores, including products typically sold by our Babies segment. On average, a typical Toys – U.S. store offers approximately 8,000 to 10,000 active items year-round. We believe we offer customers the most comprehensive selection of merchandise in the retail toy industry and are able to provide vendors with a year-round distribution outlet for the broadest assortment of their products.

 

   

International. Our International segment sells a variety of products in the learning, entertainment, core toys, juvenile and seasonal categories through 715 owned, licensed and franchised stores that operate in 34 countries and through our Internet sites internationally. Net sales from our owned and licensed locations in our International segment are derived from 665 traditional toy stores, as well as 30 side-by-side stores and 20 specialty baby-juvenile stores that operate in Australia, Austria, Canada, France, Germany, Japan, Portugal, Spain, Switzerland, and the United Kingdom. On average, a typical International store carries a range of 7,500 to 9,500 active items. Our differentiated assortment, proportionately higher private label or exclusively licensed product offerings, and quality service levels enable us to command a reputation as the shopping destination for toys, games, juvenile, and family leisure products.

 

   

Babies. Our Babies segment targets the pre-natal to infant market by offering a variety of juvenile products in the baby gear, infant care, apparel, commodities, furniture, bedding, and infant toys categories through 260 specialty baby-juvenile stores that operate in 42 states in the United States. On average, a typical Babies store offers approximately 24,000 active items year-round. Our Babies segment also offers a computerized baby registry service, which we believe registers more expectant parents than any other retailer in the domestic market. Our focus on the baby-juvenile market allows us to offer the broadest range of baby-juvenile products and deliver a high level of customer service and product knowledge. We believe these factors are important to parents who are expecting or have newborn children and help to differentiate us from our competitors.

Toys “R” Us – U.S.

Based on sales, we believe we are the largest specialty retailer of toys in the United States and Puerto Rico. We believe that we offer the most comprehensive selection of merchandise in the retail toy industry through our “R” Us branded stores and through the Internet. By focusing on toy and baby-juvenile products, we are able to provide customers with a comprehensive range of merchandise and our vendors with a year-round distribution outlet for the broadest assortment of their products.

We seek to differentiate ourselves from our competitors in several key areas, including product selection, product presentation, service, in-store experience, and marketing. We continue to grow and strengthen our business by:

 

   

enhancing our product offering and adding more private label and exclusive products to our mix;

 

   

offering great value to our customers through a convenient multi-channel (store and Internet) shopping experience;

 

   

renovating our toy store base in the United States to freshen our stores and enhance the shopping experience;

 

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reorganizing our store management teams to improve customer service; and

 

   

focusing on the expansion of our juvenile product offerings through our side-by-side store and “R” superstore formats.

Product Selection and Merchandise

Our product offerings are focused on serving the needs of parents, grandparents and gift-givers interested in purchasing toy, electronic and baby-juvenile products and children’s apparel. The following are our primary merchandise product categories:

 

   

Learning — educational electronics and developmental toys such as our Imaginarium products, and pre-school merchandise, such as pre-school learning products, activities and toys;

 

   

Entertainment — video game hardware and software, electronics, computer software, DVDs, and other related products;

 

   

Core Toy — boys and girls toys, such as dolls and doll accessories, action figures, role play toys and vehicles, games, plush and puzzles;

 

   

Seasonal — toys and other products geared toward the Christmas and Halloween holidays and the summer season, as well as bikes, sports merchandise, play sets and other seasonal products; and

 

   

Juvenile— baby and juvenile products and furniture, which are substantially identical to the products offered by our Babies segment, as well as apparel in sizes ranging from newborn to age eight.

We offer a wide selection of popular national toy brands including many products that are exclusively offered at, 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 earn higher margins and offer products that our customers will not find elsewhere. We offer a broad selection of private label merchandise under names such as ANIMAL ALLEY, FAST LANE, IMAGINARIUM, DREAM DAZZLERS and YOU & ME in our Toys “R” Us stores. We believe these private label brands provide a solid platform on which we can expand our product offering in the future.

Marketing

We have achieved our leading market position largely as a result of building a highly recognized brand name and delivering superior service to our customers. We use a variety of broad-based and targeted marketing and advertising strategies to reach consumers. These strategies include mass marketing programs such as catalogs and other inserts in national or local newspapers and national television and radio broadcasts. Our focus on in-store marketing is to generate strong customer frequency and increase average sales per customer. Our overall marketing efforts are carefully coordinated such that in-store marketing signage is consistent with the current television, radio and print advertisements. Our websites are used to support and supplement the promotion of products in “R” Us branded stores.

Customer Service

Compared to multi-line mass merchandisers, we believe we are able to provide superior service to our customers through our highly trained sales force. We train our store associates extensively to deepen their product knowledge and enhance their targeted selling skills in order to improve customer service in our stores. In addition, we are working to improve the allocation of products within our stores and waiting times at checkout counters.

Market and Competition

The U.S. retail toy and video game products market totaled approximately $40 billion in sales in 2007, with approximately $22 billion of sales driven by traditional toys and approximately $18 billion driven by video games. In the toy and video game products market, we compete with mass merchandisers, such as Wal-Mart, Target and Kmart; consumer electronics retailers, such as Best Buy, Circuit City and Gamestop; national and regional chains; as well as local retailers in the geographic areas we serve. In our apparel business, we compete with national and local department stores, specialty and discount store chains, as well as Internet and catalog businesses.

We believe the principal competitive factors in the toy and video game products market are product variety, quality, safety and availability, price, advertising and promotion, convenience or store location, customer support and service. We believe we are able to compete by providing a broader range of merchandise, maintaining in-stock positions as well as our convenient locations, superior customer service and competitive pricing.

 

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Seasonality

Our Toys – U.S. business is highly seasonal with sales and earnings highest in the fourth quarter due to the holiday selling season. During the last three fiscal years, more than 45% of the sales from our U.S. toy business and a substantial portion of our operating earnings and cash flows from operations were generated in the fourth quarter.

 

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Geographic Distribution of Toys - U.S. Stores

The following table sets forth the location of our Toys – U.S. stores as of February 2, 2008:

 

Location

   Number of Stores

Alabama

   7

Alaska

   1

Arizona

   10

Arkansas

   4

California

   71

Colorado

   5

Connecticut

   9

Delaware

   2

Florida

   41

Georgia

   19

Hawaii

   1

Idaho

   2

Illinois

   27

Indiana

   11

Iowa

   6

Kansas

   4

Kentucky

   7

Louisiana

   8

Maine

   2

Maryland

   14

Massachusetts

   14

Michigan

   21

Minnesota

   7

Mississippi

   4

Missouri

   11

Montana

   1

Nebraska

   3

Nevada

   4

New Hampshire

   5

New Jersey

   25

New Mexico

   2

New York

   37

North Carolina

   13

North Dakota

   1

Ohio

   27

Oklahoma

   5

Oregon

   6

Pennsylvania

   31

Rhode Island

   1

South Carolina

   7

South Dakota

   2

Tennessee

   12

Texas

   41

Utah

   5

Vermont

   1

Virginia

   19

Washington

   12

West Virginia

   4

Wisconsin

   9

Puerto Rico

   4
    

Total

   585
    

 

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Toys “R” Us - International

Our International segment operates, licenses and franchises “R” Us branded retail stores in 34 foreign countries. Our wholly-owned operations are in Australia, Austria, Canada, France, Germany, Portugal, Spain, Switzerland, and the United Kingdom and we consolidate the results of Toys-Japan. We intend to pursue opportunities that may arise in these and other countries.

We present our international customers with a one-stop shopping experience and provide a breadth of product assortment unrivaled by our competitors through our “R” Us branded stores and through the Internet. Our differentiated product assortment, proportionately higher private label or exclusively licensed product offerings, and quality service levels enable us to command a reputation as the shopping destination for toys, games, juvenile, and family leisure products.

We seek to differentiate ourselves from our competitors in several key areas, including product selection, product presentation, service, in-store experience, and marketing. We continue to grow and strengthen our business by:

 

   

enhancing our product offering and adding more private label and exclusive products to our mix;

 

   

continually reviewing our International store portfolio for new store opportunities and potential renovations to freshen our stores and enhance the shopping experience;

 

   

reorganizing our store management teams to improve customer service; and

 

   

focusing on the expansion of our juvenile product offerings through our side-by-side store and “R” superstore formats.

Product Selection and Merchandise

Similar to Toys – U.S. stores, our product offerings are focused on serving the needs of parents, grandparents and gift-givers interested in purchasing toy, electronic and baby-juvenile products and children’s apparel. The following are our primary merchandise product categories:

 

   

Learning — educational electronics and developmental toys such as our World of Imagination products and pre-school merchandise, such as pre-school learning products, activities and toys.

 

   

Entertainment —video game hardware and software, electronics, computer software, DVDs, and other related products;

 

   

Core Toy — boys and girls toys, such as dolls and doll accessories, action figures, role play toys, plush, games, and vehicles;

 

   

Juvenile —baby and juvenile products and furniture, which are similar to the products offered in our Babies segment, as well as apparel in sizes ranging from newborn to age eight; and

 

   

Seasonal — toys and other products geared toward the Christmas and other major holidays such as Three Kings, Carnival, Easter, and Golden Week and other seasonal products such as bicycles, sporting goods, play sets and other outdoor products.

Marketing

International’s marketing strategies are similar to the marketing strategies utilized by Toys “R” Us – U.S. We use press advertisements featured in national papers, catalogs/rotos distributed within newspapers, targeted door-to-door distribution, direct mailings to loyalty card members, other targeted mailings, in-store marketing and television advertising. Our focus on in-store marketing is to generate strong customer frequency and increase average sales per customer. Our United Kingdom business is especially well known for its usage of feature walls, innovative product displays and signage that direct the customer to the latest promotions and product demonstrations as well as to the products they come to buy. This promotional strategy has been replicated in our other International stores. The merchandising and marketing teams work closely to present the products in an engaging and innovative manner and one area of focus is enhancing our in-store signage. We are constantly changing our banners and in-store promotions, which are advertised throughout the year, to attract consumers to visit the stores.

Customer Service

Compared to other mass merchandisers, International is committed to providing different varieties of toy, electronic, and baby-juvenile categories throughout the year. We have a sales driven culture and dedicated sales advisers trained in their product categories in order to help provide the right product for each customer’s needs.

 

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Market and Competition

In the toy and video game products market, we compete with mass merchandisers and discounters such as Argos, Woolworths, Carrefour, Auchan, El Corte Ingles, Wal-Mart and Zellers. These competitors aggressively price in the toy and electronic space with larger dedicated selling space during the holiday season in order to build traffic for other store departments.

The competitive factors in the toy and video game products market impacting the United States are also present in other countries where we operate. We believe we are able to compete by providing a broader range of merchandise, maintaining in-stock positions as well as our convenient locations, superior customer service and competitive pricing.

Seasonality

Our International business is highly seasonal, with sales and earnings highest in the fourth quarter due to the holiday selling season. During the last three fiscal years, more than 39% of the sales from our International toy business and a substantial portion of our operating earnings and cash flows from operations were generated in the fourth quarter.

License agreements

We have license agreements with unaffiliated third party operators located outside the United States. The agreements are largely structured with royalty income paid as a percentage of sales for the use of the Toys “R” Us trademark, trade name and branding. While this business format remains a small piece of our overall International business operations, we continue to look for opportunities for market expansion. Our preferred option is to open in our successful wholly-owned format but may prefer partnerships or licensed arrangements where we believe business climate and risks may dictate.

 

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Geographic Distribution of International Stores

The following table sets forth the location of our owned, licensed and franchised stores as of February 2, 2008:

 

Location

   Number of Stores
      Australia    32
      Austria    13
*    Bahrain    1
      Canada    67
*    China    4
*    Denmark    13
*    Egypt    2
*    Finland    4
      France    37
      Germany    58
*    Hong Kong    9
*    Iceland    1
*    Israel    24
      Japan    168
*    Korea    2
*    Macau    1
*    Malaysia    10
*    Netherlands    16
*    Norway    8
*    Oman    1
*    Philippines    6
      Portugal    8
*    Qatar    1
*    Saudi Arabia    9
*    Singapore    7
*    South Africa    18
      Spain    42
*    Sweden    13
      Switzerland    6
*    Taiwan    15
*    Thailand    6
*    Turkey (1)    35
*    United Arab Emirates    5
      United Kingdom    73
    
            Total    715
    

 

* Franchised or licensed

(1)

During fiscal 2007, we terminated our franchise agreement with Turkey. Accordingly, the stores owned by the former franchisee will no longer be operated as Toys “R” Us stores, all branding will be removed during fiscal 2008, and the Company will have no franchised stores in Turkey.

Babies “R” Us

Our Babies “R” Us segment is the largest specialty retailer of baby-juvenile products in the United States and the only specialty retailer in its category that operates on a national scale in the United States. Our focus on the baby-juvenile market allows us to offer the broadest range of baby-juvenile products and deliver a high level of customer service and product knowledge. Our stores are designed for an easy shopping experience with low profile merchandise displays in the center of the store, providing a sweeping view of the entire product selection. We also utilize low fixtures and walls to maximize the presentation of merchandise and feature exclusive, new or special value products throughout the store.

 

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We seek to differentiate ourselves from competitors in several key areas, including product selection, product presentation, service, in-store experience, and marketing. We continue to grow and strengthen our business by:

 

   

being first to market and offer a wide selection of traditional and trend-right juvenile products with the right mix of branded, exclusive and private label items;

 

   

providing exceptional service through our state of the art registry, friendly and knowledgeable associates, in-house seminars and one-stop shopping environment; and

 

   

offering great value to new parents, grandparents and gift-givers through a convenient multi-channel (store and Internet) shopping experience.

Product Selection and Merchandise

Our product selection is focused to serve newborns and children up to four years of age. Consequently, we market a broad array of product sizes within multiple product categories. Because first-time parents tend to make multiple product purchases during a relatively short period of time, we seek to provide the expectant parent with a one-stop shopping venue for all baby product needs, providing what we believe is the most complete selection of baby-related products in the marketplace. The following are our primary juvenile merchandise product categories:

 

   

Baby gear – car seats, strollers, high chairs, swings, travel yards and entertainers;

 

   

Infant care – bath products, safety products, monitors, rattles, gates, potty seats, carriers and other products;

 

   

Apparel – national brands and private label in layette, playette, apparel, sleepwear, shoes and accessories in sizes from preemie to 48 months;

 

   

Commodities – diapers, wipes, formula, baby food and health and beauty aids;

 

   

Furniture – cribs, changing tables, case pieces, gliders, toy boxes and toddler furniture;

 

   

Bedding and room décor – bedding sets and accessories, bedding essentials, such as sheets, blankets, changing pads, mattress covers and sleep sacks, and room décor including storage, hampers, lamps and wall art; and

 

   

Infant toys – play mats, plush, books and videos, among other products.

Our extensive merchandise mix consists of leading national brands, exclusive products and private label merchandise. We feature brand-name products from many of the leading manufacturers of newborn and infant products. We believe that our private label and exclusive brands differentiate us from our competition while providing high quality products at competitive prices, maintaining attractive margins, and driving customer visits. Our organic/natural product offering is believed to be the largest assortment of any juvenile retailer in the United States. We also offer brand-name products that are available exclusively to us. In addition, we sell brand-name products through direct-licensing agreements with well-known designers, and under private labels, which are offered exclusively at our stores. We believe that direct-licensing relationships with brand-name designers will further differentiate our products and allow us to enhance profitability.

Marketing

The core of our marketing strategy is to communicate to expectant parents as early in their pregnancy as possible. Babies stores offer a one-stop shopping solution for new and expectant parents as well as many value-added services that are relevant to this unique audience. We use targeted marketing and various advertising techniques to reach our customer audience, to build Babies as the baby authority and to maintain a “top-of-mind” presence. Our advertising strategy includes direct mail, e-mail marketing, targeted magazine advertisements, in store bounceback programs and promotional marketing efforts. Our direct marketing program, which is mailed to both pre and postnatal guests, includes both price and item traffic driving events as well as stage and age relevant educational information. Our promotional marketing efforts are focused on working with key juvenile vendors in order to further our ability to effectively reach this targeted audience more often and to deliver more added value programs to our guests. Radio is also used to reach a broader audience for key promotions and store openings.

Each of our stores, as well as our Internet site, offers access to our comprehensive baby registry, which allows an expectant parent to list products that she or he wants and enables gift-givers to tailor purchases to the expectant parent’s specific needs and wishes. We believe that nearly one-quarter of the approximately four million infants born in the United States in 2007 had parents registered at Babies, www.babiesrus.com and/or Toys – U.S, which we believe makes it not only the largest registry of its kind, but also a key competitive advantage. Our baby registry also facilitates our direct marketing and customer relationship management initiatives.

 

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Customer Service

From our baby registry and highly trained staff, to our extensive product selection and exclusive products, we believe we are widely recognized as providing superior service as compared to our mass merchandise competitors. Each Babies store maintains a well-trained, knowledgeable and accessible staff on the sales floor to assist customers with product inquiries and purchase decisions. Our sales associates are continuously trained on product and service skills using a combination of e-learning, role playing and coaching tools. In addition, we provide a home delivery program in some of our stores for the added convenience of our customers. In addition to our baby registry, we offer a variety of helpful publications and innovative programs and services for the expectant parent, including frequent in-store product demonstrations and periodic educational seminars led by store associates and local experts.

Market and Competition

The retail baby-juvenile market in the United States is large and growing. Estimates of the size of the baby-juvenile product market in the United States vary due to extreme fragmentation of the supplier and retailer base as well as lack of agreement as to the definition of the relevant products and customer ages.

We compete with multi-line mass merchandisers, such as Wal-Mart, Target and K-Mart; national and regional chains; department stores, discount stores, supermarkets, warehouse clubs and drug stores; as well as local retailers in the geographic areas we serve. In our apparel business, we compete with national and local department stores, specialty and discount store chains, as well as Internet and catalog businesses. Our baby registry competes with baby registries of mass merchandisers and other special format and regional retailers. Within the past few years, the number of multiple registries and online registries has steadily increased. We believe the principal competitive factors in the baby-juvenile industry are product variety, quality and availability, safety, convenience, customer support and service, price, as well as functionality for our registry. We believe we are able to compete with our key competitors by providing the broadest range of merchandise and high levels of customer service at competitive prices.

 

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Geographic Distribution of Babies Stores

The following table sets forth the location of our Babies stores across the United States as of February 2, 2008:

 

Location

   Number of Stores

Alabama

   3

Arizona

   5

Arkansas

   1

California

   33

Colorado

   5

Connecticut

   5

Delaware

   1

Florida

   17

Georgia

   9

Idaho

   1

Illinois

   11

Indiana

   6

Iowa

   1

Kansas

   2

Kentucky

   3

Louisiana

   2

Maine

   1

Maryland

   5

Massachusetts

   7

Michigan

   11

Minnesota

   4

Mississippi

   1

Missouri

   5

Nebraska

   1

Nevada

   4

New Hampshire

   2

New Jersey

   14

New Mexico

   1

New York

   17

North Carolina

   8

Ohio

   10

Oklahoma

   2

Oregon

   2

Pennsylvania

   14

Rhode Island

   1

South Carolina

   3

Tennessee

   5

Texas

   20

Utah

   3

Virginia

   8

Washington

   4

Wisconsin

   2
    

Total

   260
    

Employees

As of February 2, 2008, we employed approximately 72,000 full-time and part-time individuals worldwide. Due to the seasonality of our business, we employed approximately 110,000 full-time and part-time employees during the 2007 holiday season.

 

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Distribution Centers

In the United States, we operate 10 distribution centers, which support our U.S. “R” Us branded retail stores. We also operate 9 distribution centers outside of the United States that support our International “R” Us branded stores (excluding licensed and franchised operations). During fiscal 2007, we closed two distribution centers in the United States and have outsourced these functions.

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 our operation of the fleet of trucks used to distribute merchandise provide us with operating efficiencies and the ability to maintain a superior in-stock inventory position at our stores. We seek to continuously improve our supply chain management, optimize our inventory assortment, and upgrade our automated replenishment system to improve inventory turnover.

To support our Toysrus.com and Babiesrus.com websites, we have a multi-year agreement with Exel, Inc., a leading North American contract logistics provider who provides warehousing and fulfillment services for our Internet operations in the United States.

Vendor Service

We procure the merchandise that we offer to our customers from a wide variety of domestic and international vendors. We have approximately 2,100 active vendor relationships. For fiscal 2007, our top 20 vendors worldwide, based on our purchase volume in dollars, represented approximately 40% of the total products we purchased.

We provide a number of valuable services to our vendors. Our year-round commitment to selling toy, electronic and baby-juvenile products and children’s apparel, as well as our merchandising expertise, gives vendors a meaningful opportunity to display new merchandise and reach consumers throughout the year. In addition, we are able to provide our vendors with a wide variety of data on sales trends, and marketing guidance and support, as well as early feedback on our vendors’ product development initiatives through the depth and longevity of our experienced merchandising team.

Financial Information About Our Segments

Financial information about our segments for the last three fiscal years is set forth in Note 14 to the Consolidated Financial Statements entitled “SEGMENTS.”

Trademarks and Licensing

“TOYS “R” US”®, “BABIES “R” US” ®, “IMAGINARIUM” ®, “GEOFFREY” ®, “KOALA BABY”®, the reverse “R” monogram logo, the Geoffrey character logo, 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. These trademarks are material to our business operations. We believe that our rights to these properties are adequately protected.

Available Information

Our investor relations website is www.toysrusinc.com. On this website under “COMPANY NEWS, 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 the Securities and Exchange Commission.

Our website contains the Toys “R” Us, Inc. Chief Executive Officer and Senior Financial Officers Code of Ethics (“CEO and Senior Financial Officers Code”). Any 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 on the Company’s website. These materials are also available in print, free of charge, to any investor who requests them by writing to: Toys “R” Us, Inc., One Geoffrey Way, Wayne, New Jersey 07470, Attention: Investor Relations.

 

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We are not incorporating by reference in this Annual Report on Form 10-K any information from our websites.

The public may read and copy any materials the Company files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

 

ITEM 1A. RISK FACTORS

Risks Associated with Our Business

Investors should carefully consider the risks described below and all other information in this Annual Report on Form 10-K. The risks and uncertainties described below are not the only ones that we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impact our business and operations. If any of the following risks actually occur, our business, financial condition, cash flows, or results of operations could be materially adversely affected.

Our Toys – U.S. and International businesses are highly seasonal, and our financial performance depends on the results of the fourth quarter of each fiscal year.

Our toy businesses are highly seasonal with sales and earnings highest in the fourth quarter. During the last three fiscal years, more than 40% of the 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 we achieve less than satisfactory sales, operating earnings or cash flows from operating activities during the fourth quarter, we may not be able to compensate sufficiently for the lower sales, operating earnings, or cash flows from operating activities during the first three quarters of the fiscal year. In addition, our results may be affected by dates on which important holidays fall and the shopping patterns relating to those holidays.

Our industry is highly competitive and competitive conditions may adversely affect our revenues and overall profitability.

