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Toys 'R' Us: Beaten At Its Own Game


He sings, he dances, he shakes it all about. For thousands of toddlers, Hokey Pokey Elmo was one of the great things about Christmas, 2003. But for Toys 'R' Us Inc. (TOY), Elmo was the fuzzy red embodiment of all that went wrong: He was just too cheap.

Last October, two months before the heart of the holiday rush, Wal-Mart Stores Inc. (WMT) surprised all of its competition by dropping Elmo's price from $25 to $19.50, a full $4.50 below what many retailers had paid for it. Within days, Toys 'R' Us dropped its price to $19.99. The price war dominoed all the way down the toy aisle. "Our choice was short-term profit vs. long-term market share; we chose to protect market share," says CEO John H. Eyler Jr., who thinks all stores could have sold out of the popular doll at $29.99.

That's profit Toys 'R' Us couldn't afford to lose. And by Jan. 8, Eyler and his board were hiring an investment bank to explore strategic alternatives. It's a move that could lead to a dramatically different company -- and almost certainly will seek to lessen the retailer's dependence on its traditional toy stores.

While Toys 'R' Us is in nowhere near the dire straits of KB Toys Inc. and FAO Schwarz Inc., both of which have declared Chapter 11 in recent months, 2003 was the third disappointing holiday season in a row. It was also the worst since Eyler was hired in 2000 to stanch market-share losses to Wal-Mart. The giant discounter surpassed Toys 'R' Us as the No. 1 toy seller in the late '90s and is now estimated to have at least 22% of the market.

DEBT DOWNGRADE

The holiday season resulted in a 5% drop in sales at Toys 'R' Us stores open at least a year. Net income for the year fell 27%, to $88 million, on $11.6 billion in sales. On Mar. 10, a week after the company reported those numbers, Standard & Poor's (MHP) downgraded its debt to two notches below investment-grade. The chain has $1.5 billion in cash, but S&P voiced concern about its ability to generate enough earnings. Some of its $2.3 billion debt load comes due in 2006.

Wal-Mart, on the other hand, is all smiles. In his fourth-quarter conference call, CEO Lee Scott called 2003 "an excellent toy season" and toys a "a very profitable category with a very strong gross margin." Clearly, Toys 'R' Us has little hope of competing on price with Wal-Mart. "I wouldn't want to play that game," says Duane Roberts, portfolio manager at Dana Investment Advisors Inc. in Brookfield, Wis., which owns 126,000 shares of Wal-Mart and none of Toys 'R' Us.

Can some kind of asset sale or restructuring solve the toy problem at Toys 'R' Us? The company does have thriving divisions -- Babies 'R' Us is growing and profitable, and its international business had a good year in 2003. In a Mar. 4 report, Banc of America Securities (BAC) analyst Aram Rubinson calculated the value of the company's separate parts at $3.9 billion, slightly above its current market capitalization of $3.4 billion, even after optimistic investors pushed the stock up 30% on news of the review. Toys 'R' Us shares now trade at around $15.80.

Still, few see a total breakup as likely. Toys 'R' Us has refused to comment in detail, but industry watchers say it's more likely to shutter underperforming toy stores in the U.S., possibly as many as 200, as it did last November when it announced the closing of 148 Kids 'R' Us clothing stores. Those savings, combined with the sale of some real estate holdings, could be funneled into successful stores. Babies 'R' Us, which generates just 15% of sales, already gets a third of capital investment. Keeping that unit enables Toys 'R' Us to push more products through its distribution network. And Babies' year-round sales partly balance the toy chain's fourth-quarter focus.

Whatever direction management takes, the new strategy had better get results. Eyler has spent $476 million overhauling the 681 U.S. toy stores. He cut the number of middle managers and instead hired sales staff to man the floors. He has pushed for exclusive toys, including a successful line of stuffed animals. And in the past 15 months, he has opened 2,000 toy boutiques inside Albertsons Inc. (ABS) supermarkets.

These moves have been hailed by toymakers such as Isaac Larian, CEO of MGA Entertainment Inc., which makes the hot-selling Bratz line of dolls. But they have yet to win over parents. Aurore Boone of Alpharetta, Ga., was recently at her local Wal-Mart checking out kids' bikes. She shops at Toys 'R' Us to see what's on the shelves, but of the roughly $500 she and her husband Mark spend on toys a year, more than half goes to Wal-Mart, the rest to stores such as Target (TGT). It's cheaper, and she can do her other shopping there, too.

It's a harsh new world for Toys 'R' Us, which, as the industry's original 800-pound gorilla, wiped out legions of small toy stores in the '60s and '70s with its cut-price, no-frills, big-box outlets. Now, having taught consumers that toys should be cheap, the chain is finding that they learned the lesson all too well. By Nanette Byrnes in New York, with Michael Eidam in Atlanta


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