A toy story.

Companies with non-investment-grade ratings usually don't opt for asset securitization. But for Tyco Toys, an unusual securitization strategy was key to reducing its skyrocketing costs.

Nineteen ninety-two was to be a break-out year for U.S. toy manufacturer Tyco Toys. The previous year's results were encouraging - net income of $18 million on sales of $549 million - and Tyco had many of the hottest-selling toys in the country, including the Little Mermaid fashion dolls and the Incredible Crash Dummies action figures.

The company's investment-grade credit rating helped it secure capital to acquire Universal Matchbox, the die-cast car maker, and Illco Toys, a major Sesame Street licensee. Matchbox's partially developed international distribution system provided Tyco with the opportunity to accelerate its own expansion into foreign markets and become a major international toy distributor. But while Tyco's sales in 1992 jumped to $769 million, net income remained flat because of significant costs related to the acquisitions, including a major effort to combine duplicative distribution systems.

Problems escalated in 1993. Sales of the Incredible Crash Dummies and the Little Mermaid product lines fell by more than $50 million compared to 1992 levels as the toys lost popularity among kids. Sales of Sesame Street licensed toys were hurt by strong competition in the preschool aisle, and higher video game sales affected sales of Tyco's boys' toys. To compound matters, the toy industry suffered a poor Christmas retail season in the United States, while many European markets went into an economic recession. The net result was a loss of $70 million on sales of $730 million.

FINANCE FATIGUE

By 1994 Tyco began to turn things around, but there are no quick fixes in the toy industry. Long lead times are the rule because of the cycle of product development, previews, child testing and engineering, with tooling and production in Pacific Rim countries adding even more time to the cycle.

Nevertheless, Tyco's U.S. operations returned to profitability in 1994, and overall sales for the year increased modestly to $753 million. The poor economic conditions in Europe, however, compounded problems in Italy, Germany, France and the United Kingdom, resulting in lower sales and a large operating loss from international operations. Tyco's direct import operations were still recovering from weak product sell-through in 1993 and posted disappointing results. The company initiated a series of restructuring efforts, which were to continue into 1995, including scaling back European operations, reorganizing its direct-import division, reducing the work force and consolidating operations. The $5-million restructuring charge increased the total loss for 1994 to $33 million.

While the loss was half that of the prior year's, Tyco's investment-grade credit rating was lost. By mid-year 1994, members of the existing bank group were decidedly fatigued. They began increasing rates on all facilities and aggressively stepping down availability on the inventory line. It was time for Tyco to explore its options.

Tyco began the process of identifying a lender that would recognize the value and strength of the company's core brands (which became the focus of its product development efforts) and develop solutions to deal with its weakened financial condition. When Tyco selected GE Capital Commercial Finance as its lender in September 1994, the two worked closely to objectively analyze the company's challenges and opportunities. After a thorough review of Tyco, its core business and its potential turnaround strategies, both parties agreed that despite the recent results, the core business was healthy. At the same time, however, Tyco recognized that another plain-vanilla, asset-based revolver wasn't the answer and opted instead for a complete financing, with an asset-securitization facility as its foundation.

With asset securitization, the company finances pools of receivables by issuing highly rated debt securities to capital-market investors. This funding method offers many benefits, including lowering the cost of financing, improving return on assets and other key financial ratios, and maintaining control over customer relationships, because the company continues to service its receivables.

Although investment-grade companies have used asset securitization for the last 10 years, until recently it hasn't been available to middle-market companies with non-investment-grade credit ratings, such as Tyco. The company and the lender chose this route because it offered both flexibility and the opportunity to reduce costs. It set up the financing as a $200-million domestic-receivables securitization, supplemented by a $35-million, domestic-inventory facility and two revolvers - a $35-million United Kingdom and a $20-million Canadian, both secured by inventory and receivables.

BUILDING A MODEL

A single-line specialty insurer agreed to provide a policy to cover the $200-million securitization, so Tyco could close the deal as quickly as possible. The insurer agreed to issue the policy only if the facility was investment-grade quality. But when the lender applied Tyco's data to Standard & Poor's rating model, the industry standard, it came up with an unacceptable rating outcome because of high seasonal dilutions (allowances, discounts and other offsets against accounts receivable).

