Sean McGowan analyzes how this happened, and what it means for the toy industry.

by SEAN MCGOWAN, managing director, Liolios Group

Toys “R” Us is folding. It’s sad. No doubt about it. Many of us are processing the shock. Even oldsters might find ourselves singing, “I don’t wanna grow up; I’m a Toys “R” Us kid!” Quite aside from my memories as a consumer when I was young, or taking my kids there, I had a decades-long professional connection to Toys “R” Us. I covered the stock on Wall Street for 18 years. It was the first company in which I ever bought shares of stock. I interacted with seven different CEOs, dozens of executives at various levels over the years, and was on a first-name basis with managers at several stores that I visited in doing my research.

So, yeah, it’s sad. And the industry will definitely miss it. Toys “R” Us contributed to the industry’s growth in several ways that can’t be easily replicated. It pretty much bought everybody’s toy lines. It took chances on unproven toys from unproven companies, while being a reliable partner to the industry’s strongest players. It promoted toy sales year-round. It supported in-store merchandise displays on a scale that nobody else could match. And it provided a testing lab that helped manufacturers of all sizes gauge how well their products would respond to marketing, so that marketing plans, production, and pricing could be adjusted as warranted by the test.

I think Toys “R” Us’ absence will cause the industry to lose sales. While I believe that most of the sales that would have gone to Toys “R” Us will go to other retailers, I think we all know that not all of them will; a certain amount will be lost. Kudos to Juli Lennett of The NPD Group for her recent blog post pointing out the absurdity of estimates that the industry would lose more in sales than Toys “R” Us’ total share of the business. Some have rather publicly said they think the industry will lose 15 to 20 percent of sales. I believe the industry could lose 15 percent to 20 percent of Toys “R” Us’ U.S. sales, but considering Toys “R” Us’ share of the U.S. industry was at most a low-to-mid-teens percentage, that implies that the maximum that the industry could lose is approximately 2 percent. For an industry that often shows annual growth of less than 2 percent (or even declines), it’s not an insignificant amount.

But it’s not fatal to the industry—not by a long shot. It may be fatal to some companies, either because Toys “R” Us accounted for an extremely high portion of their sales, or because the companies were in such a precarious financial condition that even a relatively small setback could be the tipping point. But the industry will get by.

Can Toys “R” Us be saved in some capacity? Could a group of manufacturers and financial backers band together and bail out what was once “The World’s Largest Toy Store?” Yes, in theory. But there are reasons to be skeptical. Putting aside the question of whether retailers such as Walmart, Target, and Amazon will remain eager to take products from vendors who “saved” a major competitor, there are reasons Toys “R” Us got to this point, and it wasn’t just debt. Even before the company’s leveraged buyout in 2005, the company was struggling to grow, and was slowly losing market share. Is this because kids stopped buying toys? No. It’s because they stopped buying them at Toys “R” Us. Why? Partly because of Amazon. Partly because Walmart and Target have grown to be so ubiquitous, and consumers shop there regularly. Partly because those retailers (and others) priced toys at loss-leading levels to build traffic.

An often-overlooked aspect of Walmart’s challenge for Toys “R” Us’ sales in the 1990s was that classic retail success factor—location, location, location. When Toys “R” Us built out its chain in the ‘70s and ‘80s (often buying the locations rather than leasing them), they chose locations that were not in shopping malls, but, rather near them, or on the way to them. This gave them the ability to benefit from the consumer traffic that the malls would generate without having to pay mall rents. But as Walmart grew and devoured share of wallet, the center of commerce in many locations shifted from the shopping mall to wherever it was that Walmart was located. If consumers shopped less at malls because they went to Walmart and the shops located near Walmart, they had less reason to drive to a Toys “R” Us.

Another reason for skepticism is that it’s not as though Toys “R” Us never tried to change its store experience. In fact, it tried many times, with Concept 2000, C-3, World of Toys, stores-within-a-store, etc. Management knew they had to make changes, and they tried many of them. And for awhile it looked like it was working—results from 2006 through 2009 were impressive. But after that, after they had used every arrow in the quiver, it turned out to be not enough.

Amazon gets a lot of blame for the woes of Toys “R” Us and other retailers. Maybe that’s deserved. But Toys “R” Us wasn’t just a victim of Amazon’s growth—it had a hand in it. After a disastrous start with its own e-commerce site in 1998, Toys “R” Us teamed up with Amazon to allow the fledgling e-commerce behemoth to handle its e-commerce. During that partnership, if you typed toysrus.com you were taken to… amazon.com. Are you kidding me? Toys “R” Us didn’t just fail to develop a superior e-commerce site, it practically put Amazon into the toy business. This arrangement persisted until Amazon chose to violate the terms of the agreement, apparently (and correctly) assuming it could do a better job on its own than as a partner of Toys “R” Us.

These competitive factors are not going away, no matter who owns however many Toys “R” Us stores. It will take a lot of time and a lot of money to get Toys “R” Us’ stores and e-commerce operation to the position it could have been in had it not been spending hundreds of millions of dollars a year on servicing its debt and paying management fees to its owners. And those other competitors won’t be sitting still while “the new Toys ‘R’ Us” regroups.

