Who Was the Real Culprit Behind the Fall of Toys "R" Us?

It's easy to say that Amazon, Walmart, and other retailers were what drove Toys "R" Us out of business. To an extent, that may have been true, buy the toy retailer wasn't hurt only by the competition.

In this segment from Industry Focus: Consumer Goods, the team discusses how the company's debt burden ultimately led to its demise. Are other companies destined to meet a similar fate in the years to come?

A full transcript follows the video.

This video was recorded on March 27, 2018.

Vincent Shen: But as long-term minded Fools, we're all too familiar with how some of Wall Street's short-term focus can result in a lot of less than desirable outcomes. Taken at face value, I don't think anybody will argue against the idea that if you want to optimize a company's operations, potentially change its management team to improve the company's overall prospects and outlook. But these investors that are focused on reducing that debt and increasing profitability for a better valuation, come harvest time, that often means cutting costs, as firms like 3G Capital are very well known for. They might sell off assets, reduce workforces. And a lot of times, these interests will align. You end up with stronger businesses that can IPO successfully or get acquired by someone else. But a lot of times, too, and this is where we're talking about our retail sector focus, you get companies that failed to make the investments they needed to compete in the current retail environment.

The list of these failures is pretty long. You have Payless ShoeSource, True Religion, and just recently, Claire's. And the big one we're going to talk about, Dan, is Toys "R" Us, which we covered not long ago after it initially declared bankruptcy, hoping for reorganization.

Dan Kline: Yeah, it's been a very sad story. [laughs]

Shen: Yeah. Why don't you give us a better idea here of how things ended up panning out for Toys "R" Us?

Kline: Three different companies arranged a leveraged buyout of Toys "R" Us. They took on about $6 billion worth of debt. And the way the business was operating at that moment, in theory, they would have paid off the debt and been able to go public. The problem is, the internet happened, and Target and Walmart both decided that toys would be a very attractive, call it a loss leader. The toy section in Target or Walmart is so the parent can get the kid a justification to do their shopping, and maybe they buy a few things. The prices at those chains forced overall prices down, as did Amazon.

So that puts Toys "R" Us in a position where margins are lower, there's less reason to go to the store, and in theory, they should be investing heavily in their website. Now, we know Toys "R" Us had a misstep where Amazon used to provide its website, and that set it back for years. But when it got out of that deal, it should have done two things. We talked about this on the last show. It should have made its stores destinations. There should have been gaming and events and demonstrations and areas where you can ride a bike and play with different expensive toys and all sorts of things to make a kid say, "Oh my God, I want to go to Toys "R" Us." The second thing it should have been doing is figuring out how to build out its digital channel.

And the reality is, not only did it do neither of those things, it actually slipped on maintenance in its stores. Stores that once at least had interesting displays became more pedestrian. And because of debt, the company stopped doing the things that probably, I assume, management knew it should have been doing, but it could only move in very small ways, because cash got tight. If you have that much debt anyways, you can't borrow $1 billion to revamp all of your stores or hire new specialists in different product areas. It becomes a self-fulfilling prophecy.

Shen: Yeah. So here, we had a company with profitability on the rise, the e-commerce business was growing, I think it logged over $1 billion of digital sales recently. But it failed to get refinancing on just a small portion of its debt, about $400 million that was coming due this year out of $5 billion total. The crazy thing is, the bigger picture beyond Toys "R" Us for the sector overall looks pretty daunting in the years ahead.

After the financial crisis, we had a lot of the struggling retailers getting scooped up at bargain prices with cheap debt financing thanks to the low interest rate environment. But a Bloomberg report mentions that only $100 million of high-yield debt in the retail sector matured last year. That number increases to almost $2 billion for 2018. Then, it balloons further to about $5 billion annually from 2019 through 2025. So the report mentions further that outside of retail, including all industries, that high-yield debt worth $1 trillion will come due in the next five years, which means a lot of companies are clamoring to refinance in the near future. Given the bearish view of retail, a lot of companies similar to Toys "R" Us might not get that refinancing that they need.

Last couple of minutes here, Dan, any takeaways you want to leave our listeners with?

Kline: Yeah. I think there's going to be a huge ripple effect because of this. If you look at just the toy space, obviously Mattel, Hasbro, but every independent toy company, is losing a major showcase. And I think it's possible, you're seeing some rumblings with Toys "R" Us of some different private groups, maybe some toy companies, buying some of the more successful locations and relaunching the brand. I don't know if that will happen with Toys "R" Us. But I think that will happen with some of these other struggling retailers, because if you're a sneaker company or a shoe company and Payless goes away, you're losing thousands and thousands of outlets. So I do think you're going to see some creative financing to keep some of these chains afloat, but a lot of people are not going to get paid back for debt that's already owed, and it's going to cause suppliers and malls and a lot of other people to go out of business.

Shen: Yeah. And that has a pretty big impact for the workforces there, as well. I'll wrap up our discussion. There's honestly a lot more to cover with private equity and the many deals that industry has executed in the past few decades, we just don't have enough time to cover it all in a single episode of IF here. But my business program at the University of Virginia had an entire course in the semester dedicated to just this topic.

I'll also say on the flip side, there have been many successful private equity transactions as well, a recent one even, that we covered on this show was with Canada Goose Holdings. So this is not a boogeyman scenario as we've tried to avoid painting Amazon to for retail, as this boogeyman that's the cause of all these issues that traditional brick-and-mortar players have had.