Factors That Will Impact the Toy Industry in 2019

by Sean McGowan, managing director, Liolios Group

Toy Fair: It’s the annual deep dive into Toyland, a time when we can all focus on the joy that new toys will bring to kids over the course of the next year, and maybe think a little less about Crazyland, where we adults get the joy sucked out of our lives.

We’re coming off a year that was strange in so many ways, including the first holiday season in more than 40 years without Toys “R” Us (TRU). The retailer’s departure not only figured prominently in the outcome of holiday sales last year, but is also a central discussion point in this column. Here, I will consider what to expect in 2019 in light of what we’re leaving behind in 2018.

TRU-ISMS

One of the biggest surprises of the first half of 2018 was the speed at which TRU went from bankruptcy to liquidation. The bankruptcy was not that shocking: It was a bit like finding out your uncle who smoked three packs a day was diagnosed with emphysema. The shocking part was not that the patient was sick, but how quickly the patient lost the fight. From the moment TRU announced its liquidation, the big question facing toy makers became, “How much of the sales I expected to make to TRU will shift to other retailers, and how quickly will that shift happen?”

Clouding this analysis was the uncertainty over the degree to which heavy retail toy sales rung up during the liquidation constituted “pantry loading,” whereby parents would simply spend their toy budgets in April rather than in November in hopes of getting a better deal during the “everything must go” sales. Plus, it wasn’t clear how much impact the extra shelf space allocated to toys at other retailers would have on total demand.

There was a four-part argument for why the industry would enjoy strong toy sales last holiday season:

There was strong evidence and speculation that the pantry-loading effect would not be that significant, with some estimates suggesting that the vast majority of the toys purchased during the liquidation were not hidden in the back of the closet, but were, in fact, consumed shortly after purchase, which paved the way for a healthy holiday season.

Competitors such as Walmart, Target, and Amazon stepped up their efforts to capture the lost TRU sales, either through extra shelf space (in the case of the brick-and-mortar retailers) and/or extra and earlier toy promotions.

The absence of TRU brought a dramatic increase in shelf space from retailers not accustomed to doing brisk business in toys, such as Best Buy, GameStop, and Barnes & Noble. This would lead to consumers making greater impulse purchases when they visited those stores, and would create a fatter pipeline to which manufacturers could ship.

Finally, at least from the vantage point of mid-year, the economy and stock market were both booming, suggesting consumers would not hold back on spending during the holiday season.

In fact, pantry loading appeared to actually happen last year. Competitors did expand their toy offerings, but were not as profligate with their purchasing, leading to shortages. The lesser-retailers clearly wanted to be out of stock on December 26—and mission accomplished. The stock market also had its worst fourth quarter since the Great Recession, dealing a damaging blow to the wealth effect.

My guess is that the percentage of toy sales that TRU lost and other retailers recaptured in 2018 was much less than the 80 percent-plus estimate that some put out there. And, of the portion that other retailers did not recapture, a significant part of it may be gone forever.

(A quick shout out to Jakks Pacific, which was pretty much alone among major public toy companies last fall saying that other retailers would not pick up the lost TRU sales right away. Not that it was “good news,” but it just turned out to be more correct than the prediction that 80 percent or more of those sales could be made up in 2018. Full disclosure: I handle investor relations for Jakks Pacific.)

Why did this happen? Even if those toys bought at half price in April were, in fact, consumed right away, it appears that parents found other things to spend their money on later in the year. Or, maybe they got distracted by the bi-annual “Most-
Important-Election-Of-Your-Life.” Or they felt a little less like St. Nick and a little more like Ebenezer Scrooge when they opened their brokerage account statements for November. Whatever the reason, the shift didn’t happen as expected—and there’s not much reason to think that it’s all coming back in 2019.


There’s a New Tariff in Town

Our president imposed a series of tariffs on imports from China and threatened to expand the range of tariffed products to everything made in China if the country didn’t meet his demands. But tariffs did not specifically target the vast majority of toys, and let’s face it: If everything made in China gets hit with a tariff, toys will only be one of a huge amount of products affected, so this is hardly an industry-specific concern. But even so, you think of China when you hear “toys,” so the concern has been center-of-mind for everyone in the toy industry.


