Toys "R" Us (NYSE:TOY) announced poor earnings Monday morning and paid the price. Though third-quarter sales increased 2.2% year over year to $2.32 billion, the gain was entirely due to currency effects. Meanwhile, the company's net loss widened to $38 million, or $0.18 per share.

Reflecting the poor quarter, Toys "R" Us lowered its full-year guidance from $1.15 to between $1.05 and $1.15. But that's not all.

In an effort to improve free cash flow, the company plans to eliminate the 146 freestanding Kids "R" Us stores, 36 freestanding Imaginarium stores, and three distribution centers that support these stores. What's more, the company intends to do most or all of this by January 31, 2004 -- the end of its fiscal year.

While Toys "R" Us doesn't want to abandon the clothing market, it's apparent that the Kids "R" US (KRU) stores were causing trouble. In the third quarter, KRU sales were down 13.5% year over year to $122 million, hurt by an 11.4% drop in same-store sales.

In direct contrast to KRU, sales at Babies "R" Us increased 9.6% to $457 million in the quarter. At the same time, same-store sales increased 3%. Based on that success, the company may reopen 15 of its soon-to-be-closed KRU stores as Babies "R" Us stores.

And there is another bright spot. With its partner Amazon (NASDAQ:AMZN), revenues at Toysrus.com jumped 15.3% to $68 million.

Still, KRU wasn't all that was bad. Same-store sales at the flagship U.S. toy division were down 3%, as video game sales declined 18% from last year's quarter. However, that figure isn't all that surprising, given that both Atari (NASDAQ:ATAR) and Activision (NASDAQ:ATVI) had lower sales due to fewer titles on the market than last year. It might be troublesome, though, if we see the same result in the seasonally strong fourth quarter.

Given its poor operating results, Toys "R" Us must now manage its cash flow. The company expects capital expenditures to come in between $300 million and $330 million, lower than the company's anticipated depreciation expense of $330 million. With that, Toys "R" Us still expects to improve upon 2002 free cash flow of $176 million.

The stock was down more than 10% to under $12 in afternoon trading. But with an unimpressive business, the company is a tough buy -- even at 11 times this year's earnings.

Activision was twice a top pick in Motley Fool Stock Advisor and is up on average more than 41% since (which, amazingly, makes it something of a laggard among David Gardner's Stock Advisor recommendations). Talk it all over on theToys "R" Usdiscussion board. Only at Fool.com. Jeff Hwang can be reached at JHwang@fool.com.