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 January 28, 2006

 

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

 

Large accelerated filer  ¨   Accelerated filer  ¨   Non-accelerated filer  x

 

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 January 28, 2006 there were outstanding 1,000 shares of common stock of Toys “R” Us, Inc. (all of which are owned by our 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, 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 risks, uncertainties and factors set forth under “Item 1A. Risk Factors” and in our reports and documents filed with the Securities Exchange Commission. We believe that all forward-looking statements are based on reasonable assumptions when made; however, we caution that it is impossible to predict actual results or outcomes or the effects of risks, uncertainties or other factors on anticipated results or outcomes and that, accordingly, one should not place undue reliance on these statements. Forward-looking statements speak only as of the date they were made, and we undertake no obligation to update these statements in light of subsequent events or developments. Actual results may differ materially from anticipated results or outcomes discussed in any forward-looking statement.


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INDEX

 

          PAGE

PART I.

         

Item 1.

  

Business

   1

Item 1A.

  

Risk Factors

   13

Item 1B.

  

Unresolved Staff Comments

   21

Item 2.

  

Properties

   21

Item 3.

  

Legal Proceedings

   21

Item 4.

  

Submission of Matters to a Vote of Security Holders

   22

PART II.

         

Item 5.

  

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

   23

Item 6.

  

Selected Financial Data

   23

Item 7.

  

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

   24

Item 7a.

  

Quantitative and Qualitative Disclosures About Market Risk

   51

Item 8.

  

Financial Statements and Supplementary Data

   53

Item 9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   107

Item 9A.

  

Controls and Procedures

   107

Item 9B.

  

Other Information

   111

PART III.

         

Item 10.

  

Directors and Executive Officers of the Registrant

   112

Item 11.

  

Executive Compensation

   115

Item 12.

  

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

   123

Item 13.

  

Certain Relationships and Related Transactions

   124

Item 14.

  

Principal Accounting Fees and Services

   126

PART IV.

         

Item 15.

  

Exhibits and Financial Statement Schedules

   128

SIGNATURES

   129

INDEX TO EXHIBITS

   130


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PART I

 

ITEM 1.    BUSINESS

 

Except as expressly indicated or unless the context otherwise requires, as used herein, the “Company,” “we,” “us,” or “our” means Toys “R” Us, Inc., and its subsidiaries. Based on sales, we are the largest specialty retailer of toys in the United States and Puerto Rico, and the only national specialty retailer of baby-juvenile products in the United States. As of January 28, 2006, our business consists of 671 Toys “R” Us stores in the United States, 230 Babies “R” Us specialty baby-juvenile stores in the United States and 641 international stores in 31 countries, of which 625 are Toys “R” Us stores and 16 are Babies “R” Us stores. Included in the 641 international stores are 336 licensed or franchised stores. Toysrus.com, our Internet subsidiary, sells merchandise on the Internet through www.toysrus.com, www.babiesrus.com, www.imaginarium.com, www.sportsrus.com, and www.personalizedbyrus.com in the United States and www.toysrus.ca in Canada. Toys “R” Us, Inc. is incorporated in the state of Delaware.

 

Our fiscal year ends on the Saturday nearest to January 31 of each calendar year. This Annual Report on Form 10-K reports on our last three fiscal years ended as follows: for the fiscal year ended January 28, 2006 (our 2005 fiscal year end), for the fiscal year ended January 29, 2005 (our 2004 fiscal year end), and for the fiscal year ended January 31, 2004 (our 2003 fiscal year end). References to 2005, 2004 and 2003 are to our fiscal years unless otherwise specified or the context otherwise requires.

 

Our retail business began in 1948 when founder Charles Lazarus opened a baby furniture store, Children’s Bargain Town, in Washington, D.C. The Toys “R” Us name made its debut in 1957. Since inception, Toys “R” Us has built its reputation as a leading consumer destination for toys and children’s products, including apparel. We opened our first Babies “R” Us stores in 1996, expanding our presence into the specialty baby-juvenile market. Based on sales, we are among the market share leaders in most of the largest markets in which Toys “R” Us retail stores operate, including the United States and United Kingdom. We attribute our market-leading positions in the toy and baby-juvenile markets to our broad product offerings, our highly recognized brand names, our substantial scale and geographic footprint, and our strong vendor relationships.

 

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, Kohlberg Kravis Roberts & Co., L.P. (“KKR”), and Vornado Realty Trust (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, 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 common stock, restricted stock and restricted stock units, fees and expenses related to the Merger, and severance, bonuses and related payroll taxes. The merger consideration was funded through the use of the Company’s available cash, cash equity contributions from the Investors and the debt financings as described more fully below. We refer to the July 21, 2005 Merger and recapitalization as the “Merger Transaction.” Please refer to the section entitled “Merger Transaction” under Item 7. “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” and Note 2 to our Consolidated Financial Statements entitled “MERGER TRANSACTION” for further details.

 

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Toys “R” Us – U.S.

 

Through our Toys “R” Us stores, based on sales, we are the largest specialty retailer of toys in the United States and Puerto Rico. In the U.S. toys and video game products market, based on sales, we were the second-largest toy retailer in 2005. We offer the most comprehensive selection of merchandise in the retail toy industry. By focusing on toys, we are able to provide customers with a comprehensive range of merchandise and vendors with a year-round distribution outlet for the broadest assortment of their products. Our product offerings include toys, plush, games, bicycles, sporting goods, VHS and DVD movies, electronic and video games, small pools, books, educational and development products, clothing, infant and juvenile furniture, and electronics, as well as educational and entertainment computer software for children. A typical Toys “R” Us store currently has year-round between 8,000 and 10,000 items, which we believe is nearly twice the number of items offered by mass merchandisers or other specialty stores that sell toys.

 

We seek to differentiate ourselves from competitors in several key areas, including product selection, product presentation, service, in-store experience, and marketing. In the last several years, we have taken a number of actions in our attempt to strengthen our franchise. These actions included:

 

    Enhancing our product offering and adding more exclusive products to our mix;

 

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

 

    Adding an Imaginarium learning and educational toy boutique to all domestic toy stores; and

 

    Reorganizing our store management teams into merchandise “Worlds” and improving customer service.

 

Operations

 

As of January 28, 2006, we operated 671 toy stores in the United States, including 419 combo stores, which combine our toy offering with approximately 5,500 square feet of children’s apparel. Our extensive experience in retail site selection has resulted in a portfolio of stores that include attractive locations in many of our chosen markets. Toys “R” Us stores, generally conform to standardized designs, are approximately 30,000 to 45,000 square feet and consist of freestanding units or are located within shopping centers. During the fiscal year 2005, we closed ten toy stores.

 

On January 5, 2006, our Board of Directors approved the closing of 87 Toys “R” Us stores in the United States. As of January 28, 2006, we closed three of these stores. All of the remaining 84 stores were closed by April 2, 2006. Twelve of these stores will be converted into Babies “R” Us stores, resulting in the permanent closure of 75 stores. For further details refer to “2005 Restructuring Initiative” in this section, Item 7 entitled “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” and Note 5 to the Consolidated Financial Statements entitled “RESTRUCTURING AND OTHER CHARGES.”

 

Product Selection and Merchandise

 

Our product offerings are primarily focused on serving the needs of parents or grandparents interested in purchasing toys for children between the ages of two and ten. We offer products according to the following merchandise “Worlds”:

 

    Core Toy—Our core toy products include boys and girls toys, such as dolls and doll accessories, action figures, role play toys and vehicles; pre-school merchandise, such as pre-school learning products, activities and toys; and our Imaginarium product offerings, which include educational and developmental products and accessories, games, ANIMAL ALLEY plush and puzzles;

 

    Seasonal—Our seasonal offerings include 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;

 

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    Juvenile or Infant Care—Our juvenile and infant care products include baby products and apparel for infants and toddlers in sizes ranging from newborn to age four;

 

    R ZONE—Our R ZONE world includes video game hardware and software, electronics, computer software and other related products;

 

    Geoffrey’s Box Office—Geoffrey’s Box Office consists of VHS and DVD movies and other content designed to appeal to parents and children; and

 

    Apparel—Apparel is offered in our U.S. Toys “R” Us combo stores and generally includes clothing in sizes ranging from newborn to age ten.

 

We offer a wide selection of popular national toy brands including many products that are unique to, or launched at, Toys “R” Us. Over the past few years, we have worked with key resources to obtain exclusive products and expand our private label brands enabling us to earn higher margins and offer products that our customers will not find elsewhere. For example, over the past several years, we have entered into exclusive branded product agreements with toy companies such as Mattel, Inc., MGA Entertainment, Inc., Lego, Fisher Price and Cranium, and have developed exclusive licensed toy lines such as Animal Planet, Viking’s Construction Sets, Magic Hair Fairytale Dora, Conga Game, and Scholastic learning products through alliances with various companies. We have also entered into joint marketing campaigns for product promotions related to, among others, Batman Begins, Star Wars, Cinderella, and Major League Baseball. We offer a broad selection of private label merchandise under names such as ANIMAL ALLEY, FAST LANE, FUN YEARS and DREAM DAZZLERS 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 methods include mass marketing programs such as catalogs and other inserts in national or local newspapers and national television and radio broadcasts. Another key part of our holiday season marketing strategy involves placing ads in newspapers on Thanksgiving Day to drive sales on the following Friday and Saturday. Our overall marketing efforts are carefully coordinated such that in-store marketing signage is consistent with the current television, radio and print advertisements.

 

Customer Service

 

Compared to mass merchandisers, 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 waiting times at checkout counters and the allocation of products within our stores.

 

Market and Competition

 

The U.S. retail toy and video game products market totaled approximately $32 billion in sales in 2005, with approximately two-thirds of sales driven by traditional toys and approximately one-third driven by video games. In the toys and video games 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 market 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. In recent years, mass merchandisers, primarily Wal-Mart and Target have expanded their market share for toys and games as they have expanded their commitment to the toy and video game categories and rolled out new stores across the United States. As with other categories, their market share gains have predominantly come from department stores, secondary mass merchandisers and independent players. Mass merchandisers use aggressive

 

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pricing policies and enlarged toy-selling areas during the holiday season to build traffic for other store departments. In addition, competition in the video game market has increased in recent years as mass merchandisers have expanded and consumer electronics retailers, such as Best Buy, Electronics Boutique and Gamestop, have all experienced significant growth.

 

We believe the principal competitive factors in the toy market are product variety, quality and availability, price, advertising and promotion, convenience or store location, customer support, and service. We believe that we are able to compete with our key competitors by providing the broadest range of merchandise and high levels of customer support and service at competitive prices.

 

Seasonality

 

Our Toys “R” Us 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 U.S. 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.

 

Geographic Distribution of Toys “R” Us Stores

 

The following table sets forth the location of our Toys “R” Us stores across the United States and Puerto Rico as of January 28, 2006:

 

Location


   Number of Stores

Alabama

   7

Alaska

   1

Arizona

   11

Arkansas

   4

California

   80

Colorado

   8

Connecticut

   10
Delaware    2

Florida

   46

Georgia

   20

Hawaii

   1

Idaho

   2

Illinois

   31

Indiana

   13

Iowa

   8

Kansas

   5

Kentucky

   8

Louisiana

   8

Maine

   2

Maryland

   18

Massachusetts

   18

Michigan

   24

Minnesota

   9

Mississippi

   5

Missouri

   13

Montana

   1

Nebraska

   3

Location


   Number of Stores

Nevada    4
New Hampshire    5
New Jersey    26
New Mexico    4
New York    45
North Carolina    15
North Dakota    1
Ohio    31
Oklahoma    5
Oregon    7
Pennsylvania    33
Rhode Island    1
South Carolina    9
South Dakota    2
Tennessee    14
Texas    49
Utah    6
Vermont    1
Virginia    21
Washington    15
West Virginia    4
Wisconsin    11
Puerto Rico    4
    
        Total USA    671
    

 

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Toys “R” Us – International

 

Toys “R” Us – International (“Toys International”) operates, licenses and franchises toy stores in 31 foreign countries. These stores generally conform to traditional prototypical designs similar to those used by Toys “R” Us – U.S., typically ranging in size from 30,000 to 45,000 square feet of space. Some international stores utilize proprietary brands and shopping “Worlds” that have been successful in the United States. The “Worlds” include Imaginarium boutiques, which are known in some countries as “World of Imagination,” and Babies “R” Us boutiques. We present our customers with a “one-stop” shopping experience and provide a breadth of product assortment unrivaled by our competitors. A typical Toys International store carries a range of 7,500 to 9,500 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.

 

We seek to differentiate ourselves from competitors in several key areas, including product selection, product presentation, service, in-store experience, and marketing. In the last several years, we have taken a number of actions in our attempt to strengthen our business. These actions included:

 

    Enhancing our product offering and adding more exclusive products to our mix;

 

    Continually reviewing our store portfolio for potential renovations to enhance the shopping experience;

 

    Adding Imaginarium / World of Imagination learning and educational toy boutiques to all stores; and

 

    Reorganizing our stores into merchandise “Worlds” and improving customer service.

 

Operations

 

As of January 28, 2006, we operated 305 international stores, 2 of which are Babies “R” Us stores, and our franchisees and licensees operated 336 franchised or licensed international stores, 14 of which are Babies “R” Us stores. During fiscal 2005, we opened 10 and closed 4 international stores, and our franchisees and licensees opened 38 and closed 4 international stores, for a total of 48 opened and 8 closed international stores, respectively. During fiscal 2006, we intend to open an estimated 19 new international stores and close 1 international store and our franchisees and licensees intend to open an estimated 38 stores and close 4 international stores, for a total of 57 proposed new and 5 proposed closing international stores, respectively. Continued store openings are a key part of our overall international growth strategy.

 

Our international division has wholly-owned operations in Australia, Austria, Canada, France, Germany, Portugal, Spain, Switzerland, and the United Kingdom. We intend to pursue opportunities that may arise in these and other countries. Sales in foreign countries (excluding sales by licensees and franchisees) represented approximately 25% of consolidated sales in 2005.

 

Product Selection and Merchandise

 

Our product offerings are similar to the offerings in Toys “R” Us stores in the United States. We sell toys, plush, games, bicycles, sporting goods, DVDs, electronic and video games, outdoor, educational and development products, clothing, infant and juvenile furniture, and electronics, as well as educational and entertainment computer software for children. We offer products according to the following merchandise “Worlds”:

 

    Core Toy—Our principal core toy products include boys and girls toys, such as dolls and doll accessories, action figures, role play toys and vehicles;

 

    Seasonal—Our seasonal offerings include toys and other products geared toward the Christmas and other major holidays such as Three Kings, Carnival, Easter, etc. Other seasonal products include bikes, sports merchandise, play sets and other wheeled goods;

 

    Juvenile or Infant Care—Our juvenile and infant care products include baby products and apparel for infants and toddlers in sizes ranging from newborn to age four;

 

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    Learning—Our learning products include educational electronics and developmental toys and related products; and

 

    R ZONE—Our R ZONE world includes video game hardware and software, electronics, computer software, DVDs, and other related products.

 

Marketing

 

Toys International marketing strategies are similar to the programs in the United States. 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 sale 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 came 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 and hypermarkets, Toys International is committed to providing different varieties of toys, games, and juvenile categories throughout the year. We have a sales driven culture and dedicated sales advisers trained in their product “Worlds” in order to help provide the right product for each customer’s needs.

 

Market and Competition

 

In the toys and video games products market, we compete with mass merchandisers, discounters, and hypermarkets such as Argos, Woolworths, Carrefore, Auchan, El Corte Ingles, Wal-Mart, and Zellers. These competitors aggressively price in the toys and games 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 market impacting the United States are present similarly in other countries where we operate. We believe we are able to compete through product assortment differentiation, maintaining in-stock positions, convenient locations, superior customer service, and competitive pricing.

 

Seasonality

 

Our Toys International 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 international toy business were generated in the fourth quarter. Our results of operations depend significantly upon the holiday selling season in the fourth quarter.

 

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Geographic Distribution of International Stores

 

The following table sets forth the location of our owned, licensed and franchised International stores located in 31 countries as of January 28, 2006:

 

Location


   Number of Stores

 

Australia

   31  

Austria

   12  

Bahrain

   1 *

Canada

   65  

Denmark

   12 *

Egypt

   2 *

France

   33  

Germany

   50  

Hong Kong

   7 *

Indonesia

   3 *

Israel

   23 *

Japan

   163 (1)

Kuwait

   1 *

Malaysia

   9 *

Mauritius

   1 *

Netherlands

   15 *

Norway

   6 *

Oman

   1 *

Portugal

   8  

Qatar

   1 *

Saudi Arabia

   7 *

Singapore

   6 *

South Africa

   14 *

Spain

   35  

Sweden

   11 *

Switzerland

   4  

Taiwan

   13 *

Location


   Number of Stores

 
Thailand    2 *
Turkey    35 *
United Arab Emirates    3 *
United Kingdom    67  
    

Total International    641  
    


 * Franchised or licensed

 

(1) Licensed operation in which we hold a 47.9% equity ownership

  

        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        

 

Toys “R” Us – Japan

 

At January 28, 2006, Toys “R” Us – Japan, Ltd. (“Toys “R” Us – Japan”), a licensee of ours, operated 163 stores, which are included in the 336 licensed or franchised international stores. Of these 163 stores, 14 stores are Babies “R” Us stores and the remainder are toy stores. During 2006, Toys “R” Us – Japan intends to open an additional four Babies “R” Us stores as well as eight Toys “R” Us stores. We have a 47.9% ownership in the common stock of Toys “R” Us – Japan and have accounted for this investment under the equity method of accounting. For a further discussion of our investment in Toys “R” Us – Japan, refer to Note 9 to the Consolidated Financial Statements entitled “INVESTMENT IN TOYS “R” US – JAPAN.” Refer to Note 28 to the Consolidated Financial Statements entitled “SUBSEQUENT EVENTS” for details of our and/or the Sponsors’ proposed increase in the number of directors on the Board of Directors of Toys “R” Us – Japan in April 2006.

 

Babies “R” Us

 

Founded in 1996, Babies “R” Us 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 U.S. scale. 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.

 

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Operations

 

In 1996, we opened our first Babies “R” Us stores. The acquisition of Baby Superstore, Inc. in 1997 added 76 locations, and our continued expansion of these stores helped Babies “R” Us become the leader in the specialty baby-juvenile market. As of January 28, 2006, we operated 230 Babies “R” Us specialty baby-juvenile retail stores in the United States. As with our Toys “R” Us – U.S. stores, our extensive experience in retail site selection has resulted in a portfolio of Babies “R” Us stores that includes attractive locations in our chosen markets. A typical Babies “R” Us store is 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. A typical Babies “R” Us store generally consists of an average 36,000 square feet, and most Babies “R” Us stores devote between 2,000 and 5,000 square feet to specialty name brand and private label clothing.

 

We opened 13 Babies “R” Us stores in 2005 and as part of our long-range growth plan, we plan to open approximately 65 new Babies “R” Us stores over the next three years, including approximately 22 stores in 2006. This growth will come from developing new stores and converting certain Toys “R” Us stores into Babies “R” Us stores. Markets for new stores are selected on the basis of proximity to other Babies “R” Us 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.

 

Product Selection and Merchandise

 

Our product selection is focused to serve newborns and children up to 4 years of age. Consequently, we must 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. Our Babies “R” Us stores typically offer over 24,000 items from approximately 250 suppliers, including:

 

    Baby gear – Our baby gear products include car seats, strollers, high chairs, swings, travel yards and entertainers;

 

    Baby accessories – Our baby accessories include bath products, safety products, monitors, rattles, gates, potty seats, carriers and other products;

 

    Consumables – Our consumable products include diapers, wipes, formula, baby food and health and beauty aids;

 

    Apparel – Our apparel category includes brand name and private label layettes, sleepwear, playwear, clothing accessories and shoes ranging in sizes from “preemie” to 48 months;

 

    Furniture – Our baby furniture includes cribs, cases, changing tables, gliders, toy boxes, mattress tables and chair sets and some toddler beds. We feature JARDINE, our exclusive brand, the WENDY BELLISSIMO licensed brand, as well as nationally recognized brands;

 

    Bedding and room décor – We carry a comprehensive selection of products for nurseries. Our bedding and room décor products include bedding sets and matching accessories, blankets, rugs, wall borders and bedding necessities, such as mattress covers, changing pads and changing pad covers. We also offer a selection of bedding basics under our private label brand, KOALA BABY, the WENDY BELLISSIMO licensed brand, as well as various brand name bedding products; and

 

    Infant toys – We offer a broad selection of infant toys, which includes play mats, plush, books and videos, among other products.

 

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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. 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. For example, we began offering products under the WENDY BELLISSIMO brand name in the fourth quarter of 2004. These products 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 convey our one stop shopping solution to new and expectant parents as well as our mission of delivering value-added services to our customers. We use various targeted marketing and advertising techniques to reach our customer audiences and promote our brands in order to reinforce and augment our “top-of-mind” reputation among consumers and thereby drive customer traffic. These methods include direct mail, juvenile magazine advertisements, e-mail and promotional marketing efforts. Our direct mail program, which includes catalogs and postcards, advertises our products and delivers useful age and stage relevant information to both pre and postnatal parents and special deals and coupons are often included to drive traffic and sales. 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. We also advertise on radio 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. Nearly one-quarter of the approximately four million infants born in the United States in 2005 had parents registered at Babies “R” Us and/or Toys “R” Us, 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.

 

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 competitors at mass merchandisers. Each Babies “R” Us 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, and our service levels are tested regularly through customer satisfaction surveys and mystery shops performed by outside consultants. In addition, we provide a home delivery program in most 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 such as grandparents’ seminars and car seat safety inspections.

 

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 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

 

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market 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, convenience, customer support and service, and 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.

