Why Are Toys Such a Bad Business?

Plus! V-Shaped Recovery, Tech Sees Like a State in Indonesia, Clever Currency Games, more...

Byrne Hobart Byrne Hobart

This is the once-a-week free edition of The Diff, the newsletter  about inflections in finance and technology. The free edition goes out  to 8,221 subscribers, up 211 week-over-week. This week’s  subscribers-only posts:

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In this issue:

Why Are Toys Such a Bad Business?

Early-stage investors sometimes use the heuristic that if a product  gets derided as a toy, it’s worth investing in. That model would have  gotten you into PCs in the 70s, the Internet in the early 90s, social  networks when the good ones were privately-held, cryptocurrencies, and  drones. The risk is investing in actual toy companies, which is usually a  terrible decision. Hasbro stock hasn’t done anything for half a decade,  and Mattel trades where it did in the early 90s. JAKKS Pacific has  destroyed most of its shareholders' wealth, and Funko is working on the  same.

This is not a new phenomenon, either. The biggest toy company in the  US in the 50s was Louis Marx & Company, whose founder made the cover  of Time. Sales declined slightly over the next decade, and  faster after that; the company was bankrupt in 1980. Coleco rode the  Cabbage Patch Kids trend in the mid-80s—in 1985, they had the highest  return on equity of any company in the Fortune 500—but they were bankrupt by 1988.

The record is no better for retailers. Toys R Us is bankrupt, of  course, and they followed FAO Shwarz, KB Toys, Right Start, and Zany  Brainy.

The toy industry has not been kind to investors, at any level.

There are a few reasons, and a few relevant lessons.

First, the toy business operates on an annual cycle. Historically,  about 40% of toy sales happen during the holiday season, and about half  of those were in the two weeks before Christmas. (That’s a dated  statistic, from about twenty years ago. Discretionary retail sales in  general have gotten spikier, since more shoppers are used to fast, free  shipping. With Amazon Prime, the Christmas shopping season starts on  December 22nd or so.) 84% of US toy sales come from China, transported  by a mix of ships and air freight, so they need to be ordered months in  advance.

And they have to be marketed: while cheap toys can compete on price,  the higher-margin ones only get sold when there’s an effective ad  campaign. Mattel created this model (and overturned Louis Marx’s  price-first approach) when they spent their entire net worth on a  one-year sponsorship of The Mickey Mouse Club in 1955.

TV ad campaigns, too, tend to be purchased in advance. About half of  TV ad spending is allocated to the upfronts—booked March through May to  be delivered by the end of the year.

This locks toy companies into a challenging bet. Every year, they  have to a) predict trends, b) invent them, and c) commit capital to  them. All without knowing how the rest of the year will turn out. Since  toy trends exist, but don’t last for very long, they have to invent new  products every year—but the technological state of the art doesn’t  advance very fast. It has all the volatility of tech, without the  progress.

A handful of companies have made serious money in toys, or, rather,  in toy-like or toy-adjacent businesses. The video game industry has  generally done well. Disney turns a profit. And Games Workshop has a  nice little business. (I wrote up in The Diff in April—note that I’ve since sold the stock, just for valuation reasons) . Lego, too, is a great business, worth an estimated $15bn.

What these companies have in common is that they escape the  demographic trap that toy manufacturers are locked into. Every year,  there’s a new cohort of six-year-olds, and they need something that a)  didn’t exist last year, but b) appeals to timeless six-year-old  sensibilities. They don’t have much brand loyalty, because a year later  the same toy is a toy for little kids. Each of these successful  companies beats that in a different way:

These companies have something else in common: they own their core  intellectual property. Video game publishers do make games based on  superheroes and sports leagues, and Lego certainly has branded sets, but  the core of each business is IP owned by the company itself; the  licensed products are a lucrative side business: it’s much easier for a  video game company to re-skin characters than for a movie company to  start a video game studio. As a case study, one popular game was originally intended to be set in the Game of Thrones universe, but ended up using in-house IP instead.  Disney, of course, sells toys based on its own characters. And while  some Lego sets are associated with outside brands at the point of  purchase, they inevitably end up being fungible with other Legos.

Because it’s a hit-driven industry, toy companies that succeed can be  immensely profitable for a while. The problem is that the difference  between a cultural landmark and a fad is visible after a decade or so,  while the decision of how much to order and how much to spend on  marketing has to happen every year regardless. So toy companies with a  hit product in year N tend to be bankrupt companies writing down the  value of their inventory to ~$0 in year N+3 or N+5.

