BUSINESSWEEK ONLINE : OCTOBER 23, 2000 ISSUE
BUSINESS WEEK E.BIZ -- COVER STORY Double Play The joint Amazon-Toys 'R' Us online toy store may become the name of the game in alliances. Here's how the deal was done Most every week since January, Jonathan E. Foster had been jetting across the country, from Chambersburg, Pa., to Mira Loma, Calif., in search of really big buildings. As chief operating officer of Toysrus.com (TOY), the toy giant's online unit, Foster was responsible for finding and outfitting huge new distribution centers. His goal: Reverse last year's holiday disaster, when a shopping blitz drowned the site's single warehouse, leading to thousands of angry parents and a Federal Trade Commission fine. By early July, Foster was almost done with his monumental task. Who would have guessed that all those gleaming new conveyor lines, a staff of hundreds, and some $75 million in investment were just days away from getting ripped to shreds? Even as Toysrus.com warehouse managers did final testing, Amazon.com Inc. (AMZN) and Toysrus.com execs were holed up in a clandestine meeting at New York's Essex House hotel, laying the groundwork for the biggest alliance to date in consumer e-commerce--one that would make everything Foster had done so far superfluous. On Aug. 10, Toys 'R' Us Inc. CEO John H. Eyler Jr. and Amazon.com CEO Jeffrey P. Bezos announced they were pooling their expertise to form a single online toy store. New Jersey-based Toysrus.com would choose and buy toys, using its parent's clout to get the hottest lineup. Amazon, in Seattle, would run the store on its site, ship the products, and handle customer service. Now both expect to become profitable much sooner than they could individually. ''It's a really smart deal,'' says Jupiter Media Metrix Inc. analyst Ken Cassar. ''It capitalizes on the strengths of each company.'' Much more than that, the deal may well change everything in e-tailing. It's a whole new era of bricks-and-clicks--one driven not by unlimited hopes and capital, but by plain pragmatism. Explains Toysrus.com CEO John Barbour: ''When you can get access to the best e-commerce partner in the world and you get to do what you're good at, you jump at it.'' The bottom line for Bezos: ''We're going to dramatically improve the customer experience.'' If the two companies can pull it off, the deal could prove a bellwether for e-tailing for years to come. Of course, there is no guarantee it will work. The companies must swiftly mesh their operations and computer systems during the busiest season of the year. And they must do it at a time when booming online sales are again expected to strain e-tailers' ability to deliver. In theory, says analyst James Vogtle of the Boston Consulting Group, the deal sounds great. ''In actuality, it will probably be a bit grim.'' The road to the deal was certainly filled with potholes, and many remain. The tale of how it came to fruition shines a light on how both newly minted e-tailers and experienced retailers are learning tough lessons: Mainly, selling to consumers in the Net Age is a whole lot tougher than it looks. And that means both must set aside their pride and do what works for customers and investors. How Amazon.com and Toys 'R' Us did it provides a guide to how others might cross e-tailing's chasm. Before their seminal deal came together, Toysrus.com and Amazon had been circling each other for many months. After Amazon opened its toy store in July, 1999, Toys 'R' Us hired Barbour, a 40-year-old Scot from Hasbro Inc., to head its online effort. Barbour, who wanted to explore an alliance with Amazon, got the O.K. from Toys 'R' Us Chairman Mike Goldstein. The Game Plan. The first meeting in Seattle on Feb. 4 failed to bear fruit. Foster, a 39-year-old former Lazard, Freres & Co. investment banker, laid out Toysrus.com's game plan for the year, and the two companies talked about their strengths. ''We were just kicking around at a high level whether it made sense to do anything together,'' recalls Amazon.com Toys General Manager Harrison Miller. Amazon had just announced a $39 million writedown of excess inventory the day before, but the bad news wasn't enough to spur it to give up any autonomy. Meanwhile, Toysrus.com was locking up a deal with Japan's Softbank Venture Capital, announced Feb. 24. For 20% of the company, Softbank pitched in $57 million. That allowed Toysrus.com to rev up: adding and improving distribution centers, hiring management, improving customer service. Then, at a Goldman, Sachs & Co. e-tailing conference in Las Vegas in April, Rex Golding, Softbank's executive managing director, buttonholed Bezos in a corridor and made his pitch. ''Amazon had already built out an infrastructure and was best of breed,'' he says. ''We were very aware that a lot of people felt we hadn't provided best of breed. My message was very simple: 'I think it makes a ton of sense. What kind of deal works for you?''' To see if an alliance would fly with customers--who often complain about the unpleasant ambience of Toys 'R' Us stores--Amazon ran focus groups with both Amazon and Toys 'R' Us customers in April. The results were promising: Customers said they associated Toys 'R' Us with deep selection, something Amazon also strives for. Says Miller: ''It became clear that matching up the brand names together became an 'Aha!' for moms.'' At the same time, Amazon's leverage was starting to fade in the spring as Net stocks took a pounding. Investors became fed up with the money-losing dot-coms. Amazon's stock dropped 36%, to $48 a share, from early February to early April. As Miller was noodling through some thoughts about a possible deal on a whiteboard in the late spring, he came up with something he thought would work. It would go far beyond Amazon's existing partnerships, which essentially charged other e-tailers cash to promote their stores on Amazon's site. Amazon had a battle-tested distribution network with plenty of excess capacity, while Toysrus.com had merchandising and purchasing expertise. If the two joined forces, he figured, they could dominate online toy