Assuming Toys “R” Us does not get saved, what does it mean for other retailers? Well, the very retailers that contributed to Toys “R” Us’ struggles in recent years are seeing its liquidation as a giant “jump ball” opportunity to claim that share. They are already wooing manufacturers with offers designed to capture whatever sales Toys “R” Us had hoped to get. I think it’s reasonable to assume that the other toy retailing giants will enjoy a lift this holiday season. That is, unless the Toys “R” Us liquidation sales induce people to do all of their holiday toy shopping very, very early this year, leaving much less money to spend on toys later in the year, in which case maybe the big lift doesn’t come until next year.

I believe there could be an opportunity for smaller toy specialty shops. Let’s face it, toy sales during the holiday season are probably going to be fully absorbed by other retailers, and it will remain difficult for small shops to get a big share of holiday sales. But I think this could be a boon to small shops out of season. If it’s April, or July, or September and parents want a special toy for an occasion, they may prefer to make a trip to a shop that has great selection, unique products, good service, and a friendly environment. I’m not sure how big and broad that opportunity is, but it seems logical that some of the sales that Toys “R” Us was doing in the off season could go to other specialty toy retailers. Unless, again, the liquidation sales soak up the family’s annual toy budget before the end of the summer.

What about a revival of KB Toys? I don’t believe that KB can make a comeback in its original form—a mall-based, small footprint toy store with a heavy offering of closeouts. But I do think there could be an opportunity to start a new chain of stores with that name that offers the unique attributes of the small specialty store. I’m not sure I’d want to be launching a new toy store chain in the middle of the liquidation sales, but let’s think long term.

What about bringing back FAO Schwarz? I’m not as optimistic about that idea. FAO Schwarz was not simply a toy store—it was a unique toy shopping experience, one that has proven to be very, very difficult to replicate on a large scale. FAO was about making that special trip to “the city” to get something that only they had. I used to quip that FAO Schwarz wasn’t in the business of selling toys, it was in the business of selling FAO Schwarz shopping bags and wrapping paper, because the fact that the toy came from FAO Schwarz mattered even more to shoppers than what the toy was. I don’t see that being any easier to execute on a large scale than it was before Toys “R” Us folded.

One final comment about some statements Dave Brandon, Toys “R” Us’ CEO said. The Wall Street Journal said that Brandon guarantees that “vendors who failed to support the retailer during the holidays, customers who shopped elsewhere, and media who chronicled the chain’s downfall will miss the retailer.” Brandon himself said, “The constituencies who have been beating us up for months will all live to regret what’s happening here.”

Well, I’m never one to kick a guy, or a company, when they’re down, and I have always counted myself a friend of Toys “R” Us. I mean no disrespect to the many hard-working people at Toys “R” Us, some of whom I’ve known for many years. But I think it’s absurd to think that this industry and its customers “failed to support” Toys “R” Us. Suppliers have bent over backwards for decades—decadesto make sure that Toys “R” Us did as well as possible. They have supported the retailer with exclusive product and special marketing programs funded by the manufacturers. They have also tolerated decades of suboptimal execution, private-label competition, and demands for expedited shipping that cost manufacturers money and sales opportunities.

I could tell hours of stories going back to the 1970s that show that the industry has always been supportive of Toys “R” Us. I can recall Toys “R” Us executives warning toy makers that they would be “watching carefully and taking names” of which manufacturers were supporting Child World and Lionel during their bankruptcies. So, in my view, the industry absolutely has supported Toys “R” Us for decades. It showed continued support last year, despite having the rug pulled out from under them by a bankruptcy filing that happened after many had already shipped significant quantities of holiday goods before they were paid. Many continued shipping after the bankruptcy. Exactly how much more support could Toys “R” Us possibly have hoped for? Was expecting to be paid for the goods they shipped a failure to support? I don’t think so.

Consumers also supported Toys “R” Us. No, I don’t mean they all refused to shop elsewhere. I mean that despite the company’s old, out-of-date stores, an inferior e-commerce site, occasionally confusing pricing, and locations that were increasingly inconvenient, millions of customers did support the company. It was not just about price, guys. If success in the toy industry were only about price, then LEGO wouldn’t have grown to be the biggest toy company. It’s about innovation, creating unique experiences, and staying relevant.

Yes, Toys “R” Us’ vendors and customers will miss the company. But this mess is not their fault, so don’t blame them.

Let me conclude with a word about the passing of Charles Lazarus. Charles was the creator of Toys “R” Us, and, therefore, the father of the “category killer” retailer. He had the vision to see how changes in the retail format could actually create primary demand, and some of the elements that led to the early success of TRU were emulated in other product categories. Charles paid me a very public and very much appreciated compliment at an investor event early in my career, and I have remained grateful ever since. He will be missed, and so will his brainchild.

Sean McGowan is a managing director on the consumer team of the Liolios Group, which provides capital market navigation and advisory services. He has been closely following the toy industry for 30 years, analyzing product trends, cost changes, marketing practices, and other aspects of how products and companies succeed (or don’t). He also follows digital gaming, sporting goods, and juvenile products. In addition, he is on the board of advisors of the Toy Industry Foundation.

 


This article was originally published in the March/April 2018 issue of The Toy Book.