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Elsewhere

V-Shaped Recovery is Here…

… just not evenly distributed. And not likely to last. In Japan, Uniqlo expects Japanese sales to be up 25% Y/Y in their August quarter,  after a 15% decline last quarter. Their regional estimates are very  much virus-driven, with optimism in China and pessimism in countries  seeing a second wave, or, in the US’s case, a 1.5th wave. And worldwide PC shipments grew in Q2, mostly due to the one-time build-out of home offices and Zoom-based schools. In China, auto sales were up 10% in Q2 ($), and China’s copper smelting is also rising ($).

Inventory restocking used to be a significant driver of GDP growth:  when the economy slowed, companies had too much inventory on hand, and  had to cut jobs to work through the excess. Once they ran out, they had  to rehire fast. Now, supply and demand for manufacturing are located in  different places (with different policies), and companies are more  averse to holding inventory for long periods, so this model isn’t as  descriptive or predictive as it once was. When the people getting fired  are the ones providing demand, it’s easy for a recession to feed on  itself, and easy for a recovery to bootstrap itself, too. When those  groups are in different countries, and when the swings in inventory are  more muted, it’s less of a factor, leading to fewer recessions but much  slower rebounds.

Tech Sees Like a State: Indonesia Edition

The Indonesion government is strapped for cash, and needs to spend  heavily to mitigate the effects of Covid-19. But the government is not  great at collecting taxes (taxes are 11-12% of GDP. For comparison,  Mexico and the Netherlands have similar-sized economies, and collect 16%  and 39%, respectively). But tech companies are great at collecting  taxes on online commerce, and tend to charge close to the Laffer peak.  So Indonesia is outsourcing taxation to them  ($) by imposing a 10% value-added tax on large Internet companies.  Google, Facebook, and Netflix have built their own “tax collection”  apparatus, and are better at catching tax-evaders and charging the right  amount. As it turns out, tax-farming wasn’t a terrible idea, just a few  centuries early

In other tax news, Chinese mainlanders working in Hong Kong suddenly owe the mainland’s 45% tax rates rather than Hong Kong’s 15%.  China seems to alternate—on a daily basis—between wanting Hong Kong to  be a financial center they control and wanting to use their control to  end Hong Kong’s status as a financial center.

Clever Currency Games

The dollar, by virtue of being the world’s most-used currency, is the  currency that least represents how currencies work. Since it’s a  reserve currency, dollars are demanded by people who don’t earn them or  spend them, but who know they’ll need them, so the US has less control  over the value of its money than any other place. To paraphrase John  Connally, it’s everyone’s currency but America’s problem.

For example, there’s no way the US could get away with this ($):

Africa’s most populous nation has long maintained several  exchange rates. In addition to the interbank and black-market rates,  there are official rates for consumers wanting dollars for school and  medical fees abroad, for Muslims making the pilgrimage to Saudi Arabia,  and for people wishing to buy hard currency at exchange bureaux.

That’s a very clever setup. Smaller countries can use a tiered  exchange-rate system to moderately encourage or discourage certain  behaviors, or to dole out favors to particular groups. Dollars are so  liquid, and used in so many places, that the US has to take a more  binary approach, of allowing or banning transactions; taxes get routed  around.

Treasuries: Bad Deal, No Alternatives

Alpha Architect has a negative view on treasuries,  arguing that they’re not a good diversifier and that yields are too low  to justify owning them. The piece goes into detail on how treasuries  function as insurance (not always!), and how they’re mostly owned by  price-insensitive buyers like regulated insurance companies and central  banks. All true. But the most important line in the piece is: “Okay,  Treasuries Aren’t Compelling: What Are My Alternatives? Answer:  Nothing.” Investments are always expressed in relative terms. In an  aging world, we shouldn’t expect anything to be cheap because there’s so  much demand for savings.

China Equity Update

Chinese CSI 300 index dropped 1.8% in the last session, and it’s now up only 14% since late June. Bloomberg profiles the wild market,  with plenty of pull quotes from new investors (“There’s no way I can  lose,” sounds like a classic bull market line, but there’s a tinge of  desperation there). One company, QuantumCTek, rose 1,000% in its IPO ($).

Video Games and Pricing Power

2K games is trying to push video game prices above the de facto ceiling of $60/copy. Video game prices have been declining in real terms,  in part because of cheaper manufacturing and distribution. As the video  game industry gets more mature, predicting sales for any given title  gets easier, which encourages publishers to invest more in production.  So cost deflation in one part of the market is offset by cost inflation  in another.