The retail industry is highly and increasingly 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; electronic retailers; national and regional chains; as well as local retailers in the geographic areas we serve. We also compete with discount stores, supermarkets and warehouse clubs. 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. Competition is principally based on product variety, quality and availability, price, convenience or store location, advertising and promotion, customer support and service. Some of our competitors have greater financial resources, lower merchandise acquisition costs, and lower operating expenses than we do.

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. Our apparel business is vulnerable to demand and pricing shifts and to less than optimal selection as a result of these factors. Competition in the video game market has increased in recent years as mass merchandisers have expanded and consumer electronics retailers have all experienced significant growth.

The baby registry market is highly competitive, with competition based on convenience, quality and selection of merchandise offerings and functionality. Our baby registry primarily competes with the baby registries of mass merchandisers, such as Wal-Mart and Target, and other specialty format and regional retailers. Some of our competitors have been aggressively advertising and marketing their baby registries through national and television and magazine campaigns. Within the past few years, the number of multiple registries and online registries has steadily increased. These trends present consumers with more choices for their baby registry needs, and, as a result, increase competition for our baby registry.

If we fail to compete successfully, we could face lower sales and may decide or be compelled to offer greater discounts to our customers, which could result in decreased profitability.

Our operations have significant liquidity and capital requirements and depend on the availability of adequate financing.

We have significant liquidity and capital requirements. Among other things, the seasonality of our businesses requires us to purchase merchandise well in advance of the holiday selling season. We depend on our ability to generate cash flow from operating activities, as well as on borrowings under our revolving credit facilities, 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 unsecured debt as non-investment grade. Any adverse change to our credit ratings could (1) negatively impact our ability to refinance our debt on satisfactory terms, and (2) increase our financing costs. While we currently have adequate sources of funds to provide for our ongoing operations and capital requirements, any inability to have future access to financing, when needed, would have a negative effect on our business.

 

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We may not retain or attract customers if we fail to successfully implement our strategic initiatives.

We continue to implement a series of customer-oriented strategic programs designed to differentiate and strengthen our core merchandise content and service levels and expand and enhance our merchandise offerings. We are improving the effectiveness of our marketing and advertising programs for our Toys “R” Us and Babies “R” Us stores. The success of these and other initiatives will depend on various factors, including the implementation of our growth strategy, the appeal of our store formats, our ability to offer new products to customers, our financial condition, our ability to respond to changing consumer preferences and competitive and economic conditions. We are also continuing with plans to reduce and optimize our operating expense structure. If we fail to implement successfully some or all of our strategic initiatives, we may be unable to retain or attract customers, which could result in lower sales and a failure to realize the benefit of the expenditures incurred for these initiatives.

Our sales may be adversely affected if we fail to respond to changes in consumer preferences in a timely manner.

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 preferences in a timely manner. Our toy and baby-juvenile products must appeal to a broad range of consumers whose preferences cannot be predicted with certainty and are subject to change. The retail apparel business fluctuates according to changes in consumer preferences dictated in part by fashion trends, perceived value and season. These fluctuations affect the merchandise in stock since purchase orders are written well in advance of the holiday season and, at times, before fashion trends and high-demand brands are evidenced by consumer purchases. If we misjudge the market for our products, we may be faced with significant excess inventories for some products and missed opportunities for other products.

Our sales may be adversely affected by changes in consumer spending patterns.

Sales of toys and baby-juvenile 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 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.

Sales of video games tend to be cyclical and may result in fluctuations in our results of operations.

Sales of video games, which have tended to account for 10% to 20% of our toy store sales, have been cyclical in nature in response to the introduction and maturation of new technology. Following the introduction of new video game platforms, sales of these platforms and related software and accessories generally increase due to initial demand, while sales of older platforms and related products generally decrease as customers migrate toward the new platforms. If video game platform manufacturers fail to develop new hardware platforms, our sales of video game products could decline.

We depend on key vendors to supply the merchandise that we sell to our customers.

Our performance depends, in part, on our ability to purchase our merchandise in sufficient quantities at competitive prices. We purchase our merchandise from numerous foreign and domestic manufacturers and importers. We have no contractual assurances of continued supply, pricing or access to new products, and any vendor could change the terms upon which they sell to us or discontinue selling to us at any time. We may not be able to acquire desired merchandise in sufficient quantities on terms acceptable to us in the future. Better than expected sales demand may also lead to customer backorders and lower in-stock positions of our merchandise.

We have approximately 2,100 vendor relationships through which we procure the merchandise that we offer to our guests. For 2007, our top 20 vendors worldwide, based on our purchase volume in dollars, represented approximately 40% of the total products we purchased. Our inability to acquire suitable merchandise on acceptable terms or the loss of one or more key vendors could have a negative effect on our business and operating results because we would be missing products that we felt were important to our assortment, unless and until alternative supply arrangements are secured. We may not be able to develop relationships with new vendors, and products from alternative sources, if any, may be of a lesser quality and/or more expensive than those from old vendors.

In addition, our vendors are subject to certain risks, including labor disputes, union organizing activities, financial liquidity, product merchantability, inclement weather, natural disasters, and general economic and political conditions, that could limit our vendors’ ability to provide us with quality merchandise on a timely basis and at a price that is commercially acceptable.

 

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For these or other reasons, one or more of our vendors might not adhere to our quality control standards, and we might not identify the deficiency before merchandise ships to our stores or customers. In addition, our vendors may have difficulty adjusting to our changing demands and growing business. Our vendors’ failure to manufacture or import quality merchandise in a timely and effective manner could damage our reputation and brands and could lead to an increase in customer litigation against us and an attendant increase in our routine litigation costs. Further, any merchandise that does not meet our quality standards could become subject to a recall, which could damage our reputation and brands, and harm our business.

International events could delay or prevent the delivery of products to our stores.

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 safety issues on materials, the imposition of import restrictions or trade restrictions in the form of tariffs, “antidumping” duties, port security or other events that could slow port activities, acts of war, terrorism or diseases, could increase the cost and reduce the supply of products available to us, which could, in turn, negatively affect our sales and profitability. In addition, port-labor issues, rail congestion, and trucking shortages can have 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 any such developments in the future.

Product safety issues, including product recalls, could harm our reputation, divert resources, reduce sales and increase costs.

The products we sell in our stores are subject to regulation by the Consumer Product Safety Commission and similar state and international regulatory authorities. Such products could be subject to recalls and other actions by these authorities. Product safety concerns may require us to voluntarily remove selected products from our stores. Such recalls and voluntary removal of products can result in, among other things, lost sales, diverted resources and increased customer service costs, which could have a material adverse effect on our financial condition.

International factors could negatively affect our business.

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 or safety regulations;

 

   

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 our International segment and, as a result, our business and financial performance.

The success of our online business depends on our ability to provide quality service to our Internet customers.

Our Internet operations are subject to a number of risks and uncertainties which are beyond our control, including the following:

 

   

changes in consumer willingness to purchase goods via the Internet;

 

   

increases in software filters that may inhibit our ability to market our products through e-mail messages to our customers and increases in consumer privacy concerns relating to the Internet;

 

   

changes in applicable federal and state regulation, such as the Federal Trade Commission Act, the Children’s Online Privacy Act, the Fair Credit Reporting Act and the Gramm-Leach-Bliley Act;

 

   

breaches of Internet security;

 

   

failure of our Internet service providers to properly perform their services in a timely and efficient manner;

 

   

failures in our Internet infrastructure or the failure of systems or third parties, such as telephone or electric power service, resulting in website downtime or other problems; and

 

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failure by us to properly and timely process on-line orders by customers, which may negatively impact future on-line and in-store purchases by such customers.

Our business exposes us to personal injury and product liability claims which could result in adverse publicity and harm to our brand and our results of operations.

We are from time to time subject to claims due to the injury of an individual in our stores or on our property. In addition, we have in the past been subject to product liability claims for the products that we sell. While our purchase orders generally require the manufacturer to indemnify us against any product liability claims, there is a risk that if the manufacturer becomes insolvent we would not be indemnified. Any personal injury claim made against us or, in the event the manufacturer was insolvent, any product liability claim made against us, whether or not it has merit, could be time consuming, result in costly litigation expenses and damages, result in adverse publicity or damage to our reputation and have an adverse effect on our results of operations.

Our business operations could be disrupted if our information technology systems fail to perform adequately or we are unable to protect the integrity and security of our customers’ information.

We depend upon our information technology systems in the conduct of our operations. If our information technology systems fail to perform as anticipated, we could experience difficulties in replenishing inventories or in delivering our products to store locations in response to consumer demands. Any of these or other systems related problems could, in turn, adversely affect our sales and profitability.

Additionally, a compromise of our security systems resulting in unauthorized access to certain personal information about our customers could adversely affect our reputation with our customers and others, as well as our operations, and could result in litigation against us or the imposition of penalties. In addition, a security breach could require that we expend significant additional resources related to our information security systems.

Our results of operations could suffer if we lose key management or are unable to attract and retain experienced senior management for our business.

Our future success depends to a significant degree on the skills, experience and efforts of our senior management team. The loss of services of any of these individuals, or the inability by us to attract and retain qualified individuals for key management positions, could harm our business and financial performance.

If our internal controls are found to be ineffective, our financial results may be adversely affected.

We have previously identified a material weakness in our internal control over financial reporting. This material weaknesses has been fully remediated as of February 2, 2008 as described further in Item 9A in this Annual Report on Form 10-K. However, future material weaknesses in our internal control over financial reporting could result in material misstatements in our financial statements not being prevented or detected and could adversely impact the accuracy and completeness of our financial statements, which in turn could harm our business.

We may experience fluctuations in our tax obligations and effective tax rate.

We are subject to income taxes in the United States and numerous foreign jurisdictions. We record tax expense based on our estimates of future tax payments, which include reserves for estimates of probable settlements of foreign and domestic tax audits. At any one time, many tax years are subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these issues. As a result, we expect that throughout the year there could be ongoing variability in our quarterly tax rates as taxable events occur and exposures are re-evaluated. Further, our effective tax rate in a given financial statement period may be materially impacted by changes in the mix and level of earnings or by changes to existing accounting rules or regulations.

Changes to accounting rules or regulations may adversely affect our results of operations.

Changes to existing accounting rules or regulations may impact our future results of operations. Other new accounting rules or regulations and varying interpretations of existing accounting rules or regulations have occurred and may occur in the future. Future changes to accounting rules or regulations or the questioning of current accounting practices may adversely affect our results of operations.

 

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Changes to estimates related to our property and equipment, or operating results that are lower than our current estimates at certain store locations, may cause us to incur impairment charges.

We make certain estimates and projections in connection with impairment analyses for certain of our store locations in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” We review for impairment all stores for which current cash flows from operations are negative or the construction costs are significantly in excess of the amount originally expected. An impairment charge is required when the carrying value of the asset exceeds the estimated fair market value of the primary asset. These calculations require us to make a number of estimates and projections of future results. If these estimates or projections change, we may be required to record impairment charges on certain of these store locations. If these impairment charges are significant, our results of operations would be adversely affected.

The Sponsors control us and may have conflicts of interest with us in the future.

Investment funds or groups advised by or affiliated with the Sponsors currently indirectly control us through their ownership of 98.2% of the voting stock of our parent holding company. As a result, the Sponsors have control over our decisions to enter into any corporate transaction and have the ability to prevent any transaction that requires the approval of stockholders. In addition, the Sponsors may have an interest in pursuing dispositions, acquisitions, financings or other transactions that, in their judgment, could enhance their equity investments, even though such transactions might involve risks to us as a company.

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.

The Sponsors are also in the business of making investments for their own accounts in companies, and may from time to time acquire and hold interests in businesses that compete directly or indirectly with us. One or more of the Sponsors may also pursue acquisition opportunities that may be complementary to our business and, as a result, those acquisition opportunities may not be available to us. So long as investment funds associated with or designated by the Sponsors continue to indirectly own a significant amount of the outstanding shares of common stock of Holdings, the Sponsors will continue to be able to strongly influence or effectively control our decisions.

Risks Related to Our Substantial Indebtedness

Our substantial indebtedness could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry, expose us to interest rate risk to the extent of our variable rate debt and prevent us from meeting our obligations under the various debt instruments.

We are highly leveraged. As of February 2, 2008, our total indebtedness was $5,874 million, including $37 million of payment obligations relating to capital lease obligations.

Our substantial indebtedness could have important consequences, including, among others, the following:

 

   

making it more difficult for us to make payments on the debt, as our business may not be able to generate sufficient cash flows from operating activities to meet our debt service obligations;

 

   

increasing our vulnerability to general economic and industry conditions;

 

   

requiring a substantial portion of cash flows from operating activities to be dedicated to the payment of principal and interest on our indebtedness, and as a result, reducing our ability to use our cash flows to fund our operations and capital expenditures, capitalize on future business opportunities and expand our business and execute our strategy;

 

   

exposing us to the risk of increased interest expense as certain of our borrowings are at variable rates of interest;

 

   

causing us to make non-strategic divestitures;

 

   

limiting our ability to obtain additional financing for working capital, capital expenditures, debt service requirements and general, corporate or other purposes; and

 

   

limiting our ability to adjust to changing market conditions and reacting to competitive pressure and placing us at a competitive disadvantage compared to our competitors who are less highly leveraged.

We may be able to incur substantial additional indebtedness in the future, subject to the restrictions contained in our debt instruments. If new indebtedness is added to our current debt levels, the related risks that we now face could intensify. 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 included in our debt instruments. Even if we were able to refinance or obtain additional financing, our costs of new indebtedness could be substantially higher than our costs of existing indebtedness.

 

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Our debt agreements contain covenants that limit our flexibility in operating our business.

The agreements governing our indebtedness contain various covenants that limit our ability to engage in specified types of transactions, and may adversely affect our ability to operate our business. Among other things, these covenants limit our and our subsidiaries’ ability to:

 

   

incur additional indebtedness;

 

   

pay dividends on, repurchase or make distributions with respect to our capital stock or make other restricted payments;

 

   

issue stock of subsidiaries;

 

   

make certain investments, loans or advances;

 

   

transfer and sell certain assets;

 

   

create or permit liens on assets;

 

   

consolidate, merge, sell or otherwise dispose of all or substantially all of our assets;

 

   

enter into certain transactions with our affiliates; and

 

   

amend certain documents.

A breach of any of these covenants could result in default under our debt agreements, which could prompt the lenders to declare all amounts outstanding under the debt agreements to be immediately due and payable and terminate all commitments to extend further credit. If we were unable to repay those amounts, the lenders could proceed against the collateral granted to them to secure that indebtedness. If the lenders under the debt agreements accelerate the repayment of borrowings, we cannot ensure that we will have sufficient assets and funds to repay the borrowings under our debt agreements.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

 

ITEM 2. PROPERTIES

The following summarizes our worldwide operating stores and distribution centers as of February 2, 2008 (excluding licensed and franchised operations in our International segment):

 

     Owned    Ground
Leased(a)
   Leased    Total

Stores:

           

Toys - U.S

   272    141    172    585

International

   79    27    398    504

Babies

   36    99    125    260
                   
   387    267    695    1,349

Distribution Centers:

           

United States

   7    —      3    10

International

   5    —      4    9
                   
   12    —      7    19
                   

Total Operating Stores and Distribution Centers

   399    267    702    1,368
                   

 

(a)

Owned buildings on leased land.

We maintain former stores and distribution centers that are no longer part of our operations. Approximately half of these facilities are owned and the remaining locations are leased. We have tenants in more than half of these facilities, and we continue to market those facilities without tenants for disposition. The net costs associated with these facilities are reflected in our Consolidated Financial Statements, but the number of surplus facilities is not listed above.

 

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Portions of our debt are secured against certain direct and indirect interest in our properties. See Note 3 to the Consolidated Financial Statements entitled “SHORT-TERM BORROWINGS AND LONG-TERM DEBT” for further details.

We believe that our current operating stores and distribution centers are adequate to support our business operations.

 

ITEM 3. LEGAL PROCEEDINGS

Toysrus.com previously operated three co-branded on-line stores under a strategic alliance agreement with Amazon.com. On May 21, 2004, we initiated litigation against Amazon.com and its affiliated companies in the Superior Court of New Jersey, Chancery Division, Passaic County (the “New Jersey Trial Court”) to terminate our strategic alliance agreement with Amazon.com, to which Amazon.com responded by filing a counterclaim against us and our affiliated companies. On March 31, 2006, the New Jersey Trial Court entered its order granting our request for termination of the agreement and denying Amazon.com’s request for relief on its counterclaim. The parties each filed timely Notices of Appeal with the Appellate Division. On June 2, 2006, Amazon.com filed a lawsuit against us in the Superior Court of Washington, County of King (the “Washington Court”) for money damages allegedly arising from services it was required to provide to us during the wind-down period pursuant to the final order entered in the New Jersey Trial Court. The Washington Court stayed the matter before it in favor of the New Jersey proceedings. We believe that Amazon.com’s maintenance of the appeal of the New Jersey Court’s order and Washington Court lawsuit are without merit.

In addition to the litigation discussed above, we are, and in the future, may be involved in various other lawsuits, claims and proceedings incident to the ordinary course of business. The results of litigation are inherently unpredictable. Any claims against us, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in diversion of significant resources. The results of these lawsuits, claims and proceedings cannot be predicted with certainty. However, we believe that the ultimate resolution of these current lawsuits, claims and proceedings will not have a material adverse effect on our Consolidated Financial Statements taken as a whole.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

 

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PART II

 

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

In connection with the closing of the Merger, the Company Common Stock, par value $0.10, was converted into the right to receive $26.75 per share, and we requested that the New York Stock Exchange file with the Securities and Exchange Commission an application on Form 25 to strike the Company Common Stock from listing and registration thereon. On July 26, 2005, the New York Stock Exchange confirmed that such filing had been made.

As a result of the Merger, the Company Common Stock is privately held, and there is no established trading market for our stock. As of the date of this filing, there was one holder of record of the Company Common Stock.

 

ITEM 6. SELECTED FINANCIAL DATA

 

     Fiscal Years Ended

(In millions, except earnings per share data and number of stores)

   February 2,
2008
    February 3,
2007
    January 28,
2006
    January 29,
2005
   January 31,
2004

Operations

           

Net sales (1)

   $ 13,794     $ 13,050     $ 11,333     $ 11,155    $ 11,367

Net earnings (loss) (2)

     153  (3)     109  (3)     (384 ) (4)     252      63

Basic earnings per share

     n/a       n/a       n/a       1.17      0.30

Diluted earnings per share

     n/a       n/a       n/a       1.16      0.29

Financial Position at Year End

           

Working capital

   $ 685     $ 347     $ 348     $ 1,806    $ 1,865

Real estate, net

     2,401       2,331       2,386       2,400      2,328

Total assets

     8,952       8,295       7,863       9,272      9,801

Long-term debt (5)

     5,824       5,722       5,540       1,860      2,349

Stockholders’ (deficit) equity

     (389 )     (675 )     (724 )     4,325      3,974

Common shares outstanding

     —         —         —         215.9      213.6

Number of Stores at Year End

           

Toys - U.S

     585       586       671       681      685

International (6)

     715       678       641       601      574

Babies

     260       251       230       217      198

Kids “R” Us - U.S

     —         —         —         —        44
                                     

Total Stores

     1,560       1,515       1,542       1,499      1,501
                                     

 

(1)

Includes Net sales of $1,643 million and $1,650 million due to consolidation of Toys-Japan for the fiscals 2007 and 2006, respectively.

(2)

Includes the impact of restructuring and other charges. See Note 2 entitled “RESTRUCTURING AND OTHER CHARGES” in our Consolidated Financial Statements for further information.

(3)

Includes the impact of net gains on sales of properties of $33 million and $110 million in fiscals 2007 and 2006, respectively.

(4)

Includes $410 million of transaction and related costs and $22 million of contract settlement and other fees.

(5)

Excludes current portion of long-term debt.

(6)

Includes licensed and franchised stores.

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help facilitate an understanding of our historical results of operations during the periods presented and our financial condition. This MD&A should be read in conjunction with our Consolidated Financial Statements and the accompanying notes, and contains forward-looking statements that involve risks and uncertainties. See “Forward-Looking Statements” and Item 1A. entitled “RISK FACTORS.” Our MD&A includes the following sections:

EXECUTIVE OVERVIEW provides an overview of our business and financial performance for fiscal 2007 compared to fiscal 2006.

RESULTS OF OPERATIONS provides an analysis of our consolidated and segment results of operations for fiscal 2007 compared to fiscal 2006 and fiscal 2006 compared to fiscal 2005.

LIQUIDITY AND CAPITAL RESOURCES provides an overview of our cash flows, financing, short-term investments and contractual obligations.

CRITICAL ACCOUNTING POLICIES provides a discussion of our accounting policies that require critical judgment, assumptions and estimates.

RECENT ACCOUNTING PRONOUNCEMENTS provides a brief description of significant accounting standards which were adopted during fiscal 2007 as well as accounting standards which we have not yet been required to implement and may be applicable to our future operations. This section also refers to Note 20 to the Consolidated Financial Statements entitled “RECENT ACCOUNTING PRONOUNCEMENTS.”

EXECUTIVE OVERVIEW

Our Business

We generate sales, earnings and cash flows by retailing toys, baby-juvenile, electronic products and children’s apparel worldwide. We operate all of the “R” Us branded retail stores in the United States and Puerto Rico, as well as approximately 70% of the “R” Us branded retail stores internationally. The balance of the “R” Us branded retail stores outside the United States are operated by franchisees and licensees, which do not have a material impact on our Net sales. We also sell merchandise through our Internet sites at www.toysrus.com and www.babiesrus.com in the United States, and through other Internet sites internationally.

As of February 2, 2008, we operated 1,560 “R” Us branded retail stores worldwide in the following formats:

 

   

Traditional toy store, which typically ranges in size from 30,000 to 46,000 square feet and devotes approximately 5,500 square feet to boutique areas for specialty baby-juvenile products, learning products or apparel;

 

   

Specialty baby-juvenile store, which typically ranges from 30,000 to 37,000 square feet and devotes approximately 2,000 to 5,000 square feet to specialty name brand and private label clothing;

 

   

Side-by-side store, which ranges in size from 30,000 to 46,000 square feet and devotes approximately 20,000 to 34,000 square feet to traditional toy products and 10,000 to 12,000 square feet to specialty baby-juvenile products; and

 

   

“R” superstore, which typically ranges from 60,000 to 64,000 square feet by combining a traditional toy store of approximately 32,000 square feet with a specialty baby-juvenile store of approximately 30,000 square feet.

Our extensive experience in retail site selection has resulted in a portfolio of stores that include attractive locations in many of our chosen markets. Markets for new stores and formats are selected on the basis of proximity to other “R” Us branded stores, demographic factors, population growth potential, competitive environment, availability of real estate and cost. Once a potential market area is identified, we select a suitable location based upon several criteria, including size of the property, access to major commercial thoroughfares, proximity of other strong anchor stores or other destination superstores, visibility and parking capacity.

