E-commerce didn’t kill the retail star, but it did change it. In this week’s episode of Industry Focus: Consumer Goods, host Dylan Lewis and Motley Fool contributor Dan Kline take a deep dive into two retail concepts — Toys R Us 2.0 and Five Below (NASDAQ:FIVE) — to explain today’s retail landscape. Why will Toys R Us’ second act probably end in failure? How is Five Below putting up stellar returns, quarter in and quarter out? What does it take to Amazon-proof your retail concept, and what kinds of stores are doing that best? Could Toys R Us find success in new frontiers? Tune in to find out.
A full transcript follows the video.
This video was recorded on Feb. 12, 2019.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It’s Tuesday, February 12, and we’re talking about Toys R Us’ second act. I’m your host, Dylan Lewis, and I’ve got fool.com’s Dan Kline on Skype. Dan, what’s going on?
Dan Kline: I’m surprised to be talking about Toys R Us yet again. Did you play us in with a slowed-down version of the Toys R Us theme song, like when a sitcom would do that in the ’80s to show that something sad has happened?
Lewis: We won’t know until after Dan Boyd has had his hands on this audio. Will he? Who could say? He likes to surprise us, though! Dan, Toys R Us is one of those stories, kind of like Sears, it just keeps coming back. It doesn’t seem to go away.
Kline: Well, here’s the problem. Toys R Us is a lost example. The company declared bankruptcy. When it declared bankruptcy, it had every intention of coming back under restructuring, and it wasn’t able to work that out with its debt holders. That put it in a position where it had to close all its stores, give up its retail portfolio, miss an entire holiday season for the most part — it had kiosks in some Kroger stores. And now, in the U.S. at least, it’s starting from scratch. And that is a very difficult position to be in, even if the company no longer has that looming debt that was sort of crushing everything it was trying to do.
Lewis: Before we get into some of the more recent developments with this company, it’s probably worth giving a little bit of a history lesson with how we got there. You alluded to this. A lot of the current situation that we see with Toys R Us is the result of some of the leveraged buyout action that the company went through when it went from being a publicly traded company to a private company some years back.
Kline: Let’s explain what a leveraged buyout is. A leveraged buyout is when a company buys another company, mostly using the company that they’re buying to fund the deal. Toys R Us took on, I believe the number was $6 billion worth of debt, though it’s been awhile, I don’t remember that exactly. In doing that, they entered a market where toy sales were slowing, they were going online, there was more competition from big box retailers, and instead of being able to pivot and redo their stores, move to an omnichannel model, make the stores interactive, and add all sorts of fun stuff that kept Toys R Us at the head of the pack when it comes to toy stores, they did not have the money to do that because all their money went into debt servicing. It created a situation where the chain got old very quickly. It wasn’t forced out of business because there was no demand for toys. It was forced out of business because it sort of couldn’t keep pace with where the market was going and make its debt payments.
Lewis: That’s one of the major criticisms that people have of these LBOs. The company behind this one, KKR, is one of the most famous firms for this strategy. Anyone that has seen or read Barbarians at the Gate is familiar with this firm. It creates a lot of operational problems for the company that has been acquired because you’re saddled with debt and really can’t do a lot of the investments that you’d like to be able to put into your business to make sure that you’re keeping pace with the trends in your industry.
Kline: It only makes sense in a market where there’s incredible growth. This one happened at the sweet spot for a bad time. The industry had been growing, but Amazon hadn’t quite stepped up yet. Almost the second this deal closed, all of a sudden, Toys R Us was faced with this massive new competition. The presence of Amazon actually forced Target and Walmart to lower prices for toys because toys became a draw to their stores, so they weren’t going to make the same margin that Toys R Us needed to make on what was their only product.
Lewis: The news that we have now, Dan, with Toys R Us, is that they’re trying to come back. Let’s take it to present with this company and then talk a little bit about the retail landscape broadly.
Kline: A company called TRU Brands now owns all of the remaining Toys R Us assets. That includes actual stores in Europe and some of the rest of the world. In the U.S., it’s really just intellectual property, the Toys R Us brand. Their intent is to launch new stores. They’ve been very vague about that, so it could be pop-ups at first, it could be more like what they did with Kroger, store-within-a-store, but they intend to have a stand-alone retail presence. That’s where things get a little bit scary when you look at the current retail marketplace.
