November 26 2007: 11:19 AM EST
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Toys 'R' Us stages a comeback

Despite weaker economic conditions, stronger competition, and looming recall fears, the toy retailer seems to be turning around.

By Suzanne Kapner, Fortune writer

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CEO Storch's big bet on pink seems to be paying off.

NEW YORK (Fortune) -- Back in January, when planning got underway for the current holiday shopping season, Toys "R" Us executives huddled in a war room in the company's Wayne, N.J. headquarters and grappled with an important question.

"We knew pink was going to be big," said Gerald Storch, the company's chief executive. "But the question was, how big should we bet on it?

Though such questions may seem trivial, they can mean the difference between profits and losses for retailers who live and die by trends. That is especially true for "Toys "R" Us, which gets nearly half its sales and all of its profits from the all-important fourth quarter, and has struggled to stay afloat for the last few years.

Bet too big on a single idea and wind up swimming in excess merchandise. Don't bet big enough, and risk missing out on sales.

For Toys "R" Us, the pink gamble appears to be paying off. Items like a pink version of Hasbro's popular Monopoly board game, designed exclusively for Toys "R" Us, turned out to be a big draw with Black Friday shoppers and helped the company differentiate itself from discount store rivals.

Though Toys "R" Us will not release fourth quarter sales until after the close of its fiscal year in February, early signs indicate that the company, which only two years ago was struggling to survive, is off to a strong start this holiday season.

"We met our sales goals for the weekend," said Ronald Boire, the president of Toys "R" Us North America.

The fact that Toys "R" Us executives were even discussing what trends might be hot this Christmas shows how much the company has changed since Storch, a former Target executive, took the helm in 2006, following a $6.6 billion leveraged buyout by investors KKR Group, Bain Capital and Vornado Realty Trust. Gone are the days when Toys "R" Us was outgunned by Wal-Mart (Charts, Fortune 500) on prices and turned off customers with stores that were dirty, crowded and out of stock.

After slipping for more than five years, sales at stores open at least a year stabilized in 2006 and grew 3.1 percent so far this year through August. Cash flow and margins are expanding, and Toys "R" Us is now on more solid ground as it tries to head off competition from rivals, as well as a slew of safety issues that have surfaced this year in the wake of toy recalls.

The improvements come despite a sluggish economic environment, and a particularly tough season for toy sales. Analysts expect the $22 billion toy industry to contract slightly this year, perhaps by 1 percent, as consumers rein in spending and think twice before snapping up toys that may be coated in lead paint or some other harmful substance. With $13 billion in annual sales, Toys "R" Us remains the second largest toy retailer in the country behind Wal-Mart.

In a further sign of belt-tightening, the National Retail Federation said yesterday that although more consumers were out shopping on Black Friday, they spent an average of 3.5 percent less per transaction.

Rather than panicking and rushing to slash prices the way Wal-Mart did earlier this year, Toys "R" Us executives said they are sticking with a game plan that relies as much on improved layouts that make stores easier to shop, more and better trained sales clerks and quicker operations that keep shelves freshly stocked with merchandise, as it does on discounts.

That's not to say Toys "R" Us is shying away from competitive pricing. The company offered 101 door busters on Black Friday, four times as many as it did the year before, and stepped up its advertising to ensure the message was not lost on shoppers. "Our marketing was more aggressive this year," Boire said.

Analysts and company executives said they do not yet see the makings of a price war similar to the one that ravaged the toy industry in 2003, when FAO Schwarz and KB Toys both filed for bankruptcy protection.

"The spread between prices at Wal-Mart and Toys 'R' Us is about the same as it was last year," said Sean McGowan, who tracks prices in weekly surveys. "I'm not seeing a lot of cutthroat pricing yet."

To ensure Toys 'R' Us not only stays competitive, but also keeps on top of new ideas, Storch hired fellow Target alumni Robert Giampietro, who was named senior vice president of trends and innovation in May.

Even before Giampietro was on board, Storch and his team were pinpointing trends for the upcoming holiday season. Storch noticed that pink items had started to pick up steam. Pink baseball caps and jerseys had become big sellers for major league baseball teams, for instance. A pink notebook computer from Vtech and a pink digital camera from Fisher-Price were both popular with Toys "R" Us shoppers last Christmas.

This year, Storch wanted to make an even bigger statement with pink. He turned to toy manufacturers like Hasbro (Charts) and Fischer-Price, which is owned by Mattel (Charts, Fortune 500), and asked them to develop special products that would only be available at Toys "R" Us, including a pink version of Monopoly and a pink Twister set.

"The way Toys 'R' Us went about this was very similar to what Target (Charts, Fortune 500) does," McGowan, the analyst, said. "They didn't just say to Hasbro, 'Show me what you've got.' Instead, they worked together to come up with ideas that would make these products stand out."

There are other signs of innovation at Toys "R" Us. The company has branched beyond toys and now sells pet supplies, GPS systems and musical instruments in its stores. It's also opening toy stores adjacent to its popular Babies "R" Us chain, a strategy that it says boosts sales at both concepts significantly.

"The idea is that we can sell anything related to the child or the family," Storch said.

After several years of shrinking its store base by closing or selling stores, Toys "R" Us, opened four superstores this year, the first time it has grown since 2004. Dozens of new stores are planned for 2008, though Storch would not reveal an exact number. The company operates 586 U.S. toy stores, 678 toy stores abroad and 251 Babies "R" Us locations.

Toys "R" Us still faces numerous challenges, including a disproportionate dependence on the fourth quarter for sales and profits, a common problem among toy retailers.

Another potential drag is the company's heavy debt load, the result of its leveraged buyout, although the majority of that debt does not begin to come due for another three years.

All in all, though, analysts give the company high marks for its strategy. "Toys "R" Us is in a very good position heading into this holiday season," said Tiffany Co, an analyst with Fitch Ratings - a sign that even in the cutthroat world of toy retailing, there are still some happy endings. To top of page

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