As part of our worldwide growth strategy, we plan to open a number of new outlets for our toy and specialty baby-juvenile businesses by identifying attractive locations in new markets and converting existing stores into different formats. For fiscal 2008, we plan to invest in several remodels and will continue to test different store formats, such as side-by-side stores and “R” superstores, to maximize returns.

 

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Our current reportable segments are Toys “R” Us – U.S. (“Toys – U.S.”), Toys “R” Us – International (“International”) and Babies “R” Us (“Babies”). The following is a brief description of our segments:

 

   

Toys – U.S. Our Toys – U.S. segment sells a variety of products in the learning, entertainment, core toys, seasonal and juvenile categories through 585 stores that operate in 49 states in the United States and Puerto Rico and through our Internet sites in the United States. Toys – U.S. Net sales are derived from its various store formats, which include 553 traditional toy stores, 28 side-by-side stores and 4 “R” superstores. Toys – U.S. includes all results of side-by-side and “R” superstores, including products typically sold by our Babies segment. On average, a typical Toys – U.S. store offers approximately 8,000 to 10,000 active items year-round. We believe we offer customers the most comprehensive selection of merchandise in the retail toy industry and are able to provide vendors with a year-round distribution outlet for the broadest assortment of their products.

 

   

International. Our International segment sells a variety of products in the learning, entertainment, core toys, juvenile and seasonal categories through 715 owned, licensed and franchised stores that operate in 34 countries and through our Internet sites internationally. Net sales from our owned and licensed locations in our International segment are derived from 665 traditional toy stores, as well as 30 side-by-side stores and 20 specialty baby-juvenile stores that operate in Australia, Austria, Canada, France, Germany, Japan, Portugal, Spain, Switzerland, and the United Kingdom. On average, a typical International store carries a range of 7,500 to 9,500 active items. Our differentiated assortment, proportionately higher private label or exclusively licensed product offerings, and quality service levels enable us to command a reputation as the shopping destination for toys, games, juvenile, and family leisure products.

 

   

Babies. Our Babies segment targets the pre-natal to infant market by offering a variety of juvenile products in the baby gear, infant care, apparel, commodities, furniture, bedding, and infant toys categories through 260 specialty baby-juvenile stores that operate in 42 states in the United States. On average, a typical Babies store offers approximately 24,000 active items year-round. Our Babies segment also offers a computerized baby registry service, which we believe registers more expectant parents than any other retailer in the domestic market. Our focus on the baby-juvenile market allows us to offer the broadest range of baby-juvenile products and deliver a high level of customer service and product knowledge. We believe these factors are important to parents who are expecting or have newborn children and help to differentiate us from our competitors.

In order to properly judge our business performance, it is necessary to be aware of the following challenges and risks:

 

   

Seasonality Our worldwide toy store business is highly seasonal with sales and earnings highest in the fourth quarter. During the last three fiscal years, more than 40% of the 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. Our Babies segment is not significantly impacted by seasonality.

 

   

Increased competition – Our businesses operate in a highly 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 product variety, quality and availability, safety, price, advertising and promotion, convenience or store location, and customer service. Price competition in the United States toy retailing business continued to be intense during the 2007 holiday season.

 

   

Spending patterns and product migration – In recent years, toy sales have been impacted by children migrating from 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. This pattern or migration 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 products are also available at a wider range of retailers than our traditional competitors, our Net sales and profitability could be adversely affected and we could experience excess inventories.

 

   

Video game business – The video game category is a significant merchandising category in the 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% to 20% of our toy store net sales. Competition in the video game market has increased as the leading discounters, such as Wal-Mart and Target have expanded, and specialty players, such as Best Buy, Electronics Boutique, and GameStop, have all experienced significant growth leading to greater competing demands for limited supplies of hot products. Due to intense competition as well as the maturation of this category, the video game category will continue to experience volatility that may impact our net sales.

 

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Financial Performance

As discussed in more detail in this MD&A, the following financial data represents an overview of our financial performance for fiscal 2007 compared to fiscal 2006:

 

     Fiscal Years Ended  

($ in millions)

   2007     2006  

Net sales growth (as compared to prior year)

     5.7 %     15.2 %(1)

Gross margin (as a percentage of Net sales)

     34.8 %     33.8 %

Selling, general and administrative expenses (as a percentage of Net sales)

     27.2 %     26.4 %

Net earnings

   $ 153     $ 109  

 

(1)

Net sales increased by $1,650 million or 14.6% due to the consolidation of Toys-Japan beginning in fiscal 2006.

Net sales for fiscal 2007 increased due to benefits in foreign currency translation, increased Net sales from new store openings, comparable store net sales improvements at all of our segments and increases in our Internet-based Net sales. Partially offsetting these increases were decreases due to store closings and a decrease of approximately $152 million in fiscal 2007, which had 52 weeks, compared to fiscal 2006, which had 53 weeks.

Gross margin as a percentage of Net sales for fiscal 2007 increased primarily due to improvements in initial markup at all of our segments, partially offset by increased markdowns at our Toys – U.S. and Babies segments.

Selling, general and administrative expenses (“SG&A”) as a percentage of Net sales for fiscal 2007 increased primarily due to increases in store occupancy and payroll-related expenses as a result of new store openings, increases in advertising expenses and the impact of foreign currency translation.

Net earnings for fiscal 2007 increased primarily due to increases in Gross margin as a result of increased overall Net sales, and decreases in Interest expense and Depreciation and amortization expenses, partially offset by increases in SG&A, decreases in Net gains on sales of properties and increased Income tax expense.

RESULTS OF OPERATIONS

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”). As a result of our control, our ownership in Toys-Japan and other factors, we have consolidated the results of Toys-Japan into our Consolidated Financial Statements effective as of the beginning of the first quarter of fiscal 2006. Refer to Note 1 to the Consolidated Financial Statements entitled “SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES” for further information. We had previously accounted for our investment in Toys-Japan using the equity method of accounting. For comparability purposes, we have provided a Consolidated Statement of Operations for fiscal 2005 on a non-GAAP adjusted basis in order to provide comparable presentation to our reported results for fiscals 2007 and 2006. We believe that providing this financial statement as if we had consolidated Toys-Japan provides investors with a measurement of operating results which are comparable with subsequent periods. We believe that this performance measurement may assist investors in assessing performance between periods and in developing expectations of future performance. We use these items in internal performance measures to analyze performance between periods, develop internal projections and measure management performance. Non-GAAP pro forma financial measures should be viewed in addition to, and not as an alternative for, the reported Consolidated Statement of Operations for fiscal 2005.

 

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Pro Forma Consolidated Statements of Operations

 

     Fiscal Years Ended  

(In millions)

   February 2,
2008
    February 3,
2007
    January 28, 2006  
     (As reported)     (As reported)     (Pro forma)     Toys-Japan     Elimination     (As reported)  

Net sales

   $ 13,794     $ 13,050     $ 12,961     $ 1,628     $ —       $ 11,333  

Cost of sales

     8,987       8,638     $ 8,784       1,132       —         7,652  
                                                

Gross margin

     4,807       4,412       4,177       496       —         3,681  
                                                

Selling, general and administrative expenses

     3,748       3,450       3,414       461       (2 )     2,955  

Depreciation and amortization

     394       409       429       29       —         400  

Net (gains) losses on sales of properties

     (33 )     (110 )     3       —         —         3  

Restructuring and other charges

     2       14       33       —         —         33  

Contract settlement fees and other

     —         —         22       —         —         22  

Transaction and related costs

     —         —         410       —         —         410  
                                                

Total operating expenses

     4,111       3,763       4,311       490       (2 )     3,823  
                                                

Operating earnings (loss)

     696       649       (134 )     6       2       (142 )

Other (expense) income:

            

Interest expense

     (503 )     (537 )     (401 )     (7 )     —         (394 )

Interest income

     27       31       31       —         —         31  
                                                

Earnings (loss) before income taxes and minority interest

     220       143       (504 )     (1 )     2       (505 )

Income tax expense (benefit)

     65       35       (117 )     4       —         (121 )

Minority interest

     2       (1 )     (3 )     —         (3 )     —    
                                                

Net earnings (loss)

   $ 153     $ 109     $ (384 )   $ (5 )   $ 5     $ (384 )
                                                

Comparable Store Net Sales

We include, in computing comparable store net sales, stores that have been open for at least 56 weeks (1 year and 4 weeks) from their “soft” opening date. Soft opening is typically two weeks prior to the grand opening.

Comparable stores generally include:

 

   

Stores that have been remodeled while remaining open;

 

   

Stores that have been relocated to new buildings within the same trade area, in which the new store opens at about the same time as the old store closes; and

 

   

Stores that have expanded in their current locations.

By measuring the year-over-year sales of merchandise in the stores that have a history of being open for a full comparable 56 weeks or more, we can better gauge how the core store base is performing since it excludes store openings, major remodels and closings.

Various factors affect comparable store net sales, including the number of stores we open or close, the general retail sales environment, consumer preferences and buying trends, changes in sales mix among distribution channels, our ability to efficiently source and distribute products, changes in our merchandise mix, competition, current local and global economic conditions, the timing of our releases of new merchandise and promotional events, the success of marketing programs, and the cannibalization of existing store net sales by new stores. Among other things, weather conditions can affect comparable store net sales because inclement weather can require us to close certain stores temporarily and thus reduce customer traffic in those stores. Even if stores are not closed, many customers may decide to avoid going to stores in bad weather. These factors have caused our comparable store net sales to fluctuate significantly in the past on an annual, quarterly and monthly basis and, as a result, we expect that comparable store net sales will continue to fluctuate in the future.

 

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Table of Contents
     Comparable Store Net Sales Performance  

(In local currencies)

   Fiscal
2007 (1)
    Fiscal
2006 (1)
    Fiscal
2005
 

Toys - U.S.

   2.2 %   0.6 %   (1.4 )%

International

   2.7 %(2)   2.6 %(3)   3.1 %(3)

Babies

   2.0 %   4.8 %   5.7 %

 

(1)

Fiscal 2007 measures the variances between the 52 weeks ended February 2, 2008 and the 52 weeks ended February 3, 2007. Fiscal 2006 measures the variances between the 53 weeks ended February 3, 2007 and the 53 weeks ended February 4, 2006.

(2)

Includes wholly-owned operations. Toys-Japan is considered a wholly-owned operation beginning fiscal 2006. Excluding a 2.9 percentage point impact of Toys-Japan, the increase in comparable store net sales for our International segment would have been 5.6% for fiscal 2007.

(3)

Includes wholly-owned operations except Toys-Japan, which was consolidated beginning in fiscal 2006.

Percentage of Net Sales by Product Category

 

     Fiscal Years Ended  
     February 2,
2008
    February 3,
2007
    January 28,
2006
 

Juvenile

   31.6 %   30.9 %   30.0 %

Learning

   20.3 %   21.1 %   21.2 %

Entertainment

   17.4 %   16.1 %   15.9 %

Core Toy

   16.6 %   17.2 %   17.9 %

Seasonal

   12.9 %   13.5 %   13.8 %

Other(1)

   1.2 %   1.2 %   1.2 %
                  

Total

   100.0 %   100.0 %   100.0 %
                  

 

(1)

Consists primarily of shipping revenues related to our Internet-based sales for Toys-U.S. and non-product related other revenues.

Store Count by Segment

 

     Segment Store Count
     February 2,
2008
   Fiscal 2007     February 3,
2007
   Fiscal 2006     January 28,
2006
        Opened    Closed        Opened    Closed    

Toys - U.S

   585    3    (4 )   586    —      (85 )   671

International(1)

   715    46    (9 )   678    47    (10 )   641

Babies

   260    9    —       251    22    (1 )   230
                                    

Total

   1,560    58    (13 )   1,515    69    (96 )   1,542
                                    

 

(1)

At the end of fiscals 2007, 2006 and 2005, we licensed and franchised 211, 190, and 336 stores, respectively. As of January 28, 2006, 163 of these stores related to Toys-Japan, which is considered wholly-owned beginning in fiscal 2006. The financial impact of income from our licensed and franchised stores is not material to our consolidated results of operations.

 

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Table of Contents

Fiscal 2007 Compared to Fiscal 2006

Net Earnings

 

     Net Earnings

(In millions)

   Fiscal
2007
   Fiscal
2006
   Change

Toys “R” Us Consolidated

   $ 153    $ 109    $ 44

We generated Net earnings of $153 million in fiscal 2007 compared to $109 million in fiscal 2006. Net earnings increased primarily due to an improvement in Gross margin of $395 million, a decrease in Interest expense of $34 million and a decrease in Depreciation and amortization of $15 million, partially offset by an increase in SG&A of $298 million, a decrease in Net gains on sales of properties of $77 million, and an increase in Income tax expense of $30 million. Each of these changes includes the effect of foreign currency translation, which in total accounted for approximately $19 million of the increase in Net earnings.

Net Sales

 

     Net Sales  
                          Percentage of Net sales  

($ in millions)

   Fiscal
2007
   Fiscal
2006
   $ Change    % Change     Fiscal
2007
    Fiscal
2006
 

Toys - U.S.

   $ 5,955    $ 5,894    $ 61    1.0 %   43.2 %   45.2 %

International

     5,344      4,780      564    11.8 %   38.7 %   36.6 %

Babies

     2,495      2,376      119    5.0 %   18.1 %   18.2 %
                                       

Total Net sales

   $ 13,794    $ 13,050    $ 744    5.7 %   100.0 %   100.0 %
                                       

Net sales increased by $744 million, or 5.7%, to $13,794 million in fiscal 2007 from $13,050 million in fiscal 2006. Foreign currency translation accounted for approximately $329 million of the increase.

The increase in Net sales for fiscal 2007, excluding foreign currency translation, was primarily the result of Net sales increases due to new stores, improved comparable store net sales at all our segments, and increases in our Internet-based Net sales. Partially offsetting these increases were decreases due to the closing of 85 stores in our Toys – U.S. segment in fiscal 2006. Additionally, our reporting period for fiscal 2007 included 52 weeks compared to 53 weeks for fiscal 2006, which caused a decrease in Net sales of approximately $152 million in fiscal 2007 compared to fiscal 2006.

Toys – U.S.

Net sales for the Toys – U.S. segment increased by $61 million, or 1.0%, to $5,955 million for fiscal 2007 compared to $5,894 million for fiscal 2006. The increase in Net sales was primarily a result of increases in comparable store net sales and Internet-based Net sales. These increases were partially offset by decreased Net sales as a result of the closing of 85 stores in fiscal 2006. Additionally, our reporting period for fiscal 2007 included 52 weeks compared to 53 weeks for fiscal 2006, which caused a decrease in Net sales of approximately $57 million in fiscal 2007 compared to fiscal 2006.

The comparable store net sales increase in fiscal 2007 was primarily a result of an increase in our entertainment category as a result of strong demand for video game hardware and software, including the Nintendo Wii and Nintendo DS video game systems and related accessories. These increases were partially offset by lower sales in our learning and core toy categories, primarily due to a decline in sales of older product lines.

International

Net sales for the International segment increased by $564 million, or 11.8%, to $5,344 million for fiscal 2007, compared to $4,780 million for fiscal 2006. Excluding a $329 million increase in Net sales due to foreign currency translation, Net sales of our International segment increased primarily due to new store openings and an increase in comparable store net sales. Additionally, our reporting period for fiscal 2007 included 52 weeks compared to 53 weeks for fiscal 2006, which caused a decrease in Net sales of approximately $49 million in fiscal 2007 compared to fiscal 2006.

 

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The comparable store net sales increase in fiscal 2007 was primarily impacted by increases in our entertainment, juvenile and core toys categories. The entertainment category increased primarily due to continued strong demand for the Nintendo Wii, Nintendo DS and Sony PlayStation 3 video game systems and related accessories. The increase in the infant care category was primarily due to increased demand for furniture, bedding and consumables. The core toys category increased primarily due to higher sales of licensed action figures. These increases were partially offset by decreases in our seasonal category primarily due to decreased demand for outdoor products and bicycles.

Babies

Net sales for the Babies segment increased by $119 million, or 5.0%, to $2,495 million for fiscal 2007 compared to $2,376 million for fiscal 2006. The increase was primarily a result of Net sales from new store openings, as well as an increase in comparable store net sales. Additionally, our reporting period for fiscal 2007 included 52 weeks compared to 53 weeks for fiscal 2006, which caused a decrease in Net sales of approximately $46 million in fiscal 2007 compared to fiscal 2006.

The comparable store net sales increase in fiscal 2007 was primarily a result of increases in our commodities and infant care categories. The commodities category was positively impacted by continued strong demand for value-package products, baby foods and other new products. The infant care category increased primarily due to strong demand for safety products, monitors and infant feeding products. Increases in these categories were partially offset by lower sales in the furniture category.

Cost of Sales and Gross Margin

We record the costs associated with operating our distribution networks as a part of 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 margins of other retailers that include similar costs in their cost of sales.

The following costs are included in Cost of sales:

 

   

merchandise acquired from vendors;

 

   

freight in;

 

   

markdowns;

 

   

provision for excess and obsolete inventory;

 

   

shipping costs;

 

   

provision for inventory shortages; and

 

   

credits and allowances from our merchandise vendors.

 

     Gross Margin  
                    Percentage of Net sales  

($ in millions)

   Fiscal
2007
   Fiscal
2006
   $ Change    Fiscal
2007
    Fiscal
2006
    % Change  

Toys - U.S.

   $ 1,912    $ 1,829    $ 83    32.1 %   31.0 %   1.1 %

International

     1,905      1,645      260    35.6 %   34.4 %   1.2 %

Babies

     990      938      52    39.7 %   39.4 %   0.3 %
                                       

Total Gross margin

   $ 4,807    $ 4,412    $ 395    34.8 %   33.8 %   1.0 %
                                       

Consolidated Gross margin increased by $395 million to $4,807 million in fiscal 2007 from $4,412 million in fiscal 2006. Gross margin as a percentage of Net sales increased by 1.0 percentage point in fiscal 2007 compared to fiscal 2006. Our fiscal 2007 included 52 weeks compared to 53 weeks in fiscal 2006, which caused a decrease in Gross margin of approximately $53 million in fiscal 2007 from fiscal 2006. Foreign currency translation accounted for approximately $122 million of the increase.

Gross margin as a percentage of Net sales was positively impacted by improvements in initial markup at all of our segments and decreased markdowns at our International segment, partially offset by increased markdowns at our Toys – U.S. and Babies segments. Markup is the difference between an item’s cost and its retail price (expressed as a percentage of its retail price). Factors that affect markup include vendor offerings and negotiations, vendor income, sourcing strategies, market forces like the cost of raw materials and freight, and competitive influences. Markdowns are the reduction in the original or previous price of retail merchandise. Factors that affect markdowns include inventory management and competitive influences. The definition and method of calculating markup, markdowns, and gross margin varies across the retail industry.

 

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Toys – U.S.

Gross margin increased by $83 million to $1,912 million in fiscal 2007 compared to $1,829 million in fiscal 2006. Gross margin as a percentage of Net sales in fiscal 2007 increased by 1.1 percentage points compared to fiscal 2006. The increase in Gross margin as a percentage of Net sales was primarily due to improved initial markup, which contributed a 1.2 percentage point increase, partially offset by increased markdowns, which contributed a 0.1 percentage point decrease.

The improved initial markup was primarily a result of increased sales of private label products. The increase in markdown costs was the result of planned increases in promotional events.

International

Gross margin increased by $260 million to $1,905 million in fiscal 2007 compared to $1,645 million in fiscal 2006. Gross margin as a percentage of Net sales in fiscal 2007 increased 1.2 percentage points compared to fiscal 2006. The increase in Gross margin as a percentage of Net sales was primarily due to improved initial markup and decreased markdowns, each of which contributed 0.6 percentage point increases. Foreign currency translation accounted for approximately $122 million of the increase.

The improved initial markup was primarily due to favorable changes in our sales mix toward higher margin products such as juvenile furniture and apparel in our infant care category and licensed products in our core toy category. Additionally, our change in accounting method for valuing merchandise inventories of our international wholly-owned subsidiaries from the retail inventory method to the weighted average cost method (see Note 6 to the Consolidated Financial Statements entitled “CHANGE IN ACCOUNTING PRINCIPLE”) contributed an approximate $13 million increase to our Gross margin for fiscal 2007.

Babies

Gross margin increased by $52 million to $990 million in fiscal 2007 compared to $938 million in fiscal 2006. Gross margin as a percentage of Net sales in fiscal 2007 increased by 0.3 percentage points compared to fiscal 2006. The increase in Gross margin as a percentage of Net sales was primarily due to improved initial markup, which contributed a 1.0 percentage point increase, partially offset by increased markdowns, which contributed a 0.7 percentage point decrease.

The improved initial markup was primarily a result of a favorable change in our sales mix toward higher margin products in the infant care, bedding and baby gear categories. This increase in initial markup was partially offset by additional markdowns to keep inventory current, as well as markdowns resulting from planned increases in promotional events.

Selling, General and Administrative Expenses (“SG&A”)

The following are the types of costs and income included in SG&A:

 

   

Store payroll and related payroll benefits;

 

   

Rent and other store operating expenses;

 

   

Advertising expenses;

 

   

Costs associated with operating our distribution network, including costs related to moving merchandise from distribution centers to stores;

 

   

Impairment losses on long-lived assets;

 

   

Other corporate-related expenses; and

 

   

Other income.

 

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     SG&A  

($ in millions)

   Fiscal
2007
   Percentage
of Net sales
    Fiscal
2006
   Percentage
of Net sales
 

Toys “R” Us - Consolidated

   $ 3,748    27.2 %   $ 3,450    26.4 %

SG&A expenses increased $298 million to $3,748 million in fiscal 2007 compared to $3,450 million in fiscal 2006. As a percentage of net sales, SG&A expenses increased 0.8 percentage points. Foreign currency translation accounted for approximately $89 million of the increase.

In addition to the impact of foreign currency translation, the increase in SG&A expenses was primarily due to increases in store occupancy, payroll-related and advertising expenses. Store occupancy and payroll-related expenses increased primarily due to new store openings at our International and Babies segments, increased costs to improve store layouts at our Toys – U.S. segment, and higher store staffing expenditures to support increased sales and training initiatives throughout all of our segments. Advertising expenses increased due to increased print advertising and promotional activities at all of our segments.

Depreciation and Amortization

 

     Depreciation and Amortization  

(In millions)

   Fiscal
2007
   Fiscal
2006
   Change  

Toys “R” Us - Consolidated

   $ 394    $ 409    $ (15 )

Depreciation and amortization decreased by $15 million to $394 million in fiscal 2007 compared to $409 million in fiscal 2006. The decrease was primarily attributed to $24 million of accelerated depreciation related to the fiscal 2005 restructuring initiative recorded in the first quarter of fiscal 2006. The decrease was partially offset by higher depreciation expense at Babies and International due to new store openings and an approximate $6 million effect related to foreign currency translation.