Slow Boat from China

In a not-unrelated development, we are finally seeing the long-anticipated large-scale “de-Chinafication” of toy manufacturing. Tariffs—even those not yet imposed—are not the primary catalyst. The move to find manufacturing capacity outside of China has been underway for a long time, intensifying with each double-digit annual increase in the wages of workers in toy factories in Shenzhen and elsewhere, stoked by the desire of China’s leaders to move up the economic food chain by expanding production of higher-value products and moving away from low-value products, such as toys.

Many U.S. companies found that countries such as Vietnam have adequate, modern factories and access to transportation infrastructure. The workers in these factories also typically don’t have to travel hundreds of miles to go back home for Lunar New Year celebrations, so there is less disruption in January. There is no way that Vietnam, Thailand, Cambodia, and other countries can absorb all the manufacturing capacity in Southern China overnight, but the move out of China is underway, much like the move out of Japan and Hong Kong began a generation ago.


Go Big or Go Home

In the immediate wake of TRU’s demise, there was a prediction (which I agreed with) that the industry would see a massive wave of consolidation as larger companies swallowed smaller ones. The theory was that smaller companies were over-indexed to TRU, would find it much harder to replace those lost sales, and would be hurt much more by unpaid receivables. Well, the massive wave of post-TRU consolidation didn’t crest… yet. We still expect to see many smaller companies get acquired (or go under), but the buyers may not be the largest companies in the industry. Instead, private equity bottom-feeders may do the buying, or mid-sized players that are nimble enough to avoid getting burnt by the TRU bankruptcy, but are large enough to absorb other companies or product lines.


Crude to be Kind

The sharp drop in the price of crude oil over the course of 2018 would normally be a significant potential tailwind for toy makers looking to cut costs. And that may very well turn out to be the case. The price of crude oil ended 2018 roughly a third less than its peak in October, and more than 20 percent below where it was at the end of 2017. Often oil prices are a proxy for expectations of future economic activity—and if the drop in crude is driven more by diminished demand than by surging supply—it could be a harbinger for a recession, which is nobody’s idea of a tailwind.


Crazy Rich Licenses

By just about any measure, 2019 is shaping up to be an insane year for toyetic entertainment licenses, with movies such as Toy Story 4, Frozen 2, multiple Marvel and DC Comics features, Star Wars: Episode IX, live-action remakes of Disney classics, and more. History not only says that consumers’ appetites can have limits, but also that some of these properties have showed a bit of fatigue at retail lately. We like the position a company, like Funko finds itself in: It will have products tied to just about all of the major toyetic content this year, in addition to some TV content not likely to generate sales of traditional toys, such as Game of Thrones and Stranger Things. (More disclosure: I handle investor relations for Funko.)


Overall Prediction

My forecast for the industry this year is that it will be a good year. Retail inventories are lean, there are many toy drivers, the economy remains relatively robust, manufacturing costs should be manageable, and the comparisons in the second half look pretty easy. In addition, for the first time in many years, the talk at Toy Fair won’t be, “So, what do you think will happen with TRU this year?” This is the first time in about 10 years that manufacturers won’t have to worry about the credit worthiness of one of their largest customers.

If there is talk about “What will happen with TRU?,” it will center on whether the brand can successfully and sustainably revive in a new retail structure, and/or whether its various private label product lines can be successfully marketed under the Geoffrey LLC brand. Both of these are happier things to speculate about than whether or not a retailer accounting for a large share of industry sales will survive.

I wish you all a successful Toy Fair, and a prosperous 2019.

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 more than 30 years, analyzing product trends, cost changes, marketing practices, and other aspects of how products and companies succeed (or don’t). In addition to toy companies, his clients include companies in the sporting goods, video game, eSports, and consumer packaged goods businesses. He is also on the board of advisors of the Toy Industry Foundation.

 


This article was originally published in the February 2019 issue of The Toy Book.