How eToys Could Have Made It
By Arlene Weintraub
What a way for this toy story to end. In retrospect, founder Toby Lenk poured so much money and energy into turning his Web upstart eToys into one of the most famous names on the Net that many assumed the company would be part of an elite group of Web survivors, along with Amazon.com, Yahoo!, and auction site eBay. But on Feb. 5, the once high-flying e-tailer inched closer to bankruptcy, when it announced that it would shut down and lay off its remaining 293 employees Apr. 6.
It was the latest development in eToys' downward spiral, which started when the company said in December that holiday sales wouldn't come anywhere near its earlier estimate of $210 million. In January, eToys laid off 700 employees, shut down two warehouses, and closed its British operation. Faced with the prospect of runnning out of cash by spring, the company hired Goldman, Sachs & Co. to find a buyer. But any hope that eToys will be rescued has all but disappeared.
The lessons in eToys' fate? Actually, they involve more about what doesn't work in online retailing than what does. This much is clear: If you expect to become a billion-dollar e-tailer, you cannot limit yourself to a single product category plagued by intense competition and seasonal peaks. Television ads may make you famous (most marketing studies showed that parents just loved the eToys ads), but they won't drive sales on their own. And, most important, a pure player ignores at his own risk the deep pockets and brand recognition of traditional retailers. Those not willing to partner with market leaders are better off focusing on small niches that may not generate massive sales but can at least produce a profit.
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It's ironic that Lenk considered the niche option when he launched eToys in June, 1997. He and his first employee, Frank Han, had a long discussion they later jokingly called "to Barbie or not to Barbie." (For more on the turnaround-in-progress at Barbie's maker, Mattel, see "Barbie Is Turning Heads on Wall Street Again".)
Han thought the company should stay small and focus on educational toys. But Lenk wanted to shoot for the stars, building a massive online toy warehouse that would give Toys 'R' Us a run for its money. The key, Lenk thought, was focusing on customer service and convenience. "Toby was convinced he could solve the problem of parents hating Toys 'R' Us," Han said in a June, 2000, interview.
That was Lenk's first miscalculation. No company -- online or off -- can take on a well-established market leader and win without offering consumers a compelling reason to switch. "Customer service in and of itself doesn't do it," says Jupiter analyst Ken Cassar. Offering the lowest prices might work better, but that would be impossible for eToys. Without the volume-buying power of a Toys 'R' Us or Wal-Mart Stores, eToys couldn't compete on price. And Lenk couldn't engage in wholesale discounting because profit margins in mass-market toys are already low, hovering around 20%.
Those same factors have proven to be deadly for other narrow product categories on the Internet -- pet supplies and beauty products among them. But some niche players are making it online by thinking small. SmarterKids.com, for example, sells only educational toys, which have margins of 40% to 50%. The company, which recently merged with catalog retailer Earlychildhood, is expecting revenues of about $69 million this year, an operating profit of a couple of million, and 25% revenue growth per year.
It's far from the blistering 100% growth eToys promised investors it could maintain to reach profitability in 2003, but that doesn't faze SmarterKids CEO David Blum. "Small is sustainable," Blum says. "You have to come to grips with reality. I don't think eToys ever did."
But small just wasn't Lenk's size. Although he declined an interview request for this article, Lenk was adamant in past meetings that eToys could succeed as a pure-play e-tailer if it spent heavily to build the company's global presence and brand. By doing so, the company would hit the $750 million in annual sales that it need to break even, he predicted. Co-workers say he developed an a devotion to that vision, pounding the table and repeating the mantra "all kids, all Internet," even after investors started demanding quicker progress toward profitability.
Lenk spent lavishly on marketing, allocating two-thirds of eToys' $56 million advertising budget on pricey TV spots in 1999 and 2000. But that didn't do much beyond turning eToys into a household name. "The focus was on brand-building rather than revenue-building," says Robert Labatt, research director at Gartner Group.
To build sales, eToys needed to home in more closely on its target customers and give them incentives to buy from the site. Although eToys distributed a new catalog in November to try to push sales, it never offered freebies, not even free shipping, as Toysrus.com offered for orders topping $100. Lenk shunned such guerilla-like tactics, even though, in retrospect, they might have turned more site visitors into buyers. "Coupons, free shipping, 30% off Barbie -- you can't make money doing that," he declared in a June interview with BusinessWeek. A few carefully planned price promotions might have helped raise eToys' rate of converting site visitors into buyers, say analysts. In December, just 8.7% of visitors moved through the checkout line at eToys, compared with a 13.9% buy rate at Amazon.com, according to PC Data. "Couponing would have encouraged more people to at least try eToys," says Leo Griffin, an Internet consultant at Los Angeles-based Monitor Marketspace.