Net Gains on Sales of Properties

 

     Net Gains on Sales of Properties

(In millions)

   Fiscal
2007
    Fiscal
2006
    Change

Toys “R” Us - Consolidated

   $ (33 )   $ (110 )   $ 77

Net gains on sales of properties decreased by $77 million to $33 million in fiscal 2007 compared to $110 million in fiscal 2006. The decrease was primarily due to the net gain in fiscal 2006 of $91 million related to the sales of 38 stores primarily to an affiliate of one of our Sponsors, Vornado Surplus 2006 Realty LLC.

Refer to Note 5 to our Consolidated Financial Statements entitled “PROPERTY AND EQUIPMENT” for a description of our net gains on sales of properties.

Restructuring and Other Charges

 

     Restructuring and Other Charges  

(In millions)

   Fiscal
2007
   Fiscal
2006
   Change  

Toys “R” Us - Consolidated

   $ 2    $ 14    $ (12 )

Restructuring and other charges decreased by $12 million to $2 million in fiscal 2007 compared to $14 million in fiscal 2006.

During fiscal year 2007 we recorded $2 million of net charges which were from prior years’ initiatives and are primarily due to changes in management’s estimates for events such as lease terminations, assignments and sublease income adjustments.

For fiscal 2006, we incurred $12 million of net charges related to our 2005 initiatives. The remaining $2 million of net charges related to 2004 and earlier initiatives.

Refer to Note 2 to our Consolidated Financial Statements entitled “RESTRUCTURING AND OTHER CHARGES” for a description of our different restructuring initiatives.

 

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Table of Contents

Interest Expense

 

     Interest Expense  

(In millions)

   Fiscal
2007
   Fiscal
2006
   Change  

Toys “R” Us - Consolidated

   $ 503    $ 537    $ (34 )

Interest expense decreased by $34 million for fiscal 2007 compared to fiscal 2006. The decrease in Interest expense was primarily due to reduced average borrowings outstanding under our revolving credit facilities and reduced amortization of deferred financing costs in fiscal 2007, which decreased Interest expense by approximately $69 million. These decreases were partially offset by charges related to changes in the fair values of our derivatives which do not qualify for hedge accounting, which increased Interest expense by approximately $35 million for fiscal 2007 compared to fiscal 2006. Additionally, the overall decrease was partially offset by the effect of foreign currency translation, which in total caused an increase of approximately $8 million.

Interest income

 

     Interest Income  

(In millions)

   Fiscal
2007
   Fiscal
2006
   Change  

Toys “R” Us - Consolidated

   $ 27    $ 31    $ (4 )

Interest income decreased by $4 million for fiscal 2007 compared to fiscal 2006 primarily due to more efficient global cash management.

Income Tax Expense

 

     Income Tax Expense  

(In millions)

   Fiscal
2007
    Fiscal
2006
    Change  

Toys “R” Us - Consolidated

   $ 65     $ 35     $ 30  

Consolidated effective tax rate

     29.5 %     24.5 %     5.0 %

The increase in income tax expense of $30 million reflects a combination of factors. The primary reason for the increase in income tax expense is the increase in pre-tax earnings, adjustments to the current and deferred tax accounts, net changes in valuation allowance and an increase in liabilities for unrecognized tax benefits.

Fiscal 2006 Compared to Fiscal 2005

Net Earnings (Loss)

 

     Net Earnings (Loss)

(In millions)

   Fiscal
2006
   Fiscal
2005
    Change

Toys “R” Us Consolidated

   $ 109    $ (384 )   $ 493

We generated Net earnings of $109 million in fiscal 2006 compared to a Net loss of $384 million in fiscal 2005. The consolidation of Toys-Japan had no impact on net earnings, but did affect amounts classified in the Consolidated Statement of Operations. Excluding the impact of Toys-Japan on amounts classified in the Consolidated Statement of Operations, Net earnings increased primarily due to the absence of Transaction and related costs of $410 million incurred in connection with the Merger Transaction in fiscal 2005 (described in Note 13 to our Consolidated Financial Statements entitled “MERGER TRANSACTION”), an improvement in Gross margin of $268 million, and an increase in Net gains of $113 million related to the sales of properties in fiscal 2006. The increase in Net earnings was partially offset by a decrease in Income tax benefit of $164 million, and an increase in Interest expense of $138 million as a result of a full year of interest expense on the increased borrowings related to the Merger Transaction in fiscal 2005. Our increase in SG&A expenses of $61 million was partially offset by reduced Depreciation and amortization of $30 million due to the retirement of assets related to the fiscal 2005 restructuring initiatives and the absence of the loss on early extinguishment of debt and Contract settlement fee expense of $22 million.

 

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Net Sales

 

     Net Sales  
                           Percentage of Net sales  

($ in millions)

   Fiscal
2006
   Fiscal
2005
   $ Change     % Change     Fiscal
2006
    Fiscal
2005
 

Toys - U.S.

   $ 5,894    $ 6,431    $ (537 )   (8.4 )%   45.2 %   56.8 %

International

     4,780      2,815      1,965     69.8 %   36.6 %   24.8 %

Babies

     2,376      2,087      289     13.8 %   18.2 %   18.4 %
                                        

Total Net sales

   $ 13,050    $ 11,333    $ 1,717     15.2 %   100.0 %   100.0 %
                                        

Consolidated net sales increased by $1,717 million, or 15.2%, to $13,050 million in fiscal 2006 from $11,333 million in fiscal 2005. Net sales increased by $1,650 million, or 14.6%, in fiscal 2006 due to the consolidation of Toys-Japan, and increased by $147 million in fiscal 2006 due to the changes in foreign currency translation in International. Our reporting period for fiscal 2006 included 53 weeks compared to 52 weeks for fiscal 2005, which also added incremental Net sales of approximately $134 million, net of Toys-Japan. Excluding these increases, our Net sales decreased primarily due to the closing of 85 stores in our Toys-U.S. segment in fiscal 2006. The decrease in our Toys-U.S. segment was partially offset by increased Net sales from new stores at our International and Babies segments and favorable comparable store Net sale increases at all segments. Net sales in our International and Babies segments were positively impacted by the addition of 22 Babies stores, and the opening of 26 wholly-owned International stores in fiscal 2006.

Toys – U.S.

Net sales for the Toys – U.S. segment decreased by $537 million, or 8.4%, to $5,894 million in fiscal 2006 compared to $6,431 million in fiscal 2005. The decrease in Net sales was primarily driven by the closing of 85 toy stores in the United States in fiscal 2006, and decreases in Internet-based net sales. The decrease in Net sales was partially offset by the comparable store net sales increase in fiscal 2006 compared to fiscal 2005. Our fiscal 2006 included 53 weeks compared to 52 weeks for fiscal 2005, which also added incremental sales of approximately $57 million.

Comparable store net sales in fiscal 2006 were primarily impacted by increases in the learning, seasonal and core toy categories. The increases in the learning categories were driven by a strong back to school season and strong preschool and infant toy sales. The increases in outdoor seasonal categories were primarily driven by swing sets. The increases in the core toy categories were driven by items associated with new movie releases and die-cast toys. These results were partially offset by lower sales of our apparel, juvenile, and entertainment. The decline in apparel sales was the result of reduced advertising and the elimination of larger size ranges and accompanying accessories. The decline in juvenile sales was attributable to declines in furniture and infant care categories. Entertainment’s overall performance was impacted by softness in electronics and lower video game sales in the first half of the year caused by the anticipation of new video launches, partially offset by the strong performance in the next generation of video hardware launches.

International

Net sales for the International segment increased by $1,965 million, or 69.8%, to $4,780 million in fiscal 2006 compared to $2,815 million in fiscal 2005. Net sales of International increased by $1,650 million, or 58.6%, in fiscal 2006 due to the consolidation of Toys-Japan, and increased by $147 million, or 5.2%, in fiscal 2006 due to the changes in foreign currency translation. Excluding the impact of Toys-Japan and changes in foreign currency translation, the increase in Net sales was primarily driven by the comparable store net sales increase, new stores opened in fiscal 2006, and a full year of sales at new stores added in fiscal 2005. Our reporting period for fiscal 2006 included 53 weeks compared to 52 weeks for fiscal 2005, which also added incremental sales of approximately $31 million, net of Toys-Japan.

Comparable store net sales in fiscal 2006 were primarily impacted by increases in infant care products, learning and electronics categories. The increase in infant care categories was primarily due to increases in car-related products and growth in strollers, furniture, and home décor. The increase in learning categories was primarily due to increases in educational electronics products and games. Electronics increased due to strong sales of video game hardware and software related to the next generation of video hardware launches.

 

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Babies

Net sales for the Babies segment increased by $289 million, or 13.8%, to $2,376 million in fiscal 2006 compared to $2,087 million in fiscal 2005. The increase in Net sales was primarily driven by a full year of sales at new stores added in fiscal 2005, new stores opened in fiscal 2006, and comparable store net sales increases. Our fiscal 2006 included 53 weeks compared to 52 weeks for fiscal 2005, which also added incremental sales of approximately $46 million.

Comparable store net sales in fiscal 2006 were primarily impacted by an increase in commodities categories, as well as increases in infant care products, bedding products, apparel, and baby gear products. New value packaging as well as strong sales in organic foods drove the commodities’ increase. The increase in infant care products was due to sales of higher price point items. Updated assortments in bedding products drove strong sales trends during the year. The increase in apparel sales was primarily due to increased color, size and style assortments, as well as expanded private label offerings. The increase in baby gear products was the result of updated assortments in Babies’ exclusive travel systems and coordinated travel collections.

Cost of Sales and Gross Margin

 

     Gross Margin  
                     Percentage of Net sales  

($ in millions)

   Fiscal
2006
   Fiscal
2005
   $ Change     Fiscal
2006
    Fiscal
2005
    % Change  

Toys - U.S.

   $ 1,829    $ 1,833    $ (4 )   31.0 %   28.5 %   2.5 %

International

     1,645      1,048      597     34.4 %   37.2 %   -2.8 %

Babies

     938      800      138     39.4 %   38.3 %   1.1 %
                                        

Total Gross margin

   $ 4,412    $ 3,681    $ 731     33.8 %   32.5 %   1.3 %
                                        

Consolidated Gross margin increased by $731 million to $4,412 million in fiscal 2006, from $3,681 million in fiscal 2005. Gross margin as a percentage of Net sales increased by 1.3 percentage points in fiscal 2006, compared to fiscal 2005. Gross margin increased by $463 million due to the consolidation of Toys-Japan in fiscal 2006, which decreased Gross margin as a percentage of Net sales by 0.8 percentage points for fiscal 2006, compared to fiscal 2005. Our fiscal 2006 included 53 weeks compared to 52 weeks in fiscal 2005, which added incremental Gross margin of approximately $50 million in fiscal 2006, net of Toys-Japan.

Excluding the impact of consolidation of Toys-Japan, the increase in Gross margin as a percentage of Net sales was primarily due to a 0.9 percentage point decrease in markdowns and a 1.3 percentage point increase in initial markups. Markdown costs decreased primarily due to a high level of clearance activity in fiscal 2005 that was not required in fiscal 2006. The increase in initial markup was primarily due to strong sales of higher margin infant care, learning and core toy products in International, increased sales of higher margin items such as apparel, bedding and infant care product in Babies, and improved margins in core toy categories, and infant toys and juvenile products in Toys-U.S.

Toys – U.S.

Gross margin decreased by $4 million to $1,829 million in fiscal 2006, compared to $1,833 million in fiscal 2005. Gross margin as a percentage of Net sales in fiscal 2006 increased 2.5 percentage points compared to fiscal 2005. The increase in gross margin as a percentage of net sales was primarily due to a 1.9 percentage point decrease in markdown costs and a 0.6 percentage point increase in initial markup.

Markdown costs decreased primarily due to a high level of clearance activity and restructuring in fiscal 2005 that was not repeated in fiscal 2006. The increase in initial markup was driven by improved margins in several core toy categories, preschool toys and infant toys. Video platforms, accessories and software all had improved margins resulting from improved availability of more established systems and established software titles. The juvenile categories also improved, driven by private label products.

International

Gross margin increased by $597 million to $1,645 million in fiscal 2006, compared to $1,048 million in fiscal 2005. Gross margin as a percentage of Net sales in fiscal 2006 decreased 2.8 percentage points, compared to fiscal 2005. Gross margin included $463 million due to the consolidation of Toys-Japan in fiscal 2006, which decreased Gross margin as a percentage of Net sales by 3.3 percentage points in fiscal 2006 compared to fiscal 2005.

 

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Excluding the impact of consolidation of Toys-Japan, the increase in gross margin was primarily due to an increase in initial markup, which contributed a 0.7 percentage point increase. The increase in initial markup was due to strong sales of higher margin infant care and learning products, improvements in the merchandise mix, margin growth in the juvenile categories and competitive pricing initiatives.

Babies

Gross margin increased by $138 million to $938 million in fiscal 2006, compared to $800 million in fiscal 2005. Gross margin as a percentage of Net sales in fiscal 2006 increased 1.1 percentage points compared to fiscal 2005. The increase in Gross margin as a percentage of Net sales was primarily due to a 1.2 percentage point improvement in initial markup and was partially offset by an increase in markdowns of 0.1 percentage points.

The increase in initial markup was primarily driven by sales of higher margin products in apparel, bedding and infant care categories. Markdown costs increased slightly primarily due to various promotional and clearance programs.

SG&A

 

     SG&A  

($ in millions)

   Fiscal
2006
   Percentage
of Net sales
    Fiscal
2005
   Percentage
of Net sales
 

Toys “R” Us - Consolidated

   $ 3,450    26.4 %   $ 2,955    26.1 %

SG&A expenses increased $495 million to $3,450 million in fiscal 2006 compared to $2,955 million in fiscal 2005. As a percentage of Net sales, SG&A expenses increased 0.3 percentage points. SG&A expenses included $436 million in fiscal 2006 due to the consolidation of Toys-Japan, which did not affect SG&A expenses as a percentage of net sales for fiscal 2006, compared to fiscal 2005. Our fiscal 2006 included 53 weeks compared to 52 weeks in fiscal 2005, which also added estimated incremental SG&A expenses of approximately $25 million.

Excluding the impact of the consolidation of Toys-Japan, the increase in SG&A expenses in fiscal 2006 compared to fiscal 2005 was primarily due to increases at International and Babies due to higher compensation costs of $48 million, store occupancy expenses of $57 million, and increases at our corporate headquarters due to higher professional fees of $17 million and higher severance expense of $17 million. Partially offsetting these increases were decreases in Toys – U.S. due to lower compensation costs of $46 million, store occupancy costs of $68 million, and lower selling costs of $31 million which was primarily due to a reduction in fees after terminating our agreement with Amazon.com.

Depreciation and Amortization

 

     Depreciation and Amortization

(In millions)

   Fiscal
2006
   Fiscal
2005
   Change

Toys “R” Us - Consolidated

   $ 409    $ 400    $ 9

Depreciation and amortization increased by $9 million to $409 million in fiscal 2006 compared to $400 million in fiscal 2005. The increase was primarily attributed to the inclusion of $39 million of depreciation and amortization from the consolidation of Toys-Japan. This increase was partially offset by a decrease of $21 million related to the locations identified in the fiscal 2005 restructuring initiative and other restructured properties, which were classified as held for sale and sold during fiscal 2006.

Net (Gains) Losses on Sales of Properties

 

     Net (Gains) Losses on Sales of Properties  

(In millions)

   Fiscal
2006
    Fiscal
2005
   Change  

Toys “R” Us - Consolidated

   $ (110 )   $ 3    $ (113 )

Net (gains) losses on sales of properties increased by $113 million to a net gain of $110 million in fiscal 2006 compared to a net loss of $3 million in fiscal 2005. The increase was primarily due to the net gain of $91 million related to the sales of 38 stores, primarily to Vornado Surplus 2006 Realty LLC, which is an affiliate of one of our Sponsors, and a net gain of $21 million related to the sale of one property in the United Kingdom in fiscal 2006.

 

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Table of Contents

Restructuring and Other Charges

 

     Restructuring and Other Charges  

(In millions)

   Fiscal
2006
   Fiscal
2005
   Change  

Toys “R” Us - Consolidated

   $ 14    $ 33    $ (19 )

Restructuring and other charges decreased by $19 million to $14 million in fiscal 2006 compared to $33 million in fiscal 2005. For fiscal 2006, we incurred $12 million of net charges related to our 2005 initiatives. The 2005 restructuring initiative charges consisted of $10 million for lease commitments and $6 million of asset impairment and disposal charges. These charges were partially offset by the reversal of $3 million of lease commitments on properties sold and $1 million of severance charges that we determined were no longer needed. The remaining net charges related to 2004 and earlier initiatives.

For the fiscal year ended January 28, 2006, we incurred $31 million net charges under our 2005 initiatives consisting of $22 million related to asset impairment, $1 million related to lease commitments and $8 million related to severance costs. The remaining net charges related to 2004 and earlier initiatives.

Refer to Note 2 to our Consolidated Financial Statements entitled “RESTRUCTURING AND OTHER CHARGES” for a description of our different restructuring initiatives.

Transaction and Related Costs

 

     Transaction and Related Costs  

(In millions)

   Fiscal
2006
   Fiscal
2005
   Change  

Toys “R” Us - Consolidated

   $ —      $ 410    $ (410 )

In connection with the Merger Transaction, we recorded expenses of $410 million in fiscal 2005. These expenses related to the transaction costs of $148 million, compensation expenses related to stock options and restricted stock of $222 million, as well as payments of severance, bonuses and related payroll taxes of $40 million. We did not have any expenses related to the Merger Transaction in fiscal 2006.

Contract Settlement Fees and Other

 

     Contract Settlement Fees and Other  

(In millions)

   Fiscal
2006
   Fiscal
2005
   Change  

Toys “R” Us - Consolidated

   $ —      $ 22    $ (22 )

Contract settlement fees and other was $22 million in fiscal 2005. This amount reflected the loss on early extinguishment of debt of $7 million related to the purchase of the notes associated with the equity security units and a contract settlement fee of $15 million related to the early termination of our synthetic lease for our Global Store Support Center in Wayne, New Jersey. We did not incur similar expenses in fiscal 2006.

 

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Table of Contents

Interest Expense

 

     Interest Expense

(In millions)

   Fiscal
2006
   Fiscal
2005
   Change

Toys “R” Us - Consolidated

   $ 537    $ 394    $ 143

Interest expense increased by $143 million to $537 million in fiscal 2006 compared to $394 million in fiscal 2005. The increase in Interest expense was primarily due to our significant increase in total outstanding debt, which was incurred as a result of our Merger transaction in July 2005. During fiscal 2006, we incurred 53 weeks of Interest expense as compared to 27 weeks of interest expense in fiscal 2005 on our higher debt balances, which increased Interest expense by $210 million. This increase was primarily offset by the reduction of deferred financing fee write-offs in fiscal 2005 of $59 million and the retirement of debt, which reduced Interest expense by $16 million.

Interest Income

 

     Interest Income

(In millions)

   Fiscal
2006
   Fiscal
2005
   Change

Toys “R” Us - Consolidated

   $ 31    $ 31    $ —  

Interest income remained constant at $31 million in fiscal 2006 and in fiscal 2005 due to a $6 million increase related to the consolidation of Toys-Japan, offset by a net decrease of approximately $6 million due to lower average cash balances maintained. Our cash balances earned slightly higher average interest rates during fiscal 2006.

Income Tax Expense (Benefit)

 

     Income Tax Expense (Benefit)  

(In millions)

   Fiscal
2006
    Fiscal
2005
    Change  

Toys “R” Us - Consolidated

   $ 35     $ (121 )   $ 156  

Consolidated effective tax rate

     24.5 %     24.0 %     0.5 %

The increase in Income tax expense of $156 million reflects a combination of factors. The primary reason for the increase in Income tax expense is the increase in pre-tax earnings. We also had a $41 million increase in valuation allowance related to U.S. Federal tax credits, a $19 million increase related to tax reserves for certain contingencies, and an $84 million decrease in valuation allowance related to foreign tax loss carry-forwards and other deferred tax assets.

LIQUIDITY AND CAPITAL RESOURCES

At February 2, 2008, we had no outstanding borrowings and a total of $110 million of outstanding letters of credit under our $2.0 billion secured revolving credit facility which expires in fiscal 2010. We had availability of $1.0 billion under the facility at fiscal year-end. In addition, we had no outstanding borrowings and we had availability of $401 million at fiscal year end under our multi-currency revolving credit facility (£95 million and €145 million) which expire in fiscal 2010.

Toys – Japan maintained loans under unsecured credit facilities with various financial institutions. These unsecured credit facilities consisted of approximately ¥47 billion ($439 million at February 2, 2008) in uncommitted lines of credit. We had a balance outstanding of $137 million and availability of $302 million under these facilities at February 2, 2008.

On March 31, 2008, Toys – Japan entered into an agreement with a syndicate of financial institutions, which established two unsecured loan commitment lines of credit (“Tranche 1” and “Tranche 2”) and an overdraft facility of ¥4 billion ($40 million at March 31, 2008). Under the agreement, Tranche 1 is available in amounts of up to ¥20 billion ($201 million at March 31, 2008), which expires in fiscal 2011. Tranche 2 is available in amounts of up to ¥15 billion ($151 million at March 31, 2008), which expires in fiscal 2009. At February 2, 2008, we have classified the outstanding balance of $137 million as long-term debt, as we have refinanced these borrowings subsequent to February 2, 2008 under Tranche 1, which expires in fiscal 2011.

In general, our primary uses of cash are providing for working capital, which principally represents the purchase of inventory, servicing debt, financing construction of new stores, remodeling existing stores, and paying expenses to operate our stores. We will consider additional sources of financing to fund our long-term growth. Our working capital needs follow a seasonal pattern, peaking in the third quarter of the year when inventory is purchased for the holiday selling season. Our largest source of operating cash flows is cash collections from our customers. We have been able to meet our cash needs principally by using cash on hand, cash flows from operations and our revolving credit facilities.

 

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We believe that cash generated from operations, along with our existing cash and revolving credit facilities, will be sufficient to fund our expected cash flow requirements including our holiday season inventory buildup and planned capital expenditures for at least the next 12 months. Our projected obligations for fiscal 2008 and beyond are set forth below under “Contractual Obligations.”

Cash Flows

 

(In millions)

   Fiscal
2007
    Fiscal
2006
    Fiscal
2005
 

Net cash provided by operating activities

   $ 527     $ 411     $ 671  

Net cash (used in) provided by investing activities

     (416 )     (107 )     573  

Net cash used in financing activities

     (152 )     (566 )     (1,488 )

Effect of exchange rate changes on cash and cash equivalents

     27       46       (7 )
                        

Net decrease during period in cash and cash equivalents

   $ (14 )   $ (216 )   $ (251 )
                        

Cash Flows Provided by Operating Activities

Net cash provided by operating activities for fiscal 2007 was $527 million, an increase of $116 million compared to fiscal 2006. The increase in cash provided by operating activities was primarily the result of changes in accounts payable due to extended payment terms with our vendors, lower interest payments resulting from lower average debt balances, and increased gross margins from operations. The increase was partially offset by increased spending on merchandise inventories to support additional square footage and comparable-store sales growth.