Lewis: Particularly as you see what has happened in the wake of Toys R Us leaving the retail landscape, right? We’ve seen all of these very big companies with very deep pockets all of a sudden scoop up all the market share that was left behind by Toys R Us.
Kline: There was a land grab. Toys R Us had about 19% of the toy market, about $4 billion in sales. Pretty much the second they showed any weakness, Walmart and Target started ramping up their toy efforts for the holiday season. If you walk into most Targets now, they still have much larger — I’d say maybe by a third, and that’s anecdotal based on visiting some Targets — toy selections. More aisles, more stuff.
Amazon went full into it. They did a digital toy circular, sort of like what you used to look forward to as a kid from Toys R Us before Christmas, when the big book of toy sales would come out, and you’d circle for your parents what you wanted, and of course mostly wouldn’t get.
This market is gone. The overall toy market shrunk a little bit, by a couple of percentage points, through the holiday season. The major players in it — Mattel and Hasbro — were both down. Now, they were down partially because they put a lot of their eggs in the Toys R Us basket. When you look at the selection at, say, a Target, Target has Melissa & Doug, it has more independent toy store brands, a wider selection of things like collectible trading cards. You’ve lost some market share. But there’s really no obvious place for a new Toys R Us to step in. Basically, they moved out of the apartment and now, they’re going to have to fight the new tenants to get back in.
Lewis: Right. And once consumers get used to the idea that there’s a robust toy selection at some of these big box retailers where they’re shopping anyways, all of a sudden, you don’t really feel the need for a Toys R Us.
Kline: And your kids don’t know there’s going to be a new Toys R Us. As a parent — I know you’re not a parent — from maybe the age of 3 to the age of 10, Toys R Us was a bribe. “Will you go to the grocery store with me? We can go to Toys R Us after.”
Lewis: I distinctly remember being on the kid side of that, Dan.
Kline: [laughs] Right. Once there stopped being a Toys R Us, it became, “Hey, do you want to go to Target? The grocery selection isn’t as good, but we could kill two birds with one stone.” If I had a young kid — I don’t, I have a 15-year-old — the last thing I would do is reintroduce Toys R Us into the routine. There’s that lost opportunity part of it.
The other piece — we’ve talked about this a little off camera — is, if Toys R Us is going to come back, they would have to offer a different experience than what Target and Walmart do. That’s very expensive. I used to run a toy store, that’s been talked about a lot on this show. My toy store competed with Toys R Us, Walmart, Target, who knows what else, lots of other things. We had tons of interactive areas. We had a huge model train that people could come to see. You had to work really hard to be something very different, and that requires paid experts. We’ve talked about this with Barnes & Noble. You walk into a Barnes & Noble where they sell upscale $50 to $100 board games, and you ask someone, “Why should I buy Ticket to Ride for $60 or Settlers of Catan for $75,” or whatever the numbers are, and there’s no one there that can tell you anything about how those games play, you’re not going to buy them. You’re going to go to a specialty toy store. There might be some niche for that with Toys R Us, but it’s a very expensive game to play.
Lewis: Right. I think so much of the conversation now with retail is, it’s got to be more than the goods. You can’t just be giving me the product. If you have brick-and-mortar, you need to be giving something else to customers. You look at some of the companies that have very successfully navigated the e-commerce revolution, I think the ones that do that are the ones that still stand. The easiest examples of that are the Lowe’s and Home Depot of the world, where you go there and, very similar to your board game example, you’re getting expertise in addition to the goods. Those stores in particular really benefit from the fact that people sometimes come in not really sure what they need, and they can defer to someone who knows a lot more about, say, flooring or wood paneling than they do.
Kline: Absolutely. It’s the same way at a specialty toy store. I can walk into any place that sells toys and buy Candyland and know the basic way that game plays. I can’t walk into most toy stores and figure out how to play maybe a more specialized game, Apples to Apples or how Bananagrams works. And I’m talking some very mainstream games. When I used to run the toy store, the gaming companies would come in and we’d have game days with all our employees where they would learn how to play different games. A customer could come in and describe their kid and we could say, “Oh, this game would be perfect for them,” or, “No, don’t buy that. It’s a word-based game and your kid doesn’t like words, because we know the kid, too, because he comes into the store.” And those employees generally couldn’t be minimum-wage employees. They had to be pretty highly paid. Even the hourly people that were subject experts had to be compensated, they had to be trained. That’s not something Toys R Us in its previous iterations did. You could walk into a Toys R Us and ask, “Hey, where’s the game aisle?” You could not necessarily walk in and ask any questions about specific games.