 

Geographic Distribution of Babies “R” Us Stores

 

The following table sets forth the location of our Babies “R” Us stores across the United States as of January 28, 2006:

 

Location


   Number of Stores

  

Location


   Number of Stores

Alabama

   3   

Mississippi

   1

Arizona

   4   

Missouri

   5

California

   25   

Nebraska

   1

Colorado

   5   

Nevada

   3

Connecticut

   5   

New Hampshire

   2

Delaware

   1   

New Jersey

   13

Florida

   15   

New Mexico

   1

Georgia

   9    New York    17

Idaho

   1    North Carolina    7

Illinois

   11    Ohio    10

Indiana

   6    Oklahoma    2

Iowa

   1    Oregon    2

Kansas

   1    Pennsylvania    13

Kentucky

   2    Rhode Island    1

Louisiana

   2    South Carolina    3

Maine

   1    Tennessee    4

Maryland

   4    Texas    16

Massachusetts

   6    Utah    3

Michigan

   11    Virginia    7

Minnesota

   3    Washington    3
              
          Total    230
              

 

Toysrus.com

 

Toysrus.com sells merchandise to the public via the Internet at www.toysrus.com, www.babiesrus.com, www.imaginarium.com, www.sportsrus.com, and www.personalizedbyrus.com. We launched our e-commerce website in 1998.

 

In 2000, we entered into a strategic alliance agreement with Amazon.com, Inc. (“Amazon.com”) and launched a co-branded toy store. Toysrus.com operates three co-branded online stores under the strategic alliance agreement with Amazon.com. These online stores sell toys, collectible items, and video games through the Toysrus.com website; baby products through the Babiesrus.com website; and learning and information products through the Imaginarium.com website. Our online operations provide a broad range of our product offerings, including many products and brands available exclusively online. Customers can create a baby registry online that is accessible at all U.S. Babies “R” Us and Toys “R” Us locations, and they can also edit a store-created registry online. Our Internet operations have become a fast-growing distribution channel for us, with more than 120 million site visits in 2005. Amazon.com also provides certain website services for our online sports merchandise store, Sportsrus.com, that has been operating since September 2003. An unrelated third party handles order fulfillment for Sportsrus.com and a separate unrelated third party handles order fulfillment for Personalizedbyrus.com.

 

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On May 21, 2004, we, Toysrus.com, LLC, and two other affiliated companies, filed a lawsuit against Amazon.com and its affiliated companies seeking to terminate the strategic alliance agreement with Amazon.com and its affiliated companies due to breaches of the agreement by Amazon.com. On June 25, 2004, Amazon.com filed a counterclaim against us and our affiliated companies. On March 31, 2006 the trial court entered a final order in our favor terminating the strategic alliance agreement with Amazon.com as of that date and denying any relief to Amazon.com on its counterclaim. The court also established a wind-down period through June 30, 2006, during which time Amazon.com will continue to operate the co-branded stores. On April 3, 2006 Amazon.com filed a Notice of Appeal and filed a Motion for Stay of Judgment in the trial court. On April 20, 2006, the trial court denied Amazon.com’s request for a stay. Amazon.com filed a request in the appellate court on April 21, 2006 for emergent relief from the trial court’s denial of its request for a stay, and on that same day, the appellate court refused Amazon.com’s motion for an immediate stay and determined to consider Amazon.com’s request on the normal briefing schedule. In anticipation of these favorable rulings, we have been planning the launch of an independent website using our own domain names. For further details refer to Item 3 entitled “LEGAL PROCEEDINGS” and to Note 24 to the Consolidated Financial Statements entitled “LITIGATION AND LEGAL PROCEEDINGS.”

 

On October 26, 2004, Toys “R” Us, Inc., acquired all of the issued and outstanding shares of capital stock of SB Toys, Inc., for $42 million in cash. SB Toys, Inc. was previously owned by SOFTBANK Venture Capital and affiliates (“SOFTBANK”) and other investors. Prior to this acquisition, SB Toys, Inc. owned a 20% interest, as a minority shareholder, of Toysrus.com, LLC, our Internet subsidiary. As a result we recorded a 20% minority interest in consolidation to account for the ownership stake of SB Toys, Inc. Beginning in the fourth quarter of 2004, we recognized 100% of the results of Toysrus.com, LLC in our consolidated financial statements.

 

Employees

 

As of January 28, 2006, we employed worldwide approximately 59,000 full-time and part-time individuals. Due to the seasonality of our business, we employed approximately 90,000 full-time and part-time employees during the 2005 holiday season.

 

Vendor Service

 

We have approximately 1,300 to 1,500 vendor relationships through which we procure the merchandise that we offer to guests. For 2005, our top 20 vendors worldwide, based on our purchase volume in dollars, represented approximately 39% of the total products we purchased. Most of our foreign sourced merchandise comes from China, and we purchase that merchandise in U.S. dollars.

 

We provide a number of valuable services to our vendors. Our year-round commitment to selling toys and baby products, 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, product testing, 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.

 

2005 Restructuring Initiative

 

On January 5, 2006, our Board of Directors approved the closing of 87 Toys “R” Us stores in the United States. As of January 28, 2006, we closed three of these stores. All of the remaining 84 stores were closed by April 2, 2006. Twelve of these stores will be converted into Babies “R” Us stores, resulting in the permanent closure of 75 stores. The decision to take this action resulted from a comprehensive review and evaluation of our U.S. stores over the past several months. We retained Gordon Brothers Retail Partners, LLC to assist us in connection with the orderly sale of the inventory in these stores.

 

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In connection with the closing and conversion of these stores, we recorded $94 million of costs and charges during 2005. We estimate an additional $55 million of charges will be recorded in the first quarter of 2006. The $94 million of costs and charges include $41 million of inventory markdowns and liquidator fees that were recorded in cost of sales and $22 million of depreciation that was accelerated through the closing periods of the stores. The remaining $31 million of costs and charges are included in restructuring and other charges in the Consolidated Statement of Operations, and consist of $22 million relating to asset impairments, $1 million relating to lease commitments, and $8 million relating to severance costs. As a result of the store closings, approximately 3,000 employee positions have been eliminated.

 

Details of restructuring and other charges, as well as other strategic initiatives, are described in Item 7. entitled “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” and within Note 5 to the Consolidated Financial Statements entitled “RESTRUCTURING AND OTHER CHARGES.”

 

Closing of Kids “R” Us and Imaginarium Freestanding Stores

 

On November 17, 2003, we announced our decision to close all 146 of the remaining freestanding Kids “R” Us stores and all 36 of the freestanding Imaginarium stores, as well as three distribution centers that support these stores due to accelerated deterioration in their financial performance. On March 2, 2004, we entered into an agreement with Office Depot, Inc. (“Office Depot”) under which Office Depot agreed to acquire 124 of the former Kids “R” Us stores for $197 million in cash, before commissions and fees, plus the assumption of lease payments and other obligations. Twenty-four properties were excluded from the agreement with Office Depot and these properties are being marketed for disposition or have been disposed of to date. As of January 28, 2006, all of the freestanding Kids “R” Us and Imaginarium stores have been closed.

 

Financial Information About Industry Segments

 

Information about industry segments is set forth within Note 23 to the Consolidated Financial Statements entitled “SEGMENTS.”

 

Distribution Centers

 

In the United States, we operate 12 distribution centers, which support our U.S. toys and baby stores. We also operate eight distribution centers outside of the United States that support our International toy stores.

 

These distribution centers employ warehouse management systems and material handling equipment that help to minimize overall inventory levels and distribution costs. We believe the flexibility afforded by our warehouse/distribution system and by operating the fleet of trucks used to distribute merchandise, provide us with operating efficiencies and the ability to maintain a superior in-stock inventory position at our stores. We are currently implementing initiatives to improve our supply chain management and to optimize our inventory assortment. We are also expanding our automated replenishment system to improve inventory turnover.

 

Trademarks

 

“TOYS “R” US”®, “BABIES “R” US” ®, “IMAGINARIUM” ®, “GEOFFREY” ®, “TOYSRUS.COM”® as well as variations of our family of “R” Us marks, either have been registered, or have trademark applications pending, with the United States Patent and Trademark Office and with the trademark registries of many foreign countries. We believe that our rights to these properties are adequately protected.

 

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,

 

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and Current Reports on Form 8-K, as well as amendments to those reports as soon as reasonably practicable after we electronically file with or furnish such material to the Securities Exchange Commission.

 

Our website contains the Toys “R” Us, Inc. Chief Executive Officer and Senior Financial Officers Code of Ethics (“CEO and Senior Financial Officers Code”), which is our code of ethics for our Chief Executive Officer and our senior financial officers. 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.

 

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

 

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 facing the Company. Additional risks and uncertainties not presently known to the Company or that it currently deems immaterial may also impair the Company’s business and operations. If any of the following risks actually occur, the Company’s business, financial condition, cash flows, or results of operations could be materially adversely affected.

 

Our Toys “R” Us business is highly seasonal, and our financial performance depends on the results of the fourth quarter of each year

 

Our Toys “R” Us 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 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 key 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 Babies “R” Us business is not significantly impacted by seasonality, with sales generally spread evenly across all the four quarters of the fiscal year.

 

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

 

The retailing 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 such as Wal-Mart, Target, and Kmart; electronic retailers, such as Best Buy and Circuit City; national and regional chains; as well as local retailers in the market areas we serve. 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 may have greater financial resources, lower merchandise acquisition costs, and lower operating expenses than our Company.

 

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

 

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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, such as Best Buy, Circuit City and Gamestop, have all experienced significant growth.

 

In addition, 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 Toys “R” Us business 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 $2 billion five-year secured revolving credit facility to finance the carrying costs of this inventory, to pay for capital expenditures and to maintain operations. Standard & Poor’s and Moody’s rate our unsecured debt as non-investment grade. Our credit ratings could (1) negatively impact our ability to finance our operations on satisfactory terms, and (2) have the effect of increasing 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 company.

 

We may not retain or attract customers if we fail to implement successfully our strategy

 

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 offering in our Babies “R” Us stores. We are also broadening the scope 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 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 are unsuccessful at implementing 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 demands 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, perceived value and season. These fluctuations affect the merchandise in stock since purchase orders are made well in advance of the season and, at times, before fashion trends and high-demand brands are evidenced by consumer purchases.

 

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We cannot assure you that we will be able to continue to meet changing consumer demands in the future. If we misjudge the market for our products, we may be faced with significant excess inventories for some products and missed opportunities for other products. In addition, because we place orders for products well in advance of purchases by customers, we could experience excess inventory if our customers purchase fewer products than anticipated.

 

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.

 

Toy sales may be negatively impacted by the trend toward age compression

 

Toy sales may be negatively impacted by “age compression,” which is the acceleration of children leaving traditional play categories at increasingly younger ages for more sophisticated products such as cell phones, DVD players, CD players, MP3 devices, and other electronic products. The age compression pattern tends to decrease consumer demand for traditional toys. To the extent that we are unable to offer consumers more sophisticated products or that these more sophisticated items are also available at a wider range of retailers than our traditional competitors, our sales and profitability could be detrimentally affected and we could experience excess inventories.

 

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 domestic 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. New video game platforms have historically been introduced approximately every five years. 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 1,300 to 1,500 vendor relationships through which we procure the merchandise that we offer to guests. For 2005, our top 20 vendors worldwide, based on our purchase volume in dollars, represented approximately 39% 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 we currently purchase.

 

In addition, our vendors are subject to certain risks, including labor disputes, union organizing activities, vendor financial liquidity, inclement weather, natural disasters, and general economic and political conditions,

 

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that could limit our vendors’ ability to provide us with quality merchandise on a timely basis and at a price that is commercially acceptable. 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 would damage our reputation and brands, and harm our business.

 

Our inability to obtain commercial insurance at acceptable prices or our failure to adequately reserve for self-insured exposures might have a negative impact on our business.

 

Insurance costs continue to be volatile, affected by natural catastrophes, fear of terrorism and financial irregularities and other fraud at publicly traded companies. We believe that commercial insurance coverage is prudent for risk management, and insurance costs may increase substantially in the future. In addition, for certain types or levels of risk, such as risks associated with earthquakes, hurricanes or terrorist attacks, we may determine that we cannot obtain commercial insurance at acceptable prices. Therefore, we may choose to forego or limit our purchase of relevant commercial insurance, choosing instead to self-insure one or more types or levels of risks. We insure a substantial portion of our general liability and workers’ compensation risks through a wholly-owned insurance subsidiary, in addition to third party insurance coverage. Provisions for losses related to self-insured risks are based upon independent actuarially determined estimates. We maintain stop-loss coverage to limit the exposure related to certain risks. The assumptions underlying the ultimate costs of existing claim losses are subject to a high degree of unpredictability, which can affect the liability recorded for such claims. For example, variability in inflation rates of health care costs inherent in these claims can affect the amounts realized. Similarly, changes in legal trends and interpretations, as well as a change in the nature and method of how claims are settled can impact ultimate costs. Although our estimates of liabilities incurred do not anticipate significant changes in historical trends for these variables, any changes could have a considerable effect upon future claim costs and currently recorded liabilities and could have a material impact on our consolidated financial statements.

 

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 the imposition of import restrictions or trade restrictions in the form of tariffs, “antidumping” duties, acts of war, terrorism or diseases such as the bird flu, 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, over the past few years, port-labor issues, rail congestion, and trucking shortages have had an impact on all direct importers. Although we attempt to anticipate and manage such situations, both our sales and profitability could be adversely impacted by such developments in the future.

 

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;

 

    International military, political, diplomatic and terrorist incidents;

 

    Government instability;

 

    Nationalization of foreign assets; and

 

    Tariffs and governmental trade policies.

 

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We cannot ensure that one or more of these factors will not negatively affect International and, as a result, our business and financial performance.

 

The success of our Internet operations depends on our ability to provide quality service to our Internet customers

 

The success of our online business depends on our ability to provide quality service to our Internet customers. Our internet segment Toysrus.com operates online stores pursuant to a strategic alliance agreement with Amazon.com.

 

On May 21, 2004, we, Toysrus.com, LLC, our Internet subsidiary, and two other affiliated companies, filed a lawsuit against Amazon.com and its affiliated companies requesting termination of our strategic alliance agreement with Amazon.com. On June 25, 2004, Amazon.com filed a counterclaim against us and our affiliated companies.

 

On March 31, 2006 the trial court entered a final order in our favor terminating the strategic alliance agreement with Amazon.com as of that date and denying Amazon.com’s counterclaim. The court also established a wind-down period through June 30, 2006, during which time Amazon.com will continue to operate the co-branded stores. On April 3, 2006 Amazon filed a Notice of Appeal and filed a Motion for Stay of Judgment in the trial court. On April 20, 2006, the trial court denied Amazon.com’s request for a stay. Amazon.com filed a request in the appellate court on April 21, 2006 for emergent relief from the trial court’s denial of its request for a stay, and on that same day, the appellate court refused Amazon.com’s motion for an immediate stay and determined to consider Amazon.com’s request on the normal briefing schedule. For further details refer to Item 3 entitled “LEGAL PROCEEDINGS” and Note 24 to the Consolidated Financial Statements entitled “LITIGATION AND LEGAL PROCEEDINGS”.

 

In anticipation of these favorable rulings, we have been planning for the launch of an independent website at our domain names, however, we may not be able to provide the same level of website and fulfillment services ourselves or through other third parties, which could have a negative effect on the sales and profitability of our online business.

 

Our Internet operations are also 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; and

 

    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.

 

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

 

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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 brand 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

 

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

 

Our results of operations could suffer if we lose key management or are unable to attract and retain the talent required 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 and our parent company to attract and retain qualified individuals for key management positions, could harm our business and financial performance.

 

We reported a material weakness in our internal control over financial reporting and if we are unable to improve our internal controls, our financial results may not be accurately reported

 

Management’s assessment of the effectiveness of our internal control over financial reporting as of January 28, 2006 identified a material weakness in our internal controls in our financial reporting process due mainly to our lack of the appropriate complement of personnel, including technically qualified personnel, and the inability of our information technology systems to consistently perform necessary functions. As a result of this material weakness, management determined that our disclosure controls and procedures were not effective as of January 28, 2006. The material weakness and our plan to remediate that material weakness are described in Item 9A. entitled “CONTROLS AND PROCEDURES” of this Annual Report on Form 10-K.

 

The initiatives we have taken to improve the reliability of our internal controls and to remediate the material weakness are ongoing. However, we might be unable to hire sufficient qualified personnel and or obtain the necessary technological upgrades needed to remediate the material weakness. We cannot be certain that these measures will ensure that we implement and maintain adequate controls over our financial reporting processes and that we will remediate the material weakness described in this Annual Report on Form 10-K. Any failure to implement required new or improved controls or to remediate the material weakness, or difficulties encountered in their implementation could prevent us from accurately reporting our financial results, result in material misstatements in our financial statements or cause us to fail to meet our reporting obligations. In addition, we cannot assure you that we will not in the future identify further material weaknesses in our internal control over financial reporting that we have not discovered to date, which may impact the reliability of our financial reporting and financial statements. Insufficient internal controls could also cause investors to lose confidence in our reported financial information.

 

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. For example, on December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued Statement No. 123R, “Share Based Payment,” which requires us, starting in the first quarter of fiscal 2006, to measure compensation costs for all stock-based compensation at fair value and record compensation expense equal to that value over the requisite service period. A change in accounting rules or regulations may even affect our reporting of transactions completed before the change is effective. Other new accounting rules or regulations and varying

 

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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.

 

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 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 undiscounted future cash flows over the life of the lease. These calculations require us to make a number of estimates and projections of future results, often up to 20 years into the future. If these estimates or projections change or prove incorrect, we may be, and have been, 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 group advised by or affiliated with the Sponsors currently indirectly control us through their ownership of 98.7% 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. For example, if we encounter financial difficulties or are unable to pay our debts as they mature, the interests of the Sponsors as equity holders may conflict with our interests. 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. For example, the Sponsors could cause us to make acquisitions that increase the amount of indebtedness that is secured or sell assets, which may impair our ability to make payments under the debt instruments.

 

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 also are in the business of making investments 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 our common stock, even if such amount is less than 50%, 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 January 28, 2006, our total indebtedness was $5,947 million, including $12 million of payment obligations relating to capital lease obligations.

 

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Our substantial indebtedness could have important consequences, including:

 

    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 flow 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 flow 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 rates 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 to react to competitive pressure and placing us at a competitive disadvantage compared to our competitors who are less highly leveraged.

 

Our subsidiaries and 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. Additionally, our costs of new indebtedness could be substantially higher.

 

For the fiscal year 2005, our interest expense was $394 million compared to $130 million for the fiscal year 2004. Based on our overall interest rate exposure related to floating rate debt outstanding at January 28, 2006, a 1% increase in interest rates would have had an unfavorable annualized impact on pre-tax earnings of $31 million in 2005.

 

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 which 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 in respect of 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 material 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

 

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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 assure you 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 store and distribution center facilities as of January 28, 2006 (excluding International licensed and franchised stores):

 

     Owned

   Ground
Leased (a)


   Leased

   Total

Stores:

                   

Toys “R” Us

   313    152    206    671

International

   81    23    201    305

Babies “R” Us

   31    85    114    230
    
  
  
  
     425    260    521    1,206

Distribution Centers:

                   

United States

   9    —      3    12

International

   5    —      3    8
    
  
  
  
     14    —      6    20
    
  
  
  

Total Operating Stores and Distribution Centers

   439    260    527    1,226
    
  
  
  

(a) Owned buildings on leased land.

 

Our Global Store Support Center facility in Wayne, New Jersey was originally financed under a lease arrangement commonly referred to as a “synthetic lease.” Under this lease, unrelated third parties arranged by Wachovia Development Corporation, a multi-purpose real estate investment company, funded the acquisition and construction of the facility. On June 1, 2005, we purchased our Global Store Support Center facility for a purchase price of $128.8 million pursuant to the purchase election option under the lease arrangement.

 

Refer to Note 11 to the Consolidated Financial Statements entitled, “SEASONAL FINANCING AND LONG-TERM DEBT” for a description of real estate-related financings.

 

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

 

ITEM 3.    LEGAL PROCEEDINGS

 

On May 21, 2004, we, Toysrus.com, LLC, our Internet subsidiary, and two other affiliated companies, filed a lawsuit against Amazon.com and its affiliated companies related to our strategic alliance with Amazon.com. The lawsuit was filed to protect our exclusivity rights in the toy, game, and baby products categories for the online e-commerce site on the Amazon.com platform. The complaint sought temporary and permanent injunctive and declaratory relief to protect our rights during the litigation and to end the agreement, monetary damages and

 

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contract rescission against Amazon.com. The suit was filed in the Superior Court of New Jersey, Chancery Division, Passaic County. On June 25, 2004, Amazon.com filed a counterclaim against us and our affiliated companies alleging breach of contract relating to inventory and selection requirements. This counterclaim sought monetary damages and invoked contract termination rights. On March 1, 2006, the trial court issued its opinion granting our request for termination of the agreement and denying Amazon.com’s request for relief on its counterclaim. On March 31, 2006, the trial court entered a final order in our favor terminating the strategic alliance agreement with Amazon.com as of that date and establishing a wind-down period through June 30, 2006, during which time Amazon.com will continue to operate the co-branded stores. The court also denied Amazon.com any relief on its counterclaim. On April 3, 2006, the trial court entered an amended final order, which clarified several minor issues in the final order. In anticipation of these favorable rulings, we have been planning for the launch of an independent website at our own domain names. On April 3, 2006, Amazon filed a Notice of Appeal and also filed a Motion for Stay of Judgment in the trial court. On April 20, 2006, the trial court denied Amazon.com’s request for a stay. Amazon.com filed a request in the appellate court on April 21, 2006 for emergent relief from the trial court’s denial of its request for a stay, and on that same day, the appellate court refused Amazon.com’s motion for an immediate stay and determined to consider Amazon.com’s request on the normal briefing schedule. We believe Amazon.com’s pending motion for stay of the order terminating the strategic alliance agreement, as well as its pending appeal of the order, is without merit and will be denied.

