Of course Toys R Us has filed for bankruptcy protection. We’re in the midst of a retail apocalypse. Brick-and-mortar chains are losing market share to e-commerce. Big box and mall-based stores are suffering from declines in foot traffic. Kids—even little kids—prefer tablets, phones, and screens to toys and games. Live births have fallen since the onset of the Great Recession, so there are fewer toddlers for which to buy stuffed animals. How would you expect Toys R Us to survive in the Amazon age?
And yet, in some ways, this was not inevitable—or it was not inevitable that Toys R Us would meet its end as a viable company so soon. In the New York Times, Kevin Roose writes this week about how Best Buy, another big-box retailer beset by competition from e-commerce whose products are subject to massive deflation, is actually doing quite well. “Revenue figures have beaten Wall Street’s expectations in six of the last seven quarters,” Roose writes. “The company’s stock price has risen more than 50 percent in the past year. Workers are happy.”
What accounts for the difference? In two words, the balance sheet. And in one word, management. Toys R Us was owned and run by financial engineers when what it needed most was some business re-engineering.
In 2005, Toys R Us was taken private by a consortium of private equity investors—KKR, Bain Capital, and Vornado Realty Trust—for $6.6 billion. In recent years private equity investors have talked a good game about how they improve businesses. But the reality is they use a blunt instrument to impose discipline on the managers they hire to run their companies: debt.
Leverage can be a powerful motivating tool—unless you stay current on your debt, you go bust and surrender ownership. Businesses with large debt loads often act with great urgency to restructure, to cut costs, and to rationalize so they can be sure they have the cash to survive. This exercise often makes companies stronger and more valuable. The tactic works particularly well in industries where managers can rely on steady growth and don’t have to fret too much about fundamentally reinventing the business.
But this modus operandi has its limits if you’re in a deflationary environment and have a tough time maintaining positive margins. And it especially has its limits if your industry is facing fundamental, life-threatening disruption, like, say, Amazon. In these instances, the necessity to pay interest first crowds out other investment. Every penny you spend making bondholders and banks whole is a penny not spent on building new payment systems, constructing whiz-bang superefficient distribution centers, acquiring labor-saving robots, sprucing up stores so that they are more appealing to customers, or raising wages so you can attract and retain the best salespeople and managers in an increasingly competitive labor market.
There’s no guarantee that retailers who successfully make such investments will thrive. But if you’re not trying that hard, there’s no way to keep up with better capitalized competitors. Unfortunately, for the past decade, while it should have been aggressively reinventing itself, Toys R Us has been laboring under $5 billion in debt used to finance the acquisition. In 2016, a year in which Toys R Us sales fell 2.2 percent to $11.5 billion, the company spent $457 million on interest payments on its $4.6 billion in long-term debt. By comparison, the company’s operating income for the whole year was $460 million. Put another way, after paying interest, Toys R Us had only a few million dollars to invest.
Best Buy provides a good example of how to turn around a company in the same position as Toys R Us. The companies were suffering from all the same macro woes. And electronics is a brutal business. But Best Buy’s CEO is a professional business engineer, not a financial engineer. As Roose notes, since taking over in 2012, Hubert Joly, a former McKinsey consultant, has managed a turnaround by focusing on low prices, investing in customer service (so that people could have consultations on products before buying), revamping stores so they have dedicated kiosks for popular manufacturers like Apple, and quietly cutting costs.
In the most recent fiscal years, Best Buy’s sales were essentially flat at $39.4 billion. But the chain, whose sales are nearly four times larger than those of Toys R Us, has only $1.4 billion in debt—about one-third the total Toys R Us has. In all of fiscal 2017, Best Buy spent only $72 million on interest—just .2 percent of its revenues, compared with 4 percent of revenues for Toys R Us. The sharply different financial profile means that Best Buy, for the past several years, has had a far greater ability to use the cash flow it generates to pay for investments that bolster its competitive standing instead of simply channeling it all to interest payments.
Toys R Us could have borrowed from Best Buy’s playbook and added some wrinkles: strengthen its logistics systems so it could compete on price with Amazon, create party and play spaces for kids, spend more to hire employees who will engage children, offer toy and gadget repair. Ultimately, Toys R Us was undone by the lack of the precise attribute that it aims to appeal to in its core customers: imagination.