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TEARS IN TOYLAND

Discount chains continue to erode toy store sales

BY ED McKINLEY

Wal-Mart helped spoil FAO’s holidays.

It had to be one of the unmerriest Christmases ever for the $38 billion toy retailing business. In the run-up to the recent holiday selling season, FAO Inc. filed for bankruptcy protection for the second time in a year, closed its Zany Brainy stores and sought a buyer for its Right Start and FAO Schwarz stores. Toys ‘R’ Us posted third-quarter losses and shut its Kids ‘R’ Us and Imaginarium stores. Then, in mid-January, KB Toys followed FAO in filing for Chapter 11.

Some attribute the trouble to Wal-Mart’s pricing policies. Wal-Mart, the biggest purveyor of toys in the United States, started deep-discounting high-profile toys weeks earlier than usual this holiday season, blowing out popular merchandise at prices some observers say were below wholesale. Others say it’s not that simple.

“You can’t blame Wal-Mart” for other retailers’ problems, counters Christopher Byrne, a New York City-based industry analyst and consultant who serves on the editorial board of Toy Wishes magazine. “Wal-Mart is completely within their rights to sell products for whatever they want to sell them for.”

Competitors followed the leader as best they could. Toys ‘R’ Us tried to match Wal-Mart on promotional toys and ran ads assuring customers that it had the most-wanted merchandise in stock.

Such countermoves notwithstanding, Wal-Mart appears poised to continue gaining market share in the toy business, analysts say. As America’s largest company in sales terms, Wal-Mart accounts for about 25 percent of U.S. toy sales, Byrne says. No. 2 Toys ‘R’ Us claims 21 percent of the market, and KB follows with 15 percent.

Wal-Mart, which now operates nearly 1,500 Wal-Marts and more than 1,300 Supercenters nationwide, usually aims for 30 percent of the market in every merchandise category it carries and may aspire to that level in toys, says Heather E. Brilliant, a retail analyst at Chicago-based research firm Morningstar. Legions of Americans who don’t normally shop at Wal-Mart have come to regard the chain as a toy leader, and they drop in to buy presents for the children on their holiday shopping lists, she points out.

Ten years ago, when Wal-Mart started getting serious about toys, the chain controlled only about 13 percent of the market, while Toys ‘R’ Us held 20 percent, according to Tom Goetzinger, a senior analyst at Morningstar. And the portion Wal-Mart has snared from Toys ‘R’ Us is even bigger than those numbers suggest, he says, because Toys ‘R’ Us has turned around and made up part of the loss by seizing share from other toy retailers.

Wal-Mart’s share of toy sales continues to grow partly because the retailer is still increasing its store count, says Beth Azor, president of Terranova Corp., a Miami-based real estate services firm. “Success with publicly owned companies has a lot to do with expansion and has a lot to do with opening stores,” she says.

Toys ‘R’ Us is fighting back. Last year it closed its Imaginarium and Kids ‘R’ Us stores so that it can focus on its more profitable Toys ‘R’ Us, Babies ‘R’ Us and Web site divisions.

Then there’s the pricing. Wal-Mart drastically cuts prices on toys that are advertised on children’s television shows, says Byrne. One Barbie doll that was selling for $19.99 to $22.99 in most stores early this past holiday season was usually discounted at Wal-Mart to $16.48 and sometimes was priced as low as $12.43, he points out. “To a consumer, that’s a significant saving; that’s as much as $10 — almost 50 percent off what it is at other places.”

Children want the toys they’ve seen on television, and offering them at low prices builds traffic, says Byrne. “What’s counterintuitive is they’ve been trying to drive sales early in the season by slashing the prices on toys,” he said.

For basic toys, Wal-Mart’s prices are more in line with those of other stores, though its prices overall are about 15 percent lower, says Goetzinger, who characterizes the difference as “pretty significant.”