Net cash provided by operating activities for fiscal 2006 was $411 million, a decrease of $260 million compared to fiscal 2005. The decrease in cash provided by operating activities was primarily the result of the significant reduction in fiscal 2005 of working capital as a result of inventory management improvements, increased cash used for operating expenses and increased interest payments on higher average debt balances in fiscal 2006. These increases in cash used were partially offset by increased gross margins from our operations, the absence of $410 million transaction costs related to the Merger Transaction, and $22 million of contract settlement fees related to the purchase of our Wayne, N.J. headquarters facilities in fiscal 2005. The above changes in our net cash provided by operating activities in fiscal 2006 included $65 million of cash provided due to the consolidation of Toys-Japan in fiscal 2006.

Cash Flows (Used in) Provided by Investing Activities

Net cash used in investing activities for fiscal 2007 was $416 million, an increase of $309 million compared to fiscal 2006. The increase in net cash used in investing activities was primarily due to a $158 million decrease in cash inflows from the sale of fixed assets, the purchase of $168 million of short-term investments, and a $41 million increase in capital expenditures. The increase in net cash used in investing activities was partially offset by a $58 million increase in cash flows resulting from a $17 million release of previously restricted cash in fiscal 2007 compared to a $41 million increase in restricted cash related to property financings in fiscal 2006.

Our capital expenditures are primarily for financing construction of new stores and remodeling existing stores. In addition, our capital expenditures include costs to improve and enhance our information technology systems. For fiscal 2008, we plan to continue to increase our capital spend as we focus on future store improvement and growth in all our segments.

Net cash used in investing activities for fiscal 2006 was $107 million, a decrease of $680 million compared to cash provided by investing activities in fiscal 2005. The change in cash used in investing activities was primarily the result of the absence of cash generated from the sale of $953 million of our short-term investments in fiscal 2005. This was partially offset by a $207 million increase in cash inflows from the sale of fixed assets in fiscal 2006 and an increase in restricted cash, which was $66 million less than the increase in fiscal 2005. Increases in capital expenditures related to store expansions of $112 million in fiscal 2006 were offset by the absence of the $112 million payment to purchase our Wayne, N.J. headquarters facilities in fiscal 2005. The above changes in our net cash used in investing activities in fiscal 2006 included $22 million of cash used due to the consolidation of Toys-Japan.

 

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Cash Flows Used in Financing Activities

Net cash used in financing activities was $152 million for fiscal 2007, a decrease of $414 million from fiscal 2006. The decrease in net cash used in financing activities was primarily due to a $3,020 million decrease in debt repayments, partially offset by a $2,663 million reduction in borrowings. The decrease in gross borrowings and repayments reflects a reduction in refinancing activities compared to fiscal 2006.

Net cash used in financing activities was $566 million for fiscal 2006, a decrease of $922 million from fiscal 2005. The decrease in cash used in financing activities was primarily due to the payment of $6,248 million in fiscal 2005 for the repurchase of Company Common Stock, stock options and restricted stock, and equity security units and warrants and a decrease in capitalized debt issuance costs of $210 million. These decreases in cash used were partially offset by a reduction in borrowings of $3,528 million to $3,801 million, an increase in repayments of borrowings of $608 million to $4,308 million, and the absence of capital contributions by our affiliates of $1,279 million in fiscal 2005 and a reduction of proceeds from the exercise of stock options of $87 million. The above changes in our net cash used in financing activities in fiscal 2006 included $45 million of cash used due to the consolidation of Toys-Japan in fiscal 2006.

Short-term Investments

As of February 2, 2008, we held $168 million of municipal auction-rate securities, which are classified under Current assets as Short-term investments on our Consolidated Balance Sheet. Subsequent to February 2, 2008, we reduced our holdings of auction-rate securities at par value through the normal auction process. As of the date of this filing, the remaining balance of these securities was $24 million, which, subsequent to February 2, 2008, we failed to sell through the normal auction process. All of our auction-rate securities are currently rated AAA, the highest investment grade rating afforded by credit rating agencies. We believe we will be able to liquidate these investments without loss within the next year, and that these securities are not impaired. Refer to our Consolidated Financial Statements for further discussion of our auction-rate securities in Note 7 entitled “SHORT-TERM INVESTMENTS.”

Debt

Our credit facilities and loan agreements contain customary covenants, including, among other things, covenants that restrict our ability to incur certain additional indebtedness, create or permit liens on assets, or engage in mergers or consolidations. Certain of our agreements also contain various and customary events of default with respect to the loans, including, without limitation, the failure to pay interest or principal when the same is due under the agreements, cross default provisions, the failure of representations and warranties contained in the agreements to be true and certain insolvency events. If an event of default occurs and is continuing, the principal amounts outstanding thereunder, together with all accrued unpaid interest and other amounts owed thereunder, may be declared immediately due and payable by the lenders. Were such an event to occur, we would be forced to seek new financing that may not be on as favorable terms as our current facilities. We are currently in compliance with our financial covenants relating to our debt.

 

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During fiscal 2007, we made the following significant changes to our debt structure:

 

   

In connection with our short-term debt, Toys – Japan made net repayments of $36 million, of which a portion related to the consolidation of KK Funding Corporation (“KKFC”), a special purpose entity formed with the limited purpose of borrowing and lending funds to Toys-Japan.

 

   

We borrowed and repaid $879 million under our revolving credit facilities.

 

   

We made net payments of $66 million related primarily to scheduled long-term debt, capital leases and the repayment of long-term debt in connection with the consolidation of KKFC.

 

   

Toys-Delaware repaid $44 million of principal of the $200 million asset sale facility and $4 million of principal of the secured term loan facility due fiscal 2012 with proceeds from the properties sold and from the lease termination agreement consummated during fiscal 2007. At February 2, 2008, the $200 million asset sale facility was fully repaid. Refer to Note 5 to the Condensed Consolidated Financial Statements entitled “PROPERTY AND EQUIPMENT” for additional information on each transaction.

 

   

On July 9, 2007, we notified the lenders for our $800 million secured real estate loan that we were exercising our first maturity date extension option, which extended the maturity date of the loan from August 9, 2007 to August 9, 2008. The other key terms of the loan were not changed as a result of the extension. We have the ability and intent to exercise our two remaining maturity date extension options to August 2009 and August 2010.

Refer to Note 3 to the Consolidated Financial Statements entitled “SHORT-TERM BORROWINGS AND LONG-TERM DEBT” for further details.

Contractual Obligations

Our contractual obligations consist mainly of payments related to long-term debt and related interest, operating leases related to real estate used in the operation of our business and product purchase obligations. The following table summarizes our contractual obligations associated with our long-term debt and other obligations as of February 2, 2008:

 

     Payments Due By Period

(In millions)

   Fiscal
2008
   Fiscals
2009 & 2010
   Fiscals
2011 & 2012
   Fiscals
2013 and
thereafter
   Total

Operating leases

   $ 510    $ 987    $ 862    $ 2,078    $ 4,437

Less: sub-leases to third parties

     22      37      25      35      119
                                  

Net operating lease obligations

     488      950      837      2,043      4,318

Capital lease obligations

     14      13      6      4      37

Short-term borrowings and long-term debt (1)

     36      2,240      1,938      1,623      5,837

FIN 48 liabilities

     62      50      8      4      124

Interest payments (2)

     360      673      374      233      1,640

Purchase obligations (3)

     1,119      60      —        —        1,179

Other (4)

     88      55      19      45      207
                                  

Total contractual obligations

   $ 2,167    $ 4,041    $ 3,182    $ 3,952    $ 13,342
                                  

 

(1)

We have classified our $800 million secured real estate loans due August 9, 2008 and our $1.3 billion unsecured credit agreement due December 9, 2008 as annual maturities of 2010 because we have the ability and intent to extend the due dates to August 9, 2010 and December 7, 2010, respectively. We have also reclassified $137 million due fiscal 2008 as long-term as we have refinanced this amount on March 31, 2008, which extended the due date to fiscal 2011. Refer to Note 3 to the Consolidated Financial Statements entitled "SHORT-TERM BORROWINGS AND LONG-TERM DEBT".

(2)

In an effort to manage interest rate exposure, we have entered into interest rate swaps to achieve an acceptable balance between fixed and variable rate debt. $2.6 billion of debt was effectively subject to fixed interest rates and $3.1 billion of debt was effectively subject to variable interest rates. The interest payments in the table for the $3.1 billion of variable rate debt were based on the indexed interest rates in effect at February 2, 2008.

(3)

Purchase obligations consist primarily of open purchase orders for merchandise as well as an agreement to purchase fixed or minimum quantities of goods that are not included in our Consolidated Balance Sheet as of February 2, 2008.

(4)

Includes website services obligations, minimum royalty obligations, pension obligations, risk management liabilities, and other general obligations.

 

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Obligations under our operating leases and capital leases in the above table do not include contingent rent payments, payments for maintenance and insurance, or taxes. The following table presents these amounts paid for fiscals 2007, 2006 and 2005:

 

(In millions)

   Fiscal
2007
   Fiscal
2006
   Fiscal
2005

Taxes

   $ 60    $ 61    $ 56

Maintenance and insurance

     47      44      42

Contingent rent

     10      9      2
                    

Total

   $ 117    $ 114    $ 100
                    

Off-balance Sheet Arrangements

We have an off-balance sheet arrangement as a result of the credit agreement between Toys Properties and Vanwall Finance PLC (“Vanwall”), a special purpose entity established with the limited purpose of issuing notes, and entering into the credit agreement with Toys Properties. Per the credit agreement, Vanwall is required to maintain an interest rate swap which effectively fixed the variable LIBOR rate at 4.56%, the same as the fixed interest paid by Toys Properties to Vanwall. The fair market value of this interest rate swap at February 2, 2008 was approximately $11 million. Management performed an analysis in accordance with FIN 46(R) and concluded that Vanwall should not be consolidated. Refer to Note 3 entitled “SHORT-TERM BORROWINGS AND LONG-TERM DEBT” for further details.

Credit Ratings

As of February 2, 2008, our current credit ratings, which are considered non-investment grade, were as follows:

 

     Moody’s    Standard and Poor’s

Long-term debt

   B2    B

Outlook

   Stable    Stable

During fiscal 2007, Moody’s confirmed our B2 corporate credit rating and upgraded the outlook to Stable.

During fiscal 2007, Standard and Poor’s upgraded our corporate credit rating from B- with a Stable outlook to B with a Stable outlook.

Other credit ratings for our debt are available; however, we have disclosed only the ratings of the two principal nationally recognized statistical rating organizations.

Our current credit ratings, as well as any adverse future actions taken by the rating agencies with respect to our debt ratings, could (1) negatively impact our ability to finance our operations on satisfactory terms and (2) increase our financing costs. Our debt instruments do not contain provisions requiring acceleration of payment upon a debt rating downgrade.

The rating agencies may, in the future, revise the ratings with respect to our outstanding debt.

CRITICAL ACCOUNTING POLICIES

Our Consolidated Financial Statements have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosures of contingent assets and liabilities as of the date of the Consolidated 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 policy to be critical if it requires assumptions to be made that were uncertain at the time they were made, and if changes in these assumptions could have a material impact on our consolidated financial condition or results of operations.

 

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Merchandise Inventories

We value our merchandise inventories at the lower of cost or market, as determined by the weighted average cost method for our International segment and the retail inventory method for our Toys-U.S. and Babies segments. Cost of sales under the weighted average cost method represents the weighted average cost of the individual items sold; whereas cost of sales under the retail method is calculated using an average margin realized on an entire department of inventory. Cost of sales under both methods is also affected by adjustments to reflect current market conditions, merchandise allowances from vendors, expected inventory shortages and estimated losses from obsolete and slow-moving inventory.

On February 4, 2007, we changed our accounting method for valuing our International subsidiaries’ (excluding Toys-Japan) merchandise inventories from the retail inventory method to the weighted average cost method. This change in accounting principle was a result of implementing a perpetual inventory system in our International locations that allows management to track our inventory costs at a product level. We have accounted for the change in accounting principle prospectively, in accordance with Statement of Financial Accounting Standards (“SFAS”) No.154, “Accounting Changes and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3.” As of February 4, 2007, the cumulative effect of this change in accounting principle was a reduction in merchandise inventory of $13 million, an increase in deferred tax assets of $4 million and a net increase in Stockholders’ deficit of $9 million. Refer to Note 6 to the Consolidated Financial Statements entitled “CHANGE IN ACCOUNTING PRINCIPLE” for further details. Prior to fiscal 2007, Toys – Japan was the only International subsidiary already utilizing a similar perpetual inventory system and following the weighted average cost method. As of February 2, 2008, approximately 38% of total merchandise inventories were valued under the weighted average cost method.

Merchandise inventories for the Toys – U.S. segment, 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 represented approximately 45% of total merchandise inventories, as of February 2, 2008. The excess of replacement or current cost over stated LIFO value is de minimis. All remaining Merchandise inventories for our U.S. segments are stated at the lower of FIFO (first-in, first-out) cost or market value as determined by the retail inventory method. We plan to change our accounting method for valuing merchandise inventories for our U.S. segments from the retail inventory method to the weighted average cost method in fiscal 2008 when our perpetual inventory system is implemented at our U.S. segments. The change in accounting principle for our U.S. segments is not expected to have a material impact on our Consolidated Financial Statements.

We receive various types of allowances from our vendors based on negotiated terms. These allowances are generally treated as an adjustment to the purchase price of our merchandise inventories and are recorded at interim periods based on management’s estimates. These estimates are derived using available data and our historical experience and include 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. We also use these estimates on an interim basis to record our provisions for expected inventory shortage and to adjust certain inventories to a LIFO basis. We adjust these estimates to actual amounts at the completion of our physical inventory counts and finalization of all vendor allowance agreements. In addition, we perform an inventory-aging analysis for identifying obsolete and slow-moving inventory. We establish a reserve to reduce the cost of our inventory to its estimated net realizable value based on the inventory type and receipt date. Inventory and related reserves are reviewed on an interim basis and adjusted, as appropriate, to reflect management’s current estimates.

Our estimates may be impacted by changes in certain underlying assumptions and may not be indicative of future activity. For example, factors such as slower inventory turnover due to changes in competitors’ tactics, consumer preferences, consumer spending and unseasonable weather patterns could cause excess inventory requiring greater than estimated markdowns to entice consumer purchases. Such factors could also cause sales shortfalls resulting in reduced purchases from vendors and an associated reduction in vendor allowances. Changes in our estimates and assumptions could materially impact cost of sales in our Consolidated Financial Statements.

Excess Facilities and Long-lived Asset Impairment

Based on an overall analysis of store performance and expected trends, management periodically evaluates the need to close underperforming stores. Reserves are established at the time of closing for the present value of any remaining operating lease obligations, net of estimated sublease income, and at the communication date for severance, as prescribed by SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The key assumptions in calculating the reserves include the timeframe expected to terminate lease agreements, the number of terminated employees for severance and the estimation of sublease income. If actual experience differs from our estimates, the resulting reserves could vary from recorded amounts. Reserves are reviewed periodically and adjusted when necessary.

 

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We also review the carrying value of all long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable, in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” We will record an impairment loss when the carrying value of the underlying asset group exceeds its fair market value.

In determining whether long-lived assets are recoverable, our estimate of undiscounted future cash flows over the estimated life or lease term of a store is based upon our experience, historical operations of the store, an estimate of future store profitability and economic conditions. The future estimates of store profitability and economic conditions require estimating such factors as sales growth, inflation and the overall economics of the retail industry. Since we forecast our future undiscounted cash flows for up to 25 years, our estimates are subject to variability as future results can be difficult to predict. If a long-lived asset is found to be non-recoverable, we record an impairment charge equal to the difference between the asset’s carrying value and fair market value. We estimate fair market value based upon future cash flows, discounted at a rate that approximates our weighted average cost of capital, or by using other reasonable estimates of fair market value, if available. In fiscal 2007, we recorded $13 million of impairment charges related to non-recoverable long-lived assets. Impairments in fiscal 2007 were partially due to the relocation of toy stores and also due to underperforming stores relative to historical or planned operating results. In the future, we plan to relocate additional stores and may incur additional asset impairments.

Goodwill Impairment

Goodwill is evaluated for impairment annually and whenever we identify certain triggering events that may indicate impairment, in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.” We test for impairment of our goodwill by comparing the fair value and carrying values of our reporting units. If the carrying value exceeds the fair value, we would then calculate the implied fair value of our reporting unit goodwill as compared to its carrying value to determine the appropriate impairment charge.

We estimate the fair value of our reporting units using widely accepted valuation techniques such as discounted cash flow, comparable transactions, and market multiple analyses. These techniques use a variety of assumptions including projected market conditions, discount rates and future cash flows. Although we believe our assumptions are reasonable, actual results may vary significantly and may expose us to material impairment charges in the future. We conducted our annual impairment test of the $365 million in goodwill as of the first day of the fourth quarter of fiscal 2007 and determined our goodwill was not impaired. In order to evaluate the sensitivity of the fair value calculations on the goodwill impairment test, we applied a hypothetical 10% decrease to the fair values of each reporting unit. For fiscal 2007, this hypothetical decrease would have triggered additional testing and analysis, which may have resulted in a goodwill impairment charge to our Toys-Japan reporting unit which had a goodwill balance of $6 million as of the first day of the fourth quarter of fiscal 2007.

Self-Insured Liabilities

We self-insure a substantial portion of our workers’ compensation, general liability, auto liability, property, medical, prescription drug and dental insurance risks, in addition to maintaining third party insurance coverage. We estimate our provisions for losses related to self-insured risks using actuarial techniques and estimates for incurred but not reported claims. We record the liability for workers’ compensation on a discounted basis. We also maintain stop-loss coverage to limit the exposure related to certain risks. The assumptions underlying the ultimate costs of existing claim losses can vary, which can affect the liability recorded for such claims.

Although we feel our reserves are adequate to cover our estimated liabilities, changes in the underlying assumptions and future economic conditions could have a considerable effect upon future claim costs, which could have a material impact on our Consolidated Financial Statements. Our reserve for self-insurance was $99 million as of February 2, 2008. A 10% change in our self-insured liabilities would have impacted pre-tax earnings by approximately $11 million for the fiscal year ended February 2, 2008.

Revenue Recognition

We recognize revenue in accordance with the SEC Staff Accounting Bulletin No. 104 “Revenue Recognition,” (“SAB 104”). Revenue related to merchandise sales, which is approximately 99.4% of total revenues, is generally recognized for retail sales at the point of sale in the store, and when the customer receives the merchandise shipped from our web sites. Discounts provided to customers are accounted for as a reduction of sales. We record a reserve for estimated product returns in each reporting period based on historical return experience and changes in customer demand. Actual returns may differ from historical product return patterns, which could impact our financial results in future periods.

 

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Gift Cards and Breakage

We sell gift cards to customers in our retail stores, through our web sites, through third parties, and in certain cases, provide gift cards for returned merchandise and in connection with promotions. We recognize income from gift cards when the customer redeems the gift card, or when the likelihood of the gift card being redeemed by the customer is remote (“breakage”) and we have determined that we do not have a legal obligation to remit the value of unredeemed gift cards to the relevant jurisdictions. Income related to customer redemption is included in Net sales, whereas income related to breakage is recorded as other income, which is included in our Consolidated Financial Statements as a reduction to Selling, general and administrative expenses. We determine the gift card breakage rate based on historical redemption patterns. Based on our historical information, we concluded that the likelihood of our gift cards being redeemed beyond three years from the date of issuance is remote. At that three-year date, we recognize income for the remaining outstanding balance.

In fiscal 2007, we recognized $17 million of net breakage income related to unredeemed gift cards, representing an approximate breakage rate of 4% on gift cards issued in 2004. The actual redemption of gift cards after three years may differ in the future due to changes in consumer behavior and the underlying economic environment. A change of 1% in the estimated breakage rate would have impacted our pre-tax earnings by approximately $4 million for the fiscal year ended February 2, 2008.

Income Taxes

We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). Our provision for income taxes and effective tax rates are calculated by legal entity and jurisdiction and are based on a number of factors, including our income, tax planning strategies, differences between tax laws and accounting rules, statutory tax rates and credits, uncertain tax positions, and valuation allowances. We use significant judgment and estimates in evaluating our tax positions.

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 from 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. We record deferred tax assets and liabilities for any temporary differences between the tax reflected in our Consolidated Financial Statements and tax bases. We establish valuation allowances when we believe it is more likely than not that our deferred tax assets will not be realized. For example, we would establish a valuation allowance for the tax benefit associated with a loss carry-forward in a tax jurisdiction if we did not expect to generate sufficient taxable income to utilize the loss carry-forward. Changes in future taxable income, tax liabilities and our tax planning strategies may impact our effective tax rate, valuation allowances and the associated carrying value of our deferred tax assets and liabilities.

At any one time our tax returns for many tax years are subject to examination by U.S. Federal, foreign, and state taxing jurisdictions. We establish tax liabilities in accordance with Financial Accounting Standards Board (“FASB”) Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attributes of income tax positions taken or expected to be taken on a tax return. Under FIN 48, the impact of an uncertain tax position taken or expected to be taken on an income tax return must be recognized in the financial statements at the largest amount that is more-likely-than-not to be sustained. An uncertain income tax position will not be recognized in the financial statements unless it is more-likely-than-not to be sustained. We adjust these tax liabilities, as well as the related interest and penalties, based on the latest facts and circumstances, including recently published rulings, court cases, and outcomes of tax audits. To the extent our actual tax liability differs from our established tax liabilities for unrecognized tax benefits, our effective tax rate may be materially impacted. 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 tax balances reflect the more-likely-than-not outcome of known tax contingencies.

RECENT ACCOUNTING PRONOUNCEMENTS

Adoption of FIN 48

On February 4, 2007, we adopted FIN 48, which clarified the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS 109 and prescribed a recognition threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under FIN 48, the impact of an uncertain tax position taken or expected to be taken on an income tax return must be recognized in the financial statements at the largest amount that is more-likely-than-not to be sustained. An uncertain income tax position will not be recognized in the financial statements unless it is

 

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more-likely-than-not to be sustained. As a result of the adoption of FIN 48, we reduced our opening Retained deficit by $21 million and decreased our liability for unrecognized tax benefits by $21 million as of February 4, 2007. In addition, we recorded additional liabilities for unrecognized tax benefits and corresponding tax assets of $148 million. For further information, refer to Note 12 to the Consolidated Financial Statements entitled “INCOME TAXES.”

Adoption of SFAS 158

As of February 2, 2008, we adopted SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS 158”). SFAS 158 requires sponsors of defined benefit pension plans to recognize the funded status of their postretirement benefit plans on the consolidated balance sheet, measure the fair value of plan assets and benefit obligations as of the date of the fiscal year-end consolidated balance sheet and provide additional disclosures. Per the recognition and transition requirements of SFAS 158, adjustments were reflected to recognize the funded status, which is the difference between the fair value of plan assets and the projected benefit obligations, of our pension plans in our fiscal 2007 Consolidated Balance Sheet, with a corresponding adjustment to Accumulated other comprehensive income (loss), net of tax. The adjustment to Accumulated other comprehensive income (loss), at adoption, represents the net unrecognized actuarial loss and unrecognized prior service costs, both of which were previously netted against the plans’ funded status in our Consolidated Balance Sheets pursuant to the provisions of SFAS No. 87, “Employers’ Accounting for Pensions.”

