Toys Were Us The bad news keeps on coming at the nation's biggest--oops, second-biggest--toy retailer. Fixing it won't be child's play.
By Katrina Brooker Reporter Associate Patty de Llosa

(FORTUNE Magazine) – On Thursday, Aug. 26, Toys "R" Us CEO Robert Nakasone was convinced that his ailing company was on the verge of a turnaround, and he was eager to prove it.

That morning Nakasone had arranged a grand tour for me of the new Toys "R" Us showcase store in Alpharetta, Ga. My tour guide--Gregg Treadway, the vice president of new stores--put on a good show. Marching me down aisles of Barbies and Pokemon, he pointed to the carpeted floors, the skylights, the TV monitors playing videos of The Lion King and The Little Mermaid. He talked enthusiastically about stepped-up customer service (employees now get Geoffrey the Giraffe stickers for being nice to "guests"). In the 18 months since Nakasone had taken over Toys "R" Us, Treadway told me, "a new spirit has been breathed into the company. I can't explain it, it's just something we all feel. Something is really happening here."

Four hours later, Nakasone was out of a job.

At Toys "R" Us this was a shock. "I'm sorry--I did not know," a tearful PR director said over the phone that afternoon, assuring me she wouldn't have sent me down to Alpharetta if she'd known this was coming. Treadway, stunned, called me from the airport in Atlanta. He'd heard the news from a CNN TV monitor at the gate. "You could've knocked me over with a feather," he said, sounding shaken. "I honestly don't know what's going on." No one else seemed to either. "This is very confusing," said Francesca Brockett, senior vice president of new business development. A week earlier she'd told me about a six-point strategic plan she and Nakasone had come up with to kick off the millennium.

The only official explanation of his sudden resignation came from Michael Goldstein, chairman of the board and now acting CEO. He said Nakasone had resigned because of differences with the board "regarding the direction of the company." In a phone interview I asked Goldstein to elaborate on these differences. "They were minor," he said. The CEO of an $11 billion company resigned over minor differences? Come on. Goldstein didn't budge. "This was his decision," he insisted, adding: "It was amicable." And that's all the explanation he gave me, the rest of the press, shareholders, analysts, and his own executives.

But Nakasone's abrupt exit was not his decision, nor was it amicable. And his clash with the board was not about differences concerning the direction of the company. It was about who's to blame for running the company into the ground, him or them. Nakasone is out, but the question remains: Who was the problem?

It's no secret that Toys "R" Us is in trouble. The company has endured flat sales and seven consecutive quarters of lousy earnings--last quarter, net income dropped 25%. Over the past five years the stock has sunk 65%. And over the past ten years the company's market share has slipped from 25% to 17%. Last year Wal-Mart overtook it as the No. 1 toy retailer in the country.

And there's no question that Toys "R" Us is due for a big overhaul. It has needed one for years now. The only mystery is why the company hasn't gotten on with it. "It's hard when you've got a founder--a genius who built the company--to try to tell him that things have to change," says RoAnn Costin, a Toys "R" Us director. "It's hard to bring it up with Charles."

Charles is Charles Lazarus, the Toys "R" Us chairman emeritus. He's the genius who built Toys "R" Us up from nothing, who throughout the '80s ruled the toy world. When he created the Toys "R" Us format--a warehouse packed with every kind of Barbie and Hot Wheels imaginable--there was nothing else like it. "It was revolutionary," says Neil Stern, a retail consultant. In its heyday Toys "R" Us grew at the rate of 30% a year. By the end of the '80s it had driven its two biggest competitors, Child World and Lionel, into bankruptcy. After that it had the toy market pretty much locked up.

But then the world changed. Child World may be gone, but now Toys "R" Us has much tougher competitors: Wal-Mart and the Internet. Wal-Mart sells Pokemon, Furby, Barbie, and Hot Wheels--most of the toys that Toys "R" Us has--at cheaper prices. A harried mom wandering the aisles at the Alpharetta Toys "R" Us told me, "I don't usually come here. I'll just pick something up when I'm at Wal-Mart." And whatever you can't find at Wal-Mart, chances are you can now find it on eToys or Amazon.com.

Faced with this, Toys "R" Us still clings to its old format. "Have you taken a look at the stores lately? They're stuck in the '70s," scoffs Bruce Krysiak, the former COO of Toys "R" Us. Customers once raved about Toys "R" Us' no-frills maze of a thousand Barbies. Now they call it "trashy," "dirty," and "a scary experience." As for the service: "It stinks."

The trouble is that Toys "R" Us can't get past its glory days. There is no doubt that Lazarus, now 72, was a genius of his time. Today he is officially retired, but he still attends some board meetings and wields great influence with the directors. Getting even the smallest changes past him is a struggle. Last year he tried to block the company from selling a new line of educational toys (the fastest-growing segment of the toy market). "He said, 'That's not our customer,'" board member Costin recalls. When he finally relented, she says, "he was shocked" that the toys went on to become a big hit.

