(FORTUNE Magazine) – Is the toy store doomed? With FAO heading back to bankruptcy and Toys "R" Us reeling from its $38 million third-quarter loss and the announcement of more store closures, many are starting to wonder whether we'll all be buying our toys at discounters soon. We caught up with John Eyler (who ran FAO Schwarz from 1992 to 2000 and has been CEO of Toys "R" Us for the past three years) to talk about Wal-Mart, price wars, and the new Elmo. --Julie Schlosser

Q: Is the toy store dying?

A: Absolutely not. We've gone from losing market share seven years in a row to gaining share the past three. People say, You can't possibly make money competing with Wal-Mart. Well, we made $229 million last year in the toy business. So I guess you can.

Q: After you reported your third-quarter results, CNBC's Kudlow & Cramer eulogized your mascot, Geoffrey, on national TV. What's your response?

A: You can't question why we don't close an increasingly unprofitable business like Kids "R" Us, and then when you close it, have people say, Gee, that's a signal that the company is not doing well. It is all about making sure you have clean, desirable stores and have quality service to help people make the right selection. We are disappointed that it isn't coming easier, but we certainly are not discouraged, because we see significant progress.

Q: How closely do you watch Wal-Mart?

A: We watch it every day.

Q: And what's your strategy for competing with Bentonville?

A: We sell 9,000 different toys. There are about 200 toys that are highly recognizable, and those are where Wal-Mart has extraordinarily aggressive pricing. Four years ago only 5% of what we sold was exclusive. Today almost 20% of what we sell is exclusive, whether it is an exclusive G.I. Joe or our own Animal Alley plush animals. On exclusive products we make between 15% and 20% higher margins, then we take those dollars and reinvest them to lower our prices on the most competitive products.

Q: Your former employer FAO is filing for bankruptcy again. Is the company salvageable?

A: FAO has high quality and fabulous service and is a growable brand. But when you tie it together with Zany Brainy and the Right Start, it can't possibly earn enough money for that whole portfolio to be successful. So the answer is, Can it be successful? Yes. Can it be successful in its current corporate structure? I don't believe so.

Q: Talk about why you're opening Toy Box stores in Albertson's grocery stores.

A: When someone needs a $10 birthday gift, they aren't going to drive ten miles to a Toys "R" Us. But if they are in a Wal-Mart, a Target, or a grocery store, they will just pick it up, because it is so easy.

Q: Analysts are predicting a cutthroat holiday season. Are you worried?

A: The bad news is that there is no tangible sign that the economy at the consumer level is going to be any better. Until we see some firming up of the job category and consumer confidence, you are not going to see surging consumer spending. The good news is that as a company we are far better prepared than we were a year ago.

Q: Finally, what's the hot toy this Christmas? And how is Geoffrey holding up?

A: The most visible toy is Hokey Pokey Elmo. And aside from the premature announcement of Geoffrey's death, he is holding up pretty well.