People tend to visit toy specialty stores much more often during the holidays, but shop Wal-Mart all year for other merchandise. That makes Wal-Mart a logical place to pick up a toy for a birthday present when the customer needs just a single item and might not want to make a special trip to buy it, says Goetzinger. “That steady demand makes Hasbro and Mattel more apt to want to supply Wal-Mart, even though they’re getting squeezed by them on prices,” he said.

How much Wal-Mart can pressure suppliers for lower prices isn’t well known among outsiders, which means few can really say whether the chain sells loss leaders below wholesale, according to Brilliant. “Wal-Mart has so much power to extract better prices that, while other retailers may be leading us to believe Wal-Mart is selling below wholesale, wholesale could be different at Wal-Mart from what KB Toys or somebody else pays.”

Whatever Wal-Mart pays, competitors feel the effects, says Kathleen McHugh, executive director of the Glenview, Ill.-based American Specialty Toy Retailing Association. “What Target and Wal-Mart have done is a shame,” she said. “With loss leaders they blow everybody away. They sell for below wholesale, which attracts people into their stores, and they’ve captured them.”

If Wal-Mart continues to amass power, says McHugh, many will suffer, as the giant retailer siphons money out of smaller communities, forces independent retailers out of business and displaces workers. “We’ll wind up being able to shop in only a few places if it continues.”

Tell that to Toys ‘R’ Us, the Wayne, N.J.-based retailer that has struggled against Wal-Mart. After posting a $38 million third-quarter loss on sales of $2.32 billion, Toys ‘R’ Us announced the closing of all 146 Kids ‘R’ Us stores and its 36 Imaginarium stores late last year.

“From where I sit, it seems like a very smart and strategic move,” Byrne says of the closings. “It’s hard to compete with a Wal-Mart or a Target in children’s apparel [a deflationary category the retailer sold at the Kids ‘R’ Us stores]. Toys ‘R’ Us isn’t a destination for that stuff. Operationally, they have to get out of leases if they can, because that’s a real drain on revenue.”

Jettisoning those stores also allows Toys ‘R’ Us to concentrate on its stronger brands — Toys ‘R’ Us and Babies ‘R’ Us stores and Toysrus.com, the Web site the retailer operates with Amazon.com, Byrne says. He also praises the TV ads that promoted the chain’s holiday season in-stock position by showing a customer who was elated at finding a Hokey Pokey Elmo in a Toys ‘R’ Us store. In the background, an associate brought in a palette filled with the toys, which are based on the popular Sesame Street character.

Toys ‘R’ Us Chairman, President and CEO John Eyler Jr. also deserves credit for turning in a solid performance in three years with the company, says Morningstar’s Goetzinger. Eyler has been lauded for cleaning up the formerly messy stores, keeping the shelves stocked and using computers to shift associates from inventory duty to selling.

Wal-Mart sells toys for 15 percent less than they cost at the toy chains, representing a significant saving for those wishing to do all their holiday toy shopping in one place.

Focusing on private-label toys, such as the Animal Planet line, has also benefited Toys ‘R’ Us, says Goetzinger. “That’s so important for a struggling retailer like Toys ‘R’ Us, because profits are higher,” he said. “When you develop something yourself, you don’t have to share the money with [a manufacturer] or compete with Wal-Mart to get it.”

Still, even those steps may fail to save Toys ‘R’ Us. “Sometimes you end up in a competitive situation where the headwinds are so fierce you don’t break through no matter what you do,” Goetzinger said. The retailer may well have done everything possible, he adds, but it’s still losing ground, and Eyler’s welcome changes represent the company’s third restructuring in a decade.

The retailer hasn’t achieved its goal of breaking even in the first three quarters of the year and then adding $1 to $1.15 in earnings per share for the fourth, says Goetzinger. “Toys ‘R’ Us has had a flat top line for a number of years now. Operating margins have been cut in half over the last seven years. They’ve felt the brunt of the large shift to Wal-Mart.”

With 681 Toys ‘R’ Us stores, 183 Babies ‘R’ Us units and four Geoffrey stores in smaller markets, the chain doesn’t have much room to grow in the United States, observers say. In the early ’90s the company entered the slow growth or decline phase of its life cycle, according to Goetzinger, pointing out that to expand the store base now, it would have to come up with something new in a mature industry.