Lewis: If a company is not willing to make those kinds of investments in its employees to have a nice, rich expertise with them, the flip is that they need to be willing to offer some other type of experience that maybe isn’t as dependent on the employee but still gives the customer something. A couple of chains I think of with that are TJ Maxx and Ollie’s Bargain Outlet in particular. In that case, it’s the bargain hunting that they’re really giving people.
Kline: Costco fits in that vein as well. There’s a cool thing that you could do with a toy store where every time a customer comes in, you don’t know what you’re going to see. You change your displays a lot, you bring in interesting merchandise, you have a tie-in with something that isn’t just Christmas, maybe it’s a movie or something else that’s going on that’s not in the mainstream. But, again, doing that requires very active management. When I was running a single toy store, I could go to the distributor and notice that they were sitting on slot car sets tied to a movie that didn’t do well. I could buy those at $0.10 on the dollar, sell them at $0.30 on the dollar to very happy customers that don’t care that they’re getting Dukes of Hazzard slot car sets when nobody watched that movie. That’s not something that’s easy to do as a toy store, especially because you’re competing with Ollie’s and Big Lots and some of the other places — Costco — that are already doing that.
Lewis: One thing that’s pinched toys and gaming in particular, looking at industry trends here, is the fact that when it comes to video games and consoles and video game sales, they’ve been disintermediated. There was this great relationship where they sold the console, and then every single time you wanted a game, you were going back to either GameStop, Toys R Us, one of those big companies to get the next version of Madden or something like that. That’s not happening anymore, either.
Kline: That’s not happening. I think Toys R Us actually hastened that not happening. Obviously, you can download games. That’s generally how I buy games, is via download. On the other hand, if I want to play a game quickly, I still will go out to GameStop and buy it — or, really, if my kid was to play a game quickly, because I’m not playing a ton of games. Do you remember what it was like to buy a game at Toys R Us?
Lewis: Oh, it was a zoo!
Kline: You’d walk in, and all the games are locked up, sometimes behind a glass wall. Not even like at Target where it’s tethered and you have to get someone to get it for you, but you can at least flip it around and read the box. At Toys R Us, everything was behind security. You had to find someone. It was super unpleasant. I think that actually pushed people first to GameStop and then to digital downloads. That market’s not coming back.
Where Toys R Us could go with video games is, they could offer the experience of virtual reality headsets, come in and play for an hour, really high-speed connections, gaming tournaments. There are starting to be stand-alone places in malls — at least, our mall has one — that offer that. That’s definitely something you could have in a toy store. But how you turn that into revenue beyond just renting the headset or the setup for an hour becomes tricky because those are very pricey items that Toys R Us probably won’t be the cheapest source for.
Lewis: If listeners haven’t caught on at this point, we’re using Toys R Us as an example here to talk about a lot of companies that are doing things very well in the retail space. One name that we haven’t talked about, but I think absolutely deserves mention here, is Five Below.
Kline: I love Five Below! Five Below is growing super rapidly. I’m not dollar store guy, and Five Below has managed to straddle that line where it has, say, semi-disposable headphones that I know I’m going to break a million pairs, I’m going to lose them, I buy them for my son because he has no ability to not chew on his headphones and destroy them. That’s something you’ll learn when you have kids someday. But, also, you might find weird Japanese candy or a defunct flavor of soda that they bought all of, or a T-shirt that you could wear to paint the house because it costs $3. It’s a really smart business model based on having a core of value of certain items where you know you can always get, I don’t know, a big box of Junior Mints at a cheap price, and headsets and minor accessories, lightning cables, things like that. And, you never know, maybe today there’ll be yoga mats, maybe there’ll be kickballs, maybe there’ll be costume jewelry. It’s a really fun model and it’s exploding.
I think we both marveled online that they claim — and we didn’t verify this — that their average store buildout takes eight months to pay itself off. That’s not a number other companies ever report because usually, it’s three to five years. That’s a tremendous side that this concept is very expandable. They added 53 stores in the last quarter, and they’re growing pretty much as fast as can be.
