Toys R Us failure points to structural business model failure, not just digital

Den Howlett Profile picture for user gonzodaddy March 14, 2018
The Toys R Us collapse points to structural problems inside a heavily debt leveraged business model, not a failure in digital.



The news that Toys R Us is shutting down both its U.S and UK operations is a blow to brands like Mattel and Hasbro that leaves them with distribution dilemmas and a share price headache.  According to an FT report on 8th March (paywall):

Mattel — whose brands include Barbie, American Girl and Hot Wheels — dropped 5.07 per cent to $15.16, while Hasbro — the seller of toys from popular franchises including Star Wars and Frozen — fell 3.6 per cent in after-hours trading to $90.

Both companies saw their holiday sales hampered by the US bankruptcy filing of Toys R Us, the storied US toy retail chain that has wrestled with a hefty debt load while more consumers do their shopping online instead of at one of its stores.

According to some reports Toys R Us accounted for some 15-20% of U.S. toy sales. If you're a brand with that level of commitment to Toys R Us then that's a big chunk of the supply chain that you now have to reconfigure for the likes of Amazon or other retailers - perhaps Kohl's or yourself.

The more important aspect of this lies in what happened to Toys R Us and why they could not close out a rescue plan under Chapter 11 bankruptcy that would have seen suppliers taking a hit but not a knock out blow. A little history helps explain the problem in the context of both technology and business models.

A sad history

At its peak, Toys R Us was considered a category killer, devising a formula that effectively shut out any local competition by offering a 'pile them high' approach that offered the consumer tremendous choice while giving brands a nearly guaranteed set of sales outlets, some of which were owned and some of which were franchised.

But as competitors Walmart, Target and, more recently, Amazon entered the fray, Toys R Us specialty status worked against them and their market share shrank.

A leveraged buyout in 2005 by KKR, Bain Capital and Vornado Realty Trust promised great things. But...the new investors made a critical error.

The investors saddled Toys R Us with massive and increasing amounts of debt to the point where the last publicly reported accounts show 'liabilities subject to compromise' of $4.35 billion and a stockholders' deficit of just shy of $2 billion.

The debt burden meant that Toys R Us was not able to make the switch to digital quickly enough to offset the Amazon and Big Box effect, in part because it was paying off debt and carried interest out of dwindling cash flow at a time when its market share was being eroded.

It is this combination of debt combined with an inability to respond appropriately to existential threats in a post Recession environment that has led to the slow but steady decline in Toys R Us fortunes.

Pointing fingers

There are hopes that a small number of U.S. stores along with those in Canada will survive the firestorm but for all practical purposes, it is game over for Toys R Us.

Should we point to the move to digital as a prime culprit? No. That would be wrong-headed. We've seen plenty of examples where companies have appeared to get it wrong, only to manage something of a turnaround. Stuart's recent Hugo Boss report is but one example.

Private equity and debt are killers

Should we point to private equity dictates? Yes. Saddling the company with debt servicing costs of over $900 million in 2016 and 2017 along with a total of $6 billion in interest payments alone was never going to allow the company, already under multiple threats from discounters and digital, to make any significant changes to its business. Period.

Toys R Us had become tired and irrelevant, with an image and model that was stuck in the 1980s. In February, retail analyst Steve Dresser said:

"The general feel isn't one of fun, it's one of tiredness," he says.

"I stumbled on one in York - it was quite sad. The first sign you see is that they reserve the right to check your bags as you leave. That's a horrendous message in a toy shop. As a customer, you don't really feel valued.

"That shouldn't be what a toy shop is. It should be a place of joy."

Toys R Us' demise was not inevitable, he argues. They just weren't dynamic enough.

"They signed their own death warrant."


My take

High street retail is under the cosh in many markets and it is almost a knee-jerk certainty that you'll hear CEOs on earnings calls talking the digital talk. That is a part but only a part of the problem.

Let's not forget that Amazon, while it is the supposed elephant in the room only accounts for a tiny fraction of all retail sales. But it has one thing going for it that the high street doesn't - the market favorite of growth. That allows it pretty much unfettered access to capital.

On the other hand, there is no getting away from the fact that in a post Recession world, even though interest rates remain stubbornly low, cash is king. Operating cash flow provides the oxygen that in turn fuels business model shifts. The problem for high street retailers is that business model innovation isn't happening quickly enough for their already pressured margins to improve anytime soon.

That isn't necessarily their fault. Remember that as middlemen, the retailer has to juggle numerous supply chain issues and the strength that once came from being a channel master is being eroded as brands pursue technology driven omni-channel strategies.

For brands, the problem is different. They have to remain innovative and relevant to changing trends, something which has not always been easy, although Adidas is showing the way with a combination of a shift in focus towards celebrity endorsed clothing and away from sportswear - I recently got a great deal on some Adidas own brand tops but paid nose bleed for something cooler - while at the same time opening up new markets and cutting out the middleman by upping their online game. (sic)

As always these are interesting times but if you are in retail and wondering about technology investments then before thinking about that element you'd better be darned sure your existing business model provides enough cashflow to pay for expansion into new modes of operation.

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