May 28 (Bloomberg) -- Toys “R” Us Inc., the largest U.S. toy-store chain, acquired FAO Schwarz to take over the retailer’s flagship Fifth Avenue store in New York and increase its market share.

Toys “R” Us plans to continue operating FAO Schwarz’s two retail stores in New York and Las Vegas under the same name, along with the company’s Web site and catalog businesses, Toys “R” Us said late yesterday in a statement. The retailer, based in Wayne, New Jersey, didn’t disclose a purchase price.

The deal combines two closely held retailers that have faced increased competition from the Internet and discount chains during the recession. U.S. retail sales of toys generated $21.6 billion in 2008, a 3 percent drop from 2007, according to researcher NPD Group Inc. Mass merchant, discount and online retailers saw the most modest declines, NPD said, as consumers looked for ways to buy non-necessities at the lowest cost.

“Financially, I think it’s brilliant,” Chris Byrne, a New York-based toy-industry analyst and director of content at TimetoPlayMag.com, said today in a telephone interview. “You get all of the cachet and the look of a specialty store and a destination with the operational efficiencies of a giant like Toys “R” Us.”

At Wal-Mart Stores Inc., the world’s largest retailer, entertainment, electronics and toys accounted for 14 percent of sales in the year that ended Jan. 31.

$1-$2-$3 Fun

Toys “R” Us has responded to the effects that rising U.S. unemployment and declining home values are having on consumers by creating value shops at the front of its stores to showcase toys at low prices. The “$1-$2-$3 Fun” shops offer about 100 items for $3 or less, including kazoos, puzzles and costume jewelry, the company said in April.

The company also said last month that it would add new household products near the front of its stores to make shopping more convenient for parents. The “R” Market shops carry about 1,300 products, including laundry detergent, cleaning supplies, paper goods and snacks.

Macy’s will close the 260 FAO Schwarz shops in its stores by November, Jim Sluzewski, a spokesman for the second-largest department-store operator, said today. Macy’s, based in Cincinnati, first opened the shops in the second half of last year, and had planned to expand them to 675, Sluzewski said.

A unit of D.E. Shaw & Co. acquired FAO Schwarz out of bankruptcy in 2004. The toy retailer sought protection from creditors after it failed to compete on prices offered by discount retailers such as Target Corp., analysts said at the time.

Tom Hanks in ‘Big’

FAO Schwarz’s Fifth Avenue store is known for the piano featured in the Tom Hanks movie “Big” and its oversized stuffed animals. The company was founded in 1862 by Frederick August Otto Schwarz and his three brothers.

“It represents an opportunity,” Gerrick Johnson, an analyst at BMO Capital Markets in New York, said today in a telephone interview. “Who knows what they can do with this brand, because the brand is so powerful.”

The roots of Toys “R” Us date back to 1948, when 25-year- old Charles Lazarus opened a baby furniture store and started focusing on toys in 1957. The company adopted the name Toys “R” Us and went public in 1978.

Toys “R” Us agreed to be acquired in 2005 for $6.6 billion by an investment group including Kohlberg Kravis Roberts & Co., Bain Capital LLC and Vornado Realty Trust. The retailer operates about 600 stores in the U.S. and operates, licenses or franchises more than 700 stores in 33 countries outside of the U.S., according to the company’s Web site.

Barring the acquisition of FAO Schwarz, “we probably would have lost an iconic American brand,” TimetoPlayMag.com’s Byrne said. “I can’t imagine who would have bought it. It makes a lot of sense.”

To contact the reporter on this story: Allison Abell Schwartz in New York at aabell@bloomberg.net; Jeran Wittenstein at jwittenstei1@bloomberg.net.

Last Updated: May 28, 2009 11:12 EDT