You’ve Got to Have Friends

With help from partner, may have a business model that works.
Kris FrieswickAugust 1, 2001

Ray Arthur, CFO of, is one of the few survivors of the online toy industry. is poised to dominate the online toy market this coming holiday season and expects $300 million in revenues for fiscal 2001 — up more than 60 percent from last year. With close ties to parent Toys “R” Us Inc., and with agreeing to handle all fulfillment, inventory management, and Web operations, has created an E-commerce model that may actually work.

This achievement is all the more notable because it seemed so farfetched 18 months ago. “In the past two years,” says CEO John Barbour, “we’ve gone from being the roadkill of the industry to being the visionaries.”

But Barbour and Arthur aren’t opening the champagne quite yet. Last year the company lost $260 million (including restructuring charges) on revenues of $180 million. Partner is facing its own problems. And as grows, conflicts with its parent over product allocation, pricing, and incentives are likely to increase, especially as it faces the inevitable pressure from venture backers to go public or sell out.

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Right now the site’s position as king of online toys owes as much to its unbeatable brand and the failures of its competitors as to its strategic maneuvers. These grant the company a window of opportunity, but no guarantees. As CFO, Arthur has to juggle the demands of investors, parent, and partners if is to survive and create shareholder value. And unhappily, the company has a rich history of dropping the balls.

A Tough Start-Up

Before the site was even launched, it caught flak. During the 1998 holiday season was a nonstarter, and pure-play competitor eToys dominated the online toy market. EToys went public in May 1999 and quickly amassed a market capitalization of $7.8 billion, 35 percent higher than Toys “R” Us Inc. In August 1999 a deal with venture firm Benchmark Capital collapsed, according to published reports, when Toys “R” Us Inc. wouldn’t give the site the autonomy and full-pricing independence that Benchmark sought. Shortly after,’s first CEO, Robert Moog, left by mutual agreement after a month on the job, and Toys “R” Us Inc. CEO Robert Nakasone was fired.

Things got worse when the site launched. In anticipation of the 1999 season, enthusiastically marketed the site in its Big Book, the annual Toys “R” Us catalog that reaches more than 60 million U.S. homes every November. Predictably, site volume exploded and the servers couldn’t handle it. Although the company quadrupled its server capacity within a week, in mid-December it suffered a technical glitch that caused it to miss its holiday shipping guarantee on thousands of orders. Immediately, overnighted $100 gift certificates to affected customers, redeemable in its stores. Still, the Federal Trade Commission fined the company $350,000 for misrepresenting shipping policies.

“At that point, management at Toys “R” Us Inc. said, ‘If we’re going to play in this space, we’ve got to get serious about it. Let’s go out and get some first-class talent,’ ” says Arthur, who had 20 years of experience in public accounting, pharmaceutical, and consumer-products firms before joining Toys “R” Us Inc. as controller in January 1999. In February 2000, eager to catch up to its rivals but in need of a cash infusion, Toys “R” Us Inc. followed the tide of companies “unlocking their Internet assets” and sold 20 percent of to Softbank Venture Capital and Softbank Capital Partners for $57 million.

Between Parent and Child

The accompanying subsidiary agreement created a separate management structure (which included Arthur), a new board of directors, and a separate compensation structure to attract executives like Arthur, who became CFO at that time. That’s where the separation ended.

In direct contrast to Benchmark’s approach, the Softbank deal solidified the bond between parent and subsidiary. Today piggybacks onto the Toys “R” Us Inc. purchasing agreements, even though the dot-com does its own merchandising and purchasing. The two units sell inventory back and forth at cost. For a royalty fee, the dot-com leverages the Toys “R” Us brand. It mines Toys “R” Us Inc.’s customer data. It does point-of-purchase marketing at 850 U.S. stores as well as through the Big Book. CEO Barbour reports to the board, headed by Toys “R” Us Inc. chairman and CEO John Eyler, giving Toys “R” Us Inc. de facto control as majority shareholder.

The agreements created so many touch points that in December 2000, consolidated its San Francisco operations into those at Fort Lee, New Jersey, in the backyard of Toys “R” Us Inc.’s Montvale, New Jersey, headquarters.

But still wanted some protection, and it got it. At Softbank’s insistence, the agreement guarantees “fair and equitable” product allocation. This clause affects those situations in which must aggregate its order — usually for the hottest toys — with that of Toys “R” Us Inc. For instance, after aggregated orders for the Sony PlayStation 2 were placed last season, the manufacturer announced it could ship only half the orders. Without the allocation provision, Toys “R” Us Inc. could have divided product as it pleased. Instead, the Web site got its full, prorated portion of the orders, says Arthur. In addition, may develop independent buying contracts with vendors that use Toys “R” Us Inc.’s financial terms.