 

From time to time, in the ordinary course of business, we are involved in various legal proceedings, including commercial disputes, personal injury claims and employment issues. We do not believe that any of these proceedings will have a material adverse effect on our financial condition, results of operations, or cash flows.

 

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 AND RELATED

STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

In connection with the closing of the Merger, the Company’s common stock, par value $0.10 (the “Company Common Stock”), 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 has been made.

 

As a result of the Merger, our 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 our common stock.

 

ITEM 6.    SELECTED FINANCIAL DATA

 

     Fiscal Year Ended

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


   Jan 28,
2006


    Jan 29,
2005


   Jan 31,
2004 (1)


   Feb 01,
2003 (1)


   Feb 02,
2002 (1)


Operations (2)

                                   

Net Sales

   $ 11,275     $ 11,100    $ 11,320    $ 11,305    $ 11,019

Net (Loss) Earnings

     (384 )     252      63      213      68

Basic Earnings Per Share

     n/a       1.17      0.30      1.03      0.34

Diluted Earnings Per Share

     n/a       1.16      0.29      1.02      0.33

Financial Position at Year End

                                   

Working Capital

   $ 348     $ 1,806    $ 1,865    $ 1,185    $ 618

Real Estate—Net

     2,386       2,400      2,328      2,263      2,202

Total Assets

     8,366       9,768      10,265      9,451      8,138

Long-Term Debt (3)

     5,540       1,860      2,349      2,139      1,816

Stockholders’ (Deficit) Equity

     (724 )     4,325      3,974      3,815      3,207

Common Shares Outstanding

     n/a       215.9      213.6      212.5      196.7

Number of Stores at Year End

                                   

Toys “R” Us—U.S.

     671       681      685      685      701

Toys “R” Us—International (4)

     641       601      574      544      507

Babies “R” Us—U.S.

     230       217      198      183      165

Kids “R” Us—U.S.

     —         —        44      146      184

Imaginarium—U.S.

     —         —        —        37      42

Total Stores

     1,542       1,499      1,501      1,595      1,599

(1) Restated to reflect a correction in our accounting practices for leases and leasehold improvements. Refer to Note 3 to the Consolidated Financial Statements entitled “RESTATEMENT OF FINANCIAL STATEMENTS FOR ACCOUNTING FOR LEASES AND LEASEHOLD IMPROVEMENTS” for details.
(2) Certain fiscal years include the impact of restructuring and other charges. In addition, the fiscal year ended January 31, 2004 was impacted by the adoption of an accounting change. For further details, see Note 4 to the Consolidated Financial Statements entitled “CHANGES IN ACCOUNTING.”
(3) Excludes current portion.
(4) Includes licensed and franchised stores.

 

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

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide the readers of our financial statements with a narrative discussion about our businesses. The MD&A should be read in conjunction with our consolidated financial statements and the related notes, and contains forward-looking statements that involve risks and uncertainties. See “Forward-Looking Statements” and Item 1A. entitled “RISK FACTORS.”

 

OVERVIEW

 

Restatement

 

As disclosed in Note 3 to the Consolidated Financial Statements entitled “RESTATEMENT OF FINANCIAL STATEMENTS FOR ACCOUNTING FOR LEASES AND LEASEHOLD IMPROVEMENTS” we restated our previously issued financial statements for the fiscal year ended January 31, 2004, to reflect corrections in our accounting practices for leases and leasehold improvements. Consequently, our results as of January 31, 2004, as presented in our consolidated financial statements and the MD&A, reflect the balances and amounts on a restated basis.

 

Our Business

 

The company generates sales, earnings, and cash flows by retailing toys, baby-juvenile 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 50% of the “R” Us branded retail stores internationally. Our reportable segments are Toys “R” Us – U.S., which operates toy stores in 49 states and Puerto Rico; Toys “R” Us – International, which operates, licenses or franchises stores in 31 foreign countries; Babies “R” Us, which operates specialty baby-juvenile stores in 40 states; Toysrus.com, our internet subsidiary; and Kids “R” Us, which had limited activity during the first half of 2004 and had no activity during 2005. As of January 28, 2006, there were 1,542 “R” Us branded retail stores operating in the following formats:

 

    671 Toys “R” Us toy stores throughout the United States and Puerto Rico which offer toy, baby-juvenile, and children’s clothing products;

 

    641 international stores, of which 625 are Toys “R” Us stores and 16 are Babies “R” Us stores. Included in the 641 stores are 336 licensed or franchised stores; and

 

    230 Babies “R” Us specialty baby-juvenile stores in the United States.

 

In addition, we sell merchandise through our Internet sites at www.toysrus.com, www.babiesrus.com, www.imaginarium.com, www.sportsrus.com, www.toysrus.ca, and www.personalizedbyrus.com.

 

On July 21, 2005, we were acquired by an investment group consisting of entities advised by or affiliated with Bain Capital Partners LLC, Kohlberg Kravis Roberts & Co. and Vornado Realty Trust (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. As a result of the merger, we are a wholly-owned subsidiary of Toys “R” Us Holdings, Inc. Refer to the section entitled “The Merger Transaction” below for further details.

 

The following is a description of our segments:

 

   

Toys “R” Us – U.S. We sell toys, plush, games, sporting goods, movies, electronic and video games, small pools, books, educational products, clothing, infant and juvenile furniture, and electronics. Our toy stores offer approximately 8,000 to 10,000 items year-round, through our Toys “R” Us stores, based upon net sales; we are the largest specialty retailer of toys in the United States. In the U.S. toys and

 

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games market (including video game products), based upon net sales we are the second-largest toy retailer. We offer the most comprehensive selection of merchandise in the retail toy industry. By focusing on toys, we are able to provide customers with a comprehensive range of merchandise, and we are able to provide vendors with a year-round distribution outlet for the broadest assortment of their products.

 

    Toys “R” Us – International. Our International division operates, licenses and franchises toy stores in 31 foreign countries. These stores generally conform to traditional prototypical designs similar to those used by Toys “R” Us – U.S., typically ranging in size from 30,000 to 45,000 square feet of space. Our International division has wholly-owned operations in Australia, Austria, Canada, France, Germany, Portugal, Spain, Switzerland, and the United Kingdom. We believe that growth opportunities exist outside of the United States for the Toys “R” Us store and Babies “R” Us store formats. We also plan to open smaller format toy stores in Europe and expand the Babies “R” Us presence through standalone stores and increased space allocation within existing Toys “R” Us stores. We intend to continue the growth of our private label and exclusive brands to increase our margins and offer unique products to our customers.

 

    Babies “R” Us. Babies “R” Us stores target the pre-natal to infant market by offering room settings of juvenile furniture, such as cribs, dressers, changing tables, bedding, and accessories. In addition, we provide baby gear, such as play yards, booster seats, high chairs, strollers, car seats, toddler and infant plush toys, and gifts. We also offer a computerized baby registry service, and we believe that Babies “R” Us registers more expectant parents than any other retailer in the domestic market. Our 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, which we believe is important to parents who are expecting or have newborn children, and helps to differentiate us from competitors. We opened 13 Babies “R” Us stores since January 29, 2005. As part of our long-range growth plan, we plan to open approximately 65 new Babies “R” Us stores over the next three years, including approximately 22 stores in 2006.

 

    Toysrus.com. Toysrus.com sells merchandise to the public via the Internet at Toysrus.com, Babiesrus.com, Imaginarium.com, Sportsrus.com, Personalizedbyrus.com, and the recently added Toysrus.ca (which operates in Canada). We launched our e-commerce website in 1998. In 2000, we entered into a strategic alliance with Amazon.com, Inc. (“Amazon.com”) and launched a co-branded toy store. Under the strategic alliance, this co-branded store offers toys and video games (Toysrus.com), baby products (Babiesrus.com), and learning and educational products (Imaginarium.com). As a result of the litigation with Amazon.com, on March 31, 2006, the trial court entered a final order in our favor terminating the strategic alliance agreement with Amazon.com as of that date and establishing a wind-down period through June 30, 2006, during which time Amazon.com will continue to operate the co-branded store. In anticipation of this favorable ruling, we have been planning for the launch of an independent website at our domain names. Refer to Note 28 to the Consolidated Financial Statements, entitled “SUBSEQUENT EVENTS” for details on the favorable outcome of Toysrus.com’s and the Company’s lawsuit against Amazon.com and its affiliated Companies.

 

We believe the following are our principal challenges and risks, predominantly for the Toys “R” Us – U.S. division:

 

    Increased competition – Our businesses operate in a highly and increasingly competitive retail market. We face strong competition from discount and mass merchandisers, national and regional chains and department stores, local retailers in the market areas we serve, and Internet and catalog businesses. We compete on the basis of product variety, quality and availability, price, advertising and promotion, convenience or store location, customer support, and service. Price competition in the United States toy retailing business continued to be intense during the 2005 holiday season. We believe that success in this competitive environment can be achieved through enhancing the shopping experience for our guests, superior inventory management, strengthening brand loyalty, and competitive pricing. We also continue to focus on strengthening our relationships with our vendors.

 

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    Spending patterns and age compression – In recent years, toy sales have been negatively impacted by “age compression,” which is the acceleration of children leaving traditional play categories at increasingly younger ages for more sophisticated products such as cell phones, DVD players, CD players, MP3 devices, and other electronic products. The age compression pattern tends to decrease consumer demand for traditional toys. To the extent that we are unable to offer consumers more sophisticated products or that these more sophisticated items are also available at a wider range of retailers than our traditional competitors, our net sales and profitability could be detrimentally 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 10-20% of our domestic toy store net sales. We have seen significant declines in sales in this category during the last several years, primarily as a result of intense competition, as well as the maturation of this category. 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. Net sales of video merchandise for the fifty-two weeks ended January 28, 2006, represented 12.9% of domestic toy sales versus 13.6% for the same period last year.

 

    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. If less than satisfactory sales, operating earnings or cash flows from operations are achieved during the key fourth quarter, we may not be able to compensate sufficiently for the lower sales, operating earnings, or cash flows from operations during the first three quarters of the fiscal year. Our Babies “R” Us business is not significantly impacted by seasonality.

 

The Merger Transaction

 

On March 17, 2005, we entered into an Agreement and Plan of Merger, dated as of March 17, 2005 (the “Merger Agreement”), with Global Toys Acquisition, LLC (“Parent”) and Global Toys Acquisition Merger Sub, Inc. (“Acquisition Sub”) to sell our entire company to entities directly and indirectly owned by an investment group consisting of entities advised by or affiliated with Bain Capital Partners LLC, Kohlberg Kravis Roberts & Co., L.P. (“KKR”) and Vornado Realty Trust (collectively, the “Sponsors”).

 

On July 21, 2005, the transaction was consummated by 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, through a $6.6 billion merger of Acquisition Sub with and into the Company, with the Company being the surviving corporation in the merger (the “Merger”). 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, 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 common stock, restricted stock and restricted stock units, fees and expenses related to the Merger, and severance, bonuses and related payroll taxes. The Merger consideration was funded through the use of the Company’s available cash, cash equity contributions from the Investors and the debt financings as described more fully below. We refer to the July 21, 2005 Merger and recapitalization as the “Merger Transaction.”

 

The Merger Transaction has been accounted for as a recapitalization and accordingly, there was no change in the basis of the assets and liabilities of Toys “R” Us, Inc. Therefore, all operations of Toys “R” Us, Inc. prior to the Merger Transaction are reflected herein at their historical amounts. Immediately following the consummation of the Merger Transaction, we implemented an inversion transaction whereby one of our dormant subsidiaries, became the new parent of Toys “R” Us, Inc. and is now known as Toys “R” Us Holdings, Inc.

 

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For the fifty-two weeks ended January 28, 2006, the fees and expenses related to the Merger Transaction and the related financing transactions principally consisted of advisory fees and expenses of $78 million, financing fees of $135 million, sponsor fees of $81 million, and other fees and expenses of $74 million. Of the $368 million of costs, approximately $243 million were expensed, $148 million as transaction related costs and $95 million as amortization of debt issuance cost, interest expense, and real estate taxes. The remaining amount of $125 million was capitalized as debt issuance costs.

 

In connection with the Merger Transaction we entered into other definitive agreements as further described in Note 2 to the Consolidated Financial Statements entitled “MERGER TRANSACTION.”

 

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”). In addition, we have provided certain information on an adjusted basis to reflect accounting changes and unusual items (non-GAAP measures). Management uses these non-GAAP measures to evaluate operating performance. We have incorporated this information into the discussion below because we believe it is a meaningful measure of our normalized operating performance and will assist you in understanding our results of operations on a comparative basis and in recognizing underlying trends. This adjusted information supplements, and is not intended to represent a measure of performance in accordance with, disclosures required by GAAP.

 

Comparable Store Sales

 

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

 

Various factors affect comparable store 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 sales by new stores. Among other things, weather conditions can affect comparable store sales because inclement weather can require us to close certain stores temporarily and thus reduce store traffic. 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 sales to fluctuate significantly in the past on an annual, quarterly and monthly basis and, as a result, we expect that comparable store sales will continue to fluctuate in the future.

 

     Comparable Store Net
Sales Performance


 

(In local currencies)


   2005

    2004

    2003

 

Toys “R” Us –  U.S.

   (1.4 )%   (3.7 )%   (3.6 )%

Toys “R” Us –  International (1)

   3.1 %   0.6 %   2.1 %

Babies “R” Us

   5.7 %   2.2 %   2.8 %

 

(1) Includes wholly-owned operations only.

 

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     Divisional Store Count

          Increase /          Increase /      
     2005

   (Decrease)

    2004

   (Decrease)

    2003

Toys “R” Us – U.S.

   671    (10 )   681    (4 )   685

Toys “R” Us – International (1)

   641    40     601    27     574

Babies “R” Us

   230    13     217    19     198

Kids “R” Us

         —       —      (44 )   44
    
  

 
  

 

Total

   1,542    43     1,499    (2 )   1,501
    
  

 
  

 

 

(1) Includes 305 wholly-owned and 336 licensed and franchised stores as of January 28, 2006; 299 wholly-owned and 302 licensed and franchised stores as of January 29, 2005; and 293 wholly-owned and 281 licensed and franchised stores as of January 31, 2004.

 

Net (Loss) Earnings

 

     Consolidated Net (Loss) Earnings

           Increase /          Increase /     

(In millions)


   2005

    (Decrease)

    2004

   (Decrease)

   2003

Net (loss) earnings

   $ (384 )   $ (636 )   $ 252    $ 189    $ 63

 

2005 compared to 2004

 

We generated a net loss of $384 million in 2005 compared to net earnings of $252 million in 2004, primarily due to charges of $410 million related to the Merger Transaction in 2005 and higher interest expenses of $264 million as a result of increased borrowings related to the Merger Transaction in 2005, as well as contract settlement fees and other expenses of $22 million. In addition, we incurred $22 million of accelerated depreciation related to our announced Toys “R” Us – U.S. store closings and $34 million of restructuring and other charges for 2005. Refer to Notes 2 and 5 to the Consolidated Financial Statements entitled “MERGER TRANSACTION” and “RESTRUCTURING AND OTHER CHARGES,” respectively, for further details on these charges. The change in net (loss) earnings in 2005 was partially offset by the net tax benefit of $62 million and the net earnings generated by the additional net sales of $175 million in 2005 compared to 2004.

 

2004 compared to 2003

 

Consolidated net earnings increased by $189 million to $252 million in 2004 compared to $63 million in 2003, primarily due to a reduction of $94 million in our 2004 selling, general and administrative expenses compared to 2003 as well as a net tax benefit of $89 million in 2004 compared to 2003 as a result of the reversal of previously accrued income taxes. Additionally, reduced restructuring and other charges of $59 million in 2004 compared to 2003 contributed to higher net earnings for 2004. These amounts were partially offset by the reduced net earnings from the decrease of $220 million in net sales in 2004 compared to 2003. Our 2004 consolidated financial statements were impacted by the adoption of the provisions of Emerging Issues Task Force (“EITF”) Issue No. 03-10, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor, by Resellers to Sales Incentives Offered to Consumers by Manufacturers” (“EITF 03-10”). Beginning in the first quarter of 2004, sales have been recorded net of coupons that were redeemed. Under the provisions of EITF 03-10, when we receive credits and allowances from vendors for coupons related to events that meet the direct offset requirements of EITF 03-10, we recognize the related reimbursement as a reduction of cost of sales, during the period of redemption. Our 2003 consolidated financial statements have been restated as permitted by the provisions of EITF 03-10.

 

We receive credits and allowances that are related to formal agreements negotiated with our vendors. These credits and allowances are predominantly for cooperative advertising, promotions, and volume related purchases.

 

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Credits and allowances received from vendors that do not meet the direct offset requirements of EITF 03-10 have been recorded as a reduction of product costs in accordance with EITF Issue No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor” (“EITF 02-16”). Our 2004 and 2003 consolidated financial statements were impacted by the implementation of EITF 02-16. We adopted the provisions of EITF 02-16 at the beginning of 2003. Under this guidance, amounts received from vendors are considered a reduction of product cost, unless certain restrictive provisions are met. EITF 02-16 was effective for all new arrangements, and modifications to existing arrangements, entered into after December 31, 2002. Beginning in 2003, we began to treat cooperative advertising arrangements as a reduction of product cost. For further details on the impact of adoption of EITF 02-16 and EITF 03-10 refer to Note 4 to the Consolidated Financial Statements entitled “CHANGES IN ACCOUNTING.” The adoption of EITF 02-16 and EITF 03-10 had no impact on our consolidated statements of cash flows.

 

Our consolidated financial statements for 2004 and 2003 also include restructuring and other charges, some of which are recorded in cost of sales. In addition, our consolidated financial statements for 2003 include depreciation that was accelerated during the closing periods of the Kids “R” Us stores. Refer to Note 5 to the Consolidated Financial Statements entitled “RESTRUCTURING AND OTHER CHARGES” for further details.

 

Consolidated Net Sales

 

2005 compared to 2004

 

     Net Sales

 

(In millions)


   2005

   % of
net sales


    2004

   % of
net sales


    Percentage
Growth/(Decline)


 

Toys “R” Us – U.S.

   $ 5,975    53.0 %   $ 6,104    55.0 %   (2.1 )%

Toys “R” Us – International

     2,793    24.8 %     2,739    24.7 %   2.0 %

Babies “R” Us

     2,078    18.4 %     1,863    16.8 %   11.5 %

Toysrus.com

     429    3.8 %     366    3.3 %   17.2 %

Kids “R” Us (1)

     —      —         28    0.2 %   (100.0 )%
    

  

 

  

 

Total net sales

   $ 11,275    100.0 %   $ 11,100    100.0 %   1.6 %
    

  

 

  

 


(1) Reflects the effect of our decision to close all of our freestanding Kids “R” Us stores, as previously announced on November 17, 2003.

 

Consolidated net sales increased by 1.6% to $11.3 billion in 2005 from $11.1 billion in 2004. Excluding the impact of foreign currency translation that decreased net sales for 2005 by $61 million, and a $28 million decline in net sales associated with the previously announced Kids “R” Us store closings, total net sales increased by $264 million, or 2.4%, compared to 2004.

 

The increase in net sales for 2005 was primarily the result of net sales increases in our Babies “R” Us division of 11.5% to $2.1 billion, and net sales increases in our International division of 4.2% to $2.9 billion (excluding the effect of currency translation). These increases in net sales in our Babies “R” Us and International division were primarily due to the addition of 13 Babies “R” Us stores in the United States and the opening of ten wholly-owned international stores in 2005, slightly offset by the closures of four wholly-owned international stores in 2005. In addition, comparable store net sales at our Babies “R” Us and International divisions showed favorable increases, as shown in the table above under “Comparable Store Net Sales Performance.” These increases were partially offset by net sales decreases in our Toys “R” Us – U.S. division primarily due to comparable store net sales declines of 1.4% in 2005.

 

Toys “R” Us – U.S.

 

Net sales for the Toys “R” Us – U.S. division decreased by $129 million, or 2.1%, to $5.98 billion compared to $6.10 billion in 2004. Net sales declines were primarily the result of a dramatic increase in the price of fuel

 

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and a soft video cycle anticipated before the release of new platforms. In addition, comparable store net sales at our Toys “R” Us – U.S. division declined 1.4% in 2005 compared to 2004. Video net sales declined approximately 7% compared to 2004. The closing of 10 U.S. toy stores during 2005 also negatively affected net sales in our Toys “R” Us – U.S. division by contributing approximately $34 million to the net sales declines. In addition, three hurricanes that impacted store performance in the Southeast, accounted for approximately $14 million of the net sales declines.

 

Toys “R” Us – International

 

Net sales for the International division increased by $54 million, or 2.0%, for 2005, compared to 2004. Excluding the adverse effects of $61 million of foreign currency translation, net sales for the International division increased by $115 million, or 4.2%, for 2005 versus 2004. The increase in net sales was driven by increases in comparable store net sales of 3.1% due to strong net sales in our core toy, learning, and juvenile products categories, partially offset by a decrease in net sales in our video games and consumer electronics categories. The opening of ten wholly-owned international stores, slightly offset by the closure of four wholly-owned international stores, also contributed to our sales growth in 2005.

 

Babies “R” Us

 

Net sales for the Babies “R” Us division increased by $215 million, or 11.5%, for 2005 compared to 2004, primarily as a result of a 5.7% increase in comparable store net sales as well as the contribution of approximately $31.7 million in net sales from the additional 13 new stores opened in 2005. Our diaper/formula, gifts, bedding, health and beauty aids, infant care, and wood furniture categories all had double-digit net sales increases. The net sales increase was also driven by the impact of enhanced advertising events.