sales, estimated by Forrester Research Inc. to hit $3.6 billion, or 10% of the overall toy market by 2004. In early June, he called Foster at Toysrus.com to pitch the idea. They met in a small, windowless conference room at Chicago's O'Hare Hilton Hotel, and Miller scribbled each company's assets and challenges on a whiteboard. That laid the groundwork for a crucial June 28 meeting. During an all-day round of negotiations at New York's Essex House, Golding and vice-presidents from each company hammered out the financials and operational responsibilities and got tantalizingly close. At 7 p.m., Toys 'R' Us Chairman Goldstein and Amazon's then-President Joseph Galli (since departed to be CEO of e-marketplace VerticalNet) joined most of the group at a private room in the plush Patroon restaurant nearby, arriving separately to avoid notice. By mid-July, negotiations went into overdrive, with execs constantly phoning in between meetings in Seattle, New York, and Chicago. Bezos and Eyler met several times for dinner in July. At one two-hour dinner, Bezos says, he was especially impressed with what Eyler, formerly at toy retailer F.A.O. Schwarz, did to make those stores a pleasure to shop in. Top Secret. On July 28, Eyler flew to Seattle to meet with Bezos and his team. They devised code names to prevent leaks: The deal was Project Stream, after Amazon's headquarters near the water in Seattle. Amazon was Amberjack, an 80-pound saltwater fish, and Toysrus.com was Trout. Golding, on vacation on Cape Cod, was tethered to the phone with both companies over several days of intense negotiations. While the deal was largely done, still at issue were the timing and the finances, says Bezos--how much Amazon's annual fee should be, how it should share revenue, and what it would get per toy sold. Amazon wanted assurances that Toysrus.com would allocate enough toys to the site and that the parent company would support it with marketing. To avoid paying too much, Toysrus.com wanted the longest fixed-price deal it could get, and the teams argued over how much Toys 'R' Us branding, such as its giraffe logo, the site would carry. ''You could argue that the page should have more giraffe on it, more Toys 'R' Us on it,'' admits Foster. Finally, just days after Toysrus.com started up its Mira Loma (Calif.) distribution center, the final agreements were signed on Aug. 9. The reason why Toysrus.com was willing to chuck all that work and expense: a frank admission that it simply couldn't do it all itself. ''We would have required a lot more capital,'' says Golding, who estimates that the money the company had already spent would only cover buildout for 2000. The real work was only beginning. Several teams started jetting back and forth between the two companies' headquarters. They had to get training underway for customer service, coordinate marketing, link financial and tracking systems, and determine where to put Toysrus.com's inventory in Amazon's four distribution centers around the country. Says Bezos: ''We wanted to launch in early September so we could keep refining through October.'' That's when they realized cultural differences needed to be smoothed out, too. Toysrus.com thought it had product measurements down, for instance, but not precisely enough for obsessive Amazonians. Noah's Ark-style, one of each Toysrus.com product that Amazon didn't already have was shipped to Seattle, weighed and measured, and the data uploaded into Amazon's system so it could plan where they'd fit in its warehouses. By Aug. 31, products started flowing into Amazon's centers. On Sept. 14, the joint store was launched. The speed of the deal and the approaching holiday season mean a lot of things won't get done, raising the already sky-high risks. For one, Amazon couldn't upgrade its system to tax purchases made out of Toysrus.com's inventory. Under current law, that means customers can't return products bought online to Toys 'R' Us stores. ''That's a problem,'' says Kurt Barnard, president of Barnard's Retail Trend Report, a retail consultant. To critics, such shortcomings, along with the abandoned buildout, expose Toys 'R' Us' lack of commitment to selling online. Toys 'R' Us has little incentive to promote the new site, says analyst Lauren Cooks Levitan of Robertson Stephens. Toys 'R' Us insists it will, but that it would simply take too much money and time to do it on its own. Indeed, both sides still have a lot to prove to show the alliance will work. Amazon has never undertaken a task like this before. This Christmas will show whether its hurried preparations were enough to avoid unexpected costs. For instance, Amazon has to coordinate the tricky placement of products in distribution centers to avoid shipping separate boxes from different locations for a single order--at twice the shipping cost. The linchpin for Toysrus.com will be persuading its parent to give it enough hot and exclusive toys. ''The problem they may have is not getting as much consideration as top stores may get when it comes time to allocate products,'' says Jupiter's Cassar. The two companies' efforts are coming together not a moment too soon. In early November, Toys 'R' Us kicks off its holiday season, sending out 62 million copies of the venerable ''Big Toy Book'' catalog of this year's toy products--the very thing that caused shoppers to overrun Toysrus.com's site last year. So it won't be long before Santa will know what to bring Amazon.com and Toysrus.com this year: a lump of coal or sugar-plum profits. By HEATHER GREEN _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP					RELATED ITEMS EBIZ Contents for issue dated Oct. 23, 2000 Cliff-Hanger Christmas TABLE: Building the Perfect E-Tailer TABLE: Breakeven or Bust TABLE: E-Tailers vs. Retailers Double Play TABLE: Toys `R' Both of Us Service, Please TABLE: Profile of the Online Shopper ONLINE EXTRA: Q&A with Toysrus.com CEO John Barbour ONLINE EXTRA: Q&A with Amazon CEO Jeffrey Bezos ONLINE EXTRA: Q&A with Toys 'R' Us CEO John Eyler INTERACT E-Mail to Business Week Online

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