How Culture Clash Sank the Toys 'R' Us Deal

Baldwin Louie — Fri, 20 Aug 1999 18:00:00 -0400

Having missed out on the first e-Christmas shopping boom at the end of last year, Toys "R" Us (TOY) CEO Robert Nakasone knew he had to get cracking early in 1999. Still sore about losing the title of top offline toy retailer to Wal-Mart, Nakasone went on the offensive. Between January and April, he talked with anyone he could - inside and outside of Toys - about jump-starting a Web business to thwart the dot-com upstarts.

After aborted attempts to team up with rivals - namely Toysmart.com and Brainplay.com - in April Nakasone hit paydirt: a deal with Benchmark Capital to help fund and build its new online business operation. In announcing the deal, Nakasone called it a major step in the company's strategy "to be the clear leader in the online retail market for toys and children's products by fourth quarter 1999."

But what was heralded in early spring as a precedent-setting arrangement - matching retailing's old guard with the e-commerce-savvy venture community - unraveled last week. In the postmortem, both sides are pointing fingers. People close to Toys allege Benchmark wanted too large a stake in the Toysrus.com business. Those on the VC side maintain Toys management was naive to think it wouldn't have to relinquish part of the business in exchange for Benchmark money and connections.

The partnership fell apart because the two sides couldn't agree on who would own the Internet venture, confirms Benchmark general partner Robert Kagle. "We imagined that it would be an independent company that could be capitalized independently," he says. "At some level, that was inconsistent with Toys "R" Us shareholders' interests."

The breakdown of the relationship is a costly one for both parties involved. Benchmark, which has enjoyed a string of successful e-commerce ventures from eBay (EBAY) to Ariba, is now saddled with a high-profile failure. When the two companies announced the partnership in April, Benchmark hailed it as the first in a new type of alliance that would enable traditional corporations to tap into the magic of Silicon Valley's entrepreneurialism. But Kagle now says that for such partnerships to work, companies need to be willing to relinquish some control and give venture capitalists a shot at "unlimited potential returns." He adds that Benchmark is evaluating several such ventures.

"What we can't afford as VCs is be a consultant to large corporations," Kagle notes. "If you look at returns in the venture business, you'll see that results of VCs really rely on the balls that not only go out of the park, but also roll down the street for a while."

The perception of failure may not linger long for Benchmark. However, the same can't be said for Toys. The company's stumbles may have already cost it another e-Christmas.

Toys' problems are as systemic as they are cultural. What may have brought on the demise of the Benchmark partnership - and potentially its 1999 holiday season - is a clash between the freewheeling Silicon Valley spirit and the controlling bureaucracy of corporate America.

"The key lesson, as we see a lot of companies forging partnerships together, is the cultural fit," says Lauren Cooks Levitan, an analyst with BancBoston Robertson Stephens. "At the end of the day, it is really critical to have a sense of whether they can work together. Toys "R" Us is not the most nimble of companies."

The first sign that the deal wasn't working out came just before Independence Day, when Robert Moog, Toys' first choice to head up its online operation, backed out. Moog, who introduced Nakasone and Toys Chairman Michael Goldstein to Benchmark in April, says he left because he didn't think Toys was committed to pouring more than money into the division. He says it became clear that Toys had no intention of competing directly with its retail stores. "That was the naive part," he adds.

"Toys "R" Us really wants to be successful, but sometimes it's just too difficult to change the way you do things," Moog says, noting that the company wasn't willing to match the discounts offered by online retailers for fear of upsetting store managers.

Toys' problems began years ago. Amid declining market share in the mid-1990s, management pledged to revamp its operations. It went on a campaign to renovate its stores across the country, widening aisles and training store clerks to be more attentive and helpful. It threw hundreds of millions of dollars at the problem - yet still lost share to Wal-Mart. "People hate shopping at [Toys "R" Us] stores," says Levitan, who adds that eToys in particular has successfully exploited the shortcomings of its offline rival as a marketing tool.

In Toys' renewed Internet effort, results have come slowly while costs have piled up. The company said last week that it will spend $80 million online this year (including up to $36 million in the current quarter) to spruce up its Web site.

