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For Lego, an Online Lifeline?

When he was a three-year-old boy, Neal McClatchey's father introduced him to Lego. The father and son bonded by building Lego sets together. Today, Neal is 13 years old, and his interests have since expanded. In his house in Murfreesboro, Tenn., a bustling city southeast of Nashville, Neal watches lots of TV, listens to music on his CD player, surfs the Internet, and does his homework from a PC in his bedroom. And, of course, he plays video games such as Tony Hawk Pro Skater. "My friend has a half-pipe in his yard," boasts Neal.

But Neal still likes playing with Lego. In fact, his room is sprinkled with hundreds of Lego blocks, and models of pirate ships and other structures are perched like sentinels on his shelves.

The toy keeping Neal's interest these days is a tool called Lego Digital Designer. It's a piece of free software Neal downloaded from the Lego Web site that lets him create his own 3D models. Earlier this year, Neal submitted a bunch of his models to a design contest sponsored by Lego. In February, he was selected as 1 of 10 contest winners by his peers out of 8,000 submissions.

"THE WRONG PATH." As a reward, Lego this July began selling those models on its Web site. Neal's pirate ship is part of an amusement-park set available for $69.99, and his Five Star Lego Hotel is featured in an airport set retailing for $39.99. "Most of my friends are not into Lego, but they think it's cool I won this contest," says Neal. "It's fun trying to build your own things."

Lego is the world's oldest toy company, an analog enterprise wrestling with the more complicated digital world. In the last two years, the fabled Danish toymaker has lost nearly $500 million on $2.3 billion in sales, according to its latest annual report. But by focusing on the reinvention of its core construction toys for kids like Neal, Lego may have found a strategy to help turn around the 73-year-old privately held company beloved by children all over the world.

"It took us a couple of years to realize we were going down the wrong path," says Soren Torp Laursen, the 42-year-old president of Lego Americas. "We are back to our roots."

BETTER RELATIONS. For Lego, its roots are the Lego brick and a value system that emphasizes children's imagination and freedom. As part of a turnaround plan announced last spring, Lego said it would abandon its forays into theme parks, clothing, and software. This July, Lego sold its LegoLand parks group to Blackstone Capital Partners for about $450 million, retaining a 30% stake in a newly formed venture that combined the parks with the assets of Merlin Entertainments. Lego still sells software and kids fashion through licensing partners, but it no longer makes the products.

Lego has also laid off 1,000 employees over the last two years and is now down to about 6,000 workers. Just as important, it has worked hard to improve its relationships with toy retailers by creating better in-store displays and filling a higher percentage of orders. "Soren has done a fantastic job," says John Barbour, President of the U.S. division of Toys 'R' Us (TOY). "They are probably our most improved supplier this year. His leadership has made a massive difference."

And on Aug. 29, BusinessWeek has learned, Lego will release a new version of Lego Factory, a recently launched brand that combines Digital Designer with the ability to let customers to share their personal designs as well as order the bricks necessary to build those custom models, all via the site. It will be the first time kids can order parts for the designs they've built. "We're taking the phenomenon of mass customization to a whole new level," says Michael McNally, senior brand relations manager for Lego.

NOW NO. 3. It's too early to declare the turnaround plan an unqualified success but early results suggest it's working. Spurred by sales of its Star Wars-themed Lego sets and other construction toys, Lego this year has been the fastest-growing company among the top five toy manufacturers, according to researcher NPD Funworld. Thanks to its 21% growth this year, Lego has vaulted ahead of LeapFrog (LF) and Bratz-maker MGA Entertainment to become the third-largest toy company in the world, according to NPD Funworld.

In its core construction-toy market, which represents about 4% of the $20 billion toy industry, Lego has increased its market share to 69% as of the end of June, 2005, up from 64% the year-ago period, says NPD. "Because of the uniqueness of their product, they've been able to carve out a niche for themselves," says NPD analyst Anita Frazier. For the entire year, Lego CEO Laursen expects to increase sales and make a small profit. "It's obviously not enough, but it's a step in the right direction," he says.

Lego execs are cautious because they know children are fickle -- and that 50% of a toy company's sales come through in the last six weeks of the year. Analysts say a slew of Harry Potter-themed Lego sets to be released for the holidays will help keep the momentum going. "They are probably one of the most improved companies in 2005," says Sean McGowan, managing director of investment bank Harris Nesbitt. But he warns: "I'm not sure what happens when Star Wars and Harry Potter aren't in the theatres."

MODEL FOR THE FUTURE? One answer that may keep the turnaround alive next year and beyond is the release of the new Lego Factory. As children become more and more accustomed to instant gratification from increasingly sophisticated amusements, toy analysts say kids are less likely to spend time building things than playing with video games or their iPods. Child researchers call this phenomenon "age compression," and it's a major concern within the toy industry.

Lego is betting that its Lego Factory will help reengage children, serving as a model for the future, and some analysts say it could work. "By getting kids more involved in the development of the toy, they may be more willing to make that investment," says McGowan. "It could keep kids coming back for repeat visits."

By enabling kids to customize and share their own designs, Lego is tapping into the Internet's growing ability to bring people together to develop and market new ideas and products. If the Lego Factory takes off, Lego managers say the idea of giving more control to their customers could be applied to other products.

"I MIGHT BUY THAT." Some of the groundwork has already been laid. is the 11th most visited Web sites among children, according to Nielsen NetRatings. And after releasing the Digital Designer tool last year, 1 million children have downloaded it. "We have 100 designers in-house," says Lego Vice-President for Interactive Experiences Lizbeth Pallesen. "Maybe we should have 300,000 designers who don't work for Lego." CEO Laursen goes even further: "The company should be run by consumers," he says.

If Neal McClatchey is any sign, Lego may be on to something. When told of the forthcoming Factory toy, Neal says he thinks it's a really good idea. "It would be a lot more fun," he says, to be able to design, share, and offer your models for sale. "If I like what other people are building, I might buy that too," he says.

Still, if Lego wants kids to run the company, it may be in for a few surprises. When asked if he had any advice for Lego, Neal didn't shy away. "It would be cool if they could lower the price of Legos," he says. "The smallest new Lego Factory set is $40. $20 would be a better price."

By Spencer E. Ante in New York

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