As a result of the adoption of SFAS 158, we recorded a $5 million decrease to pension asset, a $2 million decrease to pension liability, and a $3 million decrease to Accumulated other comprehensive income as of February 2, 2008. For further information, refer to Note 15 to the Consolidated Financial Statements entitled “DEFINED BENEFIT PENSION PLANS.”

Future Adoptions

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. In February 2008, SFAS 157 was amended by FASB Staff Position (“FSP”) 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Its Related Interpretive Accounting Pronouncements That Address Leasing Transactions” and FSP 157-2, “Effective Date of FASB Statement No. 157: Fair Value Measurements.” As such, SFAS 157 (as amended) is partially effective for measurements and disclosures of financial assets and liabilities for fiscal years beginning after November 15, 2007 and is fully effective for measurement and disclosure provisions on all applicable assets and liabilities for fiscal years beginning after November 15, 2008. These statements will affect the measurement standards of our critical accounting policies and may have a material impact on our Consolidated Financial Statements. We are currently evaluating the impact that these statements will have on our Consolidated Financial Statements.

Refer to Note 20 to the Consolidated Financial Statements entitled “RECENT ACCOUNTING PRONOUNCEMENTS” for a discussion of other recent accounting pronouncements and their impact on our Consolidated Financial Statements.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk from potential changes in interest rates and foreign exchange rates. We regularly evaluate our exposure to these risks and take measures to mitigate these risks on our consolidated financial results. We enter into derivative financial instruments to economically manage our market risks related to interest rate and foreign currency exchange. We do not participate in speculative derivative trading. The analysis below presents our sensitivity to selected hypothetical, instantaneous changes in market interest rates and currency exchange rates as of February 2, 2008.

Foreign Exchange Exposure

Our foreign currency exposure is primarily concentrated in the United Kingdom, Continental Europe, Canada, Australia and Japan. We believe the countries in which we own assets and operate stores are politically stable. We face currency translation exposures related to translating the results of our worldwide operations into U.S. dollars because of exchange rate fluctuations during the reporting period. We enter into certain foreign currency-denominated derivative contracts to manage variable cash flows of our foreign currency-denominated debt (as discussed under Interest Rate Exposure below). Changes in foreign exchange rates affect interest expense recorded in relation to our foreign currency-denominated derivative instruments and debt instruments. As of February 2, 2008, one of our foreign currency-denominated derivatives qualified for hedge accounting treatment.

 

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The following table illustrates the estimated sensitivity of a 10% change in foreign currency rates to our future pre-tax earnings, based on our foreign currency-denominated derivative instruments and debt instruments outstanding at February 2, 2008:

 

(In millions)

   Impact of
10% Increase
    Impact of
10% Decrease
 

Derivative instruments

   $ 1     $ (1 )

Debt instruments

     (11 )     11  
                

Total pretax income exposure to foreign exchange risk

   $ (10 )   $ 10  
                

The above sensitivity analysis assumes our mix of foreign currency-denominated debt instruments and derivatives and all other variables will remain constant in future periods. These assumptions are made in order to facilitate the analysis and are not necessarily indicative of our future intentions. As of February 3, 2007, we estimated that a 10% hypothetical change in foreign exchange rates would impact on our pre-tax earnings by $29 million. During fiscals 2007 and 2006, we entered into foreign exchange forward contracts to manage our currency risks associated with the purchase of merchandise inventories. The decrease in our exposure to foreign currency risk related to exchange forward contracts in fiscal 2007 from fiscal 2006 is primarily due to management’s decision to discontinue its practice of entering into foreign exchange forward contracts under our merchandise import program during fiscal 2007.

Interest Rate Exposure

We have a variety of fixed and variable rate debt instruments and short-term investments that expose our future consolidated financial results to the market risks of interest rate fluctuations. 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 and interest rate caps to maintain that balance. A change in interest rates on variable rate debt impacts our pre-tax earnings and cash flows. A portion of our derivatives qualifies for hedge accounting as variable cash flow hedges. Therefore, for designated cash flow hedges, the effective portion of the changes in the fair value of derivatives are recorded in other comprehensive income (loss) and subsequently recorded in the Consolidated Statement of Operations at the time the hedged item affects earnings.

The following table illustrates the estimated sensitivity of a 1% change in interest rates to our future pre-tax earnings on our derivative instruments, variable rate debt instruments and short-term investments outstanding at February 2, 2008:

 

(In millions)

   Impact of
1% Increase
    Impact of
1% Decrease
 

Derivative instruments:

    

Interest rate swaps

   $ 17     $ (17 )

Variable rate debt

     (36 )     36  

Short-term investments

     2       (2 )
                

Total pretax income exposure to interest rate risk

   $ (17 )   $ 17  
                

The above sensitivity analysis assumes our mix of financial instruments and all other variables will remain constant in future periods. These assumptions are made in order to facilitate the analysis and are not necessarily indicative of our future intentions. Refer to the LIQUIDITY AND CAPITAL RESOURCES section of our MD&A for further discussion of changes in our auction-rate securities subsequent to February 2, 2008. As of February 3, 2007, we estimated that a 1% hypothetical change in interest rates could potentially have caused either an $8 million increase or a $25 million decrease on our pre-tax earnings. The difference in our exposure to interest rate risk in fiscal 2007 from fiscal 2006 is primarily due to the change in the market exposure from our interest rate caps. Refer to our Consolidated Financial Statements for further discussion of our debt in Note 3 entitled “SHORT-TERM BORROWINGS AND LONG-TERM DEBT”, our derivative instruments in Note 4 entitled “DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES” and our short-term investments in Note 7 entitled “SHORT-TERM INVESTMENTS.” At this time, we do not anticipate material changes to our interest rate risk exposure or to our risk management policies. We believe that we could mitigate potential losses on pre-tax earnings through our risk management objectives, if material changes occur in future periods.

 

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

     PAGE

Report of Independent Registered Public Accounting Firm

   46

Consolidated Statements of Operations

   47

Consolidated Balance Sheets

   48

Consolidated Statements of Cash Flows

   49

Consolidated Statements of Stockholders’ (Deficit) Equity

   50

Notes to Consolidated Financial Statements

   51

Quarterly Results of Operations (Unaudited)

   91

Schedule I – Parent Company Condensed Financial Statements

   92

 

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Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders of

Toys “R” Us, Inc.:

We have audited the accompanying consolidated balance sheets of Toys “R” Us, Inc. and subsidiaries (the "Company") as of February 2, 2008 and February 3, 2007, and the related consolidated statements of operations, stockholders' (deficit) equity, and cash flows for each of the three fiscal years in the period ended February 2, 2008. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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, such consolidated financial statements present fairly, in all material respects, the financial position of Toys “R” Us, Inc. and subsidiaries as of February 2, 2008 and February 3, 2007, and the results of their operations and their cash flows for each of the three fiscal years in the period ended February 2, 2008, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

As discussed in Note 6 to the consolidated financial statements, effective February 4, 2007, the Company changed its accounting method for valuing the merchandise inventories of its international wholly-owned subsidiaries from the retail inventory method to the weighted average cost method. As discussed in Note 15 to the consolidated financial statements, effective February 2, 2008, the Company adopted the recognition and disclosure provisions of Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132(R).” As discussed in Note 12 to the consolidated financial statements, effective February 4, 2007, the Company adopted Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes- an interpretation of FASB Statement No. 109.” As discussed in Note 1 to the consolidated financial statements, effective February 3, 2007, the Company elected application of Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” As discussed in Note 9 to the consolidated financial statements, effective January 29, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment,” as revised.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of February 2, 2008, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated May 2, 2008 expressed an unqualified opinion on the Company's internal control over financial reporting.

New York, New York

May 2, 2008

 

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Toys “R” Us, Inc. and Subsidiaries

Consolidated Statements of Operations

 

     Fiscal Years Ended  

(In millions)

   February 2,
2008
    February 3,
2007
    January 28,
2006
 

Net sales

   $ 13,794     $ 13,050     $ 11,333  

Cost of sales

     8,987       8,638       7,652  
                        

Gross margin

     4,807       4,412       3,681  
                        

Selling, general and administrative expenses

     3,748       3,450       2,955  

Depreciation and amortization

     394       409       400  

Net (gains) losses on sales of properties

     (33 )     (110 )     3  

Restructuring and other charges

     2       14       33  

Contract settlement fees and other

     —         —         22  

Transaction and related costs

     —         —         410  
                        

Total operating expenses

     4,111       3,763       3,823  
                        

Operating earnings (loss)

     696       649       (142 )

Other (expense) income:

      

Interest expense

     (503 )     (537 )     (394 )

Interest income

     27       31       31  
                        

Earnings (loss) before income taxes and minority interest

     220       143       (505 )

Income tax expense (benefit)

     65       35       (121 )

Minority interest

     2       (1 )     —    
                        

Net earnings (loss)

   $ 153     $ 109     $ (384 )
                        

See Notes to the Consolidated Financial Statements.

 

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Table of Contents

Toys “R” Us, Inc. and Subsidiaries

Consolidated Balance Sheets

 

(In millions - except share amounts)

   February 2,
2008
    February 3,
2007
 

ASSETS

    

Current Assets:

    

Cash and cash equivalents

   $ 751     $ 765  

Short-term investments

     168       —    

Accounts and other receivables

     256       230  

Merchandise inventories

     1,998       1,690  

Current deferred tax assets

     80       43  

Prepaid expenses and other current assets

     140       129  
                

Total current assets

     3,393       2,857  

Property and equipment, net

     4,385       4,333  

Goodwill, net

     366       365  

Deferred tax assets

     197       95  

Restricted cash

     131       148  

Other assets

     480       497  
                
   $ 8,952     $ 8,295  
                

LIABILITIES AND STOCKHOLDERS’ DEFICIT

    

Current Liabilities:

    

Short-term borrowings

   $ —       $ 151  

Accounts payable

     1,534       1,303  

Accrued expenses and other current liabilities

     996       848  

Income taxes payable

     128       142  

Current portion of long-term debt

     50       66  
                

Total current liabilities

     2,708       2,510  

Long-term debt

     5,824       5,722  

Deferred tax liabilities

     21       74  

Deferred rent liabilities

     261       248  

Other non-current liabilities

     374       282  

Minority interest in Toys - Japan

     153       134  

Commitments and contingencies

    

Stockholders’ Deficit

    

Common stock ($0.01 par value; authorized 3,000 shares, outstanding 1,000 shares)

     —         —    

Additional paid-in-capital

     10       4  

Accumulated deficit

     (419 )     (584 )

Accumulated other comprehensive income (loss)

     20       (95 )
                

Total stockholders’ deficit

     (389 )     (675 )
                
   $ 8,952     $ 8,295  
                

See Notes to the Consolidated Financial Statements.

 

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Toys “R” Us, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

 

     Fiscal Years Ended  

(In millions)

   February 2,
2008
    February 3,
2007
    January 28,
2006
 

Cash Flows from Operating Activities:

      

Net earnings (loss)

   $ 153     $ 109     $ (384 )

Adjustments to reconcile net earnings (loss) to net cash provided by operating activities:

      

Depreciation and amortization

     394       409       400  

Amortization of debt issuance costs

     31       63       90  

Net (gains) losses on sales of properties

     (33 )     (110 )     3  

Stock compensation expenses arising from cash settlement

     —         —         195  

Deferred income taxes

     (115 )     (13 )     (80 )

Stock option compensation expense

     6       4       33  

Proceeds received from settlement of derivatives

     —         9       34  

Non-cash portion of restructuring, other charges and impairments

     20       22       33  

Equity in loss of Toys - Japan, net of dividend

     —         —         10  

Other

     6       (12 )     14  

Changes in operating assets and liabilities:

      

Accounts and other receivables

     (13 )     21       (51 )

Merchandise inventories

     (220 )     11       387  

Prepaid expenses and other operating assets

     21       (8 )     (13 )

Accounts payable, accrued expenses and other liabilities

     169       (81 )     112  

Income taxes payable

     108       (13 )     (112 )
                        

Net cash provided by operating activities

     527       411       671  
                        

Cash Flows from Investing Activities:

      

Capital expenditures

     (326 )     (285 )     (285 )

(Purchase) sale of short-term investments

     (168 )     —         953  

Acquisition of minority interest in Toysrus.com

     —         (6 )     —    

Cash effect of the consolidation of Toys-Japan

     —         6       —    

Decrease (increase) in restricted cash

     17       (41 )     (107 )

Proceeds from sale of fixed assets

     61       219       12  
                        

Net cash (used in) provided by investing activities

     (416 )     (107 )     573  
                        

Cash Flows from Financing Activities:

      

Long-term debt borrowings

     906       3,643       7,004  

Short-term debt borrowings

     232       158       325  

Long-term debt repayment

     (1,020 )     (4,124 )     (3,526 )

Short-term debt repayment

     (268 )     (184 )     (174 )

Purchase of derivatives

     (1 )     (9 )     —    

Dividend paid to Toys - Japan minority interest

     (1 )     (5 )     —    

Repurchase of common stock

     —         —         (5,891 )

Repurchase of stock options and restricted stock

     —         —         (227 )

Capital contributed by Sponsors

     —         —         1,279  

Repurchase of equity security units and warrants

     —         —         (130 )

Proceeds received from exercise of stock options

     —         —         87  

Proceeds received from issuance of common stock

     —         —         20  

Capitalized debt issuance costs

     —         (45 )     (255 )
                        

Net cash used in financing activities

     (152 )     (566 )     (1,488 )
                        

Effect of exchange rate changes on cash and cash equivalents

     27       46       (7 )
                        

Cash and cash equivalents:

      

Net decrease during period

     (14 )     (216 )     (251 )

Cash and cash equivalents at beginning of period

     765       981       1,232  
                        

Cash and cash equivalents at end of period

   $ 751     $ 765     $ 981  
                        

Supplemental Disclosures of Cash Flow Information:

      

Income taxes paid, net of refunds

   $ 72     $ 63     $ 70  

Interest paid

   $ 444     $ 496     $ 272  

See Notes to the Consolidated Financial Statements.

 

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Toys “R” Us, Inc. and Subsidiaries

Consolidated Statements of Stockholders’ (Deficit) Equity

 

     Common Stock     Additional
paid-in-
capital
    Unamortized
value of
restricted
stock
    Accumulated
other
comprehensive
income (loss)
    Retained
earnings
accumulated
(deficit)
    Total
stockholders’
equity
(deficit)
 
     Issued     In Treasury            

(In millions)

   Shares     Amount     Shares     Amount            

Balance, January 29, 2005

   300.4     $ 30     (84.5 )   $ (1,658 )   $ 405     $ (5 )   $ (7 )   $ 5,560     $ 4,325  

Net loss for the period

   —         —       —         —         —         —         —       $ (384 )   $ (384 )

Foreign currency translation adjustments, net of tax

   —         —       —         —         —         —         (63 )     —         (63 )

Unrealized gain on hedged transactions, net of tax

   —         —       —         —         —         —         18       —         18  

Minimum pension liability adjustments, net of tax

   —         —       —         —         —         —         (3 )     —         (3 )
                        

Total comprehensive loss

                     (432 )

Exercise of stock options, net

   —         —       4.8       96       (9 )     —         —         —         87  

Tax benefit related to stock plan activities

   —         —       —         —         16       —         —         —         16  

Issuance of restricted stock, net and other

   —         —       0.3       5       5       (11 )     —         —         (1 )

Amortization of restricted stock

   —         —       —         —         —         16       —         —         16  

Exercise of equity security units (“ESUs”)

   —         —       0.9       19       1       —         —         —         20  

Treasury stock repurchase

   —         —       (221.0 )     (5,891 )     —         —         —         —         (5,891 )

Contribution of capital by affiliate

   —         —       —         —         1,279       —         —         —         1,279  

Repurchase of options and awards, net of related compensation costs

   —         —       —         (28 )     15       —         —         —         (13 )

Obligations for net cash settlement of awards and ESUs

   —         —       —         —         (109 )     —         —         —         (109 )

Repurchase of ESUs and warrants

   —         —       (0.9 )     (21 )     —         —         —         —         (21 )

Cancellation of treasury stock

   (300.4 )     (30 )   300.4       7,478       (1,603 )     —         —         (5,845 )     —    
                                                                    

Balance, January 28, 2006 (1)

   —       $ —       —       $ —       $ —       $ —       $ (55 )   $ (669 )   $ (724 )

Net earnings for the period

   —         —       —         —         —         —         —         109       109  

Foreign currency translation adjustments, net of tax

   —         —       —         —         —         —         (42 )     —         (42 )

Unrealized loss on hedged transactions, net of tax

   —         —       —         —         —         —         (1 )     —         (1 )

Minimum pension liability adjustments, net of tax

   —         —       —         —         —         —         3       —         3  
                        

Total comprehensive income

                     69  

Cumulative effect of SAB 108 adjustments

   —         —       —         —         —         —         —         (24 )     (24 )

Stock compensation expense

   —         —       —         —         4       —         —         —         4  
                                                                    

Balance, February 3, 2007 (1)

   —         —       —         —       $ 4       —       $ (95 )   $ (584 )   $ (675 )

Net earnings for the period

   —         —       —         —         —         —         —         153       153  

Foreign currency translation adjustments, net of tax

   —         —       —         —         —         —         121       —         121  

Unrealized loss on hedged transactions, net of tax

   —         —       —         —         —         —         (3 )     —         (3 )
                        

Total comprehensive income

                     271  

Cumulative effect of change in accounting principle, net of tax (Note 6)

   —         —       —         —         —         —         —         (9 )     (9 )

Cumulative effect of adoption of FIN 48 (Note 12)

   —         —       —         —         —         —         —         21       21  

Effect of adoption of SFAS 158, net of tax (Note 15)

   —         —       —         —         —         —         (3 )     —         (3 )

Stock compensation expense

   —         —       —         —         6       —         —         —         6  
                                                                    

Balance, February 2, 2008 (1)

   —         —       —         —       $ 10       —       $ 20     $ (419 )   $ (389 )
                                                                    

 

(1)

$0.01 par value; authorized 3,000 shares, outstanding 1,000 shares.

See Notes to the Consolidated Financial Statements.

 

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Toys “R” Us, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization

As used herein, the “Company,” “we,” “us,” or “our” means Toys “R” Us, Inc., and its consolidated subsidiaries except as expressly indicated or unless the context otherwise requires. We are the largest specialty retailer of toys in North America and the only national specialty retailer of baby-juvenile products in the United States. As of February 2, 2008, our business consisted of 585 Toys “R” Us stores in the United States (“Toys-U.S.”), 260 Babies “R” Us specialty baby-juvenile stores in the United States (“Babies”), 715 international stores in 34 countries, of which 695 were Toys “R” Us stores and 20 were Babies “R” Us stores (“International”). Included in the 715 International stores were 211 licensed or franchised stores. We also sell merchandise on the Internet. Toys “R” Us, Inc. is incorporated in the state of Delaware.

Principles of Consolidation

The Consolidated Financial Statements include the accounts of the Company and its wholly-owned subsidiaries. We eliminate all inter-company balances and transactions.

Investment in Toys “R” Us-Japan

In fiscal 2006, we began consolidating Toys “R” Us – Japan, Ltd. (“Toys – Japan”), of which we own approximately 48% of its common stock. During fiscal 2006, we (together with our “Sponsors”, 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) took control of a majority of the board of directors of Toys-Japan. We had previously accounted for our investment in Toys—Japan using the “equity method” of accounting. As a result, the amounts in our fiscal 2005 Consolidated Financial Statements are not comparable with our Consolidated Financial Statements for fiscals 2007 and 2006.

For fiscal 2007, we consolidated Net sales of $1,643 million, Operating earnings of $15 million, and Net earnings of $4 million related to Toys—Japan. For fiscal 2006, we consolidated Net sales of $1,650 million, an Operating loss of $12 million, and Net loss of $3 million. In fiscals 2007 and 2006, Toys-Japan paid dividends of $3 million and $10 million, respectively, of which $2 million and $5 million, respectively, were paid to the minority interest.

For fiscal 2005, our equity in the loss of Toys-Japan was $3 million, which was included in Selling, general and administrative expenses (“SG&A”) in our Consolidated Statement of Operations, and we received dividends of $5 million.

Consolidation of Variable Interest Entities

In December 2003, the Financial Accounting Standards Board (“FASB”) issued Financial Interpretation (“FIN”) No. 46 (revised December 2003), “Consolidation of Variable Interest Entities” (“VIEs”) (“FIN 46(R)”). 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 is viewed to be effectively in the same position as the parent in a parent-subsidiary relationship.

We evaluate our lending vehicles, including our commercial mortgage-backed securities, structured loans and any joint venture interests to determine whether we are the primary beneficiary of a VIE. The primary beneficiary will absorb a majority of the entity’s expected losses, receive a majority of the entity’s expected residual returns, or both, as a result of holding a variable interest.

During fiscal 2007, we identified KK Funding Corporation (“KKFC”) as a VIE and concluded that in accordance with FIN 46(R) it should be consolidated. During fiscal 2006, we identified Vanwall Finance PLC (“Vanwall”) as a VIE and concluded that in accordance with FIN 46(R) Vanwall should not be consolidated. We will continue to assess whether Vanwall should not be consolidated. For further details, refer to Note 3 entitled “SHORT-TERM BORROWINGS AND LONG-TERM DEBT.”

 

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Table of Contents

Fiscal Year

Our fiscal year ends on the Saturday nearest to January 31. Unless otherwise stated, references to years in this report relate to the fiscal years below:

 

Fiscal Year

   Number of Weeks    Ended

2007

   52    February 2, 2008

2006

   53    February 3, 2007

2005

   52    January 28, 2006

Adoption of Securities and Exchange Commission Staff Accounting Bulletin No. 108

In the fourth quarter of fiscal 2006, we adopted Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). As permitted under the transition provisions of SAB 108, in fiscal 2006, we recorded a cumulative $(24) million adjustment to opening retained deficit. The increase (decrease) on the Consolidated Balance Sheet as of January 29, 2006 was as follows:

 

(In millions)

   Deferred
Tax
Assets
    Income
Taxes
Payable
   Deferred
Tax
Liabilities
    Cumulative
Adjustment
to Retained
Deficit

Accounting for income taxes

   $ (5 )   $ 20    $ (1 )   $ 24

Use of Estimates

The preparation of our Consolidated 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 Consolidated Financial Statements and during the applicable periods. We base these estimates on historical experience and other factors that we believe are reasonable under the circumstances. Actual results may differ materially from these estimates and such differences could have a material impact on our Consolidated Financial Statements.

Cash and Cash Equivalents

We consider our highly liquid investments with original maturities of less than three months at acquisition to be cash equivalents. Book cash overdrafts issued but not yet presented to the bank for payment are reclassified to accounts payable.