 

Toysrus.com

 

Net sales at Toysrus.com increased by $63 million, or 17.2%, for 2005 compared to 2004. The net sales increase was driven by approximately 13% growth in total orders and a 5% increase in average order dollar value, which contributed to a 27% growth in baby product sales, and 17% growth in toy sales, partially offset by a 5% decline in video game sales.

 

2004 compared to 2003

 

     Net Sales

 

(In millions)


   2004

   % of
net sales


    2003

   % of
net sales


   

Percentage

Growth/(Decline)


 

Toys “R” Us – U.S.

   $ 6,104    55.0 %   $ 6,326    55.9 %   (3.5 )%

Toys “R” Us – International

     2,739    24.7 %     2,470    21.8 %   10.9 %

Babies “R” Us

     1,863    16.8 %     1,738    15.3 %   7.2 %

Toysrus.com

     366    3.3 %     371    3.3 %   (1.3 )%

Kids “R” Us (1)

     28    0.2 %     415    3.7 %   (93.3 )%
    

  

 

  

 

Total net sales

   $ 11,100    100.0 %   $ 11,320    100.0 %   (1.9 )%
    

  

 

  

 


(1) Reflects the effect of our decision to close all of our freestanding Kids “R” Us stores, as previously announced on November 17, 2003.

 

Consolidated net sales decreased by 1.9% to $11.1 billion in 2004 from $11.3 billion in 2003. Excluding the impact of foreign currency translation that increased net sales for 2004 by $227 million, and a $387 million decline in net sales associated with the previously announced Kids “R” Us store closings, total net sales decreased by $60 million, or 0.6%, compared to 2003.

 

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The decrease in net sales for 2004 was primarily the result of declines in comparable store net sales at the Toys “R” Us – U.S. division, which posted comparable store sales declines of 3.7% for 2004. These decreases in net sales were partially offset by net sales increases in our Babies “R” Us division of 7.2% to $1.9 billion in 2004, and net sales increases in our International division of 1.7% (excluding the effect of currency translation) to $2.5 billion in 2004. These increases in net sales in our Babies “R” Us and International divisions were primarily due to the addition of 19 Babies “R” Us stores in the United States and seven wholly-owned international stores in 2004. In addition, comparable store net sales at our Babies “R” Us and International divisions showed favorable increases, as shown in the table above under “Comparable Store Net Sales Performance.”

 

Overall net sales decreases in 2004 were primarily attributable to soft sales in the Toys “R” Us – U.S. division, resulting from decreases in net sales of video game products of 8.9% in 2004. These declines reflected price deflation of video game products associated with increased competition and the continued maturation of this category.

 

Toys “R” Us – U.S.

 

Net sales for the Toys “R” Us – U.S. division decreased by $222 million, or 3.5%, to $6.1 billion in 2004 compared to 2003. Comparable store net sales at our Toys “R” Us – U.S. division declined 3.7% in 2004. Net sales were impacted by a 9% decline in video hardware and games due to maturing platforms. An overall decline in most juvenile categories, most significantly baby gear, also contributed to the net sales decline. In addition, we experienced sales declines in our action figures, Barbie and Barbie accessories, and games and collectible cards categories.

 

Toys “R” Us – International

 

Net sales for the International division increased by $269 million, or 10.9%, for 2004 compared to 2003. Excluding the effects of $227 million of foreign currency translation, net sales for the International division increased $42 million, or 1.7%, for 2004 versus 2003. The increase in net sales was driven by increases in comparable store net sales of 0.6%, as well as from strong net sales in learning and juvenile products. In addition, the opening of seven new wholly-owned international stores, slightly offset by the closure of five wholly-owned international stores, contributed to our sales growth.

 

Babies “R” Us

 

Net sales for the Babies “R” Us division increased by $125 million, or 7.2%, for 2004 compared to 2003, driven by a 2.2% increase in comparable store net sales as well as the contribution of approximately $32.9 million in net sales from the addition of 19 new stores in 2004. The increase in net sales was also driven by strong net sales in diaper/formula, juvenile accessories, baby gear, and apparel categories.

 

Toysrus.com

 

Net sales at Toysrus.com decreased by $5 million, or 1.3%, for 2004 compared to 2003. The net sales decrease was the result of the November 1, 2003 sale of Toysrus.com’s entire 55% investment in the common stock of Toysrus.com – Japan to Toys “R” Us – Japan, subsequent to which the financial statements of Toysrus.com – Japan were consolidated into the results of Toys “R” Us – Japan and no longer in our results. Excluding the sales of Toysrus.com – Japan, net sales increased by 3.4% compared to 2003.

 

Cost of Sales and Gross Margin

 

We record the costs associated with operating our distribution network as a part of consolidated selling, general, and administrative expenses (“SG&A”), including those costs that primarily relate to transporting

 

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merchandise from distribution centers to stores. Therefore, our consolidated gross margin may not be comparable to the gross margin of other retailers that include similar costs in their cost of sales. Credits and allowances received from vendors are recognized in consolidated cost of sales and also have a positive impact on our consolidated gross margin.

 

The following costs are included in “Cost of Sales:”

 

    The cost of acquired merchandise from vendors;

 

    Freight in;

 

    Markdowns;

 

    Provision for inventory shortages; and

 

    Credits and allowances from our merchandise vendors.

 

Consolidated Gross Margin

 

2005 compared to 2004

 

     Gross Margin

 

(In millions)


   2005

   % of
net sales


    2004

   % of
net sales


 

Toys “R” Us – U.S.

   $ 1,678    28.1 %   $ 1,771    29.0 %

Toys “R” Us – International

     1,026    36.7 %     1,006    36.7 %

Babies “R” Us

     791    38.1 %     706    37.9 %

Toysrus.com

     128    29.8 %     108    29.5 %

Kids “R” Us (1)

     —      —         3    10.7 %
    

  

 

  

Total gross margin

   $ 3,623    32.1 %   $ 3,594    32.4 %
    

  

 

  


(1) Reflects the effect of our decision to close all of our freestanding Kids “R” Us stores, as previously announced on November 17, 2003.

 

Consolidated gross margin, as a percentage of net sales, in 2005 decreased by 0.3 percentage points, but increased in absolute dollars by $29 million, compared to 2004. Gross margin for 2004 included $157 million in inventory markdowns which negatively impacted gross margin as a percentage of net sales by 1.4 percentage points in 2004. These markdowns affected our Toys “R” Us, International and Kids “R” Us divisions by $132 million, $15 million, and $10 million, respectively. Excluding the impact of the markdowns, gross margin as a percentage of net sales decreased 1.7 percentage points, or $128 million, in 2005 compared to 2004. The decrease in gross margin was attributable to increased price competitiveness and increased promotions and markdowns to maintain inventory quality.

 

Toys “R” Us – U.S.

 

Gross margin as a percentage of net sales for Toys “R” Us – U.S. decreased by 0.9 percentage points, or $93 million, compared to 2004. Gross margin for 2004, included a special $132 million charge related to an initiative to liquidate selected older store inventory which negatively impacted gross margin as a percentage of net sales by 2.2 percentage points in 2004.

 

Excluding the impact of the 2004 inventory initiative, gross margin as a percentage of net sales for 2005 decreased 3.1 percentage points, or $225 million, compared to 2004.

 

The decrease in gross margin as a percentage of net sales was mainly due to promotional efforts built around stringent inventory management efforts to minimize slow-moving, low-return inventory. Promotional

 

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markdowns were approximately $102 million higher than 2004 which helped drive inventory levels for the Toys “R” Us – U.S. down by approximately $360 million year over year. This was in part due to increased response rates to direct mail offerings and gift card promotions. The increase in promotional markdowns reduced gross margin as a percentage of net sales by 1.7 percentage points. In addition, we recorded $41 million in inventory markdowns and liquidator fees related to our announced Toys “R” Us – U.S. store closings as detailed further in Note 5 to the Consolidated Financial Statements entitled, “RESTRUCTURING AND OTHER CHARGES.” This reduced gross margin as a percentage of net sales by 0.7 percentage points in 2005. The decrease in gross margin dollars was also attributable to the overall net sales decline of $129 million in 2005, which reduced gross margin dollars by approximately $43 million. Also, lower inventory purchases reduced the amount of volume rebates, which reduced gross margin dollars by approximately $38 million in 2005. This reduced gross margin as a percentage of net sales by 0.6 percentage points.

 

Toys “R” Us – International

 

Gross margin as a percentage of net sales for Toys “R” Us – International in 2005 remained flat compared to 2004, but increased in absolute dollars by $20 million. Gross margin for 2004 included special inventory markdowns of $15 million related to an initiative to liquidate selected older store inventory. The inventory markdowns negatively impacted gross margin as a percentage of net sales by 0.6 percentage points for 2004. Excluding the effect of inventory markdowns in 2004, gross margin as a percentage of net sales for the International division decreased 0.6 percentage points, but increased in absolute dollar value by $5 million, for 2005 compared to 2004.

 

The decrease in 2005 gross margin compared to 2004 as a percentage of net sales (excluding the impact of the special $15 million inventory markdown taken in 2004), was primarily due to a 0.4 percentage point decline in our initial markup, due to product mix and currency impact, coupled with a 0.4 percentage point increase in regular markdowns, partially offset by a 0.2 percentage point improvement in inventory shortage.

 

Babies “R” Us

 

Gross margin as a percentage of net sales for Babies “R” Us in 2005 increased by 0.2 percentage points, or $85 million, compared to 2004. The increase in gross margin as a percentage of net sales was the result of improved overall initial markup of 0.4 percentage points driven by the diaper/formula and infant care categories offset by product mix and lower margin on imports of 0.5 percentage points. An increase of 0.2 percentage points in supplier promotional support and purchase allowances also contributed to the improvement. The increase in gross margin as percentage of sales was also attributable to the overall net sales increase of $215 million in 2005 compared to 2004, which increased gross margin dollars by approximately $80 million.

 

Toysrus.com

 

Gross margin as a percentage of net sales for Toysrus.com in 2005 increased by 0.3 percentage points, or $20 million, compared to 2004. The increase in gross margin as a percentage of net sales was primarily due to a continued shift of business toward higher margin baby products, such as infant bedding, wooden furniture, infant care, and baby accessories, all posting double-digit sales increases compared to 2004.

 

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2004 compared to 2003

 

     Gross Margin

 

(In millions)


   2004

   % of
net sales


    2003

   % of
net sales


 

Toys “R” Us – U.S.

   $ 1,771    29.0 %   $ 1,918    30.3 %

Toys “R” Us – International

     1,006    36.7 %     869    35.2 %

Babies “R” Us

     706    37.9 %     654    37.6 %

Toysrus.com

     108    29.5 %     102    27.5 %

Kids “R” Us (1)

     3    10.7 %     131    31.6 %
    

  

 

  

Total gross margin

   $ 3,594    32.4 %   $ 3,674    32.5 %
    

  

 

  


(1) Reflects the effect of our decision to close all of our freestanding Kids “R” Us stores, as previously announced on November 17, 2003.

 

Consolidated gross margin, as a percentage of net sales, decreased by 0.1 percentage points to 32.4% during 2004, and included the unfavorable impact of $157 million in inventory markdowns recorded in 2004 primarily to liquidate selected older toy store inventory and therefore enhance store productivity and supply chain efficiency. The markdowns were also intended to accelerate inventory turnover and generate additional cash flow. These markdowns affected our Toys “R” Us – U.S., International and Kids “R” Us divisions. Excluding the unfavorable impact of these inventory markdowns, consolidated gross margin was 33.8% for 2004.

 

Consolidated gross margin for 2003 included the unfavorable impact of the initial implementation of the provisions of EITF 03-10 and EITF 02-16 of $74 million. In addition, consolidated gross margin for 2003 included store closing inventory markdowns of $49 million related to the closing of the Kids “R” Us and Imaginarium freestanding stores.

 

Excluding the impact of inventory markdowns in 2004 and 2003, as well as the initial implementation impact of EITF 03-10 and EITF 02-16 in 2003, consolidated gross margin, as a percentage of net sales, increased by 0.3 percentage points to 33.8% for 2004. The increases in gross margin of 0.3 percentage points in 2004 reflected the impact of a favorable shift in the sales mix, driven in part by sales increases in higher margin exclusive and licensed product lines.

 

Toys “R” Us – U.S.

 

Gross margin as a percentage of net sales for the Toys “R” Us – U.S. division was 29.0% for 2004 compared to 30.3% for 2003. Gross margin for 2004 included a special $132 million unfavorable charge related to a 2004 initiative to liquidate selected older store inventory. The decline in gross margin for 2004 was attributable to the impact of this initiative. This initial change represented an unfavorable impact of 2.2 percentage points for 2004. Excluding the unfavorable impact of this initiative, gross margin increased from 30.3% in 2003 to 31.2% in 2004.

 

The 2003 gross margin of 30.3% for the Toys “R” Us – U.S. division included an unfavorable impact of $53 million due to the initial implementation of the provisions of EITF 03-10 and EITF 02-16. The implementation of these provisions adversely affected gross margin for 2003 by 0.9 percentage points. Excluding the effect of inventory markdowns in 2004 and the effect of the implementation of EITF 03-10 and EITF 02-16 in 2003, gross margin for the Toys “R” Us division for 2004 remained in line with 2003 at 31.2%.

 

Toys “R” Us – International

 

The International division reported an increase in gross margin of 1.5 percentage points to 36.7% for 2004 up from 35.2% for 2003. Gross margin for 2004 included inventory markdowns of $15 million, which adversely affected gross margin by 0.6 percentage points. Excluding the effect of inventory markdowns, gross margin was 37.3% for 2004.

 

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Gross margin for 2003 for the International division included the implementation effects of EITF 03-10 and EITF 02-16. Implementation of these provisions adversely affected gross margin for 2003 by 0.6 percentage points. Excluding the effect of inventory markdowns in 2004 and the effect of implementation of EITF 03-10 and EITF 02-16 in 2003, gross margin for the International division increased by 1.5 percentage points in 2004. These increases reflected the effects of favorable shifts in sales mix offset by a highly promotional and competitive environment in most of our foreign markets.

 

Babies “R” Us

 

Babies “R” Us reported a 0.3 percentage point increase in gross margin to 37.9% of net sales for 2004. Gross margin for 2003 for the Babies “R” Us division included the unfavorable impact of the initial implementation of the provisions of EITF 03-10 and EITF 02-16 of $6 million. The implementation of these provisions adversely affected gross margin for 2003 by 0.4 percentage points.

 

Toysrus.com

 

Toysrus.com reported an increase of 2.0 percentage points in gross margin as a percentage of net sales to 29.5% compared to 2003. The inventory markdowns and the implementation of EITF 03-10 and EITF 02-16 did not affect gross margin at Toysrus.com. The increase in gross margin for Toysrus.com in 2004 reflected a favorable shift of business from lower margin video game products to higher margin baby and toy products, as well as lower markdowns due to improved inventory management.

 

Selling, General and Administrative Expenses

 

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

 

    Store payroll and related payroll benefits;

 

    Rent and other store operating expenses;

 

    Advertising expenses;

 

    Costs associated with operating our distribution network that primarily relate to moving merchandise from distribution centers to stores; and

 

    Other corporate-related expenses.

 

2005 compared to 2004

 

     Selling, General and Administrative Expenses

 

(In millions)


   2005

   % of net sales

    2004

   % of net sales

 

Toys “R” Us Consolidated

   $ 2,899    25.7 %   $ 2,932    26.4 %

 

Consolidated SG&A expenses, as a percentage of net sales, decreased by 0.7 percentage points, or $33 million, for 2005 compared to 2004. The decrease in SG&A expenses, as a percentage of net sales compared to 2004, was partially due to the decrease in the Toys “R” Us – U.S. division’s SG&A expenses, including savings in advertising, payroll expenses and overhead charges. Payroll savings were primarily driven by lower hourly payroll and related payroll taxes as a result of lower sales, lower medical costs and a lower bonus payout. These savings were partially offset by increases in, higher facility maintenance costs, higher utility costs and higher property taxes as well as the Babies “R” Us division’s higher distribution center and store support center costs primarily due to new store growth and to support higher store for store sales. Fixed expenses were leveraged by large sales increases in the Toysrus.com division, which resulted in a decrease in SG&A as a percentage of sales.

 

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2004 compared to 2003

 

     Selling, General and Administrative Expenses

 

(In millions)


   2004

   % of net sales

    2003

   % of net sales

 

Toys “R” Us Consolidated

   $ 2,932    26.4 %   $ 3,026    26.7 %

 

Consolidated SG&A expense as a percentage of net sales for 2004 decreased by 0.3 percentage points compared to 2003. The decrease for 2004 reflected a $68 million reduction in payroll and related benefits as a result of our decision to close the Kids “R” Us division. In addition, the decrease reflected net proceeds from a settlement with MasterCard and Visa of $20 million in 2004. In addition, we recorded a $14 million gain for the sale of real estate of our former toy store in Santa Monica, California in 2004. These savings were offset by additional expenditures that we incurred during 2004 related to our strategic review initiative and Sarbanes-Oxley compliance totaling $29 million. Consolidated SG&A for 2004 included adjustments related to straight-line rent expense of $2 million.

 

Transaction and related costs

 

We recorded expenses of $410 million in 2005 which reflected $148 million of expenses to execute the Merger Transaction, $222 million of stock compensation costs associated with the Merger Transaction related to stock options and restricted stock as well as $40 million of severance, bonuses and related payroll taxes.

 

Contract settlement fees and other

 

Contract settlement fees and other was $22 million for the fifty-two weeks ended January 28, 2006. This amount resulted from the loss on early extinguishment of debt of $7 million related to the purchase of the notes associated with our equity security units and a contract settlement fee of $15 million related to the early termination of our synthetic lease of our Global Store Support Center in Wayne, New Jersey.

 

Depreciation and Amortization

 

2005 compared to 2004

 

     Depreciation and Amortization

 

(In millions)


   2005

   % of net sales

    2004

   % of net sales

 

Toys “R” Us Consolidated

   $ 400    3.5 %   $ 354    3.2 %

 

Depreciation and amortization was $400 million in 2005 versus $354 million in 2004. Depreciation for 2005 included $22 million in accelerated depreciation related to our announced Toys “R” Us – U.S. store closings as detailed in Note 5 to the Consolidated Financial Statements, entitled “RESTRUCTURING AND OTHER CHARGES.” The increase in depreciation and amortization is also attributed to an increase of $16 million in capital expenditures from $269 million in 2004 to $285 million in 2005.

 

2004 compared to 2003

 

     Depreciation and Amortization

 

(In millions)


   2004

   % of net sales

    2003

   % of net sales

 

Toys “R” Us Consolidated

   $ 354    3.2 %   $ 368    3.3 %

 

Depreciation and amortization was $354 million in 2004 versus $368 million in 2003. Depreciation for both 2004 and 2003 included the effect of shorter depreciation or amortization periods for leasehold improvements, which increased expenses by $21 million and $20 million, respectively. Depreciation for 2004 also included the effect of the sale of the Kids “R” Us real estate during 2004 which decreased depreciation by approximately $15

 

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million. Depreciation and amortization for 2003 also included $24 million of depreciation recorded during the fourth quarter of 2003 that was accelerated through the closing periods for the freestanding Kids “R” Us and Imaginarium stores.

 

Interest Expense

 

2005 compared to 2004

 

     Interest Expense

 

(In millions)


   2005

   % of net sales

    2004

   % of net sales

 

Toys “R” Us Consolidated

   $ 394    3.5 %   $ 130    1.2 %

 

Interest expense, as a percentage of net sales, increased by 2.3 percentage points, or $264 million, for 2005 compared to 2004. This increase was primarily due to the substantial increased borrowings as a result of the Merger Transaction as well as increased short-term interest rates on our floating rate debt. In addition, interest expense for 2005 included $90 million of deferred financing cost amortization incurred in connection with borrowings related to the Merger Transaction. As a result of the substantial borrowings we entered into as a part of the Merger Transaction, we anticipate that interest expense will remain high in the foreseeable future.

 

2004 compared to 2003

 

     Interest Expense

 

(In millions)


   2004

   % of net sales

    2003

   % of net sales

 

Toys “R” Us Consolidated

   $ 130    1.2 %   $ 142    1.3 %

 

Interest expense, as a percentage of net sales, decreased by 0.1 percentage points, or $12 million, for 2004 compared to 2003. The $12 million decrease in 2004 was comprised of a $42 million reduction in interest expense as a result of long-term debt principal repayments offset by an $18 million increase in interest expense related to the annualizing of long-term debt issued during 2003, and a $12 million increase due to rising short-term interest rates.

 

Interest Income

 

2005 compared to 2004

 

     Interest Income

 

(In millions)


   2005

   % of net sales

    2004

   % of net sales

 

Toys “R” Us Consolidated

   $ 31    0.3 %   $ 19    0.2 %

 

Interest income, as a percentage of net sales, increased by 0.1 percentage points, or $12 million for 2005 compared to 2004. This increase was a result of higher interest rates on our investments partially offset by decreased average cash balances.

 

2004 compared to 2003

 

     Interest Income

 

(In millions)


   2004

   % of net sales

    2003

   % of net sales

 

Toys “R” Us Consolidated

   $ 19    0.2 %   $ 18    0.2 %

 

Interest income, as a percentage of net sales remained flat for 2004 compared to 2003. While we experienced a decrease in our average cash balances, it was offset by higher interest rates on our investments.

 

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Income Taxes

 

2005 compared to 2004

 

During 2005 and 2004, the effective tax rates were (24.0)% and (30.4)%, respectively. The primary reason for the change in the 2005 effective tax rate was due to the reversal of $200 million of tax reserves in 2004, as further described in Note 20 to the Consolidated Financial Statements entitled, “INCOME TAXES.”