Lewis: Yeah, it’s been a wildly successful concept. What’s kind of funny to me is, they’ve been around for quite some time. This stock has only recently caught up to a lot of the major investments they’re making in their footprint. You look at this business, they’re posting 20% year over year growth. Pretty incredible for someone in the retail space. A lot of that coming from the new stores they’re opening. I think their comps number is closer to 3% or 4%.
Kline: I think this story is a lot like Dollar General, which I’ve talked about on the show before. Investors are so hung up on same-store sales, they don’t look at the fact that when your top selling price is $5, there’s somewhat going to be a max for what your store reaches. What’s interesting about Five Below is that they very quickly can ramp up to that number, they can eke out a little bit — 2%, 3%, 4% — of same-store growth, but they can open another store five miles down the road, or six or whatever the exact number is, and do the same thing, because it’s not a store you’re really going to travel for, but it’s a store that draws very well wherever it is.
Another very important thing that makes this an attractive stock is Five Below doesn’t need to be in super expensive retail. It’s a destination on its own. Most of the ones that I’ve been to — and I’ve been to maybe five or six of them — are in secondary strip malls. They’re not even always at — if it’s a Target strip mall, maybe they’re really far away from Target, so you have to move your car to get there. That holds their costs down. It’s also sort of like a big strip mall store, but not a big box store, so their costs are also very well constrained.
Lewis: You were talking a little bit about the opportunity when you’re selling everything at $5 and below. Management is also experimenting with this $10 below concept. It’s clear they’re interested in iterating on this idea. I think that at its core, they’re providing a store experience that’s really fun for kids, too. At $5 or $10, most kids can go in with their holiday money, their birthday money, maybe their allowance or something like that, and feel like they can buy most things in the store, which is fun for kids.
Kline: We talked about how I used to bribe my son with a trip to Toys R Us. Now, I bribe him with a trip to Five Below. I could say, “You have a budget of $5,” and he could buy two things — a candy, a soda, a little electronic gizmo. There’s a lot of selection and a lot of fun. One of the things kids really like is having control. When you’re under 16, you don’t get to make very many of your own decisions. What you eat is controlled, some of what you wear is dependent upon your parents. So, walking into a store where, for a pretty limited amount of money, I can give you a lot of choices, that concept resonates really well.
Lewis: I was looking at the Five Below story, Dan, as we were doing the prep for this show, and admittedly it wasn’t a name I was super familiar with. But I started seeing all these metrics and I was like, “Wow, 20% year over year revenue growth, opening a lot of stores, that payback period on the stores that they’re building is really strong.” I think what makes retail investing so tough, though, is the concept is a winner, but the stock is trading at like 55 times trailing earnings, which is expensive for retail stock.
Kline: It is. But I think you have to look at this — I don’t want to say this is an internet-proof concept, but I’ve used some of those websites where you could buy dollar items and they show up three weeks later. And then, when it arrives, you’re like, “Why did I buy a dollar laser pointer that doesn’t work? Why did I buy a stylus for my iPad?” There’s an instant gratification of the Five Below model, and I don’t think that’s going to go away. I think we’ve seen with Costco that people are willing to walk into a store and make sort of dumb impulse purchases. With Costco, maybe that makes you more careful in the future. If you’re spending $3 stupidly, are you really going to change that habit? It’s really a price of admission that’s well worth it even if you make dumb purchases every time.
Lewis: To bring it back around to our conversation about Toys R Us, Dan, how are you feeling about the turnaround? I know most of the focus is going to be in Europe and overseas short term, but ultimately, this brand wants to get back into the United States in a more established retail presence. What do you make of that?
Kline: Dylan, have you ever seen a store go out of business in the United States and then make a big comeback?
Lewis: I have not, Dan. [laughs]
Kline: Have you have you been to Bradley’s? Caldor? Circuit City? Any of those made a big comeback?
Lewis: No, unless I’m visiting the retail graveyard, I don’t think I’ve seen any of those recently.
Kline: The reality is, some of those stores — Circuit City being one of the examples — had this sort of same “Oh, we’re coming back.” The only example I could give you of a brand that has come back is that Sharper Image closed all its stores, but now exists as a licensing play. I think there’s some market for Toys R Us to do holiday pop-ups, to do licensed products, maybe to be a store-within-a-store. On this show, I’ve talked about how JCPenney added toys to all its stores, but literally all they did was stuff a bunch of toys in their store. There’s no rhyme or reason to the selection. Nobody there knows anything about it. If they contracted out to a Toys R Us and said, “Why don’t you put a toy store in all of our stores?” If the dying remains of Sears did the same thing, there might be market for this. But I do not believe there is any logic to opening stand-alone Toys R Us stores, unless they’re tourist destinations in, like, New York and Las Vegas.
