EE Economic Environment Dominance by high-profile, cost-efficient companies is making it difficult for new entrants in this industry to attract customers and secure a spot in the market. 80 May 2013 The RMA Journal
by Lindsay Holloway Today, Lincoln Logs and Lite-Brites are considered retro, and the days of visiting the local mom-and-pop toy store are a thing of the past. The hobby and toy stores industry has been through some big changes over the past few decades and even more so in the past five years. Stores are struggling to remain relevant as big-box discounters and web-based retailers increasingly dominate the playground. On top of landscape shifts, stores in the industry are also struggling to turn a profit. Upstream manufacturers are raising purchase costs as they produce more expensive electronic toys to keep up with changing consumer preferences. They also are in a battle against increasing prices for inputs, particularly steel and plastics. Tightening market conditions during the recession only exacerbated the industry s struggles, especially when per capita disposable income declined for the first time in 18 years, dropping 3.6% in 2009. Spending dropped nationwide, and consumers curtailed purchases of discretionary products like those sold at hobby and toy stores. Despite making adjustments, such as expanding their product offerings or launching a retail website, many hobby and toy stores couldn t survive the tough operating conditions. Small and independent shops were forced to close or were acquired by larger companies. As a result, the number of companies in the industry has fallen at a steady clip over the past five years. And as larger surviving companies closed their unprofitable shops, the total number of store locations dropped at a similar rate. Although the saturated industry experienced a slight uptick in 2011 as the economy slowly turned around, the number of companies and store locations has been contracting each year for the past decade, according to market research firm IBISWorld. Steady consolidation in the already highly concentrated hobby and toy stores industry has caused market share concentration to increase over the period. The industry s top four companies accounted for about 87.0% of total industry revenue in 2012, up from about 82.0% in 2007. Spending Plummets during the Recession As the recession caused per capita disposable income levels to contract, consumer sentiment plunged 25.5% in 2008 and consumer spending fell nearly 2.0% in 2009 after declining 0.6% in 2008. Although the drops in consumer spending may not appear drastic compared with other metrics, they were the first in a nearly 30-year streak of positive growth. The rapid deterioration in the housing and financial markets led to a simultaneous tightening of credit and high unemployment, crippling incomes and preventing consumers from maintaining their spending habits. Understandably, expenditures on discretionary goods took the biggest hit. Because products that hobby and toy stores sell are largely discretionary, these purchases were the first to go when consumers tightened their purse strings. And when people did shop for toys and crafts, they bought fewer big-ticket items and sought out the cheapest prices, often found at big-box discount stores or online retailers. As a result, revenue of the hobby and toy stores industry dropped 3.1% in 2008 and 1.5% in 2009, according to IBISWorld. May 2013 The RMA Journal 81
Risk Rating Figure 1 6.5 6.0 5.5 5.0 4.5 4.0 Overview of the Hobby and Toy Store Industry Yearr 04 05 06 07 08 09 10 11 12 13 Industry Risk Division Risk: Retail Trade Economy Risk: Entire US Economy Supercenters Changing the Retail Game Although individual stores compete with one another within the industry, their biggest competitors actually operate in other industries. In particular, mass merchandisers and discount stores like Walmart, Target, and Costco pose the biggest threat to hobby and toy stores a threat that resonates across the larger retail sector. In fact, Walmart has been the leading national toy retailer since the early 1990s, according to Bloomberg Businessweek. Warehouse clubs and supercenters have been one of the fastest-growing industries in the retail sector, according to IBISWorld. Even when household budgets were strained during the recession, this industry expanded as new valuefocused shoppers looked to the lower prices at discount stores. Because warehouse clubs and supercenters sell comparable products to those at hobby and toy stores (in addition to other general merchandise), customer visits to toy stores have slowed in favor of the lower prices and one-stop shopping available at supercenters. These stores are able to offer heavily discounted prices by leveraging their size. Their significant economies of scale allow them to source directly from manufacturers that they have relationships with, effectively avoiding costs associated with the middleman, and to purchase inventory in bulk at lower prices. The companies are then able to pass on these cost savings to