Restricted Cash

Restricted cash represents collateral and other cash that is restricted from withdrawal. As of February 2, 2008 and February 3, 2007, we had restricted cash of $131 million and $148 million, respectively. Such restricted cash primarily serves as collateral for certain property financings we entered into during fiscal 2005.

Accounts and Other Receivables

Accounts and other receivables consist primarily of receivables from vendor allowances and consumer credit card and debit card transactions.

Short-Term Investments

Our short-term investments are comprised of municipal auction-rate securities which are securities with interest rates that reset periodically through an auction process. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”), we classify auction-rate securities as available-for-sale and carry them at fair value with any unrealized gains and losses reported in Accumulated other comprehensive income (loss). We classify auction-rate securities as short-term based on our ability and intent to sell within the next fiscal year. There are no cumulative gross unrealized holding gains or losses relating to these auction-rate securities as of February 2, 2008. All income from these investments is recorded as interest income.

 

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In accordance with our investment policy, we place our investments with issuers who have high-quality credit and limit the amount of investment exposure to any one issuer. We seek to preserve principal by limiting default risk, market risk and reinvestment risk.

We review the key characteristics of our marketable securities portfolio and their classification in accordance with generally accepted accounting principles on an annual basis, or when indications of potential impairment exist. If a decline in the fair value of a security is deemed by management to be other than temporary, the cost basis of the investment is written down to fair value, and the amount of the write-down is included in the determination of Net earnings. Refer to Note 7 to the Consolidated Financial Statements entitled “SHORT-TERM INVESTMENTS” for further details.

Merchandise Inventories

We value our merchandise inventories at the lower of cost or market, as determined by the weighted average cost method for our International segment and the retail inventory method for our Toys-U.S. and Babies segment. Cost of sales under the weighted average cost method represents the weighted average cost of the individual items sold, whereas cost of sales under the retail method is calculated using an average margin realized on an entire department of inventory. Cost of sales under both methods is also affected by adjustments to reflect current market conditions, merchandise allowances from vendors, estimated inventory shortages and estimated losses from obsolete and slow-moving inventory.

Prior to fiscal 2007, all of our subsidiaries, except Toys-Japan, used the retail inventory method to value merchandise inventories. As of February 2, 2008 and February 3, 2007, approximately 38% and 10%, respectively, of total merchandise inventories were valued under the weighted average cost method.

Merchandise inventories for the Toys–U.S. segment, 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 represented approximately 45% and 43% of total merchandise inventories, as of February 2, 2008 and February 3, 2007, respectively. The excess of replacement or current cost over stated LIFO value is immaterial. All remaining merchandise inventories for our U.S. segments are stated at the lower of FIFO (first-in, first-out) cost or market value as determined by the retail inventory method. We plan to change our accounting method for valuing merchandise inventories for our U.S. segments from the retail inventory method to the weighted average cost method in fiscal 2008 when our perpetual inventory system is implemented domestically. Refer to Note 6 to the Consolidated Financial Statements entitled “CHANGE IN ACCOUNTING PRINCIPLE” for further details on the accounting change in our International segment.

Property and Equipment, Net

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 capitalize interest for new store construction-in-progress in accordance with SFAS No. 34 “Capitalization of Interest Cost.” Capitalized interest amounts are immaterial.

Impairment of Long-Lived Assets and Costs Associated with Exit Activities

For any store closing where a lease obligation still exists, we record the estimated future liability associated with the rental obligation less any estimated sublease income on the date the store is closed in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”

We review the carrying value of all long-lived assets, such as property and equipment, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable, in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” We will record an impairment loss when the carrying value of the underlying asset group exceeds its estimated fair value based on quoted market prices or other valuation techniques. During fiscal 2007, we recorded total impairment losses of $13 million at our Toys and International segments, which was included in Selling, general and administrative expenses. Impairments in fiscal 2007 were primarily due to the relocation of toy stores as well as the identification of underperforming stores. In the future, we plan to relocate additional stores and may incur additional asset impairments. In fiscal 2006, we did not record material impairment charges. Refer to Note 2 entitled “RESTRUCTURING AND OTHER CHARGES” for details of fiscal 2005 impairment charges.

 

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Asset Retirement Obligations

We account for asset retirement obligations (“ARO”) in accordance with SFAS No. 143, “Accounting for Asset Retirement Obligations” (“SFAS 143”) and FIN No. 47 “Accounting for Conditional Asset Retirement Obligations – An Interpretation of FASB Statement No. 143” (“FIN 47”), which require us to recognize a liability for the fair value of obligations to retire tangible long-lived assets when there is a contractual obligation to incur such costs. We recognize a liability for asset retirement obligations and capitalize asset retirement costs and amortize these costs over the life of the assets. As of February 2, 2008 and February 3, 2007, we had approximately $51 million and $41 million, respectively recorded for ARO’s.

Goodwill, Net

Goodwill is evaluated for impairment annually and whenever we identify certain triggering events that may indicate impairment, in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). We test for impairment of our goodwill by comparing the fair value and carrying values of our reporting units. We estimated fair value of these reporting units on the first day of the fourth quarter of each year, which for fiscal 2007 was November 4, 2007, using the market multiples approach, the comparable transactions approach and the discounted cash flow analysis approach. These approaches require us to make certain assumptions and estimates regarding industry economic factors and future profitability of acquired businesses. It is our policy to conduct impairment testing based on our most current business plans, which reflect changes we anticipate in the economy and the industry. If the carrying value exceeds the fair value, we would then calculate the implied fair value of our reporting unit goodwill as compared to its carrying value to determine the appropriate impairment charge. Based on our estimates of our reporting unit fair values, we determined that none of the goodwill associated with these reporting units was impaired.

Details on goodwill by segment are as follows:

 

(In millions)

   February 2,
2008
   February 3,
2007

Toys - U.S

   $ 40    $ 40

International

     7      6

Babies

     319      319
             

Total

   $ 366    $ 365
             

Debt Issuance Costs

We defer debt issuance costs, which are classified as non-current other assets, and amortize the costs into Interest expense over the term of the related debt facility. Unamortized amounts at February 2, 2008 and February 3, 2007 were $109 million and $124 million, respectively. Deferred financing fees amortized to Interest expense for fiscals 2007, 2006 and 2005 were $31 million, $63 million, and $90 million, respectively, which is inclusive of accelerated amortization due to certain debt repayments.

Insurance Risks

We self-insure a substantial portion of our workers’ compensation, general liability, auto liability, property, medical, prescription drug and dental insurance risks, in addition to maintaining third party insurance coverage. Provisions for losses related to self-insured risks are based upon actuarial techniques and estimates for incurred but not reported claims. We record the liability for workers’ compensation on a discounted basis. We also 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. As of February 2, 2008 and February 3, 2007, we had $99 million and $94 million, respectively, of reserves for self-insurance risk.

Commitments and Contingencies

We are subject to various claims and contingencies related to lawsuits and taxes, as well as commitments under contractual and other commercial obligations. We recognize liabilities for contingencies and commitments when a loss is probable and estimable. For additional information on our commitments and contingencies, refer to Note 18 to our Consolidated Financial Statements entitled “COMMITMENTS AND CONTINGENCIES.”

 

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Leases

We lease store locations, distribution centers, equipment and land used in our operations. We account for our leases under the provisions of SFAS No. 13, “Accounting for Leases” (“SFAS 13”), and subsequent amendments, which require that leases be evaluated and classified as operating or capital leases for financial reporting purposes. Assets held under capital lease are included in Property and equipment, net. As of February 2, 2008 and February 3, 2007, accumulated amortization related to capital leases for property and equipment was $39 million and $25 million, respectively.

Operating leases are recorded on a straight-line basis over the lease term. At the inception of a lease, we determine the lease term by assuming the exercise of renewal options that are reasonably assured if a significant economic penalty exists for not exercising such options. Renewal options are exercised at our sole discretion. The expected lease term is used to determine whether a lease is capital or operating and is used to calculate straight-line rent expense. Additionally, the useful life of buildings and leasehold improvements are limited by the expected lease term. Refer to Note 11 to our Consolidated Financial Statements entitled “LEASES” for further details.

Substantially all of our leases include options that allow us to renew or extend the lease term beyond the initial lease period, subject to terms and conditions agreed upon at the inception of the lease. Such terms and conditions include rental rates agreed upon at the inception of the lease that could represent below or above market rental rates later in the life of the lease, depending upon market conditions at the time of such renewal or extension. In addition, many leases include early termination options, which can be exercised under specified conditions, including, upon damage, destruction or condemnation of a specified percentage of the value or land area of the property.

Deferred Rent

We recognize fixed minimum rent expense on non-cancelable leases on a straight-line basis over the term of each individual lease starting at the date of possession, including the build-out period, and record the difference between the recognized rental expense and amounts payable under the leases as deferred rent liability. Deferred rent liabilities are shown as separate line items on our Consolidated Balance Sheets and were $261 million at February 2, 2008 and $248 million at February 3, 2007. Landlord incentives and abatements are included in Deferred rent liabilities and amortized over the term of the lease.

Financial Instruments

We have entered into foreign exchange forward contracts to minimize the risk associated with currency fluctuations relating to our foreign subsidiaries. As of February 2, 2008, we have discontinued our practice of entering into these types of contracts under our merchandise import program. We have entered into derivative financial arrangements such as interest rate swaps and interest rate caps to hedge interest rate risk associated with our long-term debt. We account for derivative financial instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended (“SFAS 133”), and record the fair values of these instruments, based on information provided by reliable, independent third parties, within our Consolidated Balance Sheets as Other assets and liabilities. SFAS 133 defines requirements for designation and documentation of hedging relationships, as well as ongoing effectiveness assessments, which must be met in order to qualify for hedge accounting. We record the changes in fair value of derivative instruments, which do not qualify for hedge accounting, in our Consolidated Statements of Operations. If we determine that we do qualify for hedge accounting treatment, the following is a summary of the impact on our Consolidated Financial Statements:

 

   

For designated fair value hedges, changes in fair values of the hedged items for the risks being hedged are recorded in earnings.

 

   

For designated cash flow hedges, the effective portion of the changes in the fair value of derivatives are recorded in other comprehensive income (loss) and subsequently recorded in the Consolidated Statement of Operations at the time the hedged item affects earnings.

 

   

For designated cash flow hedges, the ineffective portion of a hedged derivative instrument’s change in fair value is immediately recognized in Interest expense in the Consolidated Statements of Operations.

During the fiscals 2007, 2006 and 2005, we did not have any designated fair value hedges. Refer to Note 4 to our Consolidated Financial Statements entitled “DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES” for more information related to our accounting for derivative financial instruments. We did not have significant credit risk related to our financial instruments at February 2, 2008 and February 3, 2007.

Foreign Currency Translation

The functional currencies of our foreign subsidiaries are as follows:

 

   

Australian dollar for our subsidiary in Australia;

 

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British pound sterling for our subsidiary in the United Kingdom;

 

   

Canadian dollar for our subsidiary in Canada;

 

   

Euro for subsidiaries in Austria, France, Germany, Spain, and Portugal;

 

   

Japanese yen for our subsidiary in Japan; and

 

   

Swiss franc for our subsidiary in Switzerland.

Assets and liabilities are translated into U.S. dollars using the current exchange rates in effect at the balance sheet date, while revenues and expenses are translated using the average exchange rates during the applicable reporting period. The resulting translation adjustments are recorded in Accumulated other comprehensive income (loss) within Stockholders’ deficit. Gains and losses resulting from foreign currency transactions have been immaterial and are included in SG&A.

Revenue Recognition

We generally recognize sales, net of customer coupons and other sales incentives, at the time the customer takes possession of merchandise, either at the point of sale in our stores or at the time the customer receives shipment for products purchased from our websites. We recognize the sale from lay-away transactions when our customer satisfies all payment obligations and takes possession of the merchandise. We record sales net of sales, use and value added taxes.

Other revenues of $83 million, $76 million, and $58 million for fiscals 2007, 2006, and 2005, respectively, are included in Net sales. Other revenues consist of shipping, licensing and franchising fees, warranty and consignment income, and other non-core product related revenue.

Reserve for Sales Returns

We reserve amounts for sales returns for estimated product returns by our customers based on historical return experience, changes in customer demand, known returns we have not received, and other assumptions. The balances of our reserve for sales returns were $10 million and $11 million at February 2, 2008 and February 3, 2007, respectively.

Gift Cards and Breakage

We sell gift cards to customers in our retail stores, through our web sites, through third parties, and in certain cases, provide gift cards for returned merchandise and in connection with promotions. We recognize income from gift cards when the customer redeems the gift card or when the likelihood of the gift card being redeemed by the customer is remote (“breakage”) and we have determined that we do not have a legal obligation to remit the value of unredeemed gift cards to the relevant jurisdictions. Income related to customer gift card redemption is included in Net sales, whereas income related to breakage is recorded in other income and is included in our Consolidated Financial Statements as a reduction to SG&A. We determine the gift card breakage rate based on historical redemption patterns. Based on our historical information, we concluded that the likelihood of our gift cards being redeemed beyond three years from the date of issuance is remote. At that three-year date, we recognize breakage income for the remaining outstanding balance.

Prior to the fourth quarter of 2006, each gift card was assessed a dormancy fee after a period of non-use, which reduced the gift card liability and resulted in income recognition in the period assessed. The amounts of dormancy income recorded for fiscals 2006 and 2005 were $11 million and $12 million, respectively. In fiscal 2006, we discontinued the practice of assessing dormancy fees. In fiscal 2006, we accumulated a sufficient level of historical data to determine an estimate of gift card breakage for the first time. We recognized $17 million and $15 million of breakage income in fiscals 2007 and 2006, respectively.

Credit Card Agreement and Loyalty Program

In the fourth quarter of fiscal 2006, we entered into a five-year Credit Card Program agreement (the “Agreement”) with a third-party credit lender to offer co-branded and private label credit cards to our customers. The credit lender provides financing for our customers to purchase merchandise at our stores and other businesses and funds and administrates the customer loyalty program for credit card holders.

Under the Agreement, we received an up-front incentive payment for entering into the Agreement, which is deferred and will be amortized ratably over the life of the agreement. In addition, we receive bounty fees for credit card activations and royalties on the co-branded and private label credit cards. Bounty fees are recognized ratably over the life of the contract based upon our expected performance. Royalties are recognized when earned and realizable. During fiscals 2007 and 2006, we recognized $39 million and $11 million of other income relating to the credit card program. At February 2, 2008 and February 3, 2007, a total of $19 million of deferred credit card income is included in Other non-current and current liabilities in our Consolidated Balance Sheets. Partially offsetting the income from the credit card program are costs incurred to generate the income such as sales discounts provided to customers upon activation.

 

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Cost of Sales and SG&A Expenses

The following table illustrates costs associated with each expense category:

 

“Cost of sales”

  

“SG&A”

•        Merchandise acquired from vendors;

  

•        Store payroll and related payroll benefits;

•        Freight in;

  

•        Rent and other store operating expenses;

•        Markdowns;

  

•        Advertising expenses;

•        Provision for excess and obsolete inventories;

 

•        Shipping costs;

  

•        Costs associated with operating our distribution network, including costs related to moving merchandise from distribution centers to stores;

•        Provision for inventory shortages; and

  

•        Impairment losses on long-lived assets;

•        Credits and allowances from our merchandise vendors

  

•        Other corporate related expenses; and

  

•        Other income.

Other income, which is included as a reduction of SG&A, was $75 million, $48 million and $21 million for fiscals 2007, 2006 and 2005, respectively. Other income primarily consists of income from our credit card program, breakage income and dormancy fees.

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. We 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 (“EITF”) No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor” (“EITF 02-16”) since such funds are not a reimbursement of specific, incremental, identifiable costs incurred by us in selling the vendors’ products.

In addition, we record sales net of in-store coupons that we redeem, in accordance with 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”).

Advertising Costs

Gross advertising costs are recognized in SG&A at the point of first broadcast or distribution and were $412 million in fiscal 2007, $353 million in fiscal 2006, and $307 million in fiscal 2005.

Pre-opening Costs

The cost of start-up activities, including organization costs, related to new store openings are expensed as incurred.

 

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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 utilizing a half-year convention. We amortized computer software costs of $16 million during fiscals 2007, 2006 and 2005.

Income Taxes

Income taxes are accounted for in accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). Under SFAS 109, deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the Consolidated Financial Statements. Our effective tax rate in a given financial statement period may be materially impacted by changes in the mix and level of earnings.

At any one time our tax returns for many tax years are subject to examination by U.S. Federal, foreign, and state taxing jurisdictions. We establish tax liabilities in accordance with FIN No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attributes of income tax positions taken or expected to be taken on a tax return. Under FIN 48, the impact of an uncertain tax position taken or expected to be taken on an income tax return must be recognized in the financial statements at the largest amount that is more-likely-than-not to be sustained. An uncertain income tax position will not be recognized in the financial statements unless it is more-likely-than-not to be sustained. We adjust these tax liabilities, as well as the related interest and penalties, based on the latest facts and circumstances, including recently published rulings, court cases, and outcomes of tax audits. To the extent our actual tax liability differs from our established tax liabilities for unrecognized tax benefits, our effective tax rate may be materially impacted.

At February 2, 2008, we reported unrecognized tax benefits in Accrued expenses and other liabilities and Other non-current liabilities in our Consolidated Balance Sheet. These reserves do not include a portion of our unrecognized tax benefits, which have been recorded as a reduction of Deferred tax assets related to net operating losses. At February 3, 2007, we reported tax reserves in the Income taxes payable line of our Consolidated Balance Sheet. For further information, refer to Note 12 to the Consolidated Financial Statements entitled “INCOME TAXES.”

Stock-Based Compensation

Effective January 29, 2006, we adopted SFAS No. 123(R) (revised 2004), “Share-Based Payment” (“SFAS 123(R)”). Under the provisions of SFAS 123(R), stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period. As we were a nonpublic entity at the date of adoption, which used the minimum value method for pro forma disclosures under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), we were required to apply the prospective transition method. As such, we have applied SFAS 123(R) to new awards and to awards modified, repurchased or cancelled since January 29, 2006. We continue to account for any portion of awards outstanding at January 28, 2006 that has not been modified, repurchased or cancelled using the provisions of Accounting Principles Board (“APB”) Opinion 25 (“APB 25”).

SFAS 123(R) requires cash flows, if any, resulting from the tax benefits from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. The adoption of SFAS 123(R) did not have a material impact on our operating and financing cash flows.

 

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NOTE 2 – RESTRUCTURING AND OTHER CHARGES

Our Consolidated Financial Statements for fiscals 2007, 2006 and 2005 included the following pre-tax charges related to restructuring initiatives:

 

(In millions)

   Fiscal
2007
   Fiscal
2006
   Fiscal
2005

2005 Initiative

        

Restructuring charges and other

   $ 2    $ 12    $ 31

Depreciation and amortization

     —        24      22

Cost of sales

     —        3      41
                    

Total charges related to 2005 initiative

   $ 2    $ 39    $ 94
                    

2003 and prior years’ initiatives

        

Restructuring charges and other

   $ —      $ 2    $ 2

SG&A

     —        —        5
                    

Total charges related to 2003 and prior years’ initiatives

   $ —      $ 2    $ 7
                    

Total

   $ 2    $ 41    $ 101
                    

During fiscal 2007 we recorded charges of $7 million and reversed $5 million of previously recorded reserves based on changes in estimated lease commitments. During fiscal 2006, we incurred $22 million of charges relating to lease commitments and disposal charges, which were partially offset by the reversal of $8 million of previously recorded reserves primarily related to lease commitments and severance. During fiscal 2005, we incurred $33 million of charges relating to lease commitments and disposal charges.

Restructuring charges and reversals are related to prior years’ initiatives and are primarily due to changes in management’s estimates for events such as lease terminations, assignments and sublease income adjustments.

Our Consolidated Balance Sheets as of February 2, 2008 and February 3, 2007 include these restructuring reserves in Accrued expenses and other current liabilities and Other non-current liabilities, which we believe are adequate to cover our commitments. We currently expect to utilize our remaining reserves through January 2019. The following is a description of our individual restructuring initiatives and a roll-forward of the related charges and reserves.

 

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2005 Initiatives

On January 5, 2006, our Board of Directors approved the closing of 87 Toys “R” Us stores in the United States. By the end of the first quarter 2006, all 87 stores had been closed. Twelve of these stores have been converted into Babies “R” Us stores, which reopened in the fall of 2006, resulting in the permanent closure of 75 stores. As a result of the store closings, approximately 3,000 employee positions were eliminated.

A reconciliation of the activity for the 2005 initiative, by major type of cost during the fiscals 2007 and 2006 is as follows:

 

(In millions)

   Lease
Commitments
    Asset
Impairment
    Severance     Inventory
Markdowns
    Accelerated
Depreciation
    Total  

Balance at January 28, 2006

   $ 1     $ —       $ 8     $ 34     $ —       $ 43  
                                                

Charges

     10       6       —         3       24       43  

Reversals

     (3 )     —         (1 )     —         —         (4 )

Utilized

     (9 )     (6 )     (7 )     (37 )     (24 )     (83 )

Reclassification(1)

     12       —         —         —         —         12  
                                                

Balance at February 3, 2007

   $ 11     $ —       $ —       $ —       $ —       $ 11  
                                                

Charges

     3       —         —         —         —         3  

Reversals

     (1 )     —         —         —         —         (1 )

Utilized

     (4 )     —         —         —         —         (4 )
                                                

Balance at February 2, 2008

   $ 9     $ —       $ —       $ —       $ —       $ 9  
                                                

 

(1)

Reclassification of straight-line lease reserves recorded in prior periods related to the restructured properties.

2003 and Prior Year’s Initiatives

In fiscal 2003, we decided to close all 146 freestanding Kids “R” Us stores and all 36 freestanding Imaginarium stores, as well as three distribution centers that supported these stores, due to deterioration in their financial performance. In fiscal 2001, we closed stores, eliminated a number of staff positions, and consolidated five store support center facilities into our Global Store Support Center facility in Wayne, New Jersey. In fiscals 1998 and 1995, we had strategic initiatives to reposition our worldwide operations.