Lewis: Yeah, I actually wonder if the brand is as strong as we might think it is. We’re a little bit longer in the tooth than most kids. I wonder if my cousin’s kids, who are 8 to 12, even really have a strong association with Toys R Us the way that I did, where I was eagerly waiting for that holiday circular because that was the digest for gifts. I don’t think they have that experience.
Kline: No. My son doesn’t. Even though we went to Toys R Us a lot, it was just one of the places that sold toys. It was the place that had only toys, so that made it a little bit cooler. I do think there’s a concept of a stand-alone toy store that could work, but I’m talking they could launch 20 of them, not another 600 stores. They are much better off partnering, leveraging the brand name, taking advantage of the fact that the older generation knows what Toys R Us is, so it becomes a seal of approval. But the idea that there’s going to be a Toys R Us back in every mall, that just seems crazy to me.
Lewis: Yeah, I’m with you on that one, Dan. I think also, when you leave a space and other people are able to swallow up your market share so easily, as we’ve seen with big box and as we’ve seen with Amazon, that makes it a lot tougher to reenter, and I worry that they’re not going to be able to do that.
Kline: The thing we haven’t talked about much is that Amazon, Walmart, and Target can live with very slim margins. When I ran the toy store, we had to make, essentially, if it cost $10, we had to sell it for $20, it’s called keystoning in the retail world. There were some things that were less than that. Lego you weren’t allowed to sell at that margin. But in order to cover my overhead, that was basically what you had to do. Target needs to get you into the store so you buy groceries, so you buy a grill, so you buy furniture, whatever else you’re buying at Target. They don’t care if they only make 8% on toys or 0% sometimes.
Lewis: Yeah, to your point earlier, they want to make it easy for parents to shop if they have kids. If toys are the loss leader, so be it.
Kline: Yeah. That’s very hard to compete with. If you and I open up a sandwich shop next to Joe’s Free Sandwiches, our sandwiches would have to be pretty damn amazing so we could charge for them. And I’m not sure there’s room. Look, I ran a really cool toy store that does really well to this day, but that store had 75 years of history in that location, all sorts of museum-level things drawing people to it, and a very active owner who changed things up and made the merchandise cool. And I’m not sure you can bring that independent vibe to a chain of toy stores. I’m not even sure a chain of toy stores can buy in some of the ways that you have to to make an independent toy store work. So, again, have Barnes & Noble bring Toys R Us in as their toy brand, have JCPenney do it. Put toy stores in Best Buy, that would work. But don’t open your own stand-alone stores. It’s just a march to another bankruptcy.
Lewis: So, we’re not buying the retail presence of Toys R Us 2.0. But perhaps in this whole lesson here, there are some good investing takeaways for folks.
Kline: Yeah, absolutely. You should look at retail models that work and require you to go into the store. Five Below, I don’t know if they have a website. It doesn’t make a lot of sense for them to have one. But let’s pretend they do. My experience at Five Below is just, what am I going to see? What am I going to buy? Maybe I went in because I was going to buy candy before the movies, and I see that there’s a deal on a few other things I need, so I end up spending $18 instead of $3. That model has proven to work over and over again. You mentioned TJ Maxx. I mentioned Costco. Those are the sustainable brands, especially ones that have huge growth potential. Five Below has leverage when it looks for locations. It can go to developers and say, “Hey, I’m a draw. You need tenants. I get a better deal.” They’re going to be in a very favorable real estate position for quite a while.
Lewis: All right, Dan, a pleasure as always chatting with you! Thanks for hopping on the show!
Kline: Thanks for having me!
Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or you want to reach out and say hey, you can shoot us an email over at firstname.lastname@example.org or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes or Spotify, or you can check out videos of this podcast over on YouTube. As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against stocks mentioned, so don’t buy or sell anything based solely on what you hear. Thanks to Dan Boyd for all his work behind the glass. For Dan Kline, I’m Dylan Lewis. Thanks for listening and Fool on!