Everything Must Go ... Online: No More Toying Around With eToys and Toys R Us

eToys menaces toysrus.com, but the Toys R Us empire strikes back.
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Editor's note: This story is part of

TSC's

three-day series on the e-tailing Internet wars.

With its uninspiring performance in real-world toy sales, an online store owned by

Toys R Us

(TOY)

appears to be dead meat going up against the sleek, Internet-only retailer

eToys

(ETYS:Nasdaq). But a closer look at the online effort of Toys R Us suggests that the lurching giraffe of the toy industry may have more going for it than people realize.

This category, which is expected to account for 5% of all U.S. toy sales by 2003, according to

Forrester Research

, is shaping up to be the next big turf war on the scale of

Amazon.com

(AMZN) - Get Report

and

Barnes & Noble

(BKS) - Get Report

.

The similarities are striking. Like Barnes & Noble, Toys R Us is one of the largest players in the real world. But its failure to jump on the Net early in the game places it in the position of playing catch-up to eToys, which is a tiddlywink in comparison by sales and market reach. And in a sign that competition is heating up,

Consolidated Stores

(CNS) - Get Report

said last week that it would combine its

kbtoys.com

Web site with

BrainPlay.com

and form a new entity,

KBToys.com

.

Not Exactly Hours of Fun
Stock price of Toys R Us over two years

The shortcomings of the Paramus, N.J.-based Toys R Us are clear, both anecdotally and in the numbers. Like everyone's cable TV operator, Toys R Us is one of those businesses that no consumer rushes to defend. Maybe it's the missing salespeople or the sluggish lines or just the annoyance of shopping with kids as they whine for a Barbie, a Furby or a Ken Griffey Jr. video game.

Meanwhile, operating income for Toys R Us plummeted to $281 million in fiscal 1998, ended Jan. 31, 1999, from $844 million one year earlier, amid restructuring costs and nearly flat revenue at $11.2 billion. Given Toys R Us' problems executing its business offline, its ability to execute online seems dubious. And the current

toysrus.com

Web site isn't encouraging. For example, unlike virtually all other established online retailers (including eToys), toysrus.com neither lets users search for products from its home page nor makes an obvious link from that page to a site search.

In comparison, eToys looks pretty good. The Santa Monica-based retailer, which launched its store in October 1997, has zoomed from selling $530,000 worth of toys online in the third quarter ended December 1997 to $22.9 million in the same quarter one year later. The site is elegantly designed, and its IPO last week was enthusiastically received: At the end of its first day of trading, eToys stock had nearly quadrupled from its offering price of $20 a share, and the company had a market cap of $7.8 billion, bigger than the Toys R Us market cap of $5.7 billion.

But recent moves by Toys R Us indicate that it has a lot more going for it than its current Web site.

Toys R Us said it would establish toysrus.com as a separate subsidiary, one that would be located in Silicon Valley and will run all the parent company's online businesses. It has an outside investor in toysrus.com:

Benchmark Capital

, the Silicon Valley venture capital firm that has earned a staggering return on its investment in online auctioneer

eBay

(EBAY) - Get Report

. The toysrus.com subsidiary is completely rebuilding the company's Web site, which will launch in the second quarter. Toys R Us acquired a $30 million warehouse in Memphis, Tenn., specifically for toysrus.com. And it hired a game industry veteran to run toysrus.com -- Bob Moog, founder and chairman of

University Games

.

So what advantages does toysrus.com have that will enable it to catch up to eToys?

How They Stack Up
Toy sales in most recent fiscal year

Source: Company reports and Prudential Securities

It starts with getting the goods from manufacturers. While eToys sold $30 million worth of toys in its fiscal year ending March 31, Toys R Us sold $6.58 billion worth of toys in the U.S. in its latest fiscal year, according to

Prudential Securities

. That's more than 200 times what eToys was selling. "They have a huge buying power advantage," says David Friedensohn, CEO of online video retailer

BigStar Entertainment

.

Toys R Us' volume purchases mean it should be able to get product at a lower price than does eToys, says Moog. In addition, he says the vast Toys R Us inventory will help the online subsidiary get access to new and exclusive as well as low-supply products. "Toys R Us will use every advantage it has with its vendors to assist toysrus.com," Moog says.

A second advantage for toysrus.com appears to be the Memphis warehouse. Memphis is a key location; being in the same city as

FedEx's

(FDX) - Get Report

national shipping hub makes for speedy deliveries. Plus, the warehouse, by different accounts, is no ordinary warehouse. It is highly automated, with internal conveyor belts and other equipment. A state-of-the-art warehouse facility can be 60% or 70% more productive than a nonautomated one, says Robert Milner, a real estate broker and logistics consultant with

Colliers Wilkinson & Snowden

in Memphis.

Meanwhile, eToys is trying to improve its warehouse and fulfillment system, according to disclosures in its prospectus. During the quarter ended March 31, when eToys had a gross profit of $821,000, the company reported it lost $270,000 from inventory theft, or more than 4.4% of the quarter's sales.

"That's high. That's a problem," says Rich Frank, senior manager, loss prevention and safety services for

DFS

, a distribution and fulfillment subsidiary of

Spiegel

(SPGLA)

. For retailers, inventory shrinkage from theft and paperwork errors combined usually amount to less than 2% of sales, he says. eToys said in its filing that it's arranging to get new warehouse space in Utah.

An eToys spokeswoman said the company wouldn't be able to comment for the article, because of the IPO.

As far as getting people to come to its Web site, Toys R Us will have resources that eToys doesn't, Moog says. "Everything that Toys R Us does will have branding for toysrus.com," says Moog. That includes every bag given to customers, every receipt, signage in the parent's stores and on all advertising, he says.

But publicizing a Web site's name in this manner hasn't proven effective yet, says Ken Cassar, an analyst in the digital commerce group of

Jupiter Communications

. Such measures won't work without an independent marketing and promotion effort for the Web site, he says. (Both eToys and Toys R Us are Jupiter research clients.)

And an association with Toys R Us is not necessarily an advantage for an online retailer. The demographics of the real world don't match the Web's, and people haven't necessarily had good experiences shopping Toys R Us offline or online (the site suffered from slowdowns in the holiday season, according to several reports).

Yes, the online/offline demographics are different, Moog says, pointing out that Toys R Us shoppers are mostly female, unlike the more more sex-balanced Internet. And, Moog admits, "the store experience could be better than it is." But, he says, he'll be able to persuade people that it's "a safe, good experience to shop at toysrus.com."

Moog says he's getting one more important thing from Toys R Us: independence. Toys R Us hasn't hemmed him in, he says, on issues such as product pricing, which could possibly cannibalize in-store sales. The message he has gotten from the Toys R Us board and CEO Robert Nakasone, he says, is: "If we're going to lose anything from our stores, we'll lose them to ourselves."

Concludes Moog, "Right now, it's considered a negative by many, many people to have a connection to a brick-and-mortar company. We are going to prove that is an incredible advantage."