The Rise and Fall of eToys

As the calendar flipped over into the year 2000, the future looked promising for fledgling Internet retailer eToys.

Sure, the company got a load of bad publicity when it failed to deliver some Christmas toys on time, and its stock had fallen 70 percent from its peak of $84 a share three months earlier.

But it had quintupled its customer base to 2 million, and had sold more toys than rival Toys R Us during the all-important holiday season. And its recently opened British site was successful beyond all expectations.

"We believe our largest quarterly loss is behind us," founder and chief executive Toby Lenk wrote to shareholders last March.

Stock Price Measured in Pennies

Lenk turned out to be an optimist. The losses got bigger — so much bigger, in fact, that they eventually drove eToys out of business.

The company said last week it will file for bankruptcy protection within days. Its Web site is scheduled for an imminent shutdown, and its stock price is measured in pennies. Its cash will run out at the end of the month, and shortly after that the remaining employees will leave their Los Angeles headquarters for the last time.

Analysts say eToys' swift demise was the result both of the company's ambitious plans and a sour investing climate that began last spring and has since buried dozens of dot-com companies.

"What they did right was create a wonderful brand name, increase sales at a phenomenal rate and become the premier online resource for people to buy toys," said T.K. MacKay, a stock analyst with Morningstar Inc.

"What they did wrong was to operate a business without the financial capacity to weather a downturn in the retail market. Everyone expected sales to continue to be robust last Christmas and they weren't. Their balance sheet couldn't handle a hiccup like that."

Healthy Respect for Bricks and Mortar

When he founded eToys in 1997, Lenk rejected the notion that an online toy store couldn't compete with traditional outlets. That may yet be true, but for now it seems the physical presence of Toys R Us, Wal-Mart and others are too hard to overcome.

"You need to have a healthy respect for the presence that bricks and mortar have in this business," said Melissa Williams, an analyst at Gerard Klauer Mattison. "Wal-Mart and Toys R Us dominate toy retailing and continue to dominate toy retailing online. It's not just as simple as building something online and they will come."

Lenk declined to be interviewed by The Associated Press. Calls to three eToys board members who resigned last week were not immediately returned.

Lenk left his job as a corporate vice president in the strategic planning group at the Walt Disney Co. to found eToys. Early investors included Intel Corp. and Sequoia Capital.

Dogged by Publicity Over Late Shipments

The company raised $166 million when it went public in May 1999. On the first day of trading, its stock price on the Nasdaq Stock Market nearly quadrupled to about $76.50 a share.

During its first holiday shopping season after going public, the site was swamped with orders, as were other online toy sites. EToys sold more than any of its competitors, but the publicity over late shipments dogged the company. Analysts say it also made customers wary of holiday Web shopping during the 2000 holiday season.

After the 1999 experience, eToys embarked on an ambitious and expensive plan to increase its capacity and expand its product offerings.

It spent $150 million to build two distribution centers — one in California and the other in Virginia. Together the facilities covered 2 million square feet. To smooth out the seasonal nature of the toy business, the company would soon introduce a Summer Store, selling such items as swimming pools, camping gear and hopscotch chalk.

"They ramped up spending pretty aggressively," Williams said. "They could have run the business much more modestly. But when they made those decisions, it was a much different market than what it ended up being."

Wall Street's Romance With Tech Companies

The change was marked by the dark days of March and April 2000, when Wall Street's no-questions-asked romance with tech companies was replaced by impatient demands for profits. Funding for Internet companies dried up. Once-soaring stocks plummeted and dot-coms began announcing lower revenue and wider losses.

In the notoriously low-margin toy industry, competitors such as Toysmart.com, Toytime.com and Redrocket.com closed their doors. The shakeout left eToys and Toys R Us as the two largest competitors online.

Toys R Us made a smart move in late summer by partnering with Amazon.com — Amazon would host the toyseller's Web operations and Toys R Us would provide the toys. The move allowed both companies to weather what few anticipated — a slowing economy and weak holiday sales.

EToys had told investors to expect sales of up to $240 million in the quarter ended Dec. 31, 2000, and an operating loss up to $67 million. With that performance, all that was needed was one more round of financing in 2001 before turning its first profit by 2002.

But the Christmastime sales never came. Wary shoppers passed up virtual stores and instead visited Wal-Mart, Toys R Us, Target and other physical stores.

Small Marketplace Pursued on Grand Scale?

In mid-December, the company dropped its bombshell — sales would be about half of what was expected. The operating loss turned out to be nearly $86 million, more than half of its overall revenue in the pivotal quarter.

In January, the company laid off more than half its staff. In February, it sent layoff notices to its remaining workers and reiterated it had only enough cash to stay open until the end of March. Trading in eToys stock was halted Feb. 26 at 9 cents a share.

"In the end, it may just have been too small a market to pursue on the grand scale they did," Williams said. "Their management team was as good as it gets. The business model was just too aggressive and was going to take longer than they had."

In early December, just days before breaking the bad news, Lenk sounded optimistic in an interview published in The Wall Street Journal.

"We're just a little bit short of the finish line," he said. "The only thing that doesn't work is that I didn't start this two or three years earlier. Then I'd be profitable by now, I believe."