But a closer look at the model revealed the methodology couldn't objectively apply to a company like Tyco, which has an unusual receivables schedule. For example, Tyco sells merchandise all year long, yet most invoices to retailers don't come due until the fourth quarter, so dilutions appear after the Christmas season. It's not accurate to say a dilution appearing in January should apply to a sale made in the previous November. In reality, such a sale could have taken place as early as July, because products are often sold on dated terms in the toy industry.

Working off this theory, Tyco and the lender used historical data to investigate every type of dilution the company experienced, including coop advertising programs, damaged-goods allowances, pricing allowances and others. It determined which dilutions were controllable, such as a pricing allowance with a specific cap, or predictable, as demonstrated by a stable trend over time.

Then the project team pulled controllable or predictable dilutions out of the S&P model. It compared historical dilutions to predicted reserves, using the information to create a matrix that would predict future results. The matrix enabled the underwriters to develop a more appropriate rating model that took into consideration the reserve methodologies of Tyco, GE Capital and the S&P model. This allowed the team to determine appropriate reserves for Tyco and account for them independently.

Since Tyco's sales cycle runs in two seasons, the revised model had a six-month lag to correlate dilutions against appropriate sales. For example, December sales were measured against the previous June's dilutions. This season-to-season system would be continuous throughout the year.

Another stumbling block was the standard theory of "spike impact" - periods of time when dilutions increase greatly and then return to normal. When spikes occur, the company must increase reserves, forcing it to set aside a large portion of its financing for reserves. For example, a typical securitization might have an average dilution of 10 percent over a one-year period. But if a spike of 30 percent occurs during the year, the standard theory concludes another similar spike could happen again at any time. Under this theory, 40 percent of a company's financing would have to be set aside for reserves.

But a spike won't necessarily occur simply because dilutions in January are higher than in December. This dilution scenario happens every year at Tyco because of the toy industry's unique dilution and receivables relationship, so it's really more accurate to evaluate spikes by comparing January of the previous year to the current January. Only if this year's dilutions are higher should the company commit more reserves.

CLEANING UP - AND DOWN

Starting from scratch, the lender developed a "clean-down" procedure, which is commonly used with asset-based loans but is a new wrinkle for securitization. The clean down accelerated loan payments during the period of December through March, when the majority of Tyco's receivables were paid each year. Also, a new mechanism allowed Tyco to take a substantial portion of collections to repay the loan during this time, but also keep an adequate cushion (through other inventory lines that were part of the deal) to ensure operating viability.

This was a completely new idea for an investment-grade world where loan payback is practically a given - after all, if it weren't, it wouldn't be investment grade. The insurer hadn't heard of the clean-down technique. Neither had the rating agencies. It works like this: As with an asset-based loan, the lender controls cash collections during the clean-down period, and the company works on a daily borrowing base. As the history of dilutions develops for the current season, reserves are increased in accordance with any deterioration in dilutions.

Once the insurer and the rating agencies understood the clean-down concept and how it was being applied to the securitization, they supported the idea. Armed with a realistic rating model and a flexible loan pay-down method, Standard & Poor's agreed Tyco's receivables pool warranted an investment-grade rating of BBB. The deal was closed and funded in February 1995.

With access to a reliable source of working capital, Tyco's picture improved in 1995. Domestic sales of $709 million resulted in a net loss of $30.4 million, an improvement of $5 million over 1994. Major international consolidations resulted in one-time charges for restructuring, but the new structure has positioned Tyco to emerge competitively in its international markets. Tyco successfully completed a $96.6-million preferred-stock offering in June 1996, and the entire company is now poised to return to profitability.

If your company is contemplating securitization as a method of financing, this deal can offer some important lessons: From the very beginning, establish an open and honest working relationship with your lender. Be prepared to discuss every issue with your lending partner. When it comes to reporting, remember that providing concise and complete information will give you credibility and more options.

It's also important to be flexible. Tyco demonstrated this by sacrificing liquidity during the clean-down period in return for greater availability when it was needed.

Finally, when you're shopping for a lender, look for an organization that understands your company and industry and can respond favorably if you experience a downturn, instead of pulling the plug. That'll ensure your financing story has a happy ending.

Mr. Pearce is vice chairman and CFO of Tyco Toys in Mount Laurel, N.J. Ms. Midkiff is vice president of GE Capital Commercial Finance in Stamford, Conn. Her phone number is [phone].