 

2004 compared to 2003

 

During 2004 and 2003, the effective tax rates were (30.4)% and 32.0%, respectively. Our effective tax rate in 2004 reflects the tax benefit of a reversal of previously accrued income taxes of $200 million based on the settlement of an IRS audit, and a $54 million tax charge on the repatriation of previously indefinitely reinvested foreign earnings.

 

Foreign Currency Translation

 

Foreign currency translation had an unfavorable impact on our consolidated and international operating earnings for 2005 of $16 million, and a favorable impact on our consolidated and International operating earnings for 2004 and 2003 of $17 million and $20 million, respectively. The 2005 impact resulted in a decrease in operating earnings for the International division of 7%. Conversely, for 2004 and 2003, operating earnings of the international division benefited, by 10% and 13% respectively. The unfavorable impact on consolidated net earnings for 2005 was 5%. For 2004 and 2003, the favorable impact on consolidated net earnings was 8% and 5%, respectively.

 

Other

 

Inflation did not have a significant impact on our consolidated net earnings in 2005, 2004 or 2003.

 

RESTRUCTURING AND OTHER CHARGES

 

On January 5, 2006, our Board of Directors approved the closing of 87 Toys “R” Us stores in the United States. As of January 28, 2006, we closed three of these stores. All of the remaining 84 stores were closed by April 2, 2006. Twelve of these stores will be converted into Babies “R” Us stores, resulting in the permanent closure of 75 stores. The decision to take this action resulted from a comprehensive review and evaluation of our U.S. stores over the last several months of 2005. We retained Gordon Brothers Retail Partners, LLC to assist us in connection with the orderly sale of the inventory in these stores.

 

In connection with the closing and conversion of these stores, we recorded $94 million of costs and charges during 2005. We estimate an additional $55 million of charges will be recorded in the first quarter of 2006. The $94 million of costs and charges include $41 million of inventory markdowns and liquidator fees that were recorded in cost of sales and $22 million of depreciation that was accelerated through the closing periods of the stores. The remaining $31 million of costs and charges are included in restructuring and other charges in the Consolidated Statement of Operations, and consist of $22 million relating to asset impairments, $1 million relating to lease commitments, and $8 million relating to severance costs. As a result of the store closings, approximately 3,000 employee positions have been eliminated.

 

On August 11, 2004, we announced our intention to restructure our Global Store Support Center operations in Wayne, New Jersey. As a result, we recorded termination costs of $14 million associated with this action in the second quarter of 2004 and additional net costs of $7 million in the second half of 2004. Of these total charges, $13 million were recorded in restructuring and other charges related to severance and lease commitments, and charges of $8 million were recorded in selling, general and administrative expenses, comprised of $2 million for payroll-related costs and $6 million for stock option compensation charges resulting

 

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from modifications to stock option agreements for the severed executives. As of January 28, 2006, $1 million of reserves for termination costs remain to complete this initiative.

 

On November 17, 2003, we announced our decision to close all 146 of the remaining freestanding Kids “R” Us stores and all 36 of the freestanding Imaginarium stores, as well as three distribution centers that support these stores due to deterioration in their financial performance. On March 2, 2004, we entered into an agreement with Office Depot, Inc. (“Office Depot”) under which Office Depot agreed to acquire 124 of the former Kids “R” Us stores for $197 million in cash, before commissions and fees, plus the assumption of lease payments and other obligations. Twenty-four properties were subsequently excluded from the agreement with Office Depot and these properties are being marketed for disposition or have been disposed of to date. As of January 28, 2006, all of the free standing Kids “R” Us and Imaginarium stores were closed. During 2005, we recorded a loss of $1 million on the sale of property and $2 million of vacancy-related costs. We expect to record additional charges for the accretion of interest related to vacancy costs for closed facilities until their disposition. Charges in connection with these initiatives may be subject to revision for changes in estimates.

 

In 2001, we recorded net charges of $184 million to close a number of stores, to eliminate a number of staff positions, and to consolidate five store support center facilities into our Global Store Support Center facility in Wayne, New Jersey. During 2005, we incurred additional charges of $1 million related to store closings and utilized $13 million of reserves. This reduced our remaining reserves from $63 million at January 29, 2005 to $51 million at January 28, 2006.

 

We had $22 million of reserves remaining at January 28, 2006, from restructuring charges previously recorded in 1998 and 1995, primarily for long-term lease commitments, that will be utilized in 2006 and thereafter. During 2005, we recorded a net reversal of $1 million resulting from adjustments to lease shortfall reserves.

 

Refer to Note 5 to the Consolidated Financial Statements entitled “RESTRUCTURING AND OTHER CHARGES” for further details.

 

LIQUIDITY AND CAPITAL RESOURCES

 

We fund inventory expenditures during normal and peak periods through cash flows from operating activities, available cash, and our revolving credit facilities. Our working capital needs follow a seasonal pattern, peaking in the third quarter of the year when inventory is received for the holiday selling season. Our largest source of operating cash flows is cash collections from our customers. In general, our primary uses of cash are financing construction of new stores, remodeling existing stores, debt servicing, completing restructuring initiatives and providing for working capital, which principally represents the purchase of inventory.

 

We have been able to meet our cash needs principally by using cash on hand, cash flows from operations, our variable rate revolving credit facilities and the multicurrency revolving facilities.

 

Additionally, we have lines of credit with various banks to meet certain of the short-term financing needs of our foreign subsidiaries. At January 28, 2006, we had an unused amount of $2 billion under our secured revolving credit facility and a total of $343 million of unused amounts under our multi-currency revolving credit facilities (95 million British Pounds and 145 million Euro). As a result of our new borrowing arrangements following the Merger Transaction, effective July 21, 2005, we cancelled our previous unsecured $685 million credit facility.

 

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, and planned capital expenditures for at least the next 12 months. In addition, we will consider additional sources of financing to fund our long-term growth.

 

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(In millions)


   2005

    2004

    2003

 

Toys “R” Us Consolidated

                        

Net cash provided by operating activities

   $ 671     $ 748     $ 797  

Net cash provided by (used in) investing activities

     573       (477 )     (774 )

Net cash (used in) provided by financing activities

     (1,488 )     (476 )     422  

Effect of exchange rate fluctuations on cash

     (7 )     25       (40 )
    


 


 


Net (decrease) increase in cash and equivalents

   $ (251 )   $ (180 )   $ 405  
    


 


 


Net cash provided by operating activities

   $ 671     $ 748     $ 797  

Less: Capital expenditures

     (285 )     (269 )     (262 )
    


 


 


Free cash flow

   $ 386     $ 479     $ 535  
    


 


 


 

Free cash flow is a non-GAAP measure. We believe free cash flow is an important metric, as it represents a measure of how profitable a company is on a cash basis after the deduction of capital expenses, as most retail companies require regular capital expenditures to build and maintain stores and purchase new equipment to keep the business growing. We use this metric internally as we believe our sustained ability to increase free cash flow is an important driver of value creation.

 

Cash flows from operating activities

 

(In millions)


   2005

    2004

    2003

Net (loss) earnings

   $ (384 )   $ 252     $ 63

Adjustments to reconcile net earnings to net cash from operating activities:

                      

Depreciation and amortization

     400       354       368

Other non-cash reconciling adjustments

     332       (33 )     83

Decrease in merchandise inventories

     387       221       133

Other changes in operating assets and liabilities

     (64 )     (46 )     150
    


 


 

Net cash provided by operating activities

   $ 671     $ 748     $ 797
    


 


 

 

Net cash provided by operating activities for 2005 was $671 million, a decrease of $77 million compared to 2004, due primarily to the increased net loss as a result of transaction costs related to the Merger, increased interest payments on new borrowings we incurred in connection with the Merger, decline in the income tax benefit, and losses on early extinguishment of debt and contract settlement fees.

 

Net cash provided by operating activities for 2004 was $748 million and included the favorable impact of an increase in year on year earnings, reduced inventory levels resulting from continued inventory management improvement, and the reduction in cash invested in prepaid and other operating assets driven primarily by a reduction in the over-funding of the Company’s supplemental executive retirement program assets of $35 million. These benefits were offset by non-cash income related to the reversal of approximately $200 million in income tax reserves related to settlement of certain IRS audits.

 

Net cash provided by operating activities for 2003 reflected an increase of $222 million resulting from favorable variances for inventory, accounts receivable and accounts payable brought about by improved inventory and cash flow management and the effect of inventory liquidation at our Kids “R” Us stores. Inventories at Kids “R” Us decreased by $83 million to $4 million during 2003, and were liquidated as the remaining freestanding stores closed during the first half of 2004. In addition, cash flow from operating activities for 2003 reflected the effect of the non-cash portion of restructuring and other charges of $63 million for the year.

 

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Cash flows from investing activities

 

(In millions)


   2005

    2004

    2003

 

Capital expenditures

   $ (285 )   $ (269 )   $ (262 )

Sale (purchase) of short-term investments and other

     953       (382 )     (572 )

Purchase of SB Toys, Inc.

     —         (42 )     —    

(Increase) decrease in restricted cash

     (107 )     —         60  

Proceeds from sale of fixed assets

     12       216       —    
    


 


 


Net cash provided by (used in) investing activities

   $ 573     $ (477 )   $ (774 )
    


 


 


 

Net cash provided by investing activities was $573 million for 2005. The increase was primarily due to proceeds from the sale of $953 million of our short-term investments. This increase was partially offset by the $16 million increase in capital expenditures in 2005, as well as an increase of $107 million in restricted cash which serves as collateral for certain property financings we entered into during 2005. Capital expenditures in 2005 included the cost related to the opening of 13 new Babies “R” Us stores in the United States, 10 new wholly-owned International toy stores, as well as a $112 million payment to purchase the Wayne Global Store Support Center, which was previously leased.

 

Cash flows used in investing activities for 2004 decreased by $297 million. The decrease was driven by the receipt of net proceeds from the sale of Kids “R” Us assets of $157 million, the net proceeds from the sale of our store in Santa Monica, California of $24 million, $15 million related to the sale of one of our former Store Support Center locations and an additional $20 million related to the sale of other fixed assets. In addition, our investment in short term and other securities decreased by $190 million versus 2003. These decreases were partially offset by $42 million related to the acquisition of SB Toys, Inc., previously a minority shareholder in Toysrus.com. Capital expenditures of $269 million for the opening of 19 new Babies “R” Us stores and one new toy store in the United States, seven new wholly-owned international toy stores, as well as on-going maintenance and improvement capital expenditures, were in line with 2003.

 

Cash flows used in investing activities for 2003 increased by $379 million. This increase was due to higher investments in short term and other securities of $572 million. Capital expenditures of $262 million for the opening of 16 new Babies “R” Us stores, six new wholly-owned international toy stores, information technology projects, and on-going maintenance and improvement capital expenditures were $133 million lower as compared to 2002. This decrease was due to the completion of the Mission Possible formatting during 2002.

 

In addition, our capital expenditures in each of the preceding three years included costs to improve and enhance our information technology systems.

 

During 2006, we plan to continue to expand our Babies “R” Us store base in the United States and our Toys “R” Us store base abroad. However, we can provide no assurance that this expansion will occur.

 

Cash flows from financing activities

 

(In millions)


   2005

    2004

    2003

 

Short-term and long-term borrowings

   $ 7,329     $ —       $ 792  

Short-term and long-term repayments

     (3,700 )     (503 )     (370 )

Repurchase of common stock

     (5,891 )     —         —    

Repurchase of stock options and restricted stock

     (227 )     —         —    

Capital contributed by affiliate

     1,279       —         —    

Other financing activities, net

     (278 )     27       —    
    


 


 


Net cash (used in) provided by financing activities

   $ (1,488 )   $ (476 )   $ 422  
    


 


 


 

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Net cash used in financing activities was $1,488 million for 2005 reflecting the proceeds from our long-term debt borrowings of $7,004 million, our short-term debt borrowings of $325 million, capital contributions by our affiliates of $1,279 million, total proceeds of $107 million related to the issuance of common stock and the exercise of stock options. These cash inflows were offset by the repurchase of common stock under the Merger Transaction of $5,891 million, debt repayments of $3,700 million, repurchase of options and restricted stock of $227 million, repurchase of equity security units and warrants of $130 million, and capitalized debt issuance costs of $255 million.

 

Net cash flow used in financing activities in 2004 included the payment of $466 million to retire our 500 million Euro-denominated bonds.

 

Net cash flow from financing activities in 2003 included the net proceeds of $792 million from notes issued under a “shelf” registration statement filed with the Securities and Exchange Commission. Long-term debt repayments in 2003 included $342 million to retire our 475 million Swiss Franc note that matured on January 28, 2004.

 

As part of the Merger Transaction, during 2005, we made the following significant changes to our debt structure:

 

    $1.0 Billion European Facilities Agreement and £95 Million and €145 Million Multi-Currency Revolving Credit Facilities. On July 21, 2005, Toys “R” Us (UK) Limited, our indirect wholly-owned subsidiary, entered into a senior facilities agreement with a syndicate of financial institutions. Under the agreement, a $1.0 billion bridge facility and multi-currency revolving credit facilities in an amount of up to £95 million and €145 million, respectively, were made available to Toys “R” Us (UK) Limited and other European affiliates of Toys “R” Us (UK) Limited. The facilities are, to the extent legally possible, guaranteed by Toys “R” Us (UK) Limited’s immediate holding company, Toys “R” Us Europe, LLC, and their respective material subsidiaries, and secured by a lien over assets of the borrowers and guarantors under the facilities. The $1.0 billion bridge facility had a scheduled maturity of July 21, 2006. The revolving credit facilities have a scheduled maturity of July 21, 2010. If the borrowings outstanding under the bridge facility were to exceed $857 million at the maturity date, $282 million could have been converted into a 5 1/2 year senior facility, and $575 million could have been converted into a six-year senior facility. Any remaining borrowings in excess of $857 million would have been due upon maturity. The bridge facility has an annual interest rate of LIBOR plus 1.50% and/or EURIBOR plus 1.50%. As of January 28, 2006, we had borrowed the full amount of $1.0 billion on the bridge facility. Following the end of fiscal 2005, on February 9, 2006, we repaid all of the outstanding borrowings under the bridge facility using property financing as well as available funds. We classified $122 million of the bridge facility as current portion of long-term debt, as this amount was paid by using the available funds, and classified $886 million as long-term debt, as this amount was paid from the funds received from our property financing. Refer to Note 28 to the Consolidated Financial Statements, entitled “SUBSEQUENT EVENTS” for details on our new long-term financing arrangements. During 2005, we entered into various swap agreements to hedge our exposure related to these facilities. Refer to Note 13 to the Consolidated Financial Statements, entitled “DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES.” The multi-currency revolving credit facilities carry an annual interest rate of LIBOR plus 1.50% and/or EURIBOR plus 1.50%. We had no borrowings under the revolving credit facilities as of January 28, 2006.

 

The bridge facility and multi-currency revolving credit facilities agreement contains covenants, including, among other things, covenants that restrict the ability of Toys “R” Us (UK) Limited, Toys “R” Us Europe, LLC, and their respective subsidiaries to incur certain additional indebtedness, create or permit liens on assets, or engage in mergers or consolidations. In addition, for so long as the $1.0 billion bridge facility remained outstanding, Toys “R” Us Europe, LLC was required to comply with certain financial covenants, including requirements to maintain a ratio of consolidated earnings before interest, taxes, depreciation, and amortization (EBITDA) to net interest payable of not less than 2.0:1.0 and a

 

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ratio of consolidated total net debt to consolidated EBITDA of no greater than 6.5:1.0. Following repayment of the bridge facility, the minimum ratio of consolidated EBITDA to net interest payable required under the facility will increase to 4.0:1.0 and the maximum ratio of consolidated total net debt to consolidated EBITDA required under the facility will decrease to 4.0:1.0 for the third accounting quarter in each fiscal year and 2.75:1.0 for the first, second and fourth accounting quarters. At January 28, 2006, prior to the repayment of the bridge facility, Toys “R” Us Europe, LLC’s ratio of consolidated EBITDA to net interest payable was 6.4:1.0 and Toys “R” Us Europe, LLC’s ratio of consolidated total net debt to consolidated EBITDA was 4.6:1.0.

 

    $800 Million Secured Real Estate Loans. On July 21, 2005, certain indirect wholly owned subsidiaries entered into mortgage loan agreements totaling $800 million, 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. Direct and indirect interests in certain real property located in the United States secured the loans. As of January 28, 2006, we had $800 million outstanding under these loan agreements.

 

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 loan agreements.

 

    $1.3 Billion New Holdco Credit Agreement. 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. We used a portion of the proceeds to repay approximately $927 million of existing indebtedness under the bridge loan agreement, dated as of July 21, 2005, described above. The remainder of the proceeds from the transaction, after establishing a restricted cash account of $107 million as collateral, was used to pay expenses in connection with the transaction and to reduce existing indebtedness under a revolving credit facility. The 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. Concurrently with the making of the loan, we entered into an interest rate cap agreement to effectively cap the interest rate on LIBOR at 7.50% for the initial term of the loan. The loan is secured in part by 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, respectively. 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 “R” Us – Delaware, Inc. (“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. The credit agreement has a three-year term and provides for two one-year extensions at the election of the borrower. 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.

 

   

$2 Billion Secured Revolving Credit Facility. On July 21, 2005, we, including Toys-Delaware, our direct wholly-owned subsidiary, Toys “R” Us (Canada) Ltd / Toys “R” Us (Canada) Ltee, our indirect wholly-owned subsidiary, and certain other domestic subsidiaries entered into a $2.0 billion five-year secured revolving credit facility, carrying an annual interest rate of LIBOR plus 1.75%-3.75%, with a syndicate of financial institutions. The 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

 

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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-Delaware and certain of its subsidiaries to incur certain additional indebtedness, create or permit liens on assets, engage in mergers or consolidations, pay dividends or repurchase capital stock or 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 of $125 million, 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 a minimum of $125 million. Pricing for the facility is tiered based on levels of excess availability.

 

As of January 28, 2006, we had no borrowings under this facility and had $165 million of letters of credit outstanding. On July 21, 2005, we cancelled our previous unsecured credit facility of $685 million, which had no outstanding balances.

 

Borrowings under this secured revolving credit facility are made and/or guaranteed by Toys-Delaware and certain of its subsidiaries and are secured by the tangible and intangible assets (with specified exceptions) of the borrowers, Babiesrus.com, LLC, Toysrus.com, Inc. and certain subsidiaries of Toys-Delaware. The debt is subject to mandatory prepayment provisions as specified in the credit agreement.

 

    $1.9 Billion Unsecured Bridge Facility. On July 21, 2005, we entered into a bridge loan agreement with a syndicate of financial institutions. Upon consummation of the Merger Transaction, Toys-Delaware became the borrower under this agreement. The bridge loan agreement originally provided for a one-year term unsecured credit facility of $1.9 billion, carrying an annual interest rate of LIBOR plus 5.25%. Any outstanding bridge loans on July 21, 2006 (the “Conversion Date”) will be automatically converted into term loans with a six-year term (“Term Loans”). On and after the first anniversary of the Conversion Date, lenders collectively holding at least 51% of the Term Loans may elect to exchange their Term Loans for exchange notes, which will mature on July 21, 2012. On December 9, 2005, we repaid $927 million of the outstanding bridge loan balance in conjunction with the execution of the $1.3 Billion New Holdco Credit Agreement, details of which appear above. As of January 28, 2006, we had $973 million outstanding under our bridge loan agreement. The borrowings under the bridge loan agreement are guaranteed by Toys “R” Us, Inc. (until the bridge loans are converted to term loans on July 21, 2006), certain subsidiaries of Toys-Delaware, and certain other entities. In connection with the principal repayment, a pro-rata portion of previously capitalized transaction costs in the amount of approximately $32 million was expensed in 2005.

 

The bridge loan agreement contains 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.

 

We entered into the following additional borrowings subsequent to our year ended January 28, 2006:

 

   

On January 23, 2006, Toys “R” Us Iberia Real Estate, S.L., our indirect wholly-owned subsidiary, entered into a secured loan agreement with a syndicate of financial institutions. The loan is secured by, among other things, selected Spanish real estate, which has been or will be acquired by the borrower. On February 1, 2006, the loan agreement was drawn down, and pursuant to which we borrowed €135.1 million. The maturity date for the loan is February 1, 2013. The loan has an interest rate of 1.50% plus mandatory costs plus EURIBOR. We have entered into hedging arrangements whereby we have fixed the interest under the loan at 4.505% plus mandatory costs per annum. The loan agreement contains covenants, including, among other things, covenants that restrict the ability of the borrower to engage in mergers or consolidations, incur additional indebtedness, or create or permit liens on assets. The loan also requires the company to maintain an interest coverage ratio of 110%. On January 23, 2006, Toys “R” Us France Real Estate SAS, our indirect wholly-owned subsidiary, entered into a secured loan agreement with a syndicate of financial institutions. The loan is secured by, among other things, selected

 

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French real estate, which has been or will be acquired by the borrower. On February 1, 2006, the loan agreement was drawn down, and pursuant to which we borrowed €65.2 million. The maturity date for the loan is February 1, 2013. The loan has an interest rate of 1.50% plus mandatory costs plus EURIBOR. We have entered into hedging arrangements whereby we have effectively fixed the interest under the loan at 4.505% plus mandatory costs per annum. The loan agreement contains covenants, including, among other things, covenants that restrict the ability of the borrower to engage in mergers or consolidations, incur additional indebtedness, or create or permit liens on assets. The loan also requires the company to maintain an interest coverage ratio of 110%.

