ONE FOOL'S OPINION
Is Toys "R" Us Toying with E-commerce? Dale Wettlaufer (TMF Ralegh)
August 17, 1999
Toys "R" Us (NYSE: TOY) rose slightly this morning after the company reported second quarter results yesterday and Prudential's sales force beat the drum on an upgrade to "accumulate" from "hold." While the company met the mean estimate of EPS of $0.05, that's pretty much a "big deal" development for the quarter. If you help guide the numbers, you should be meeting them. Perhaps more germane to the situation is the company reporting a 4% quarterly increase in same-store sales, "driven by stronger merchandising trends." Internationally, same-store sales increased 6% before currency translation.
For the quarter, the conversion of 80 stores to the redesigned C-3 format, intended to present the customer with a more logical layout and improve the merchandising presentation, actually held back same-store sales improvements. The company is on-track to finish the conversion of 170 stores to the new format by the all-important holiday season. In other initiatives, the company's press release discussion of its Internet strategy was discouraging, to say the least. A little over 10% of the press release was devoted to discussing the company's progress with respect to the most eventful development in retailing in the second half of the decade and perhaps one of the most eventful developments of the century: the Internet. And even then, "We have made great progress with respect on our Internet strategy" doesn't really give too much detail to what's going on.
The company reiterated that it thinks John Barbour, who comes to the company's toysrus.com unit from Hasbro (AMEX: HAS), has the CEO goods to make Toys "R" Us' online efforts a success. Investors already know what the company thinks of Barbour -- they like him. Great. What was new was the company's announcement that it has broken off its relationship with Benchmark Capital, one of the more successful and interesting venture capital firms today. Among the general partners is Bill Gurley, who was part of the team that brought Amazon.com (Nasdaq: AMZN) public.
This pertains to Toys "R" Us in that the company already looked like just another retailer that is looking at its Internet strategy as a rearguard action rather than one of the key drivers of its economic future. Toys "R" Us already parted ways with its first toysrus.com CEO, who wanted to optimize its supply chain and merchandising for online retailing. In that instance, it appeared as though the company wasn't willing to engage in tactics that would conflict with its in-place assets -- its stores and relationships. In ditching Benchmark, the company is showing continued confusion in its online retailing thinking. In his latest Above the Crowd column, Bill Gurley talks about the evolving world of e-tailing and makes some observations that point more to agreement on strategies designed to take advantage of the company's current asset base:
"The first shift to expect is a bifurcation in the e-tailing community. We will increasingly need to delineate between e-tailers that handle inventory and physical distribution (physical e-tailers) and those that don't (virtual e-tailers). Many people believed that virtual e-tailing was the optimal way to go because of the lack of investment in true physical assets (both products and warehouse infrastructure). Return on investment would be higher if you were simply a bit-based business. However, because of the evolution outlined above, the virtual e-tailer may be in the most tenuous position. The barriers to entry in order taking are simply too low."
One would have to believe that no huge bricks-and-mortar retailer can make the transition to online retailing completely painlessly. There are sure to be conflicts of all sorts. In cutting off two relationships with people who probably had some different ideas on how the online effort should be handled, where one of them was probably thinking of how best to leverage in-place assets, the outward signs at Toys "R" Us look like this is another bullheaded retailer that really isn't taking the Internet seriously. Yeah, sure, they acknowledge the challenge, but what are they willing to do? Protecting the core of a company that is building little, if any, economic value (in the sense of showing a return on capital above and beyond cost of capital, not in the sense of throwing a ton of capital at a business and producing expanding EPS) at the expense of stifling what is not a nice-to-have thing but a need-to-have thing is pretty discouraging for investors who might be examining Toys "R" Us at this point.
Yes, cash flow grew last year at Toys "R" Us and the company bought back nearly three-quarters of a billion dollars in common stock, but that happened along with the net issuance of over $350 million in debt and on a nearly half a billion dollar swing in inventory investment. And what effect is the $546 million restructuring charge having on reported net income this year? Some value investors are going to focus in on the gross cash flow, free cash flow, and share buybacks, but it just doesn't mean a heck of a lot on an ongoing basis, wherein you're looking at a ten-year cash flow analysis of the firm.
The way things look at present, there's no abiding enthusiasm for online retailing that is evident from the outside. The outward signs don't point to a company that really wants to cross the chasm. If you're an Amazon.com or an eToys.com (Nasdaq: ETYS) shareholder, you have to be loving what's happening at Toys "R" Us.