Toys R Us' poor holiday sales cast doubts on its future

Key Points
  • Toys R Us' profit margins were squeezed as Amazon and big-box retailers slashed prices to bring customers into their stores.
  • Toys R Us discounted roughly 10 percent more of its products in holiday 2017 compared with the prior year, according to Market Track.
  • Poor holiday performance may force the retailer to renegotiate the terms of its debt with its lenders.
Goods at the Toys R Us store are marked down in price as the company faces bankruptcy.
Tony Margiocchi | Barcroft Images | Getty Images

Holiday sales this past year ballooned, but those riches didn't extend to Toys R Us. The bankrupt toy store missed significantly on every number that mattered, sources say, likely forcing the retailer to renegotiate key lending terms.

Sales were down more than hoped as was traffic and the amount of toys in stock it got out the door. Meanwhile, its profits were squeezed as Amazon and big-box retailers Target and Walmart slashed prices to reel in customers. For these retailers, toys could act as bait, with the hope that once shoppers came for the toys they would also purchase other items with higher profit margins. Toys R Us doesn't have any such buffer.

Toys R Us discounted roughly 10 percent more of its products in holiday 2017 compared with the prior year, according to Market Track. The company had a "material miss" on its holiday sales, said a person familiar with the results. This at the same time Amazon said it had its best year across the board.

The poor holiday numbers may require Toys R Us to renegotiate the terms of its debt with its lenders, sources say. They will hover over Toys R Us as it works with debtholders over the next couple of weeks to draft its plans for moving forward. The lenders will have to determine if the Toys R Us business plan is supportable, said the sources.

Toys R Us is shutting stores in these states
Toys R Us is shutting stores in these states

Toys R Us needs help from debtholders and the largest toy companies — Mattel and Hasbro — in order to emerge from bankruptcy protection by the summer as planned, sources say.

Mattel and Hasbro need confidence not only in Toys R Us' ability to emerge from bankruptcy, but also the retailer's ability to escape the same fate twice. One Toys R Us bankruptcy filing already materially impacted both of their businesses.

The sources requested anonymity because the information is confidential. Toys R Us declined to comment.

The Wayne, New Jersey-based retailer last week announced plans to shutter roughly 180 stores across the country, or about one-fifth of its U.S. store fleet, in an effort to focus on its most profitable stores. (Here's a map showing where Toys R Us stores are going dark.) The retailer has roughly 66,000 employees worldwide.

Toys R Us filed for bankruptcy in September, weighed down by $4.9 billion in debt. Those obligations were a vestige of its $6.6 billion acquisition by , Bain Capital Partners and real estate investment trust Vornado Realty Trust in a 2005.

Under bankruptcy protection, the retailer had thought it would be afforded the financial flexibility to drive its turnaround. Toys R Us is opening "play labs" to make its stores more "experiential," a favorite buzzword among retailers trying to create reasons for shoppers to come through the door.

But the challenges for Toys R Us may be more fundamental than investors had thought.

Shopping habits have materially changed, as parents flock to Amazon and other online vendors.

For brick-and-mortar retailers, it isn't as easy as simply investing in e-commerce. It is expensive to build out an effective online platform, and it is costly to ship items. When shoppers buy online, a store also can miss out on impulse buys shoppers are more likely to make in the store.

Meantime, toys don't have the appeal that they used to, as children look elsewhere to gadgets for entertainment, one of the season's top performers.

"What's the advantage of having a store [devoted to one thing] unless you have something to go to that place for. Toys doesn't do it anymore," said Gerrick Johnson, an equity analyst at BMO Capital Markets.

Toy woes have carried over to Mattel and Hasbro, both of whom have already been battered by Toys R Us' bankruptcy. Mattel in October suspended its quarterly dividend and its bonds have since been downgraded by credit ratings agency Moody's. Mattel in particular has struggled to evolve from its Barbie past.

"Mattel's business (desperately) needs reinvestment in order to stimulate sales growth and engage consumers on a sustained basis. Brands are tired and lack relevance in a millennial
parent led marketplace," wrote analysts at Jefferies this November.

The theory has long been that Mattel and Hasbro will unconditionally support Toys R Us by continuing to ship goods and offering flexible financial terms, because the retailer is so intrinsic to the health of the toy industry. Toys R Us sells more toys year-round than its competitors and discounts less.

But as challenges deepen, it has become a vicious circle: the toymakers need Toys R Us to support the industry, but the industry has become so weak they may not have the strength to prop it up.

WATCH: The rise and fall of Toys 'R' Us

The rise and fall of Toys 'R' Us
The rise and fall of Toys 'R' Us