One reason an investment should be sold is if the original investment thesis has been impaired. This could occur for many reasons, but in the case of Toys R’ Us, intense competition from both diversified retailers such as Walmart as well as online competitors caused Toys R’ Us to no longer be the low-cost and most convenient retailer of toys. In this article, I will put myself in the shoes of a Toys R’ Us investor in the 1980s to see if there were any signs of this narrowing of the moat and to see what the results would’ve been if the stock was sold when the evidence was convincing.
The investment thesis
Charles Lazarus founded Toys R’ Us, a discount toy retailer, in 1957. By 1966, it generated $12m in sales. However, the company needed funds for expansion, so Lazarus sold it to Interstate Stores for $7.5m in the same year. Unfortunately, Interstate’s overextension led to bankruptcy following the recession of 73/74. In 1974, Lazarus took charge of restructuring and focused on the profitable Toys R’ Us chain by selling off unprofitable divisions.
Lazarus’s unique pricing strategy set Toys R’ Us apart from its competitors. He offered the most popular items at little or no profit, leading customers to assume that Toys R’ Us was the lowest price retailer, and therefore do the rest of their shopping there.
In 1979, Toys R’ Us earned $17m in profit on $349m in sales and had 72 stores, up from 51 in 1974. By 1981, Toys R’ Us had 101 stores and achieved $750m in sales, with its market share in the US toy market increasing from 5% in 1978 to 9% in 1981.
In a nutshell, the investment thesis was based on the following features:
- Toys R’ Us had the founder running the business, who had demonstrated a strong track record of running the operation.
- They were one of the lowest-cost toy retailers, were growing rapidly and still had a huge runway.
- Therefore, the investment thesis in 1981 was that the business would use its scale to continue to offer the lowest prices, therefore continuing to grow its market share, profits and ultimately intrinsic value.
As of 1981, the business had $750m in sales, and assuming a 5% profit margin (the figure they earned in 1979), they would’ve been earning roughly $37m in profit. Let’s assume an investor made this bet in 1981 at a $700m market capitalisation, valuing the company at 20x earnings.
Results of Toys R’ Us between 1981 and 1995
In the years following this hypothetical investment in 1981, the results of the company were as follows.
As we can see above, the next fourteen years were very prosperous for Toys R’ Us. Furthermore, in 1988, it was reported in the Wall Street Journal that Toys R’ Us sold $330.80 worth of merchandise per square foot annually, with Child World selling only $221.70, and Lionel just $193.10. Average sales for a Toys R’ Us store were $8.4 million; Child World, $4.9 million; and for Lionel, $4.4 million. This provided some evidence of how well Toys R’ Us was doing during this period.
If the investor held their stock over this period, the market capitalisation would’ve grown from the $700m purchase price to a high of $11b in Q4 1994 or a low of $6b in Q4 1995. The investment results would’ve been a 15 bagger as of Q4 1994 (23% annualised return) or an 8 bagger (16% annualised return) at the low of 1995.
The sell decision
As of 1995, Toys R’ Us had grown into a huge company, stretching multiple different retail chains (such as Babies R’ Us and Kids R’ Us) and 1,115 stores. However, they had now reached a 25% market share in the United States, and were seeing growth rates slow in recent years.
The original thesis was that Toys R’ Us would use their scale to maintain the lowest prices in the market thus being able to consistently gain market share and grow over time.
As of 1997 however, Toys R’ Us had seen their US toy market share reduce to 18.4%, down from 25% in 1990. During this period, Walmart, one of its intense competitors, increased their share from 9.5% in 1990 to 16.4% in 1997.
Before 1990, Walmart had avoided the low-margin toy sector for years but began stocking up on toys using them as loss leaders to get customers into its stores. This was a major setback for Toys R’ Us because their competitive edge of being the lowest-cost retailer was being impaired. It is very difficult to compete with another business that is willing to operate on such low margins. In Walmart’s case, toys would’ve been a very small component of their sales, so operating on very low or negative margins in this category wouldn’t have made much of an impact on their overall results. However, if Toys R’ Us attempted to match this, they would’ve simply been losing money.
This new competitive landscape led to falling margins for Toys R’ Us too, seeing their net profit margin fall from 6.7% in 1990 to 4.3% in 1997.
Management noted that 1998 was “a year of enormous challenge and change”. The CEO noted that comparable sales declined by 4% while international same-store sales declined by 2%. However, the letter stated that the reasons for these results were a combination of overall toy industry weakness, retail price deflation of video games and deflationary impacts of clearance sales. It would’ve been up to the investor to decide whether these headwinds were temporary or whether there was an impairment to the competitive edge. The market share decline from 1990 to 1997 points to the issues being secular and indicative of a narrowing of the moat.
In 1998, the company reported a net loss of $132 million, after incurring $698 million of gross restructuring charges. While management noted that these restructuring costs led to an improvement in the business, with underperforming stores being closed down, several distribution centres and administrative offices being consolidated, and same-store inventories reducing due to taking aggressive markdowns on clearance products, these decisions also signalled that Toys R’ Us was in a much tougher position compared with the 1980s.
The company also began taking on more debt than in the past, increasing its long-term debt-to-equity ratio from 10% in 1990 to 22% in 1997.
Given the circumstances, an investor should have chosen to sell the stock. Selling need not have been a rushed decision. As Mohnish Pabrai explains, “One thing about selling is you don’t need to rush; you can be sloppy on the selling.” The investor could have sold between 1995 and 1998, after seeing convincing evidence that Toys R’ Us’ market share and competitive position was weakening. If they did this, they could’ve earned anywhere between a 14x return (selling for a market capitalization of $10 billion) or a 5x return (selling for a market capitalization of $4b).
The following chart illustrates the lowest and highest market capitalization Toys R’ Us traded for between 1994 and 2001:
Summary
This case study serves as a powerful reminder of the importance of assessing a company’s competitive advantage and being vigilant about any impairments over time. If the investor sees evidence that goes against their original investment thesis, selling is the right course of action. It also shows that the reduction in the size of the moat can be seen in the numbers.
Another consideration from this case study is that oftentimes an investor has a considerable amount of time to convince themselves that the evidence they are seeing is more “signal” than “noise” and should still be able to sell and achieve satisfactory results.
Thank you for reading!