KBkids.com, eToys and, to a somewhat lesser extent, Amazon stand to benefit from the failure of the Benchmark and Toys "R" Us partnership. Executives at eToys, though, downplay the impact that the Toys "R" Us online debacle will have on their business. "We would not change a thing we are doing because there are other competitors out there," says Steve Scoch, eToys' CFO.

Aside from cash, Benchmark was supposed to help Toys recruit a management team with e-commerce expertise, develop a strategy for shipping orders from a central location and set up shop in Northern California. For its part, Toys bought a new $30 million warehouse in Memphis and formed a separate e-commerce business division.

As of today, Toys has only the Memphis warehouse to show for its efforts. The incoming Toysrus.com CEO, John Barbour, takes the reins August 30. He's been working weekends to catch up, but he still has to attend to tasks like recruiting a management team and finding office space; it's undecided whether they'll run operations from New Jersey or California. "It's his call," says Susan McLaughlin, a spokeswoman for the company.

At this point, nobody seems to be taking Toys' bold prediction of future online supremacy very seriously.

"We've had our management team in place for six months now," says Srikant Srinivasan, founder of Brainplay and now CEO of KBkids.com, the joint Web venture between Brainplay and the 1,400-store KB Toys chain. "We've been working seven days a week since then. I find it very hard to believe that someone can wave a magic wand and make everything appear in October."

Thanks to the association with its parent, Toysrus.com management will be able to secure this year's expected top-selling products, like the Sega Dreamcast videogame system. But Barbour is inheriting a Web operation that last year was dogged with problems. While the company has been selling online since last summer, frequent site outages at the height of the shopping season, poor selection, minimal marketing and an inadequate order-fulfillment system made it a weak competitor to eToys and Brainplay last holiday season.

Toys may have the selection this year, but it could very well be outdone in an equally crucial category: marketing. EToys nabbed an $18 million, three-year marketing deal with America Online (dossier), and KBkids.com has already begun plugging its site in stores. "KB spends $60 million a year in advertising, and we're going to get tagged on that," says Srinivasan. "We'll have our own campaign, which will be many tens of millions, as well."

When asked whether Toys was sticking by its plan to lead the online toy market by the end of the year, Toys "R" Us' McLaughlin sounded a more humble note: "Whew. I'm glad I didn't say that. But no, we're not backing off. We're going to be putting everything behind Toysrus.com to bring it up to the level it needs to be."

Toy Wars

The 1998 holiday season was a milestone for commerce online and offline. After decades of dominance, Toys "R" Us had a dreadful Christmas, recording a 7 percent drop in sales for stores open more than a year. Worse yet, Wal-Mart nudged out Toys to become the biggest toy retailer in the world. According to market researcher NPD Group, Wal-Mart accounted for 17.4 percent of the $21 billion industry; Toys had a 16.8 percent share.

But neither company has made much noise on the Internet. Both promise big changes this fall. Observers are dubious.

Wal-Mart wants to doll up its general-merchandiser model for the Web. It's a tried-and-true business plan offline that's unproven on the Internet. Wal-Mart wants to relaunch its site this fall with 25 product categories. (Most analysts peg October as the expected date.) The retail giant intends to start selling only the most popular products per category. And even though the company refuses to say what types of products it will carry, analysts agree toys are a certainty.

For instance, Wal-Mart's virtual toy aisles are expected to stock what will likely be the top 10 percent to 15 percent of toys sold this year. So while Wal-Mart Online may be the place for this year's Furby, it's probably not a good bet for finding a rare Mr. Potato Head.

Selection has never been Wal-Mart's strong suit, anyway; it's usually led on price. But in a field of discount merchants, can the retailer be a force? Jim Preissler, an analyst for Paine Webber, doesn't think Wal-Mart is going to ruin anyone's Christmas. Conversely, he doesn't believe eToys is going to steal Christmas from Toys "R" Us or Wal-Mart, either. "At this point, no one has the advantage," he says.

- B.W.

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How Culture Clash Sank the Toys 'R' Us Deal