So Many Toys, So Little Joy

As playthings become ever-cheaper and more ubiquitous -- and as kids grow jaded -- the entire industry is facing some painful prospects

TOYS
Parents and adults, you might as well face it: The gift of a new toy to a child may not elicit the squeals of delight everyone likes to associate with holiday shopping anymore. These days, toys are sold everywhere -- supermarkets, drugstores, tourist destinations, online. And because toys are cheaper than ever, the most ordinary occasion has become a gift-giving event.

First dentist appointment? Why not reward the brave little one with a new action figure or doll. Going to a friend's for dinner? Forget flowers for the hostess, bring a board game for late-night entertainment. Need to ward off an eight-year-old's meltdown during an airplane trip? A video game should do the trick.

In 1990 51% of toy purchases were for Christmas and Chanukah, and only 28% for "no special occasion," according to a special study for BusinessWeek Online conducted by toy-market researcher NPD Group in Port Washington, N.Y. But by 2002, only 38% of toy purchases were for holiday gifts, and the amount given for any reason was up to 31%.

PRIMED FOR BACKLASH.

  Yet, per-capita spending on toys in the U.S. is more than $300 -- nearly three times the level in Europe and more than 10 times that in Asia and Latin America, according to a November research report on the toy industry from brokerage Harris Nesbitt Gerard. "Now, to set Christmas apart as a holiday associated with giving gifts, people feel they need to provide a really huge quantity of toys," observes Richard Hastings, chief economist at retail research firm Bernard Sands.

The result is kids numbed to the barrage and parents primed for a backlash against rampant consumerism, he says. "Children today are living in a world of tons of toys," says Hastings (see "Old Toy Favorites Lead the Way").

As the U.S. gears up for its annual holiday toy-shopping frenzy, the surprising truth is that the $21 billion U.S. toy business is hurting. Competition at both the retail and manufacturing level has become far more intense over the past decade. As prices have fallen, dollar sales have been roughly flat for the past five years and are slipping so far this year, according to NPD. As manufacturers and sellers get squeezed, profits are harder to come by.

FEWER STORES.

  Retailers are really taking it on the chin. On Nov. 18, no less than venerable toy retailer Toys 'R' Us (TOY ) shocked Wall Street with its third-quarter loss of $38 million, 25% steeper than last year and twice what analysts expected, even as sales in the quarter rose 2.2%, to $2.3 billion. Toys, which does the bulk of its business in the fourth quarter, is profitable on an annual basis (see "More Work Needed at Toys 'R' Us).

And FAO (FAOO ) -- parent of FAO Schwarz, Zany Brainy, and Right Start -- briefly sought bankruptcy protection early in 2003 and is now scrambling for capital to get it through the holiday season. After going public with its liquidity problems in early November, its stock is back below $1 after trading as high as $6 in October.

In cities around the country, independent toy stores are falling by the wayside. Only those with an easily reached, highly trafficked retail location are surviving, says Hastings. To boost profits, Toys 'R' Us now plans to close its freestanding Kids 'R' Us and Imaginarium stores. It and other toy sellers are also filling the shelves with private-label toys, which are cheaper to make and carry higher margins.

SELLING EVERYWHERE.

  A few bright spots do exist. Board-game makers are looking forward to a jolly holiday (see "Board Games Pass Go"), and a few companies are bucking the trend (see "American Girl's All-American Success"). The trouble is, more private-label merchandise and toy-store closings mean less shelf space for brand-name toys, which puts pressure on manufacturers. They, in turn, have developed alternative channels to distribute products -- including developing private-label goods, distributing products in supermarkets and drugstores, and going direct to customers via online and catalog sales.

LEGO Group is opening freestanding stores and is also selling to supermarkets, drug chains, and craft stores. KB Toys is acting as a toy distributor to Sears (S ) and CVS (CVS ). All this adds up to more toys in more places -- and more competition.

