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Tuesday, October 13, 1998

Toys R Us Inc.
Website: http://www.toysrus.com
Phone: 201-262-7800
Price (10/12/98): $16 5/16


If only this was play money. For Toys R Us, the world's leading toy retailer, the last few months have amounted to more than just a stumble in a fiscal playground. The bloody noses have been gushing as sales have gone flat and earnings have swung lower.

Toys R Us is facing a competitive environment where discount superstores like Wal-Mart (NYSE: WMT) and warehouse clubs like Costco (Nasdaq: COST) are marking down toys as loss leaders or simply as part of a low-margin effort to make the difference up in volume. The New Jersey-based Toys R Us could have joined in on the aggressive price cuts and suffered through lower margins. Despite expanding its discounted closeout offerings, it chose to take the higher road. It held firm on prices, allowing Wal-Mart to gain market share.

The irony is that margins were destined to suffer anyway. Toy trends have moved away from the high-margin virtual pets, dolls, and action figures and have favored video game console software sales with meager markups.

In the end, that has meant fewer Geoffrey Dollars for the company's bottom line. Like a Parker Brothers' Monopoly board game, the company has had to take three steps back. Investors aren't passing Go! They aren't collecting that $200.


Toys R Us owns more than 1400 stores worldwide. As of last month, that included 697 namesake toy stores in the U.S. and 448 overseas, as well as 214 Kids R Us children clothing stores.

Two years ago the company acquired Baby Superstores and now owns 101 Babies R Us units.


Income Statement
12-month sales: $11,188 million
12-month income: $457 million
12-month EPS: $1.60
Profit Margin: 4.1%
Market Cap: $4453.3 million

Balance Sheet
Cash: $273 million
Current Assets: $3,251 million
Current Liabilities: $3,116 million
Long-term Debt: $787 million

Price-to-earnings: 10.2
Price-to-sales: 0.4


The early warning signs were false. When Mattel (NYSE: MAT) and Hasbro (AMEX: HAS) began reporting weaknesses due to lower sales to Toys R Us back in March, it was not a sluggish toy retailer at fault -- it was a case of aggressive inventory management. Taking a page out of the "just in time" inventory management approach that was developed stateside but mastered in Japan in the 1980s, the retailer began to keep only minimal levels of inventory rather than loading up the backroom. Then again, "just in time" was geared towards the manufacturing sector where the various raw suppliers would be in sync to provide the needed parts just... in... time.

Toys R Us was simply purchasing the finished goods in more conservative amounts, trimming warehouse and distribution costs. With fickle shoppers quickly turning this week's Teletubby into next week's closeout bin fodder, it made sense not to overstock. Still, it was ironic. Just the month before, Toys R Us had reported earnings below estimates because, among other things, the company had a historically high inventory shortage over the crucial holiday shopping season.

But a company in flux can be a dangerous thing. Around that time the company was also announcing changes to try to revitalize the units. Offering extracurricular activities like ballet classes may have sounded like novel ways to draw afternoon foot traffic, but it sounded strangely similar to the desperate measures that Discovery Zone had tried en route to bankruptcy.

So by the time Toys R Us announced a $495 million charge for store closings to go along with a snail's pace approach to expansion back in September, in essence halting the perpetual revenue and earnings growth investors had come to expect, the shares had already been weak. Investors who were smart enough to see the tides of change in the spring had sprung.


How do you reinvent a giant? It won't be easy. The big question is what is longer, the neck of the company's mascot, Geoffrey the Giraffe, or the road to a turnaround? While Toys R Us continues to be the leading toy seller in the country, Wal-Mart continues to gain at Toys' expense. Earlier this year Toys R Us had a 19% market share to Wal-Mart's 15% stake. With the plaything specialist pausing to catch its breath, it might allow for a shift in leadership to Sam Walton's company over the next year.

But you can't fault Toys R Us for trying. Two years from now most of the stores will be converted to the new "C-3" format. Due to even more inventory reductions (be wary, Mattel and Hasbro shareholders), the company will be able to rework the stores to allow for more selling space. Rather than the present aisle after aisle format, the store will have different segment-specific areas.

C-3 P.U.? I don't think so. The different areas do sound enticing. Media World will try to cash in on similar setups for electronic toys that have been initiated by the likes of CompUSA (NYSE: CPU) and Best Buy (NYSE: BBY). Toys R Us has long been missing the interactive excitement that has been limited to a Nintendo 64 on display with the rest of the goodies behind glass. The hands-on approach is long overdue.

Deal World will feature the discounted clearance items that have been awkwardly showcased at either the entrance or during the flea market style sidewalk sales. Marking down with class has been a Wal-Mart specialty, and it's a good time for Toys R Us to address the issue at least in terms of its own closeout items.

The vague Kids R Us division will be incorporated into the namesake stores with enclosed apparel sections. Kudos again. Toys R Us was not able to navigate the age groups as well as Gap (NYSE: GPS) has managed to do in its retailing strategy. Kids R Us was not the logical expansion vehicle for a standalone concept, and as for Babies R Us, just remember that there was a reason why Baby Superstores was bought out at a fourth of what it was trading for the year before.

So while investors may have been right to shy away from a company trying to drum up sales with tutu-clad youngsters twirling about or using other gimmicks, they might very well be wrong to dismiss the company's new direction. It makes sense. Eventually it will make dollars -- Geoffrey Dollars.

-Rick Aristotle Munarriz

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