Unlike the reported terms of the Benchmark deal, the Softbank agreement also gives the Web site permission to set its own pricing. This means it can compete directly with Toys “R” Us Inc., but it has chosen not to do so. The dot-com fears that vendors, which still consider Toys “R” Us Inc. their bread and butter, would be scared off if they thought the dot-com was cannibalizing sales from the stores.

Arthur also doesn’t want to price out of profitability. “Certainly, if we were going to try to drive volume,” says Arthur, “we could lower prices, but it would be at the expense of profitability. We have very competitive margins to start with. If you knock $2 off the price of an action figure, you’re taking away the profit margin.” further addresses cannibalization concerns by selling a variety of “Web only” products or product packages that aren’t available in the stores (for instance, the Game Boy Advance package with games and an accessory). Even with these efforts, though, Arthur says that the dot-com struggles to convince vendors to set up separate buying relationships with it. “If we can get recognition from a vendor as a viable channel, we get more total product allocation, but we also have to let them know that our business is not cannibalizing the stores. We believe it’s actually driving business to the stores,” he adds. has no hard data to prove this, but Arthur says some research shows that many customers browse on the Internet, but purchase at a store.

Chance Cards

The Softbank deal was inked at the perfect time for — just as the online toy market imploded. closed up shop, joining ToyTime and RedRocket. Online leader was in trouble (and eventually closed in April 2001). By spring, through attrition if nothing else, emerged as the leader for the upcoming 2000 holiday season. It needed to ramp up fast to grab the opportunity.

Barbour claims that was never in danger from its competitors. “The E-tailers were not even a close threat,” he says. “It shows how little people know about the toy business to think that they were. This business is about understanding the markets and having the backup of a major organization, and none of the pure-plays had that. No one believed we were going to get outplayed.”

Except maybe by themselves. In spring 2000 the company made another very expensive decision. To meet holiday volume, it leased and built out three state-of-the-art warehouses for Shortly thereafter, executives called Barbour and said they were ready to talk about an alliance. Barbour had long considered outsourcing’s Web site, fulfillment, and inventory management, and had broached the idea with Amazon in early 2000, but Amazon wasn’t interested. It wanted to sell toys, too. One season of doing it on its own changed the company’s perspective, says Arthur. In summer 2000 entered negotiations with, and in August it signed a deal.

But not before it had completed the warehouses. Arthur says the company had no choice: “We were continuing to build out those fulfillment centers because we needed them for the season and we had no assurance that we weren’t going to have to use them.” The decision cost more than $100 million in nonrecurring costs and charges when it shuttered the facilities and laid off 600 warehouse employees.

The deal was worth the trouble, says Arthur. Under the 10- year contract, Amazon handles customer service, warehousing, fulfillment, and the creation and maintenance of the Web site itself. has become the exclusive toy seller on Amazon and does all inventory management, merchandising, purchasing, and marketing on the co-branded site. also takes over sales of all video games and cedes responsibility for CDs and books to Amazon. Items purchased on the site cannot be returned to the stores, but the site does not charge sales tax. (Prior to the Amazon deal, customers could return merchandise to the stores.) pays Amazon a fixed per-unit fee for every item shipped; an annual service fee, paid quarterly; a small percentage of dot-com revenues; and warrants for 5 percent of Arthur says the agreement reduces its operating expenses by 40 percent by cutting the costs of carrying full warehouse capacity that is only needed for peak season. It gives the site a stable E-commerce platform and a fixed fulfillment and distribution cost structure. It also allows to tap into the Amazon customer base through video game sales and incidental traffic.

The new site, launched in September 2000, handed its first problem-free holiday season. The site did $124 million in holiday transactions, with a 99 percent on-time delivery rate. (The site co-branded with Amazon launched in May 2001, and, its higher-end, educational toy store, goes live this month.)

The Amazon deal, says Morningstar analyst T.K. MacKay, is “the right strategy for Toys “R” Us, simply because it joins the most powerful brand name in offline toy retail with the most powerful brand in online retail space.” Adds Sally Wallick, a retail analyst with Legg Mason Wood Walker: “This alliance is one of those unusual partnerships that works for everybody. It takes the heat off of [], solves some of their problems, and allows them to be toy merchants. That’s their strength.”