 

    On February 8, 2006, Toys “R” Us Properties (UK) Limited (“Toys Properties”), our indirect wholly-owned subsidiary, entered into a credit agreement with Vanwall Finance PLC as the Issuer and as Senior Lender and The Royal Bank of Scotland PLC as Junior Lender, which included a series of Secured Senior Loans comprising an initial principal amount of approximately £347.0 million and a Junior Loan comprising an initial principal amount of up to £62.4 million. The Senior Lender and Junior Lender have also agreed to provide an aggregate of approximately £10.8 million in additional loans under specified conditions. The loans are secured by, among other things, selected UK real estate, which has been or will be acquired by the borrower. The credit agreement contains customary covenants, including, among other things, 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. The credit agreement has a seven-year term and Toys Properties is required to repay the loans in part in quarterly installments from the first anniversary date. The final maturity date is April 7, 2013. The credit agreement also contains 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 credit agreement, cross default provisions, the failure of representations and warranties contained in the Credit Agreement to be true and certain insolvency events with respect to Toys Properties. The Senior Loan bears interest at an annual rate of mandatory costs plus 4.5575% plus a margin ranging from 0.28% to 1.50% and the Junior Loan bears interest at an annual rate of mandatory costs plus LIBOR plus a margin of 2.25%. Toys Properties has entered into hedging arrangements in relation to its floating rate exposure under the credit agreement, whereby Toys Properties effectively fixed the interest under the Junior Loan at 6.8075% plus mandatory costs per annum. The proceeds from the above-described U.K. transaction, together with other available funds, were used to repay all of the outstanding indebtedness under the bridge facility component of the Senior Facilities Agreement entered into by Toys “R” Us (UK) Limited on July 21, 2005 and to pay part of the transaction costs. In connection with the financing transaction, we revised our estimated amortization period of the $1.0 billion European bridge facility deferred transaction costs and, as a result, recorded an additional $27 million in amortization expense in the thirteen-week period ended January 28, 2006.

 

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Contractual Obligations and Commitments

 

Our contractual obligations consist mainly of operating leases related to real estate used in the operation of our business, and long-term debt. Below are the operating leases and principal amounts due under long-term debt issuances, as well as other obligations:

 

Contractual Obligations at January 28, 2006

 

     Payments Due By Period

(In millions)


   2006

   2007-2008

   2009-2010

   2011 and
thereafter


   Total

Operating leases

   $ 328    $ 606    $ 536    $ 1,256    $ 2,726

Less: sub-leases to third parties

     25      41      25      63      154
    

  

  

  

  

Net operating lease obligations

     303      565      511      1,193      2,572

Capital lease obligations

     4      6      1      1      12

Interest payments (a)

     392      630      425      644      2,091

Long-term debt

     403      2,150      —        3,359      5,912

Purchase obligations (b)

     1,051      —        —        —        1,051

Guarantees (c)

     6      12      12      14      44

Other (d)

     130      139      113      8      390
    

  

  

  

  

Total contractual obligations

   $ 2,289    $ 3,502    $ 1,062    $ 5,219    $ 12,072
    

  

  

  

  


(a) $1.8 billion of debt was subject to fixed interest rates and $4.1 billion of debt was subject to variable interest rates. The interest payments in the table for the $4.1 billion of variable rate debt were based on the indexed interest rates in effect at January 28, 2006.
(b) Purchase obligations consist primarily of open purchase orders for merchandise that are not included in our consolidated balance sheet as of January 28, 2006. Certain of these open purchase orders allow us to cancel the order without recourse.
(c) We are the guarantor of various loans to Toys “R” Us – Japan from third parties in Japan. For further details see Note 9 to the Consolidated Financial Statements entitled “INVESTMENT IN TOYS “R” US – JAPAN.”
(d) Includes minimum royalty obligations, pension obligations, risk management liabilities, and other general obligations.

 

We are in compliance with all covenants associated with the above contractual obligations. The covenants include, among other things, requirements to provide financial information and public filings and to comply with specified financial ratios. Non-compliance with associated covenants could give rise to accelerated payments, requirements to provide collateral, or changes in terms contained in the respective agreements.

 

We currently have a $2 billion secured credit facility from a syndicate of financial institutions. The 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. Additionally, we have multi-currency revolving credit facilities in an amount of up to £95 million and €145 million, which are secured by a lien over certain assets. We had a $685 million unsecured committed revolving credit facility from a syndicate of financial institutions on January 29, 2005, which we terminated on July 21, 2005. There were no outstanding loan balances under these credit facilities at the end of 2005, 2004 or 2003. Additionally, we have lines of credit with various banks to meet certain of the short-term financing needs of our foreign subsidiaries.

 

Credit Ratings

 

On October 21, 2005, Standard & Poor’s revised our corporate credit rating to B-, a two-level downgrade from our previous rating of B+. On October 17, 2005, Moody’s revised our corporate credit rating to B2, a

 

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one-level downgrade from our previous rating of B1. These current ratings are considered non-investment grade. Our current ratings are as follows:

 

     Moody’s

   Standard and Poor’s

Long-term debt

   B2    B-

Outlook

   Negative    Stable

 

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

 

Our current credit ratings, as well as future rating agency actions, could (1) negatively impact our ability to finance our operations on satisfactory terms, and (2) have the effect of increasing our financing costs. Our debt instruments do not contain provisions requiring acceleration of payment upon a debt rating downgrade.

 

In connection with the financing transactions undertaken or planned as a result of the Merger Transaction, it is possible that the rating agencies will further revise the ratings in respect of our outstanding debt securities. At this time, we are unable to predict the ratings to be so assigned to our outstanding debt by the rating agencies.

 

OFF-BALANCE SHEET ARRANGEMENTS

 

Our Global Store Support Center facility in Wayne, New Jersey was originally financed under a lease arrangement commonly referred to as a “synthetic lease.” Under this lease, unrelated third parties arranged by Wachovia Development Corporation, a multi-purpose real estate investment company, funded the acquisition and construction of the facility. On June 1, 2005, we purchased our Global Store Support Center facility for a purchase price of $128.8 million pursuant to the purchase election option under the lease arrangement.

 

We guarantee 80% of Toys “R” Us – Japan’s three installment loans from a third party in Japan, totaling 6.5 billion yen ($56 million). See Note 9 to the Consolidated Financial Statements entitled “INVESTMENT IN TOYS “R” US – JAPAN” for a further discussion on these guarantees.

 

CRITICAL ACCOUNTING POLICIES

 

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosures of contingent assets and liabilities as of the date of the financial statements and during the applicable periods. We base these estimates on historical experience and on other factors that we believe are reasonable under the circumstances. Actual results may differ materially from these estimates under different assumptions or conditions and could have a material impact on our consolidated financial statements.

 

We believe the following are our most critical accounting policies that include significant judgments and estimates used in the preparation of our consolidated financial statements. We consider an accounting estimate to be critical if it requires assumptions to be made that were uncertain at the time they were made, and if changes in these estimates could have a material impact on our consolidated financial condition or results of operations:

 

Merchandise Inventories:

 

Merchandise inventories for the Toys “R” Us – U.S. division, other than apparel, are stated at the lower of LIFO (last-in, first-out) cost or market value, as determined by the retail inventory method and represent approximately 52% of total merchandise inventories. All other merchandise inventories are stated at the lower of FIFO (first-in, first-out) cost or market value as determined by the retail inventory method.

 

 

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We receive various types of merchandise and other types of allowances from our vendors based on negotiated terms. We use estimates at interim periods to record our provisions for inventory shortage, to adjust certain inventories to a LIFO basis, and to record merchandise allowances from our vendors. These estimates are based on the development of the cost-to-retail ratios (estimated average markup percentages for product categories), consumer price index data, estimated inventory turnover, and the accounting for retail price adjustments. These estimates are based on available data and are adjusted to actual amounts at the completion of our physical inventories, finalization of all vendor allowance agreements, and the closing of our books at the end of our fiscal year. In addition, we perform an inventory-aging analysis for determining obsolete inventory. Our policy to write down inventory to its net realizable value is based on various management’s assumptions. Among them is the establishment of criteria to identify and write down obsolete inventory based on the type and the inventory’s receipt date. Inventory is reviewed on an interim basis and adjusted as appropriate to reflect write-downs determined to be necessary.

 

Factors such as slower inventory turnover due to changes in competitors’ tactics, consumer preferences, consumer spending and unseasonable weather patterns, among other factors, could cause excess inventory requiring greater than estimated markdowns to entice consumer purchases, resulting in an unfavorable impact on our consolidated financial statements. Sales shortfalls due to the above factors could cause reduced purchases from vendors and associated vendor allowances that would also result in an unfavorable impact on our consolidated financial statements.

 

Excess Facilities and Long-lived Assets 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 point of closure for the present value of any remaining operating lease obligations, net of estimated sublease income, and at the communication date for severance and other exit costs, as prescribed by SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” Two key assumptions in calculating the reserve include the timeframe expected to terminate lease agreements and estimation of other related exit costs. If actual timing and potential termination costs differ from our estimates, the resulting reserves could vary from recorded amounts. Reserves are reviewed periodically and adjusted, when necessary.

 

We 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 review for impairment all stores for which undiscounted current cash flows from operations are negative, or the construction costs are significantly in excess of the amount originally expected. Impairment results when the carrying value of the assets exceeds the undiscounted future cash flows over the life of the lease. Our estimate of undiscounted future cash flows over the lease term is based upon our experience, historical operations of the stores and estimates of future store profitability and economic conditions. The future estimates of store profitability and economic conditions require estimating such factors as sales growth, employment rates, lease escalations, inflation on operating expenses and the overall economics of the retail industry for up to 20 years in the future, and are therefore subject to variability and difficult to predict. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the carrying value and the asset’s fair value. The fair value is estimated based upon future cash flows (discounted at a rate that approximates our weighted average cost of capital) or other reasonable estimates of fair market value.

 

Goodwill is evaluated for impairment annually under the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” which requires us to estimate future cash flows to measure the recoverability of goodwill. Future indicators of impairment for long-lived assets, other than goodwill, could result in asset impairment charges. In addition, while we have concluded that our goodwill of $359 million as of January 28, 2006 will be fully recoverable in future periods, changes in estimated future cash flows could require us to record impairment charges on goodwill.

 

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Self-Insured Liabilities:

 

We insure a substantial portion of our workers’ compensation, general liability, auto liability and property insurance risks through a wholly-owned insurance subsidiary, in addition to third party insurance coverage. Provisions for losses related to self-insured risks are based upon independent actuarially determined estimates. We maintain stop-loss coverage to limit the exposure related to certain risks. The assumptions underlying the ultimate costs of existing claim losses are subject to a high degree of unpredictability, which can affect the liability recorded for such claims. For example, variability in inflation rates of health care costs inherent in these claims can affect the amounts realized. Similarly, changes in legal trends and interpretations, as well as a change in the nature and method of how claims are settled can impact ultimate costs.

 

Although our estimates of liabilities incurred do not anticipate significant changes in historical trends for these variables, any changes could have a considerable effect upon future claim costs and currently recorded liabilities and could have a material impact on our consolidated financial statements.

 

Derivatives and Hedging Activities:

 

We enter into derivative financial arrangements to hedge a variety of risk exposures, including interest rate and currency risks associated with our long-term debt, as well as foreign currency risk relating to import merchandise purchases. We account for these hedges in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and we record the fair value of these instruments within our consolidated balance sheet.

 

Gains and losses from derivative financial instruments are largely offset by gains and losses on the underlying transactions. The ineffective portion of an instrument’s change in fair value will be immediately recognized in earnings. Generally, the contract terms of hedge instruments closely mirror those of the item being hedged, providing a high degree of risk reduction and correlation. At January 28, 2006, we recorded derivative assets of $9 million and derivative liabilities of $2 million.

 

We intend to continue to meet the conditions for hedge accounting. However, if hedges were not to be highly effective in offsetting cash flows attributable to the hedged risk, the changes in the fair value of the derivatives used as hedges could have an impact on our consolidated financial statements. Assuming that all derivatives at January 28, 2006 were deemed ineffective, our consolidated pre-tax earnings would be favorably impacted by $7 million.

 

Revenue Recognition:

 

Revenue is recognized for retail sales at the point of sale in the store and for purchases from our website, when the merchandise is shipped and risk of ownership transfers. 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.

 

Income Taxes:

 

The Company’s provision for income taxes is based on a number of factors, including our income, permanent differences, temporary differences, statutory tax rates and credits, tax reserves, and valuation allowances, by legal entity and jurisdiction. A schedule of the current and deferred provision for income taxes is included in Note 20 to the Consolidated Financial Statements entitled “INCOME TAXES.”

 

The Company’s effective tax rate is determined by dividing the provision for income taxes by our (loss) earnings before income taxes. Our effective tax rate is based on our income, statutory tax rates, valuation allowances, permanent items, and various tax planning opportunities available to us, by jurisdiction. Significant

 

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judgment is required in determining our effective tax rate and in evaluating our tax positions. A reconciliation of the effective tax rate to the statutory 35% U.S. federal income tax rate is included in Note 20 to the Consolidated Financial Statements entitled “INCOME TAXES.”

 

The Company establishes tax reserves when, despite the belief that our tax return positions are fully supportable, it is probable we may not succeed in defending our positions. We adjust these reserves, as well as the related interest, based on the latest facts and circumstances, including progress made during the course of a tax audit. U.S. federal, foreign, and state tax authorities regularly examine the Company’s tax returns. While it is often difficult to predict the final outcome of, the timing of, or the tax treatment of, any particular tax position or deduction, we believe that our reserves reflect the probable outcome of known tax contingencies. The Company maintains its tax reserves in the Income taxes payable account.

 

Tax law and accounting rules often differ as to the timing and treatment of certain items of income and expense. As a result, the tax rate reflected in our tax return (our current or cash tax rate) is different than the tax rate reflected in our consolidated financial statements. Some of the differences are permanent, while other differences are temporary as they reverse over time. Temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in a future tax return for which we have already recorded a tax benefit in our current financial statements. An example would be a loss carry forward for federal, foreign or state tax purposes. We establish valuation allowances for our deferred tax assets when we believe it is more likely than not that the expected future taxable income or tax thereon will not support the use of a deduction or credit. An example would be a valuation allowance for the tax benefit associated with a loss carryover in a tax jurisdiction that the Company does not expect to generate sufficient taxable income to utilize the loss carryover. Deferred tax liabilities generally represent items that can be deducted currently on the tax return and will be expensed in our consolidated financial statements in a future year. An example would be accelerated depreciation on fixed assets where the Company has deducted more depreciation in the tax return that was expensed in the consolidated financial statements. The Company maintains the current and non-current portion of its deferred tax assets in the Prepaid expenses, derivatives and other current assets, and the Other assets accounts, respectively, and maintains the current and non-current portion of its deferred tax liabilities in the Accrued expenses and other current liabilities, and Deferred income tax accounts, respectively. Schedules showing the major temporary differences that give rise to the deferred tax assets and deferred tax liabilities are included in Note 20 to the Consolidated Financial Statements entitled “INCOME TAXES.”

 

During 2005, management determined that the Company would no longer permanently reinvest any of its foreign earnings outside the United States. As such, we have established deferred U.S. income tax on the current and cumulative earnings of our foreign subsidiaries.

 

Stock-Based Compensation

 

We account for stock options using the intrinsic method in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Options Issued to Employees” (“APB 25”) and its related interpretations. We typically issue options with exercise prices equal to the market price of the stock at the date of grant and therefore do not recognize stock compensation expense for these grants. However, certain post-merger grants whose defined vesting schedules were considered to be not substantive or which were considered as replacement awards for cancelled grants have been accounted for as variable awards. In addition, for awards where a contingent event giving rise to a put right on options is within the control of the employee, the related options are accounted for as a variable liability award. Compensation costs on awards requiring variable plan accounting are estimated and recorded each period until the measurement date. We recognized stock-based compensation expense of $222 million in connection with the Merger and recapitalization. Refer to Note 12 to the Consolidated Financial Statements entitled “STOCK-BASED COMPENSATION” for further details.

 

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Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by SFAS No. 148, “Accounting for Stock-based Compensation – Transition and Disclosure an Amendment of FASB Statement No. 123” requires the disclosure of pro forma net income determined as if we had adopted the fair value method. Under SFAS 123, the estimated fair value of stock options is calculated through the use of option pricing models and is amortized to expense over the options’ vesting period. These models require subjective assumptions, including expected life, which affect the calculated values.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

Refer to Note 27 to the Consolidated Financial Statements entitled “RECENT ACCOUNTING PRONOUNCEMENTS” for a discussion of 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. The countries in which we own assets and operate stores are politically stable, and we regularly evaluate these risks and have taken the following measures to mitigate these risks: our foreign exchange risk management objectives are to stabilize cash flow from the effects of foreign currency fluctuations; we do not participate in speculative hedges; and we will, whenever practical, offset local investments in foreign currencies with liabilities denominated in the same currencies. We also enter into derivative financial instruments to hedge a variety of risk exposures including interest rate and currency risks.

 

Our foreign currency exposure is primarily concentrated in the United Kingdom and Continental Europe, Canada, Australia and Japan. We face currency exposures that arise from translating the results of our worldwide operations into U.S. dollars from exchange rates that have fluctuated from the beginning of the period. We also face transactional currency exposures relating to merchandise that we purchase in foreign currencies. We enter into forward exchange contracts to minimize and manage the currency risks associated with these transactions. The counter-parties to these contracts are highly rated financial institutions and we do not have significant exposure to any single counter-party. Gains or losses on these derivative instruments are largely offset by the gains or losses on the underlying hedged transactions. For foreign currency derivative instruments, market risk is determined by calculating the impact on fair value of an assumed one-time change in foreign exchange rates relative to the U.S. dollar. Fair values were estimated based on market prices, where available, or dealer quotes. With respect to derivative instruments outstanding at January 28, 2006, a 10% appreciation of the U.S. dollar would have no impact on pre-tax earnings in 2005 and would increase comprehensive income in 2005 by $15 million, while a 10% depreciation of the U.S. dollar would have no impact on pre-tax earnings in 2005 and would decrease comprehensive income in 2005 by $13 million. Comparatively, considering our derivative instruments outstanding at January 29, 2005, a 10% appreciation of the U.S. dollar would have increased pre-tax earnings in 2004 by $1 million and increased comprehensive income in 2004 by $19 million, while a 10% depreciation of the U.S. dollar would have decreased pre-tax earnings in 2004 by $1 million and decreased comprehensive income in 2004 by $21 million. Considering our derivative instruments outstanding at January 31, 2004, a 10% appreciation of the U.S. dollar would have increased comprehensive income in 2003 by $19 million, while a 10% depreciation of the U.S. dollar would have decreased comprehensive income in 2003 by $19 million.

 

We are faced with interest rate risks resulting from interest rate fluctuations. We have a variety of fixed and variable rate debt instruments. In an effort to manage interest rate exposures, we strive to achieve an acceptable balance between fixed and variable rate debt and have entered into interest rate swaps to maintain that balance. For interest rate derivative instruments, market risk is determined by calculating the impact to fair value of an assumed one-time change in interest rates across all maturities. Fair values were estimated based on market prices where available or dealer quotes. A change in interest rates on variable rate debt impacts earnings, cash

 

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flow and the fair value of debt. A change in interest rates on fixed rate debt does not impact the fair value of debt, earnings or cash flow. Based on our overall interest rate exposure related to floating rate debt outstanding at January 28, 2006, January 29, 2005, and January 31, 2004, a 1% increase in interest rates would have had an unfavorable annualized impact on pre-tax earnings of $31 million in 2005, $20 million in 2004, and $20 million in 2003. A 1% decrease in interest rates would have had a favorable annualized impact on pre-tax earnings of $31 million in 2005, $20 million in 2004, and $20 million in 2003. A 1% increase in interest rates would not impact the carrying value of our long-term debt at January 28, 2006. At January 29, 2005, a 1% increase in interest rates would decrease the fair value of our long-term debt by approximately $98 million, respectively. A 1% decrease in interest rates would not impact the carrying value of our long-term debt at January 28, 2006. At January 29, 2005, a 1% decrease in interest rates would increase the fair value of our long-term debt by approximately $107 million, respectively.

 

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ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

     PAGE

Report of Independent Registered Public Accounting Firm

   54

Consolidated Statements of Operations

   56

Consolidated Balance Sheets

   57

Consolidated Statements of Cash Flows

   58

Consolidated Statements of Stockholders’ Equity

   59

Notes to Consolidated Financial Statements

   60

Quarterly Results of Operations (Unaudited)

   106

 

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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 sheet of Toys “R” Us, Inc. and subsidiaries (the “Company”) as of January 28, 2006, and the related consolidated statements of operations, stockholder’s (deficit) equity, and cash flows for the fifty-two week period ended January 28, 2006. Our audit also included the financial statement schedule listed in the Index at Item 15 (a). 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 audit.

 

We conducted our audit 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 audit provides a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of January 28, 2006, and the results of its operation and its cash flows for the fifty-two week period ended January 28, 2006, 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 as a whole, presents fairly, in all material respects, the financial information set forth therein.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of January 28, 2006, 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 April 28, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the Company’s internal control over financial reporting because of a material weakness.

 

/s/    Deloitte & Touche LLP

 

New York, New York

April 28, 2006

 

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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 as of January 29, 2005, and the related consolidated statements of operations, stockholders’ (deficit) equity, and cash flows for the years ended January 29, 2005 and January 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Toys “R” Us, Inc. and subsidiaries at January 29, 2005, and the consolidated results of their operations and their cash flows for the years ended January 29, 2005 and January 31, 2004, in conformity with U.S. generally accepted accounting principles.

 

As discussed in Note 3 to the consolidated financial statements, the Company has restated its financial statements for the years ended January 29, 2005 and January 31, 2004 to correct its accounting for leases and leasehold improvements.

 

As discussed in Note 4 to the consolidated financial statements, in the year ended January 29, 2005, the Company adopted EITF 03-10, “Application of Issue No. 02-16 by Resellers to Sales Incentives Offered to Consumers by Manufacturers,” retroactive to February 2, 2003. In the year ended January 31, 2004, the Company adopted the provisions of EITF 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor,” effective February 2, 2003.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Toys “R” Us, Inc.’s internal control over financial reporting as of January 29, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated April 28, 2005 expressed an unqualified opinion on management’s assessment and an adverse opinion on the effectiveness of internal control over financial reporting.

