I noticed articles that blamed Amazon directly for the demise of Toys ‘R’ Us. This is a frustrating thinking trap and fallacy that I see often: Using the present day to explain the past decisions. Such explanations make no causal sense.
We should look at the role of private equity in the business of retailing toys.
Private toys don’t last all summer long
Toys ‘R’ Us came to a demise a few days after I wrote the post on Lego’s continuing toy problems. I read the articles and tweets with wistful nostalgia, bemoaning the fate of Toys ‘R’ Us with some studious indifference. I did not grow up in the United States, and hence, it is reasonable that I find the nostalgia for the disappearance of a retail chain with no childhood connection, not very compelling.
However, there is another reason for the bemusement: In my mind, shopping for toys as an experience pales in comparison with hours playing with the toys.
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Now on to history and theory.
Toys ‘R’ Us has been well covered in the recent news articles, but I wanted to write a story threading two powerful yet disparate forces that were in play at the end of Toys ‘R’ Us.
Amazon & Private Equity
It is somewhat obvious to point out that Amazon’s phenomenal success on online retailing (along with changing consumer tastes and evolution from physical toys to video gaming), has been slowly spiraling the toy industry to its eventual doom. However, this is NOT the main reason for its demise.
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LBO Short-Termism.
As a researcher of Operations, one of the issues that have disappointed me about the Private Equity industry, given the not-insignificant talents of students that go work in it, is the gulf between emphasis vs. practice in Private Equity.
In theory, one of the substantial goals is operational restructuring. Inefficiency is the devil, and the devil is in the details. In fact, in the underbelly of organizational behemoths, the pathogens of inefficiencies, confoundedness, and indiscipline thrive. Taking a company private is meant to help diagnostic forensics, cut waste, and augur in better efficiency.
In practice, it was all about financial restructuring: all LBOs all the time.
A behavioral economist would see hyperbolic discounting run amok. LBOs encouraged armchair math, guaranteed windfalls, and tax benefits. Its considerable latent costs were happily externalized in the pre-2008 era. The bumper benefits of LBOs contrast with operational improvements, in which benefits are accrued gradually over time. “Operations” is unsexy: the improvement process is clunky, and payoffs trickle in overtime. LBOs are like bathroom redesigns, and Operations are repaired pipes, air filters, and HVAC systems of redesigned homes. One’s benefit is immediate and visible, and others have to be lived through to be realized.
The exuberance of seeking finite horizon goals (sales, quick turnaround, etc.) lends itself well to financial restructuring, even as the act taking a company private is supposed to provide operational independence to make some choices.
As this Bloomberg report correctly argues, Toys ‘R’ Us is a cautionary tale from the exuberant days of LBOs and poor private equity decisions. (A good contrast would be Best Buy and a meaty topic for a future post). Toys ‘R’ Us went private in 2005, and since then, a significant fraction of the operating income has been spent in paying the interest towards the loan, until the operating income itself dwindled.
Running a firm under these circumstances would involve decisions that that is not much different from the decisions of people living paycheck to paycheck under high-interest payday loans. The goal is almost to survive to the next days, hoping for a miracle.
This is where the comparison to Amazon becomes relevant.
Comparisons, even by respected experts, involve a dim view on the Toys ‘R’ Us’ collaboration with Amazon. In 2000, Toys “R” Us entered a 10-year agreement with Amazon. Amazon would essentially be the website for Toys ‘R’ Us online and operate their online sales, all for an annual fee of $50M and a percentage of sales revenues. This collaboration can be considered as a bad decision only with all the artillery of hindsight wisdom. Why? I make two points.
1. Amazon in the Year 2000.
First, Amazon in 2000 was not the Amazon of 2015. In 2000, they were a $2.7B company whose revenues were smaller than Barnes and Noble, they were not a “tech” company, and for sure, they were not even selling shoes online. (Although, looking at the annual report, the long game plan has always existed. I will get into this plan at the end of this post).
On the other hand, in the dot com boom, Toys ‘R’ Us, was coming out of a particularly difficult period that followed settling an anti-trust case, that cost them more than $40.5M in toys and cash. Given the onerous challenges it was facing, Toys ‘R’ Us was strapped without clarity. They had to quickly scale online presence, and Amazon solved this precise problem for Toys ‘R’ Us.
However, the relationship did not last long: the leading cause was perhaps the joint effort was too successful in terms of revenues. However, it created acrimony on how to sharing revenues, and whether partners were putting in commensurate efforts. The relationship nosedived quickly and ended litigiously. Toys ‘R’ Us sued Amazon, seeking to end the partnership, which finally ended in 2006.
2. Target
On the second point note that Toys ‘R’ Us was not the only firm engaged in such a partnership with Amazon. Before the “obvious emergence” of omnichannel marketing, Target and Amazon had an online channel partnership which also eventually turned sour. The 2006 article I linked to, cites Target as a firm seeking to expand its partnership with Amazon. Target stuck with Amazon much longer. It was already late 2011 when Target eventually quit the relationship — a partnership that lasted eons in eCommerce time.
Despite operating in a market with heavier competition for tighter margins (than in the Toy Industry), Target is one retail firm that has been weathering the e-commerce storm. Elaborating on the same point, given the market structure and lengthier relationship with Amazon, Target was even more exposed to the competitive risks from Amazon’s actions than Toys ‘R’ Us ever was.
In fact Toys ‘R’ Us had structural advantages that Target did not have. Buying toys is (still) an experiential process, prone to impulse purchase decisions. Moreover, the demand market is highly seasonal, and with tightly knit supply chains with upstream oligopolies (Lego, Mattel, Hasbro). All of this is challenging for e-commerce. This is one market that Amazon has still not made that much inroad into (especially compared to other markets, like books, shoes, kitchen items).
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This is the landscape in which Toy ‘R’ Us pulled out of the relationship in 2005, went private, and subsequently did everything wrong.
If partnering with Amazon in the early aughts was the main cause for Toys ‘R’ Us’s downfall, Target must have been in much worse shape, and gotten worse much earlier.
So to understand the Toys ‘R’ Us story, we have to look at the dog that did not bark — something that Target or Amazon did NOT do over the period — they did not go private.
Back to Private Equity
On one hand, the story of Toys ‘R’ Us has demonstrated how poor private equity decisions have hurt retailers operating healthy markets, through debt financing and short term decisions …
On the other hand, Amazon has shown how a firm can utilize the public markets to finance long-term growth. Amazon forged ahead by emphasizing two things: a relentless focus on improving efficiency online, and putting customers ahead of the investor class, at each step.
It is hard to replicate Amazon, but private investors chortled Toys ‘R’ Us — without a focus on eCommerce efficiency or customers — sending it south, even as Amazon was hurtling north.
Notes:
- This article is an updated post of my earlier article. My apologies to Brian Aldiss, for my meager attempt at clever titling.