Turmoil in Toyland

By Karl Taro Greenfeld

There's a kid in Alex Gonzales' seventh-grade class--we won't mention any names--who still plays with X-Men plastic action figures. "He's kind of weird," says Alex, 11, of Fontana, Calif. "None of us play with X-Men anymore. We like PlayStation better." Toy-industry experts call this "age compression"--boys shunning G.I. Joe and girls dissing Barbie at ever younger ages in favor of computer games and sporting goods. And it is just one of the obstacles confronting Toys "R" Us as the nation's No. 1 retailer of playthings tries to get itself back on track.

Toys "R" Us faces quickening competition from such all-purpose discount stores as Wal-Mart and Target. Its bloated inventory system costs hundreds of millions of dollars each year. It must somehow cut costs while remodeling stores and bolstering employee training and service. And Toys "R" Us managers can only pray, as they do each fall but even more so this year, that among the new toys they have bought by the trainload are a few hits--the Tickle Me Elmos and Power Rangers--that will fill parking lots with minivans.

Attacking its problems, Toys "R" Us recently declared that it was closing 59 stores, laying off as many as 3,000 workers and taking a $495 million charge against earnings to slash inventory, a move that jolted its two biggest suppliers, Hasbro and Mattel, into announcing that they expect lower earnings. Toys "R" Us has undertaken a redesign of its stores and a new strategy of broadening its merchandise to include children's clothing and electronics. But it will also have to pull off a more difficult transformation. Says Sean McGowan, an industry analyst with Gerard Klauer Mattison in New York City: "Toys 'R' Us has a lot of stuff my 14-year-old daughter would like, but there is no way she and her friends will go there." Toys "R" Us, he added, has to change the way it is perceived.

This marks a sad pass for a brand name that, while dreaded by many parents, spelled excitement to a generation of kids, many of whom have kids of their own. Founded by Charles Lazarus in 1957, Toys "R" Us was the original "category killer"--industry jargon for a chain of large stores that offered low prices on almost every product and brand in its category and killed competing local retailers. (Think Home Depot or Petco.) Lazarus transformed an industry once dominated by mom-and-pop toy stores, eventually launching 1,462 Toys "R" Us outlets and gaining a 25% market share by 1990, the company's peak year.

Erik Gustafson, manager of the Steinroe Young Investor Fund, says the toy retailer and other category killers such as Circuit City and CompUSA have become victims of their own success, encouraging shoppers to expect everything to be on sale all the time. "The category killers are going to have to live with lower profit margins going forward," says Gustafson. That is good news for the consumer, but not for shareholders who have watched Toys "R" Us' stock price get cut in half over the past 12 months, to a little more than $16 a share.

Some relief could come with strong sales this fall. Generally, the fourth quarter, which includes Halloween and Christmas, accounts for half of all toy sales. But like the recording and movie industries, the toy trade is driven by hits. So far this year, "there isn't a superhit toy out there," says Eugene Gilligan, executive editor of the toy-industry trade publication Playthings. "The biggest hit for the past year has been Beanie Babies, and Toys 'R' Us doesn't even carry them." But retailers have high hopes for several potential breakout toys, from a microchip-loaded version of venerable Legos building sets to computer games such as Nintendo's Pokemon that even Alex, jaded at age 11, might like.

Even if several new toys catch fire in the shopping season that is just starting, Toys "R" Us will have to fight harder than ever for its slice of the profit. Wal-Mart's share of the $35 billion toy-retailing industry has grown from 10% in 1990 to 16% this year; over the same period Target's share has more than doubled, to 7%. The discount stores use toys as "traffic builders," attracting families with low prices on popular toys and then making higher profits on such items as clothing and appliances. "Wal-Mart and Target carry only the 50 or 100 hottest toys," says David Miller, president of the Toy Manufacturers of America. "Toys are only a fraction of their business, so they can use them as loss leaders."

Meanwhile, parents seeking upscale educational toys these days can find them at newcomers Noodle Kidoodle and Imaginarium. Little wonder that Toys "R" Us' market share has declined to 20%. The competition is so brutal these days that the company's chief executive, Robert Nakasone, told TIME in an interview at his Paramus, N.J., offices that "when you earn a dollar, it's got someone else's blood on it."

Toys "R" Us has also hurt itself over the past year, analysts say, with neck-snapping shifts in strategy and laggard execution of the blocking and tackling aspects of retailing, such as controlling inventory and providing polite and knowledgeable service. An assistant manager at a New Jersey Toys "R" Us outlet led a visitor through a cavernous storage room piled floor to ceiling with everything from Micro Machines to mattresses. The store's inventory, she said, often surpasses $1 million. Multiply that by the 1,462 Toys "R" Us stores, and you see the scope of the problem.

At other Toys "R" Us stores, while many customers praise the selection of games and toys, several complain about service and, surprisingly, prices. Third-grader Kirby Turnage IV, shopping in Pensacola, Fla., says that "my brother and sisters like Toys 'R' Us better, but I keep telling them Target is better. The prices are better." His father, Kirby Turnage III, observes that the Toys "R" Us lines are too long and that there is a "lack of customer service." And Denver Toys "R" Us shopper Tonya Howard says, "The people here have an attitude."

To address the chain's problems, Nakasone's predecessor last January ballyhooed "Concept 2000," a revitalization plan calling for, among other things, less cluttered, brighter, cleaner stores. But only a month later, Nakasone took over, and in September he replaced the plan with something he calls "C-3." (Don't ask.) It targets service improvements as well as inventory reductions. It promises a $500,000-a-store renovation that will include an oval "racetrack" layout providing 18% more selling space. And it envisions a diversification into products such as clothing and electronics, which Nakasone hopes will attract more customers outside the busy holiday season.

Industry analysts are skeptical, especially about the diversification plans. "If there's one thing I can tell you about apparel, it's that we do not need any more capacity in the U.S.," says Peter Caruso, a Merrill Lynch analyst who covers Toys "R" Us. Caruso also doubts that the company's dubious reputation for service will attract many buyers of electronics, who want sales personnel with up-to-date knowledge of competing products' features.

Nakasone counters that the naysayers underestimate his company's strengths. "We have an enormously strong brand," he says. "The idea that we're on the balls of our ass is ridiculous. We are a very profitable company." To be sure, Toys "R" Us last year posted earnings of $490 million on revenues of $11 billion. But it is the trends in market share and earnings that have analysts concerned. Earnings for the most recent quarter were just 5[cents] a share, down from 13[cents] a year ago.

One reason can be seen at 3:15 on a sunny weekday afternoon at KidsWorld, a two-acre Toys "R" Us superstore in Elizabeth, N.J. There are barely a dozen cars in the parking lot. The aisles inside the store are spacious, well lighted--and empty. A row of 20 cash registers stands idle while a lone clerk in a red apron and braids rings up a diaper sale for Kim Essen, 29, and daughters Samantha, 21 months, and Alana, 6 months. As Kim wheels her cart out of the store, she turns and says, "I like shopping here because it's always empty." That's one competitive advantage that Nakasone will be glad to lose.

--With reporting by Daniel Eisenberg/New York, Timothy Roche/Pensacola and Richard Woodbury/Denver

With reporting by Daniel Eisenberg/New York, Timothy Roche/Pensacola and Richard Woodbury/Denver