The Toys "R" Us board is made up mostly of Lazarus' old friends and former employees. "They're real insiders," says Krysiak, who as COO sat on the board. "If I were CEO, I'd want to reconstitute that board."

When Lazarus retired in 1994, he picked Mike Goldstein as his successor. No one was surprised. Goldstein "does whatever Charles tells him," says one Toys "R" Us executive. "Mike is Charles." But Goldstein fumbled badly as CEO. During his tenure, Toys "R" Us' market share dropped from 20% to 18%. Its stock price sank 25%. He resigned as CEO in 1998 and became chairman.

On Feb. 25, 1998, Nakasone was named CEO. That same day, Toys "R" Us announced it would miss earnings targets for fiscal 1997. And that was just the beginning.

Last Christmas was a complete disaster. In an effort to streamline the back office, Nakasone cut the company's inventory by $500 million. It was the right idea, but badly executed. Suppliers stuck with the excess product were furious (Mattel blamed Toys "R" Us for a $350 million hit to sales). Worse, Toys "R" Us stores were left short on merchandise right in the middle of the holiday crush. At the same time, the company's new e-commerce site, toysrus.com, crashed in late November and stayed down intermittently for the next four weeks--an almost inconceivable blunder that caused the company to miss out on the first e-Christmas. When it was all over, the company had incurred net losses of $132 million for 1998. This year things didn't get much better. In July newly hired e-commerce chief Robert Moog left after just eight weeks on the job. And in August the company's partnership with the Internet venture capital firm Benchmark Capital blew up in a dispute over control of toysrus.com.

Despite his troubles, Nakasone managed to make some headway at Toys "R" Us. He committed more than $100 million to overhaul Toys "R" Us stores. The new stores, like the one I visited in Alpharetta, feature a new Under a Dollar section, a Learning Center, and video stations customers can play games on. This fall the company will launch 170 of these redesigned stores. To address Toys "R" Us customer-service problems, Nakasone hired Disney's Magic Institute to give the entire company--executives, store managers, sales associates--seminars on how to treat "guests." In August he acquired Imaginarium, a niche retailer of educational toys, to give Toys "R" Us access to a higher-end market. Online, Nakasone spent $30 million to get toysrus.com ready for the 1999 holiday season. This summer Nakasone took a big stand on behalf of the online store when he backed it in a dispute with Toys "R" Us' real-world stores over the issue of Internet discounts.

When Nakasone was forced out, it was still too early to tell whether any of his plans would pay off. But a week before he left the company his managers clearly believed he'd gotten a momentum going. "He's encouraging us to take risks, to throw out new ideas," gushed Mike Shannon, Toys operating chief, eight days before the CEO's departure. "He is an outstanding leader." The day after Nakasone's exit, Goldstein said he agreed with "all the major initiatives" Nakasone had made. In fact, Goldstein now says he plans to stick with Nakasone's overall strategy for the company. "That makes no sense," fumed one Toys "R" Us manager when she heard the comment. "Then why fire the guy?"

Nakasone started out as a Lazarus protege. Like Goldstein, he was an insider--a 14-year Toys "R" Us veteran. In fact, when Lazarus retired, he almost named Nakasone successor. But almost immediately after Nakasone took over the reins of Toys "R" Us, his relationship with Lazarus and the rest of the board began to sour.

High-level executives at Toys "R" Us say Nakasone was convinced that the root of the company's troubles was in its boardroom. He demanded that Goldstein and Lazarus replace certain members of the board, insiders say. He even tried to get Goldstein to hire a search firm to look for new directors. When one old-timer, Howard Moore--the company's former merchandising chief and an old pal of Lazarus'--came up for reelection, Nakasone tried to get him kicked off the board, without success. "I think he really pissed Charles off," says one top executive.

By this summer all the infighting had taken a toll. In what many saw as a sign of disapproval, Lazarus did not show up for a June analysts' meeting in Alpharetta, where Nakasone launched his new store concept. "That was a big deal for him; and for Charles not to come, it was a slap in the face," says a Toys "R" Us manager who attended.

Now, with hindsight, Toys executives say they should have known what was coming.

Somebody had to take the fall for the Toys "R" Us mess. But was Nakasone the right target? "We'll have to see how Christmas goes," says Graham Tanaka, an investment manager and a Toys "R" Us shareholder. "If Christmas goes well, then the board is going to have a lot of explaining to do" because that will mean Nakasone's strategy is working.

In the meantime Goldstein is busy searching for a new CEO. Easier said than done. Says one retail consultant: "Who's going to take that job? With that board, that kind of job security, who would want it?" But Goldstein insists "a lot of people are interested in the job" and that he'll have a new hire by Christmas. Either way, the future Toys "R" Us CEO is in for a rough ride.

REPORTER ASSOCIATE Patty de Llosa