 

/s/ Ernst & Young LLP

 

New York, New York

April 28, 2005

 

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Toys “R” Us, Inc. and Subsidiaries

 

Consolidated Statements of Operations

 

     52 Weeks Ended

 

(In millions)


   January 28,
2006


    January 29,
2005


    January 31,
2004


 
                 (As restated)  

Net sales

   $ 11,275     $ 11,100     $ 11,320  

Cost of sales

     7,652       7,506       7,646  
    


 


 


Gross margin

     3,623       3,594       3,674  

Selling, general and administrative expenses

     2,899       2,932       3,026  

Transaction and related costs

     410       —         —    

Depreciation and amortization

     400       354       368  

Restructuring and other charges

     34       4       63  

Contract settlement fees and other

     22       —         —    
    


 


 


Total operating expenses

     3,765       3,290       3,457  
    


 


 


Operating (loss) earnings

     (142 )     304       217  

Other (expense) income:

                        

Interest expense

     (394 )     (130 )     (142 )

Interest income

     31       19       18  
    


 


 


(Loss) earnings before income taxes

     (505 )     193       93  

Income tax (benefit) expense

     (121 )     (59 )     30  
    


 


 


Net (loss) earnings

   $ (384 )   $ 252     $ 63  
    


 


 


 

See Notes to Consolidated Financial Statements.

 

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Toys “R” Us, Inc. and Subsidiaries

 

Consolidated Balance Sheets

 

(In millions)


   January 28,
2006


    January 29,
2005


 

ASSETS

                

Current Assets:

                

Cash and cash equivalents

   $ 981     $ 1,232  

Short-term investments

     —         953  

Accounts and other receivables

     218       171  

Merchandise inventories

     1,488       1,884  

Net property assets held for sale

     —         7  

Prepaid expenses, derivative assets and other current assets

     216       160  
    


 


Total current assets

     2,903       4,407  
    


 


Property and equipment:

                

Real estate, net

     2,386       2,393  

Other, net

     1,789       1,946  
    


 


Total property and equipment

     4,175       4,339  

Goodwill

     359       353  

Deferred tax assets

     457       426  

Restricted cash

     107       —    

Other assets

     365       243  
    


 


     $ 8,366     $ 9,768  
    


 


LIABILITIES AND STOCKHOLDERS’ (DEFICIT) EQUITY

                

Current Liabilities:

                

Accounts payable

   $ 1,118     $ 1,023  

Accrued expenses and other current liabilities

     900       881  

Income taxes payable

     130       245  

Current portion of long-term debt

     407       452  
    


 


Total current liabilities

     2,555       2,601  
    


 


Long-term debt

     5,540       1,860  

Deferred tax liabilities

     531       485  

Deferred rent liabilities

     260       269  

Other non-current liabilities

     204       228  

Stockholders’ (Deficit) Equity

                

Common Stock

     —         30  

Additional paid-in-capital

     —         405  

(Deficit) retained earnings

     (669 )     5,560  

Accumulated other comprehensive loss

     (55 )     (7 )

Unearned compensation

     —         (5 )

Treasury shares, at cost

     —         (1,658 )
    


 


Total stockholders’ (deficit) equity

     (724 )     4,325  
    


 


     $ 8,366     $ 9,768  
    


 


 

See Notes to Consolidated Financial Statements.

 

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Toys “R” Us, Inc. and Subsidiaries

 

Consolidated Statements of Cash Flows

 

     52 Weeks Ended

 

(In millions)


   January 28,
2006


    January 29,
2005


    January 31, 2004
(As restated)


 

Cash Flows from Operating Activities:

                        

Net (loss) earnings

   $ (384 )   $ 252     $ 63  

Adjustments to reconcile net loss to net cash used in operating activities:

                        

Depreciation and amortization

     400       354       368  

Amortization of restricted stock

     16       7       10  

Amortization of debt issuance costs

     90       —         —    

Stock compensation expenses arising from cash settlement

     195       —         —    

Deferred income taxes

     (80 )     (40 )     27  

Stock option compensation expense

     17       6       —    

Minority interest in Toysrus.com

     —         (6 )     (8 )

Proceeds received from settlement of derivatives

     34       —         —    

Non-cash portion of restructuring and other charges

     34       4       63  

Equity in loss of Toys “R” Us – Japan, net of dividend

     10       (11 )     (16 )

Other

     16       7       7  

Changes in operating assets and liabilities:

                        

Accounts and other receivables

     (51 )     (3 )     58  

Merchandise inventories

     387       221       133  

Prepaid expenses and other operating assets

     (13 )     76       28  

Accounts payable, accrued expenses and other liabilities

     112       (45 )     117  

Income taxes payable

     (112 )     (74 )     (53 )
    


 


 


Net cash provided by operating activities

     671       748       797  
    


 


 


Cash Flows from Investing Activities:

                        

Capital expenditures

     (285 )     (269 )     (262 )

Proceeds from sale (purchase) of short-term investments

     953       (382 )     (572 )

Purchase of SB Toys, Inc.

     —         (42 )     —    

(Increase) decrease in restricted cash

     (107 )     —         60  

Proceeds from sale of fixed assets

     12       216       —    
    


 


 


Net cash provided by (used in) investing activities

     573       (477 )     (774 )
    


 


 


Cash Flows from Financing Activities:

                        

Long-term debt borrowings

     7,004       —         792  

Short-term debt borrowings

     325       —         —    

Long-term debt repayment

     (3,526 )     (503 )     (370 )

Short-term debt repayment

     (174 )     —         —    

Repurchase of common stock

     (5,891 )     —         —    

Repurchase of stock options and restricted stock

     (227 )     —         —    

Capital contributed by affiliate

     1,279       —         —    

Repurchase of equity security units and warrants

     (130 )     —         —    

Proceeds received from exercise of stock options

     87       27       —    

Proceeds received from issuance of common stock

     20       —         —    

Capitalized debt issuance costs

     (255 )     —         —    
    


 


 


Net cash (used in) provided by financing activities

     (1,488 )     (476 )     422  
    


 


 


Effect of exchange rate changes on cash and cash equivalents

     (7 )     25       (40 )
    


 


 


Cash and Cash Equivalents:

                        

(Decrease) increase during period

     (251 )     (180 )     405  

Beginning of period

     1,232       1,412       1,007  
    


 


 


End of period

   $ 981     $ 1,232     $ 1,412  
    


 


 


Supplemental Disclosures of Cash Flow Information:

                        

Income taxes paid, net of refunds

   $ 70     $ 27     $ 33  

Interest paid

   $ 272     $ 143     $ 117  

 

See Notes to Consolidated Financial Statements.

 

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Consolidated Statements of Stockholders’ (Deficit) Equity

 

    Common Stock

    Additional
paid-in-capital


   

Unamortized

value of
restricted
stock


    Accumulated
other
comprehensive
loss


    Retained
earnings
(deficit)


    Total
stockholders’
equity
(deficit)


 
    Issued

    In Treasury

           

(In millions)


  Shares

    Amount

    Shares

    Amount

           

Balance, February 1, 2003 (as restated)

  300.4     $ 30     (87.9 )   $ (1,722 )   $ 414     $ —       $ (152 )   $ 5,245     $ 3,815  

Net earnings for the period

  —         —       —         —         —         —         —         63       63  

Foreign currency translation adjustments

  —         —       —         —         —         —         105       —         105  

Unrealized loss on hedged transactions, net of tax

  —         —       —         —         —         —         (5 )     —         (5 )

Minimum pension liability adjustment, net of tax

  —         —       —         —         —         —         (12 )     —         (12 )
   

 


 

 


 


 


 


 


 


Total comprehensive income

                                                                151  

Issuance of restricted stock, net and other

  —         —       1.1       15       (7 )     —         —         —         8  
   

 


 

 


 


 


 


 


 


Balance, January 31, 2004 (as restated)

  300.4     $ 30     (86.8 )   $ (1,707 )   $ 407     $ —       $ (64 )   $ 5,308     $ 3,974  
   

 


 

 


 


 


 


 


 


Net earnings for the period

  —         —       —         —         —         —         —         252       252  

Foreign currency translation adjustments

  —         —       —         —         —         —         58       —         58  

Unrealized loss on hedged transactions, net of tax

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

Minimum pension liability adjustment, net of tax

  —         —       —         —         —         —         2       —         2  
   

 


 

 


 


 


 


 


 


Total comprehensive income

                                                                309  

Exercise of stock options, net

  —         —       1.9       37       (6 )     —         —         —         31  

Stock compensation expense

  —         —       —         —         6       —         —         —         6  

Issuance of restricted stock, net and other

  —         —       0.4       12       (2 )     (12 )     —         —         (2 )

Amortization of restricted stock

  —         —       —         —         —         7       —         —         7  
   

 


 

 


 


 


 


 


 


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

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

Unrealized gain on hedged transactions, net of tax

  —         —       —         —         —         —         18       —         18  

Minimum pension liability adjustment, 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 )
   

 


 

 


 


 


 


 


 



(1) 1,000 shares of common stock, par value $.01 per share, outstanding.

 

See Notes to Consolidated Financial Statements.

 

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Notes to Consolidated Financial Statements

 

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Organization

 

Except as expressly indicated or unless the context otherwise requires, as used herein, the “Company,” “we,” “us,” or “our” means Toys “R” Us, Inc., and its subsidiaries. We are 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 January 28, 2006, our business consists of 671 Toys “R” Us stores in the United States, 230 Babies “R” Us specialty baby-juvenile stores in the United States, 641 international stores in 31 countries, of which 625 are Toys “R” Us toy stores and 16 are Babies “R” Us stores. Included in the 641 stores are 336 licensed or franchised stores. Toysrus.com, our internet subsidiary, sells merchandise on the Internet through www.toysrus.com, www.babiesrus.com, www.imaginarium.com, www.sportsrus.com, and www.personalizedbyrus.com in the United States and www.toysrus.ca in Canada. Toys “R” Us, Inc. is incorporated in the state of Delaware.

 

Effective July 21, 2005, the Company became a wholly-owned subsidiary of Toys “R” Us Holdings, Inc. (“Holdings”).

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of the Company and its subsidiaries. We eliminated all material inter-company balances and transactions. We translated all assets and liabilities of foreign operations at current rates of exchange at the balance sheet date and translated the results of foreign operations at average rates in effect for the period. We show any unrealized translation gains or losses as a component of the line item accumulated other comprehensive (loss) income within the consolidated statements of stockholders’ (deficit) equity.

 

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 52-week fiscal years below:

 

Fiscal Year


   Number of Weeks

   Ended

2005

   52    January 28, 2006

2004

   52    January 29, 2005

2003

   52    January 31, 2004

 

Use of Estimates

 

The preparation of these financial statements requires us to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosures of contingent assets and liabilities as of the date of the financial statements and during the applicable periods. We base these estimates on historical experience and on other factors that we believe are reasonable under the circumstances. Actual results may differ materially from these estimates under different assumptions or conditions and could have a material impact on our consolidated financial statements.

 

Reclassifications

 

We have made certain reclassifications to prior period information to conform to current presentations. In 2004, we reclassified our auction rate securities and variable rate demand notes from cash and cash equivalents to

 

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Notes to Consolidated Financial Statements—(Continued)

 

short-term investments for the current and prior years. We have also made corresponding adjustments to our consolidated statements of cash flows to reflect the gross purchases and sales of these securities as investing activities rather than as a component of cash and cash equivalents. As of January 28, 2006, we no longer own auction rate securities or variable rate demand notes. The fair value of these investments at January 29, 2005 was $953 million.

 

We reclassified certain 2004 balances from cash and cash equivalents related to credit card receivables into accounts receivable. Accordingly, our cash and cash equivalents were reduced by $18 million as of January 29, 2005.

 

In the consolidated statements of cash flows for 2003, we reclassified $60 million in decreases to restricted cash from cash flows from financing activities to cash flows from investing activities.

 

Cash and Cash Equivalents

 

We consider our highly liquid investments with original maturities of less than three months 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 primarily represents cash that serves as collateral and other cash that is restricted from withdrawal. As of January 28, 2006, restricted cash represents the restriction of $107 million, all of which serves as collateral for certain property financings we entered into during 2005. As of January 29, 2005, we had no restricted cash.

 

Merchandise Inventories

 

Merchandise inventories for the Toys “R” Us – U.S. division, other than apparel, are stated at the lower of LIFO (last-in, first-out) cost or market value, as determined by the retail inventory method and represent approximately 52% of total merchandise inventories. All other merchandise inventories are stated at the lower of FIFO (first-in, first-out) cost or market value as determined by the retail inventory method.

 

Property and Equipment

 

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.

 

For any store closures where a lease obligation still exists, we record the estimated future liability associated with the rental obligation on the date the store is closed in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”

 

We 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 review for impairment all stores for which current cash flows from operations are negative, or the construction costs are significantly in

 

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Notes to Consolidated Financial Statements—(Continued)

 

excess of the amount originally expected. Impairment results when the carrying value of the assets exceeds the undiscounted future cash flows over the life of the lease. Our estimate of undiscounted future cash flows over the lease term is based upon our experience, historical operations of the stores and estimates of future store profitability and economic conditions. The future estimates of store profitability and economic conditions require estimating such factors as sales growth, employment rates, lease escalations, inflation on operating expenses and the overall economics of the retail industry for up to 20 years in the future, and are therefore subject to variability and difficult to predict. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the carrying value and the asset’s fair value. The fair value is estimated based upon future cash flows (discounted at a rate that approximates our weighted average cost of capital) or other reasonable estimates of fair market value.

 

Insurance Risks

 

We insure a substantial portion of our workers’ compensation, general liability, auto liability and property insurance risks through a wholly owned insurance subsidiary, in addition to third party insurance coverage. Provisions for losses related to self-insured risks are based upon independent actuarially determined estimates. We maintain stop-loss coverage to limit the exposure related to certain risks. The assumptions underlying the ultimate costs of existing claim losses are subject to a high degree of unpredictability, which can affect the liability recorded for such claims. For example, variability in inflation rates of health care costs inherent in these claims can affect the amounts realized. Similarly, changes in legal trends and interpretations, as well as a change in the nature and method of how claims are settled can impact ultimate costs. As of January 28, 2006, we discounted a portion of our reserves for self-insurance risk related to our workers’ compensation insurance.

 

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, refer to Note 25 entitled “COMMITMENTS AND CONTINGENCIES.”

 

Deferred Rent

 

The Company recognizes fixed minimum rent expense on non-cancelable leases on a straight-line basis over the term of each individual lease including the build-out period. The difference between recognized rental expense and amounts payable under the lease is recorded as a deferred lease liability.

 

Financial Instruments

 

We enter into forward foreign exchange contracts to minimize the risk associated with currency movement relating to our foreign subsidiaries. We recognize the gains and losses, which offset the movement in the underlying transactions, as part of such transactions. We recognize changes in fair value currently in earnings unless specific hedge accounting criteria are met. Pre-tax gross deferred unrealized losses on the forward contracts were $2 million and $2 million at January 28, 2006 and January 29, 2005, respectively. We include the related receivable, payable and deferred gain or loss in “other assets” and “other non-current liabilities” on the consolidated balance sheets.

 

At January 28, 2006, we had $294 million notional amount of short-term outstanding forward contracts maturing in 2006. At January 29, 2005, we had $335 million notional amount of short-term outstanding forward contracts that matured in fiscal 2005. We entered into these contracts with counter-parties that have high credit ratings and with which we have the contractual right to net forward currency settlements.

 

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We also enter into derivative financial arrangements to hedge interest rate risk associated with our long-term debt. We enter into interest rate swaps and/or caps to manage this interest rate risk. At January 28, 2006, we had interest rate caps on $2.1 billion of debt; these derivatives had a market value of less than $1 million. Additionally, we had interest rate swaps with a total notional value of $989 million; these swaps had a total market value of $8 million.

 

Foreign Currency Translation

 

The functional currency of our foreign subsidiaries is as follows:

 

    Australian Dollar for our subsidiary in Australia;

 

    British Pound for our subsidiary in the United Kingdom;

 

    Canadian dollar for our subsidiary in Canada;

 

    Euro for subsidiaries in Austria, France, Germany, Spain, and Portugal; 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 at the average exchange rates during the period. The resulting translation adjustments are recorded as other comprehensive income within shareholders’ equity. Gains and losses resulting from foreign currency transactions have not been significant and are included in selling, general and administrative expenses.

 

Consolidation of Variable Interest Entities

 

In December 2003, the FASB issued Interpretation No. 46 (revised December 2003) (“FIN 46(R)”), “Consolidation of Variable Interest Entities.” Implementation of the provisions of FIN 46(R) was effective for the first reporting period after March 15, 2004. FIN 46(R) requires the consolidation of entities that are controlled by a company through interests other than voting interests. Under the requirements of this interpretation, an entity that maintains a majority of the risks or rewards associated with VIEs, also known as Special Purpose Entities, is viewed to be effectively in the same position as the parent in a parent-subsidiary relationship.

 

We have determined that we have not created or entered into any VIEs during the fiscal year that would require consolidation by us.

 

Revenue Recognition

 

We recognize sales at the time the guest takes possession of merchandise, either at the point of sale in our stores or at the time of shipment for products purchased from our websites. We recognize the sale from layaway transactions when our guests satisfy all payment obligations and take possession of the merchandise. We recognize the sale from gift cards and the issuance of store credits as they are redeemed.

 

Reserve for Sales Returns

 

We reserve amounts for sales returns for estimated product returns by our guests based on that subsidiaries’ historical return experience, changes in customer demand, known returns we have not received, and other assumptions. The balance of our reserve for sales returns was $9 million for both 2005 and 2004.

 

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Notes to Consolidated Financial Statements—(Continued)

 

Cost of Sales and Selling, General, and Administrative Expenses

 

The following table illustrates costs associated with each expense category:

 

“Cost of sales”


     

“SG&A”


•   The cost of acquired merchandise from vendors;

 

•   Freight in;

 

•   Markdowns;

 

•   Provision for inventory shortages; and

 

•   Credits and allowances from our merchandise vendors.

     

•   Store payroll and related payroll benefits;

 

•   Rent and other store operating expenses;

 

•   Advertising expenses;

 

•   Costs associated with operating our distribution network that primarily relate to moving merchandise from distribution centers to stores; and

 

•   Other corporate related expenses.

 

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 No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor” (“EITF 02-16”).

 

We have also applied the provision of EITF Issue 03-10, “Application of EITF Issue No. 02-16, ‘Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor,’ by Resellers to Sales Incentives Offered to Consumers by Manufacturers” (“EITF 03-10”). EITF 03-10 applies to coupon arrangements entered into or modified after November 25, 2003. We adopted the provisions of EITF 03-10 beginning in 2004. Our 2005 and 2004 sales are recorded net of in store coupons that we redeemed. The transition provisions for EITF 03-10 provided for restatement of our comparable fiscal 2003 consolidated financial statements. Refer to Note 3 entitled “RESTATEMENT OF FINANCIAL STATEMENTS FOR ACCOUNTING FOR LEASES AND LEASEHOLD IMPROVEMENTS” and to Note 4 entitled “CHANGES IN ACCOUNTING” for further details on the impact on our results due to the adoption of EITF 03-10.

 

Advertising Costs

 

Gross advertising costs are recognized in selling, general and administrative expenses (“SG&A”) at the point of first broadcast or distribution and were $307 million in fiscal 2005, $336 million in fiscal 2004, and $364 million in fiscal 2003.

 

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,

 

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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.

 

Income Taxes

 

Income taxes are accounted for using the asset and liability method. Under this method, deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the consolidated financial statements. We record 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. Our effective tax rate in a given financial statement period may be materially impacted by changes in the mix and level of earnings.

 

Stock-Based compensation

 

We account for stock options using the intrinsic method in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Options Issued to Employees” (“APB 25”) and its related interpretations. We typically issue options with exercise prices equal to the market price of the stock at the date of grant and therefore do not recognize stock compensation expense for these grants. However, certain post-merger grants whose defined vesting schedules were considered to be not substantive or which were considered as replacement awards for cancelled grants have been accounted for as variable awards. In addition, for awards where a contingent event giving rise to a put right on options is within the control of the employee, the related options are accounted for as a variable award. Compensation costs on awards requiring variable plan accounting are estimated and recorded each period until the measurement date. We recognized stock-based compensation expense of $222 million in connection with the Merger and recapitalization. Refer to Note 12 entitled “STOCK-BASED COMPENSATION” for further details.

 

Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by SFAS No. 148, “Accounting for Stock-based Compensation – Transition and Disclosure an Amendment of FASB Statement No. 123” requires the disclosure of pro forma net income determined as if we had adopted the fair value method. Under SFAS 123, the estimated fair value of stock options is calculated through the use of option pricing models and is amortized to expense over the options’ vesting period. These models require subjective assumptions, including expected life, which affect the calculated values.

 

The following table illustrates the effect on net (loss) earnings had we applied the fair value recognition provision of SFAS 123:

 

(In millions)


   2005

    2004

    2003
(as restated)


 

Net (loss) earnings – as reported

   $ (384 )   $ 252     $ 63  

Add: Total employee-related stock-based compensation expense, included in reported net earnings (loss), net of related taxes

     143       8       6  

Less: Total employee-related stock-based compensation expense determined under fair value based method for all awards, net of related taxes

     (22 )     (19 )     (40 )
    


 


 


Net (loss) earnings – pro forma

   $ (263 )   $ 241     $ 29  
    


 


 


 

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Notes to Consolidated Financial Statements—(Continued)

 

The weighted-average fair value at the date of grant for stock options granted during fiscal 2005, 2004 and 2003 were $5.76 per option, $4.96 per option and $2.86 per option, respectively. The Black-Scholes option-pricing model was used to estimate the fair value of each option on the date of grant except with respect to options granted after July 21, 2005 for which the minimum value method was used.

