More Work Needed at Toys 'R' Us

It has already spruced up stores and cut prices, but such moves still haven't been enough to put it back at the top of its game

Until recently, Wall Street had been hoping that this holiday season would herald a turnaround for Toys 'R' Us (TOY ) in its struggle against discount stores. In the last two years, the toy retailer made many of the changes investors and analysts thought might return Toys 'R' Us to its former dominance. It remodeled stores, refreshed inventory, and became more price-competitive on popular toys. This was supposed to be the Christmas that delivered the reward for those changes.

Alas, the holidays now look highly uncertain. Worse yet, the longer-term outlook isn't too bright, either. The most recent evidence of Toys 'R' Us' challenges came on Nov. 17, when the Wayne (N.J.)-based outfit said sales at U.S. stores open at least a year fell 3% in the third quarter, including an 18% decline in video-game sales. It lost 18 cents per share, or $38 million, in the quarter, double the consensus a 9-cent loss. Sales for the quarter did rise 2.2%, to $2.3 billion. But Toys 'R' Us cut guidance on earnings for the year to a range of $1.05 to $1.15 a share, down from the expected $1.15.


  After the disappointing news, investors drove the shares down 17% in two sessions, to $10.50. The stock rebounded a bit on Nov. 20 to nearly $11. Still, against a backdrop of growing optimism that the economic recovery may be faster and stronger than expected, Toys 'R' Us faces an uphill battle in convincing investors it has what it takes to outperform its peers.

Rivals like Target (TGT ) and Wal-Mart (WMT ) started promoting toys earlier and more aggressively this year, analysts say. Prudential Equity Group analysts released results from a pricing survey on 50 "hot" toys in mid-November that showed Toys 'R' Us' prices were 5.5% higher than those at Wal-Mart.

Price is a major factor in toy buying. Toys 'R' Us has rivals beat when it comes to selection. But discounters are all too willing to trade losses on popular toys for store traffic. Their goal is to lure holiday shoppers with rock-bottom toy prices and the convenience of being able to buy nontoy items -- usually higher-margin products -- at the same time. Toys 'R' Us can't really compete against that.


  Little wonder the crucial end-of-year income burst -- Toys loses money in the fiscal year's first nine months -- has been on the decline. In the fourth quarter of 2001, it reported earnings per share of $1.39 and in 2002, $1.30. Analysts on average expect $1.22 per share for the upcoming holiday quarter, a 7% decline.

Like many analysts, Harris Nesbitt Gerard's Sean McGowan, who has followed Toys 'R' Us for 17 years, says its recent efforts to improve have been on the mark. "There's a vibrancy to the business." But he fears more drastic measures may be needed for a turnaround to take hold. Wal-Mart is getting stronger, he points out.

He expects Toys 'R' Us will fall short of the lowered total-year guidance, reporting closer to $1 per share in earnings. "They're showing up and losing the game," says a frustrated McGowan. (His firm doesn't do investment baking with Toys 'R' Us, and he personally doesn't own its shares.)


  The giant isn't idly watching its prospects deteriorate. At its third-quarter earnings briefing, CEO John Eyler announced plans to close money-losing Kids 'R' Us and Imaginarium educational-toy stores. While those are good strategic moves, analysts say, more is needed to help generate cash flow for 2003 and beyond. The planned shutdowns were long overdue, McGowan argues, and Toys 'R' Us should be considering more "radical changes" like a spin-off or sale of its relatively strong Babies 'R' Us chain of 193 stores.

Toys 'R' Us didn't return calls requesting comment. And even though the Babies 'R' Us group has been doing well, the parent still needs to fix its main toy business to get back on track. Closing more underperforming core Toys 'R' Us stores would help. "Out of 681-plus U.S. stores, there have to be several dozen that need to be looked at," McGowan says.

Eric Jemetz, consumer analyst at New Amsterdam Partners, agrees. "They're being too hopeful," of turning around underperforming stores. "They need to retrench and make investments in their best stores." Jemetz points to the booming traffic at the Times Square Toys 'R' Us store in New York as a smart investment. (Jemetz doesn't own the stock, and neither does his firm.)


  While analysts say Toys 'R' Us' balance sheet is in decent shape, ratings agences are pressuring the company to improve financial performance. After the third-quarter earnings report, Standard & Poor's lowered its outlook for Toys 'R' Us' credit rating to "negative," noting that it doesn't expect "operating performance to meaningfully improve until the U.S. toy business turns." Fitch Ratings has followed suit.

Some analysts remain hopeful that Toys 'R' Us can engineer a rebound. In the long run, "I'm not completely pessimistic," says Joseph Beaulieu, analyst at independent research firm Morningstar. "I don't believe Wal-Mart will take over the world and that there isn't room for specialty retailers."

Perhaps. But ultimately, Toys 'R' Us needs to get smaller and more focused to stand a chance of staying viable next to discount giants, analysts say. It has taken some steps, but it needs to do more. Until then, investors who play with this stock will likely find it's not much fun at all.

By Amy Tsao in New York

Edited by Beth Belton

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