The following is a reconciliation of the activity during fiscals 2007 and 2006:

 

(In millions)

   2004
initiative
    2003
initiative
    2001
initiative
    1998 and 1995
initiatives
    Total  

Balance at January 28, 2006

   $ 1     $ 8     $ 51     $ 22     $ 82  
                                        

Charges

     —         4       2       —         6  

Reversals

     —         (2 )     (1 )     (1 )     (4 )

Utilized

     (1 )     (6 )     (9 )     (5 )     (21 )
                                        

Balance at February 3, 2007

   $ —       $ 4     $ 43     $ 16     $ 63  
                                        

Charges

     —         —         4       —         4  

Reversals

     —         —         (2 )     (2 )     (4 )

Utilized

     —         (2 )     (9 )     (6 )     (17 )
                                        

Balance at February 2, 2008

   $ —       $ 2     $ 36     $ 8     $ 46  
                                        

 

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NOTE 3 – SHORT-TERM BORROWINGS AND LONG-TERM DEBT

A summary of the Company’s consolidated short-term borrowings and long-term debt as well as the effective interest rates on our outstanding short-term borrowings and variable rate debt as of February 2, 2008 and February 3, 2007, respectively, is outlined in the table below:

 

(In millions)

   February 2,
2008
   February 3,
2007

Short-term borrowings

     

Toys-Japan 0.52%-0.89% short-term bank loans due fiscal 2007 (0.69%)

   $ —      $ 151
             

Long-term debt (1)

     

Note due in semi-annual installments through February 20, 2008 (1.75% and 1.75%)(2)

   $ 21    $ 49

Toys-Japan 0.77%-1.18% loans due fiscal 2008 (0.87%)(3)

     137      —  

Asset sale facility, due July 19, 2008 (9.32%)

     —        44

Secured real estate loan, due August 9, 2008 (5.54% and 6.62%)(4)

     800      800

Unsecured credit agreement, due December 9, 2008 (6.26% and 8.32%)(4)

     1,300      1,300

$2.0 billion secured revolving credit facility, expires fiscal 2010

     —        —  

Multi-currency revolving credit facility, expires fiscal 2010

     —        —  

Toys-Japan 1.20%-2.80% loans due fiscals 2010-2014 (1.70% and 1.75%)

     153      152

7.625% notes, due fiscal 2011(5)

     517      522

Secured term loan facility, due fiscal 2012 (9.55% and 9.67%)

     797      800

Unsecured credit facility, due fiscal 2012 (9.41% and 10.32%)

     180      180

French real estate credit facility, due fiscal 2012 (4.51% and 4.51%)

     95      84

Spanish real estate credit facility, due fiscal 2012 (4.51% and 4.51%)

     196      173

U.K. real estate senior credit facility, due fiscal 2013 (5.02% and 5.02%)

     696      700

U.K. real estate junior credit facility, due fiscal 2013 (6.84% and 6.81%)

     124      121

7.875% senior notes, due fiscal 2013(5)

     392      391

7.375% senior notes, due fiscal 2018(5)

     407      408

8.750% debentures, due fiscal 2021(6)

     22      22

Capital leases and other

     37      42
             
     5,874      5,788

Less current portion

     50      66
             

Total long-term debt

   $ 5,824    $ 5,722
             

 

(1)

We maintain derivative instruments on certain of our long-term debt, which impact our effective interest rates. Refer to Note 4 to our Consolidated Financial Statements entitled “DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES” for further details.

(2)

On February 20, 2008, we paid the final installment of this note.

(3)

We have classified these loans as long-term debt, because we refinanced these obligations on March 31, 2008, which extended the due dates to fiscal 2011.

(4)

We have classified these loans as long-term debt, because we have the ability and intent to extend the due dates to fiscal 2010.

(5)

Represents obligations of Toys “R” Us, Inc. legal entity. For further details on parent company information, refer to Schedule I - Condensed Financial Statements and Notes to the Condensed Financial Statements.

(6)

Represents obligations of Toys “R” Us, Inc. and Toys-Delaware.

Our credit facilities and loan agreements contain customary covenants, including, among other things, covenants that restrict our ability to incur certain additional indebtedness, create or permit liens on assets, or engage in mergers or consolidations. Certain of our agreements also contain various and customary events of default with respect to the loans, including, without limitation, the failure to pay interest or principal when the same is due under the agreements, cross default provisions, the failure of representations and warranties contained in the agreements to be true and certain insolvency events. If an event of default occurs and is continuing, the principal amounts outstanding thereunder, together with all accrued unpaid interest and other amounts owed thereunder, may be declared immediately due and payable by the lenders. We are currently in compliance with all of our financial covenants (as described below) related to our outstanding debt.

 

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The total fair market values of our short-term borrowings and long-term debt, with carrying values of $5.9 billion at February 2, 2008 and February 3, 2007, were $5.1 billion and $5.8 billion, respectively. The fair market values of our long-term debt are estimated using the quoted market prices for the same or similar issues and other pertinent information available to management as of the end of the respective periods.

The annual maturities of short-term borrowings, capital leases and long-term debt at February 2, 2008 are as follows:

 

(In millions)

   Annual
Maturities

2008(1)(2)

   $ 50

2009

     24

2010(1)

     2,229

2011(2)

     676

2012

     1,268

2013 and subsequent

     1,627
      

Total

   $ 5,874
      

 

(1)

We have classified our $800 million secured real estate loan due August 9, 2008 and our $1.3 billion unsecured credit agreement due December 9, 2008 as annual maturities of fiscal 2010, because we have the ability and intent to extend the due dates to August 9, 2010 and December 7, 2010, respectively.

(2)

We have classified $137 million of Toys-Japan loans due fiscal 2008 as annual maturities of fiscal 2011, because we have refinanced the obligations on March 31, 2008, which extended the due dates to fiscal 2011.

Toys-Japan 0.77%-1.18% loans due fiscal 2008 ($137 million at February 2, 2008)

Toys – Japan maintained loans under unsecured credit facilities with various financial institutions. These unsecured credit facilities consisted of approximately ¥47 billion ($439 million at February 2, 2008) in uncommitted lines of credit, under which Toys – Japan had borrowings outstanding of $137 million and $151 million at February 2, 2008 and February 3, 2007, respectively. The interest rates on these loans ranged between TIBOR plus 0.18%-0.50%. Availability under these lines of credit at February 2, 2008 was $302 million.

On March 31, 2008, Toys – Japan entered into an agreement with a syndicate of financial institutions, which established two unsecured loan commitment lines of credit (“Tranche 1” and “Tranche 2”) and an overdraft facility of ¥4 billion ($40 million at March 31, 2008). Under the agreement, Tranche 1 is available in amounts of up to ¥20 billion ($201 million at March 31, 2008), which expires in fiscal 2011, and bears an interest rate of TIBOR plus 0.63% per annum. Tranche 2 is available in amounts of up to ¥15 billion ($151 million at March 31, 2008), which expires in fiscal 2009, and bears an interest rate of TIBOR plus 0.35% per annum. The agreement contains covenants, including, among other things, covenants that require Toys —Japan to maintain a certain minimum level of net assets and profitability during the agreement terms. The agreement also restricts the Company from reducing its ownership percentage in Toys – Japan. At February 2, 2008, we have classified the outstanding balance of $137 million as long-term debt, as we have refinanced these borrowings subsequent to February 2, 2008 under Tranche 1, which expires in fiscal 2011.

$2.0 billion secured revolving credit facility, expires fiscal 2010 ($0 at February 2, 2008)

Our $2.0 billion five-year secured revolving credit facility bears a tiered floating interest rate of LIBOR plus 1.00%-3.75% per annum. This credit facility is available for general corporate purposes and the issuance of letters of credit. Borrowings under this credit facility are secured by tangible and intangible assets, subject to specific exclusions stated in the credit agreement. The credit agreement contains covenants, including, among other things, covenants that restrict the ability of Toys “R” Us-Delaware, Inc. (“Toys-Delaware”), our direct wholly-owned subsidiary, and certain of its subsidiaries to incur certain additional indebtedness, create or permit liens on assets, engage in mergers or consolidations, pay dividends, repurchase capital stock, make other restricted payments, make loans or advances, engage in transactions with affiliates, or amend material documents. The revolving credit facility also requires that Toys-Delaware maintain a minimum excess availability greater than or equal to the lesser of $125 million or 10% of the calculated borrowing base, meaning that the borrowing base (generally consisting of specified percentages of eligible inventory, credit card receivables and certain real estate less any applicable availability reserves) must exceed the amount of borrowings under the credit facility by the minimum excess availability. Interest rate pricing for the facility is tiered based on levels of excess availability. At February 2, 2008, we had no outstanding borrowings and a total of $110 million of outstanding letters of credit under this credit facility which expires in fiscal 2010. We had availability of $1.0 billion under this facility at fiscal year-end and paid commitment fees of $6 million in both fiscals 2007 and 2006.

 

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Multi-currency revolving credit facility, expires fiscal 2010 ($0 at February 2, 2008)

Our multi-currency revolving credit facility is available in amounts of up to £95 million ($186 million) and €145 million ($215 million), and bears a tiered floating interest rate of LIBOR plus 1.50% - 2.00% per annum. The facility is guaranteed by Toys “R” Us Europe, LLC, and its respective subsidiaries, and secured by a lien over assets of the borrowers and guarantors under the facility. The multi-currency revolving credit facility agreement contains covenants, including, among other things, covenants that restrict the ability of Toys “R” Us Europe, LLC, and its respective subsidiaries to incur certain additional indebtedness, create or permit liens on assets, or engage in mergers or consolidations. At February 2, 2008, we had no outstanding borrowings and current availability of $401 million under this credit facility which expires in fiscal 2010. We paid commitment fees of $2 million in both fiscals 2007 and 2006.

Asset sale facility, due July 19, 2008 ($0 at February 2, 2008)

On July 19, 2006, Toys-Delaware entered into secured credit facilities with a syndicate of financial institutions (the “Secured Credit Facilities”). The Secured Credit Facilities consisted of an $804 million secured term loan facility (discussed below) and a $200 million asset sale facility. The asset sale facility carried an interest rate of LIBOR plus 3.00%-4.00%. During fiscal 2007, Toys-Delaware repaid $44 million of principal of the $200 million asset sale facility with proceeds from the properties sold in fiscal 2007 and from the lease termination agreement consummated during fiscal 2007. Refer to Note 5 to the Consolidated Financial Statements entitled “PROPERTY AND EQUIPMENT” for additional information. As of February 2, 2008, all borrowings under this facility were fully repaid.

Secured real estate loan, due August 9, 2008 ($800 million at February 2, 2008)

On July 21, 2005, certain indirect wholly-owned subsidiaries entered into mortgage loan agreements totaling $800 million with a syndicate of financial institutions, carrying annual weighted average interest rates of LIBOR plus 1.30%. Each of these loan agreements has a two-year term and provides for three one-year extensions at the election of the borrower. The Secured real estate loan is secured against direct and indirect interests in certain real property located in the United States. The loan agreements contain covenants, including, among other things, covenants that restrict the ability of the borrowers to incur additional indebtedness, create or permit liens on assets or engage in mergers or consolidations, commingle assets with affiliates, amend organizational documents, and initiate zoning reclassification of any portion of the secured property. In addition, these covenants restrict certain transfers of, and the creation of liens on, direct or indirect interests in the borrowers except in specified circumstances. The debt is subject to mandatory prepayment as specified in the agreement.

On July 9, 2007, we notified the lenders that we were exercising our first maturity date extension option (the “First Extension Option”), which extended the maturity date of the loan from August 9, 2007 to August 9, 2008. The other terms of the loan were not changed as a result of the extension. We have the ability and intent to exercise our two remaining maturity date extension options to August 2009 and August 2010.

Unsecured credit agreement, due December 9, 2008 ($1.3 billion at February 2, 2008)

On December 9, 2005, TRU 2005 RE Holding Co. I, LLC, our indirect wholly-owned subsidiary, entered into a credit agreement with a syndicate of financial institutions, pursuant to which we borrowed $1.3 billion. The syndicate includes affiliates of Kohlberg Kravis Roberts & Co., L.P., an indirect equity owner of the Company, which participated in 6% of the loan amount in fiscals 2007 and 2006. This loan has an interest rate of either 3.00% plus LIBOR or 2.00% plus the higher of (i) 0.50% in excess of the overnight Federal funds rate and (ii) the prime lending rate. The loan restricts the use of certain cash accounts and contract rights. The initial maturity date is December 9, 2008. The credit agreement provides for two maturity date extension options to December 8, 2009 and December 7, 2010 of which we have the ability and intent to exercise.

The credit agreement contains covenants, including, among other things, covenants that restrict the ability of the borrower or the guarantors, which are our indirect wholly-owned subsidiaries Wayne Real Estate Company, LLC, MAP Real Estate, LLC, TRU 2005 RE I, LLC, and TRU 2005 RE II Trust, to create or permit liens on assets, incur additional indebtedness, modify or terminate the master lease that these companies have with Toys-Delaware or engage in mergers or consolidations. In addition, these covenants restrict certain transfers of, and the creation of liens on, direct or indirect interests in the borrower and the guarantors. This credit agreement contains certain borrowing base conditions related to the real property assets owned by the guarantors, which, if the assets cease to comply with such conditions, could result in a required repayment of all or a portion of the loan.

 

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Secured term loan facility, due fiscal 2012 ($797 million at February 2, 2008)

On July 19, 2006, Toys-Delaware entered into the Secured Credit Facilities with a syndicate of financial institutions. The syndicate includes affiliates of Kohlberg Kravis Roberts & Co., L.P., an indirect equity owner of the Company, which participated in 10% and 5% of the loan amount in fiscals 2007 and 2006, respectively. The Secured Credit Facilities consisted of an $804 million secured term loan facility and a $200 million asset sale facility (discussed above). Obligations under the Secured Credit Facilities are guaranteed by substantially all domestic subsidiaries of Toys-Delaware and the borrowings are secured by accounts receivable, inventory and intellectual property of Toys-Delaware and the guarantors. The Secured Credit Facilities contain customary covenants, including, among other things, covenants that restrict the ability of Toys-Delaware and certain of its subsidiaries to incur certain additional indebtedness, create or permit liens on assets, or engage in mergers or consolidations. If an event of default under the Secured Credit Facilities occurs and is continuing, the commitments may be terminated and the principal amount outstanding, together with all accrued unpaid interest and other amounts owed may be declared immediately due and payable by the lenders. The term loan facility bears interest equal to LIBOR plus 4.25% per annum and matures on July 19, 2012. On November 2, 2007, Toys-Delaware used $4 million of the $29 million proceeds from property sold during the third quarter of fiscal 2007 (refer to Note 5 to the Consolidated Financial Statements entitled “PROPERTY AND EQUIPMENT”) to repay a portion of the secured term loan facility. At February 2, 2008, the unamortized discount recorded for the $800 million secured term loan facility was $3 million.

Unsecured credit facility, due fiscal 2012 ($180 million at February 2, 2008)

On December 1, 2006, Toys-Delaware entered into an unsecured credit facility (the “Unsecured Credit Facility”) with a syndicate of financial institutions and other lenders. The syndicate includes affiliates of Vornado Realty Trust and Kohlberg Kravis Roberts & Co., L.P., indirect equity owners of the Company, which each participated in 15% of the loan amount in fiscals 2007 and 2006. The Unsecured Credit Facility matures on January 19, 2013 and bears interest equal to LIBOR plus 5.00% per annum or, at the option of Toys-Delaware, prime plus 4.00% per annum.

In addition, obligations under the Unsecured Credit Facility are guaranteed by substantially all domestic subsidiaries of Toys-Delaware. The Unsecured Credit Facility contains the same customary covenants as those under the Secured Credit Facilities. At February 2, 2008, the unamortized discount for the Unsecured Credit Facility was $1 million.

€63.9 million French and €132.4 million Spanish real estate credit facilities, due fiscal 2012 ($95 million and $196 million at February 2, 2008, respectively)

On January 23, 2006, our indirect wholly-owned subsidiaries Toys “R” Us France Real Estate SAS and Toys “R” Us Iberia Real Estate S.L. entered into the French and Spanish real estate credit facilities, respectively. These facilities are secured by, among other things, selected French and Spanish real estate. The maturity date for each of these loans is February 1, 2013. The loans have interest rates of EURIBOR plus 1.50% plus mandatory costs per annum. The loan agreements contain covenants that restrict the ability of the borrowers to engage in mergers or consolidations, incur additional indebtedness, or create or permit liens on assets. The loan agreements also require the borrower to maintain interest coverage ratios of 110%.

£354.5 million U.K. real estate senior and £63.0 million U.K. real estate junior credit facilities, due fiscal 2013 ($696 million and $124 million at February 2, 2008, respectively)

On February 8, 2006, Toys “R” Us Properties (UK) Limited (“Toys Properties”), our indirect wholly-owned subsidiary, entered into a series of secured senior and junior loans with Vanwall as the Issuer and Senior Lender and The Royal Bank of Scotland PLC as Junior Lender. These facilities are secured by, among other things, selected U.K. real estate. The U.K. real estate senior credit facility bears interest of 5.02% plus mandatory costs. The U.K. real estate junior credit facility bears interest at an annual rate of LIBOR plus a margin of 2.25% plus mandatory costs. On February 8, 2007, Toys Properties borrowed an additional $4 million from the Junior Lender.

The credit agreements contain covenants that restrict the ability of Toys Properties to incur certain additional indebtedness, create or permit liens on assets, dispose of or acquire further property, vary or terminate the lease agreements, conclude further leases or engage in mergers or consolidations. Toys Properties is required to repay the loans in part in quarterly installments. The final maturity date for these credit facilities is April 7, 2013.

Vanwall is a variable interest entity established with the limited purpose of issuing and administering the notes under the credit agreement with Toys Properties. Vanwall has issued £355.8 million ($699 million at February 2, 2008) of multiple classes of

 

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commercial mortgage backed floating rate notes (the “Floating Rate Notes”) to third party investors (the “Bondholders”), which are publicly traded on the Irish Stock Exchange Limited. The proceeds from the Floating Rate Notes issued by Vanwall were used to fund the Senior Loan to Toys Properties. Per the Credit Agreement, Vanwall is required to maintain an interest rate swap which effectively fixed the variable LIBOR rate at 4.56%, the same as the fixed interest rate paid by Toys Properties to Vanwall. The fair market value of this interest rate swap at February 2, 2008 was approximately $11 million. Our loan agreement with Vanwall requires the Company to indemnify Vanwall against any loss or liability that Vanwall incurs as a consequence of any part of the loan being repaid or prepaid, including costs relating to terminating all or part of their interest rate swap. Management has performed an analysis of Vanwall in accordance with FIN 46(R) and has concluded that the Company is not the primary beneficiary of any gains or losses from Vanwall’s interest rate swap and the entity should not be consolidated.

Guarantees

Toys “R” Us, Inc. currently guarantees 80% of Toys-Japan’s three installment loans from a third party in Japan, totaling $45 million. These loans have annual interest rates of 2.60% – 2.80%, are due from 2012 to 2014, and are reported as part of the Toys-Japan loans of $153 million at February 2, 2008.

Other Debt

In May 2001, Toys-Japan entered into a secured borrowing arrangement with KKFC, a special purpose entity formed with the limited purpose of borrowing and lending funds to Toys-Japan. The borrowings under this arrangement are secured against certain security deposit receivables. In connection with this arrangement, KKFC entered into an interest rate swap in order to convert the fixed interest payments received from Toys-Japan into variable interest rate payments, as required by its lenders. In addition, Toys-Japan signed various agreements (“Agreements”) which indemnified KKFC from any losses resulting from the transaction.

In fiscal 2007, KKFC was notified by its lenders that they would no longer continue to renew its loan. Under the Agreements, Toys-Japan was required to lend KKFC the full amount to repay its lenders and post collateral of $4 million to cover the liability position of the interest rate swap. Therefore, the repayment of the loan and posting of collateral by Toys-Japan on behalf of KKFC was identified as a reconsideration event under FIN 46(R) and impacted the variable interest of Toys-Japan in KKFC. Management has performed an analysis of KKFC in accordance with FIN 46(R) and has concluded that we are the primary beneficiary and should consolidate this special purpose entity. The consolidation resulted in the recognition of a $20 million net repayment of third party debt. In addition, the consolidation of this entity resulted in the recognition of an interest rate swap of $4 million. Refer to Note 4 to our Consolidated Financial Statements entitled “DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES” for further details.

NOTE 4 – DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

SFAS 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires the recording of all derivatives as either assets or liabilities on the balance sheet measured at estimated fair value and the recognition of the unrealized gains and losses. We record the fair market value of our derivatives, based on estimates, in Other assets and Other non-current liabilities within our Consolidated Balance Sheets. The changes in fair value of derivatives are recorded in the Consolidated Statements of Operations in Interest expense, unless the derivative is designated as a hedge. In certain defined conditions, a derivative may be specifically designated as a hedge for a particular exposure. The effective portion of a cash flow hedge is recorded to Accumulated other comprehensive income (loss); the ineffective portion of a cash flow hedge is recorded to Interest expense. The accounting for derivatives depends on the intended use of the derivatives and the resulting designation. For our derivatives that are designated under SFAS 133 as cash flow hedges, no material ineffectiveness existed at February 2, 2008 and February 3, 2007.

During fiscals 2007 and 2006, we entered into derivative financial arrangements to manage a variety of risk exposures, including interest rate risk associated with our long-term debt and foreign currency risk relating to import merchandise purchases. We entered into interest rate swaps and/or caps to manage interest rate risk in order to reduce our exposure to variability in expected future cash outflows attributable to the changes in LIBOR and EURIBOR rates. We entered into foreign exchange forward contracts to manage certain currency risks associated with the settlement of payables related to our merchandise import program. As of February 2, 2008, we discontinued our practice of entering into foreign exchange forward contracts under our merchandise import program. Derivatives related to our merchandise import program were not designated as hedges under SFAS 133 and are marked to market through Interest expense.

 

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During fiscal 2007, we recorded a net loss of $8 million to Accumulated other comprehensive income (loss) related to the change in the fair value of our variable cash flow hedges. We reclassified a net loss of $2 million to Interest expense from Accumulated other comprehensive income (loss) for fiscal 2007. This reclassification primarily relates to the allocated time value of the premiums on the options of certain interest rate caps, partially offset by the amortization of cash received on previously terminated swaps. In fiscal 2006, we reclassified a net gain of $1 million to Interest expense from Accumulated other comprehensive income (loss). We expect to reclassify a net loss of approximately $3 million in fiscal 2008 to Interest expense from Accumulated other comprehensive income (loss). In addition, we recorded net losses of $35 million and $2 million in fiscals 2007 and 2006, respectively, to Interest expense, which relate to the changes in our derivatives that did not qualify for hedge accounting under SFAS 133. In fiscal 2005, derivative activity had a nominal impact to our Consolidated Financial Statements.

The following table presents our outstanding derivative contracts as of February 2, 2008 and February 3, 2007:

 

               As of February 2, 2008     As of February 3, 2007  

(In millions)

Related Items (in Local Currency) (1)

   Effective Date    Maturity Date    Notional
Amount
(In USD)
   Ending
Balance at
Fair Value
    Notional
Amount
(In USD)
   Ending
Balance at
Fair Value
 

Derivative Assets:

                

Foreign Exchange Forwards

                

Merchandise import program (Varies) (2)

   Varies    Varies    $ —      $ —       $ 106    $ 1  

Interest Rate Swaps

                

French real estate credit facility due fiscal 2012 (EUR)

   February 2006    February 2013      95      4       84      5  

Spanish real estate credit facility due fiscal 2012 (EUR)

   February 2006    February 2013      196      8       173      10  

U.K. real estate junior credit facility due fiscal 2013 (GBP)

   February 2006    April 2013      120      2       121      6  

Interest Rate Caps

                

Secured real estate loan due August 9, 2008 (USD)

   July 2005    August 2008      800      —         800