customers. Most hobby and toy stores are small independent operators an estimated 18,923 companies are operating 21,409 stores in 2013 so they don t have the size or cash reserves to negotiate favorable contracts or make bulk purchases. IBISWorld estimates that more than 70% of industry companies in 2012 were single-owner or family-run enterprises. (See Figure 1 for an overview of the industry.) E-tailers Continue to Steal Shoppers Further competition stems from online retailers of hobby goods and toys. The growing trend toward online shopping has been taking the greater retail sector by storm, and the hobby and toy stores industry is no exception. Every year, more than 100 million Americans purchase goods from the online retail marketplace. The e-commerce industry is one of the fastest growing in the United States, with thousands of retail and auction websites popping up each year. Given strong growth in the percentage of households with at least one computer, the number of broadband Internet connections, and the percentage of services conducted online, online retail industries, including those specializing in toys and hobby goods, have been expanding steadily. Like with most online retailers, shopping at web-based hobby and toy stores has risen in popularity because these outlets offer customers convenience and the ability to compare products and prices. Because e-tailers don t operate storefronts and have no rent and staff to pay, overhead costs are generally lower, so the e-tailer can pass the cost savings on to customers. Additioally, online toy and hobby stores often offer discounted or free shipping, which increases the value and convenience of shopping online versus visiting a hobby or toy store. Rising Purchase Costs Strain Profits As the primary supplying industry, manufacturers of toys, dolls, and games have a strong influence on hobby and toy stores. In turn, these manufacturers are dependent on producers of toys key inputs, such as steel, plastic, and resin. Over the past five years, prices of these inputs have been rising steadily. According to the Bureau of Labor Statistics, the price of plastic materials and resin increased at an average 82 May 2013 The RMA Journal
annual rate of 3.5% from 2007 to 2012. This ascent includes spikes of 9.8%, 10.1%, and 9.4% in 2008, 2010, and 2011, respectively. Although the price actually dropped from 2012 to 2013, it is forecast to continue on its upward trend through 2018, increasing an average of 2.5% per year. Meanwhile, although they are expected to level out in the coming years, steel prices also increased at a steady rate over the past five years, showing similar spikes in 2008, 2010, and 2011. Rises in input prices have rippled through the supply chain, making hobby goods and toy production more expensive and increasing purchase costs for wholesalers and retailers. In addition to the higher input prices, stores inventory costs have also increased in line with the growing popularity of electronic toys and games. As toy manufacturers innovate and children gravitate toward more advanced toys, the youth electronics segment has expanded significantly in the past five years Research and development of electronic toys, which often require semiconductors, involves substantial costs and thus makes them more expensive to produce. Once again, manufacturers are passing these costs on to toy wholesalers and retailers. Given greater costs and no comparable increase in demand indeed, demand fell during the recession industry profitability has contracted considerably. Thinning margins rendered some hobby and toy stores helpless, pushing down the number of locations 7.5% in 2009, following the 2008 input price spikes. Struggling Shops Close and Consolidate The inhospitable operating environment left many hobby and toy stores no choice but to shut down. Small companies with only one or two locations were forced to exit the industry completely, while larger companies closed unprofitable locations and focused on boosting margins at surviving ones. As a result, IBISWorld estimates the number of companies in the hobby and toy stores industry fell from 21,782 in 2007 to 19,133 in 2012, representing an average decline of 2.6% per year. Similarly, the total number of store locations dropped an annualized 3.0% over the period, to 21,733 in 2012 and an annualized 3.0% from 2007 to 2012. Other consolidation occurred as some of the industry s larger companies acquired competitors to expand Figure 2 Hobby and Toy Stores Risk Rating Risk component Weight Score Structural risk 25% 4.77 Growth risk 25% 5.34 Sensitivity risk 50% 4.74 OVERALL RISK 4.90 product offerings, geographic reach, and market share. These more fortunate operators not only have the capital to buy out niche players and expand, but can also leverage their size to keep costs low the way warehouse clubs can. Leading toy retailer Toys R Us holds a market share of 47.7% and operates nearly 900 stores nationwide (which includes its Babies R Us stores). Like its external industry competitors, the company s