Removing the emphasis on TV would have also helped the company conserve cash after the April dot-com market swoon. eToys' total spending on TV and print ads in 2000 was about $36 million, the same as it was in 1999. Other dot-coms, meanwhile, were cutting back. Amazon lowered its TV and radio spending 40%, to $10.7 million, even before the holiday quarter started, according to ad tracker CMR. Web superstore buy.com slashed its ad budget by 58%, to $3.2 million. It also cut TV spending 89%, to a mere $363,000, for the January to September, 2000, period. Not Lenk. "eToys just kept going at full throttle," says Tom Wyman, a former analyst with J.P. Morgan Chase & Co.
The ad campaign backfired on more than just the bottom line. eToys needed more product lines to reach its $750 million annual sales target and justify the expense of its new $80 million distribution network. In July, 1999, Lenk started to branch out by buying online baby-supply retailer BabyCenter. In 2000, he added party supplies, hobbies, and specialty toys and planned to introduce eToys private-label merchandise and clothes.
But soon he found himself facing a huge new marketing challenge. Unlike Amazon, eToys couldn't just start adding products and expect consumers to change their mindset about what the company was. "They built this wonderful brand that symbolized toys, and they were trapped by that," Wyman says. eToys might have remained standing had Lenk been willing to negotiate with what he considered to be the enemy. In early summer, top executives of Toys 'R' Us set up a meeting with Lenk to discuss how the two companies might work together, according to a source close to Toys 'R' Us. But Lenk held fast to his belief that eToys could make a go of it without an offline partner.
That was a big mistake. In August, Toys 'R' Us announced it had teamed with Amazon.com to handle orders at Toysrus.com. Each company would play to its strength: Amazon would take care of fulfillment, while Toys 'R' Us would control inventory and be posted on the Amazon site. Toys 'R' Us would pay a fee for orders delivered, and Amazon would also share in revenue.
The deal turned out to be a godsend for Toysrus.com. Holiday sales at the site tripled, to $124 million, even though overall online toy biz sales were up just 40% over the 1999 level, according to Merrill Lynch & Co. Sales at eToys rose just 23%. "That was a deal eToys could have made," says Kevin Silverman, an analyst for ABN-Amrr. Such a deal would have not only boosted eToys' holiday revenues but its image as well.
Analysts estimate that Toysrus.com pulled in $150 million during the holiday quarter and that Amazon probably took a cut of $37 million to $52 million. That revenue could have belonged to eToys, helping justify the $80 million it spent on the warehouses and giving it staying power. Says Wyman: "It would have helped build the perception that eToys will make it over the long haul, which would have helped the stock price, and may have led to eToys getting more financing."
eToys could have taken a cue from Drugstore.com as well. The reason Drugstore.com is still around, while MotherNature.com and dozens of beauty sites aren't, can be summed up in one name: Rite-Aid. Four months after Drugstore.com was launched in February, 1999, it partnered with Rite-Aid to handle its customers' online prescriptions. "Being able to leverage the reputation of the stores is a huge benefit," says CEO Peter Neupert. That partnership, as well as a deal to be Amazon's exclusive health and beauty provider, helped Drugstore.com convert 16.4% of its site visitors into buyers in December -- the highest customer-conversion rate among the top 20 e-tailers, according to PC Data.
Why Lenk didn't find a bricks-and-mortar partner is a mystery to those who think he should have seen the writing on the wall a year ago. "That's when investors started demanding that companies get closer to profitability faster," recalls SmarterKids' CEO Blum, adding that he started looking for a merger candidate in January, 2000. "We realized we needed a partner, and we had better find one while we still had cash in the bank."
With his cash reserves running down, Lenk may no longer have time to find an alternative to eToys bankruptcy. Some analysts have speculated that the technology behind eToys' sophisticated site and its distribution facilities might be attractive to a traditional company looking to boost its online presence. These analysts name Wal-Mart and Target as the most likely suitors. But they say while the giant retailers might be interested in some of eToys' assets, neither one is likely to buy the whole company, even with its stock trading at under $1, down from a peak of more than $80 in October, 1999.
To some of those involved in building what was one of the Web's most well-known brands, the increasing probability that eToys will go the way of the Cabbage Patch Doll has been hard to comprehend. "When the cash crunch came, [Lenk] needed to make a series of short-term decisions that would have conserved money," says Phil Polishook, the former marketing vice-president at eToys, who left in November, 1999, and is now at venture-capital firm Redpoint Ventures. "But he just continued on his path."
Lenk's belief that eToys could move full-steam ahead, without regard to the demands of either his industry or the stock market, may have caused eToys to get thrown out of the sandbox before its time. It's a lesson that surviving e-tailers should take to heart.
Weintraub is a correspondent in BusinessWeek's Los Angeles bureau
Edited by Douglas Harbrecht