However, the 10-year duration of the Amazon deal might as well be 1,000 years — and Amazon is clearly the less stable partner. In March, Amazon announced its intention to be profitable by fourth- quarter 2001, excluding a variety of noncash charges, like interest expense. It hasn’t said when it will show a profit by traditional accounting methods. Meanwhile, analysts are pushing Amazon for more detail on its cash position, and many predict it will face a cash crisis and debt crunch unless it discloses details soon. Its stock, at around $15 in early July, is flirting with two-year lows. If Amazon goes down, it takes’s entire business with it.

Arthur doesn’t appear worried. “We did a lot of research,” he says. “We didn’t go into it blindly. We have a lot of confidence in it. The way we look at it, there are going to be a couple of long-term big players out there, and we’re going to be one. We believe Amazon is going to be out there.” Just to be on the safe side, though, the deal includes what Arthur calls “price renegotiation levers” as part of the contract, and neither party can walk away unilaterally.

Winning the Game

Arthur views cannibalization, cross-incentives, and returns as minor issues that he will eventually work out. His main focus is on plugging’s cash drain. executives are cagey on the topic of when profitability might occur.

“Profitability is our key driver right now,” says Arthur. “It’s going to be an interesting year. As much as I’d love to say we know exactly how much we’re going to sell this year, it’s like throwing darts at a board, because of the market consolidation and people’s attitudes toward the Internet.” Toys “R” Us Inc. CEO Eyler has said the site should be profitable in 2002.

“I would be stunned if they tried to take the dot-com public in the next year,” says Morningstar’s MacKay, “even if the market were ripe for that type of thing. John Eyler is focused on bringing the company out of the trenches. It doesn’t make sense that he’s concerned about divesting businesses and doing an IPO or setting up another class of share.”

But Softbank has other priorities. Although parent Softbank Corp. showed increased net profits last year, its dot-com holdings are getting pummeled. D. Rex Golding, principal managing director of Softbank Venture Capital and the partner on the deal (he sits on its board), says that he’s in it for the long haul. Yet, even though Softbank invested an additional $37 million in in February, he says “the long-term objective is an IPO, and I still believe that that’s a viable strategy. A lot of people get hung up on the fact that there aren’t a lot of dot-com IPOs going on right now. The important thing is that we have a five-year perspective on this. We invested in early 2000, so we have a long way to go.”

Web-channel IPOs have proven phenomenally bad at generating value. Judging from the brief history of such events thus far, the only beneficiaries of these public offerings have been the recipients of the IPO proceeds.

Then there are the operational hazards. Cross-incentives with bricks- and-mortar store management, and cross-marketing programs, both crucial components of’s success strategy, are difficult to negotiate between separate corporations. “That doesn’t mean it couldn’t work,” says Arthur, “but it could be problematic.” An expanded investor base would undoubtedly press for more direct competition with Toys “R” Us Inc., but increasing that competition would validate vendors’ cannibalization concerns and perhaps jeopardize the site’s ability to generate independent buying contracts with toy merchants.

In fact, many companies, including and (Kmart’s online division), are finding that it’s cheaper and more efficient to keep a Web division under the corporate umbrella. Both of these companies were strongly branded, venture-backed online retail powerhouses that generated sizable revenues and intended to go public, but pulled back into their parent companies to eliminate operational redundancies and speed profitability. Bluelight, which in May announced management changes and has all but announced a spin-in, was also funded by Softbank Venture Capital under the direction of Golding. So perhaps an IPO is not so viable, or inevitable, after all. Which, given its potential perils, should make Arthur glad.

Despite the challenges, Arthur and executives can take credit for constructing one of the most promising E-tailing models around. And since is just about the last man standing, failure is hard to imagine. But given the vagaries of online retailing, one false step and it could be the roadkill of the industry again fast. The best thing Arthur can do for is to stick close to Toys “R” Us Inc., keep a very close eye on’s financials, hold off on an IPO as long as possible, and maintain his commitment to business as usual. And keep grinning.

Kris Frieswick ([email protected]) is a staff writer at CFO.

Toy Wars

Toys “R” Us is losing market share to Wal-Mart.

Rank Retailer % of Dollars
1998 1999 2000
1 Wal-Mart 17.4 17.4 19.0
2 Toys “R” Us 16.8 15.6 16.5
3 Kmart 8.0 7.2 7.4
4 Target 6.9 6.8 7.2
5 KB Toys/Toy Works 4.9 5.1 4.7