The two largest manufacturers -- Mattel (MAT ) should do $4.9 billion in sales in 2003 and Hasbro (HAS ) $3.1 billion, according to U.S. Bancorp Piper Jaffray estimates -- are faring better this year. But their fortunes have improved only after working to cut costs and streamline operations following numerous acquisitions, as the industry consolidated in the late 1990s.

LEAPFROG FLOPS.

  Boosting profits remains an elusive game. Mattel, maker of Barbie, Hot Wheels, and Fisher-Price brands, posted third-quarter sales that were essentially flat, while profit margins slipped. Gross margin was 49.3% in the third quarter, a decline of 1.1 percentage points from a year ago. Much of the drop was due to higher costs for raw materials used to make and package toys.

Even LeapFrog Enterprises (LF ) the rising star of toy manufacturing, now ranked No. 3 with an expected $679 million in sales, according to Piper Jaffray, is under pressure. On Oct. 22 it announced a 25% increase in net profits in the third quarter, to $33.4 million on sales of $204 million, but it missed analysts' estimates nonetheless. The high-flying shares had plunged from $46 before the announcement to $30 by Nov. 20 (BW subscribers see, 12/1/03, "Leapfrogging Leapfrog").

The pressure on profits isn't going away as retailers increasingly compete on price. Independent toy consultant Chris Byrne sums up the dynamic: "One word: Wal-Mart." He, like many in the industry, believes the No. 1 toy seller in the U.S. is selling hot advertised items below cost. "They squeeze margin, and in some places eliminate it," he says.

A BIG THREE.

  A survey of toy prices by Prudential Equity Group analysts found that Wal-Mart's (WMT ) prices on a basket of top-selling toys was 5.5% cheaper than Toys 'R' Us and 11.2% cheaper than Target (TGT ). "Wal-Mart appears to be far more aggressive on price this year than last," Prudential's Nov. 12 report concluded.

Why so aggressive? Retailers of all stripes are trying to attract toy shoppers to their stores in hopes they'll buy higher-margin items in other departments. Piper Jaffray estimates that by yearend the top three retailers, all of which are gaining market share, will control 50% of the U.S. toy market (Wal-Mart with 20%, Toys 'R' Us with 18%, and Target with 12%).

Manufacturers scrambling to find ways to make products cheaper have already outsourced the vast majority of production overseas. Piper Jaffray estimates that 90% of toys are imported, most of them from China. Mattel and Hasbro are improving fundamentals mainly by reducing costs and eliminating debt.

WHAT ELSE YA GOT?

  Demographics aren't helping the industry, either. The 88 million children of the baby boomers are growing out of the toy-playing stage. In 2000, children under 12 made up 21.3% of the population, a recent low, and are estimated to decline to 19.8% in the next 10 years, according to Harris Nesbitt Gerard analyst Sean McGowan, who believes the number of children between ages five and nine is dropping in absolute terms as well.

Plus, children seem to be outgrowing their toys at an earlier age, says Maria Weiskott, editor-in-chief of toy industry trade magazine Playthings. Kids as young as nine may feel bored with toys that 12-year-olds used to embrace. "That's hitting the traditional toy industry very hard," she says. "Kids are more sophisticated, and therefore the industry is hard-pressed to come out with more sophisticated toys," she says. NPD estimates 62% of toys purchased are requested by the child.

So far this year the industry doesn't have a winner on its roster that will ignite sales. "There's no real standout toy that we've seen that's going to take off and drive the industry in the fourth quarter," says Michael Redmond, senior industry analyst at NPD, which found consumer shopping excitement "chilly" in an October survey. It also noted that parents plan to do less buying at discounters this year, which could give the manufacturers a little more leverage to increase profit margins next year.

"Consumers have gotten smarter," Byrne says. "They're deciding 'I'm not going out in the snow at 4 a.m. to stand outside of a Toys 'R' Us for a hot toy." For now, many companies in the industry are having trouble staying afloat, even as children swim in year-round sea of toys.

By Amey Stone, with Amy Tsao and Eric Wahlgren, in New York

Edited by Douglas Harbrecht

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