Dec. 11 (Bloomberg) -- KB Toys Inc., the 86-year-old toy retailer, filed for bankruptcy with plans to close its stores, citing a “sudden drop” in sales in the past two months.

The Chapter 11 filing comes three years after KB Toys ended a previous bankruptcy by closing almost half of its 1,200 stores. The chain has shut hundreds more since amid increased competition from Wal-Mart Stores Inc., Toys “R” Us Inc. and Target Corp., which together control about two-thirds of the U.S. toy market, according to industry analyst Sean McGowan.

“Just about everyone I’ve talked to in the toy industry has been concerned about their survival for years,” McGowan, at Needham & Co. in New York, said in an interview.

KB Toys, based in Pittsfield, Massachusetts, operates 277 mall-based stores and 154 locations in outlet malls or strip centers. Its bankruptcy follows that of retailers Linens ‘n Things Inc., Circuit City Stores Inc. and Steve & Barry’s LLC heading into what may be the worst holiday-shopping season in four decades.

“I think we’ll see more bankruptcies in the first six months of next year than we’ve seen in the past five years combined,” Britt Beemer, chairman and founder of America’s Research Group, said today in a Bloomberg Radio interview. “We’re in a retail environment that clearly I would describe as a retail freefall.”

Distribution Sale

KB Toys will try to sell its wholesale distribution business, according to papers filed today in U.S. Bankruptcy Court in Wilmington, Delaware. The fate of its online operation, which sells toys and games through the www.kbtoys.com Web site, wasn’t mentioned in the court filing.

More than a dozen U.S. retailers have entered bankruptcy this year as consumers cut spending during a yearlong recession, according to data compiled by Bloomberg. Circuit City and Boscov’s Inc. have said they will reorganize and leave court protection as smaller chains, while Linens ‘n Things, Sharper Image Corp., and Value City Department Stores LLC all plan to liquidate.

KB Toys owes as much as $500 million to creditors and has assets valued at the same amount, according to today’s filing. The debt includes $190 million owed to lenders. Among the top unsecured creditors listed in court papers are Li & Fung Toy Manufact 1/F, Hong Kong Spinners Inc., owed $27.2 million, and Mattel Inc., owed $1.3 million.

Prentice Capital

The company is controlled by Prentice Capital Management Inc., which acquired a majority stake when KB Toys left bankruptcy three years ago.

Joel Waite, a lawyer for KB Toys, wasn’t immediately available for comment. Geoffrey Webb, the company’s director of advertising, didn’t immediately return a call.

Of KB Toys’ almost 11,000 employees, about 6,500 are temporary workers brought in for the holidays, Controller Raymond Borst said in court documents.

The company said it has about $480 million in sales annually, making it the leading mall-based toy retailer in the U.S. KB Toys holds no more than 2 percent of the U.S. toy market, and most of those sales will be absorbed by its three biggest rivals, McGowan said.

20 Percent Drop

Sales were little changed from Feb. 3 until Oct. 4, KB Toys said. Since then, sales have dropped almost 20 percent, the company said.

“The liquidity crisis is directly attributable to a sudden and sharp decline in consumer sales,” Borst said in court documents.

The company offered buy-two, get-one-free on its entire stock of Barbie dolls and accessories and Fisher-Price preschool toys until 12 p.m. on the day after Thanksgiving. On its Web site, KB Toys is selling dolls for as much as one-third off, electronics for as much as 50 percent off, and learning systems for as much as 75 percent off.

McGowan estimates toy sales will drop 4 percent to 5 percent in the holiday season and about 4 percent for 2008. The holiday fourth quarter comprised 55 percent of Mattel’s total sales last year and 40 percent for Hasbro Inc., the maker of Transformers action figures and the Monopoly board game.

McGowan said KB Toys also was hurt by “factors that were present in their first bankruptcy.” The company’s costs are too high, it struggles to compete with Wal-Mart, the toy industry isn’t growing much, and the retailer doesn’t carry video games, he said.

The case is In re KB Toys Inc., 08-13269 U.S. Bankruptcy Court, District of Delaware (Wilmington).

To contact the reporters on this story: Steven Church in Wilmington, Delaware, at schurch3@bloomberg.net; Heather Burke in New York at hburke2@bloomberg.net.

Last Updated: December 11, 2008 16:48 EST