The Rise and Fall of eToys

L O S   A N G E L E S, March 5, 2001 -- As the calendar flipped over into the year2000, the future looked promising for fledgling Internet retailereToys.

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

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

"We believe our largest quarterly loss is behind us," founderand 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 — somuch bigger, in fact, that they eventually drove eToys out ofbusiness.

The company said last week it will file for bankruptcyprotection 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 remainingemployees will leave their Los Angeles headquarters for the lasttime.

Analysts say eToys' swift demise was the result both of thecompany's ambitious plans and a sour investing climate that beganlast 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 onlineresource for people to buy toys," said T.K. MacKay, a stockanalyst with Morningstar Inc.

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

Healthy Respect for Bricks and Mortar

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

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

Lenk declined to be interviewed by The Associated Press. Callsto three eToys board members who resigned last week were notimmediately returned.

Lenk left his job as a corporate vice president in the strategicplanning group at the Walt Disney Co. to found eToys. Earlyinvestors 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 StockMarket nearly quadrupled to about $76.50 a share.

During its first holiday shopping season after going public, thesite was swamped with orders, as were other online toy sites. EToyssold more than any of its competitors, but the publicity over lateshipments dogged the company. Analysts say it also made customerswary of holiday Web shopping during the 2000 holiday season.

After the 1999 experience, eToys embarked on an ambitious andexpensive plan to increase its capacity and expand its productofferings.

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

"They ramped up spending pretty aggressively," Williams said."They could have run the business much more modestly. But whenthey made those decisions, it was a much different market than whatit 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 companieswas replaced by impatient demands for profits. Funding forInternet companies dried up. Once-soaring stocks plummeted anddot-coms began announcing lower revenue and wider losses.

In the notoriously low-margin toy industry, competitors such asToysmart.com, Toytime.com and Redrocket.com closed their doors. Theshakeout left eToys and Toys R Us as the two largest competitorsonline.

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

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

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

Small Marketplace Pursued on Grand Scale?

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

In January, the company laid off more than half its staff. InFebruary, it sent layoff notices to its remaining workers andreiterated it had only enough cash to stay open until the end ofMarch. 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 pursueon the grand scale they did," Williams said. "Their managementteam was as good as it gets. The business model was just tooaggressive and was going to take longer than they had."

In early December, just days before breaking the bad news, Lenksounded optimistic in an interview published in The Wall StreetJournal.

"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 twoor three years earlier. Then I'd be profitable by now, I believe."

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