 

As there were a number of options granted during the years 2003 through 2005, a range of assumptions is provided below:

 

     2005

   2004

   2003

Expected stock price volatility (1)    0.000 – 0.237    0.302 – 0.458    0.473 – 0.548
Risk-free interest rate    3.8% – 4.5%    2.7% – 3.9%    2.3% – 3.4%
Weighted average expected life of options    6 years    5 years    5 years

  (1) Fair value is calculated using the minimum value method for the options granted after July 21, 2005.

 

The effects of applying SFAS 123 and the results obtained through the use of the Black-Scholes option-pricing model may be different than the results obtained by using other subjective assumptions.

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (Revised 2004), “Share-based Payment” (“SFAS 123(R)”), which replaces SFAS 123 and amends APB 25 and SFAS No. 95, “Statement of Cash Flows” (“SFAS 95”). SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on fair value. SFAS 123(R) also requires the benefit of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as currently required.

 

For private companies, SFAS 123(R) is effective for the first annual reporting period beginning after December 15, 2005. The Company adopted SFAS 123(R) as of the beginning of its fiscal year 2006 using the “prospective transition” method allowed for private companies. As described above, the Company will measure compensation costs related to its share-based awards under APB 25, as allowed by SFAS 123, and provides pro forma disclosure in the notes to the financial statements of the effects of accounting for share-based payments under SFAS 123, as required by that standard. As the intrinsic value method of APB 25 has rarely resulted in the recognition of expense in the Company’s financial statements related to the options granted prior to January 28, 2006, the Company expects the adoption of SFAS 123(R) to have an impact on its results of operations for options granted after adoption. The impact of the adoption of SFAS 123(R) cannot be predicted at this time because it will depend on the level of share-based payments granted in the future. However, had the Company adopted SFAS 123(R) in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net (loss) earnings.

 

NOTE 2 – MERGER TRANSACTION

 

On March 17, 2005, we entered into an Agreement and Plan of Merger, dated as of March 17, 2005 (the “Merger Agreement”), with Global Toys Acquisition, LLC (“Parent”) and Global Toys Acquisition Merger Sub, Inc. (“Acquisition Sub”) to sell our entire company to Parent and Acquisition Sub, which were entities directly and indirectly owned by an investment group consisting of entities advised by or affiliated with Bain Capital Partners LLC, Kohlberg Kravis Roberts & Co., L.P., and Vornado Realty Trust (collectively, the “Sponsors”).

 

On July 21, 2005, the transaction was consummated by 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, through a $6.6 billion merger of Acquisition Sub with

 

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Notes to Consolidated Financial Statements—(Continued)

 

and into the Company, with the Company being the surviving corporation in the merger (the “Merger”). 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, par value $.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 common stock, restricted stock and restricted stock units, fees and expenses related to the merger, and severance, bonuses and related payroll taxes.

 

The Merger consideration was funded through the use of the Company’s available cash, cash equity contributions from the Investors and the debt financings as described more fully below. We refer to the July 21, 2005 Merger and recapitalization as the “Merger Transaction.”

 

The Merger Transaction has been accounted for as a recapitalization and accordingly, there was no change in the basis of the assets and liabilities of Toys “R” Us, Inc. Therefore, all operations of Toys “R” Us, Inc. prior to the Merger Transaction are reflected herein at their historical amounts.

 

The following principal equity capitalization and financing transactions occurred in connection with the Merger Transaction:

 

    Aggregate cash equity contributions of $1.3 billion were made by the Investors; and

 

    We, directly or through our subsidiaries, entered into: (1) a new $2.0 billion secured revolving credit facility, of which $700 million was drawn at closing, (2) a new $1.9 billion unsecured bridge loan agreement, all of which was drawn at closing, (3) a new secured $1.0 billion European bridge loan facility and multi-currency revolving credit facilities in an amount of up to £95 million and €145 million, of which $1.0 billion was drawn at closing, and (4) $800 million of new mortgage loan agreements, all of which was drawn at closing. Refer to Notes 11, 13, 14 and 18 for further details on seasonal financing and long-term debt, derivative instruments and hedging activities, equity security units, and stock purchase warrants.

 

The proceeds from the equity capitalization and financing transactions, together with $1.2 billion of our available cash, were used to fund the:

 

    Purchase of common stock outstanding of approximately $5.9 billion;

 

    Purchase of all stock options, restricted stock, and restricted stock units of the Company under the terms of the Merger Agreement of approximately $227 million;

 

    Settlement of our equity security units of approximately $114 million;

 

    Purchase of all stock warrants of approximately $17 million;

 

    Fees and expenses related to the Merger Transaction and the related financing transactions of approximately $368 million; and

 

    Severance, bonuses and related payroll taxes of approximately $40 million.

 

For fiscal 2005, the fees and expenses related to the Merger Transaction and the related financing transactions principally consisted of advisory fees and expenses of $78 million, financing fees of $135 million, sponsor fees of $81 million, and other fees and expenses of $74 million. Of the $368 million of costs, approximately $243 million were expensed, $148 million as transaction related costs and $95 million as amortization of debt issuance cost, interest expense, and real estate taxes. The remaining amount of $125 million is capitalized debt issuance costs.

 

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Notes to Consolidated Financial Statements—(Continued)

 

Transaction and related costs

 

We recorded expenses of $410 million for fiscal 2005. These costs reflect $148 million of expenses related to the Merger transaction, compensation expenses associated with the Merger Transaction related to stock options and restricted stock of $222 million, as well as severance, bonuses and related payroll taxes of $40 million.

 

For fiscal 2005, we capitalized $42 million in fees and expenses related to the Domestic New Holdco and European financing transactions. Refer to Notes 11 and 28 entitled, “SEASONAL FINANCING AND LONG TERM DEBT” and “SUBSEQUENT EVENTS,” respectively, for further details. As a result of the new financing transactions, we recognized approximately $59 million in accelerated amortization expense during fiscal 2005.

 

In connection with the closing of the Merger, the Company notified the New York Stock Exchange that all of the Company’s common stock, par value $0.10 (the “Company Common Stock”), was converted into the right to receive $26.75 per share, and 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 has been made.

 

Immediately following the consummation of the Merger Transaction, we implemented an inversion transaction (the “Inversion”) whereby one of our dormant subsidiaries became the new parent of Toys “R” Us, Inc. and is now known as Toys “R” Us Holdings, Inc. (“Holdings”), as follows:

 

    Holdings’ shares of common stock held by Toys “R” Us, Inc. were cancelled. The Certificate of Incorporation of Holdings was amended to authorize two classes of common stock, Class L Common and Class A Common (collectively, the “Common Stock”); and

 

    The Investors’ shares of Toys “R” Us, Inc. common stock (including the shares held by management) were automatically converted into shares of Holdings. All of the shares of Common Stock were issued in “strips” of stock, which consisted of one share of Class L common stock and nine shares of Class A common stock so that each Investor owns the same proportionate interest in Class L and Class A common stock. Subsequent to the conversion, the Investors and management have the same ownership interests in Holdings as they previously did in Toys “R” Us, Inc.

 

Immediately following the consummation of the Merger Transaction and the Inversion, the Company was indirectly owned 32.9% by each of the Sponsors, 1.1% by the Fourth Investor and 0.2% by management.

 

In connection with the Merger and the Inversion, effective as of July 21, 2005, the Company’s Certificate of Incorporation was amended to change the Company’s authorized common stock from 650,000,000 shares of common stock, par value $.10 per share, to 3,000 authorized shares of common stock, par value $.01 per share. As of January 28, 2006, there were 1,000 shares of common stock held by Holdings.

 

Executive Severance Obligations

 

In connection with the Merger Transaction, for fiscal 2005, we recorded $28.6 million of payments to senior executives whose employment with the Company ceased. Based upon current compensation levels at January 28, 2006, if all of the remaining senior executives who have retention agreements with the Company were separated and received the severance benefits specified under their respective agreements, our additional costs would be in the range of $28 million to $33 million.

 

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Notes to Consolidated Financial Statements—(Continued)

 

NOTE 3 – RESTATEMENT OF FINANCIAL STATEMENTS FOR ACCOUNTING FOR LEASES AND LEASEHOLD IMPROVEMENTS

 

During fiscal 2005, we re-evaluated our lease accounting practices and corrected our accounting for leases, specifically the accounting for operating leases with scheduled rent increases and leasehold improvements. Under the requirements of Financial Standards Accounting Board (FASB) Technical Bulletin 85-3, “Accounting for Leases with Scheduled Rent Increases,” rent expense should be amortized on a straight-line basis over the term of the lease.

 

We have restated our previously issued financial statements for the fiscal years ended January 31, 2004 and February 1, 2003, the respective quarterly financial information, as well as the first three quarters of the fiscal year ended January 29, 2005, to reflect the above corrections in our accounting practices for leases and leasehold improvements.

 

We adjusted the initial lease terms to include rent holiday periods and option renewals that are reasonably assured of being exercised and included the straight-line effect over the lengthened term to include option periods with escalating rents, which had the effect of increasing previously reported rent expense. We also reviewed our leasehold improvements to ensure amortization over the shorter of their economic lives or adjusted term and in certain instances shortened the depreciation or amortization periods for leasehold improvements, which had the effect of increasing previously reported annual depreciation and amortization expense.

 

Following is a summary of the cumulative effects of these changes on our consolidated statements of operations for fiscal year 2003. In addition, our consolidated statement of operations for the 2003 fiscal year also reflects the restatement adjustment for the implementation of EITF 03-10. Refer to Note 4 entitled “CHANGES IN ACCOUNTING” for further details.

 

     Consolidated Statement of Earnings

 

Year ended January 31, 2004

(In millions)


   As restated

    Lease
adjustments


    EITF 03-10
adjustments


    As previously
reported


 

Net sales

   $ 11,320     $ —       $ (246 )   $ 11,566  

Cost of sales

     7,646       —         (203 )     7,849  
    


 


 


 


Gross margin

     3,674       —         (43 )     3,717  

Selling, general and administrative expenses

     3,026       4       —         3,022  

Depreciation and amortization

     368       20       —         348  

Restructuring and other charges

     63       (22 )     —         85  
    


 


 


 


Total operating expenses

     3,457       2       —         3,455  

Operating earnings (loss)

     217       (2 )     (43 )     262  

Other (expense) income:

                                

Interest expense

     (142 )     —         —         (142 )

Interest and other income

     18       —         —         18  
    


 


 


 


Earnings (loss) before income taxes

     93       (2 )     (43 )     138  

Income tax (benefit) expense

     30       (4 )(a)     (16 )     50  
    


 


 


 


Net earnings (loss)

   $ 63     $ 2     $ (27 )   $ 88  
    


 


 


 



 

(a) Includes the benefit associated with the cumulative impact of the lease accounting restatement on the effective tax rate.

 

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Notes to Consolidated Financial Statements—(Continued)

 

NOTE 4 – CHANGES IN ACCOUNTING

 

In the first quarter of 2004, we applied the provisions of Emerging Issues Task Force (EITF) Issue No. 03-10, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor, by Resellers to Sales Incentives Offered to Consumers by Manufacturers” (EITF 03-10). Beginning in the first quarter of 2004, sales have been recorded net of coupons that were redeemed. Under the provisions of EITF 03-10, when we receive credits and allowances from vendors for coupons related to events that meet the direct offset requirements of EITF 03-10, we will recognize as a reduction of cost of sales the related reimbursement during the period of redemption. Credits and allowances received from vendors that do not meet the direct offset requirements of EITF 03-10 will be recorded as a reduction of product costs in accordance with EITF Issue No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor”, which we applied at the beginning of 2003. Our 2003 consolidated financial statements have been restated to the current year’s presentation, as permitted by the provisions of EITF 03-10.

 

The following table outlines the unfavorable impact of the adoption of EITF 02-16 and restatement for EITF 03-10 on our 2003 earnings before income taxes:

 

     EITF

   Source of change

(In millions)


  

02-16

Adoption


  

03-10

Restatement


   Total

   Implementation

  

Current

Period


   Total

Year ended January 31, 2004

   $ 50    $ 43    $ 93    $ 74    $ 19    $ 93

 

The provisions of EITF 02-16 and EITF 03-10 did not permit adoption through a cumulative effect adjustment at the beginning of 2003. As noted above, if we had been permitted to record a cumulative effect adjustment at the beginning of 2003, the unfavorable impact on 2003 earnings before income taxes would have been reduced by $74 million for the year ended January 31, 2004. The recognition of credits and allowances received from vendors for the current period effect noted above, and for all periods subsequent to 2003, will be driven by changes in vendor agreements, the amount of credits and allowances received from vendors, and changes in sales and inventory levels. The adoption of EITF 02-16 and EITF 03-10 had no net impact on our consolidated statements of cash flows.

 

NOTE 5 – RESTRUCTURING AND OTHER CHARGES

 

Our consolidated financial statements for fiscal 2005 included the following pre-tax charges related to restructuring initiatives from current and prior years, and are as follows:

 

(In millions)


  

Restructuring

and other charges


   

Depreciation

and amortization


  

Cost of

Sales


   SG&A

   Total

 

2005 Initiatives

   $ 31     $ 22    $ 41    $ —      $ 94  

2004 Initiatives

     0       —        —        5      5  

2003 Initiatives

     3       —        —        —        3  

2001 Initiatives

     1       —        —        —        1  

1995 and 1998 Initiatives

     (1 )     —        —        —        (1 )
    


 

  

  

  


Total

   $ 34     $ 22    $ 41    $ 5    $ 102  
    


 

  

  

  


 

At January 28, 2006, we had total remaining reserves of $125 million to complete all of these restructuring initiatives. We believe that remaining reserves at January 28, 2006 are adequate to complete these initiatives and commitments. See below for a further discussion of individual restructuring initiatives and related charges and reserves.

 

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Notes to Consolidated Financial Statements—(Continued)

 

2005 Initiatives

 

On January 5, 2006, our Board of Directors approved the closing of 87 Toys “R” Us stores in the United States. As of January 28, 2006, we closed three of these stores. All of the remaining 84 stores were closed by April 2, 2006. Twelve of these stores will be converted into Babies “R” Us stores, resulting in the permanent closure of 75 stores. The decision to take this action resulted from a comprehensive review and evaluation of our U.S. stores during the second half of 2005. We retained Gordon Brothers Retail Partners, LLC to assist us in connection with the orderly sale of the inventory in these stores.

 

In connection with the closing and conversion of these stores, we recorded $94 million of costs and charges during 2005. We estimate an additional $55 million of charges will be recorded in the first quarter of 2006. The $94 million of costs and charges include $41 million of inventory markdowns and liquidator fees that were recorded in cost of sales and $22 million of depreciation that was accelerated through the closing periods of the stores. The remaining $31 million of costs and charges are included in restructuring and other charges in the Consolidated Statement of Operations, and consisted of $22 million relating to asset impairments, $1 million relating to lease commitments and $8 million relating to severance costs. As a result of the store closings, approximately 3,000 employee positions have been eliminated.

 

Details on the activity of charges and reserves for the fiscal year ended January 28, 2006 are as follows:

 

(In millions)


   Initial
Charge


   Utilized

    Balance at
January 28,
2006


Lease commitments

   $ 1    $ —       $ 1

Asset impairment

     22      (22 )     —  

Accelerated depreciation

     22      (22 )     —  

Inventory markdowns and liquidator fees

     41      (7 )     34

Severance

     8      —         8
    

  


 

Total remaining restructuring reserves

   $ 94    $ (51 )   $ 43
    

  


 

 

2004 Initiatives

 

On August 11, 2004, we announced our intention to restructure our Global Store Support Center operations in Wayne, New Jersey. As a result, we recorded termination costs of $21 million associated with this action during 2004. Of these total charges, $13 million were recorded in restructuring and other charges related to severance and lease commitments, and charges of $8 million were recorded in selling, general and administrative expenses, comprised of $2 million for payroll-related costs and $6 million for stock option compensation charges resulting from modifications to stock option agreements for severed executives.

 

For fiscal 2005, we recorded $5 million of net charges related to our 2004 initiatives for stock option compensation charges, recorded in selling, general and administrative expenses. While the stock option compensation charges are part of the 2004 restructuring initiative, they are not part of the restructuring reserve account but rather included as a component of stockholders’ (deficit) equity. As of January 28, 2006, $1 million of reserves for termination costs remained to complete this initiative.

 

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Notes to Consolidated Financial Statements—(Continued)

 

Details on the activity of charges and reserves for the fiscal year ended January 28, 2006 are as follows:

 

(In millions)


   Balance at
January 29,
2005


   Adjustments

   Utilized

    Balance at
January 28,
2006


Severance

   $ 8    $ —      $ (8 )   $ —  

Other compensation

     2      —        (1 )     1
    

  

  


 

Total remaining restructuring reserves

   $ 10    $ —      $ (9 )   $ 1
    

  

  


 

 

2003 Initiatives

 

On November 17, 2003, we announced our decision to close all 146 of the remaining freestanding Kids “R” Us stores and all 36 of the freestanding Imaginarium stores, as well as three distribution centers that support these stores due to deterioration in their financial performance. As of January 28, 2006, all of the freestanding Kids “R” Us and Imaginarium stores were closed.

 

On March 2, 2004, we entered into an agreement under which Office Depot, Inc. agreed to acquire 124 of the former Kids “R” Us stores for $197 million in cash, before commissions and fees, plus the assumption of lease payments and other obligations. Twenty-four properties were excluded from the agreement with Office Depot, Inc., and are being separately marketed for disposition or have been disposed of to date. All closings were completed by January 29, 2005 and net cash proceeds of approximately $150 million were received. A $53 million gain associated with this transaction was recorded during fiscal 2004. An additional $2 million gain for the disposition of other Kids “R” Us properties was also recorded during fiscal 2004.

 

As outlined in the summary table below, we recorded charges of $3 million during fiscal 2005, for the disposition of the other Kids “R” Us stores. Charges for fiscal 2005 included a loss of $1 million on the sale of property and $2 million of vacancy-related costs. We expect to record additional charges for the accretion of interest related to vacancy costs for closed facilities until their disposition. Charges in connection with these initiatives may be subject to revision for changes in estimates. At January 28, 2006, we had $8 million of reserves remaining for these initiatives.

 

Details on the activity of charges and reserves for the fiscal year ended January 28, 2006 are as follows:

 

(In millions)


   Balance at
January 29,
2005


   Adjustments

   Utilized

    Balance at
January 28,
2006


Lease commitments

   $ 13    $ —      $ (5 )   $ 8

Sale of Kids “R” Us real estate

     —        1      (1 )     —  

Vacancy costs and other

     —        2      (2 )     —  
    

  

  


 

Total remaining restructuring reserves

   $ 13    $ 3    $ (8 )   $ 8
    

  

  


 

 

2001 Initiatives

 

In 2001, we recorded net charges of $184 million to close a number of stores, to eliminate a number of staff positions, and to consolidate five store support center facilities into our Global Store Support Center facility in Wayne, New Jersey. During fiscal 2005, we incurred additional charges of $1 million related to store closings and utilized $13 million of reserves. This reduced our remaining reserves from $63 million at January 29, 2005 to $51 million at January 28, 2006.

 

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Notes to Consolidated Financial Statements—(Continued)

 

Other Prior Year Initiatives

 

We had $22 million of reserves remaining at January 28, 2006 from restructuring charges previously recorded in 1998 and 1995, primarily for long-term lease commitments, that will be utilized in 2006 and through 2016. During fiscal 2005, we recorded a net reversal of $1 million resulting from adjustments to lease shortfall reserves.

 

NOTE 6 – MERCHANDISE INVENTORIES

 

Merchandise inventories for the Toys “R” Us – U.S. division, other than apparel, are stated at the lower of LIFO (last-in, first-out) cost or market value, as determined by the retail inventory method and represent approximately 52% of total merchandise inventories as of January 28, 2006. All other merchandise inventories are stated at the lower of FIFO (first-in, first-out) cost or market value as determined by the retail inventory method. If all inventories had been valued at the lower of FIFO, cost or market, inventories would be unchanged at January 28, 2006, and January 29, 2005. Details on the components of our consolidated merchandise inventories are as follows:

 

Details on the components of our consolidated merchandise inventories are as follows:

 

(In millions)


   2005

   2004

Toys “R” Us – U.S.

   $ 721    $ 1,085

Toys “R” Us – International

     402      402

Babies “R” Us

     323      349

Toysrus.com

     42      48
    

  

Total

   $ 1,488    $ 1,884
    

  

 

NOTE 7 – GOODWILL

 

Details on goodwill by division are as follows:

 

(In millions)


   2005

   2004

Toys “R” Us – U.S.

   $ 29    $ 29

Babies “R” Us

     319      319

Toysrus.com

     11      5
    

  

Total

   $ 359    $ 353
    

  

 

On January 17, 2006, Toys “R” Us – Delaware, Inc. (“Toys-Delaware”), a subsidiary of the Company, acquired all of the outstanding stock options and shares of Toysrus.com, Inc., including the minority interest not owned by the Company. Each holder of shares in Toysrus.com received $1.13 per share less applicable withholding taxes. Each option holder received an amount in cash, less applicable withholding taxes, equal to the value of the option calculated using an option-pricing model based on the $1.13 per share. As a result of this transaction, the company recognized a total of $6 million of additional goodwill.

 

The $319 million of Babies “R” Us goodwill relates to the 1997 acquisition of Baby Super Stores, Inc., which is now part of the Babies “R” Us reporting unit. The $29 million of goodwill relates to the 1999 acquisition of Imaginarium Toy Centers, which is now part of the Toys “R” Us – U.S. reporting unit. The $5 million of Toysrus.com goodwill relates to the 2004 acquisition of SB Toys, Inc., which is now part of Toysrus.com.

 

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