While Walmart (NYSE:WMT) and Amazon.com (NASDAQ:AMZN) have taken some sales from Toys R Us, they've also eroded margins across the entire toy category -- which put further pressure on the toy-only retailer.
The two retail giants did not kill Toys R Us. You can blame that on KKR, Bain Capital, and Vornado Realty Trust. Those three firms put up $1.3 billion in cash and assumed $1 billion in debt when they purchased the toy retailer for a total value of $7.5 billion in 2005.
It's called a leveraged buyout (LBO). That's what happens when private equity firms put up a limited amount of cash and then use a company's own equity to purchase it. It's a formula that saddles a company with debt, giving it very little capacity to invest in itself or respond to changing market conditions.
Where Toys R Us went wrong
Ideally, with an LBO, the new owner does one of two things. Sometimes a company gets broken up and sold off for parts. That approach makes sense when a business holds valuable assets such as real estate that might be worth more on their own than as parts of the whole.
In the second scenario, the buyout firm hopes to operate the business profitably and then take it public as a way to cash out its stake that it mostly didn't pay for in the first place. In general, an LBO is followed by spending cuts, layoffs, and other money-saving initiatives to create enough cash flow to service the huge amount of debt.
The Toys R Us purchase happened just before the retail market began to massively change. In 2005, it wasn't yet clear how dominant Amazon would become, and while Walmart sold toys, it wasn't pricing them aggressively yet.
At that point, Toys R Us could still have pivoted. It was losing its status as the only place kids could see a massive display of toys. It could, however, have begun to become a destination in other ways, including adding live gaming, interactive displays, in-store demos, and weekday events for younger children.
In later years, as Amazon grew, Toys R Us could have invested in its website, app, and built a loyalty program. That would have been easier if the chain had a loyal audience of toy and game fans flocking to its gaming nights and other in-store events.
It was only a matter of time
Walmart and Amazon did make things harder for Toys R Us, but retailers including Best Buy and Target have shown that with proper investment and differentiation, it's possible to compete. Toys R Us never had that chance. It was already so saddled with debt that it had very little runway once things went wrong.
The toy retailer didn't get the chance to reinvent itself the way so many other retailers have. It's possible, of course, that management still would have failed -- there are a lot more Sears and Circuit City stories than there are Best Buy-type success stories -- but we'll never know.
Toys R Us has told its employees that it plans to close all its stores in the United States unless it can find a buyer for some of them. This happened because its owners made a bad bet on a leveraged buyout. Amazon and Walmart may have helped things along, but if you were filling out an autopsy report, an insurmountable mountain of debt brought on by an irresponsible LBO would be listed as the cause of death.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Daniel B. Kline has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.