size gives it significant buying power to achieve lower unit costs and access to exclusive product agreements with manufacturers. Notable acquisition activity in the industry occurred in 2009, when Toys R Us acquired troubled competitor KB Toys and high-end brand FAO Schwarz. KB Toys 460 stores were shuttered that year, but FAO Schwarz continues to operate as a successful toy retailer under Toys R Us Inc., having celebrated its 150th anniversary in 2012. Acquisition activity has also contributed to the industry s falling number of enterprises. Efforts to Bolster Profits Closing unprofitable stores helped some industry players withstand tightening margins, but it wasn t enough to keep overall industry profit from declining over the past five years, especially since the majority of companies are singlestore operators. Hobby and toy stores nationwide engaged in various cost-cutting measures to reduce expenses in a period of falling demand. In addition to employee reductions due to closed stores, owners of surviving stores cut staff and wages where possible. Behind purchase costs, employee compensation is the second-largest industry expense, according to IBISWorld estimates. Even during times of high demand, such as the holiday season, hobby and toy stores lowered wage costs by hiring temporary or parttime workers. In a similar strategy, some companies launched pop-up stores to maximize sales potential during the busiest shopping season. These temporary stores, which are much smaller than regular stores and offer a limited May 2013 The RMA Journal 83
20 15 MATURITY Company consolidation level of economic importance stable QUALITY GROWTH High growth in economic importance, weaker companies close down developed technology and markets KEY FEATURES IN A MATURE INDUSTRY Revenue grows at same pace as economy Company numbers stabilize; M&A stage Established technology & processes Total market acceptance of product & brand Rationalization of low margin products & brands 10 % OF GROWTH IN SHARE OF ECONOMY 5 0 Used Goods Stores Hobby & Toy StoresX Toy & Craft Supplies Wholesaling Computer Stores Fabric, Craft & Sewing Supplies Stores QUANTITY GROWTH Many new companies, minor growth in economic importance, substantial technology change -5 Used Goods Stores DECLINE Shrinking economic importance -10-10 -5 0 5 10 15 20 % OF GROWTH IN NUMBER OF ESTABLISHMENTS selection of merchandise, save a company on inventory, rent (through smaller square footage and shorter leases), wages, and other overhead costs.toys R Us, for example, opened 656 Toys R Us Expresses throughout shopping centers worldwide during the 2010 holiday season. This strategy helped the company boost revenue 2.2% in 2010 after two years of declines. Some companies expanded their product offerings to be more competitive and to include higher-margin products. Although sales of youth electronics slowed briefly after peaking in 2007, according to the Toy Industry Association, electronic toys and games remain a popular product segment in the industry as kids increasingly demand more advanced and adult-like toys. These products do cost retailers more initially because they are more expensive to manufacture, but their wider profit margins generally benefit sellers. A Risky and Lackluster Outlook Despite valiant efforts to stay profitable, overall the industry saw its profits fall from 2.6% of revenue in 2007 to about 2.0% in 2012. Although the hobby and toy stores industry is in the mature stage of its life cycle, profit, revenue, and company and store numbers have all been falling over the past five years. IBISWorld expects the industry outlook to strengthen only slightly, with revenue and profit staying relatively flat. As a result of the tough operating conditions, IBISWorld estimates that overall risk in the hobby and toy stores industry will be moderate. As shown in the table, growth risk, which makes up one-quarter of an industry s total risk score and evaluates expected future performance, is relatively high at 5.3 (on a scale of 1 to 9). Figure 2 shows the overall risk rating for the industry. The industry is expected to stay highly competitive and highly concentrated. The most significant threat to prospective entrants or lenders is the level of external competition from both mass merchandisers and e-tailers. As in the past decade, these alternate craft and toy retailers will continue to entice consumers with their lower prices and convenient shopping. Potential entrants or lenders to the industry also need to consider the level of market dominance exerted by the industry s three largest players. Dominance by high-profile, cost-efficient companies makes it difficult for new entrants to attract consumers and secure a spot in the market. And as these dominant companies continue to leverage their economies of scale and expand their market share, small companies, both new and old, will have a tough time competing in the foreseeable future. Lindsay Holloway is a research editor at IBISWorld. Contact her at Lindsayh@ibisworld.com. 84 May 2013 The RMA Journal