families worldwide. I would argue that while most of those consumer dollars would not otherwise have been spent on toys, some of them would have been, especially as this generation matures, prices come down a bit, and the library of family-friendly games grows. In other words, video games didn’t matter much to overall toy sales last year, but the same is unlikely to be true in 2014. We track the prices of several commodities that are either important inputs to toy manufacturers or have an impact on overall consumer sentiment, including resin, zinc, steel, cotton, paper, memory chips, and gasoline. Assuming current prices hold, most of these commodities will be pretty close to the average levels seen in 2013, so, barring a sudden spike (always a possibility), a modest price increase should cover cost increases. One input cost I don’t have good data on is labor, but anecdotally I hear it’s rising rapidly in China and is likely to continue to do so for a host of reasons. Now, let’s talk about the gorilla in the room—Toys “R” Us. It was at Toy Fair last year that Jerry Storch announced he was stepping down as CEO, but remaining on as chairman of the board. Since then, the company named Antonio Urcelay as CEO (first on an interim basis, and then permanently, although Urcelay will continue to be based in Spain). Total sales were down 3.4 percent in the October quarter, the
FEBRUARY 2014
ninth consecutive quarterly sales decline. Same-store sales for the holiday season fell 4.7 percent in the U.S., and 3 percent outside the U.S. Gross profit margins, which rose year-over-year in every quarter of 2012, showed a decline in each of the first three quarters of 2013. Total debt of nearly $5.7 billion is barely lower than it stood right after the buyout more than eight years ago, although it has been restructured in a way that leaves no material repayments due for several years. Toys “R” Us is the largest specialty retailer of toys, but not all that the chain sells is traditional toys. In fact, the weakest categories in recent years have been video games (which it classifies as “entertainment”) and juvenile products. The two categories that represent traditional toys are what Toys “R” Us calls “core toys” and “learning,” and these categories combined have done significantly better than the company’s total sales, posting flat to higher sales on an annual basis from 2009 through 2012, and most of the quarters in that period. But even these categories are down about 2 percent worldwide in the first three quarters of 2013. Vornado, which owns about a third of Toys “R” Us, recently said it may be required to write its investment down to zero. This may be largely the result of an accounting treatment, but it’s certainly not what the company had in mind in 2005.
An industry that barely grows in pace with inflation cannot afford to have one of its largest customers, which accounts for a double-digit percentage of most companies’ sales, be the source of continual concern. My prediction for 2014 is that Toys “R” Us will continue to cut costs, and may benefit from a rise in births as well as a long-overdue uptick in video game sales. But the fundamental challenges posed by traditional brick-and-mortar rivals, as well as the burgeoning market share of Amazon and other online rivals, will not fall away any time soon. It is probably in the near-term interests of many toy industry players that Toys “R” Us continues to be healthy enough to support the category year-round through promotion, displays, and test marketing. But it’s also critical that the company reinvent itself enough to survive. Storch and his team pulled many levers to grow sales and profits, and many of them worked, at least for a time. The company will need even more creative solutions in the future. ■
Sean McGowan is a managing director in the equity research department of Needham & Co., a New York-based investment bank. He has been covering toy stocks since 1986, and has also covered video games, juvenile products, sporting goods, and consumer electronics.
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