Discounters undercut Toys ‘R’ Us on most prices, and the specialty retailer can’t provide the convenience of toy shopping in a store that fulfills lots of other needs and desires at the same time, so the chain can’t attract enough repeat business, Goetzinger says.

Another specialty retailer, KB, which has headquarters in Pittsfield, Mass., may not be able to compete with the discounters on price but can sometimes beat them in the quest for convenience, says Terranova’s Azor. KB bills itself as the “largest combined mall-based and online specialty toy retailer,” with 1,300 stores.

If a consumer is in a shopping center and needs a toy for a birthday gift, she might decide to buy it at KB and save a trip to Toys ‘R’ Us or a discounter where the price is lower, says Azor. “If they’re buying 10 toys for five kids, they go to Wal-Mart,” she says.

KB stores average 3,500 square feet, but there are also 200 KB Toy Works stores that measure about 7,500 square feet, according to company reports.

The chain, which imposed a moratorium on payments to some vendors just before Christmas, said in its January bankruptcy statement that it will close an unspecified number of underperforming stores. KB declined to talk to SCT.

Meanwhile, KB’s alliance with Sears, Roebuck and Co. brought KB-branded toy departments to 600 of the 870 Sears department stores in the United States in time for the 2003 holiday season, says Morningstar’s Brilliant.

Sears owns the inventory in the departments and hopes the toys will build traffic, she says. The departments were tested in a few stores during the 2002 holiday season; no data from the recent big rollout was available.

KB departments are also operating in CVS pharmacies, according to Byrne. He also says he considers KB a pioneer in establishing boutiques in general merchandise stores, but adds that the chain is quickly getting plenty of company. Toys ‘R’ Us has launched Toy Box departments in supermarkets, including Albertsons and Jewel-Osco, and in pharmacies such as Sav-on Drugs. FAO set up toy departments in a number of department stores, among them the Saks chains of Bergner’s, Boston Store, Carson Pirie Scott, Herberger’s, McRae’s, Parisian, Proffit’s and Younkers.

FAO apparently made its move into department stores too late, however. The bankrupt company seemed to many observers to be disintegrating during the holiday season. At the end of December FAO sold its New York City FAO Schwarz flagship store and another in the Forum Shops, Las Vegas, plus its Web site, catalog business and other assets for $20 million. The company is expected to liquidate the other 13 FAO Schwarz stores. FAO also sold its 34 Right Start units and liquidated its 89 Zany Brainy stores.

In the FAO Schwarz stores the retailer offered just about the same toys as its competitors, trying unsuccessfully to differentiate itself on service, says Byrne. Without unique merchandise, the storied, 141-year-old store lost its magic; it should have sought to base its identity on product, not service, he says.

“To many consumers, somebody telling you a little bit of information and [offering] free gift-wrapping is not worth a 20 percent incremental cost on the toy,” Byrne said. What’s more, he adds, hardly anyone is ashamed of seeking bargains these days. “It’s a discount world.”

While troubles were mounting at the FAO Schwarz stores, FAO failed to revive Zany Brainy and didn’t find a way to handle the many leases it had taken on, says Byrne.

Smaller retailers, meanwhile, need to set themselves apart by offering toys that aren’t available at the big chains, says McHugh. The alternatives offered by specialty stores range from wooden toys to limited-edition dolls to developmental items, she says.

Independent toy-store operators choose wares with “play value,” as opposed to the toys advertised on TV, many of which never get much use anyway, because there isn’t much children can do with them, McHugh says.

A good number of the people who open toy stores come from the ranks of educators, notes Shannon Eis, a spokeswoman for the Toy Industry Association in New York City. “There is such experience among them in children’s play,” she said.

Many independent toy merchants go into the business because they love children or love toys, but they find themselves compelled to become effective business people, McHugh says. Thus, even the most dedicated toy people discover, this business isn’t mere fun and games.

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